1 2 3 4 5 6 University 7 =

Please Support This Work by Writing an Amazon Review 1 2 3 University 4 5 6 =Warren Buffett 22 23 & Charlie Munger 24 25 at the 26 27 ANNUAL SHAREHOLDERS MEETING 28 29 30 31 32 33 Daniel Pecaut 34 35 with 36 37 Corey Wrenn 38 39 40 41

Please Support This Work by Writing an Amazon Review 21 Copyright © 2018 by Daniel Pecaut & Corey Wrenn 22 23 All rights reserved. This book or any portion thereof may not be reproduced or used 24 in any manner whatsoever without the express written permission of the publisher 25 except for the use of brief quotations in a book review or scholarly journal. 26 First Printing: 2017 27 28 ISBN: 978-0-9984062-6-8 29 10 Design by Mauna Eichner and Lee Fukui 11 Cover Illustration by Allison Baer 12 13 Pecaut and Company 14 401 Douglas Street, Suite 415 15 Sioux City, IA 51101 16 17 www.PecautandCompany.com 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 1 2 3 4 5 6 7 This book is dedicated to my hero, Russell B. Pecaut (1902–2000, Dow 8 Jones Industrial Average: 67–11,551). Papa, as we grandkids called him, 9 was a good-natured, honest, and unfailingly upbeat gentleman. He 10 encouraged me greatly in my career. He taught me that optimism is 11 a choice and that your word is your bond. This world could use a few 12 more like Russell Pecaut. Papa, this one’s for you. 13 14 —Daniel Pecaut 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 CONTENTS 1 2 A 3 4 5 6 7 8 THE ELECTRONIC RECORD 9 ix 10 INTRODUCTION 11 xi 12 13 14 1986 01 2002 101 15 1987 05 2003 111 16 17 09 121 1988 2004 18 1989 15 2005 131 19 1990 19 2006 143 20 21 23 153 1991 2007 22 1992 29 2008 167 23 1993 35 2009 183 24 25 41 201 1994 2010 26 1995 47 2011 217 27 1996 53 2012 233 28 29 61 247 1997 2013 30 1998 69 2014 265 31 1999 77 2015 275 32 33 85 285 2000 2016 34 2001 91 2017 303 35 36 37 APPENDIX I: 38 IN THE BEGINNING . . . 39 THERE WAS CAPITAL ALLOCATION 40 319 41 21 APPENDIX II: 22 THE SPECTACULAR 23 GROWTH IN POPULARITY 24 325 25 APPENDIX III: 26 LESSONS FROM THE 27 BERKSHIRE MALL 28 327 29 10 APPENDIX IV: 11 CASH/BOND/STOCK RATIOS 12 329 13 APPENDIX V: 14 ON CURATING THIS BOOK 15 331 16 17 ACKNOWLEDGMENTS 18 333 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 THE 1 2 ELECTRONIC RECORD 3 4 A 5 6 7 8 9 Asked why he is on TV so much, Buffett responded that he likes 10 having the electronic record, so there is no chance of him being 11 misquoted or misunderstood. If he’s on Charlie Rose, he knows the 12 record will be permanent and will be exactly what he said. 13 —Excerpt from our notes at 14 the 2010 Shareholders Meeting 15 16 What follows in this book is not an electronic record. This is the result 17 of feverish note-taking during 32 years of Berkshire Hathaway’s annual 18 shareholders meetings. While we, the authors, believe these notes capture 19 the essential meaning and intention conveyed, we apologize in advance 20 for any misrepresentations. 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

ix INTRODUCTION 1 2 A 3 4 5 6 7 8 My dad was also my hero, just like the case with you. Dick clearly 9 was a terrific guy and a sound thinker. You were lucky to have him 10 as a father, teacher, and inspiration. 11 —Warren E. Buffett 12 (written on the back of a Pecaut & Company newsletter) 13 14 15 16 17 After my dad, Dick Pecaut, passed away in 2009, I wrote a loving tribute 18 to him in my investment firm’s monthly newsletter. Days later, I received 19 one of the newsletters back. Handwritten, on the back of that newsletter, 20 was a note from the Oracle of Omaha, Warren Buffett. The man whose 21 mindset, strategies, and investing insights my business partner, Corey, 22 and I have studied for three decades. The man whose wisdom we are 23 honored to share with you in the coming pages. 24 Buffett’s short note served as a heartwarming footnote to my father’s 25 life work as an investment advisor. It also served as validation of both the 26 newsletters that make up this book and our work as investment advisors. 27 We have been longtime Berkshire Hathaway commentators. Our 28 analyses of its chairman, Warren Buffett, and vice chairman, Charlie 29 Munger, have been featured in the New York Times, Money Magazine, 30 Schiff’s Insurance Observer, and a host of other leading investment publi- 31 cations. One of our newsletters was referenced in James O’Loughlin’s 32 * book, The Real Warren Buffett: Managing Capital, Leading People. 33 For years, we sent our newsletter, unsolicited, to Berkshire Hathaway’s 34 headquarters. But until this thoughtful reply, we never knew if anyone 35 † actually opened the envelopes. 36 37 * A Berkshire-approved reading list pick which was for sale at the 2015 meeting. † When Corey and I were in Mexico in early 2016, he met a broker from Omaha who had 38 traded with Berkshire in the early 1980s. Corey told him he worked for an investment firm, 39 Pecaut & Company, in Sioux City, Iowa, which is 90 minutes away from Omaha. The broker said, “Pecaut? Oh yeah, I read your newsletter.” Corey said, “I don’t think we send it to you, 40 do we?” He responded, “No. I get it from someone else.” 41

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21 Corey and I were electrified. Buffett read our newsletter! It was an 22 acknowledgment that our writings and insights on value investing are of 23 interest to the master himself. On a personal level, mourning my father, 24 it was one of the warmest and most affirming notes I have ever received. 25 For that, I am eternally grateful. 26 But it wasn’t always like this. We didn’t always receive personal notes 27 from the world’s greatest investor. 28 29 How Did We Get Here? 10 11 I graduated from Harvard in 1979 with a philosophy degree. While 12 there, I took only one economics course. I found it too theoretical, not 13 anything like the investing I saw happening in my family’s business. 14 My grandfather, father, and uncle had founded Pecaut & Company, 15 a stockbrokerage firm, in 1960. My grandfather, Russell, often marveled 16 that they made money from day one and never looked back. 17 My involvement in the family business began in the late 1970s, when I 18 was working summers in the back office. I did the grunt work, including 19 updating the S&P 500 tear sheets. 20 Back then, the S&P sent its clients color-coded binders that were 21 alphabetized like a set of encyclopedias. Every month, a packet would 22 arrive in the mail with colored sheets that matched the binders. Green 23 sheets were large-company stocks. Yellow sheets were small-company 24 stocks. Blue sheets were for bonds. Someone needed to manually 25 update the binders by replacing old sheets with the new. That was my 26 job. I learned a lot by reading those sheets. 27 After graduating, I entered the firm as a full-time employee. I 28 felt inadequate and clueless. Our small, family-run operation had 29 no formal training program or structure. My dad rarely sat me down 30 to discuss how things were going. I tortured myself with my own self- 31 judgment about how poorly I thought I was doing. I learned by trial and 32 error. 33 One error was option trading. It was quick and exciting. You could 34 theoretically triple your money in a short time. Do that a few times, and 35 you’d have a good year. I spent a year trying to develop a successful 36 option trading strategy. And at the end of the year? I had made about a 37 hundred bucks. Calculating that into the amount of time spent, I had 38 made about 10 cents an hour. 39 Clearly, that wasn’t worth it. Trading in the short-term may work for 40 some people, but it wasn’t for me. I needed a better approach. 41

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Then, in 1982, I read the book The Money Masters by John Train, in 1 which he profiles nine brilliant investors, including John Templeton 2 and Warren Buffett. A light bulb came on when I finished the book. I 3 said, “I’m going back to school. These investors are my professors. My 4 curriculum is everything they say and write.” I was excited. I would study 5 the most brilliant investors in the world like they were my professors at 6 Harvard. I was on fire to learn everything I could about them and to 7 figure out how to invest like them. 8 From that point forward, I saw my role in the firm primarily as a 9 learning organism. My thought was that the more I learned, the better 10 my decision-making would be, and the better I would serve our clients. 11 Over time, my favorite professors would include Sir John Templeton 12 (of the Templeton Growth Fund),* George Michaelis of Source Capi- 13 tal (a top-performing closed-end fund), Jean-Marie Eveillard (who ran 14 what is now the First Eagle Global Fund), Bob Rodriguez (of First Pa- 15 cific Advisors), and Marty Whitman (of Third Avenue Value Investors). 16 These experts would all offer tremendous insight and direction. 17 But of all the brilliant “professors,” none of them has been more 18 instructive than Warren Buffett and Charlie Munger of Berkshire 19 Hathaway. 20 After realizing that Buffett was one of the guys to learn from, I 21 devoured all his annual letters to shareholders from Berkshire. When 22 I met a friend who had Buffett’s letters from his partnership prior to 23 taking over Berkshire, I devoured those, too. I loved reading them. 24 From where I lived, it was only a 90-minute drive to Omaha and 25 Berkshire’s annual meetings. But to attend, you had to be a share- 26 holder. 27 Undaunted, I bought a single share of Berkshire Hathaway for 28 $2,570 that year. That share paved the way for over 30 years of first-class 29 tuition from two of the greatest professors you could ever hope to learn 30 from. 31 32 33 The “University of Berkshire Hathaway” 34 I distinctly remember that first meeting in 1985. It was an electric yet 35 cozy affair at Omaha’s Joslyn Art Museum. 36 37 38 * In 1987, a group of investors and I traveled to John Templeton’s headquarters in the Baha- mas to meet with him. In his mahogany-paneled office, he was as gracious and dignified as 39 I’d imagined. That fabulous meeting remains one of the highlights of my career. 40 41

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21 A local CPA I knew, Corey Wrenn, was taking tickets at the door.* He 22 was a relatively new employee, hired by Berkshire’s audit department 23 in 1983. 24 After graduating college and working two years in public accounting 25 in Sioux City, Iowa, Corey decided that wasn’t what he wanted to do his 26 whole life. While looking for another job, he received a call from a head- 27 hunter in Omaha who told him that Berkshire Hathaway was looking 28 for an internal auditor. Corey asked, “Berkshire what?” The headhunter 29 said, “It’s run by Warren Buffett.” And Corey responded, “Warren 10 who?” He had no idea who or what they were. Nonetheless, he took 11 the job and began working alongside the six or seven other employees 12 in the audit department, auditing Berkshire’s subsidiary companies 13 and preparing schedules used for quarterly financial statements and 14 for Buffett’s use. 15 I had felt a pang of jealousy when I found out he had been hired 16 there. I envied how he would be learning firsthand from Buffett.† 17 But I wasn’t focused on Corey at the time. My eyes were on the stage. 18 Warren Buffett and Charlie Munger sat on the auditorium’s stage in 19 front of an audience of 300 shareholders (which at the time I felt was large). 20 I realized that if I were going to learn, I would have to get up and ask 21 what I was wondering about. I wrote pages and pages of detailed questions 22 with the goal of getting to the microphone. 23 I nervously asked my one question. Their clarity of mind and high 24 intellect was clear from their answer. I thought, Wow. That was a fantastic 25 answer. They took my dumb question and turned it into a masterpiece. 26 I kept thinking, What took me so long to get here? Why haven’t I been here 27 before? 28 At that meeting, I learned that Berkshire owned 80% of Wesco Financial, 29 where Charlie Munger served as the chairman. So I flew out to Pasadena 30 to attend the Wesco meeting. It was a much smaller affair. 31 * Corey was just an observer at the 1984 meeting. With fewer than 50 people in attendance, 32 he wasn’t required to do anything. But the next year, the crowd had grown significantly 33 larger, so all hands were on deck. Corey was put in charge of taking shareholders’ tickets as they flooded into the venue. But Corey was quickly overrun by the waves of people. Irv 34 Blumkin, one of the executives at Nebraska Furniture Mart, saw Corey’s plight and started 35 helping him take tickets. As Corey was looking down frantically taking tickets, one guy tried to go through without 36 a ticket. Corey called out, “Excuse me! You need a ticket.” The man stopped, and Corey 37 looked up at him. It was Warren Buffett. Corey apologized and Buffett continued on. Later on, a woman with an entourage of six or seven people passed through without a ticket. 38 Corey once again called out, “Excuse me, but you need a ticket!” She looked at him and 39 said, “I’m Susie Buffett.” So in one meeting, Corey had stopped both Warren and his wife from getting into their own meeting. Corey was quite embarrassed. 40 † Little did I know that eight years later, Corey would leave Berkshire to become my busi- 41 ness partner.

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The first Wesco meeting I attended had only 15 people, and half 1 worked for the company. Once again, I had prepared questions. After 2 asking three questions, it was clear I would be asking a lot more. 3 I felt nervous. Munger has an imposing presence behind his thick 4 Coke-bottle lenses. He seemed like an old professor who doesn’t tolerate 5 fools. I got up and stammered, “I’m sorry, I’ve got a lot of questions. It 6 looks like I’m asking all the questions. I didn’t mean to take over the 7 meeting.” 8 He was gracious, saying, “That’s what we’re here for. I’ll answer your 9 questions as long as you’ve got them. If people want to leave, they can 10 leave. But I’ll be here.”* 11 I thought, Wow. All right, then. Here we go. I don’t know how long it 12 went, but I was in heaven. There’s no doubt that having that level of 13 expertise delivered directly to me accelerated my learning. 14 The “University of Berkshire Hathaway” is what I nicknamed the ac- 15 cumulated wisdom dispensed by Warren Buffett and Charlie Munger. 16 Each year’s curriculum consists of Berkshire Hathaway’s annual re- 17 ports and the lectures at its annual meetings. That course of study, now 18 accessible in these pages, has taught Corey and me far more about in- 19 vesting than any other source. 20 Pouring over Berkshire’s reports, reading Buffett’s annual letter, 21 and listening to Buffett and Munger at the annual meeting have all 22 been central to our growth as value investors. It is the core curriculum 23 of our business education—one that easily rivals most MBA programs.† 24 It is the cornerstone of our continuing education. 25 It is, without a shadow of doubt, the best investment either of us has 26 ever made. 27 Once a year, you have arguably the greatest investment team of all 28 time on hand to answer your questions. It is a fantastic annual tutorial 29 on the world of business. Buffett admitted in the beginning that he was 30 31 32 * Although I asked many questions to Munger over the years, Corey only ever asked one. His 33 question, alongside Munger’s response, was reprinted in another Berkshire-approved read- ing list pick: Poor Charlie’s Almanack: The Wit and Wisdom of Charles T. Munger. 34 Knowing that Munger had a lake and a cabin where his family went every summer, Corey 35 wrote down and submitted a smart-ass fishing question: “I’ll be hitting the Walleye Opener next Friday night at Eagle Lake, Minnesota. Any recommendations concerning lures or bait?” 36 Munger got a chuckle out of it and responded, “I stopped fishing for walleye; I’ve become a 37 bass fisherman in my old age. But in my lake, they do better with walleye at night.” † Author Timothy Ferriss said, “As several veterans put it to me before the pilgrimage, ‘It’s 38 like an MBA in a weekend.’ I thought this was hyperbole and hero worship, but I would 39 now take it further: I think it’s one weekend that delivers more than most MBAs. Real-world strategies culled from experience? Check. Networking? Big-time check. The only thing the 40 mecca of Buffett seemed to lack was the $100K+ price tag.” 41

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21 terrified of public speaking. (He used to get physically ill at just the 22 thought of it.) 23 Thankfully, over the years, Buffett and Munger have grown ever- 24 more comfortable as educators. Today, they are excellent teachers. 25 Their wisdom and willingness to share make each annual meeting an 26 invaluable installment in a sublime lecture series. 27 28 The Unstoppable Rise of Berkshire Hathaway 29 10 Few on Wall Street would dispute the claim that Warren Buffett and 11 Charlie Munger are the greatest investors of our time. Their genius in 12 identifying and evaluating intangibles sets them apart. 13 As a value investor, your ideal situation is to find a company increasing 14 its intrinsic value. Ideally, the company would be one with a declining 15 stock price, thus creating an even better bargain as time unfolds. No one 16 has employed these principles more effectively than Buffett and Munger. 17 Over the last 50 years, they have consistently sought to own either 18 all or part of good businesses, bought at bargain prices. In addition, to 19 succeed using this approach, one must control one’s emotions. Buffett 20 and Munger are set apart by their mastery at business valuation and 21 relentless rationality in implementing this approach. 22 The results of this have been awe-inspiring. 23 Under Buffett and Munger’s leadership, Berkshire Hathaway has be- 24 come one of the greatest business stories of the 20th and 21st centuries. 25 26 A Short History 27 28 Buffett was educated at the University of Nebraska. Afterward, he enrolled 29 at Columbia Business School. He went there to learn from the father of 30 value investing, Benjamin Graham. Buffett became Graham’s star student. 31 Afterward, Graham took him on at his investment partnership, Graham 32 Newman. 33 Buffett used what he learned from that experience to start his own 34 partnership back in Omaha. He did phenomenally well from the very 35 beginning. A $10,000 investment in his partnership in 1956 grew to 36 $200,000 by 1969. That’s a 25.9% compounded annualized return. 37 Incredibly, the partnership never had a down year, even though the 38 market had six down years during that period. 39 In 1959, Buffett met Charlie Munger, who was also from Omaha, at 40 a dinner party. Each man instantly recognized the intelligence of the 41

xvi INTRODUCTI ON other. Munger had worked in law, but Buffett convinced him that he 1 should be in the investment business if he wanted to make real money.* 2 Munger started his own investment partnership, Wheeler, Munger & 3 Co., in 1962. From then on, he and Buffett worked on a number of 4 investment ideas together, both formally and informally. 5 Berkshire Hathaway was originally a New England textile company. It 6 was a deeply discounted stock, with a book value of $19. Its net working 7 capital was over $11 a share. Buffett bought shares at around $7–$8 per 8 share. Buffett was buying shares at a discount to net cash and near-cash 9 items. 10 The decline of the textile industry was underway. Berkshire Hathaway 11 was consolidating and selling assets. Then, with the cash, it was buying 12 in its stock—which was intelligent because the stock was so cheap. In 13 1963, Berkshire did a massive buy-in of almost a third of its shares. The 14 owners of Berkshire Hathaway saw Buffett’s position and didn’t want 15 him in their little fiefdom. They called Buffett, offering to pay him 16 $11.50 a share. He agreed. He’d make about a 40% profit in a short 17 period. 18 When the letter came for the offer, however, it was less than the 19 agreed-on amount—but only by pennies. Nevertheless, their dishonesty 20 upset Buffett. They were trying to chisel him out of 12.5 cents per share. 21 So Buffett went the other way and started buying increasingly more 22 shares of Berkshire until he took control. He then booted out the guy 23 who had tried to chisel him out. In 1964, Warren Buffett took control 24 of that small New England textile firm, and it became his new base for 25 making investments. 26 At the time, the move made no sense. Buffett had bought a busi- 27 ness in decline that he didn’t know how to run. He later joked that he 28 should have taken the money. That would have been the smarter thing 29 to do. 30 As it turned out, this textile company was an ideal vehicle for making 31 investments. With Berkshire Hathaway’s stock, Buffett had a publicly 32 traded corporation with captive capital. The benefits of this corporate 33 structure for managing money are significant. 34 In his previous partnership, if shareholders redeemed their shares, 35 the money would come right out of the till. Now, when shareholders sell 36 their shares in Berkshire Hathaway, that doesn’t affect its available capital. 37 38 * Munger did want to get rich, “Not because I wanted Ferraris—I wanted the independence. I desperately wanted it. I thought it was undignified to have to send invoices to other people. 39 I don’t know where I got that notion from, but I had it.” 40 41

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21 Capital doesn’t leave the corporate shell unless Buffett pays a dividend. 22 He could use this captive permanent capital to invest long-term by buying 23 businesses, in part or in whole. Berkshire’s structure also allows for making 24 opportunistic investments in special situations. 25 Over time, Buffett phased out the textile portion of the business. He 26 sold off assets to create more cash. With the cash, he began to build his 27 wealth-compounding machine. 28 In 1967, Buffett bought an insurance company, National Indemnity. 29 Insurance has been a core operation at Berkshire Hathaway ever since. 10 He loves the insurance business. With its float characteristics, it creates 11 a powerful platform for compounding wealth. 12 Insurance companies collect premiums, of which a significant portion 13 goes into reserves to pay future claims. This reserve (the “float”) earns 14 money for Berkshire, leveraging the company’s return on capital. If you 15 can operate in a way where that float is generated at a low cost and 16 you can grow it over time, you have built a wealth-compounding machine. 17 As Munger once put it, “Basically, we’re a hedgehog that knows one big 18 thing. If you generate float at 3% per annum and buy businesses that 19 earn 13% per annum with the proceeds of that float, we have figured 20 out that’s a pretty good position to be in.” Few investors understand that 21 float is one of the secrets to Berkshire’s success. 22 For every $1 of equity at Berkshire, over time there has been roughly 23 another 50 cents or so in float. By investing $1.50 for every $1 of capital 24 over the years, Berkshire has leveraged its returns. A significant portion 25 of Berkshire’s long-term outperformance can be attributed to Buffett 26 and Munger’s ability to execute on this brilliant insight. That’s not 27 something you or I can go out and do. 28 In 1972, Berkshire bought See’s Candy. While Buffett paid more 29 than he normally might have, he discovered how powerful a cash gen- 30 erator a great brand could be. It taught him about the power of brands 31 and the virtues of companies that don’t require a lot of capital to grow. 32 Selling chocolate doesn’t require a lot of innovation. It won’t become 33 obsolete. If you have a good brand, customers will keep coming back 34 every Valentine’s Day for more. 35 Those two pieces—the insurance company as a platform and 36 high-quality brands as cash generators—built the base for the 37 wealth-compounding machine that is Berkshire Hathaway. 38 Another significant company Buffett bought was GEICO, a company 39 he had a long history with. His mentor, Ben Graham, owned shares 40 of GEICO at Graham Newman. At the University of Nebraska, Buffett 41 wrote his thesis about GEICO. Looking at it now, he understood that

xviii INTRODUCTI ON with a terrific basic business model, it just had to be run the right way 1 to be successful. 2 In the mid-1970s, GEICO got into some trouble, and its stock price 3 collapsed. A new CEO, Jack Byrne, was brought in, and Buffett was confident 4 that Byrne was the man to fix it. Buffett bought a ton of GEICO stock.* 5 Munger liquidated his partnership in 1976. The Wheeler–Munger 6 partnership had earned 24.3% compounded from 1962 to 1975, versus 7 6.4% compounded for the Dow Jones Industrial Average. In 1978, 8 Munger became Berkshire Hathaway’s vice chairman. 9 In addition to being Berkshire’s vice chairman, Munger served as 10 CEO and chairman from 1984 to 2011 for Wesco Financial, the holding 11 company for Mutual Savings, a savings and loan in Pasadena. Wesco 12 was 80.1% owned by Blue Chip Stamps, which, in turn, was wholly 13 owned by Berkshire Hathaway.† Over the years, Wesco was seen as a sort 14 of “mini-Berkshire” as Munger reallocated the company’s assets into 15 reinsurance, CORT business equipment, Kansas Bankers Surety, and 16 shares of some of Charlie’s favorite stocks. 17 Over the years, Berkshire Hathaway has accumulated ownership 18 of many other wonderful businesses: utilities (Berkshire Hathaway 19 Energy), consumer products (shares of Coca-Cola), and even media 20 properties (the Buffalo News and shares of the Washington Post). 21 The public has long viewed Berkshire as a sort of mutual fund with 22 large stock holdings. This view underestimates or ignores 1) Berkshire’s 23 insurance companies’ impressive generation of low-cost float, 2) Berk- 24 shire’s impressive and growing stable of cash-generating operating busi- 25 nesses, and 3) Berkshire’s ability to orchestrate value-enhancing deals. 26 With billions in cash and fixed income securities, Berkshire is now a 27 financial Fort Knox. During the first decade of the 21st century (a.k.a. 28 “the lost decade”), Buffett was criticized for holding enormous amounts 29 of cash and bonds. During the subprime mortgage crisis, Buffett and 30 Munger went on an investing spree. 31 Berkshire was in the position of seeing every decent deal in America 32 as the nation’s “buyer of last resort.” While retail investors were selling, 33 Buffett and Munger bought and bought—and bought some more. 34 Their investments included the acquisitions of a railroad, Burlington 35 Northern Santa Fe (BNSF) and a chemical company, Lubrizol. They 36 37 * Over time, GEICO steadily bought in more shares, so Berkshire became a larger and larger percentage shareholder over time. Then, in 1996, Berkshire bought 100% control of 38 GEICO, allowing Berkshire to invest aggressively in GEICO’s growth. That progression has 39 added a lot of wealth to Berkshire. † In June 2011, Berkshire Hathaway acquired the 19.9% of Wesco that it did not already 40 own. 41

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21 did high-yield lending with warrants attached. They made capital 22 investments at BNSF and MidAmerican Energy. All told, Berkshire may 23 have put $100 billion to work at double-digit rates of return during the 24 subprime crisis. 25 Over the last 32 years, Berkshire has created a collection of fantastic, 26 independently great businesses that generate a lot of cash to grow the 27 enterprise. If Berkshire were strictly in the investment portfolio business, 28 you would need investing geniuses like Buffett and Munger to oversee 29 it and determine when to buy and sell. 10 But by owning great businesses, it is less essential to have Buffett 11 and Munger there. GEICO will keep selling auto insurance. Burlington 12 Northern will keep shipping stuff by rail. These companies will all keep 13 going without them. In doing this, they have intentionally created 14 Berkshire to extend their success past their own lifespans. 15 Today, Berkshire Hathaway is one of the world’s most powerful con- 16 glomerates. In 2017, Fortune ranked Berkshire as the nation’s second 17 largest companies(trailing only Wal-Mart)—boasting revenues of $223 18 billion, profits of $24 billion, and assets of $620 billion. With $283 bil- 19 lion of equity and $91 billion of float, Berkshire has substantial capital 20 to fund its operations. 21 In terms of market value, Berkshire now trails only Apple, Google/ 22 Alphabet, Exxon Mobil, and Microsoft for the title of America’s most 23 valuable company. Berkshire continues to represent solid value, lower- 24 than-average risk, and unparalleled quality. It is a superb company with 25 better relative value than almost anything else in the U.S. stock market. 26 27 Berkshire vs. S&P 500 (or 884,319% vs. 12,717%) 28 29 Since Buffett took over Berkshire 52 years ago, its per-share book value 30 has grown from $19 to $172,108. That’s a rate of 19.0% compounded 31 annually. Let’s compare that to the S&P 500. Since the S&P is a cross- 32 section of American businesses (as opposed to having all your eggs in 33 one basket), it’s largely considered a safe choice. To justify the risk of 34 owning Berkshire, it needs to outperform the general market. 35 Mission accomplished: 19.0% is nearly double the S&P 500’s 9.7% 36 gain for the same 52-year period. 37 Berkshire has consistently outperformed the S&P 500 during neg- 38 ative years. The S&P had 11 down years in the 52-year period. The cu- 39 mulative loss for those 11 years amounted to 251.4%. Comparatively, 40 Berkshire Hathaway had only two losing years during the same period 41

xx INTRODUCTI ON and had a cumulative gain of 117.8% for those 11 years. That’s an in- 1 credible 369.2% advantage over the S&P. 2 More than two-thirds of Berkshire’s outperformance over the S&P 3 was earned during down years. This is the fruit of Buffett and Munger’s 4 “Don’t lose” philosophy. It’s the losing ideas avoided, as much as the 5 money made in bull markets that has built Berkshire’s superior wealth 6 over the long run. 7 Utilizing compounding, a small advantage in the annual rate of 8 gain creates a huge advantage in total dollars over time. In terms of the 9 overall percentage gain from 1965–2016, a dollar invested in Berkshire 10 in 1965 experienced an amazing gain of 884,319%, versus a gain of 11 12,717% for the S&P 500. 12 Though Corey and I have been aware of the results for a number of 13 years, we still marvel at Buffett’s and Munger’s incredible achievement. 14 They have presided over one of the greatest records of wealth-building 15 in history. For five decades, money under Buffett’s control has grown at 16 a phenomenal rate. 17 18 19 “Woodstock for Capitalists” 20 As Buffett’s and Munger’s fame and wealth have grown, so has the 21 frenzy around Berkshire’s once humble annual meetings. 22 As noted, my first meeting in 1985 was a cozy, 300-attendee affair. 23 Since then, the meeting has changed many times. First it was an event, 24 then a spectacle, and now it is a full-fledged, three-day party. But in 25 1985, 300 attendees was considered large, since only 13 people attended 26 just six years before. Fast-forward to 2015, when 45,000 people were in 27 attendance.* 28 In a short period, Berkshire’s annual meetings morphed from a small 29 private lecture series into a chamber of commerce’s dream event. It may 30 be a sign of the times that so many people now flock to Omaha to hear 31 Buffett and Munger speak. It’s often called “Woodstock for capitalists.” 32 This testifies to the world’s rising interest in the realm of investment. 33 Buffett and Munger are happy to accommodate the hordes of fans, 34 friends, students, and shoppers who flock to Omaha each year. In fact, 35 they have managed to stretch out the whole affair for an action-packed, 36 three-day weekend. 37 38 39 * Appendix II chronicles Berkshire’s amazing growth over these 32 years. 40 41

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21 It’s a weekend vacation package where shareholder discounts 22 abound. Stores such as Borsheim’s (jewelry) and Nebraska Furniture 23 Mart have exclusive openings and parties for shareholders. Around 24 town, Omaha routinely features events, such as an Omaha Storm Chasers 25 baseball game, where Buffett has signed autographs and thrown out the 26 first pitch. 27 Over the weekend, shareholders are encouraged to patronize every- 28 thing in which Berkshire has an economic interest—which brings us to 29 “The Berkshire Mall,” a target-marketing retail bonanza for Berkshire 10 subsidiaries. 11 The ground floor of the CenturyLink Center turns into a mini-mall 12 for Berkshire’s shareholders. Dozens of subsidiaries form a midway of 13 booths hawking their wares.* 14 And then there’s the meeting itself, which kicks off with an original 15 short film. Over the years, these films feature skits that have featured every 16 kind of celebrity, including soap opera legend Susan Lucci, boxer Floyd 17 Mayweather, and actor Bryan Cranston (appearing in his role as Walter 18 White from Breaking Bad). 19 20 The Meeting Itself 21 22 With all the furor around the Q&A, you might be forgiven for thinking 23 it was of lesser importance. But you couldn’t be farther from the truth. 24 These two men are always the main attraction. 25 People care deeply about what they have to say and will wait for 26 hours just to ask a single question. In 1985, the Q&A session went on 27 for 2.5 hours. Now, it’s considered short if it wraps up in under six 28 hours. Such is the value attendees place on the combined wisdom of 29 these two modern-day sages. 30 Admittedly, adjusting to the larger numbers of attendees has been, 31 well, an adjustment. With so many people vying to get a question in, the 32 quality of the questions appeared—to Corey and me—to drop off. But 33 perhaps we are being unfair. Having been longtime attendees,† we miss 34 the quieter, more intimate meetings of the past. Fortunately, in 2013, the 35 quality of questions significantly improved by adding a panel of three 36 journalists and three analysts, who now ask a majority of the questions. 37 Regardless of size, though, the meetings are always informative and 38 full of Buffett and Munger’s wit and insight. 39 * To get a full picture of the spending orgy that happens in the lobby, see Appendix III. 40 † Remember, we saw Warren Buffett and Charlie Munger before they were popular and 41 cool—like seeing the Beatles playing at a bar in Hamburg before they became famous.

xxii INTRODUCTI ON

1 A Conversation Across Time 2 Corey and/or I have taken copious notes during every single Berkshire 3 meeting since that first one in 1984. In 1985, I decided I shouldn’t keep 4 them to myself and started sending them out as a newsletter to clients 5 and friends. 6 While working for Berkshire, Corey was still on my newsletter’s 7 mailing list. He remembers reading and enjoying my newsletters 8 while there. He found them to be informative and down-to-earth and 9 thought they captured the essence of the meetings. We talked on the 10 phone from time to time, and I would ask him questions. He said I 11 understood Berkshire’s business, from the outside looking in, as well as 12 anyone. 13 While at Berkshire, Corey had often thought about chronicling what 14 he learned there in a diary, but part of him thought that would be dis- 15 loyal to the corporation, so he opted against it. 16 While he didn’t formally sit down to take notes, Corey still picked 17 up gems of wisdom as he talked to his coworkers and the executives of 18 the subsidiaries and watched how these exceptional people thought. 19 As a necessity of his job, Corey was always focused on learning. The 20 subsidiaries he worked with varied greatly in their business models. 21 Nebraska Furniture Mart’s business, after all, is a lot different from 22 National Indemnity, See’s Candies, and Buffalo News. 23 While working there, Corey also went to graduate school for his 24 MBA and studied organizational theory as part of that. So during 25 his workdays, he observed how effectively Berkshire’s decentralized 26 organization functioned through the lens of what he was studying. 27 Corey became my business partner in 1992. While not disclosing 28 any of the proprietary information he had been privy to, Corey and I 29 discussed Berkshire all the time. He brought a deep understanding of 30 the culture, the values, and of the players involved. 31 At that time, he personally knew a lot of the people involved and 32 intimately understood the businesses that Berkshire owned. He had 33 spent a lot of time traveling to meet with the subsidiaries.* Ajit Jain, who 34 is often talked about as being Buffett’s replacement now, invited Corey 35 for dinner after he spent the day working at his office in New York. 36 37

* The extensive traveling was the main reason Corey decided to leave Berkshire. His first 38 child was born in 1987. After once returning home from a routine two-week trip, Corey 39 noticed that in that time his daughter had grown and “just looked different.” That really bothered him. So he was ready for a change when I approached Corey about becoming my 40 partner. 41

xxiii INTRODUCTI ON

21 Corey even had brief interactions with Buffett, talking to him briefly two 22 or three times.* 23 Corey had seen firsthand Berkshire’s high ethical standards. Corey 24 saw how Buffett, from the top, set the tone that Berkshire employees 25 would monitor and respect all laws and rules. When Corey started in 26 internal audit, computers could be purchased online without paying 27 sales tax. But, at Berkshire, if anything like that was purchased, it had to 28 be reported to corporate, so they could file the use tax returns. Buffett 29 wanted to make sure that Nebraska got their sales tax. He was adamant 10 about making sure that Berkshire paid—not more taxes than it had to, 11 but the taxes that it was responsible for. 12 Taking everything he understood from that experience, Corey has 13 contributed to the notes every year since he came to work at Pecaut & 14 Company in 1992. In the years he attended alone, I based the newsletter 15 on his notes and insights. While I wrote each newsletter, Corey rigorously 16 edited each one.† 17 Writing feverishly at each meeting, Corey and I jot down what we 18 feel are the most significant of Buffett and Munger’s comments and 19 insights. Our rigorous note-taking enables us to highlight, reflect on, 20 and pass along the golden nuggets of what we learned. 21 Once home, we do a condensed but detailed write-up of each meet- 22 ing’s notes for our clients. Those write-ups are what make up this book. 23 In addition to their words, we often address what was unsaid, inferred, 24 or implied. Our own expertise as value investors adds a depth of insight 25 that goes beyond a dry, static, verbatim reporting of events. 26 Much of the mainstream news reporting on Buffett is done without 27 deep insight into the working world of investing.‡ In these pages, you 28 will benefit from our own critical assessment of the meetings. 29 We have taken hundreds of hours of lectures and distilled them to 30 their most concentrated form. You’ve been saved the painstaking task 31 of digging through the archives to bring the gold to the surface. 32 You’ll quickly be swept up by the highlight reel of what has been a 33 fascinating, informative, and often hilarious ride through 32 years of 34 the Warren and Charlie show. 35 36 37 * Since Munger was off on his own running Wesco Financial in California, Corey never saw him except for when he attended the annual meetings. 38 † This is why I am the “I” voice in our newsletters. 39 ‡ The 2015 meeting kicked off with Buffett proactively clearing up an issue. A major reporter, who didn’t understand accounting, reported that the gross profit of one of Berkshire’s busi- 40 nesses was its net profit. The difference between the two was huge. The incident highlighted the 41 importance of having a firsthand understanding of scale, terminology, and accounting.

xxiv INTRODUCTI ON

This isn’t a book about dusty old “investment theory.” This is a cu- 1 rated collection of the best advice and insights Buffett and Munger 2 have shared over the last three decades. Shocking revelations. Funny 3 moments. Devilishly insightful strategies. 4 These newsletters form a conversation with Warren Buffett and 5 Charlie Munger spanning three decades. We have no doubt that any 6 serious investor will be fascinated and informed, in equal measure, by 7 these letters. (And we challenge you not to laugh out loud at Munger 8 and Buffett’s sibling-like haranguing.) 9 We believe these notes (excluding the annual reports) are the best 10 substitute for attending Berkshire’s annual meetings in person over the 11 last 32 years. Of course, if you were at the meetings, then this book is 12 the perfect refresher. The pages to follow will add color and definition 13 to your own memories of events. 14 The layout of the book is simple. It’s designed to put you in the 15 room with Buffett and Munger, every year for the past 32 years (1986– 16 2017).* You will see how Buffett and Munger responded to their own 17 mistakes and faced challenges as the world changed around them. The 18 book unfolds as a journey. 19 If you decide to jump on board, you will see the remarkable rise 20 of Berkshire Hathaway as it happens. You’ll come to understand the 21 genius behind it. You have in your hands fly-on-the-wall analyses of 32 22 years of annual meetings. 23 Admittedly, for most companies, that would be like watching paint 24 dry. But Berkshire Hathaway is a different kind of beast.† The company’s 25 unique success, and the strategies that made it possible, are legendary. 26 27 28 How To Use These Letters 29 This book isn’t for the first-time investor. It’s for the informed investor 30 who sees the value of being able to get deep into the mindsets of Warren 31 Buffett and Charlie Munger. If you want to walk around in their shoes 32 for the past three decades, absorb what works, and then apply it to your 33 own investments, then this book is for you. 34 Also, one significant personal benefit of value investing is peace of 35 mind. Many investors tough it out in the markets for years, living a life 36 37

* As you’ll note, as the meetings significantly increased in length, so did our newsletters. 38 Since there were more questions asked and answered, we had more data to draw from. 39 † What other annual meetings do you know of that take over an entire town for a weekend and kick-off with a movie? Or, for that matter, that can boast their own shopping mall? Of 40 course, it wasn’t always that way. 41

xxv INTRODUCTI ON

21 filled with anxiety and stress. They constantly fear that their investments 22 will disappear overnight. On the other hand, great value investors, like 23 Buffett and Munger, sleep like a baby—provided they follow simple 24 timeless principles. 25 We hope that by the time you’ve finished this book, these principles 26 will be engrained in your consciousness. We hope that your investment 27 decisions will take on a quality and depth that give you a serious com- 28 petitive edge. 29 This is not a “how-to” book. This book wrestles with the question, 10 “Why do two of the world’s greatest investors do what they do?” The 11 answer is contained in these pages. If you understand it, you will become 12 a better investor. If you can think and behave like they do, particularly 13 under pressure, you will become a great and wealthy investor. 14 This book will provide you with a deeper insight into how two of the 15 world’s greatest investors deal with investment problems as they arise. 16 You’ll witness, in real time, their reactions to events like the sovereign 17 debt crisis, the subprime crisis, and nuclear terrorism. Through it all, 18 you get an honest and frank account of mistakes made and obstacles 19 overcome. You’ll see firsthand Buffett’s rock-solid reasoning for investing 20 in Coke and See’s Candy. 21 You’ll also take a long look into the morbidly funny yet jaw- 22 droppingly astute mind of Munger on a range of issues. From the futility 23 of growing corn for fuel to the annual whipping of the modern portfolio 24 theory, Munger never misses a beat. 25 Had this been just a collection of anecdotes drawn from the last 26 5–10 years, it would have been too short of a time period to be mean- 27 ingful. Instead, this is a three-decade, year-by-year analysis of history 28 unfolding. You will be able to view Buffett and Munger’s decision- 29 making process from a unique vantage point. You have a collection 30 of insights about what went on beneath the surface of those decisions 31 over time. You see how the same timeless principles are applied to vastly 32 changing landscapes and circumstances (i.e., the internet, the demise 33 of newspapers, booms and busts, and so on). 34 While reading, you may wonder, If Berkshire got out of the market, 35 shouldn’t I do the same? or If Berkshire bought it, should I buy it too? Buffett 36 and Munger are clear in their advice—people should learn from 37 them and model their advice rather than copy their behavior. The main 38 reason is this: Unless you find yourself in the enviable position that 39 Berkshire operates in, you would do well not to copy its moves. 40 Berkshire Hathaway now represents half a trillion dollars of assets. It 41 makes direct purchases and deals of its own design. Berkshire sometimes

xxvi INTRODUCTI ON buys whole companies. Buffett and Munger play the game at a scale that 1 most investors cannot match. So instead of copying, understand why 2 they made the decisions they did. Then apply those insights to your own 3 decisions and your own position. 4 In more than one annual meeting, Buffett suggests that the best 5 investment you can make is in yourself. After a lifetime of following his 6 teachings and seeing the success in our own business, we wholeheartedly 7 agree with him. 8 These letters are a valuable resource of learning and analysis that 9 you can model for your own investing decisions. 10 But before you dive in, understand that you are about to reap the rewards 11 of the best investment we ever made, as a student at the University of 12 Berkshire Hathaway. 13 So we invite you to turn the page and step into the fascinating world 14 of the world’s greatest investment team . . . 15 16 All the best, 17 Daniel S. Pecaut 18 Pecaut & Company 19 April 2018 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

xxvii 1 1986 2 3 4 5 Venue: Joslyn Art Museum 6 7 Attendance: 500 or so 8 9 Details About This Year: 10 11 • The business of the day was concluded in a matter of 12 minutes, at which time the meeting was opened to 2.5 hours 13 of Q&A. 14 15 Stock Price: $2,475 16 One dollar invested in 1964 would now be worth $200. 17 18 Berkshire’s per-share book value has grown from $19.46 to 19 $2,073.06 (a rate of 23.3% compounded annually). 20 The S&P 500 compounded at 8.8% annually for the same period. 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

1 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1986’s Notes 22 23 24 Before I reflect on the meeting, let’s review Buffett’s philosophical 25 framework. 26 27 28 Value Investing 29 Warren Buffett is the greatest investor of our time and is the most prom- 10 inent of a group of highly successful value investors who share a com- 11 mon intellectual father, Ben Graham. Graham’s books—Security Analysis 12 (1934) and The Intelligent Investor (1949)—have become the bibles of 13 value investing. 14 Basically, Graham breaks the art of investing down into two simple 15 variables—price and value. Value is what a business is worth. Price is 16 what you have to pay to get it. Given the stock market’s manic-depressive 17 behavior, numerous occasions arise where a business’ market price is dis- 18 tinctly out of line with its true business value. In such instances, an investor 19 may be able to purchase a dollar of value for just 50 cents. Note that 20 there is no mention here of interest rates, economic forecasts, technical 21 charts, market cycles, etc. The only issues are price and value. 22 I should also note that Graham emphasizes a large margin of safety. 23 The strategy is not to buy a dollar of value for 97 cents. Rather, the gap 24 should be dramatic so as to absorb the effects of miscalculation and 25 worse-than-average luck. As Buffett puts it, “When you build a bridge, 26 you insist it can carry 30,000 pounds, but you only drive 10,000-pound 27 trucks across it.” Over time, diversified portfolios of such stocks have 28 provided superior returns with below-average risk. 29 30 31 Buffett’s Track Record 32 33 No one has employed these principles more effectively than Warren 34 Buffett. Over the last three decades, Buffett has consistently sought to 35 own either all or part of good businesses for a fair to bargain price. The 36 results have been awe-inspiring. 37 A $10,000 investment in Buffett’s partnership in 1956 grew to 38 $200,000 by 1969, a 25.9% compounded annualized return. Incred- 39 ibly, the partnership never had a down year even though there were 40 six down years in the market during that period. Superior returns with 41 below-average risk, indeed.

2 1986

In 1969, the partnership dissolved, and Berkshire Hathaway—originally 1 a small New England textile firm—became his base for making invest- 2 ments. Berkshire’s stock was $40 a share then. Today it sells around 3 $2,850, a compounded annualized growth rate of 28.5%. Thus, for three 4 decades, money under Buffett’s control has grown at a phenomenal rate. 5 Though I have been aware of the results for a number of years, I still 6 marvel at the achievement. 7 8 The Berkshire Hathaway Annual Meeting 9 10 So it was with much eagerness I attended my first Berkshire Hathaway 11 annual meeting. 12 The business of the day was concluded in a matter of minutes, at 13 which time the meeting was opened to 2.5 hours of Q&A. Of Buffett‘s and 14 Munger’s comments, here are the ones I felt to be the most significant. 15 16 On Intrinsic Business Value 17 18 This concept is the centerpiece of Buffett’s approach. Buffett defines it 19 as “what a company would bring if sold to a knowledgeable buyer.” This 20 definition departs from Ben Graham’s numbers-oriented valuation as 21 it gives value to such intangible items as management talent and fran- 22 chise value. 23 It is Buffett’s genius in identifying and evaluating these intangibles 24 that sets him apart from the crowd. 25 26 On Inflation 27 Buffett says it’s a political phenomena, not an economic one. As long 28 as politicians lack self-restraint, they will print a lot of money at some 29 point. Though it is probably two years or more down the road, Buffett 30 sees “substantial inflation” and “rates we’ve never seen before.” 31 These are powerful words for Buffett, a man much given to under- 32 statement and self-depreciation, so do not take them lightly. If Buffett 33 is correct, long–term bonds and other investments vulnerable to infla- 34 tion should be avoided. 35 36 37 On Economic Forecasting 38 True to Graham’s principles, Buffett said he pays no attention to 39 economic outlooks. His decisions are based simply on intrinsic business 40 values. 41

3 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 Interestingly, despite his feelings on inflation, Buffett has no plans 22 to alter his strategy (one that has worked for him for three decades). 23 At best, he will try to find businesses that can keep pace with inflation. 24 25 On Capital Cities/ABC 26 27 “The management of Cap Cities is the best of any public-owned company 28 in the country.” Thus, Buffett explained last year’s biggest acquisition. 29 Berkshire helped finance the merger of these two media giants, 10 investing $517 million in three million shares ($172.50 per share) of the 11 new company. 12 CCB stock currently trades at $240/share. 13 14 On the Stock Market 15 16 When the lemmings are running, Buffett notes that more money can 17 be made in the market than in buying whole companies. However, such 18 times are rare. Right now, “we see nothing in marketable securities that 19 interests us in the least.” 20 Buffett and Munger have been getting out of the market. Their favorite 21 businesses—media, consumer goods, insurance—have been marked up 22 dramatically in price during this bull market. 23 You may well ask, “If Buffett’s getting out of the market, shouldn’t 24 we do likewise?” This is a very difficult question. It is critical to learn 25 from Buffett—not to mimic him. 26 By selling, Buffett is not predicting a decline, though that will surely 27 come someday. He is simply acting on his observation that the intrinsic 28 business values of his holdings are fully reflected in current market 29 prices. 30 Berkshire Hathaway now represents $3.1 billion of assets. The num- 31 ber of companies large enough to be meaningful for Buffett is small. 32 Bargains among blue chips are virtually nonexistent. However, we are 33 not so restricted. There are thousands of wonderful small companies 34 we can consider. 35 36 37 38 39 40 41

4 1 1987 2 3 4 5 Venue: Joslyn Art Museum 6 7 Attendance: Over 500 8 9 Details About This Year: 10 11 • The meeting featured a three-hour Q&A session with 12 shareholders. 13 14 Stock Price: $2,827 15 One dollar invested in 1964 would now be worth $229. 16 17 Berkshire’s per-share book value has grown from $19.46 to 18 $2,477.47 (a rate of 23.1% compounded annually). 19 The S&P 500 compounded at 9.2% annually for the same period. 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

5 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1987’s Notes 22 23 24 Going on Tour 25 In the last two months, I have had the great privilege of seeing several of 26 the country’s wisest investors: 27 28 • George Michaelis of Source Capital, the top-performing closed- 29 end fund over the last decade, April 28, Santa Monica, CA. 10 • Charles Munger, Chairman of Wesco Financial, April 28, 11 Pasadena, CA, and Vice Chairman of Berkshire Hathaway. 12 13 • Warren Buffett, Chairman of Berkshire Hathaway, May 19, 14 Omaha, NE. 15 • As you may recall, I also had the good fortune to meet with John 16 Templeton in February. 17 18 Basically, my associate, Mark Staal, and I have adopted a world-as- 19 our-classroom approach. As such, we will continue to seek outstanding 20 individuals as our “professors.” We hope it will make us better investors. 21 At the very least, we will certainly have fewer excuses for our mistakes. 22 Here is a sampling of their collective wisdom. 23 24 On the Market 25 26 Like most value investors, they see few bargains. Michaelis holds about 27 a 40% cash level at Source Capital. Buffett and Munger are even more 28 extreme. They have sold all their non-permanent stock positions and 29 invested $1 billion in 8- to 12-year tax-free bonds. 30 As Buffett points out in the Berkshire Hathaway annual report: 31 32 “ . . . occasional outbreaks of those two super-contagious dis- 33 eases, fear and greed, will forever occur in the investment 34 community. The timing of these epidemics will be unpre- 35 dictable. And the market aberrations produced by them will 36 be equally unpredictable, both as to duration and degree. 37 Therefore, we never try to anticipate the arrival or departure 38 of either disease. Our goal is more modest: we simply attempt 39 to be fearful when others are greedy and to be greedy only 40 when others are fearful. 41

6 1987

As this is written, little fear is visible in Wall Street. Instead, 1 euphoria prevails—and why not? What could be more exhila- 2 rating than to participate in a bull market in which the rewards 3 to owners of businesses become gloriously uncoupled from 4 the plodding performances of the businesses themselves. 5 Unfortunately, however, stocks can’t outperform businesses 6 indefinitely.” 7 8 9 Noting that the Japanese stock market has gone to wild extremes, 10 Buffett wryly quoted Herb Stein: “Anything that can’t go on forever will 11 end.” 12 Buffett added, “That’s about as sophisticated as we get.” 13 14 15 On Inflation 16 17 Like John Templeton, Buffett believes significant inflation is inevitable 18 due to our government’s quick-fix attitude. “The availability of a print- 19 ing press as a short-term band aid is very tempting . . . Inflation is a nar- 20 cotic.” At the meeting, Buffett went as far as to say we will see a lot more 21 inflation, even more than we saw five years ago. 22 This has serious implications for fixed income investors. 23 Note that, to minimize market risk, Buffett’s bonds will all mature 24 within 12 years. You should consider doing likewise. 25 26 27 Know Your Limitations/Be Humble 28 29 This seems to be the major theme for all of these great investors. Tem- 30 pleton spoke of being humble as the gateway to understanding. 31 Munger noted that Tom Murphy, CEO of Capital Cities/ABC and 32 considered by Buffett to be the best business manager in the country, 33 prays every day to be humble. And we found George Michaelis to be 34 modest and self-deprecating. 35 Munger denied being humble (of course) but noted that the key to 36 his and Buffett’s success has been that “we’ve had a very low opinion of 37 our abilities.” He said that he’d rather be with a guy with an IQ of 130 38 who thinks it is 128 than a guy with an IQ of 190 who thinks it is 240. 39 The latter will get you into a lot of trouble. 40 41

7 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 False Precision 22 23 Buffett claimed that it is a terrible mistake to think that things out of a 24 computer are precise. If you have to carry it out to three decimal places, 25 it is too complicated. 26 As a result, in his 35 years of investing, Buffett says he has seen no im- 27 provement in the breed of investment managers. They are no smarter, 28 no more stable psychologically, and they make things more difficult 29 than they are. 10 Munger added that the worst mistakes are made from the nicest 11 graphs and what is really needed is “enlightened common sense.” 12 Again, knowing your limitations and the limitations of your informa- 13 tion seems to be the key. Or as Keynes said, “I would rather be vaguely 14 right than precisely wrong.” 15 16 On Insider Trading 17 18 While applauding the SEC’s effort to date, Munger observed, “When in- 19 credible rewards go to the casino operators, it is extremely unlikely that 20 civilization has reached nirvana.” 21 22 On the Insurance Industry 23 24 Buffett says the party is over, and the hangover will last longer than the 25 party. 26 Berkshire Hathaway’s insurance companies are seeing a sharp drop 27 off in premium volume. Earnings will look good for a year or two (“the 28 bar closes, but you get to finish your drink”), but business is becoming 29 intrinsically less profitable in a very discernible trend. 30 Interestingly enough, one of George Michaelis’ favorite stocks is the 31 top insurance brokerage company, Marsh & McLennan. 32 Wall Street has already concluded that the party is over and has 33 knocked the insurance stocks down to depressed levels. 34 In our portfolio, Hanover and RLI both sell at about six times 35 earnings. 36 37 On the Ideal Business 38 39 Buffett: “Something that costs a penny, sells for a dollar and is habit 40 forming.” 41

8 1 1988 2 3 4 5 Venue: Joslyn Art Museum 6 7 Attendance: 580 8 9 Details About This Year: 10 11 • The meeting’s formal business was concluded in a matter of 12 minutes. The fl oor was then opened to a three-hour Q&A 13 session with shareholders. 14 15 Stock Price: $2,957 16 One dollar invested in 1964 would now be worth $239. 17 18 Berkshire’s per-share book value has grown from $19.46 to 19 $2,974.52 (a rate of 23% compounded annually). 20 The S&P 500 compounded at 9.1% annually for the same period. 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

9 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1988’s Notes 22 23 24 On Inflation 25 26 As Buffett has been saying for several years, we will have significant 27 inflation eventually. Though the timing and degree of it are unknown, 28 inflation appears inevitable. The reason is “printing money is too easy. 29 I’d do it myself if I could.” And it is not unique to the U.S. There is a 10 worldwide bias toward inflation. 11 12 On Inflation Hedges 13 14 Given that we are going to have major inflation, several people asked 15 whether real estate, foreign currencies, leverage or hard assets should 16 then be considered. Buffett and Munger basically shot them all down: 17 18 Real Estate 19 Munger: “Everyone talks about the big money made in real 20 estate, but they forget to talk about the big money lost in 21 real estate.” 22 23 Foreign Currencies 24 Munger: “It’s hard enough to understand the culture you’ve 25 been raised in, much less someone else’s.” 26 27 Leverage 28 Buffett: “You can leverage up to your eyeballs, but you may 29 not make it across the river.” 30 31 Hard Assets 32 Munger: “Someone figured out the Van Gogh painting that 33 sold for $40 million last year yielded a 13% compounded 34 annualized return. Berkshire shareholders have done much 35 better.” 36 37 The Ultimate Inflation Hedge 38 39 What can we do then to mitigate the effects of inflation? The same thing 40 that Buffett and Munger would do if there were no inflation. We’d buy 41

10 1988 great businesses with excellent management at a fair to bargain price 1 and leave them alone. 2 While inflation is still undesirable, well-run businesses that employ 3 relatively little capital, that throw off lots of cash and that have pricing 4 flexibility will cope well with inflation. 5 6 7 On Program Trading 8 Buffett noted that anytime two commodities come together, there will 9 be arbitrage, and that is actually a good and necessary function in cap- 10 ital markets. 11 The question is whether derivative instruments such as index 12 options should exist at all. Munger’s unhedged opinion, “It’s a totally 13 asinine idea.” 14 To illustrate the point, Buffett suggested that we imagine that the 15 annual meeting was being held on a tour boat that was blown off course 16 and wrecked on a deserted island. We might elect Buffett to be chair- 17 man of the island with a mandate to maximize life on the island. He 18 would probably set half of the shareholders to work raising food, some 19 to building shelter and an inventive few to creating tools and new tech- 20 nologies for the future. Now imagine that an IQ test was given so that 21 Buffett could take 30 or 40 of the best and brightest, give them each a 22 Quotron terminal and have them trade futures on the output of the 23 food producers. It’s absurd, of course. 24 25 26 On Predicting Business Cycles 27 Buffett: “If I live X number of years, I’ll go through X number of re- 28 cessions. But if I spent all my time guessing cycles, Berkshire Hathaway 29 would be $15/share. You can’t dance in and out of businesses based on 30 forecasts.”* 31 32 33 On Salomon Brothers 34 Unlike other Berkshire businesses, such as Nebraska Furniture Mart or 35 the World Book, Buffett said he has no idea what the world of invest- 36 ment banking will look like in 10 years. However, there will be lots of 37 capital raised, and Salomon should fill an important function. 38 39 * Currently, Berkshire is $3,800/share. 40 41

11 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Buffett also reaffirmed that they like John Gutfreund, Chairman of 22 Salomon Brothers, very much. 23 Munger (whose favorite expression seemed to be, “It’s one tough 24 business.”) made one of his only enthusiastic comments of the day: 25 “Salomon is deep in talent—the ultimate meritocracy—and with that 26 talent may do very well over time.” 27 It appears to me that Salomon Brothers, which is selling below book 28 value, may be an excellent long-term core holding. 29 10 On Successor Businesses 11 12 In response to a query about the impact of compact laser disks on 13 World Book’s business, Buffett characterized himself as an “old wind- 14 mill enthusiast” and suggested that encyclopedias will be little changed 15 20 years from now. 16 In a fascinating digression, Buffett noted that “the fact that you are 17 being obsoleted does not mean you should go into the successor business.” 18 As an example, he explained that if you were a person of vision in 19 the passenger train business in 1930, you might have seen the coming 20 of the airplane. But the answer was not to get into the airline business, 21 which is a terrible business. The answer was to get out of the passenger 22 business altogether. 23 24 On the Resilience of the U.S. Economy 25 26 Buffett and Munger steadfastly refused to get into a long discussion of 27 macroeconomics. 28 Buffett noted that the U.S. economic system is strong and can take 29 a lot of abuse. He said that the difference between great economic pol- 30 icy and poor economic policy could be a difference of just 1% annually 31 in the GNP. That is, the GNP might grow at (X-1%) instead of X% due 32 to misguided policies. 33 John Templeton has shared similar thoughts. 34 In other words, rather than worry about economic projections, 35 these brilliant investors focus on finding good businesses at bargain 36 prices within our resilient economy. 37 38 On the Trade Deficit 39 40 Buffett sees the trade deficit as a far more serious problem than the federal 41 budget deficit.

12 1988

To clarify the point, he noted that Peter Minuit traded trinkets for 1 Manhattan. Now we’re trading Manhattan for trinkets! ABC sold its 2 New York office building for $750 million. In return, we buy VCRs. 3 In other words, he explained, we are trading away the farm. We 4 are sending IOUs out that are slowly being redeemed for pieces of the 5 farm. That is the consequence of a significant trade deficit. 6 7 8 Biographies: Improve Your Friends 9 My favorite comments are those that give an inside glimpse of what 10 Munger and Buffett are really like. 11 To a question about what books to read, Munger replied that he 12 is a biography nut and heartily recommended biographies as a way to 13 “make friends among the eminent dead.” Buffett quipped, “And they 14 don’t talk back.” 15 Munger went on to say that biographies give you marvelous expe- 16 rience, extend your range and may even improve the quality of your 17 friends. He noted that Golden Arches and The Big Store offer great lessons 18 on business. 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

13 1 1989 2 3 4 5 Venue: Joslyn Art Museum 6 7 Attendance: 1,000+ 8 9 Details About This Year: 10 11 • This year’s meeting was delayed 15 minutes as over 1,000 12 people squeezed into Witherspoon Concert Hall auditorium. 13 Buffett noted, “A lot more people turn out to talk about their 14 money than to look at old paintings.” 15 16 Fortune 500 Ranking: 205th 17 18 Stock Price: $4,711 19 One dollar invested in 1964 would now be worth $381. 20 21 Berkshire’s per-share book value has grown from $19.46 to 22 $4,296.01 (a rate of 23.8% compounded annually). 23 The S&P 500 compounded at 9.4% annually for the same period. 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

15 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1989’s Notes 22 23 24 The Trade Deficit: 25 Our Most Important Economic Problem 26 27 Buffett explained that the trade deficit represents the passing out of claim 28 checks that can only be redeemed for assets or consumable items. We 29 are passing out $130 billion of claim checks annually, so we can consume 10 103% of what we produce. While it may feel pleasant now, such a life- 11 style will eventually lead to major trouble. 12 He likened the problem to eating an extra piece of toast each day. 13 One hundred extra calories per day doesn’t seem like much, and it pro- 14 vides immediate pleasure. However, after a month, you’ve consumed an 15 extra 3,000 calories and gained one pound. Keep it up and eventually 16 you will have a significant problem. 17 In sum, the trade deficit amounts to the gradual giving away of the 18 farm. As these claim checks are cashed, America gives up more and more 19 of its productive assets. Peter Minuit traded trinkets for Manhattan. 20 Now we are trading Manhattan for trinkets. 21 22 Junk Bonds: Who Will Be the Patsy? 23 24 Buffett noted that Ben Graham said people got into much more trouble 25 with a sound premise than an unsound premise. 26 As an illustration, if I recommended Alaska beachfront property to 27 you, you could dismiss it out of hand as nonsense. If I recommended 28 Florida beachfront property, you might have an interest since the prem- 29 ise is sound. Yet many people have lost their shirts buying Florida land. 30 So it is with the leverage buyout game. The enormous success of a 31 few sensible LBOs has led to wild excess. Buffett and Munger did not 32 mince words about the “creative financing” spawned by the leverage 33 buyout mania. 34 Zero-coupon bonds (actual payments made only at maturity) and 35 payment-in-kind (PIK) bonds (payments made in more of the same 36 paper) only defer the moment of truth. (Munger noted that if Argentina 37 had PIKs, it would still be current.) 38 They said that there are large quantities of these bonds that will be 39 impossible to pay under most circumstances. Energies are primarily de- 40 voted to laying it off on someone else, to deciding who will be the patsy. 41

16 1989

In sum, the LBO junk bond game will go to an extreme and will stop 1 only when it cannot be done anymore. At that time, “there will be blood 2 in the streets.”* 3 4 5 Intrinsic Business Value (IBV): The Annual Question 6 This is the essence of Buffett’s value approach. 7 Buffett said to determine the IBV of an asset, simply take the pres- 8 ent value of the net cash flows from here to eternity, based on current 9 bond rates. 10 The hard part, of course, is predicting the future cash flows. Some 11 businesses are easier to predict than others. Even then, you don’t cut 12 it close. 13 Buffett noted that if he and Munger get a value of X to 3X for an 14 asset, then they attempt to buy it at 1/2X.† 15 16 17 Insurance Industry Outlook: 18 It Will Get Worse Before It Gets Better 19 Buffett and Munger had two basic observations: One was that regula- 20 tion of the insurance industry will only get more onerous. California’s 21 Proposition 103 reflects the antagonism that the public feels for the in- 22 surance industry. The other was that the industry’s underwriting losses 23 will continue to grow for at least two more years. 24 25 26 The Little Bitty Jet: Ridiculous Extravagance 27 The meetings are always laced with homespun wit and humor. 28 While Buffett prides himself on never adding the unneeded, Berk- 29 shire did purchase a corporate jet a few years ago. When asked about 30 the “little bitty jet,» Munger replied, “I am unfamiliar with this ridicu- 31 lous extravagance.” Munger flies coach. 32 33 34 * George Michaelis gives a superb summary of the LBO problem in his Source Capital first quarter report. According to Michaelis, to avoid being the patsy, one must do the following: 35 A. Avoid financing overpriced takeovers via the high yield bond market. 36 B. Avoid the equity of financial companies providing such financing. C. Avoid unrealistic valuations in your common stock portfolio based on takeover spec- 37 ulation. 38 † Buffett paid 23¼ for ServiceMaster in early 1987. We might infer, then, that he calculated ServiceMaster’s IBV at that time to be approximately 46 to 140. Today, ServiceMaster is 39 227⁄8. 40 41

17 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 The Value of Brand Names: 22 It’s Great When You Have One 23 24 See’s Candy, a Berkshire Hathaway subsidiary, is attempting to market 25 a new chocolate syrup and expects to lose money for some time on the 26 venture. Hershey’s is tough competition. It is extremely difficult to 27 break into the food business, and that is precisely why an established 28 brand name product is so valuable. 29 Similarly, Buffett said that he drank five Pepsis per day until he 10 switched to Cherry Coke. Now he drinks five Cherry Cokes per day. After 11 50 years of research, he joked that he finally noticed that there are only 12 two companies in the field. Coca-Cola and Pepsi have over 70% of the 13 soft drink market, and their market share grows each year. He finally 14 made a decision and bought one of them.* 15 16 Past Is Not Necessarily Prologue 17 18 The history of Wall Street has forever been one of boom and bust. 19 One of the reasons Buffett gave for human excess is an unthinking 20 reliance on the recent past. For example, junk bond advocates point to 21 the last 30 years of attractive “high yield” bond performance and claim, 22 therefore, that they will continue to do well. Buffett noted that such an 23 analysis is akin to thinking the sun rose because the cock crowed. Mean- 24 while, junk bonds get junkier, and a bad end seems more and more 25 likely. 26 As Buffett summed up, “If investors only had to study the past, the 27 richest people would be librarians.” 28 29 30 31 32 33 34 35 36 37 38 39 40 * Berkshire owns 6.3% of Coca-Cola. 41

18 1 1990 2 3 4 5 Venue: Orpheum Theater 6 7 Attendance: 1300 8 9 Details About This Year: 10 11 • To handle the fast-growing attendance, the venue was 12 changed to the larger Orpheum Theater. 13 14 Fortune 500 Ranking: 179th 15 16 Stock Price: $8,696 17 One dollar invested in 1964 would now be worth $703. 18 19 Berkshire’s per-share book value has grown from $19.46 to 20 $4,612.06 (a rate of 23.2% compounded annually). 21 The S&P 500 compounded at 10.2% annually for the same 22 period. 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

19 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1990’s Notes 22 23 24 Rites of Spring 25 26 Since adopting a world-as-our-classroom approach six years ago, we have 27 attended the Berkshire meeting regularly and selected others as well. 28 This year, we attended the following “classes” with some of our favorite 29 “professors”: 10 • April 30th, Omaha, Berkshire Hathaway, Warren Buffett and 11 Charles Munger 12 13 • May 7th, Los Angeles, Source Capital, George Michaelis 14 • May 8th, Pasadena, Wesco Financial, Charles Munger 15 16 They shared a great many insights I would like, in turn, to share with 17 you. However, there was such a striking emphasis on one concept by these 18 gentlemen. I thought it might be most beneficial at this time to review 19 that theme. 20 21 Buy Wonderful Businesses 22 23 “It is far better to buy a wonderful company at a fair price 24 than a fair company at a wonderful price.” 25 —Warren Buffett 26 27 According to each of the above meetings and the Berkshire Hathaway 28 annual report, the key to investment success is to buy wonderful busi- 29 nesses. 30 Like many great truths, this may seem obvious, but it is not. In fact, it 31 is a complete departure from the value approach recommended by the 32 philosophical father of value investing, Benjamin Graham. 33 At the Source Capital annual meeting, Michaelis explained that 34 there have been two basic themes in value investing: 1) buy assets and 35 2) buy earnings power. 36 The first approach focuses on buying a company well below its 37 liquidating value. 38 Ben Graham was an asset bargain hunter, which was probably the 39 appropriate approach coming out of the depression as he did. 40 The problem with buying assets cheap, as Michaelis sees it, is that 41 the only way to increase the value is through some sort of event.

20 1990

Buffett expressed much the same thoughts in his annual report, call- 1 ing the asset style of investing the “cigar butt approach.” Unless you are 2 a liquidator, you may end up waiting a long time for that “puff” of profit. 3 Michaelis prefers the earnings power approach. If a company earns 4 very high returns year after year, he explained, then, ultimately, those 5 will be the shareholders’ returns as well. 6 At the Wesco Financial annual meeting, Munger put it this way: what 7 he wants are “idiot-proof” businesses. He pointed to Coca-Cola and the 8 Washington Post as examples and described them as “first liens against 9 the passage of time.”* 10 11 12 Institutional Blindness 13 What is fascinating is that each of these gentlemen came to the idea of 14 buying good businesses on his own. 15 Michaelis told me that the subject was never discussed at the Harvard 16 Business School. 17 At the Wesco Financial meeting, Munger noted that when Ben Graham, 18 one of the most brilliant teachers, taught Warren Buffett, Graham’s 19 most brilliant student, the subject never came up. 20 Munger lamented that business schools would produce better man- 21 agers if they would study what makes a good business good and what 22 makes a bad business bad. But they don’t. 23 When asked why they don’t, Munger replied that for business 24 schools to do so would mean calling into question the flawed morals and 25 performance of America’s largest corporations, the same corporations 26 that hire many of the business schools’ students. 27 Munger explained that the business schools are merely heeding Ben 28 Franklin’s advice: “Keep your eyes wide open before marriage and half 29 shut thereafter.” 30 “Business schools are good at keeping their eyes half shut,” Munger 31 concluded. 32 33 34 35 36 37 38 39

* Buffett has, in the past, credited Munger with steering him toward buying wonderful busi- 40 nesses versus buying asset bargains. 41

21 1 1991 2 3 4 5 Venue: Orpheum Theater 6 7 Attendance: 1,700 8 9 Details About This Year: 10 11 • Fans were greeted in the lobby by a fl oor-to-ceiling Coca-Cola 12 display. Coca-Cola President Don Keough and his “minimum 13 wage helper,” Warren Buffett, were adorned in red Coca- 14 Cola aprons and serving beverages. 15 • The 1,700 people who fl ocked into the old Orpheum 16 Theater marked a six-fold increase over the attendance 17 in 1984. The mere size of the crowd made for a festive 18 atmosphere (and, we believe, less penetrating questions at 19 the meeting). That aside, the meeting was informative as 20 always, full of Buffett’s and Munger’s wit and insight. 21 22 Fortune 500 Ranking: 170th 23 24 Stock Price: $6,687 25 26 One dollar invested in 1964 would now be worth $541. 27 Berkshire’s per-share book value has grown from $19.46 to 28 $6,437 (a rate of 23.7% compounded annually). 29 30 The S&P 500 compounded at 9.6% annually for the same period. 31 32 33 34 35 36 37 38 39 40 41

23 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1991’s Notes 22 23 24 Coke Is It 25 26 To explain Berkshire’s purchase of 7% of Coca-Cola, Buffett deferred 27 to Coca-Cola President Don Keough, who noted that his company has 28 been selling “simple pleasure” for 105 years and is now available in 170 29 countries. Big growth should come from overseas. While Coke sells 300 10 drinks per person per year in the U.S., it sells just 59 drinks per person 11 outside the U.S. 12 Buffett has frequently mentioned the value of consumer franchises 13 over the years. His appraisal of Coca-Cola is unequivocal: “the most 14 valuable franchise in the world.” 15 16 Permanent Holdings 17 18 Buffett has classified Berkshire’s holdings in Capital Cities/ABC, Coca- 19 Cola, GEICO and the Washington Post as “permanent” and listed three 20 characteristics for such holdings: 21 1. Good economic characteristics 22 23 2. Able and trustworthy management 24 3. We like what the company does 25 26 He allowed that economics are not the only issue for him (“What’s 27 the sense of getting rich if you discard associations you enjoy?”). But 28 even if they were, some permanent holding would be likely. He noted 29 that there aren’t that many wonderful, large enduring businesses— * 30 even fewer than he thought 15 years ago. 31 32 Buying Stocks: Like Buying Food 33 Buffett made his annual statement that he will not comment on any in- 34 vestments that Berkshire might be accumulating except as required by 35 securities law. Good ideas are rare, and competition in accumulation 36 may push the stock price up. 37 Buffett noted that many investors illogically become euphoric when 38 stock prices rise and are downcast when they fall. This makes no more 39

40 * Berkshire Hathaway certainly fits the “permanent holding” criteria: the economics are 41 powerful, and management could not be more able or of greater integrity.

24 1991 sense than if you bought some hamburger one day, returned the next 1 day to buy more but at a higher price, and then felt euphoric because 2 you had bought some cheaper the day before. If you are going to be a 3 lifelong buyer of food, you welcome falling prices and deplore price 4 increases. So should it be with investments. 5 6 7 The Financial World 8 9 Buffett and Munger have had a great deal to say about the failings of 10 our financial system in recent years. They foresaw problems in the junk 11 bond market, the savings and loan industry and the banking industry.* 12 Buffett explained that financial disasters come about because stupid 13 decisions in financial companies are not accompanied by immediate 14 pain. Instead, people give you more money. Seeing this, competitors 15 indulge in mindless imitation. Thus, when failure comes, it is huge. 16 Buffett and Munger have pointed to a number of LBO debacles and 17 have taken exception to a “kill-’em-at-birth” mentality on the part of 18 some promoters. 19 In the case of Interco’s bankruptcy, Munger found it hard to imagine 20 more irresponsible conduct. Leveraged to the gills, Interco was virtually 21 assured of failure from the start. 22 Buffett also cited a need for a better insurance solvency system. As 23 with S&Ls and banking, the present system doesn’t catch companies 24 until much damage is done. 25 Munger commented that despite the “stupid megalomania” at First 26 Executive Life, it received an “A” rating from the rating agencies right 27 up to its collapse. Financial companies don’t have to be bad. To the ex- 28 tent there is tough-minded, independent management—such as Carl 29 Reichardt and Paul Hazen at Wells Fargo—such companies can do well. 30 Unfortunately, such managers are rare.† 31 32 33 Media Business: Considerably Less Marvelous 34 While there will be some cyclical rebound, Buffett believes the secular 35 trend for media is not good. 36 37 38 * Read Munger’s 1988, 1989, and 1990 Wesco Financial letters for a brilliant treatise on the 39 rise and fall of this economic anachronism. † As of December 31, 1990, Berkshire owned just under 10% of Wells Fargo (five million 40 shares at an average cost of $57.88 per share) and recently filed to buy up to 22%. 41

25 UNIVERSITY OF BERKSHIRE HATHAWAY

21 With more electronic ad conveyance and direct-mail substitutes, cer- 22 tain areas of the media industry are quickly turning from marvelous 23 businesses into mediocre ones. 24 Buffett still considers Berkshire’s media holdings to be fine busi- 25 nesses compared to American industry generally, but considerably less 26 marvelous than he would have thought just a few years ago. 27 28 Advice to MBA Graduates 29 10 Buffett: “Do what you enjoy the most. Work for people you admire. You 11 can’t miss if you do that.” 12 13 I Help the Captain 14 When asked how he spends a day, Buffett responded that he tap dances 15 into work (obviously, he’s following his own career advice), reads a lot, 16 talks on the phone a bit, and that’s about it. 17 When the same question was directed at Munger, he told the story 18 of the World War II Air Force captain who was bored stiff in Panama. As 19 the general reviewed the officers, he asked the captain what he did. The 20 frustrated captain answered, “I don’t do one damn thing.” The general 21 asked the same of his lieutenant. The lieutenant replied, “Well, sir, I 22 help the captain.” 23 24 25 Looking for Seven-Footers 26 In looking for investments and for business managers, Buffett recom- 27 mends a cream-skimming approach. He suggests adopting the mindset 28 of a basketball coach who, in a crowd of people, will immediately begin 29 talking to the seven-footers. You only need one good player to make a 30 difference. 31 Munger also claimed that much can be discerned from “the paper 32 record.” The documented record of how people have behaved over 33 many years has far more predictive power than a personal interview. 34 Buffett added that this is why they don’t hire fresh MBA graduates. 35 There is no record of on-the-job performance. 36 37 The Inefficient Theory: Where’s an Orangutan 38 When You Need One? 39 40 Buffett and Munger have made a hobby out of tweaking the nose of 41 academia and its pet investment theory, the efficient market theory.

26 1991

The theory holds that since markets are totally efficient, it does no good 1 to think about businesses.* 2 Three professors won the Nobel Prize last year for additions to the 3 theory. 4 Munger calls it a grand structure built on a false premise and bluntly 5 concludes, “A well-educated orangutan could see the success of our 6 approach, and yet no one is doing it.” 7 8 9 The Insurance Industry 10 While Buffett is not upbeat short term, he is upbeat long term about 11 Berkshire’s prospects in insurance. 12 Munger pointed out that a period of major distress is approaching 13 and that declining equity plus asset problems equals opportunity for 14 Berkshire. 15 Of all their businesses, Buffett believes the insurance business has 16 the greatest potential. 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 * If that’s true, Berkshire must be a mirage. 41

27 1 1992 2 3 4 5 Venue: Orpheum Theater 6 7 Attendance: 2,000 8 9 Details About This Year: 10 11 • The 2,000 people who fl ocked into the old Orpheum 12 Theater marked an eight-fold increase over the attendance 13 in 1984. 14 • Former Berkshire Hathaway employee Corey Wrenn 15 becomes a partner at Pecaut & Company. 16 17 Fortune 500 Ranking: 158th 18 19 Stock Price: $9,068 20 21 One dollar invested in 1964 would now be worth $733. 22 Berkshire’s per-share book value has grown from $19.46 to 23 $7,745 (a rate of 23.6% compounded annually). 24 25 The S&P 500 compounded at 10.4% annually for the same 26 period. 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

29 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1992’s Notes 22 23 24 Guinness: Another International Company 25 26 Commenting on Berkshire’s investment of $265 million in shares of 27 Guinness PLC, the world’s largest purveyor of assorted liquors, Buffett 28 noted that, like Coca-Cola and Gillette, Guinness receives the vast ma- 29 jority of its profits from overseas. 10 Munger pointed out that liquor can be a status symbol and that 11 Guinness’ products enjoy the rare and remarkable quality that the 12 higher the price, the higher the perceived value. Buffett added that 13 some people equate price with value in investment banking services 14 and business schools. So it is with scotch.* 15 16 More on The Real Thing 17 18 Buffett mentioned that roughly 20% of Berkshire’s look-through earn- 19 ings now comes from international sales, the largest percentage of 20 which comes from Coca-Cola. 21 Each day, the average person drinks 64 ounces of something. In 22 1991, 25% of those 64 ounces were soft drinks, surpassing water as 23 America’s number one beverage! That means about 730 soft drinks per 24 capita per year are consumed, of which approximately 42% are Coca- 25 Cola products. Worldwide consumption shows remarkably similar pat- 26 terns, and the number of soft drinks consumed is rising continuously. 27 Buffett noted that this illustrates why he pays so little attention to 28 macroeconomic factors. Owning the right business is the key. 29 Coca-Cola went public in 1919 at $40 per share. In 1920, the stock 30 plunged to 19½ as sugar prices changed. After seven decades of wars, 31 depression, etc. that initial $40 share would now be worth $1.8 million 32 (About 16% compounded annually). 33 It is far more fruitful to decide whether a product can sustain itself 34 than make economic predictions.† 35

36 * Berkshire’s cost translates to about $42.40 per Guinness ADR (American depositary re- 37 ceipt), which currently trade at $55. Given Buffett attempts to buy companies for 50 cents on the dollar, we might infer that he believes Guinness’ intrinsic value would be in the 38 neighborhood of $80 or more per ADR. 39 † The fact that Buffett volunteered the percentage of look-through earnings coming from overseas suggests that he has been intentional in repositioning Berkshire to benefit from 40 growth abroad. We have discussed the boom in free enterprise around the globe numerous 41 times in this newsletter. Buffett may have seen it coming years ago.

30 1992

1 Executive Compensation 2 With many executives making tens of millions in compensation in 1991, 3 this has been a hot topic in the press. Buffett’s response: 4 5 1. There should be no cap (you simply cannot overpay for truly great 6 performance). 7 2. Longevity is irrelevant. 8 9 3. Relate compensation directly to the performance of the business. 10 (Yardsticks will vary depending on the business and the amount of 11 capital employed). 12 What he finds objectionable is the large sums being paid for mediocre 13 performance. 14 15 16 The Case for a Non-Executive Chairman 17 Comments on compensation related to a larger discussion of the role 18 of corporate boards. 19 Buffett noted that every corporate employee has to answer to someone 20 else, except for the president. Too often the CEO also serves as chairman 21 of the board. Given that the chairman calls the board meetings and sets 22 the agenda, it is difficult for the board to evaluate the CEO properly. 23 The central question is how do you set up a cooperative institution with 24 an oversight board that will flash a yellow light when necessary but not so 25 often that it disrupts operations. Buffett’s idea—one that he has publicly 26 suggested at Salomon Brothers—is a non-executive chairman. Such a 27 person could see to it that the CEO is properly evaluated and monitored. 28 29 30 Speaking of Salomon Brothers 31 Buffett was asked about his heroic efforts in saving Salomon Brothers 32 from the treasury scandal. 33 Buffett responded by telling the story of the shark pool at Sea World— 34 which, the tour guide explained, no one had ever dared to swim across 35 despite a $1,000,000 prize for doing so. Suddenly, there was a splash. 36 A man paddled furiously and emerged on the other side, sharks nip- 37 ping at his heels. The tour guide gushed, “What bravery! You are the 38 first man ever to swim across the shark pool. What will you do with your 39 million dollar prize?” The man responded, “Hire a detective to find the 40 S.O.B. who pushed me in.” 41

31 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Light Hand on the Rudder 22 23 When asked about capital allocation decisions at Berkshire’s investee 24 corporations, Buffett claimed that he and Charlie were far less influen- 25 tial than we might think. 26 Munger said they had nothing like control and quoted Clarence 27 Darrow: “Captain of my fate? Hell, I don’t even pull an oar!” 28 29 Modern Portfolio Theory: 10 The Annual Rebuttal 11 12 Buffett noted with fascination that what is taught about investing has 13 gone backward over the last 40 years. 14 Munger claimed that it is because professors are so enamored by 15 modern portfolio theory. For the man with a hammer, every problem 16 looks like a nail. 17 Buffett continued the thought, noting that because computers can 18 generate huge amounts of data, modern portfolio theorists end up 19 looking for answers in chicken tracks. They ignore the simple fact that 20 when you buy a business, you own a business. 21 In conclusion, Buffett mused that he and Charlie, as buyers of good 22 businesses, should support the study of modern portfolio theory: “If 23 you’re in the sailing business, you want to set up flat-earth scholarships.” 24 25 On Market Timing 26 27 I found this story remarkable: 28 When Buffett graduated from Columbia University in the 1950s, 29 both his teacher, Benjamin Graham, and his father told him that it was 30 not a good time to get into the securities business. The Dow had just 31 surpassed the 200 mark. Buffett had $10,000 at the time. If he had 32 waited, he claims he would still have $10,000. 33 Munger put it this way: “We’re predicting how people will swim 34 against the current. We’re not predicting the current itself.” 35 I find Buffett’s story stunning because the two people who most cer- 36 tainly knew Buffett was one great swimmer (investor) discouraged him 37 from entering the water because they were concerned about the current 38 (market). Even Ben Graham succumbed to the seduction of making 39 a market call, which illustrates just how difficult it is to focus on identify- 40 ing great swimmers instead of predicting the current. 41

32 1992

1 All Investing Is Value Investing 2 Buffett commented that the distinction between the growth and value 3 styles of investing is nonsense. 4 Value is the only concern for any economic commitment. To calcu- 5 late your expected return, compute the discounted present value of the 6 flow of all cash from the business between now and judgment day. To do 7 so, you must A) determine the amounts and certainty of cash flows in 8 and out and B) select a discount rate. 9 Buffett noted that growth can enhance or detract from the calculated 10 value. For example, electric utilities were forced to grow and to invest 11 capital in the 1970s, which lowered their returns. 12 More dramatically, Buffett noted that the assured growth of the 13 airline industry has been a death sentence to American investors. Since 14 Kitty Hawk, the industry has lost money every year! Yet the industry asks 15 for more money from investors every year. The idea is to find invest- 16 ments that give you money, not take it. 17 Munger observed that studying airlines teaches you about competi- 18 tion in a high fixed-cost business with a fungible commodity. 19 Buffett also noted that book value is seldom meaningful in analyzing 20 the value of a business. Book value simply records what was put into the 21 business. The key to calculating value is determining what will come out 22 of the business. 23 Buffett explained that buying a business is much like buying a bond 24 with no maturity and with a blank coupon. You must write in the coupon, 25 and the accuracy of that coupon is the essence of intelligent investing. 26 If you cannot guess the coupon with any accuracy, then do not invest in 27 the business. 28 29 30 Corporate Returns on Equity: The “Equity” Coupon 31 A corporation’s return on equity approximates its equity coupon. 32 My question, then, was whether the 13% return on equity that Amer- 33 ican industry has averaged over the last few decades was likely to change 34 materially in the next few decades. 35 Buffett cited his 1977 Fortune article (in which he discussed his 36 stocks-as-bonds analysis) noting that the average return on equity was 37 12% then. He saw little to change that. Maybe 13% was okay. 38 Then he and Munger started to chip away at the 13% noting the 39 following: 40 41

33 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 • Post-retirement medical benefits amount to a huge liability for 22 corporate America that has been accruing for 20 years but is only 23 now beginning to be reported on balance sheets. Deduct 1⁄4 to 3⁄8 of 24 a point. 25 • Stock options and other executive compensation that goes 26 unreported by GAAP accounting. There is another 1⁄4 to 3⁄8. 27 28 • Overfunded pensions that have led to faithfully recorded prepaid 29 pension costs, which are not what they would call earnings. 10 When they got done, they decided a 12% average return on equity 11 was more likely to be the correct number. 12 Buffett said there is a bias toward inflating the numbers in U.S. 13 accounting. As Munger so delicately phrased it, “The difference between 14 12% and 13% is the corruption in U.S. accounting . . . the moral and 15 intellectual failing of the U.S. accounting system.” 16 17 18 The General Market: Not Cheap 19 After restating that the level of the market has no impact on their pur- 20 chase decisions, Buffett allowed that the market is not cheap. 21 Munger described the last 12 years as hog heaven and stated that 22 future returns will not be as high—the investment money of the world 23 can only grow so fast. 24 Buffett was even more emphatic: “There’s no way investment returns 25 can match what has been achieved.” 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

34 1 1993 2 3 4 5 Venue: Orpheum Theater 6 7 Attendance: 2,000 8 9 Details About This Year: 10 11 • Bus service was introduced to take shareholders from the 12 venue to and from Nebraska Furniture Mart, Borsheims, 13 various hotels and the airport. 14 15 Fortune 500 Ranking: 158th 16 17 Stock Price: $11,770 18 One dollar invested in 1964 would now be worth $951. 19 20 Berkshire’s per-share book value has grown from $19.46 to 21 $8,854 (a rate of 23.3% compounded annually). 22 The S&P 500 compounded at 10.2% annually for the same 23 period. 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

35 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1993’s Notes 22 23 24 World Markets 25 26 Buffett continues to like world markets, noting that a large percentage 27 of the earnings of Coca-Cola (80%), Guinness (80%) and Gillette (67%) 28 comes from abroad. 29 With over 20% of Berkshire’s look-through earnings coming from 10 overseas, Buffett has intentionally positioned Berkshire over the last five 11 years for the globalization of the world economy. 12 An interesting point—Berkshire’s position in U.K.-based Guinness 13 is unhedged. Buffett claimed that currency hedging would be not only 14 expensive and time-consuming but unnecessary as well since Guinness 15 itself already earns money in many different currencies. In the long 16 run, the currency factors should wash out.* 17 Munger took advantage of the topic to take a shot at the “diseconomies 18 of scale” of bureaucracy. Where a large corporation might go bonkers 19 and develop an entire floor of currency traders—probably hedging the 20 company on currencies for which it had no exposure—Berkshire seeks 21 to keep things simple, “so the chairman can sit and read annual reports 22 all day.” 23 24 Value Investing: A Mispriced Gamble 25 26 As in years past, Buffett pointed out that the rational value of any eco- 27 nomic asset equals the discounted present value of all future cash flows 28 (in as well as out). 29 He believed the long-term government bond rate (plus a point or 30 two if interest rates are low) is the appropriate discount rate for most as- 31 sets. While predicting cash flows for companies is much tougher than 32 for bonds, it can be much more rewarding. 33 Munger noted that many analysts look at huge bodies of past data 34 looking for clues, which results in enormous misspent effort (generally 35 proportional to the IQs of those doing it). True investing is really more 36 like betting against a parimutuel system, trying to find a 2-to-1 shot that 37 pays 3 to 1. Value investing is looking for a “mispriced gamble.” 38 Buffett chimed in, saying that they would have no edge if they tried 39 to evaluate every horse. They have an edge only if they pick their spots. 40 41 * Mark Holowesko, director of research at the Templeton Group, says much the same thing.

36 1993

The danger of relying on historical statistics or formulas is that you end 1 up betting on a 14-year-old horse with a great record but is now ready 2 for the glue factory. 3 4 5 Rate of Change “Normal” 6 7 I have often stated to clients that the rate of change in the world is 8 accelerating. 9 While I still stand by that notion, Buffett disagrees, saying that the 10 amount of change in the business world today is normal. The simple fact 11 is that businesses come and go, and there are always a certain number 12 of 14-year-old horses on their way to the glue factory. (He recommended 13 Carol Loomis’ Fortune article “The Dinosaurs” as a case in point.) 14 15 16 Generics vs. Brands 17 Buffett noted that generics are a threat in any industry where the leaders 18 earn high returns on equity. In many industries, that risk is increasing. 19 Generics have been doing well, but not all brands are alike. Where 20 the pricing umbrella has been raised too high (cigarettes, cornflakes, 21 diapers) and where much marketing muscle has been lost to retailers, 22 brands are quite vulnerable to generics. 23 In the case of Philip Morris, the price of Marlboro was steadily raised 24 to $2.00 per pack, enabling $1.00 per-pack generics (a $500 per-year 25 differential for a 10-pack-per-week smoker) to grab significant market 26 share. Philip Morris recently responded by dramatically cutting the 27 price of Marlboro. 28 In contrast, Gillette has a much larger moat around its business 29 castle. The annual difference in the cost of Sensor blades versus the 30 cheapos might be only $10 per year. Plus, there is a substantial quality 31 differential built on lots of technology. (For example, putting those tiny 32 springs in the Sensor required the development of a laser that can make 33 15 spot welds in a tenth of a second). 34 Likewise with Coca-Cola, which has kept its pricing low. Coke sold 35 for 0.8 cents per ounce many decades ago, and today sells for 2 cents 36 per ounce. Few food items have gone up less in price. Put another way, 37 with 700 million 8-ounce servings worldwide every day, Coke sold 250 38 billion servings last year and made $2.5 billion, or 1 cent per serving. 39 That leaves Sam’s Cola with very little room to maneuver. In addition, 40 Coke has a worldwide infrastructure that is very impressive. 41

37 UNIVERSITY OF BERKSHIRE HATHAWAY

21 See’s Candy vs. generic chocolate? Buffett said he just hopes that few 22 men, come Valentine’s Day, will say “Here, honey, I took the low bid.” 23 24 Danger in Derivatives for Salomon 25 26 Regarding the alarmingly rapid growth of derivatives, Buffett said there 27 is no question in his mind that there exists the possibility of an explosive 28 chain reaction with huge financial outcomes. 29 Munger added that the derivatives market is bigger than the futures 10 markets now and that to have money cascading in on people who sit 11 in front of computer screens all day is a reliable source of craziness. 12 The pyramiding of intertwining contracts and abilities to pay is very 13 dangerous. 14 While Salomon Brothers is alert to the danger, Buffett noted that Sa- 15 lomon cannot hedge away the systemic risk of a collapse in derivatives. 16 17 Berkshire Stock Split? 18 19 Every year Buffett explains that he wants Berkshire to have great long- 20 term shareholders and that splitting the stock would only work against 21 that. Instead, it would attract people like the man who ordered a pizza 22 and, when the vendor asked if he wanted it cut into eight pieces or four, 23 the man replied, “Make it four, I could never eat eight.” 24 Munger added that $13,000 is a perfectly reasonable amount to pay 25 for a partnership interest in a fine business. 26 27 Reinsurance Opportunities 28 29 Buffett noted that with risks growing faster than the cost of living, the 30 world is groping for a new reinsurance concept. Many companies need 31 reinsurance on a very large scale. 32 A contributing factor is the collapse of Lloyd’s of London, which 33 Munger doubts can be fixed (and whose collapse he believes should be 34 studied worldwide as a case study in stupidity).* † 35 36 * Our sense is that Buffett and Munger see huge opportunity here and would look for the 37 amount of reinsurance underwritten to expand. 38 † Wesco Financial, 80% owned by Berkshire, recently announced the sale of its Mutual Sav- ings subsidiary, freeing up over $300 million of capital. Berkshire can now cede significant 39 amounts of reinsurance to Wesco’s Wes-FIC insurance arm. Wesco Financial’s stock has 40 rocketed from 90 to 110 in recent weeks. 41

38 1993

1 Inflation Will Return 2 While amazed at how low inflation has stayed, Buffett said that, at some 3 point, inflation will return. “It’s just in remission.” 4 Munger agreed, noting in his characteristically upbeat way that “the 5 failure rate of all great civilizations is 100%.” 6 Though no business benefits by inflation, Buffett believes Berkshire 7 is better positioned for it than most. 8 9 10 Key to Successful Investing 11 When asked for great investment books to read, Buffett cited The Intel- 12 ligent Investor (as always) but then downplayed the idea that investment 13 secrets are hidden in books. 14 Investing is not that complicated, he explained. Other than learning 15 accounting, which is the language of business, the real key to investment 16 success is to have the right mindset with a temperament compatible with 17 those principles. As long as you stay within your circle of competence 18 (and know where the perimeter is), you will do fine. 19 Munger put it even more succinctly, noting that few humans have an 20 edge if they try to follow 40 companies or more (such as yours truly). 21 Eight or 10 in a lifetime, or even one, will get you your return. 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

39 1 1994 2 3 4 5 Venue: Orpheum Theater 6 7 Attendance: 3,000 8 9 Details About This Year: 10 11 • After nine years of working the meetings as an employee of 12 Berkshire, our own Corey Wrenn was fi nally able to sit and 13 enjoy the meeting. 14 • Buffett mused that the only place large enough to hold next 15 year’s meeting might be AK-SAR-BEN—the local race track. 16 Years ago, the meetings were held at the Joslyn Art Museum. 17 Buffett observed that in moving from a temple of culture 18 to an old vaudeville theater and, prospectively, to a den of 19 gambling, Berkshire was sliding down the cultural scale. 20 21 Fortune 500 Ranking: 158th 22 23 Stock Price: $16,348 24 25 One dollar invested in 1964 would now be worth $1,322. 26 Berkshire’s per-share book value has grown from $19.46 to 27 $10,083 (a rate of 23% compounded annually). 28 29 The S&P 500 compounded at 10.2% annually for the same 30 period. 31 32 33 34 35 36 37 38 39 40 41

41 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1994’s Notes 22 23 24 Derivatives 25 At last year’s meeting, Buffett noted that the use of derivatives has exploded 26 and that he would not be surprised if a failure in derivatives triggered 27 a financial catastrophe sometime in the decade ahead. Since then, the 28 rest of the world has taken heed. 29 Asked for a follow-up, Buffett emphasized that derivatives actually 10 serve a useful purpose. However, when ignorance is combined with 11 borrowed money, you get interesting outcomes. 12 Alluding to Proctor and Gamble’s embarrassing loss in derivatives, 13 Buffett noted that anytime you go from selling soap to putt writing on 14 bonds, you have made a big jump. 15 When asked if he had anything to add, Munger, in his usual gregarious 16 fashion, said, “No.” Buffett quipped, “I may have to shut him off.” 17 18 Super Catastrophes 19 20 Catastrophe coverage in the insurance industry is in disarray. 21 Buffett noted that the industry still has its head in the sand regarding 22 worst-case scenarios. Too many insurers make the mistake of underwriting 23 based on experience rather than exposure. 24 Buffett claimed that the insurance industry has vastly underestimated 25 the full potential of what a super catastrophe could do. 26 For example, the LA earthquake was a pretty big one (but not the 27 Big One). Loss estimates of $4.5 billion seemed low to Buffett.* But a 28 catastrophe would need to exceed $8 billion to trigger any of Berkshire’s 29 supercat policies. Yet these losses have already exceeded many compa- 30 nies’ estimates of “probable maximum loss.” If it had been the Big One, 31 a number of companies would have been wiped out. 32 Likewise, Buffett estimates that a hurricane hitting Long Island or 33 Miami could easily be a $15–$20 billion event, an event for which the 34 insurance industry is insufficiently prepared. 35 36 Swimming Naked in the Reinsurance Pool 37 With $5 billion of new money entering the reinsurance field last year, 38 Buffett acknowledged that there is more competition in the catastrophe 39 reinsurance business. 40 41 * They have since been revised to $6 billion.

42 1 9 9 4

In the short run, this has led to some price deterioration. In the long 1 term, Buffett remains optimistic, noting that new competitors may feel 2 pressure from their investors to “do something” (i.e., writing business 3 whether or not the price is right), while Berkshire can pick its spots. 4 In addition, Buffett noted that Berkshire’s premier strength and 5 reputation constitute a significant competitive advantage. 6 He observed that the nature of reinsurance seems to lead to stupid 7 things done en masse. All of a sudden, the money is gone. “You don’t 8 find out who’s been swimming naked until the tide goes out.” 9 10 11 The Indefensible 12 Buffett accused Munger of planting a question about Berkshire’s 13 corporate jet, The Indefensible. The parsimonious Munger reputedly 14 flies coach. 15 Buffett admitted that Charlie has pointed out to him that the back 16 of the plane invariably arrives at the same time as the front and acknowl- 17 edged, “Charlie’s even more of an expert on buses.” 18 19 20 Evaluating Management 21 22 Buffett gave two criteria for evaluating the performance of management: 23 1) How well do they run the business? and 2) How well do they treat the 24 owners? 25 Business performance should be compared to that of the competi- 26 tion, include review of capital allocation decisions and take into account 27 the hand management was dealt. 28 While good managers might think about the owners, Buffett said 29 that he has found poor managers seldom do. Finding good managers is 30 a difficult, but essential task. 31 Munger shared the story of the headmaster who told the graduating 32 class, “5% of you will become criminals. I know exactly who you are, 33 but I’m not going to tell you because it would deprive you of an air of 34 excitement.” 35 36 37 Job Description 38 Buffett explained that one of his jobs is to identify and keep good manag- 39 ers. The trick is, since most such managers are financially independent, 40 they need another reason to work. 41

43 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Buffett tries to keep it fun and interesting, to compensate them 22 fairly based on performance and to leave them alone to do what they 23 do best. 24 Munger observed that the concept of treating the other fellow as if 25 the roles were reversed was a sound one. 26 Buffett’s other job is to allocate capital. “Aside from that, we play 27 bridge.” 28 29 Greenspan 10 11 Buffett said he felt the actions of Federal Reserve Chairman Alan 12 Greenspan were quite sound given that part of his job is “to take away 13 the punch bowl at the party.” 14 Buffett noted that it is not an easy job. As you lean against the wind, 15 if the wind changes, you will fall flat on your face. 16 When Buffett asked Munger for his assessment of Greenspan’s per- 17 formance, the monosyllabic Munger replied, “Fine.” Buffett exclaimed, 18 “Greenspan is safe!” 19 20 What vs. When 21 22 Berkshire, Buffett explained, is in the business of acquiring businesses 23 and, in the manner of people buying groceries or cars, welcomes lower 24 prices. 25 Buffett said that they know how to evaluate businesses. They do not 26 know how to predict market swings. “It is crazy to give up something you 27 know for something you do not.” 28 Munger added that they are agnostic on macroeconomic factors. 29 Instead, they spend all their time on individual businesses. “To think 30 about what will happen versus when is a far more efficient way to 31 behave.” 32 33 Acquiring 100% of Businesses 34 35 When acquiring businesses, Buffett’s preference is to buy the entire 36 company. Unfortunately, sellers of 100% of a business tend to demand 37 a fair price. At the same time, competing buyers operating with OPM 38 (other people’s money) tend to pay more optimistic prices. Most cor- 39 porate managers believe they are better off if they are managing some- 40 thing larger, especially if the purchase is made with OPM. They get the 41 upside with no downside. “Animal spirits compete in 100% purchases.”

44 1 9 9 4

As a result, a greater percentage of Berkshire’s corporate holdings 1 consist of partial ownership positions purchased in the stock market, 2 where more foolish prices can prevail. 3 4 5 Wesco Financial Valuation 6 Part of the game with Berkshire is to try to calculate its intrinsic business 7 value. While Buffett and Munger give plenty of clues, the shareholders 8 are challenged to come up with their own appraisal of intrinsic business 9 value. 10 Buffett says he has been pleased with the way Berkshire’s share price 11 has generally reflected its value over the years. 12 In a surprising break from tradition, Munger actually calculates the 13 value of Wesco Financial (80% owned by Berkshire) in the Wesco annual 14 report, coming up with $100/share. 15 Munger explained that he thought the buyers of the stock were a little 16 crazy (Wesco Financial peaked at 149, and the current price is about 17 117), and he did not like attracting people in at high prices. He called 18 it “a one-time quirk.”* 19 20 21 Modern Portfolio Theory Described 22 Buffett and Munger took their annual shot at debunking modern port- 23 folio theory. 24 Buffett defined risk as “the possibility of harm or injury.” 25 In modern portfolio theory, beta is used as a measure of the volatility 26 and, thus, the risk of an investment. However, Buffett sees the use of beta 27 as nonsense, emphatically stating, “Volatility is no measure of risk to us.” 28 For example, super catastrophe insurance will lose money in a given 29 year, but over a decade, Buffett expects to make money—more money 30 than writing something predictable. 31 He said it is Wall Street nonsense to say that something that earns a 32 lumpy 20% to 80% is “riskier” than something that earns a predictable 33 5% year after year. 34 Buffett said that while he is risk averse, we would be surprised at how 35 much he might put on a seven-to-five flip. “We go where the probabilities 36 are good.” 37 Munger summed up, “We act as if we never heard of modern finance 38 theory, which can only be described as disgusting.” 39 40 * When is the last time you heard a chairman talk his own stock down? 41

45 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 What’s the Tax Rate in Bangladesh Anyway? 22 23 Buffett said he believes in progressive taxes, though he would prefer a 24 steeply progressive tax on consumption rather than on income. 25 Munger noted that there is a point where income tax becomes coun- 26 terproductive, but we are not there yet. 27 Buffett pointed out that the rich are very well-treated in America. 28 For those who feel unfairly burdened, Buffett suggested transporting 29 them to Bangladesh, so the rich could find out how much of their 10 wealth is them and how much is society. 11 12 Information Hypeway 13 14 Asked about the boom in information technology, Buffett replied that 15 his primary information source is the same as it was 40 years ago: annual 16 reports. 17 He emphasized that it is judgment that has utility in measuring price 18 and value. What is needed is not quick information, but good informa- 19 tion. 20 Buffett concluded that if the mail and quotes were delayed three 21 weeks, he would do just fine.* 22 23 Think for Yourself 24 25 The need for independent thinking has long been a theme at Berkshire 26 meetings. 27 This year, Buffett cautioned that you cannot let the market think for 28 you—“you cannot get rich with a weathervane.” 29 Buffett said to beware projections (“Don’t ask the barber if you need 30 a haircut.”) and to keep things simple (“I’d rather multiply by three 31 than by pi.”). 32 Munger noted that it is such an obvious point, yet many believe if 33 they just hire someone, they can do something difficult. He labeled it 34 “one of the most dangerous human ideas” and told the story of a man 35 and his building. The man said he had learned to fear three things: an 36 architect, a contractor and a hill. 37 Munger concluded that you do not need hierarchical thinking. 38

39 * In a similar vein, John Templeton told us that his investment results improved when he 40 moved to the Bahamas, where the Wall Street Journal arrived three days late. 41

46 1 1995 2 3 4 5 Venue: Holiday Inn Convention Center 6 7 Attendance: 4,300 8 9 Details About This Year: 10 11 • A number of foreign countries were represented in the 12 audience this year, as well as shareholders from 49 of the 50 13 states (those ever-practical Vermonters stayed home). 14 • To handle the record crowd, Berkshire continued its slide 15 down the cultural scale: from the Joslyn Art Museum years 16 ago to the Orpheum Theater to the Holiday Inn Convention 17 Center. 18 19 • Prior to the meeting, giant television screens replayed 20 Nebraska’s Orange Bowl win over Miami. (The locals 21 apparently found this to be in extremely good taste.) 22 • The Q&A went on for nearly fi ve hours. 23 24 Fortune 500 Ranking: 295th 25 26 Stock Price: $20,435 27 28 One dollar invested in 1964 would now be worth $1,652. 29 Berkshire’s per-share book value has grown from $19.46 to 30 $14,426 (a rate of 23.6% compounded annually). 31 32 The S&P 500 compounded at 9.9% annually for the same period. 33 34 35 36 37 38 39 40 41

47 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1995’s Notes 22 23 24 Buying Businesses 25 26 Normally the business portion of the meeting is railroaded through in a 27 few minutes. This year’s took longer as shareholders approved a motion 28 that would allow Berkshire to issue up to one million shares of preferred 29 stock. Buffett called it another form of currency with which to buy 10 businesses. 11 Buffett noted that Berkshire is equally willing to acquire companies 12 whole or in part. Quoting Woody Allen, “The advantage of being bisexual 13 is you’ve doubled your chances for a date on Saturday night.” 14 One recent 100% purchase for Berkshire was Helzberg’s, a Kansas 15 City-based chain of 150 jewelry stores. 16 Buffett praised Barnett Helzberg as just the sort of talented, high- 17 integrity operator Berkshire seeks. 18 Buffett predicted that Helzberg’s will become a big factor for Berkshire 19 over time and added that he may have one or two more such purchases 20 to report for next year’s meeting. 21 Asked if he had anything to add, the taciturn Munger shook his head. 22 Buffett quipped, “For a minute there, I thought Charlie was going to 23 have a near-life experience!” 24 25 EVA: No Value Added 26 27 Each year, Buffett and Munger toss cold water on hot academic theories. 28 This year’s variation was an inquiry about “Economic Value Added,” or 29 EVA. 30 Munger noted it is less silly than the capital asset pricing model, but 31 it forces the right answer. 32 Buffett added that people market these fad theories to justify needing 33 high priests. “If all it takes is the Ten Commandments, it makes it tough 34 on religion. ‘Listen to your customers’ as a business principle does not 35 require a 300-page book.” 36 37 On Projections 38 39 In another poke at human foibles, Munger claimed projections do 40 more harm than good as they are prepared by people desiring a certain 41 outcome.

48 1995

He quoted Mark Twain: “A mine is a hole in the ground owned by 1 a liar.” 2 Buffett said the meticulous preparation of most projections tells you 3 it is simply a ritual to justify what an executive wants to do anyway. 4 Munger concluded that the paper record is key. “Something with 5 a lousy past record and a bright future . . . that’s an opportunity we’re 6 going to miss.” 7 8 9 Salomon Brothers 10 Despite recent problems, Buffett and Munger expressed confidence 11 that Salomon Brothers will be around for a long time. 12 Munger observed Salomon had a bad break with having a bad year 13 right on the heels of installing a new compensation system. 14 Regarding the exodus of executives at Salomon, Buffett noted that 15 some left of their own volition and that some did not. Those that stayed 16 have more of the owner/manager mindset Salomon seeks to build. 17 Munger added that Wall Street has more jealously effects than 18 elsewhere even though “jealousy is the only sin you can never have any 19 fun at.” 20 21 22 On Newspapers and Elevators 23 24 While not as attractive as they were 15 years ago, Buffett noted that 25 newspapers still have exceptionally good economics. He went so far as 26 to say that if he could own only one business, it would probably be a 27 newspaper in a one-newspaper town. 28 Munger scoffed at the paranoia of newspaper proprietors who worry 29 about rising newsprint prices: “People don’t care what floor the elevator 30 is on, just which way it’s going.” 31 Buffett added that a 15-year graph of newspaper advertising rates 32 versus newsprint prices would show ad rates have done far better. 33 34 35 Intrinsic Business Value 36 A central concept of Buffett’s philosophy is intrinsic business value, the 37 value a knowledgeable buyer would pay for the business. 38 Buffett said shareholders are presented all the numbers needed in 39 the Berkshire annual report to estimate Berkshire’s intrinsic business 40 value. 41

49 UNIVERSITY OF BERKSHIRE HATHAWAY

21 He dropped a hint saying the discussion of Berkshire’s $3 billion of 22 float was the most important page in the report. 23 He went even further, saying, “Berkshire’s price relative to our intrinsic 24 business value offers more value than most any stock we see.” 25 26 Derivatives 27 28 Buffett predicted derivative calamities two years ago. Since then, there 29 have been a number of them, from Barings PLC to Orange County. 10 Buffett noted, when million-dollar nonphysical transactions swing 11 on just a signature, there is potential for lots of mischief. 12 He observed that derivatives, instead of transferring or moderating 13 risk, create risk on a huge scale (rendering regulation of borrowing limits 14 on securities meaningless). 15 Munger registered strong disapproval: “If I ran the world, there 16 would be no option exchanges . . . The world has gone bonkers.” 17 18 Keeping It Simple 19 Regarding Berkshire, Munger noted that few companies have ever been 20 constructed that require so little intelligence to maintain. 21 He reminisced that someone once subpoenaed their staffing papers 22 regarding an acquisition. “Not only did we not have any staffing papers, we 23 did not have any staff!” 24 25 26 Stocks 27 In discussing the $268 million write down of Berkshire’s USAir pre- 28 ferred stock from the original investment of $358 million, Buffett noted 29 you do not have to make it back the way you lost it. 30 Munger said that mistake is made frequently by those who gamble, 31 continuing to gamble when the right thing would be to walk away. 32 Buffett emphatically summed up his case for reason over emotion: “A 33 stock does not know you own it, the price you paid, who recommended 34 it, the prices someone else paid . . . the stock does not give a damn.” 35 36 Business Castles 37 38 Munger said the ideal business has a wide and long-lasting moat around 39 a terrific castle with an honest lord. The moat represents a barrier to 40 competition and could be low production costs, a trademark, or an ad- 41 vantage of scale or technology.

50 1995

They regard Coca-Cola as the standard (of which Berkshire owns 1 100 million shares). 2 Buffett noted it is important to differentiate between a business 3 where you have to be smart once versus one where you have to stay smart. 4 For example, in retail, you are under assault at all times versus a newspaper, 5 where you just need to be first. 6 Buffett quoted the Southern newspaper publisher who, when asked 7 of the secrets of his success, replied, “Monopoly and nepotism.” 8 9 10 Financial World 11 With holdings in Freddie Mac, Wells Fargo, Salomon Brothers, PNC 12 Bancorp and American Express, Berkshire has a significant stake in the 13 world of finance. 14 While finance is not an inherently attractive industry, Buffett believes 15 there will be opportunities for shrewd operators of scale to earn above- 16 average returns as the financial industry consolidates. 17 Buffett expects significant change over the next 20 years with Micro- 18 soft even perhaps finding a way around the present system. 19 Similarly, Berkshire has built enduring advantage in the highly 20 competitive catastrophe insurance market. Berkshire has $13 billion of 21 equity. Its largest competitors have less than $1 billion. 22 23 24 Accounting 25 26 Accounting is the language of business, and Buffett and Munger are 27 critical of those who abuse it. 28 Regarding a failed FASB proposal for the accounting of stock op- 29 tions, Buffett expressed sharp disappointment with American business 30 leaders who were cynical in the way they persevered in “seeing the value 31 of pi stay at three.” 32 Munger concluded, “Corruption won.” 33 On a general note, Buffett said, when accounting appears confusing, 34 avoid the company. The confusion may well be intentional and reveal 35 the character of the management. 36 37 38 National Debt 39 Buffett noted that debt is meaningless without looking at the ability 40 to pay. 41

51 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 With a 35% annual profit interest (tax) in America’s corporate earn- 22 ings and a 15%–33% share of personal income, the government is very 23 solvent. 24 Even with U.S. national debt at 60% of GDP (versus 125% of GDP 25 at the end of World War II), Buffett does not think the national debt is 26 a big worry. 27 28 Learning 29 10 In a fascinating digression, Munger pointed out that no one has ever 11 found a way to teach, so all are wise. 12 Munger rued that he has had great difficulty communicating even to 13 his own children. “It’s extraordinary how resistant some are to learning.” 14 “Especially when it’s in their own interest to do so,” Buffett continued. 15 He concluded, quoting Bertrand Russell, “Most men would rather 16 die than think. Many have.” 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

52 1 1996 2 3 4 5 Venue: Holiday Inn Convention Center 6 7 Attendance: Over 5,000 8 9 Details About This Year: 10 11 • Buffett threw out the fi rst pitch, “a premature sinker,” at the 12 Saturday Omaha Royals baseball game. 13 • A pre-meeting comedy video featured appearances by, 14 among others, Tom Brokaw, Susan Lucci and Bill Gates. 15 16 • Attendees lined up hours before the meeting for a good seat. 17 CNBC stationed a camera crew outside the doors for daylong 18 meeting coverage. 19 20 Fortune 500 Ranking: 292nd 21 22 Stock Price: $32,165 23 One dollar invested in 1964 would now be worth $2,600. 24 25 Berkshire’s per-share book value has grown from $19.46 to 26 $19,011 (a rate of 23.8% compounded annually). 27 The S&P 500 compounded at 10.7% annually for the same 28 period. 29 30 31 32 33 34 35 36 37 38 39 40 41

53 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1996’s Notes 22 23 24 The “B” Shares—A Non Event 25 26 The first 75 minutes of the meeting involved questions about Berkshire’s 27 filing to issue “B” shares, which would have 1⁄30th the value and 1⁄200th 28 the voting rights of the “A” shares. 29 Buffett explained the purpose of the “B” issuance was to head-off 10 the creation of unit trusts by brokerage firms that would buy Berkshire 11 shares for unit trust holders. People purchasing units of such trusts 12 would incur unnecessary costs and tax consequences and could well 13 have unrealistic expectations about future returns. 14 Buffett noted the “B” shares would create a flexible supply of shares 15 (as each “A” share would be convertible into 30 “B” shares) and would 16 avoid false inducements to buy. In fact, Buffett stressed that neither he 17 nor Charlie think the stock is undervalued. 18 Buffett also stressed the supply of “B” shares on the underwriting 19 would be expanded to meet demand.* 20 Buffett noted that on many initial public offerings (IPOs), Wall 21 Street firms intentionally limit supply, so the stock has a big first-day pop, 22 creating a “hot issue.” However, that just means Wall Street’s favorite 23 clients, not the company, are getting the enormous benefits of a hot 24 IPO market. 25 At Berkshire they engaged in a bit of reverse engineering—“How do 26 we keep people from buying our stock?” 27 Buffett likened the thought process to singing a country song back- 28 ward . . . “then you get your house back, your wife back.” 29 According to Munger, the “B” offering was a non-event, amounting 30 to only about 1% of Berkshire’s shares outstanding. 31 When Buffett asked if he had anything else to add, Munger said, 32 “No.” Buffett quipped, “Charlie does not get paid by the word.” 33 34 Microsoft 35 36 The founder of Microsoft, Bill Gates, and Buffett have become good 37 friends. 38

39 * The original filing was for 115,000 shares. The actual offering totaled 517,000 shares at 40 $1,110 each. 41

54 1996

The pre-meeting video made light of their recent trip to China, re- 1 porting that a computer nerd and a carpet salesman from Omaha had 2 endangered U.S.-Sino relations. 3 Buffett spoke highly of Gates’ managerial talent and business focus. 4 But, ever principled, Buffett said technology is just not something they 5 want to bet on. 6 7 8 GEICO: We’ll Be Very Happy 9 In 1976, Berkshire started buying shares of GEICO, whose direct 10 marketing method of selling auto insurance gives it an enormous cost 11 advantage. 12 GEICO has since grown to become the seventh largest auto insurer 13 in the U.S. 14 At year-end 1995, Berkshire’s $45.7 million investment had grown 15 to $2.4 billion. In 1995, Berkshire agreed to buy the rest of GEICO for 16 $2.3 billion. 17 Buffett said he believes the move is a huge plus for Berkshire, not- 18 ing that GEICO is an outstanding company with a low-cost distribution 19 method and has widened its competitive moat by its focus on lowering 20 costs. With 2.5% of the U.S. auto market, GEICO has a huge pool to 21 grow from. 22 Buffett believes GEICO can flourish a bit more by being wholly 23 owned by Berkshire. “In five years, we will be very happy with GEICO.” 24 25 26 Intrinsic Business Value 27 Each year, Buffett is asked about the intrinsic business value of Berk- 28 shire. Each year, he notes that all the information required for such a 29 calculation is in the annual report. 30 He did point out that to look merely at break-up value is a mistake. 31 Such a process misses the interesting dynamics of Berkshire’s collection 32 of businesses. A better method would be to calculate the stream of cash 33 generated by Berkshire and discount it back to the present. 34 As an example, he noted that a break-up value analysis of the $8.7 35 million Berkshire paid to Jack Ringwalt to buy National Indemnity 29 36 years ago would have missed entirely the value of the float-generating 37 characteristics of the business (float which now totals $7 billion!). 38 Buffett admitted that the value of that acquisition was far greater 39 than he knew at the time. 40 41

55 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Add the $7 billion of float to Berkshire’s $5 billion of deferred taxes, 22 and you have an extra $12 billion in “assets” that a break-up valuation 23 would miss. 24 25 Buybacks: Intensify Ownership 26 27 On a related topic, Buffett noted that corporate stock buybacks add to 28 shareholder value only if the purchases are made at prices below intrinsic 29 business value. Pay above intrinsic business value and you hurt share- 10 holder value. 11 He added, however, for a really wonderful business, he would come 12 up with a much higher intrinsic business value than most. 13 As an example, he noted that Berkshire’s original 7% stake in Coca- 14 Cola is now 8% with about 1% being added via buybacks. 15 Even more dramatic, Berkshire’s 33% stake in GEICO grew to 50% 16 with 20 years of stock repurchases. 17 Such repurchases proved very wise, even when GEICO was selling at 18 twice book value. 19 Buffett summarized, “With a scarce and powerful business, cap 20 shrink intensifies our ownership.” 21 22 Float 23 24 Buffett offered a beautiful explanation of float, comparing it to bank 25 deposits. 26 Bank deposits provide banks funds to invest. They come at an 27 explicit cost, the rate of interest paid to the depositor plus operating 28 costs. Similarly, insurance companies generate funds for investment (i.e., 29 float) as policyholders pay premiums upfront in return for a promise 30 of financial coverage in the event of future calamities. 31 Unlike bank deposits, however, the costs of float are unknown until 32 the policies expire and the claims are settled. 33 For Berkshire, the float, on average, has cost zero. In addition, it has 34 grown dramatically from $7 million in 1967 to $7 billion today. 35 Buffett cautioned that ordinary insurance is not a good business and 36 that float, per se, is not a blessing. To make it work, the insurance com- 37 pany must be run right, ideally with competitive advantages and the 38 ability to maximize them. If you can get float cheap and in increasing 39 quantities, float becomes a very important asset—something even more 40 important than Buffett could have guessed in 1967. 41

56 1996

Munger concluded that one of Buffett’s tricks is that he keeps 1 learning. 2 3 4 Warren Hit By a Truck? Too Damn Bad 5 Every year, Buffett gets the “What-if-you-get-hit-by-a-truck?” question. 6 Munger asked rhetorically, “Will Coca-Cola stop selling Cokes be- 7 cause Warren is no longer here? Will Gillette stop selling razor blades 8 because Warren is no longer here?” 9 He noted that Berkshire’s collection of businesses has been lovingly 10 put together so as not to require continuous intellect at headquarters. 11 Munger finishes, “And if you are upset that Berkshire would lose 12 Warren’s capital allocation skills, well, that is just too damn bad.” 13 Buffett joked, “Ever the sympathetic ear.” 14 15 16 Annual Reports 17 Buffett said he prefers annual reports that read like a half partner filling 18 you in on what is going on. Unfortunately, he sees no way to mandate 19 such reports. 20 Still, he noted that it is amazing what you can do with “outside” 21 information. All kinds of information is available, but you have to read 22 it yourself. 23 Buffett claimed that in 40 years, he has never gotten an idea from a 24 Wall Street report. 25 26 27 Diversification: Twaddle 28 Buffett and Munger took their annual poke at modern portfolio theory 29 (MPT) by zeroing in on popular notions about diversification. 30 Buffett noted that he likes to put a lot of money in things he feels 31 strongly about. Diversification makes no sense for someone who knows 32 what they are doing. “To buy number one on your list equally with number 33 37 strikes us as madness. Diversification is a protection against igno- 34 rance, a confession that you do not know the businesses you own.” 35 Buffett claimed that three wonderful businesses is more than you 36 need in this life and would serve you much better than 100 average busi- 37 nesses. 38 Munger took off the gloves, “Much of what is taught in corporate 39 finance classes is twaddle.” 40 41

57 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Buffett continued, saying that MPT has no utility. It is elaborate with 22 lots of little Greek letters to make you feel you are in the big leagues. 23 The ever understated Munger claimed that as a student of demen- 24 tia, he would rate MPT as beyond classification. 25 Buffett concluded that his trust owns only one stock, and he is per- 26 fectly content. 27 28 Borsheim’s 29 10 Buffett announced that last year’s special Sunday opening for Berkshire 11 Hathaway shareholders set a single-day sales record at Borsheim’s. This 12 year’s crowd bested that record by 60%. 13 Munger reported with great relish that a shareholder bought 14 $54,000 of jewelry at Borsheim’s and asked Munger to autograph the 15 receipt. 16 Munger exclaimed, “Now that is the kind of autograph we like to give! 17 Go thou, and do likewise.” 18 Buffett added that the autograph hound was not a member of Charlie’s * 19 family. 20 21 Disney: Share of Mind 22 With Disney’s takeover of Capital Cities/ABC, Berkshire has become a 23 major owner of Disney. 24 While there is plenty of competition in the entertainment busi- 25 ness, Buffett said he would rather start with Disney’s hand and Michael 26 Eisner running the show, by far. 27 The key according to Buffett is “share of mind.” What place will 28 Disney have in the minds of billions of children? He noted that while it 29 is hard to beat the name recognition of Coca-Cola, Disney is up there. 30 It is also nice to recycle Snow White every seven or eight years. Buffett 31 likened it to having a huge oil field where you pump and sell all the oil, 32 it eventually seeps back into the ground, and you get to sell it all over 33 again. 34 35 Wonderful Companies 36 37 Munger allowed that Berkshire’s portfolio is a product of their “slen- 38 der abilities.” 39 * A related story—when Bill Gates was in the market for a wedding ring, Buffett flew him 40 to Omaha for special treatment at Borsheim’s. Buffett noted that when he got married, he 41 spent 6% of his net worth on the ring. He encouraged Gates to do likewise.

58 1996

Buffett added that they are slim in their ability to predict where 1 change will lead. Thus, they are much better at products where change 2 will not mean as much: soft drinks, candy, shaving, chewing gum. 3 “There’s not a whole lot of technology going into the art of the chew.” 4 Buffett said the mindset of owning wonderful companies has 5 worked far better than he would have predicted 20 years ago. 6 7 8 We Love Focus 9 Buffett was emphatic in saying that they love focused management. 10 Coca-Cola and Gillette both lost their focus along the way. When they 11 regained their focus, it added billions of dollars to shareholder wealth. 12 GEICO lost its focus in the early 1970s and nearly went out of business. 13 Buffett said he loves the focus Coca-Cola and Gillette have on max- 14 imizing their potential for global distribution with 80% and 70% of 15 profits, respectively, coming from abroad now. 16 17 18 Downsizing 19 While it is no fun being the village blacksmith when the car comes 20 along, Buffett noted that it is in the interests of society to get maximum 21 output per unit of input. Businesses should become more efficient, not 22 less so. Since 1900, efficiencies in farming have freed much of the farm 23 workforce to pursue other activities. 24 He encouraged people to read a recent Forbes article on how jobs have 25 changed over the past 100 years. He claimed that there is no more dis- 26 placement now than 10 years ago, though it is in the interests of society 27 to care for those who are displaced. 28 Munger said to think of the problem in reverse. While he could 29 not name one business ruined by downsizing, he could think of many 30 ruined by bloat. 31 He concluded, “There’s no social benefit to idle employment.” 32 33 34 Ownership: Cost of Capital 35 Buffett has long chastised the way stock options are handed out in 36 boardrooms. 37 He said it is awful the way businesses reward executives with no 38 regard for capital. For example, a 10-year fixed price option is basically 39 an interest-free loan. A more appropriate option plan would set the 40 strike price at not less than fair intrinsic business value and would have 41

59 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 a yearly step-up relating to the cost of capital. Executives would still have 22 no downside, but at least there would be a carrying cost of ownership. 23 Munger said he preferred the old-fashioned way—have executives 24 buy stock in the market. 25 Buffett concluded that there is a very easy way to think like a share- 26 holder: Become one. 27 28 29 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

60 1 1997 2 3 4 5 Venue: AK-SAR-BEN 6 7 Attendance: 7,700 8 9 Details About This Year: 10 11 • In past years, we have privately accused the University of 12 Berkshire Hathaway of becoming a party school. This year 13 Buffett admitted as much, calling it the “capitalist’s version 14 of Woodstock.” 15 • It may be a sign of the times that so many thousands of 16 people fl ocked to Omaha to hear Buffett and Munger speak. 17 People came from all 50 states and over a dozen foreign 18 countries. 19 20 Fortune 500 Ranking: 132nd 21 22 Stock Price: $34,159 23 24 One dollar invested in 1964 would now be worth $2,761. 25 Berkshire’s per-share book value has grown from $19.46 to 26 $25,488 (a rate of 24.1% compounded annually). 27 28 The S&P 500 compounded at 11.1% annually for the same 29 period. 30 31 32 33 34 35 36 37 38 39 40 41

61 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1997’s Notes 22 23 24 McDonald’s: Not Inevitable 25 26 In this year’s annual report, Buffett referred to Coca-Cola and Gillette 27 as “The Inevitables” due to their massive market dominance. 28 Normally, Buffett does not discuss recent purchases but did so with 29 McDonald’s (as of year-end, Berkshire owned over 30 million shares 10 of McDonald’s at a cost of $1.265 billion). 11 He explained that with food, you will never get the total certainty of 12 dominance of Coca-Cola or Gillette. People move around with restau- 13 rants, seeking variety. Convenience is a huge factor—people stop at the 14 one they see. 15 In contrast, Buffett claimed there will never be another major soft 16 drink company. Coke’s infrastructure is incredible. 17 Munger noted that many have failed at having a successful chain of 18 restaurants (e.g., Howard Johnson’s). The restaurant business is much 19 tougher than the razor business. With food, people will switch with 20 competitive pricing. Meanwhile, Gillette sees few customers changing 21 their shaving habits to save a few dollars. The Gillette Sensor has been 22 a huge success. 23 24 Irrational Exuberance 25 26 Buffett repeated his warning in the annual report that you can pay too 27 much even for a wonderful business and that the overpayment risk is 28 currently quite high. 29 Munger was emphatic, guaranteeing that real inflation-adjusted 30 returns will be lower in the long-term future. 31 Buffett said it would not surprise him in the least if stocks averaged a 32 4% return over the next 10 years.* 33 Buffett explained that falling interest rates and a huge earnings 34 improvement over the past decade combined to produce much higher 35 U.S. stock valuations. Those factors are widely recognized now. 36 Buffett noted that after a while, people can become captivated by 37 rising prices, and the conditions are there for bubble-type excess. 38 39

40 * Contrast this to the Louis Harris & Associates survey (commissioned by Liberty Financial) 41 where the majority of mutual fund investors polled expect double-digit returns to continue.

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1 Returns on Equity 2 On a related topic, Buffett admitted he never thought average returns 3 on corporate equity would go to 22%. 4 He added that it does not seem sustainable with long-term interest 5 rates of 7% and a substantial savings rate. Competitive forces should 6 come into play to drive returns lower. 7 Munger cited two contributing factors: 8 1. It became fashionable for corporations to buy-in shares 9 10 2. Anti-trust became more lenient toward acquisitions of competitors. 11 Munger noted it cannot go on forever. At 15% a year, stock returns 12 are growing far faster than the economy itself. Sooner or later, some- 13 thing has to happen. 14 Buffett added, if real GDP grows at 3% annually and the capitalized 15 value of American industry grows at 10% annually, eventually it gets 16 absurd. With a $7 trillion GDP and a $7 trillion market cap, we are not 17 there yet, but projecting it out, it goes off the tracks. 18 Buffett allowed that, if current returns on equity are sustainable and 19 there is no change in interest rates, you can justify 7000 on the Dow. 20 However, if interest rates move up or returns on equity decline, market 21 values would be pulled down. 22 23 Flightsafety International 24 25 Last year, Berkshire Hathaway acquired Flightsafety International. 26 Munger joked that due to a counter revelation, they would change 27 the name of the Berkshire corporate jet from “The Indefensible” to 28 “The Indispensable.” 29 Buffett said Flightsafety’s simulators are so good that a pilot may 30 spend 100% of a five-week training program on them. A joint venture 31 with Boeing provides global growth opportunities for Flightsafety. 32 33 Business Risk 34 Owning a stock means owning a piece of a business. 35 Accordingly, Buffett noted there are several key business risks. 36 The first involves capital structure. A company with a ton of debt 37 could be a candidate for foreclosure. 38 The second relates to the nature of the business and its capital re- 39 quirements. With commercial airlines, for example, tons of capital is 40 required upfront, and competition is intense. 41

63 UNIVERSITY OF BERKSHIRE HATHAWAY

21 A third risk occurs with commodity businesses. Unless you’re the 22 low-cost producer, these are poor businesses to own. 23 Overall, Berkshire seeks low-risk businesses with sustainable compet- 24 itive advantages and strong capital structures. 25 26 27 Market Risk 28 If the business is sound, there remains the risk of paying too much. 29 Here, the risk is time versus loss of principal. If you overpay, it will take 10 time for the business value to catch up to the price paid. 11 The key is to remember that the market exists to serve you, not in- 12 struct you. Volatility is a huge plus to real investors. 13 14 15 Intel 16 17 Buffett noted one of his rules is understanding the business, to be able to 18 have a pretty good idea where it will be in 10 years. That excludes a very 19 large group of opportunities, from cocoa beans to rubles. As a result, 20 Berkshire has seldom invested in technology, passing on even Intel and 21 Microsoft. 22 In a fascinating digression, Buffett recounted how he was on the 23 Grinnell College endowment committee in the 1960s when Grinnell 24 bought 10% of the private placement that founded Intel. Despite know- 25 ing the chairman of Intel, who explained the business to him at length, 26 Buffett claimed he was a poor student. A few years later, the investment * 27 committee sold Grinnell’s Intel shares. 28 29 GEICO 30 31 Buffett proclaimed GEICO is doing even better than he expected when 32 Berkshire bought it out. 33 Voluntary auto insurance grew 10% in 1996, GEICO’s best year in 34 two decades. The first four months of 1997 have been even better with 35 premium growth approaching 20%. 36 With the growth in float and high policy-retention rates, Buffett 37 noted GEICO’s growth in intrinsic value is larger than its growth in re- 38 ported earnings. 39 40 41 * Don’t cry for Grinnell—it’s the best endowed private college in Iowa.

64 1997

Already the seventh largest auto insurer in the U.S. with 2.7% of the 1 market, GEICO should see significant market share gains in the decade 2 ahead. 3 4 5 The Ovarian Lottery 6 When asked what the ideal rate of taxation on capital gains might be, 7 Munger recalled Aristotle’s observation that systems work better when 8 perceived as fair. 9 Buffett launched into an intriguing thought problem he called “the 10 ovarian lottery.” You are to be born in 24 hours. You are also to write all 11 the rules that will govern the society in which you will live. However, you 12 do not know if you will be born bright or retarded, black or white, male 13 or female, rich or poor, able or disabled. How would you write the rules? 14 Buffett said how one comes out in this lottery is far more important 15 than anything else to one’s future. He and Munger were huge winners 16 having been born American (“in Afghanistan, we wouldn’t be worth 17 a damn”), male (at a time when many women could only be nurses 18 and teachers), white (when opportunities for minorities were slim) and 19 good at valuing businesses (in a system that pays for that like crazy). 20 Buffett noted it is important to take care of the non-winners of the 21 ovarian lottery. Therefore, some sort of taxation is in order. Given that 22 few people with money and talent are turned away from free enterprise 23 under the current system, the 28% capital gains tax is probably okay. 24 25 26 Filters 27 In the Berkshire report, Buffett claims he can give an answer on a pro- 28 spective acquisition in five minutes. 29 He can do so, first, because he is already familiar with most of the 30 companies of the size large enough for Berkshire to consider. Second, fil- 31 ters simplify the decision-making process. Munger noted people under- 32 rate the importance of a few big ideas. Filters work really well because 33 they are so simple. 34 Over the course of the meeting, they gave out numerous such filters. 35 Here are a few: 36 37 Opportunity Cost—Munger noted that for any corporate stock, 38 a bond is an alternative. You must choose the best opportunity 39 you can understand. He summed up, “Life is a whole series of 40 opportunity costs.” 41

65 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Quality People—Buffett said he looks for a manager who bats .400 22 and loves it. Munger noted there are many wonderful people and 23 many awful people. Avoid the awful. Stick to those who take their 24 promises seriously. 25 Good Businesses—Go with those that are understandable with a 26 sustainable edge. The pond you choose is far more important than 27 how well you swim. 28 29 10 Executive Compensation 11 Buffett and Munger took their annual shot at executive stock options, 12 the use of which has become epidemic. 13 Buffett argued such options should have a step-up in exercise price. 14 Otherwise, they simply become a royalty on the corporation’s buildup 15 of retained earnings. 16 In addition, Buffett argued such options should reflect the business’ 17 intrinsic value, not simply the market price. 18 Munger remarked that the accounting of options is weak, corrupt 19 and contemptible. 20 Buffett chimed, “Other than that, we’re undecided.” 21 In Munger’s view, the payment of options has gone to wretched 22 excess. 23 Despite the excess, Buffett said the real sin is mediocre management. 24 That is what costs the shareholders money. It is almost impossible to 25 overpay for good management. 26 For example, Coca-Cola’s market value was $4 billion and stagnant 27 when Roberto Goizueta took over in 1981. Today, the market value is $150 28 billion. 29 The right manager can have an absolutely huge impact. Find people 30 with brains, energy and integrity, and you can own the world. 31 32 Insurance 33 34 Berkshire takes on very large exposures (up to $1 billion) with its super- 35 cat writings. 36 Buffett explained that, while such exposures can be large dollar 37 amounts, Berkshire knows exactly what they are. 38 Munger noted that a billion-dollar loss would be just 2.5% of liquid 39 assets. The real supercat risks are those borne unwittingly by insurance 40 companies that could be wiped out by an unforeseen event. 41

66 1997

Buffett recalled Twentieth Century Industries, which all but went 1 broke after the Northridge Earthquake. 2 Buffett intoned, “Surprises in insurance are never symmetrical. 3 They are all bad.” 4 With $7 billion of float, momentum at GEICO and unmatched capi- 5 tal for supercats, Buffett concluded, “Insurance will be a very good and 6 very big business for us.” 7 8 9 Wesco Financial: Coin Flip 10 In past years, Buffett and Munger have repeatedly cautioned that Wesco 11 Financial is not a miniature Berkshire. However, this year, Buffett called 12 it a “coin flip” as to which was a better buy. 13 He allowed that Wesco is the logical place for the small acquisition, 14 unless it’s a business Berkshire is already in.* 15 16 17 On Learning 18 19 Munger noted that Buffett is the most rational person he has ever known 20 and that Buffett’s ability to learn has been essential to the success 21 of Berkshire. 22 For example, the notion of buying only understandable, predictable 23 businesses came from painful lessons learned after owning third-level 24 department stores and manufacturers of pumps and windmills. 25 Munger claimed that See’s Candy taught them the virtues of a 26 franchise-type business. Seeing how See’s played out in the marketplace 27 led directly to their bold purchase of Coca-Cola shares in 1988. 28 Buffett was emphatic, “Without See’s, we would not have bought 29 Coke.” 30 Munger bristled at the notion that he and Buffett are “aging exec- 31 utives,” exclaiming “I don’t know anybody who’s moving in the other 32 direction!” 33 Rather than age, learning is the name of the game. Munger noted it 34 is essential to learn from both the mistakes of others as well as your own. 35 He quoted Patton: “It’s an honor to die for your country. Make sure 36 the other guys get the honor.” 37 38 * Wesco Financial did buy Kansas Bankers Surety last year, and Buffett’s comments imply there may be more to come. This change in tune may account for Wesco’s 25% run-up since 39 the annual meeting. 40 41

67 UNIVER SIT Y O F BER KSHIR E HAT HAWAY

21 Buffett and Munger each expressed amazement at how little success- 22 ful businesses are studied, from GEICO to State Farm (which went from 23 nothing in the 1920s to an incredible 25% of the personal auto market 24 today) to Berkshire itself. 25 Buffett summed up, quoting Yogi Berra, “You can observe a lot just 26 by looking.” 27 28 29 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

68 1 1998 2 3 4 5 Venue: AK-SAR-BEN 6 7 Attendance: 10,000 8 9 Details About This Year: 10 11 • During the event, this year’s Berkshire Mall sold: 12 • 3,700 pounds of See’s Candy 13 14 • 4,000 Dilly Bars 15 • 1,635 pairs of Dexter shoes 16 17 • The annual report was printed in white and red to celebrate 18 Nebraska’s NCAA football championship. 19 • This year is the exception that proves the rule. 1998 is the 20 only year we didn’t publish a newsletter about the meeting. 21 In its absence, we sent out the following two articles, from 22 July and August 1998, about Berkshire Hathaway. 23 24 Fortune 500 Ranking: 150th 25 26 Stock Price: $46,080 27 28 One dollar invested in 1964 would now be worth $3,725. 29 Berkshire’s per-share book value has grown from $19.46 to 30 $37,801 (a rate of 24.7% compounded annually). 31 32 The S&P 500 compounded at 11.7% annually for the same 33 period. 34 35 36 37 38 39 40 41

69 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Highlights From 1998’s Notes 22 23 24 Berkshire Hathaway’s Mega Merger 25 26 “Berkshire Hathaway Inc. and 27 General Re Corporation to Merge 28 29 OMAHA, Neb. and STAMFORD, Conn.—(BUSINESS 10 WIRE)—June 19, 1998—Berkshire Hathaway Inc. and 11 General Re Corporation announced today that they have 12 reached a definitive agreement to merge. 13 Under the agreement, General Re shareholders will 14 have the option at closing of accepting either 0.0035 Class A 15 shares or 0.105 Class B shares of Berkshire. The transaction 16 is expected to be tax-free to General Re shareholders. Based 17 on Thursday’s closing prices, the value of the consideration 18 to be received by General Re shareholders is approximately 19 $276.50 per General Re share. The total consideration for 20 the transaction will be approximately $22 billion. The merger 21 will be accounted for by Berkshire as a purchase. 22 Pro forma for the transaction, Berkshire would have had 23 GAAP net worth of approximately $56 billion, as of March 24 31, 1998, the highest of any company in the United States, 25 and a market capitalization today of approximately $120 26 billion.” 27 28 So begins a most remarkable press release. 29 Warren Buffett has long poked fun at the “animal spirits” of CEOs 30 and their overwhelming urge to merge. 31 Seldom has empire (and ego) expansion been more evident than 32 in this age of the mega-merger. Now Buffett has joined the fray with his 33 biggest deal to date. 34 While our numbers are very rough, we find the merger with General 35 Re especially fascinating in a number of ways: 36 37 Lack of Coverage 38 39 The most brilliant investor of our time just made the biggest deal of his 40 life, yet we’ve seen just two stories in the Wall Street Journal since the ini- 41 tial press release. The silence is deafening.

70 1998

Buffett bought $700 million of silver, and the media chattered about 1 it for weeks. Now Buffett makes an investment 30 times larger, and there 2 is silence. 3 4 5 Scale of Deal 6 This is not simply Buffett’s biggest deal—it is his biggest deal by a factor 7 of 10. The $22 billion transaction amounts to 60% of Berkshire’s share- 8 holder equity of $34.8 billion (as of March 31, 1998). This is a “bet the 9 company” deal. 10 11 12 History 13 Berkshire purchased National Indemnity in 1967. Insurance has been 14 the core operation at Berkshire Hathaway ever since. 15 One of the shrewdest minds in the insurance industry, Buffett has 16 now purchased the world’s third largest reinsurance company. 17 This deal suggests far-reaching implications for the insurance industry. 18 19 20 Buffett is Selling (I): All-Stock Deal 21 22 Issuance of shares is a sacred issue at Berkshire. 23 Buffett has long said he would never issue stock unless he received 24 more than fair value in return. 25 In the 1997 annual report, Buffett even issues a “confession,” stating 26 that “when I’ve issued stock, I’ve cost you money,” and concludes, “you 27 can be sure Charlie and I will be very reluctant to issue shares in the 28 future.” 29 Berkshire/General Re is an all-stock deal. Either Berkshire stock is 30 ridiculously overvalued or this is an exceptional deal—or both. 31 32 Buffett Is Selling (II): Changing the Bond-Stock Ratio 33 34 With a 36% capital gains tax rate and over $30 billion in unrealized cap- 35 ital gains, Berkshire would pay a heavy price to sell its stocks. To a large 36 degree, Berkshire is trapped into holding on. 37 Only under very extreme circumstances would Buffett sell. Yet in the 38 * 1997 annual, Buffett admits to selling some stocks in an effort aimed at 39 40 * Positions in Disney, Wells Fargo, Freddie Mac, and McDonald’s were reduced. 41

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21 “changing our bond-stock ratio moderately in response to the relative 22 values that we saw in each market, a realignment we have continued in 23 1998.” Clearly, Buffett is a seller of stocks. 24 The purchase of General Re dramatically changes Berkshire’s bond- 25 stock ratio. 26 27 Investment 28 Assets Stocks Stock % 29 Pre-Deal Berkshire $50 billion $40 billion 80% 10 (3/31/98) 11 Added from General RE $24 billion $5 billion 21% 12 (12/31/97) 13 Post-Deal Berkshire $74 billion $45 billion 61% 14 15 16 In one fell swoop, Berkshire reduces its stock holdings as a percent- 17 age of investment assets from 80% to roughly 61%. 18 In effect, by doing a stock merger, Berkshire is trading away 18% of 19 its holdings in Coca-Cola, American Express, Gillette, etc., but doing so 20 in a way that Berkshire pays no taxes. 21 As my kids would put it, “Way cool.” 22 23 Float 24 25 In past Berkshire annual reports, Buffett has discussed the attractive 26 float-generating characteristics of his insurance companies. 27 Since 1967, Berkshire’s average float has grown from $17 million to 28 $7 billion. 29 Buffett has argued that if such float can be generated without an un- 30 derwriting loss, a dollar of float is worth at least as much as a dollar of 31 equity even though it appears on the balance sheet as a liability (mostly 32 under “net loss reserves and loss adjustment reserves”). If the float is 33 generated with an underwriting profit, it is clearly worth more than 34 equity. 35 Berkshire has had an underwriting profit each of the past five years. 36 In the case of General Re, the underwriting record is superb with 37 an average result of breakeven (a 100.4 combined ratio) over the past 38 50 years. 39 By our calculation, General Re generates over $15 billion of float. 40 Post-deal, Berkshire will have over $22 billion of float, a tripling of 41 Berkshire’s float. (In addition, Berkshire can probably nudge the float

72 1998 higher yet by establishing higher retention rates on General Re’s exist- 1 ing business. This is suggested in the press release: “General Re will be 2 free to reduce its reliance on the retrocessional market over time, and 3 thereby have substantial additional funds available for investment.”) 4 5 Deferred Taxes 6 7 As alluded to earlier, Berkshire has over $30 billion of unrealized capi- 8 tal gains. 9 As a result, Berkshire carries a liability (labeled on the balance sheet 10 as “Income taxes, principally deferred”) of about $11 billion to reflect 11 the tax Berkshire would pay if it realized all of its gains at once. 12 However, it is unlikely Berkshire would sell all at once. Thus, the 13 actual amount of this liability lies between $11 billion (sell all now) and 14 $0 (never sell). 15 Given Berkshire’s post-deal bond-stock ratio, the likelihood of never 16 selling is markedly increased. 17 Therefore, we would argue, most of the $11 billion deferred tax 18 liability may be added back to equity. 19 20 Adjusted Shareholders’ Equity 21 22 Taking these comments on float and deferred taxes to task, here is our 23 estimate of the “adjusted” shareholders’ equity (i.e., stated equity plus 24 float plus deferred taxes) of the new Berkshire (in billions). 25 26 Shareholders Deferred 27 Equity Float Taxes Total 28 Old Berkshire 29 $35 $7 $11 $50 (3/31/98) 30 General RE 31 $8 $15 NM $39 (12/31/97) 32 Purchase Goodwill $13 33 34 New Berkshire $56 $22 $11 $89 35 36 Purchase goodwill reflects the premium over book value that Berkshire 37 is paying for General Re. 38 With 1.5 million shares out post-deal and roughly $89 billion of 39 adjusted shareholders’ equity, the new Berkshire will have about 40 $59,300 of “adjusted book value” per share. 41

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21 Valuation 22 23 In terms of assets, with Berkshire A shares selling at around $78,000/ 24 share, Berkshire is selling at 1.3 times our estimate of “adjusted share- 25 holders’ equity.” 26 On assets, 1.3 times equity is not particularly cheap for a leveraged 27 balanced fund. 28 In terms of income, adding $995 million of net income from General 29 Re to Berkshire’s $1,930 million of look-through earnings and assuming 10 a 10% growth rate, post-deal Berkshire would produce roughly $3.2 11 billion of prospective look-through earnings (about $2,145 per post- 12 deal share). 13 The A shares then sell at about 36 times earnings. 14 On earnings, a PE of 36 is rich, but there are certainly worse things 15 to own than a collection of fabulous businesses overseen by a brilliant 16 allocator of capital. 17 Especially with Internet stocks trading at 100 times revenues! Our 18 favorite comment from this year’s Berkshire annual meeting: When 19 asked how he would teach business students, Buffett said, “For the final 20 exam, I would take an Internet company and say ‘How much is this 21 worth?’ And anybody that gave me an answer, I would flunk.” 22 A small tip—by purchasing General Re at recent prices (around 23 $258/share), investors can create ownership in Berkshire—assuming 24 the deal is going through—at about a 6% discount to Berkshire’s 25 current price. 26 27 28 Buffett’s Connections 29 Time and again, Buffett’s reputation and relationships have paid divi- 30 dends for Berkshire shareholders. 31 It seems reasonable to assume the ability to trust Buffett was essential 32 to the deal. The trust goes both ways as Ron Ferguson, CEO of General 33 Re, will join Berkshire’s board. 34 35 36 Buffett Is Selling Stocks 37 38 In our recent analysis of Berkshire Hathaway’s $22 billion merger with 39 General Re (“Berkshire Hathaway’s Mega Merger”), we contend that 40 Warren Buffett is selling stocks in at least two ways. 41

74 1998

First, he is issuing $22 billion of Berkshire stock to make the pur- 1 chase. 2 Second, we speculate that by merging Berkshire’s stock-heavy portfo- 3 lio with General Re’s bond-heavy portfolio, Berkshire will dilute (“sell”) 4 pro rata its holding in Coca-Cola, Gillette, American Express, etc. 5 This marks Berkshire’s most significant sale of stock since 1969. 6 The notion that Buffett is selling elicited only moderate response 7 from our clients. Apparently, we have been cautious for so long, it is the 8 sort of thing you expect to hear from us. 9 However, we want you to know the idea has sparked interest from 10 the media. The July 31, 1998, edition of Grant’s Interest Rate Observer 11 featured the sale as its lead article. Mr. Grant was so kind as to refer to 12 our piece as “the clarifying analysis of the landmark transaction.” 13 Grant’s, in turn, is read by a fairly sophisticated investment crowd 14 (from which we have received a few calls this week). 15 Be prepared for the idea “Buffett is selling stocks” to surface elsewhere 16 in the media. 17 18 19 Buffett Is Selling Bonds 20 Buffett disclosed in Berkshire’s 1997 annual report that he had purchased 21 $4.6 billion of long-term zero-coupon bonds as a bet on declining 22 interest rates. 23 In announcing its second quarter results this week, Berkshire said that 24 it had sold its entire position of zero-coupon bonds for a substantial gain. 25 Clearly, Buffett does not think interest rates will go much lower 26 from here. 27 28 29 Cash Is King 30 The most brilliant investor of our time is selling stocks and long-term 31 bonds, raising cash. 32 This at a time when liquidity levels of public and private pension 33 plans are the lowest in 15 and 40 years, respectively. Equity mutual fund 34 cash levels are at a 22-year low of 4.6%. 35 What does it mean? 36 At a minimum, it means Buffett believes neither stocks nor long 37 bonds offer an adequate margin of safety and/or an expected return 38 above the risk-free rate of 5% offered by Treasury bills. Better to hold 39 cash and keep the powder dry for better risk/reward opportunities. 40 41

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21 More precariously, it could presage a significant sell-off. The 22 predominant fear among today’s investors has been missing out on a 23 soaring stock market. High expectations and high equity valuations 24 leave little margin for error. No one should be surprised if we have a 25 major downdraft in the market. 26 Indeed, according to a recent Wall Street Journal article, such a sell- 27 off is already underway. 28 29 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

76 1 1999 2 3 4 5 Venue: Holiday Inn Convention Center 6 7 Attendance: 15,000 8 9 Details About This Year: 10 11 • In addition to selling See’s Candy, Dexter shoes and 12 Quikut knives, a Berkshire apparel line was unveiled in 13 The Berkshire Mall. 14 15 Fortune 500 Ranking: 112th 16 17 Stock Price: $70,134 18 One dollar invested in 1964 would now be worth $5,670. 19 20 Berkshire’s per-share book value has grown from $19.46 to 21 $37,987 (a rate of 24% compounded annually). 22 The S&P 500 compounded at 12.2% annually for the 23 same period. 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 1999’s Notes 22 23 24 The Market 25 26 As in years past, Buffett was asked what he thought about the stock 27 market. As in years past, he said, “We don’t think about it.” 28 His focus has always been to find great businesses. When he finds 29 one with great management and great economics at a reasonable price, 10 he buys it either in whole (an acquisition) or in part (a stock market 11 purchase). 12 Currently, Buffett sees no bargains among large cap stocks. When 13 he cannot find things to buy, the money piles up. When he does find 14 something, he piles in. 15 Munger noted that for decades, Berkshire had 100% of its book net 16 worth in marketable securities and owned companies to boot. While 17 they may have trouble investing new money today, it is really no “trouble” 18 to have a pile of money. 19 He concluded, “There shouldn’t be any tears in the house.” 20 21 Future Returns 22 23 As they said last year, the real long-term rate of return for the U.S. stock 24 market has to go down. 25 Buffett suggested dramatically reduced expectations were called for 26 by investors. With 4%–5% GDP growth and 1% inflation, it is unlikely 27 that corporate profits will grow faster than 5%–6%. Otherwise, profits 28 will eventually be greater than the GDP! 29 Buffett quipped, “Sort of like New York having more lawyers than 30 people.” If profits cannot grow 5% or more, how can equities grow at 15%? 31 Buffett put it another way: imagine a farm (the Fortune 500) valued 32 at $10.5 trillion that produces $334 billion of profits. Paying $10.5 33 trillion for that farm would not produce a good return on investment. 34 35 The $200 Million Club 36 37 As in years past, Buffett allowed that technology and pharmaceuticals 38 are two big areas in which he has not participated. 39 However, he again highlighted his willingness to trade away big pay- 40 offs for certainty. It is much easier to pick the relative strength of Coca- 41 Cola than it is to pick a winner in software.

78 1999

Buffett reiterated the importance of staying within one’s circle of 1 competence. Jet airplane technology has been pretty static the past 2 20–30 years, making NetJets quite predictable. The Dilly Bar is more 3 certain than any software company over the next 10 years. 4 Buffett put it another way. He noted there are some 400 companies 5 in the U.S. that earn more than $200 million in after-tax profit. In five 6 years, the list may grow to 450–475. Maybe 20 of those additions will 7 come from nowhere. 8 However, dozens and dozens of small companies are priced to do so 9 currently. Many will disappoint shareholders. 10 Similarly, biotech stocks were all the rage five years ago, yet how many 11 are making $200 million today? 12 In a capitalist society, everyone is watching you. Competition is 13 fierce. The $3 billion market cap company is rare. 14 He concluded, “You want to think about the math of it.” 15 16 17 General Re 18 We remain amazed by how little attention has been paid to Berkshire’s 19 largest ever acquisition—last year’s $22 billion purchase of General Re. 20 One of the most important elements of the Berkshire Hathaway 21 wealth-compounding machine has been the generation of low-cost float 22 by its insurance operations. 23 With General Re, Berkshire’s float now totals $24 billion (up impres- 24 sively from a humble $17 million in 1967). 25 In the short run, Buffett sees little growth in float from General 26 Re due to the current softness in reinsurance markets. GEICO’s float 27 generation will have a more significant growth rate. 28 In addition, with limited investment prospects currently, investment 29 returns on the float will remain unexciting in the short run. 30 Long term, Buffett and Munger are impressed with the talent and 31 quality of the people at General Re and look forward to the opportunities 32 that being the world’s premier reinsurer may offer. 33 34 35 GEICO 36 Buffett continues to be enthusiastic about prospects for Berkshire’s 37 largest subsidiary, GEICO. 38 He expects the direct writer of auto insurance to have 4.5 million 39 policyholders by year-end (double the number GEICO had in 1995, the 40 year prior to its acquisition by Berkshire). 41

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21 Closing in on 4% of the U.S. auto insurance market currently, Buffett 22 believes GEICO will be many times bigger 10 years from now. 23 He sees the Internet as a plus. GEICO’s low prices and national rep- 24 utation have already generated Internet sales. 25 In time, Buffett believes GEICO’s direct model should grow more 26 and more powerful. 27 28 Retail and the Internet 29 10 Buffett sees that the Internet will have a huge impact on retailing. 11 In some areas, the Internet threat is so significant that he would 12 avoid them altogether (greeting cards, for example). 13 However, in other areas, the Internet will have less of an impact. Buffett 14 believes Berkshire’s furniture stores, for one, will be little affected by 15 the Internet. 16 Brand names will be important. Buffett doubts that people will go to 17 brand “X” over the Internet. For example, Buffett believes online jewelry 18 sales will go to a name people trust, such as Tiffany’s or Borsheim’s 19 (look for Borsheims.com). 20 Buffett also noted that real estate dedicated to retailing would be 21 affected. For Internet retailers, there is no rental expense. Cyber real 22 estate is free. 23 24 Tough to Predict 25 With a fascinating bit of history, Munger explained that it is tricky 26 attempting to predict what changes in technology will do: 27 The development of the streetcar led to the rise of the department 28 store. Since streetcar lines were immovable, it was thought that the 29 department store had an unbeatable position. Offering revolving credit 30 and a remarkable breadth of merchandise, the department store was 31 king. Yet in time, while the rails remained, the streetcars disappeared. 32 People moved to the suburbs, which led to the rise of the shopping center 33 and ended the dominance of department stores. 34 Now the Internet poses a threat to both. 35 36 Business Moat 37 38 Buffett noted that a dollar of earnings from “.com Inc” and a dollar of 39 earnings from “Horseshoe Corp” are equal. 40 What really matters is the “moat” around the business. The greater 41 the moat, the greater the certainty and the amount of future cash flows.

80 1999

The key dangers relate to changes in market share, changes in unit 1 demand and the allocation skills of management. 2 The bigger the moat, the less great management is needed. As Peter 3 Lynch has said, “Find a business any idiot could run because eventually 4 one will.” 5 Buffett cited Wrigley’s and Coca-Cola as businesses with wide moats. 6 With Coke, he noted that its share of mind with the world’s six billion 7 people is remarkable. Even the container is identifiable. 8 9 10 Telecommunications 11 12 Buffett agreed that there is a lot of money to be made in telecommuni- 13 cations for those who understand it. 14 While Walter Scott (Berkshire board member and chairman of 15 Level 3) has tried to explain those changes, Buffett feels he has no big 16 insight into them. 17 However, Buffett added that there is a big difference between iden- 18 tifying a growth industry and minting money. 19 He noted that AT&T’s return on equity over the years has been 20 poor. Change has hurt the company more than it has helped. 21 Similarly, he cited the airline and auto industries as examples of 22 huge growth industries where very few got rich. 23 Munger piped up that it reminds him of the World War II aircraft 24 officers: When asked by the commanding officer what they did, Lieu- 25 tenant Jones replied, “I do nothing, sir.” The second replied, “I help 26 Lieutenant Jones.” 27 Munger concluded, “That’s been my contribution to our telecom- 28 munication investments.” 29 30 31 Living Rich 32 Buffett contended that the average college student has the same stan- 33 dard of living as he does. Same food. No important difference in clothes, 34 cars, TVs. (Though Buffett could not resist yet another plug, admitting 35 that he does travel better thanks to NetJets.) 36 After you have enough for daily life, all that matters is your health 37 and those you love. Likewise in work, what really matters is that you enjoy 38 it and the people with which you work. 39 Munger concluded humorously, “What good is health? You can’t 40 buy money with it.” 41

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21 Accounting Abuse 22 23 Buffett claimed that it has become fashionable to play games with the 24 accounting of revenues and expenses.* 25 According to Munger, “big bath” accounting and the subsequent 26 release of reserves back into earnings have, together, probably been the 27 biggest abuse. 28 Buffett believes the auditors should have fixed the problem, but it 29 probably is now up to the SEC and Arthur Levitt (whom Buffett greatly 10 admires). 11 Munger warned that corruption in accounting systems was a signif- 12 icant factor in Japan’s collapse over the past decade—a lesson in how 13 important it is not to let slop into the system. 14 15 16 NetJets 17 Buffett is enthusiastic about the prospects for Executive Jet Aviation 18 (EJA), which Berkshire purchased for $750 million last year. 19 Through its NetJet program, EJA sells fractional shares of jets and 20 operates the fleet for its many owners. 21 As Buffett likes to put it, EJA makes calling up your plane like phoning 22 for a taxi. 23 He credits Rich Santulli, CEO of EJA, with having the guts and the 24 vision to turn the idea of fractional jet ownership into a major business. 25 With EJA as part of Berkshire, Buffett believes the dominance and 26 speed of growth of EJA have been enhanced. 27 He expects EJA to be a very big global company in 10 to 15 years. 28 29 30 Supercat Insurance 31 32 While current premium rates are soft, Buffett believes Berkshire’s pre- 33 eminent position in the supercatastophe reinsurance market is stronger 34 than ever. 35 There is only a short list of competitors for the high-level covers that 36 Berkshire can offer. After the next supercat, Berkshire’s “Fort Knox” 37 reputation will be extremely valuable, he predicted. 38 39 40 * The 1998 Berkshire annual report includes several pages of discussion on the topic. 41

82 1999

1 Berkshire and the S&P 500 2 Currently, 6%–7% of investment funds in the U.S. are indexed. 3 Berkshire is not in the S&P Index, though it qualifies in all respects 4 save one: liquidity. 5 Buffett suggested a 12-month phase-in process, which has been used 6 in Australia. 7 As indexing continues to grow, liquidity problems will prevail for 8 Berkshire and throughout the market. Eventually, the S&P will need to 9 adjust for that. 10 Munger concluded that Berkshire will be in the S&P Index, sooner 11 or later. 12 13 14 Always Coca-Cola 15 16 Dismissing concerns about Coca-Cola’s prospects with the strength of 17 the dollar, Buffett said what really matters is share of market and share 18 of mind. 19 Coca-Cola’s market share is marvelous, and its share of mind is over- 20 whelmingly favorable with a ubiquity of good feeling. The keys to an- 21 alyzing Coca-Cola’s economic progress are l) unit cases sold (more is 22 better), and 2) number of shares outstanding (the fewer the better). 23 While it’s true case growth slowed over the last four quarters, Buf- 24 fett believes that is temporary and unimportant to a 10-year projection. 25 (Munger interjected that 10–15 year projections can tune out a lot 26 of noise.) 27 Buffett concluded that it’s hard to think of a better business in the 28 world. There may be companies that could grow faster, but none as solid. 29 30 31 32 33 34 35 36 37 38 39 40 41

83 21 22 23 24 25 26 27 28 29 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 1 2000 2 3 4 5 Venue: Omaha Civic Auditorium 6 7 Attendance: 10,000+ 8 9 Details About This Year: 10 11 • Corey and Dan split meeting duties this year. Corey attended 12 the Berkshire meeting in Omaha while Dan attended the 13 Wesco Financial meeting in Pasadena, California. 14 15 Fortune 500 Ranking: 64th 16 17 Stock Price: $56,177 18 One dollar invested in 1964 would now be worth $4,541. 19 20 Berkshire’s per-share book value has grown from $19.46 to 21 $40,442 (a rate of 23.6% compounded annually). 22 The S&P 500 compounded at 12.4% annually for the same 23 period. 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2000’s Notes 22 23 24 25 General Re 26 Despite recent losses at Gen Re, Buffett and Munger remain steadfast in 27 their long-term optimism for their reinsurance operation. 28 They believe Berkshire has advantages in its ability to pay, willingness 29 to pay and pricing discipline verses the competition. 10 Buffett claimed that if he had known what Gen Re’s losses would be 11 prior to Berkshire’s takeover, he still would have done the deal. 12 13 14 Share of Mind 15 16 Buffett returned to a concept he has brought up numerous times, relating 17 that “if share of mind exists, the market will follow.” 18 He noted that consumer product organizations understand this. For 19 example, 75% of the people in the world have something in their mind 20 about Coca-Cola, and overwhelmingly, it is favorable. 21 Similarly, most Californians have something in their mind about 22 See’s Candy, and overwhelmingly, it is favorable. 23 Add a few more California minds over the years, make thoughts a 24 little more favorable and See’s future growth will be assured. 25 Buffett regaled shareholders with the trials and tribulations of Amer- 26 ican Express, which has maintained a very special position in people’s 27 minds about financial integrity and worldwide acceptance. 28 When banks closed in the 1930s, American Express Travelers Cheques 29 actually replaced bank activity to some degree. Despite some big mistakes 30 over the years, the American Express name has huge value and cachet 31 (which is growing even stronger under current management). 32 33 Technology Stocks: Chain Letters 34 35 Buffett and Munger were much more strident this year than last in their 36 comments on the market, claiming that stock speculation today is prob- 37 ably the highest ever in the U.S. history. 38 Munger called it the most extreme event in modern capitalism. 39 To illustrate the craziness, Buffett said that a company may have a 40 market cap of $10 billion but would be unable to borrow even $100 41

86 2000 million at the bank. Yet the owners may be able to borrow many, many 1 times that amount.* 2 Buffett compared the technology sector’s run-up to a “chain letter” 3 in which early participants reap rich rewards at the expense of those 4 that follow. 5 He referred to the dramatic increase in casino-like day-trading activity 6 as “asinine.” 7 Buffett noted that “in the last year, the ability to monetize shareholders’ 8 ignorance has never been greater” and warned that average investors 9 should reduce expectations. 10 Munger was especially acerbic about Internet speculation: “You are 11 mixing a good concept, such as the Internet, with irrational excess. But 12 if you mix raisins with turds, they are still turds.” 13 14 Internet Lowers Profit Margins 15 16 At the Wesco Financial meeting, Munger claimed that the single big- 17 gest outcome of the Internet has been little understood: buyers are the 18 winners. And that means it is quite likely corporate margins will shrink with 19 greater bandwidth. And that, in turn, may not be good for stock prices. 20 Munger noted that high profits on capital often rely on information 21 inefficiencies. A really efficient auction system will remove such ineffi- 22 ciencies as it enables the buyer to find the low price. 23 He related the story of IBM computer tab cards. With a monopoly on 24 tab cards, IBM made 25% profits. When IBM was forced to open up the 25 tab card market, lots of little companies entered the business. Bids were 26 competitive. Prices collapsed. Tab cards became a pure commodity. 27 This may well be the net effect of the Internet. 28 At the Berkshire meeting, Buffett noted that a certain streetcar 29 intersection in Omaha had once been prime retail real estate. At the 30 time, people thought, “Who would ever tear up the streetcar lines?” 31 He concluded, “With the Internet, the streetcar lines get torn up 32 every day.” 33 34 Big Truth: Know What to Avoid 35 36 At the Wesco Financial meeting, Munger took aim at performance chas- 37 ers, noting that investors need only to have a sensible way to keep wealth 38

* Some banks eager to get IPO fees have reportedly been lending to dot-com owners with 39 dot-com stock as collateral. 40 41

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21 growing (especially if they are already rich). If someone else is getting 22 rich, so what? Someone else will always be doing better. 23 He asserted that the notion that an investor or investment manager 24 should be “required” to beat everyone else is nonsense. The real key is 25 to know what you really want to avoid and give those things a wide berth 26 (such as a bad marriage, an early death, and so on). Do this and life will 27 go much better, he advised.* 28 29 10 Against the Grain 11 Buffett and Munger believe shareholders are poorly served by many of 12 today’s corporate compensation packages. 13 Buffett expressed concern about the lottery ticket mentality inherent 14 in the massive issuance of stock options. In particular, he noted that, 15 when the top person gets an outrageous amount, that gets pyramided 16 through the organization. 17 Munger concluded that a lot of the corporate compensation plans 18 of the modern era work just about the way things would work for a 19 farmer if he put a rat colony in the granary. 20 21 22 Microsoft Trial 23 24 Buffett thinks the U.S. Department of Justice attempt to break Micro- 25 soft apart is unwise. “We’ve got something working very well. It doesn’t 26 make sense to tinker with it.” 27 He noted that 20 years ago, the U.S. had an inferiority complex 28 over its place in the world. American industry was falling behind that of 29 Japan or Germany. 30 But with software development now, “We’ve just swept everyone 31 aside. We’re so far ahead that it is difficult to see who is number two.” 32 He predicted that the software sector will become ever more important. 33 34 Small Expectations 35 36 At both the Berkshire and Wesco Financial meetings, a reading and 37 rereading of Buffett’s Fortune article was recommended. 38 * It was as if Munger was responding to the following quote from Kindleberger’s Manias, 39 Panics, and Crashes: “Nothing is so disturbing to one’s well-being and judgment as to see a 40 friend get rich.” 41

88 2000

In it, Buffett suggests that expectations of a 6% annual return in 1 stocks over the next 17 years would be rational. 2 At the Berkshire meeting, Buffett said, “We do not think the general 3 ownership of equities is going to be very exciting over the next 10 to 15 4 years.” 5 At the Wesco Financial meeting, Munger noted that after the 1930s, 6 America developed a moral aversion to stocks. 7 As one comedian of the time put it, “They told me to buy stocks for 8 my old age. It worked perfectly. I bought stocks, and within six months, 9 I felt like an old man.” 10 Today stocks are extremely popular, making opportunities few and 11 far between. 12 Not despairing, Munger quoted Mr. Macawber: “Something will 13 turn up.” 14 As reported in recent letters, Berkshire is increasing its activity in the 15 purchase of wholly owned businesses. Berkshire bought several busi- 16 nesses last year, and Wesco Financial purchased Cort, a furniture rental 17 business.* 18 19 20 Effective Rationality 21 For several years, Munger, ever the philosopher, has been promoting 22 the idea that we should all employ an interdisciplinary approach to solv- 23 ing human problems. 24 By learning the primary models in each major discipline (such 25 as compound interest and probability in math and break-points and 26 back-up systems in engineering) and applying all of them, he asserts 27 that people will make better decisions. 28 In particular, the errors created from overusing any one model (“for 29 the man with the hammer, every problem looks like a nail”) can be 30 avoided. As an example, Munger discussed the economic collapse of 31 Japan. 32 Over the past decade, Japan did all the things Keynesian economics 33 would recommend, including lowering the interest rates and increas- 34 ing the money supply. The Keynesian “hammer” was surprisingly inef- 35 fective. It was Japanese psychology that the economists failed to take into 36 account. 37 38

* According to the 10-K, Wesco Financial even took advantage of the Internet boom, selling 39 roughly $30 million of Homestore.com that Cort owned in February. 40 41

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21 Chastened by their losses in the 1990 Japanese stock market crash, 22 Munger concluded that people were afraid to borrow and that banks 23 were afraid to lend no matter what the rates were. 24 At the Wesco Financial meeting, Munger recommended “effective 25 rationality” as a lifelong pursuit. 26 27 28 29 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

90 1 2001 2 3 4 5 Venue: Omaha Civic Auditorium 6 7 Attendance: 10,000+ 8 9 Details About This Year: 10 11 • Corey’s rigorous note-taking enables us to pass along the 12 following golden nuggets, as Daniel was absent this year. 13 14 Fortune 500 Ranking: 40th 15 16 Stock Price: $71,120 17 One dollar invested in 1964 would now be worth $5,749. 18 19 Berkshire’s per-share book value has grown from $19.46 to 20 $37,920 (a rate of 22.6% compounded annually). 21 The S&P 500 compounded at 11.8% annually for the same 22 period. 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2001’s Notes 22 23 24 One Big Idea: Float 25 26 Few investors understand one of the great secrets to Berkshire Hathaway’s 27 wealth-compounding machine: float. 28 Insurance companies collect premiums, of which a significant portion 29 go into reserves to pay future claims. This reserve (“float”) earns money 10 for Berkshire, leveraging the company’s return on capital. 11 Low-cost float has turbo-charged Berkshire’s returns. Furthermore, 12 Buffett has grown the float incredibly from $17 million in 1967 to $27 13 billion at year-end 2000. 14 Buffett looks for twin virtues of increased growth and reduced cost 15 for Berkshire’s float in 2001. 16 At the same time, he expects that float to grow to $30 billion 17 (roughly 10% of the U.S. total). Buffett expects the cost of float, absent a 18 mega-catastrophe, to drop under 3% on an annualized basis (versus 19 a 6% cost of float last year), with additional improvements in years to 20 come. 21 The value of float is powerful leverage. 22 As Munger put it, “Basically, we’re a hedgehog that knows one big 23 thing. If you generate float at 3% per annum and buy businesses that 24 earn 13% per annum with the proceeds of that float, we have figured 25 out that’s a pretty good position to be in.” 26 27 Reduced Expectations 28 29 In his 1999 Fortune article, Buffett talked about the unlikelihood of 30 corporate profits in the U.S. getting much higher than 6% of GDP. 31 The range has been 4%–6% historically, and we’ve been up around 32 6% recently. 33 Buffett continued that if you’re already capitalizing those profits at a 34 very big multiple, then you have to conclude that the value of American 35 business will grow roughly at the rate of GDP growth. That growth, in 36 turn, should probably be around 5% a year with a couple of points a 37 year of inflation as well. 38 Buffett concluded that stocks are a perfectly decent way to make 6% 39 or 7% a year over the next 15 to 20 years. But anybody that expects to 40 make 15% per year is living in a dream world. 41

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1 Pension Scandal 2 Buffett said it was particularly interesting how, back in the 1970s, when 3 the prospects for stocks were better, pension funds were using assump- 4 tions in the 6% range. Now, when prospects are way poorer, most pension 5 funds have built-in assumptions of 9% or better. 6 He said he didn’t know how pensions were going to make 9% or better, 7 but if assumptions were reduced, it would significantly reduce the com- 8 panies’ reported income. And no one wants to do that. 9 Buffett said it will be interesting to watch how quickly assumptions 10 change as pension shortfalls mount in the years to come. 11 Munger concluded that pension fund accounting is drifting into 12 “scandal” because of these unreasonable assumptions. 13 He compared the situation to living on an earthquake fault, building- 14 up stress and projecting that the longer it’s been without a quake the 15 less likely a quake is going to occur. It’s a dumb way to write earthquake 16 insurance and a dumb way to do pension fund planning. 17 18 19 California Utility Crisis 20 Munger observed that the production of electricity is an enormous and 21 fundamental business. But the California mess exposes a flaw in our 22 education system as all sorts of smart people—utility executives, gov- 23 ernors, journalists—have difficulty realizing the most important thing 24 with a power system is to have surplus capacity. 25 Everyone knows you build a bridge that can handle a lot more than 26 the maximum load. That same margin of safety is essential in a power 27 system. Yet according to Munger, very intelligent people are ignoring 28 this single most important and most obvious fact. 29 Buffett elaborated that the power system probably should have 30 about three elements from a societal standpoint. 31 One is to be efficient. A second would be to produce a fair but not 32 excessive return on capital to attract capital for future needs. Third, 33 you’d want Munger’s margin of safety, an ample supply. 34 In the old regulated system, operators were paid to stay 15%–20% 35 ahead of the demand curve. However, in the old regulated system, 36 operators were not paid to be efficient, so some sloppiness could result. 37 However, Buffett noted, the problems of some sloppy management 38 are nothing compared to the problem that results from inadequate 39 generation. 40 41

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21 As California deregulated, ownership of utility assets shifted to 22 people who had no interest in excess supply. In fact, they wanted too little 23 supply since a shortage would increase their return on assets. 24 So Buffett explained that a situation was created where the interests 25 of the operators diverged from those of society. You simply cannot have 26 utility plants built for X sold to entrepreneur operators for 3X and expect 27 electricity prices to fall. Buffett concluded that this was a very, very 28 basic mistake. 29 That said, Buffett said there will be a need for more power gener- 10 ation. As the electricity industry grows, it will need lots of capital, and 11 there should be ways to participate in that where Berkshire can get 12 reasonable returns on capital.* 13 14 The Biggest Mistake: Opportunity Cost 15 16 Munger observed that the most extreme mistakes in Berkshire’s history 17 show up as opportunity costs. 18 While few managements think about it, Buffett claimed blown op- 19 portunities have cost Berkshire’s shareholders “billions and billions and 20 billions of dollars.” 21 Munger gave a dramatic example of how, with the power of com- 22 pounding, blown opportunities can cost an awesome amount of money. 23 In his younger days, Munger was offered 300 shares of Belrich Oil, 24 which, by his analysis, offered no possibility of losing money and a large 25 possibility of making money. He bought. Three days later, he was offered 26 1500 shares, which he refused since he’d have to sell something to buy 27 them. 28 Munger claims that mistake, traced through to today, cost him $200 29 million. 30 Buffett qualified the notion of mistakes as those things within their 31 circle of competence. Missing a big move in cocoa futures is not an error 32 since that is something they know little about. An error is when it’s 33 something they understand, but then they don’t act on it in a big way. 34 Munger elegantly calls it “thumb-sucking.” 35 36 Liability Awards: Lottery Tickets 37 38 Buffett was quite concerned about mushrooming product liability 39 awards.

40 * Berkshire’s utility subsidiary, MidAmerican Energy, recently announced plans to build two 41 new power plants in Iowa.

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The asbestos liability mess is just one example. Unless there is a leg- 1 islative solution, Buffett sees more and more of GDP going to liability 2 awards. 3 He noted that an attorney can gamble a modest amount of time and 4 have a payoff of tens or hundreds of millions. 5 Paraphrasing Lincoln, one of Buffett’s attorney friends reportedly 6 said, “I’m just looking for 12 jurors you can fool all of the time.” 7 Munger noted that the increasing power of the bar was especially 8 pernicious. State supreme justices are on for life unless they upset some 9 particular special interest group. 10 Munger claimed this accounts for far too much tolerance for junk 11 science, junk economic testimony and trashy lawyers. And he sees few 12 signs of improvement. 13 Buffett concluded that the liability trend will probably accelerate, and 14 therefore, investors should build a margin of safety to account for it. 15 16 17 Sugar 18 19 Buffett believes that food companies are probably not at much risk of 20 product liability. 21 In the case of sugar, Buffett noted the average human body eats 22 something like 550 pounds in dry weight of food in a year, and about 23 125 pounds (over 20%) of that consists of sugar in one form or another. 24 Yet the average life span of Americans keeps going up. 25 Buffett concluded that he would not be at all worried about product 26 liability for Coca-Cola, See’s Candy or Dairy Queen. 27 28 29 The Internet: A Huge Trap 30 The idea that you could take almost any business and turn it into wealth 31 on the Internet has been pretty much discredited. 32 Buffett reported that the Internet threat to Berkshire’s furniture 33 and jewelry business has diminished substantially. Very prominent dot- 34 coms in both industries that had valuations of hundreds of millions 35 have vanished in short order. 36 What the Internet really did, asserted Buffett, is give promoters 37 the chance to monetize the hopes and greed of millions of investors 38 through venture capital markets. A lot of money transferred from the 39 gullible to the promoters. Very little real wealth has been created. 40 He concluded, “The Internet has been a huge trap.” 41

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21 Munger interjected that he and Buffett were once in the grocery de- 22 livery business, a “terrible business.” Munger observed that someone got 23 the idea it was a great business and turned it into an idea on the Internet. 24 Buffett noted that the grocery store in question was the “infamous” 25 Buffett and Son, which barely supported the family for 100 years. 26 The only way it worked, Buffett joked, was to hire guys like Munger 27 as slave labor. 28 While they took orders with a pencil instead of a keyboard, once they 29 started hauling them on trucks, they ran into the same costs as Webvan. 10 11 Brand vs. Retailers 12 13 Buffett explained that there will always be a battle between brands and 14 retailers. The retailer would like his name to be a brand. And to the extent 15 that people trust Costco or Wal-Mart as much as they trust the brands, 16 then the value of the brand moves over to the retailer from the prod- 17 uct itself. 18 Munger observed that brands such as Kellogg’s have seen a power 19 shift toward grocery chains like Wal-Mart and Costco.* He went on to 20 say that the muscle power of Sam’s Club and Costco has gotten very 21 extreme. 22 Munger boasted that a woman thanked him for her pantyhose, 23 which she’d purchased at Costco at his recommendation (Costco has 24 co-branded with Hanes). 25 Buffett quipped, “She must be pretty desperate if she’s consulting 26 with you about her pantyhose.” 27 28 Extrapolating the Past: Massively Stupid 29 30 Reprising Buffett’s Fortune article in the fall of 1999, Munger said the 31 shareholding class in America should reduce its expectations a lot. 32 In his usual understated way, Munger asserted, “It’s stupid the way 33 we extrapolate the past. Not just stupid, massively stupid.” 34 Buffett noted that it’s a mistake for any company to predict 15% 35 growth, yet plenty of them do. For one thing, unless the U.S. economy 36 grows at 15% annually, the 15% number catches up to you. Very few 37 large companies can compound at 15%. Yet during the bubble, people 38 were valuing businesses at $500 billion, and there was no mathematical 39 calculations that would possibly lead you to justify those valuations. 40 41 * Munger is on the board of Costco.

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Munger said that to some degree, stocks sell like Rembrandts. In- 1 stead of selling on the value people will get from looking at the picture, 2 they sell based on the fact that Rembrandts have gone up in price in the 3 past. If you fill every pension in America with Rembrandts, Rembrandts 4 will keep going up and up. 5 Buffett asserted that the biggest money made in Wall Street in recent 6 years has not been made by great performance, but by great promotion. 7 Munger claimed the current scene is “obscene,” with too much mis- 8 leading sales material and television emphasis on speculation. 9 10 11 Starting Early 12 13 Buffett advised younger attendees to start saving early. 14 He acknowledged that he was fortunate that his dad paid for his 15 education. As a result, he was able to save $10,000 by the time he was 16 21—a huge head start. 17 He noted that it’s much easier to save during your teen years when 18 your parents are taking care of your financial obligations. He surmised 19 that every dollar saved then is worth $20. 20 He also suggested that getting knowledge about business has a simi- 21 lar compounding effect. 22 He recommended learning about local businesses—which ones are 23 good and why, which ones went out of business, etc. As you go, you’ll 24 build a database in your mind that is going to pay off over time. 25 26 27 Invest in Yourself 28 Buffett asserted that the very best investment you can make is in yourself. 29 Buffett shared that, when he talks to students, one of the things he 30 tells them is what a valuable asset they have in themselves. 31 Buffett would pay any bright student probably $50,000 for 10% of 32 their future earnings for the rest of his life. So each student is a $500,000 33 asset just standing there. What you do with that $500,000 asset should 34 be developing your mind and talent. 35 36 37 Know the Big Cost 38 39 Buffett and Munger have repeated year after year that they seek to 40 buy businesses with enduring competitive advantages. This year, they 41

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21 treated listeners to an extended discussion of one key element of a 22 wonderful business: the cost structure. A superior cost structure is often 23 fundamental to a business’ sustainable advantage. 24 At Flightsafety the key is quality simulators, so Berkshire is investing 25 $200 million annually in flight simulators. 26 At NetJets, first-class pilots are essential, so for that business, costs 27 are very people-intensive. 28 In the carpet business, Buffett continued, only 15% of costs relate 29 to employees. The big cost in that industry is the raw materials, fibers. 10 In the insurance business, the big cost is future claims, which involves 11 lots of estimating since claims might be paid five, 10 or 20 years later. 12 In retail, the big cost is rent, with labor being a significant secondary 13 cost. 14 Buffett summarized that the big cost can vary enormously by the 15 type of business you’re in. 16 He said he doesn’t really care whether they’re buying into raw- 17 material-intensive businesses, people-intensive businesses or capital- 18 intensive businesses. The key is to understand a company’s costs and 19 why it’s got a sustainable edge against its competitors. 20 21 22 Labor Costs 23 24 This line of thought continued with a fascinating review of the airline 25 industry. 26 Buffett noted that the big problem with airlines is not so much 27 aggregate revenue, but whether your average costs are out of line with your 28 competitors. Since airline travel is pretty much a commodity business, 29 costs are the key factors. The biggest cost is labor. 30 However, Munger noted that the pilots’ union is very tough since 31 the union knows no airline can stand a prolonged shutdown with the 32 chaos it causes to routes. The figure to look for with airlines, then, is 33 cost per available seat mile and the cost per occupied seat mile. 34 At USAir, for example, when Munger and Buffett were directors for 35 a time, the costs were 12 cents a seat mile—which was fine until South- 36 west Airlines came in at 8 cents a seat mile. 37 In airlines, as with many other industries in a capitalistic society, 38 business will eventually gravitate to the low-cost player. 39 In contrast, Buffett claimed that fractional jet ownership is not a 40 commodity business. NetJets’ clients care enormously about service and 41 safety.

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He wryly observed that if you were going to buy a parachute, you 1 wouldn’t necessarily take the low bid. 2 If NetJet can maintain and grow its excellent pilot force, it should do 3 well for years and years to come. 4 5 6 Playing Chicken 7 One of the best stories of the day was how Buffett handled a strike 8 shortly after he bought the Buffalo News. 9 In a fascinating real-life study in game theory, Buffett noted that some- 10 times the weaker you are, the stronger your bargaining position may be. 11 (Buffett joked that buying the Buffalo News was Munger’s idea: 12 Munger was stuck in Buffalo during a blizzard, and he called Buffett to 13 ask what he should do. So Buffett told him to go out and buy a paper.) 14 In the early 1980s, the Buffalo News and the Courier-Express were in a 15 kind of death struggle. Thus, dealing with the union became a game of 16 chicken because if the paper closed down, everyone would lose his job. 17 The union struck on a Monday. 18 Buffett recalled that some union leaders had tears in their eyes 19 because they knew it would put them out of business. 20 Buffett took the position with the union that if you come back in a 21 day, we’re competitive. If you come back in a year, we’re out of business. 22 If you’re smart enough to figure out exactly how far you can push us 23 where we still have a business and you still have a job, you’re smarter 24 than I am, so you go home and figure it out. 25 They came back to work on Thursday, and the Buffalo News made it.* 26 Buffett observed that it was out of his hands. If the union had decided 27 to strike long enough, his investment and their jobs would have been 28 lost. 29 The Buffalo News’ weakness proved to be its bargaining strength. 30 31 32 The Berkshire Advantage 33 While Buffett lamented Berkshire’s size as an anchor to future growth, 34 he also enumerated some of Berkshire’s advantages. 35 For one, its checks clear. 36 Buffett noted that Berkshire is a preferred purchaser for many compa- 37 nies because they know the deal will not have any financing difficulties.† 38 39

* Eventually, the Courier-Express folded. 40 † Berkshire currently has $30 billion in cash. 41

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21 For example, Berkshire bought Johns Manville for cash at $13/ 22 share just after a $15/share offer fell through due to the other bidder’s 23 financing difficulties. 24 Sellers also know Berkshire’s ownership structure is stable and that 25 they will be able to run their businesses as before. 26 Buffett anticipated that Berkshire might buy 40 companies, roughly 27 two a year, over the next 20 years. 28 While the investment arena is extremely competitive, Buffett guar- 29 anteed that sometime in the next 20 years, people will do something 10 exceptionally stupid in equity markets. The question for Berkshire is, 11 will it be in a position to take advantage of it when the time comes. 12 Buffett added that there is no master plan. They will just keep 13 allocating capital as rationally as they can. 14 Munger asserted that it’s a sure thing that in 20 years, Berkshire will 15 have way more strength and value behind each share. 16 And he added, it’s an absolutely sure thing Berkshire’s annual 17 percentage rate of progress will go way down from what it has been in 18 the past. 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

100 1 2002 2 3 4 5 Venue: Omaha Civic Auditorium 6 7 Attendance: 14,000 8 9 Details About This Year: 10 11 • Nebraska Furniture Mart did $14.2 million in sales for the 12 “Berkshire Weekend.” This was up from $5.3 million in 1997 13 when special event pricing was fi rst introduced. 14 15 Fortune 500 Ranking: 39th 16 17 Stock Price: $75,743 18 One dollar invested in 1964 would now be worth $6,123. 19 20 Berkshire’s per-share book value has grown from $19.46 to 21 $41,727 (a rate of 22.2% compounded annually). 22 The S&P 500 compounded at 11% annually for the same period. 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2002’s Notes 22 23 24 25 Dampen Expectations 26 Munger asserted one of the smartest things to do now is to dampen 27 expectations way down. 28 Buffett noted there is nothing wrong with earning 6% to 7% on your 29 money. 10 With inflation so low, how much more return is capital entitled to? 11 Munger described Berkshire’s large bond holdings as a “default 12 option” reflecting their lack of enthusiasm for stocks. 13 Buffett and Munger like the Berkshire model in this environment. 14 With low-cost float, significant earnings power and occasional bargains, 15 Berkshire should do just fine. 16 17 18 Float 19 20 From modest beginnings of $12 million in float generated by National 21 Indemnity in 1967, Berkshire has grown float, incredibly, to $37 billion. 22 Buffett believes that to be roughly 9% of the estimated $400 billion 23 float generated by the U.S. property and casualty insurance industry. 24 25 26 Visuals 27 UBH went multimedia this year featuring several slides. 28 Buffett’s enthusiasm was evident as he showed a slide of the Berkshire’s 29 insurance group’s underwriting profit in Q1, a sharp reversal from last 30 year’s 13% cost of float. In addition, the slide showed Berkshire’s float 31 grew $1.8 billion in the quarter. 32 If Berkshire can consistently underwrite profitability, this $37 33 billion of float constitutes an interest-free loan with which to leverage 34 Berkshire’s earnings.* 35 Buffett credited new General Re (Gen Re) CEO Joe Brandon with 36 doing a great job in redirecting Gen Re’s culture. 37 Buffett predicted Gen Re will be Berkshire’s No. 1 asset. 38 39

40 * Invested simply in 10-year Treasuries, this float will generate $1.9 billion in annual pre- 41 tax income.

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1 Float and Oil Wells 2 Buffett compared float to oil wells where, every day, some goes out. As 3 you pump the oil, you must seek to replace it. 4 Buffett noted that Berkshire’s float has less natural run-off then any 5 other company because much of it is “long tail” business—like a long- 6 lived oil well. 7 In addition, Buffett noted that Berkshire seems to attract lots of 8 special transactions. 9 Munger concluded, “Growing float at low or no cost is almost impos- 10 sible. We intend to do it anyway.” 11 12 GEICO 13 14 The nation’s largest direct writer of auto insurance grew policies in 15 force, modestly rising to 4.8 million. 16 Buffett noted that each GEICO policyholder was worth at least 17 $1,000 to Berkshire. 18 While GEICO’S inquiry rate has slowed, a higher close rate per in- 19 quiry and rising retention rate bode well for GEICO to increase its free 20 (as long as it underwrites profitability) and growing float. 21 22 Greatest Asset: Self 23 With graduation season upon us, Buffett offered some appropriate 24 worldly wisdom. 25 Imagine a genie comes to a 17 year old and offers to get him any 26 car he wants. However, there is one catch—whatever car he chooses he 27 must make it last a lifetime. Well, you can imagine that the young man 28 would read the owner’s manual 10 times, would change the oil twice as 29 often as suggested, etc. to help that car last 50 years. 30 In the same way, Buffett continued, we each receive one body and 31 one mind for a lifetime. You cannot repair them at age 60. You must 32 maintain them. 33 One’s greatest asset is one’s self. 34 Develop your mind and good health habits when you are young, and 35 it will enhance your life. If not, you may have a wreck at age 70. 36 37 38 Asbestos Litigation: Cancer on the Economy 39 Buffett and Munger offered dire predictions for spiraling liability 40 awards related to asbestos litigation. 41

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21 Unless Congress steps in to cap awards, Buffett predicted it will get 22 much worse. 23 Munger opined that asbestos litigation has morphed into fraud, 24 leading to meritless claimants (and their attorneys) receiving huge 25 sums while merited claimants go begging. 26 Buffett reiterated that this is a huge problem for corporate America, 27 “a cancer on the economy.” 28 Always seeing opportunity in the rubble of disaster, Buffett did sug- 29 gest that the asbestos mess may offer opportunities for Berkshire to 10 acquire companies freed from asbestos liability—as it did with Johns 11 Manville. 12 13 Terrorism: Reality 14 15 Buffett noted that humanity will always include a certain percentage of 16 psychotics, megalomaniacs and religious fanatics. 17 However, where the deranged few could do little more than throw 18 rocks for centuries, modern technology has enormously increased our 19 ability to inflict damage. 20 He added that, unfortunately, humankind has not progressed simi- 21 larly in our ability to get along. 22 Munger noted pragmatically that to the extent we are less weak, 23 foolish or sloppy, 9/11 will be a plus. While we may deeply regret what 24 happened, we should not regret facing reality with more intelligence. 25 He added the current installation of safety measures should have 26 been done long ago. 27 Buffett shared that he has long been worried about a terrorist nuclear 28 disaster, and 9/11 leaves his view unchanged. 29 With millions and millions of people who hate the U.S., Buffett sees 30 the likelihood of such an event someday as a near certainty. 31 32 Terrorism and Insurance 33 34 While the insurance industry may have long recognized the potential 35 damage by the lunatic fringe, it never wrote it into the contracts. 36 Buffett noted that this was a huge error, similar to what happened to 37 the insurance industry in England in the 1940s—only after the war did 38 companies think to exclude war coverage from contracts. 39 Berkshire’s new policies exclude NCB (nuclear, chemical, biological), 40 as well as fire from a nuclear event. 41

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Without such exclusions, Buffett asserted that a nuclear act or two 1 could destroy the entire insurance industry. 2 Insurance companies have long tried to avoid natural aggregation, 3 such as limiting homes insured on a shoreline.* 4 Now, Buffett asserted, companies need to think about manmade 5 aggregation risks. 6 As an example, while most folks think of the World Trade Center 7 disaster as primarily a property/casualty loss, Buffett noted it will easily 8 go down as the largest workers’ comp loss in history. 9 While not being specific, Buffett noted that a biological terrorist 10 event could create workers’ comp claims that would boggle the mind. 11 12 13 My Crooks Look Like Crooks 14 Munger noted that enormously talented people drift into fraud. The 15 culture carries them there. 16 Munger suggested the best response to fraud is to avoid it and that 17 there are whole fields to avoid. 18 Buffett asserted, “We won’t get defrauded. My crooks look like 19 crooks—normally, they tell you things too good to be true. They have a 20 smell about them.” 21 Munger remarked that sometimes it’s annoyingly obvious. Robert 22 Maxwell of England, for example, was nicknamed “The Bouncing 23 Check.” 24 Munger wryly observed that as a satire, it would be too extreme to be 25 funny. Yet Salomon aggressively pursued business with Maxwell. 26 Buffett added that it’s a hobby of theirs to keep track of the Maxwells 27 of the world. He asserted that Wall Street is no filter—Wall Street loves 28 their investment banking fees. 29 He noted First Normandy was IPO’d by Salomon Brothers even 30 though he and Munger were on the board and told them First Normandy’s 31 record was complete baloney. The IPO was cancelled a day after the pub- 32 lic offering. Salomon’s only explanation of this embarrassment was that 33 the underwriting committee approved it. 34 Munger added that he knew of no subsequent changes on the 35 underwriting committee. 36 37 38 * Yet natural aggregation errors occur frequently. Twentieth Century Industries nearly failed in 1994 when it wrote lots of homeowners insurance along the fault line of the 39 Northridge earthquake. 40 41

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21 EBIDTA: More Fraud 22 23 In a similar vein, Munger noted that the fraud group percentage is high 24 for those who talk “EBIDTA.”* 25 Buffett noted that such enormously successful companies as Wal- 26 Mart, GE and Microsoft never mention EBIDTA. Those who do are 27 probably conning you or conning themselves or both. 28 As an example, Buffett chided telecom companies that talk about 29 “cash flow” when they are spending every dime they get. It isn’t cash 10 flow if it’s all flowing out. 11 Professor Buffett continued that the “D” (depreciation) not only re- 12 flects a real cost, but the worst kind of cost. Depreciation reflects cash 13 that is spent first, and the deductions only come later. 14 Berkshire vastly prefers businesses where you get the cash up front 15 (like insurance). 16 Similarly the “T” (taxes) is a real cost. To pretend otherwise is delu- 17 sional. 18 Buffett concluded that it was amazing to him how widespread the 19 usage of EBIDTA has become. 20 21 Derivatives: Sewage 22 23 Berkshire is shutting down the derivatives operation at Gen Re. 24 Buffett likened derivatives to hell: “easy to get into and tough to get 25 out of.” He noted that the unwinding of Enron’s derivatives contracts 26 reveals that they were all money losers. 27 Munger concluded with a gem that may prove prophetic if derivatives 28 unravel elsewhere: “To say derivative accounting in America is a sewer 29 is an insult to sewage.” 30 31 Stock Options 32 Buffett and Munger shared their disgust with the flagrant abuse of stock 33 options in corporate America. 34 Munger asked rhetorically, if you handed 60-year-old surgeons at the 35 Mayo Clinic a bunch of stock options, would that improve their behavior? 36 Munger concluded that the fact that U.S. corporations routinely 37 dole out hundreds of millions of dollars to CEOs is “demented and 38 immoral.” 39 40 * Earnings before interest, depreciation, taxes and amortization. 41

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Buffett added that options are not bad in and of themselves. 1 He asserted that options that included a cost of capital factor and 2 were issued only at or above the company’s intrinsic business value 3 would be logical. However, that’s not how it’s been done. 4 Buffett also decried the shameless and self-interested way corporate 5 CEOs have been lobbying against treating options as an expense. 6 Munger summed it up as a “Mad Hatter’s Tea Party where the only 7 consistency is that the whole thing is disgusting.” 8 9 10 Creative Accounting 11 Munger noted that one of the great inventions of all time was double- 12 entry bookkeeping by an Italian monk. 13 Accounting that undoes the monk’s work is merely a tool for folly 14 and fraud, and hurts society. 15 He called Enron one of the most disgusting examples of a business 16 culture gone wrong. Though, he noted, good may come of it to the extent 17 others take notice. 18 He concluded, “creative accounting is a curse to civilization.” 19 20 21 Index Funds and PE’s 22 23 Buffett suggested that for those who believe U.S. businesses will do well 24 over time, dollar-cost-averaging into a broad-based index is a reason- 25 able approach. 26 As to whether a PE (price earnings ratio) of 25 is “too high,” Buffett 27 stated emphatically that no one ratio really works. It couldn’t be that easy. 28 Munger cautioned that it is possible for prices to get so high that 29 index funds won’t do well. 30 In Japan, for example, the Nikkei Index returns over the past 13 31 years have been negative. 32 Furthermore, Japan made all the right Keynesian moves, lowering 33 interest rates and providing massive fiscal stimulation, to no effect. The 34 models of the past failed to predict it. 35 It’s crazy for Americans to assume that what happened to Argentina 36 * and Japan won’t happen to us. 37 38

* Again, Berkshire has voted with its feet. Berkshire is now less invested in U.S. stocks than 39 any time since the early 1970s. 40 41

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21 Fruit of the Loom 22 23 What goes around comes around. 24 For a second time, Buffett has participated in the purchase of Fruit 25 of the Loom. 26 Buffett thanked Mickey Newman, his friend and former employer at 27 Graham-Newman, for helping Berkshire to complete the acquisition of 28 Fruit of the Loom from bankruptcy. 29 Buffett explained that Fruit of the Loom was victimized by too much 10 debt and poor management. 11 Berkshire’s bankruptcy bid for Fruit of the Loom was contingent 12 on retired CEO John Holland returning to run the company. Holland 13 agreed, and the deal was done. Buffett considers Holland and the 14 brand as Fruit’s key assets. 15 This was not the first time Buffett participated in the acquisition of 16 Fruit of the Loom. 17 He reminisced that in the 1950s, a Graham-Newman controlled entity, 18 Philadelphia and Reading Coal and Iron (P&R) purchased Union 19 Underwear from Jack Goldfarb for $15 million. 20 Subsequently, Union bought the license of the Fruit of the Loom 21 name and, along with P&R, was merged into Northwest Industries. Fruit 22 went on to achieve annual pre-tax earnings of $200 million.* 23 24 Just Say No 25 26 Success in insurance, Buffett intoned, depends on taking understand- 27 able risks properly priced without undue aggregation. The ability to say 28 no is crucial. 29 He noted that Jack Ringwalt, who founded National Indemnity in 30 1941, was not an insurance guy. But with old-fashioned common sense, 31 he beat the pants off the guys in Hartford. 32 Buffett said he wanted Berkshire’s insurance arm to be exposed to as 33 much business around the world as possible through a disciplined staff. 34 Munger concluded that in insurance and investing, if you combine a 35 vast exposure with a vast decline rate, you can do very well indeed. 36

37 * In a similar vein, Buffett wrote his college thesis on GEICO, presaging Berkshire’s pur- 38 chase of a large position in GEICO in the mid-1970s and eventual takeover of GEICO in 1996. With Coca-Cola, there is the story that as a boy, Buffett counted bottle caps in pop 39 machines to see which brands sold best. Fifty years later, he bought 200 million shares of 40 the stock. 41

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1 Waiting For the Fat Pitch 2 In a similar vein, Buffett has frequently used his “waiting for the fat pitch” 3 baseball analogy to describe Berkshire’s asset allocation approach. 4 In a fascinating digression, he noted that few other corporations do 5 likewise, and as a result, the aggregate allocation record for American 6 business is poor. 7 He recalled that GEICO, which has a great business, felt compelled 8 to make three acquisitions over the past 30 years. All were duds. 9 Gillette, with a 71% worldwide market share in shaving products, 10 felt compelled to issue stock to acquire Duracell, thereby trading stock 11 in a great business for ownership of an inferior one. 12 Buffett shared that he came across a company that made 10 deals 13 in five years. As of 2001, this company was 0 for 10 on successful deals. 14 In fact, Buffett estimated the aggregate profits of the 10 purchases 15 were one-quarter of the projected amounts. 16 Munger noted many corporations have large M&A departments 17 spending huge amounts of time to do huge amounts of due diligence. 18 Yet at least two-thirds of acquisitions are duds. 19 In contrast, Munger noted that Berkshire has done many great deals 20 with no such time spent. They wait for the no-brainer, the fat pitch. 21 22 Friends and Partners 23 24 Buffett and Munger met in 1959, and they’ve been friends ever since. 25 Buffett suggested it is helpful to list the qualities you would want in a 26 friend and then seek to instill those qualities in yourself. 27 He emphasized that it’s a matter of choice, not DNA. Anyone can 28 develop good character and quality lifetime habits. 29 Munger interjected that they know very successful businessmen who 30 do not have one true friend . . . and rightly so. “That’s no way to live a 31 life,” he concluded. 32 33 Keys to Investing 34 Buffett claimed that successful investing is not complicated. The Rosetta 35 Stone of investing is to remember that a stock is part ownership in a 36 business. That principle provides the foundation for rational investing. 37 Buffett read Ben Graham’s book, Security Analysis, in 1949 when he 38 was a student at the University of Nebraska, and he’s read nothing since 39 that improves on Graham. 40 41

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21 He added that temperament is very important, especially a willingness 22 to go away from the crowd. 23 He recommended realism in defining one’s circle of competence 24 and discipline to stay within the circle. He added that it helps to insulate 25 yourself from popular opinions. You’re better off sitting and thinking.* 26 27 Coping With Reality: Just Ask Why 28 29 Munger shared that it helps to have a passionate interest in knowing why 10 things are happening. That cast of mind over a long time, he asserted, 11 will improve its ability to cope with reality. Those that don’t ask why are 12 destined for failure, even those with very high IQs. 13 Buffett noted that lots of folks with very high IQs fail financially. 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38

39 * As Sir John Templeton did by moving to the Bahamas and as Buffett has done by staying 40 in Omaha. 41

110 1 2003 2 3 4 5 Venue: Omaha Civic Auditorium 6 7 Attendance: 19,000 8 9 Details About This Year: 10 11 • In the lobby, two-time U.S. chess champion Patrick Wolff 12 took on all comers—blindfolded. Champion bridge, 13 backgammon and scrabble players were also on hand to 14 compete with shareholders. 15 16 Fortune 500 Ranking: 28th 17 18 Stock Price: $72,865 19 One dollar invested in 1964 would now be worth $5,890. 20 21 Berkshire’s per-share book value has grown from $19.46 to 22 $50,498 (a rate of 22.2% compounded annually). 23 The S&P 500 compounded at 10% annually for the same period. 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2003’s Notes 22 23 24 Great First Quarter 25 26 Buffett’s opening remarks featured a review of Berkshire’s first quarter 27 results, the best in the company’s history. 28 Berkshire earned $1.7 billion and generated $1.3 billion of float, a 29 total cash generation of $3 billion (or $100 million a day). 10 While the non-insurance subsidiaries were sluggish, reflecting the 11 economic slowdown, the insurance units are hitting on all cylinders. 12 Buffett estimated that float grew 13% to $42.5 billion, though he 13 doubted whether it could grow much from here. 14 With total U.S. property and casualty insurance float of roughly 15 $500 billion, Berkshire now accounts for about 8% of total float. More 16 importantly, Berkshire is posting underwriting profits, which means the 17 float is created at no cost. 18 Buffett noted that this “free” float has the utility of equity without 19 the dilution of issuing shares. 20 From modest beginnings of $12 million of float generated by 21 National Indemnity in 1967, this float growth has been spectacular and 22 a major driver of the growth in Berkshire’s net worth. 23 Buffett compared the compounding of wealth at Berkshire to 24 a large snowball going downhill. He noted the Berkshire snowball is 25 good-sized, can attract a lot more snow, and there is probably a lot of 26 mountain and a lot of snow left. 27 28 Acquisitions 29 30 Berkshire can be seen as a collection of great businesses. Buffett’s favor- 31 ite activity is adding to that collection. 32 He discussed Berkshire’s most recent acquisition activity. 33 For one, Berkshire has offered $1.7 billion to buy Clayton Homes, 34 the nation’s best-run builder of manufactured housing. 35 Distress in the industry made obtaining financing from fearful lenders 36 difficult.* 37 By selling to Berkshire, Clayton will have access to capital and Berk- 38 shire’s AAA credit rating. 39 * The industry distress stemmed most notably from the bankruptcy of Conseco, which was 40 the largest insurer of manufactured housing mortgages, and for which Berkadia—a joint 41 venture of Berkshire and Leucadia National—made an unsuccessful bid.

112 2003

Buffett spoke highly of the Clayton family’s management record and 1 added that Berkshire will retain the mortgages Clayton originates.* 2 Buffett also discussed Berkshire’s acquisition for $1.5 billion of Wal- 3 Mart’s McLane subsidiary, a food distribution company that serves con- 4 venience stores, fast-food restaurants and other retailers.† 5 For those potential customers loathe to do business with Wal-Mart, 6 McLane is now a more palatable distribution source. 7 8 9 NetJets 10 Resale prices of pre-owned (industry jargon for “used”) jets have 11 plunged in this soft economy. 12 While that means losses for NetJets in the near future, Buffett noted 13 that NetJets has 75% of the market, or triple that of the next three largest 14 competitors combined. Furthermore, those three major competitors 15 are all losing money. 16 Buffett predicted an industry shakeout but assured the shareholders 17 that NetJets “will not be one of the shook.” 18 Long term, he predicted that fractional jet ownership will be a big 19 global business and that there could eventually be a 10-fold increase in 20 the number of folks flying this way. 21 22 23 Accounting 24 Asked if he recommended any books on accounting, Buffett advocated 25 getting all the accounting you can if you are in business. 26 Read lots of annual reports. Learn accounting by reading good busi- 27 ness articles, especially those on accounting scandals. Try to know how 28 the numbers are put together. 29 Then, if you cannot understand it, it is probably because manage- 30 ment doesn’t want you to understand it. Management always obfuscates 31 the facts for a reason. 32 Munger complimented Buffett’s command of accounting, saying, 33 “You might as well ask him if he has any good books on breathing.” 34 Munger concluded that it takes years to integrate an understanding of 35 accounting with life’s realities. 36 37

* We see this as a major Berkshire advantage—using its AAA balance sheet and massive 38 capital to reduce financing costs and to retain profitable business that less well-capitalized 39 companies cannot. † McLane has revenue of $22 billion, of which $7 billion comes from Wal-Mart, by our 40 calculations. 41

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21 Option Accounting 22 Buffett and Munger have been stern critics of option accounting ever 23 since the rules were changed in 1993.* 24 Buffett began by noting that any option has value. It’s silly to think 25 otherwise. 26 Options issued as compensation can work if there is 1) a cost of capital 27 associated with them, and 2) the issuance is tied directly to performance. 28 Unfortunately, almost all option issuance breaks both of these rules. 29 Instead, options have served more as lottery tickets or royalties on the 10 passage of time. 11 In the 1990s, they served as the conduit for a major wealth trans- 12 fer from shareholders to employees. Boards awarded options as if they 13 were handing out candy. Consultants promoted option issuances as if it 14 were play money. CEOs looking to juice earnings were pleased to issue 15 options as they were not treated as an expense. Employees enjoyed the 16 free lottery tickets. 17 No one in the system acted to protect the shareholders. The system 18 lacks what Buffett called a “parity of concern.” 19 20 21 More Accounting 22 As Buffett and Munger warmed to the topic, Buffett railed against all 23 sorts of expenses being hidden in the footnotes: “Why not put every- 24 thing in the footnotes, then you could have just two lines to report: 25 revenue and income?” 26 Buffett warned investors that management that refuses to expense 27 options or has fanciful pension assumptions will likely take the low road 28 on other matters as well. He cautioned, “There’s seldom one cockroach 29 in the kitchen.” 30 Buffett also decried the use of EBITDA (earnings before interest, 31 taxes, depreciation and amortization) as if depreciation wasn’t a real 32 expense. 33 Not only is it an expense, Buffett asserted, it is the worst kind of expense 34 where all the money is spent upfront. 35 Munger brought down the house with this teaching tool: “Every- 36 where you see ‘EBITDA’ in some analyst’s report, simply insert the 37 words ‘bullshit earnings.’” 38 39 * We remember attending the 1993 Berkshire meeting but not understanding why they 40 were so critical of FASB. After options started being issued like candy during the bubble, we 41 finally understood.

114 2003

Inflation 1 Buffett noted that inflation is the enemy of the investor. 2 He suggested that if we had 3% real GDP growth plus 2% inflation, 3 that would equal 5% nominal GDP growth. 4 With 1% to 2% in dividends (less frictional costs), returns of 6% to 5 7% for equity investors seem a reasonable expectation and not bad in a 6 low-inflation world. 7 With a nation of 100 million workers and a $10 trillion GDP, having 8 shareholders receive a 6% to 7% return is a perfectly acceptable outcome. 9 10 Quality GDP 11 12 Buffett made an interesting observation that we had not heard before. 13 He noted that GDP is often presented as a gross number. However, 14 he emphasized that per capita GDP is far more meaningful. 15 He added that “quality of GDP” would be an added factor worth 16 knowing. GDP that leads to improved standards of living is one thing. 17 Increased GDP from hiring more security guards is another—a lower 18 quality GDP than the former. 19 Inequality Helps 20 21 Munger is fond of saying the fail rate of all great civilizations is 100%. 22 However, he noted that one of the keys to a successful society is the per- 23 ception of fairness. Fostering this perception in America are the changes 24 at the top of America’s most wealthy families. If the same families have 25 the greatest wealth for decades, it can breed resentment. But that seldom 26 happens here—the DuPont heirs, for example, have given way to the 27 hard-charging managers at the Pampered Chef.* 28 And thus, the people see the system as fair. 29 30 Taxes 31 Likewise with taxes—Buffett spoke against the Bush plan to eliminate 32 double taxation of dividends. 33 If approved, Buffett could dividend out hundreds of millions of dol- 34 lars to himself, effectively lowering his tax rate to less than 1%, while his 35 secretary continued to pay taxes at a 30% rate. Such a differential could 36 only breed resentment.† 37 38 * Pampered Chef founder Doris Christopher, a home economics teacher starting out of her 39 basement in 1980, took annual sales from $50,000 to more than $700 million in just 22 years. † Buffett recently penned an op-ed piece in the Washington Post, making a case against the 40 Bush tax plan. 41

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21 Insurance Risks 22 23 Buffett and Munger noted that in insurance, you get handed a lot of 24 money for pieces of paper, and that can tempt you into doing very silly 25 things. A few large mistakes can completely undo years of wealth accu- 26 mulation. 27 As an example, they recounted how Mutual of Omaha got into rein- 28 suring property and casualty insurers and, in short order, wiped out half 29 of Mutual’s net worth, a net worth that took decades to build. 10 Another incredible example, GEICO wrote a paltry $72,000 of 11 net premium in commercial umbrella and product liability insurance 12 from 1981 to 1983. This small “bite of the apple” was enough to create 13 a breathtaking loss of $94 million, or about 130,000% of the net pre- 14 mium it received. Most of the loss was due to uncollectable receivables 15 from deadbeat reinsurers. 16 Part of what makes the industry dangerous, according to Buffett, is 17 that if you are willing to do dumb things in insurance, they will find you. 18 He painted an elaborate picture: If you were in a rowboat in the middle 19 of the Atlantic Ocean and just whispered a really dumb insurance price, 20 insurance brokers would be swimming to you from shore . . . with their 21 fins showing. 22 23 Correlation 24 Buffett continued that when things go bad, all kinds of things correlate 25 that you wouldn’t think of. Buffett said this is deadly. If you are not aware 26 of these correlations, you have an unrecognized concentration of risk. 27 When telecom debt collapsed, for example, people found that all of 28 it was correlated.* 29 Munger warned that derivatives have the same sort of danger and 30 that the accounting for them exacerbates the problem.† 31 32 33 Lifetime Learning 34 Munger noted that one of the most remarkable qualities of his friend, Warren, 35 is that he continues to get better with age and continues to keep learning. 36 Munger recalled how, in negotiating for the purchase of See’s Candy, 37 he and Warren would have walked if the sellers had asked for $100,000 38 39 * According to Jim Crowe, CEO of Level 3, there have been 180 bankruptcies so far in the bubble burst of the telecom sector. 40 † At last year’s meeting, Munger said he would compare derivative accounting to a sewer, 41 but that would be an insult to sewage.

116 2003 more. Ira Marshall told them they would be crazy to do that. They should 1 be willing to pay up for quality. 2 Marshall was right—since paying $23 million for See’s in 1971, the 3 candy company has generated over $1 billion of pre-tax profits for 4 Berkshire. That would have been a lot to give up for a paltry $100,000 5 difference. 6 Munger asserted that their ability to take constructive criticism has 7 been a key factor in Berkshire’s success, that “Berkshire has been built 8 on criticism.” 9 Buffett added that Ben Graham’s quantitative approach was easy to 10 teach. 11 In contrast, Munger emphasized the qualitative. They have learned 12 by experience that they have made more money with a wonderful busi- 13 ness at a fair price than a fair business at a wonderful price. While the 14 qualitative insight was much harder to come by, it has proved much 15 more valuable. 16 Regarding investment learning, Buffett recommended building 17 your database so that you accumulate knowledge over a lifetime. 18 They mentioned the Wall Street Journal and Fortune as favorite sources 19 and included the usual corporate filings. 20 One thing Buffett said he never reads are analysts’ reports. “If I read 21 one, it was because the funny papers weren’t available,” he quipped. 22 23 24 Opportunity Cost 25 26 Buffett and Munger agreed that their biggest mistakes have been errors 27 of omission rather than commission. 28 Despite the lesson learned at See’s Candy, Buffett confessed to a ten- 29 dency to stop buying shares of wonderful companies if the price moves 30 up. Buffett said that he stopped buying shares of Wal-Mart at one time, 31 and his recalcitrance cost shareholders $8 billion.* 32 Munger claimed that he and Warren have been slow learners. The 33 opportunity cost of the amount of money blown by headquarters at 34 Berkshire has been “awesome.” 35 Warren agreed. 36 Having already taken a swing at consultants, accountants, politicians 37 and analysts, Munger then took a shot at CEOs and their M&A depart- 38 ments. 39

* In past years, Buffett mentioned a similar mistake with Fannie Mae. This is the first time we 40 have heard him mention Wal-Mart in this regard. 41

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21 Munger asserted that all intelligent people base decisions on oppor- 22 tunity costs. The alternative returns available should weigh on whether 23 you make a particular investment. It is freshman economics. 24 Meanwhile, Munger continued, the rest of the world has gone on 25 a crazy kick to use wild and elaborate models for gauging the cost of 26 capital and other formulas for decision-making, resulting in “perfectly 27 amazing mental malfunctions.” 28 Buffett quipped, “Is there anybody we have forgotten to offend?” 29 10 11 The Fat Pitch 12 Buffett advised attendees that the “market is there to serve you, not to 13 instruct you.” 14 Munger advocated developing a temperament of owning securities 15 without fretting. If you focus on the price, you are really saying that you 16 believe the market knows more than you do. If you think of the value 17 of the business instead of the price, you will sleep better. If the market 18 were to shut down for five years, Acme Brick would still be turning out 19 bricks, and Dairy Queen would still be selling Dilly Bars. 20 They suggested that investing is more like parimutuel betting, where 21 you need only be right a few times as long as you don’t take a big loss. 22 Munger noted that most financial institutions do exactly the oppo- 23 site, fielding large research departments to track all 500 companies in 24 the S&P 500. 25 In contrast, Buffett said he only needs one or two good ideas a year. 26 In this way, Buffett seeks to emulate batting-great Ted Williams, who 27 knew his success resided in waiting for the fat pitch. 28 29 30 Big Opportunity in Energy 31 32 Buffett suggested to shareholders that MidAmerican Energy was already 33 a big business for Berkshire but could become much bigger, especially 34 if outdated laws are changed. 35 The energy field represents billions of dollars of opportunity: “We’re 36 not dealing with lemonade stands here.” 37 In addition, Buffett believes that they have fabulous managers with 38 David Sokol and Greg Abel. 39 Buffett noted that Berkshire brings something to the utility field, 40 and in fact, in 2002 it brought it, buying pipelines from companies that 41 would have otherwise gone into bankruptcy.

118 2003

1 Derivatives Warning 2 Buffett and Munger have warned of the dangers of derivatives for several 3 years. 4 Concerned that the warning has not been acted upon, Buffett allowed 5 Fortune magazine to reprint his thoughts on derivatives shared in the 6 annual shareholder letter, where he referred to them as “financial weapons 7 of mass destruction.” 8 In the energy field, nearly every utility in the country was brought to 9 ruin with participation in the sort of derivatives trading championed by 10 Enron. 11 In 1998, Long-Term Capital Management nearly paralyzed the entire 12 financial system with troubles magnified by the use of derivatives. 13 Munger grumbled that with engineering, safety is an enormous 14 concern, but with derivatives, it’s as if no one gave a damn about safety. 15 Furthermore, both parties of the typical derivative trade book an 16 immediate profit on the trade—this false accounting has sparked a 17 ballooning of the business. 18 Buffett added that, while participants claim derivatives help spread 19 risk, he believes that they have actually intensified risk since a few large 20 players do much of the business.* 21 Buffett cautioned that the counter-party risk in the system has been 22 little examined despite the warnings of past mishaps. 23 Munger stated that he would be amazed if he lives another five years 24 and doesn’t see a significant blow up. 25 26 The Best Story 27 28 The stories from the early days are always a treat. 29 This year, Buffett told the story of how Berkshire purchased National 30 Indemnity in 1967 from Jack Ringwalt. 31 Buffett said he had noticed that Ringwalt got into a fit of pique each 32 year for about 15 minutes, in which he would threaten to sell the company. 33 Buffett said he put a mutual friend, Charlie Heider, on alert to call 34 him the next time Ringwalt had an episode, so he could buy the company. 35 Sure enough, Heider soon called: “Jack’s ready.” 36 Buffett made the deal in the 15-minute zone, though he could tell 37 Ringwalt regretted it. Ringwalt tried to back out, asking, “I suppose 38 you’ll want to see audited financials?” 39

* This same thought has been put forward in past newsletters by Jean-Marie Eveillard, manager 40 of the First Eagle Global Fund. 41

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21 Sensing that Ringwalt was looking for an excuse to nix the deal, Buffett 22 replied, “I wouldn’t dream of asking to see audited financials.” 23 For $7 million, National Indemnity belonged to Berkshire. 24 Buffett also noted that Ringwalt was 10 minutes late for the meeting 25 because he was looking for a parking meter with a few minutes left on it. 26 Buffett joked, “That’s when I knew he was my kind of guy.” 27 28 Identical Twins 29 10 Buffett suggested the following thought problem. 11 Suppose you are in a womb with an identical twin. You are alike in all 12 ways. A genie appears with a proposition: “You will be born in the next 13 24 hours. One of you will be born in Omaha, the other in Bangladesh. 14 You two decide. You start the bidding with how much of your estate goes 15 back to society.” 16 Buffett said he would not hesitate to bid 100% of his estate, noting 17 that he probably would have died years ago of malnutrition had he been 18 born in Bangladesh. 19 The odds were 50 to 1 of his being born in the United States. He said 20 he was very lucky to be born here. 21 22 Successful Living 23 24 Buffett claimed that you are successful if the people you hope love you, 25 do love you. 26 He and Munger agreed that making money is no replacement for 27 friendship and happiness. 28 Buffett said they knew people with buildings named after them but 29 had no one who loved them. That’s no way to live. 30 Munger concluded with this joke: A minister presiding over a 31 sparsely attended funeral asked the crowd for a few kind words about 32 the deceased. After an awkward silence, he pleaded, “Isn’t there anyone 33 who can say a kind word for the deceased?” A voice from the back 34 croaked, “Well, his brother was worse.” 35 36 37 38 39 40 41

120 1 2004 2 3 4 5 Venue: Qwest Center 6 7 Attendance: Nearly 20,000 8 9 Details About This Year: 10 11 • The Qwest Center offers 194,000 square feet of exhibition 12 space for Berkshire subsidiaries. The expanded Berkshire 13 Mall now includes a 16,000 square foot Clayton Home. 14 15 Fortune 500 Ranking: 80th 16 17 Stock Price: $84,378 18 One dollar invested in 1964 would now be worth $6,821. 19 20 Berkshire’s per-share book value has grown from $19.46 to 21 $55,824 (a rate of 21.9% compounded annually). 22 The S&P 500 compounded at 10.4% annually for the same 23 period. 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2004’s Notes 22 23 24 Inflation Protection 25 26 With perhaps the most significant statement of the meeting, Buffett 27 asserted that inflation is heating up in the U.S. 28 This explains Berkshire’s shift from bonds to cash. 29 For inflation strategies, Buffett suggested, as a first line of defense, 10 that one increase his/her earning power. For example, if you are the 11 best surgeon or the best plumber in town, your wages will likely be more 12 than indexed to inflation. 13 As a second strategy, Buffett recommended owning businesses that 14 can price through inflation and have low capital expenditures to maintain 15 the business. 16 He cited See’s Candy as an example, noting that See’s has been a 17 business that can maintain its value regardless of current changes. 18 The worst sorts of businesses to own in an inflationary environment 19 are ones that require lots of capital to stay in the game and provide no * 20 real return. 21 Inflation is not the investor’s friend. Munger noted that it is virtually 22 ironclad that most people will get only a small return after inflation and 23 taxes. 24 As another line of defense, Munger suggested avoiding having “a lot 25 of silly needs in life.” 26 Buffett exclaimed, “Charlie, we’re selling consumer goods in the 27 other room! It’s OK to talk that way at home, but not here.” 28 To which Munger replied, “I do talk that way at home, but it doesn’t † 29 do any good.” 30 31 Independent Directions 32 In the furor over the lax behavior of directors, even Buffett has received 33 heat. 34 Recently, Calpers challenged his independence as a board director 35 of Coca-Cola. 36 In rebuttal, Buffett said that there is no substitute for thinking. 37 There is no magic checklist that is going to tell you in all cases whether 38 a director is independent. 39

40 * This describes most technology companies. 41 † As my grandmother used to say, “Be rich in the fewness of your wants.”

122 2004

Buffett argued that you could grab a man off the welfare line, pay 1 him a $100,000 annual director’s fee and he would meet the proposed 2 qualification of “independent.” Yet the man’s entire income would ride 3 on his fee! 4 Meanwhile, Berkshire owns roughly $10 billion worth of Coca-Cola 5 stock, but Buffett is not considered “independent” by the proposed 6 checklist. Yet who could care more about seeing that good decisions are 7 made but the largest shareholder? 8 Buffett concluded, quoting Bertrand Russell, “Most men would 9 rather die than think. Many do.” 10 11 Good Compensation 12 13 Buffett allowed that managers can make a lot of money at Berkshire, 14 but the bonuses are always related to performance. 15 For a good compensation agreement, he advised, you must under- 16 stand the keys to the business and keep it simple. 17 In a rather remarkable digression, Buffett shared how he knew that 18 the managers at MidAmerican Energy (David Sokol and Greg Abel) 19 were extraordinary, but what compensation arrangement would be 20 appropriate? He took three minutes to sketch out a proposal, showed 21 it to Walter Scott, talked to Sokol and Abel about it, made some slight 22 adjustments, and it was done. 23 He noted that the simple agreement they made with Chuck 24 Huggins, manager of See’s, in 1972 is still in place. Likewise, Berkshire’s 25 agreement with John Holland to run Fruit of the Loom runs a couple 26 of paragraphs. At GEICO, bonuses are based on the two variables that 27 * count. 28 29 Bad Compensation 30 31 In contrast, executive compensation in America exploded beyond all 32 reason over the past decade. 33 Buffett noted that executive compensation spun out of control due 34 to an “unequal intensity of interests.” While the board might see it as 35 play money, the CEO sees it as his livelihood. Thus, the CEO is most 36 motivated to seek pliant board members. 37 Buffett quipped, “They don’t look for Dobermans. They look for 38 Chihuahuas that have been sedated.” 39

* From past annuals, we believe those variables would be growth in policy holders (units) 40 and the combined ratio (profitability). 41

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21 Likewise, compensation consultants are brought in to make the 22 CEO’s case. 23 Munger concluded with characteristic understatement, “I would 24 rather throw a viper down my shirt than hire a compensation consultant.” 25 26 Guys Behaving Badly 27 28 Buffett and Munger went on to take their familiar shots at lawyers and 29 the need for tort reform, at accountants and how they sold out America 10 with spurious accounting and crooked tax shelters, at the mutual fund 11 scandal and how hundreds knew but no one told, and more. 12 Rather than reprise all the discussion of the morally marginal here, 13 we will summarize with Munger’s quote about the old robber barons: 14 “When they were talking, they were lying, and when they were silent, 15 they were stealing.” 16 17 Hair Trigger Markets 18 Munger noted that Berkshire had $31 billion of cash at year-end because 19 they had no compelling alternatives. 20 Buffett remained hopeful for opportunity because “prices some- 21 times do amazing things in securities markets.” 22 He noted that junk bonds in the fall of 2002 collapsed to where they 23 had yields to maturity of 35%–40%. Some of these same bonds now 24 yield just 6%—an incredible turnaround in just 18 months. 25 26 27 The St. Petersburg Paradox 28 Buffett asserted that the tendency to project out very high rates of growth 29 has caused investors to lose tons of money. 30 The “new economy” bubble was characterized by many such projec- 31 tions.* 32 Buffett recommended an article by Durand written 30 years ago on 33 the St. Petersburg Paradox for additional illumination. 34 As Buffett has often taught, the intrinsic value of an asset is the cash 35 it will earn from here to eternity, discounted back to the present. How- 36 ever, if your estimated growth rate is greater than your discount rate, 37 you get a value of infinity. 38 Clearly, Munger noted, you need to then back off to more realistic 39 numbers. 40 41 * Bob Rodriguez of FPA has said the same thing, referencing parabolic curves.

124 2004

While many analysts and companies persist in making 15% plus 1 growth projections, Buffett observed that this year’s Fortune 500 2 includes a 50-year retrospective that shows only a very few companies 3 were able to grow at even 10% or better over that period. 4 5 Derivatives: A Mad Hatter’s Tea Party 6 7 Buffett warned last year that derivatives could prove to be financial 8 weapons of mass destruction. They have only gotten larger since. 9 While the original idea of derivatives was to disperse risk, he ex- 10 plained, the system now has intensified risk on a few institutions. “There 11 is much more risk in the system because of derivatives,” he concluded. 12 In the case of Freddie Mac, Buffett noted that the financials were scru- 13 tinized by hundreds of analysts, a congressional oversight committee, 14 capable directors, auditors . . . and yet earnings were misstated by $6 15 billion—much of which was related to derivatives. It could just as easily 16 have been off by $12 billion. 17 Buffett warned that the scale of derivatives gets ever-larger, yet most 18 executives do not have their minds around them. 19 He confessed that he did not have his mind around the derivatives at 20 * Gen Re, and Berkshire is still unwinding that mess. 21 Buffett noted another brush with derivatives for him occurred with 22 the Salomon Brothers government bond trading scandal. Salomon 23 very nearly filed bankruptcy with $1.2 trillion in derivatives. With 24 Salomon having contracts in Japan and the U.K., as well as in the U.S., the 25 bankruptcy judge would have had an enormous mess on his hands. 26 Munger noted the common error is not thinking through the con- 27 † sequences of the consequences. 28 Buffett reflected that lots of things correlate that people don’t expect 29 to correlate. 30 Munger surmised that the whole thing is a Mad Hatter’s Tea Party 31 and that the accountants sold out. 32 33 Investment Temperament 34 Another fascinating discussion involved the role of temperament in 35 investing. 36 While intelligence is helpful, Buffett and Munger asserted that having 37 the proper temperament was far more critical. 38 39

* Six years after the acquisition. 40 † Garrett Hardin’s ‘ecolate’ filter in his book Filters Against Folly asked, “And then what?” 41

125 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Buffett mentioned the need to spend lots of time looking at companies 22 and building your database and business understanding. 23 Munger agreed that one must read a lot to be wise, but curiously noted 24 that he has found few among those who read a lot that have the proper 25 temperament. Most get confused by the mass of information. 26 Buffett claimed that successful investing requires not extraordinary 27 intellect but extraordinary discipline. Few have it. In fact, he mused, 28 “What we learn from history is that people do not learn from history.” 29 As a final proof, Buffett observed that Sir Isaac Newton, one of the 10 most brilliant men in history, wasted a good portion of his days trying to 11 turn lead into gold and lost an enormous sum in the South Sea Bubble. 12 13 Math 14 15 Munger boldly stated, “It is as if God made the world so only math can 16 understand it.” 17 He noted that if you are innumerate in business, you’ll be a klutz. 18 However, business does not require high math, and it may even be a 19 disadvantage to know high math. 20 Buffett concluded with a smile, “When my mother sang me songs 21 about compound interest, there was no need to go further.” 22 23 Errors of Omission 24 25 Buffett noted that not maximizing the rare good idea has cost share- 26 holders more than his sins of omission. 27 Though sins of omission do not hit the financial reports, Munger 28 said that they still rub their noses in it. 29 Buffett said his failure to buy Wal-Mart has cost Berkshire shareholders 30 $10 billion to date. 31 He said that he initially ran the idea by Charlie who said, “It isn’t the 32 worst idea you’ve ever had,” which, coming from Charlie, Buffett took 33 as “ungodly praise.” 34 But he got anchored on a price of $23. When the price moved up, 35 he stopped buying. 36 37 Our Own Worst Enemy 38 39 Munger observed that throughout history, people have gone crazy trying 40 to know the future. 41

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Ancient kings would have the royal fortuneteller look at sheep 1 guts to make decisions. Today, people are still just as crazy as that king, 2 looking for people who pretend to know the future, giving Wall Street 3 economic incentive to sell its nostrum. 4 Combining the under-performance of the average mutual fund with 5 the public’s habit of frequently shuffling funds, the general public has 6 gotten poor performance from contacting the “experts.” 7 Buffett asserted that his underlying premise is that business will do 8 well in America. While negative factors may move fearful investors to 9 sell, it is important to remember that at any given point in history, there 10 have always been negative factors. Yet despite wars, depressions, epi- 11 demics, etc., the Dow went from 66 to 10,000 during the 20th century. 12 He concluded, “It won’t be America that does in investors. It will be 13 the investors themselves.” 14 15 16 Thinking About the Unexpected 17 Buffett noted that he spends a lot of time thinking about what could go 18 wrong in big unexpected ways. 19 With low probability events, he asserted that people underestimate 20 them if they haven’t occurred for a while and overestimate them if they 21 occurred recently. 22 He jokes, “Noah ran into that.” 23 If there is, for example, a 10% chance of major nuclear disaster 24 in a given year, then in 50 years, there is but a 0.5% chance there will 25 not be such an event. To raise the odds to 1.0% would be meaningful 26 improvement. 27 28 29 Last Man Standing 30 Financial calamities occur more often than natural ones, Buffett 31 observed. So he advised, over the next 50 years, conduct yourself so that 32 if there is a financial crunch, you’ll get through. 33 That’s why they don’t believe in a lot of leverage at Berkshire. Through- 34 out history, it is leverage that wipes people out. 35 Buffett marveled at the all the high-IQ people with huge desire to 36 make money that got killed in the junk bond collapse in 2002. Wall 37 Street is awash in money and talent, yet there are these huge swings in 38 securities prices. This doesn’t happen with apartments in Omaha or 39 McDonald’s franchises. 40 41

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21 Munger noted that derivatives contracts can work just like margin 22 accounts (a form of leverage). If a counterparty has a ratings down- 23 grade, it has to put up more collateral, which, in turn, could cause a 24 domino effect of selling to raise collateral. 25 Buffett cautioned that there only has to be one day you cannot meet 26 a margin call. 27 He noted that absent the ability to raise capital, Gen Re could have 28 run into terrible financial trouble after 9/11. Equities fell. Capital 29 shrank. It could have triggered calls on that capital for derivatives 10 positions.* 11 Buffett summed up with regard to financial calamities: (1) don’t let 12 it wipe you out, and (2) be prepared to take advantage. Berkshire is so 13 positioned. 14 Buffett stated emphatically, “In a cataclysm, Berkshire would defi- 15 nitely be the last man standing.” 16 17 National Indemnity: Getting the Incentives Right 18 19 Our favorite discussion of the day ensued after David Winters of Mutual 20 Series asked about Berkshire’s insurance underwriting disciplines. 21 As if he had been waiting for that question all day, Buffett whipped 22 out slides showing National Indemnity’s operating history. 23 Professor Buffett’s first slide showed huge swings in premium 24 volume over the past two decades at National Indemnity (NI) as the 25 company executed its unique philosophy of writing for profit, not 26 volume.† 27 At the same time, Berkshire kept the employees. Buffett was willing 28 to suffer “high overhead” in low-volume times to teach employees that 29 they would never be laid off for lack of volume. 30 This was reflected in an expense ratio that ranged widely from as low 31 as 26% to as high as 41%. 32 Remarkably, staff count in 1980 was 372 and, in 2003, was 358. 33 With that focus on quality and discipline, NI has been profitable 34 nearly every year, a record that Buffett claimed has left others in the dust. 35 The key has been having incentives in place to get the right 36 employee behavior. And for that, you must think the business through. 37 Munger concluded, “Nobody else does it. It’s the obvious way to go. 38 Much of Berkshire is like that.” 39 * Fully reconfigured, Gen Re is now AAA-rated again. 40 † Writing feverishly, I jotted down trough-to-peak premiums of 1980/$80 million, 41 1986/$366 million, 1998/$55 million and 2003/$600 million.

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1 Habits for Life 2 When asked by a youngster for keys to living a good life, Buffett and 3 Munger were full of advice. 4 Buffett noted that most people underestimate how important good 5 habits are. 6 Munger added that it is critical to “avoid dumb stuff” like going to 7 the race track, risking AIDS, experimenting with cocaine or getting into 8 debt. He suggested developing good character and good mental habits 9 and to learn as you go. 10 On a sobering note, Buffett said he receives letters every day from 11 people in financial trouble, and he tells many of them to take bank- 12 ruptcy since they’ll never be able to catch up. 13 He warned that it is very tempting to spend more than you make. 14 Buffett also recommended hanging around people better than you. 15 Munger added, “If that causes problems with your peers, the hell 16 with them.” 17 Buffett concluded with the story of the woman who turned 103 and 18 was asked, “What do you like about being 103?” She responded, “No 19 peer pressure.” 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

129 1 2005 2 3 4 5 Venue: Qwest Center 6 7 Attendance: Some 19,000 8 9 Details About This Year: 10 11 • A new book has been introduced to our curriculum, Poor 12 Charlie’s Almanack (a nod to Munger’s hero, Ben Franklin). 13 The book offers an excellent recounting of Charlie Munger’s 14 wit and insights over the years. Corey was especially excited 15 to see that his question from last year’s Wesco Financial 16 meeting made it into the book. 17 18 Fortune 500 Ranking: 12th 19 20 Stock Price: $88,006 21 One dollar invested in 1964 would now be worth $7,114. 22 23 Berkshire’s per-share book value has grown from $19.46 to 24 $59,734 (a rate of 21.5% compounded annually). 25 The S&P 500 compounded at 10.4% annually for the 26 same period. 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2005’s Notes 22 23 24 Don’t Ask 25 26 Buffett opened his remarks by announcing he would not discuss three 27 topics: 28 1. Last year’s Nebraska football season* 29 2. What Berkshire is currently buying 10 11 3. Details of his testimony to regulators regarding the AIG probe as 12 investigators prefer witnesses not talk publicly about their testi- 13 monies. 14 15 Pricing Power 16 Buffett noted that corporate profits as a percentage of GDP were very 17 high and that corporate taxes as a percentage of total taxes were very low. 18 Some reversion to the mean for corporate earnings is to be expected.† 19 Munger noted it is hard but essential to know who can pass through 20 cost inflation. 21 Buffett added that “it is not a great business when you have a prayer 22 session before raising prices a penny.” 23 Buffett noted that he loves companies with untapped pricing power. 24 See’s Candy was an example where, in 1972, it sold 16 million pounds 25 annually for $1.95 a pound (and a $25 million profit!). It could easily raise 26 prices 10 cents a pound. Today, even newspapers and beer companies 27 have found it much tougher to raise prices. 28 Buffett concluded that you can learn a lot about the durability of the 29 economics of a business by observing price behavior. 30 31 Hair Trigger 32 33 Buffett claimed that there has never before been such a high percentage 34 of money at a hair trigger with hedge funds, currency markets, the carry 35 trade, etc. 36 There are billions of dollars riding on the press of a key. 37 This “electronic herd” could very well stampede due to some 38 exogenous event a la Long-Term Capital Management in 1998. 39 * Please don’t ask Corey, either. 40 † Bob Rodriguez of FPA and Michael Sandler of Clipper Fund also predict shrinking corpo- 41 rate margins with a likely dampening effect on the stock market.

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While determining the timing is very difficult, predicting what will 1 happen is easier. 2 Unlike a crowded theater where you can just leave your seat and run 3 for the exit, in finance, you must find someone to take your seat. Some- 4 one must be on the other side of the transaction. 5 Munger summed up that it will end badly.* 6 7 Hard Landing? 8 9 Buffett asserted that current U.S. trade policy will have very significant 10 consequences if unchanged. 11 He noted neither candidate addressed the issue in the last election. 12 Buffett disagreed with many observers who see a soft landing. With a 13 $618 billion trade deficit, how do such numbers correct “softly”? And if 14 they don’t correct, the net international investment position will grow 15 and compound. 16 To support his position, Buffett cited an op-ed piece in the Washington 17 Post, in which former Fed Chairman Paul Volker shared his apprehension 18 about these huge and possibly intractable imbalances. 19 Munger added that he is repelled by the lack of virtue in the use of 20 consumer credit and the way public finance is run. Fortunately, Munger 21 noted, a great civilization can bear a lot of abuse. 22 He went on to predict that we are at the apex of this great civilization. 23 24 Dollar Decline 25 26 Buffett noted that he could not see how we will have a rising dollar. 27 Buffett gave the analogy of a rich family with an estate so large they 28 could not see the outer reaches of their domain. They simply waited 29 at the porch for the produce to come in. They were unaware that they 30 were consuming 6% more than what was being produced. And thus, 31 they were trading away a portion of their estate in the process. 32 In a similar way, the U.S. is trading away $2 billion per day of her 33 assets as we consume roughly 6% more than we produce. In time, our 34 children will be paying “tribute” to foreign investors for our current 35 over-consumption. 36 However, Munger challenged Buffett’s sense of alarm, suggesting 37 that if foreign holders eventually owned, say, 10% of the U.S. but our 38 GDP grew 30% in the process, would that really be such a bad thing? 39

* With $66 billion in cash and bonds at the end of the first quarter, Berkshire stands ready 40 to be the buyer of last resort. 41

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21 Munger added that it is a queer occurrence to prefer currencies of 22 socialized Europe to that of the U.S. 23 Buffett concluded that Berkshire has $21 billion in foreign exchange 24 contracts. If it was up to him, they would have more. If it was up to Charlie, 25 they would have none. 26 27 Asia Could Do Well 28 29 Buffett observed that global competition is heating up as everyone 10 adopts our “best practices,” and that is a good thing for all. More trade is 11 better. With six billion people in the world, we should hope that a high 12 percentage can live well in 20 years. 13 Munger concluded that America will get richer over time but may 14 lose position in the world. 15 He suggested that Asia could do amazingly well. 16 17 Gold 18 19 While gold may be a refuge from a declining currency, Buffett observed 20 that is true for any physical asset. 21 For example, if Berkshire sold See’s Candy’s and people dealt in 22 seashells, Berkshire would get the appropriate number of seashells. 23 Likewise for Coca-Cola, oil, an acre of land. Meanwhile, gold has little 24 real utility. Some 3,000 to 4,000 tons of gold go from South Africa to 25 Fort Knox annually and do not do much along the way. 26 Ever subtle, Munger noted that with the opportunities of Berkshire 27 averaged out, gold is a dumb investment. 28 Buffett quantified: In 1940, gold was $35 per ounce. Sixty-five years * 29 later, it is $400 per ounce (not including carrying costs). 30 Buffett concluded, “This is not something that causes me to salivate.” 31 32 Real Estate Bubbles 33 Numerous questions were asked about real estate.† 34 Buffett reminisced about the bubble in farmland in Nebraska and 35 Iowa 25 years ago. Cash was trash as inflation was out of control. This 36 perception fueled the flight to farmland. 37 Buffett noted that north of Omaha, farmland got to $2,000 an acre— 38 land that he bought after the bust from the FDIC for $600 an acre. 39

40 * A 3.8% compounded annual return. 41 † Which Corey and I take as a sure sign of a bubble.

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Currently, Munger sees California and Washington D.C. as real bub- 1 bles with a 4 to 1 price ratio versus Omaha. 2 Buffett said he sold his Laguna Beach home for $3.5 million. He 3 figured the house was worth $500,000, so the one-twentieth of an acre 4 lot went for $3 million. He surmised that $60 million an acre is a pretty 5 fancy price for any kind of land. 6 Munger recounted that a friend of his sold a modest home with an 7 ocean view for $27 million. 8 Buffett quipped, “For $27 million, I’d rather stare at my bathtub.” 9 10 11 Correlation of Risk 12 Buffett warned that when there is trouble, everything correlates. Thus, 13 in managing catastrophic losses, one must think through the ripple 14 effects. 15 California, for example, has had 25 6.0 earthquakes in the last 100 16 years. Such a quake in a populated area would have enormous conse- 17 quences. At Berkshire, not only would it hit the insurance operations, 18 but it would correlate with the businesses of See’s Candy, GEICO, Wells 19 Fargo and other Berkshire subsidiaries. 20 Buffett noted that the most powerful quake in America occurred in 21 Madrid, Missouri, which has had three quakes of greater than eight on 22 the Richter Scale. 23 Buffett observed that if you take a centuries-long view, you will see 24 that extraordinary things have happened. 25 Munger noted that they have even contemplated a 60-foot tidal wave 26 hitting California (which is not known to have ever happened). 27 He doubted that any other insurance company considers risk more 28 rigorously than Berkshire. 29 Buffett added, “It’s Armageddon around here every day.” 30 Buffett concluded that with the way Berkshire conducts its affairs, he 31 won’t lose sleep no matter what. 32 33 34 Job 1: Nuclear Terrorism 35 Buffett shared that his number one concern was nuclear terrorism. He 36 recommended a book.* 37 He also mentioned a website, LastBestChance.org, where they offer 38 a free film sponsored by the Nuclear Threat Initiative. 39 40 * I believe it was Nuclear Terrorism by Graham Allison. 41

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21 He noted that this issue was also little discussed in the last election. 22 Insurance-wise, Buffett said their entire book of business has been 23 rewritten now to account for NCBs (nuclear, chemical and biological 24 hazards). 25 26 Job 2: Education Reform 27 28 After the NCB problem, Buffett sees education as the nation’s largest 29 problem. 10 He believes that a good school system is like virginity: it can be pre- 11 served but not restored. 12 As a country with $40,000 of per capita income, we have the resources. 13 Challenges include the complexity of the system, unions and the opting 14 out of the rich. To the extent the rich go to private schools and the poor 15 go to “armed camps,” we create a two-tier system of unequal opportunity. 16 And Buffett reminded us, equal opportunity has been a big factor in 17 America’s success. 18 19 Easy Money 20 21 Buffett observed that mortgage terms have gotten easier and easier as 22 housing prices have gotten higher and higher. 23 He noted this is absolutely counter to how the prudent think about 24 lending. 25 Munger added that easy lending causes more building and higher 26 prices. Eventually, when you have enough new anything, prices will 27 decline. 28 Munger concluded that such Ponzi effects in society are very import- 29 ant and yet are studied very little.* 30 31 Incentives 32 33 One of the greatest insights we have learned from UBH is how hugely 34 incentives influence what happens in the world. 35 Munger asserted that the history of what he doesn’t like in mod- 36 ern corporations comes from the directive by headquarters to have 37 earnings go up continually and smoothly, a practice he refers to as “the 38 blood brother of evil.” 39 40 * See Poor Charlie’s Almanack for more. 41

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Buffett noted that the world just does not work that way, and it leads 1 to a lot of bad things. CEOs with big egos making precise predictions 2 are kidding investors, themselves or both. This, in turn, sets up a system 3 that exerts psychological and financial pressure to do things that people 4 don’t want to do. 5 Buffett said he would be an idiot to jump in a NetJet and say to the 6 pilot, “I’m in a big hurry to get to New York.” To rush the pilot through 7 his safety procedures would be dumb. Yet companies have done this sort of 8 thing time after time with compensation systems that incentivize the wrong things. 9 For example, many corporate managers are told to submit budgets 10 and quarterly estimates. This leads to a short-term focus and undue 11 worry about the quarter. A manager who does not want to let the boss 12 down may fudge the numbers. At Berkshire, managers do not submit 13 budgets. 14 He noted that in long tail insurance, the numbers can be pretty much 15 whatever you want them to be. Berkshire’s $45 billion in loss reserves 16 could just as easily be $44.75 billion—especially if he wanted to report 17 $250 million more in earnings. 18 Buffett opined that the worldwide tendency is for management to 19 understate reserves. 20 21 22 General Motors 23 Continuing the theme of accounting and accountability, Buffett com- 24 mented that Richard Wagoner at General Motors (GM) inherited cost 25 structures brought about by contracts made long ago that now make 26 the company uncompetitive. 27 These benefit obligations are said to run as much as $2,000 per car. 28 With that cost disadvantage, GM has gone from a 50% share of the U.S. 29 auto market to 25% today. 30 In a very real sense, General Motors could be said to be owned by its 31 retirees, with $90 billion in retirement benefit obligations compared to 32 just $14 billion of equity for shareholders. 33 The real problems date back to the 1960s. Contracts negotiated at 34 that time bore no accounting consequences. Companies did not have to 35 account for pension obligations on an accrual basis then. And it was not 36 until the late 1980s that companies had to accrue for healthcare benefits. 37 As a result, earlier management agreed to generous annuity and 38 health benefits for retired workers that have compounded into this 39 enormous liability for the world’s largest auto manufacturer. 40 41

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21 Munger noted that when you fall from the 42nd floor to the 20th 22 floor and you’re doing fine, it does not mean that you don’t have a 23 serious problem. 24 Munger said if he were the owner of GM, he would solve the problem 25 immediately. 26 27 Fannie and Freddie and Derivatives 28 29 Misbegotten incentives also lie behind the troubles at Fannie Mae and 10 Freddie Mac. 11 Buffett acknowledged that things have changed a lot since he bought 12 his house in 1958 and his parents sent him to see Mr. Brown at Occi- 13 dental Savings and Loan. Today, mortgage issuers are geographically 14 distant. 15 For 25 basis points to guarantee the mortgage, issuers need not 16 worry about the individual property. 17 Buffett observed that Fannie Mae (FNM) and Freddie Mac (FRE) 18 mushroomed into huge carry trade operations built on the spread 19 between government borrowing costs and lending rates. Yet there is no 20 way one should lend for 30 years to someone who can pay it off (i.e., 21 refinance) in 30 seconds. 22 In addition, Buffett asserted that the accounting shenanigans have 23 been mind boggling, with errors in the billions of dollars. 24 The crime of it, for Buffett, is that the government is on the hook for 25 the implied guarantee of $1.5 trillion of mortgages, basically because 26 FNM/FRE wanted earnings to go up. 27 In sum, the government created the two biggest hedge funds in 28 history by issuing a blank check to entities trying to produce 15% per 29 year earnings gains—and did it by accounting means when they could 30 not do it by operations. 31 Buffett figured the system could absorb the problem if FNM/FRE 32 went into a run-off mode for a time. 33 Munger added that a lot of the troubles came from the derivatives 34 book. He asserted that stupid and dishonorable accountants allowed 35 the genie of inappropriate accounting to come out of the bottle into 36 the derivatives world. 37 Munger warned that there is much wrong with derivative account- 38 ing, and the full penalty has not been paid yet. 39 Buffett concluded, “We’re a long way from Jimmy Stewart in It’s a 40 Wonderful Life.” 41

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1 Great Managers: It’s the Wiring 2 Buffett noted the best way to find great managers is to look at the record. 3 It’s tough to go to the practice tee and predict the best golfers just 4 from their golf swings. 5 Mixing sports metaphors, he noted that the best batters are the ones 6 with the best batting averages. 7 Buffett referenced an old study that found the top correlation 8 of great managers to be the age at which managers started their first 9 businesses. 10 Buffett believes it has far more to do with the wiring than he would 11 have thought 30 years ago. 12 Munger added that it is also part intelligence and part tempera- 13 ment. Munger found he liked business very early and loved trying to 14 win at games of chance. 15 Buffett concluded humorously, “Since my dad would not let me be a 16 bookie, I went into investing.”* 17 18 19 Be Out of Step 20 Buffett suggested that the best investment you can make is to invest in 21 yourself. As for where they put their money at Berkshire, they seek to be 22 opportunistic. 23 Munger noted that Berkshire does no asset allocation. They merely 24 go where the opportunities are regardless of categories, and that is 25 totally out of step with modern investment theory. 26 Buffett noted that they got $7 billion into junk bonds in 2002 but 27 would have invested $30 billion if the bonds had stayed cheap. 28 Regarding modern asset allocation, Munger concluded, “If a thing 29 is not worth doing at all, it’s not worth doing well.” 30 31 32 Social Security 33 Buffett emphasized that Social Security is not insurance but a transfer 34 payment. 35 He stated his belief that a rich country should take care of the young 36 and the old, so Social Security should not be taken below its current 37 level. 38 39 * Clearly, Munger and Buffett have the wiring. 40 41

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21 Buffett also considered as crazy all this fear of a deficit 25 years from 22 now when we have a $500 billion deficit now. Currently, 4% of GDP 23 goes to Social Security. To think it might go to 5% or 6% of GDP many 24 years from now is not a terrible thing. 25 Buffett recommend three remedies: means test, lift the $90,000 tax 26 limit way up and raise the retirement age. 27 Munger allowed that he is a right-wing Republican but still thinks 28 the Republicans are “out of their cotton-pickin’ minds” to take on this 29 issue. 10 He figured a logical way to handle future spending needs would be 11 a consumption tax. 12 Munger declared that Social Security is one of the best things 13 government has ever done. There is nearly no fraud as it is hard to fake 14 being dead. It is a reward for work, which befits a capitalistic society. 15 Munger thought it sad that our leaders are wasting goodwill over 16 this “twaddle” when they may need it if we need to face down North 17 Korea or Iran. 18 19 10-Year Returns 20 21 Buffett noted that Berkshire has a smaller percentage of its net worth in 22 stocks than any time since 1969. 23 Though there is not as much silliness in the market as there was five 24 years ago, Buffett sees the market in a zone of valuation where he is 25 neither a buyer nor a seller. 26 From this level, Buffett thought to earn 6% to 7% in stocks over the 27 long run would be a reasonable expectation. 28 Tax-wise, investors are better treated than at any time in his lifetime. 29 People expecting 10% or more from these levels, however, are unrealistic. 30 Buffett noted that, while there have been a few times of extreme 31 valuations—1969, 1974 and 1999—most of the time we are in that in- 32 between zone. 33 Buffett remained hopeful that Berkshire would get the chance to do 34 something “screamingly intelligent” in the next few years. 35 36 Long Term, America Richer 37 38 When you are buying groceries, you welcome lower prices. Buffett 39 said Berkshire is the same way. They will be glad to see temporarily low 40 prices, so they can put their cash to work. 41

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While concerned about hair triggers and imbalances in the short 1 run, Buffett stated that he is an enormous bull on the U.S. economy 2 long term. 3 In 1790, there were four million people in America, 290 million in 4 China and 100 million in Europe. Yet 215 years later, America has 30% 5 of the world’s GDP. 6 It is an incredible success story. 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

141 1 2006 2 3 4 5 Venue: Qwest Center 6 7 Attendance: 24,000 or so 8 9 Details About This Year: 10 11 • This year’s meeting lasted the now-expected fi ve to six hours. 12 • According to Corey’s notes, there were 13 people at 13 the meeting in 1980. So this year’s turnout suggests a 14 compounded annual growth rate in attendance of nearly 15 34% over the last 26 years. Berkshire’s attendance numbers 16 have surpassed the local university (the University of 17 Nebraska Omaha has 15,000 students). 18 19 Fortune 500 Ranking: 13th 20 21 Stock Price: $88,710 22 23 One dollar invested in 1964 would now be worth $7,171. 24 Berkshire’s per-share book value has grown from $19.46 to 25 $70,281 (a rate of 21.4% compounded annually). 26 27 The S&P 500 compounded at 10.3% annually for the same 28 period. 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2006’s Notes 22 23 24 25 ISCAR Acquisition 26 Buffett and Munger opened the meeting with the announcement of 27 Berkshire’s $4 billion purchase of 80% of ISCAR, an Israeli-based man- 28 ufacturer of machine tools. 29 The usually even-tempered Buffett and Munger were very enthusiastic 10 about the deal. 11 Key points include that it is the first business Berkshire has purchased 12 outside the U.S., that the purchase increases the amount Berkshire will 13 earn in foreign currencies and that the management is terrific. 14 Buffett was especially taken by ISCAR CEO Eiton Wertheimer and 15 his family-style culture, which was reflected in the fact that ISCAR was 16 not put up for auction.* 17 Buffett concluded, “I think we’ll look back on this in five or 10 years 18 and see this as a very significant event in Berkshire’s history.” 19 20 21 Cash Going Down 22 23 Buffett has been very patient sitting on the Berkshire cash horde 24 through a period of very low short-term interest rates. 25 At last year’s meeting, he mentioned the “D” word (“dividend”). This 26 year, he changed his tune, indicating he thought it likely that over the 27 next three years they will have less cash on hand. 28 He also said Berkshire needs to keep a minimum of $10 billion 29 around in reserves for mega-cat insurance policies written. 30 So with around $40 billion on hand currently, Berkshire would need 31 to invest $30 billion over the next three years. Well, not quite. Berkshire 32 will also throw off more than $10 billion in cash annually, so that’s 33 another $30 billion over three years for Buffett to invest.† 34 35 36 * We wonder if a side benefit of the deal may be that Berkshire can allocate additional capi- 37 tal to Wertheimer’s talented management team in the future. 38 † So Buffett is implying that he thinks it likely that Berkshire can invest $30 billion to $60 billion over the next three years! How? We see at least three large possibilities: more inter- 39 national acquisitions, utility industry acquisitions, and Buffett’s stock in trade, bargain shop- 40 ping in the midst of calamity. 41

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1 Envy 2 During the Salomon Brothers government bond scandal, Buffett sat on 3 Salomon’s compensation committee and witnessed the “frenzy of envy in 4 investment banking.” If one guy received a bonus of $2 million and the 5 next guy got $2.1 million, the first guy would be miserable for the next 6 year. So it is envy, not greed, that is the dominant sin among investment 7 bankers. 8 Buffett opined that envy is the least fun of the seven deadly sins 9 because it leaves you feeling awful. 10 Gluttony has some upside—Buffett jested that some of his best times 11 were with gluttony. As for lust . . . he joked that he wouldn’t go there. He 12 concluded that envy is interesting in that it is widely practiced and, yet, 13 is the least enjoyable sin. 14 Munger, adding an ironic sidebar, noted that the SEC now requires 15 CEO pay to be listed. While it was hoped this added transparency would 16 rein in egregious compensation, the list has had the opposite effect. 17 Envious CEOs use it as a shopping list for seeking pay raises. 18 19 20 Succession 21 Year after year, this question is unfailingly asked: “What happens after 22 Warren is gone?” 23 Buffett noted that there are three obvious successors, and it will be 24 up to the board. 25 He referred to Wal-Mart as an example of “personalized institutional 26 legacy,” where the company has become even stronger since the founder 27 passed on.* 28 Speaking for the heirs of the Munger clan, Charlie shared, “We prefer 29 to wring the last drop of good out of Warren.” 30 Munger concluded rhetorically, “Do you really think Warren Buffett 31 will blow the job of passing on the faith?” 32 33 34 Finding Great Managers 35 On the subject of great managers, Buffett and Munger again explained 36 how they keep it simple. 37 38

* Unlike 20 years ago, Buffett now has a deep bench of managerial talent and a world-class 39 board, so we’re not losing any sleep over it. 40 41

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21 Munger emphasized that Berkshire does not train executives, it finds 22 them. 23 Buffett referenced a letter that led to the ISCAR acquisition. He said 24 CEO Eitan Wertheimer’s character and talent jumped off the page. 25 Munger concluded, “If a mountain like Mount Everest stands up, 26 you don’t have to be genius to see it’s a high mountain.” 27 28 Corporate Governance 29 10 Regarding corporate governance, Munger predicted that the current 11 fashions in government regulations would have little effect. 12 Buffett asserted the real question for boards of directors to consider 13 is, “To what extent do the managers think like owners?” 14 Buffett said he sees an enormous difference in boards based on that. 15 According to Buffett, the job of the board is to 1) get the right CEO, 16 2) keep the CEO from overreaching and 3) exercise independent judg- 17 ment on acquisitions. 18 Based on these priorities, boards have not done too well in recent 19 years. Meanwhile, Berkshire has assembled a first-class board. Buffett 20 claimed proudly that no other board in America has a larger percentage 21 of its net worth in the company purchased on the open market than * 22 Berkshire. 23 24 In/Out/Too Hard 25 One of our favorite Mungerisms of the meeting was his explanation of 26 the Berkshire idea-handling process. 27 There are three boxes—“in,” “out” and “too hard.” It is important to 28 know what is too hard for you and stick to what you do best. 29 He quoted IBM CEO Tom Watson, “I’m smart in spots.” 30 Buffett noted that if you’re fast, you can run the 100 meters for the 31 gold medal. You don’t have to throw the shot put. 32 Munger shared that a reporter once said to him, “You don’t seem 33 smart enough to be doing so much better than everyone else.” The key 34 is knowing the edge of one’s circle of competence. 35 36 37 Ethanol 38 While ethanol is a hot topic nationally, Buffett and Munger were decidedly 39 unenthusiastic. 40 41 * Hence our mantra: good ownership drives good stewardship.

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Buffett noted that, as a general rule, he ignores what is hot. 1 Furthermore, with all the government subsidies, it’s not clear what 2 the return on equity on an ethanol plant would be five years out. His- 3 torically, agricultural processing has not earned high returns on capital. 4 For Buffett, the key question is, “How can you gain a significant com- 5 petitive advantage?” With commodities, if you get too many producers, 6 you’ll have poor returns. 7 Munger was even more of a wet blanket, suspecting that more fossil 8 fuel energy is used than is created in the ethanol process. 9 Ever the diplomat, Munger concluded that “ethanol is a stupid way 10 to solve an energy issue.”* 11 12 Pumpkins to Mice 13 14 Buffett noted that any asset class that has had a big move will eventually 15 attract speculation. That is now the case with copper and a number of 16 other commodities. 17 In a startling admission, Buffett informed the crowd that he sold his 18 much-heralded silver position some time ago for a modest profit. 19 Munger contributed two gems to this discussion. 20 Regarding Buffett’s admission of selling silver too soon, Munger 21 said, “It’s a good habit to trumpet your failures and be quiet about your 22 successes.” 23 Regarding future speculation, Munger noted, “We have failed to 24 profit from one of the biggest commodity booms in history. And in that 25 way, we will probably continue to fail.” 26 Buffett summed up that speculative markets become like Cinderella 27 at the ball. At midnight, they will turn to pumpkins and mice. Each 28 player wants one more glass of champagne, one more dance, and then 29 they’ll get out in time. But there are no clocks on the wall. 30 31 Manufactured Housing 32 Berkshire became a big player in the manufactured housing industry with 33 the acquisition of Clayton Homes several years ago. 34 Berkshire has made a number of expansionary moves in the industry 35 since. At this meeting, they let shareholders know why. 36 Costing around $45 per square foot, manufactured homes offer 37 good value. 38 39 * The Renewable Fuels Association reports there are 101 ethanol plants in the U.S. and 32 more under construction. An estimated 20% of the corn crop is now going to ethanol 40 production. There are three IPOs of ethanol producers coming in the very near future. 41

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21 With 130,000 units produced last year, the industry accounted for 22 just 6% of all homes built. In better years, the industry has produced 23 20% of all homes. 24 The industry got oversold five years ago after years of abuse. This 25 hangover phase included working through a lot of “dumb” financing. 26 The aftermath produced numerous bankruptcies and a capital markets 27 squeeze. 28 Buffett chortled that “Clayton is so good, it’s hard to find No. 2.” 29 While it will take a few years, Munger sees manufactured housing 10 eventually taking a much larger share—“it’s so logical.” 11 Buffett predicted that the industry will get to 200,000 units or more 12 and that Clayton could easily be the biggest homebuilder in the U.S. 13 someday. 14 15 Stick-Built Housing Bubble 16 17 Munger sees the same sins that collapsed the manufactured housing 18 industry five years ago resurfacing in the stick-built industry. 19 Buffett noted that loose lending has run amuck. He cited with 20 particular interest how some lenders are counting as income interest 21 accrued but not paid. 22 Munger concluded that it’s yet another case of “dumb lending as- 23 sisted by corrupt accounting.” Buffett quipped, “Our auditing bill just 24 went up.” 25 Buffett noted that in some coastal markets, the day-traders of the 26 Internet bubble became the day-traders of condos. Now he believes that 27 the speculative bubble has clearly turned and that a significant down- 28 ward adjustment from the peak is underway. 29 30 Coca-Cola 31 32 When asked about Coca-Cola, Buffett marveled that it now sells 21 billion 33 cases of product and sells more units every year. 34 In 1997, the stock was 80 with $1.50 per share of low-quality earnings. 35 Today, the stock is 44 with $2.17 a share of better-quality earnings. 36 Every year, the company gets a little greater share of the liquids 37 consumed around the world and earns fabulous returns doing it. 38 Coca-Cola earns 100% pre-tax on tangible assets. 39 If Coke annually sells 5% more units and global population grows 40 2% annually, Coke will necessarily be selling evermore liquids to go 41 down evermore throats. And that has been happening since 1886.

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Buffett summed up, “Coke has been and will be a great business. 1 We’ll own it 10 years from now.” 2 3 4 Insurance and Hurricanes 5 Buffett offered a fascinating glimpse of how he looks at risk and reward. 6 Buffett noted that Berkshire is the No. 1 mega-catastrophe under- 7 writer in the world. Prices are up a lot. But are the exposures up even 8 more? Which is more meaningful—the last 100 years of hurricanes or 9 the last two years of hurricanes? The water temperatures have changed. 10 Nobody really knows what will happen. 11 At this point, you and I might choose the “too hard” box. Not Buf- 12 fett and Munger. Buffett announced his mega-bet: “We’re in. If the last 13 two years hold, we’re not getting enough. If the last 100 years hold, 14 we’re getting paid plenty.” 15 Buffett then thought even bigger. Katrina was a $60 billion event. 16 Berkshire took a $3.4 billion hit. 17 Buffett theorized that there could be a disaster as great as four times 18 Katrina, or $250 billion. In that event, Buffett estimated that Berkshire’s 19 exposure would be 4%, or $10 billion. 20 For that reason, Buffett wants to maintain at least a $10 billion cash 21 position. Buffett asserted, “We can play bigger than anyone and still pay.” 22 Perhaps sensing some shareholder shock at these big numbers, 23 Munger summed up, “Why shouldn’t we use our capital strength when 24 others are frightened?”* 25 26 27 Media 28 Long a favorite Buffett area of investment, the world of media now 29 offers a huge variety of sources, many of them free. 30 Meanwhile, there has been no corresponding expansion of time for 31 humans to acquire information and entertainment. 32 So media economics will continue to deteriorate as competition in- 33 creases. For newspapers, TV and cable, the future will be less attractive 34 than the past. 35 36 37 * Some more thoughts: Berkshire has float of $48 billion to 49 billion, or about 10% of the property casualty industry. Yet when the Katrina losses were tabulated, Berkshire’s share of 38 the $60 billion disaster was $3.4 billion, or just 5.7%. In Buffett’s monster disaster scenario, 39 he has Berkshire tallying just 4% of the total loss. Question: How can Buffett occasionally be “all in,” yet be so much less exposed percentage- 40 wise than the general industry? Shrewd people, yes? 41

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21 Derivatives 22 23 Buffett was early in warning of the potential dangers of the widespread 24 use of derivatives. 25 He said it is hard to predict what might happen, but strange things 26 do happen—like the Long-Term Capital Management debacle in 1998. 27 In a riveting digression, Buffett said Salomon Brothers in 1991 was 28 within 30 minutes of bankruptcy. The lawyers were drawing up the pa- 29 pers for it. However, Nick Brady, the Treasury secretary, knew Berkshire 10 and trusted Warren. At the last minute, the Treasury reversed itself. 11 It could have been absolute chaos with Salomon’s $700 million book 12 of derivatives. 13 Of course, those numbers are peanuts today. Buffett concluded, say- 14 ing derivatives are much bigger now, though better collateralized. 15 16 Weaker Dollar: Hard Landing 17 18 Buffett disagrees with those pundits that are predicting a “soft landing.” 19 Buffett feels “stronger than ever” about his weak dollar view. He 20 called it a very high probability that the U.S. currency will weaken over 21 the years given our current policies. 22 Buffett noted that Greenspan said in 2002 that the current account 23 deficit—then $350 billion—must be restrained. It has doubled since 24 then. The U.S. is a net debtor to the world to the tune of $3 trillion. 25 Buffett mused about how portfolio insurance led to a 22% decline 26 in the stock market in one day (1987’s Black Monday). 27 Like with portfolio insurance two decades ago, Buffett predicted 28 currency markets will be a catalyst for some future decline. 29 Buffett believes our eventual comeuppance will almost surely be 30 painful, and when “fire” is yelled, the currency market will play a part in 31 the rush for the door. 32 33 Inflation 34 35 Buffett noted that the CPI (Consumer Price Index) is not a particularly 36 good measure of inflation. 37 First, “core” inflation excludes food and energy. “Not much is more 38 core!” Buffett exclaimed. Second, since CPI uses a rent equivalent factor 39 for living costs, it hasn’t captured the rising cost of housing. In sum, the 40 CPI understates inflation. 41

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Munger noted that inflation is where you look. 1 A Costco board member, Munger reported that Costco has seen 2 almost no inflation in its composite flow of goods. LIFO (last in, first 3 out) adjustments for both Costco and Wal-mart have been peanuts. 4 Meanwhile, such adjustments have been big for the jewelry, carpet and 5 steel businesses. 6 Buffett noted that one possible side effect of the weaker dollar could 7 be significant inflation. It is tempting for governments to devalue what 8 they owe to reduce the burden of debt repayment 9 10 Opportunity Cost 11 12 Munger summed up this key concept as succinctly as ever: “To measure 13 opportunity cost, take your best available opportunity versus all other 14 options.” Concentrate in your best one or two ideas. 15 He went on to say in his understated way, “That’s why modern port- 16 folio theory is so asinine.” 17 Buffett noted that often the best opportunities come in the midst of 18 some convulsion. The key is to buy when others are paralyzed. Stocks in 19 1974. Junk bonds in 2002. Several years ago, numerous Korean companies 20 sold for three times earnings. 21 The key is to follow logic rather than emotion. Focus on what is im- 22 portant and knowable rather than on public opinion. 23 One fascinating side note, Buffett observed, “Any calls you get on 24 Sunday, you’re going to make money.” Those rare calls are the best 25 since they are inevitably from seriously distressed sellers. 26 He concluded that if you buy convulsion and remember that the 27 market is there to serve you, not instruct you, then you cannot miss. 28 Munger corrected his partner, “Some of you probably can miss.” 29 30 Terrorism: Ultimate Challenge 31 Buffett labeled terrorism as “the ultimate challenge of mankind,” noting 32 it is a worst-case problem. 33 Out of a global population of six billion, there will always be a small 34 percentage of crazy people bent on doing others harm. Technology 35 enables the unbalanced few to do unprecedented damage. Where 1,000 36 years ago, they might have thrown rocks or shot arrows, now there are 37 nuclear, biological and chemical weapons in the mix. 38 Munger noted that the chance of going 60 years with no nuclear 39 events was close to zero. 40 41

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21 Buffett somberly noted that the best we can do is to keep the leaders 22 awake to minimizing the threat. 23 24 Low Turnover = Owner Attitude 25 26 Buffett threw in a chart measuring Berkshire’s annual share turnover, 27 so here’s another point he really wanted to make. 28 Berkshire had 14%, Exxon Mobil 76%, GE 48%, and Wal-Mart 79%. 29 Buffett asserted that Berkshire has the lowest turnover of any major 10 company, and that is attributable to the owner attitude of Berkshire’s 11 shareholders. 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

152 1 2007 2 3 4 5 Venue: Qwest Center 6 7 Attendance: 27,000 8 9 Details About This Year: 10 11 • This year features Corey’s notes exclusively as Daniel 12 attended another institutional learning event that day—his 13 son John’s graduation from Iowa State University. 14 15 Fortune 500 Ranking: 12th 16 17 Stock Price: $110,089 18 One dollar invested in 1964 would now be worth $8,900. 19 20 Berkshire’s per-share book value has grown from $19.46 to 21 $78,008 (a rate of 21.1% compounded annually). 22 The S&P 500 compounded at 10.4% annually for the same 23 period. 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2007’s Notes 22 23 24 Good First Quarter 25 Buffett announced that Berkshire had a good first quarter (with net 26 earnings of $2.6 billion, or $1,682 per A share). 27 He noted that insurance earnings will go down with a lag effect. 28 After an extraordinary period with no major disasters, the insurance 29 businesses have booked huge profits. However, competition has caused 10 premium rates to go down, so insurance profits will follow suit. 11 Buffett warned that when hurricanes occur, Berkshire will have 12 losses, so look at last year’s profit as an offset to future losses. 13 He noted that most of the non-insurance businesses did fine. The 14 exception would be in the residential-construction-related businesses 15 like Shaw and Acme Brick, which were hit hard by the housing slowdown. 16 Buffett guessed that weakness there could continue for quite a while. 17 Overall, Buffett believes his managers continue to do a sensational 18 job. He proudly declared, “We have the best managers and shareholders 19 of any company.” 20 21 Berkshire CIO Hunt 22 Buffett caused a stir by announcing in the annual report that he is looking 23 for an investment manager to succeed him. 24 He noted he wants someone who not only learns from what has hap- 25 pened but can also envision things that have never happened, especially 26 in regard to risks. 27 He shared that they’ve received about 700 applications, including 28 one from a man recommending his 4-year old son. 29 Buffett reminisced that he undertook a similar process in 1969 when 30 he closed the Buffett Partnership and had to recommend to his investors 31 where they should put 100% of their money. 32 He chose Charlie Munger, Sandy Gottesman and Bill Ruane. Charlie 33 wasn’t interested in more partners. Sandy took separate accounts and 34 has done very well for his clients. Bill Ruane set up a separate mutual 35 fund (the Sequoia Fund), which has also done very well. 36 37 38 Stewardship: Brains Plus Caution 39 Later in the meeting, when asked about some sort of managed futures 40 fund, Buffett noted that it isn’t the investment structure that makes an 41 opportunity. “It’s brains that make an area of opportunity.”

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At the same time, Buffett noted his concern several times during the 1 meeting that some very smart people have lost a lot of money. The prob- 2 lem is that anything times zero is zero. No matter how good the record 3 was in every other year, if there is just one year with a zero, it’s all over. 4 Buffett noted that he and Charlie have seen guys go broke or close 5 to it because 99 of 100 of their decisions were good, but the 100th did 6 them in.* 7 8 9 Derivatives and the Crowded Trade 10 Buffett claimed that derivatives introduce invisible leverage into the 11 system and have made any regulation of margin requirements a joke. 12 We may not know when it becomes a super danger or when it will 13 end precisely, but he believes it will go on and increase until very un- 14 pleasant things happen because of it. 15 As one example of what can happen under forced sales, Buffett 16 reviewed October 19, 1987: The infamous Black Monday when the Dow 17 Jones Average dropped 23% in a single day. 18 It was driven by portfolio insurance, which was a joke. It was a bunch 19 of stop/loss orders, but done automatically, and the concept was heavily 20 marketed. People paid a lot of money for people to teach them how to 21 put in a stop/loss order. 22 When a lot of institutions do this, the effect is like pouring gas on 23 a fire. They created a doomsday machine that kept selling and selling. 24 You can have the same thing today because you have fund operators 25 with billions of dollars—in aggregate, trillions of dollars—who will all 26 respond to the same stimulus. It’s a crowded trade, but they don’t know 27 it. And it’s not formal. They will sell for the same reasons. Someday, you 28 will get a very chaotic situation. 29 As for what could trigger this and when, who knows? Who had any 30 idea that shooting an archduke would start World War I? 31 Munger asserted that enormously deficient accounting contributes 32 to the risk. If you get paid enormous bonuses based on profits that don’t 33 exist, you’ll keep going. What makes it difficult to stop is that most of 34 the accounting profession doesn’t realize how stupidly it’s behaving. 35 One person told Munger that the accounting is better because 36 positions are marked to market and said, “Don’t you want real-time 37 information?” 38 39 * A current example is the Bear Stearns High-Grade Structured Credit Fund, which, as we related in our Market Update, boasted 30 consecutive months of profits but is now facing 40 heavy losses due to its combination of extreme leverage and illiquid mortgage securities. 41

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21 Munger replied that if you can mark to market to report any level 22 of profits you want, you’ll get terrible human behavior. The person 23 replied, “You just don’t understand accounting.” 24 Buffett said that when he went to close out Gen Re’s derivatives 25 book, Berkshire took a $400 million loss on a portfolio that was “marked 26 to market” by the prior management and auditors. 27 Buffett joked that he wished he could have sold to the auditors 28 instead! 29 Munger concluded, “As sure as God made little green apples, this 10 will cause a lot of trouble. This will go on and on, but eventually will 11 cause a big denouement.” 12 13 The Electronic Herd 14 15 One element contributing to the crowded trade risk is the rise of what 16 Buffett calls “the electronic herd.” 17 Buffett observed that the percentage of securities that can be sold at 18 the touch of a button has gone up a lot. There’s nothing necessarily evil 19 about it. But it’s a different game, and there are consequences. If you’re 20 trying to beat the other fellow on a daily basis, you’re looking to push 21 the button quicker and quicker. 22 Buffett shared that when he and Charlie were at Salomon, they 23 talked about five or six sigma events, but that doesn’t mean anything 24 when you’re talking about real markets and human behavior. Look at 25 what happened in 1998 and in 2002. You’ll see it when people try to 26 beat the markets day by day. 27 28 Credit Contractions 29 30 Buffett observed that we have had major credit contractions in the past. 31 One occurred during the junk bond crisis in 2002 and another with 32 equities in 1974. 33 Buffett doesn’t think a contraction of credit will come from the Fed 34 stepping on the brakes. 35 More likely, he believes, would be an exogenous event to shock the 36 system. That, in turn, could cause a huge widening of credit spreads and 37 a cheapening of equities. That would be good for Berkshire because 38 it has the money to take advantage of such an event. 39 Buffett reminisced that in the old days, when credit contracted, 40 there was no money around. 41

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He mentioned trying to buy a bank in Chicago 30 or 40 years ago, 1 and the only people willing to lend to Berkshire were in Kuwait and 2 would only lend in dinars. Now that was a credit contraction! 3 He cited Jon Alter’s book, The Defining Moment: FDR’s Hundred Days 4 and the Triumph of Hope, for describing how the country was close to the 5 brink and how FDR got laws passed as fast as he could write them. In 6 this case, that was a good thing because banks were closing, and people 7 were dealing in scrip. 8 While he doesn’t see the Fed orchestrating a contraction, he noted 9 that the Long-Term Capital Management blowup in 1998 seized-up 10 world markets. People panicked about even the safest of instruments. 11 He concluded, “History doesn’t repeat itself, but it rhymes. We’ll 12 have something that rhymes.” 13 14 15 The Declining Dollar 16 Buffett believes the dollar will likely decline against most major curren- 17 cies over time unless current policies change in a major way. 18 When the carry trade made it expensive to own foreign currencies 19 directly (at one point Berkshire had over $20 billion in foreign ex- 20 change contracts), Buffett shifted his focus to buying companies that 21 earn a lot in foreign currencies. 22 Berkshire does have positions in foreign companies in its portfolio, 23 listing Petro China, POSCO and Tesco in the 2007 annual report. 24 In addition, Berkshire owns U.S. based companies that have global 25 operations. 26 He noted he would own Coca-Cola whether it was based in the U.S. 27 or in Amsterdam. 28 He admitted that Berkshire is not well-known outside of the U.S. But 29 that is changing since Eitan Wertheimer (CEO of ISCAR) entered the 30 Berkshire fold. Wertheimer is going through a procedure to get Berk- 31 shire better-known abroad. 32 Buffett assured shareholders that the entire world is on his radar 33 screen and that Berkshire hopes to be on the world’s radar screen in 34 the future. 35 Buffett surmised that Berkshire has a pretty good group of businesses 36 for the world we face. While we may not know which will be super-winners, 37 a significant number will do okay. 38 Buffett said he doesn’t buy businesses with much thought of world 39 trends, but he does think about whether businesses are subject to 40 41

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21 foreign competition, have high labor content and/or have products 22 that can be shipped in. 23 He noted that oil went from $30 to $60 a barrel while the euro went 24 from 83 cents per dollar to $1.35. Thus, the price of oil for Europeans 25 rose only 25%, while for Americans, it rose 100%. 26 He concluded that it is easy to get anchored in your own currency. 27 He also teased that Berkshire owns one currency position right now that 28 will surprise us when we hear about it next year. 29 10 The Subprime Mortgage Mess 11 12 We have expressed great concerns about the subprime mortgage melt- 13 down. 14 However, Buffett does not see that this will be “a huge anchor on the 15 economy.” 16 Especially if unemployment and interest rates do not go up, Buffett 17 believes it unlikely this factor alone will trigger anything major in the 18 general economy. 19 However, that’s not to say Buffett didn’t find anything wrong with 20 what happened. 21 He called it “dumb lending” for lenders to make a high percentage 22 of loans where people make tiny payments early on and hope to make 23 it up with higher payments later. Someone who can only make 20–30% 24 of a full payment now isn’t going to be able to make 110% payments in 25 the future. 26 The real bet was that housing prices would keep going up. Now that 27 has stopped, and there is plenty of misery in the field, especially on the 28 coasts. 29 Munger chimed in that much of the sin and folly was due to accoun- 30 tants who let lenders book profits when no one in their right mind 31 would have allowed them to do so. If accountants lie down on the job, 32 you see huge folly. 33 Buffett concluded that it will be at least a couple of years before real 34 estate recovers. The people who were counting on flipping the homes 35 are going to get flipped, but in a different way. 36 37 Executive Compensation 38 39 While there have been some remarkable examples of outrageous exec- 40 utive compensation, Buffett asserted the larger problem is having the 41 wrong manager rather than the wrong compensation system.

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It’s an enormously difficult thing to run a big company, so the 1 greater sin is having the wrong person. 2 As he’s pointed out in prior years, what really drives the compensa- 3 tion insanity is envy, not greed. Someone getting paid $2 million might 4 be quite happy until they hear about someone else that got $2.1 million. 5 In addition, compensation consultants know that getting hired in 6 the future depends on a recommendation from the CEO, so they are 7 not interested in low-balling what the compensation should be. 8 If the boards do not negotiate with some intensity, there is really no 9 one to represent the shareholders. Buffett concludes that under those 10 circumstances, it’s an unfair fight. 11 12 13 Boards of Directors 14 Buffett’s view is that the most important job of the board is to pick the 15 right CEO. 16 The second most important job is to prevent the CEO from over- 17 reaching, which often happens in acquisitions. 18 The CEO often stacks the deck before he proposes the deal and, 19 with all the focus on the acquired value to be gained, seldom carefully 20 considers how much value is being given away. 21 Buffett used himself as an example, noting that when he gave away 22 2% of Berkshire to acquire Dexter shoes, it was a dumb move, especially 23 considering what 2% of Berkshire is worth today. 24 At Berkshire, Buffett has compiled a superb board and has encour- 25 aged ownership. 26 He noted that everyone on the board at Berkshire has a lot of 27 Berkshire stock. Thus, they are in the same position as shareholders. 28 They don’t have directors and officers insurance, and they have 29 purchased the stock in the open market. It’s a real owner’s board.* 30 31 32 Modest Expectations 33 Buffett’s Fortune article in 1999 was right on, suggesting that future 34 market returns were bound to be much more modest after 17 years of 35 well-above-average returns in the 1980s and 1990s. 36 He shared that if he were writing today, he would expect equities 37 to do better than the 4.75% being paid by Treasury securities—not 38 necessarily high expectations for equities but higher than that for 39 40 * Note to regulators—here’s a corporate governance model worth examining. 41

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21 bonds for sure. And to the extent he does own bonds, he’s 100% in 22 short-term maturities.* 23 Buffett has clearly acted on his views, increasing the percentage of 24 Berkshire’s investment portfolio allocated to stocks from 41% to over 25 51% over the last 15 months. 26 Munger summed up that Warren was right in 1999 that the experience 27 from owning equities from that point would be pretty lean, so he suspects 28 Warren is right again to have modest expectations now. 29 10 Corporate Profits 11 12 U.S. corporations have been earning record profits with record profit 13 margins. 14 Buffett said he’s been amazed. Corporate profits as a percentage of 15 GDP have been higher only two or three years out of the past 75. His- 16 torically, when corporate profits get to around 8% of GDP, there’s a 17 reaction, such as higher taxes. 18 Buffett noted that to have lots of businesses earning 20% on tan- 19 gible equity in a world where corporate bonds are yielding 4–5% is 20 astonishing. 21 He suspects Congress may do something to change this. 22 Buffett concluded that Corporate America is living in a great time, 23 but history shows that this is not sustainable. 24 Munger noted that the extreme expansion of consumer credit has 25 played a role. There’s been a huge flow of profits to banks and investment 26 banks. Other countries with extreme consumer credit have suffered 27 bad consequences, such as South Korea. 28 He surmised that this is not a good time to swing for the fences. 29 Buffett added that the bust in South Korea produced some of the 30 cheapest stock prices he’s ever seen. 31 32 Private Equity Bubble 33 Unlike other bubbles, Buffett doesn’t see this one popping anytime 34 soon but perhaps slowly deflating over a number of years. 35 Since the money is locked up for 5–10 years, it’s not like people can 36 or will leave in a panic. More likely is a gradual slow down, especially if 37 the spread between high-yield bonds and safe bonds widens.† 38

39 * Which is identical to the view of FPA’s Bob Rodriguez, who sees “no value in bond land.” 40 † Which is happening right now. 41

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Another factor driving the boom is that if you have a $20 billion 1 fund and get a 2% fee, you take in fees of $400 million a year. But you 2 can’t raise another fund until you get the first one invested, so there is a 3 great rush to get all these funds invested quickly so that you can go raise 4 money for the next fund. 5 Buffett allowed that Berkshire cannot compete against these buyers 6 and that it might be some time before disillusion sets in. 7 Munger concluded that things like this can continue for a long time 8 after you’re in a state of total revulsion. 9 Buffett quipped, “The voice of total optimism has spoken.” 10 11 12 Newspapers 13 Buffett had a great thought picture to explain the long-term fate of the 14 newspaper industry. 15 Suppose Johannes Gutenberg, the inventor of modern printing, had 16 been a day trader or hedge fund manager instead so that printing was 17 never invented. Then along came the Internet and cable TV. 18 Now imagine someone coming up with this idea to chop down trees, 19 buy expensive printing presses and a fleet of trucks, all to get pieces of 20 paper to people to read about what happened yesterday. 21 It wouldn’t happen. 22 It just turned out that newspapers came first, so they have some 23 momentum. But you’re not going to reverse the decline. 24 Buffett noted that earnings at the Buffalo News are down 40% from 25 the peak. 26 Similarly, the shift to the digital world has decimated World Book 27 Encyclopedia, where unit sales have dropped from 300,000 to 22,000. 28 29 30 Gambling: A Tax on Ignorance 31 Buffett noted that people simply like to gamble. And as more states 32 legalize it, it gets easier for people to do so. 33 He shared that he had a slot machine in his house and taught his 34 children a good lesson with it. He’d give his children any allowance that 35 they wanted, and he’d have it all back by nightfall. He joked that his slot 36 machine had a terrible pay-out ratio. 37 Buffett asserted that to a large extent, gambling is a tax on ignorance. 38 You put it in, and it ends up taxing many that are least able to pay while 39 relieving taxes on those who don’t gamble. 40 41

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21 He finds it socially revolting when a government preys on its citizens 22 rather than serving them. A government shouldn’t make it easy for people 23 to take their Social Security checks and waste them by pulling a handle. In 24 addition, other negative social things can flow from gambling over time. 25 26 Buying Businesses 27 28 Buffett favors great businesses, which he defines as those having a high 29 return on capital for a long period of time, where he thinks management 10 will treat shareholders right. 11 Ideally, Buffett buys these businesses for 40 cents on the dollar, but 12 he’ll pay closer to a dollar for a really great business. 13 Munger piped in that margin of safety means getting more value 14 than you’re paying. It’s applied high school algebra. However, there is no 15 one easy mechanical formula to determine intrinsic value and margin 16 of safety. You have to apply lots of models. So it takes time to get good at 17 it. You don’t become a great investor rapidly any more than you become 18 a bone-tumor specialist quickly. 19 He added that he has no system for estimating the correct value of 20 all businesses and, in fact, puts almost all in the “too hard” pile and sifts 21 through the few easy ones. 22 Buffett broke it down into an example: 23 Let’s say you want to buy a farm, and you calculate that you can 24 make $70/acre as the owner. How much will you pay for that farm? 25 You might decide you wanted a 7% return, so you’d pay $1000/acre. 26 If it’s for sale at $800/acre, you buy, but if it’s for sale for $1200/ 27 acre, you don’t. 28 You wouldn’t base this decision on what you saw on TV or what a 29 friend said. You would do your own homework. 30 It’s the same with stocks. 31 Buffett emphasized that the ability to generate cash and reinvest is 32 critical. He noted that it is the ability to generate cash that gives Berkshire 33 its value. In addition, it is important to understand the competitive posi- 34 tion and dynamics of the business and look into the future. 35 If you were thinking about paying $900,000 or $1.3 million for a 36 McDonald’s stand, you’d better think about things like whether people 37 will keep eating hamburgers and whether McDonald’s could change 38 the franchise agreement. 39 Buffett has taught in past years that it is important to know the one 40 or two key factors in each business you own. This year, he mentioned 41

162 2007 that when he bought into USAir, an airline with high seat-mile costs of 1 12 cents, it was protected. However, trouble ensued when Southwest 2 showed up with 8-cent costs. 3 Buffett also noted that with evaluating oil and gas managers, he 4 believes the key variable should be finding costs. 5 Finally, Buffett stressed the importance of staying within one’s circle 6 of competence. Buffett said a large part of his success has come from 7 knowing how to recognize and step over one-foot bars and to recognize 8 and avoid the seven-foot bars. 9 10 11 Become a Learning Machine 12 Munger has often extolled Buffett’s relentless thirst for learning, calling 13 him a “learning machine.” 14 Buffett agreed that he is big on reading everything in sight and 15 recommended good investors should read everything they can. 16 In his case, he said that by the age of 10, he’d read every book in 17 the Omaha public library on investing, some twice! Fill your mind with 18 competing ideas, and see what makes sense to you. 19 Then you have to jump in the water—take a small amount of money, 20 and do it yourself. He joked that investing on paper is like reading a 21 romance novel versus doing something else. 22 Munger shared that Berkshire Director Sandy Gottesman, who runs 23 a large, successful investment firm (First Manhattan), asks interviewees, 24 “What do you own, and why do you own it?” If you’re not interested 25 enough to own something, then he’d tell you to find something else to do. 26 Buffett noted that he and Charlie have made money a lot of different 27 ways, some of which could not be anticipated 40 years ago. 28 Rather than a defined road map, what’s called for is a reservoir of 29 thinking and experience built by looking at markets in different places, 30 different securities, etc. 31 One good place to look is where there are few other players. The 32 RTC, Resolution Trust Corp, was a great example of a chance to make 33 a lot of money with relatively few competing players. Here was a seller 34 (the government) with hundreds of billions of dollars of real estate and 35 no money in the game, who wanted to wrap it up quickly, while many 36 buyers had no money and had been burned.* 37 38

* One of our favorites, Leucadia National Corp, was a very profitable player in the RTC 39 process. 40 41

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21 At age 19, Buffett read The Intelligent Investor. He shared that at age 22 76, he’s still running through the same thought processes he learned 23 from the book at age 19. 24 In an interesting point, Buffett again noted that you need some- 25 thing in your programming so that you don’t lose a lot of money. 26 He claimed that his best ideas haven’t done better than others’ best 27 ideas, but he’s lost less on his worst ideas. 28 29 Comments on Risk 10 11 In modern portfolio theory, beta is a measure of volatility, which, in 12 turn, is seen as a measure of risk. The higher the beta, the higher the 13 risk. At least that’s how the theory goes. 14 Buffett begs to differ, asserting volatility does not measure risk. Beta 15 is nice and mathematical, but it’s wrong. 16 For example, a couple decades ago, farmland in Nebraska went 17 from $2,000 to $600 per acre. The theory would say the “beta” of farms 18 went way up, so you would be taking far more risk buying it at $600 (as 19 Buffett did) than at $2,000/acre. 20 That, of course, is nonsense. But stocks do trade, and math types like 21 the ability of computers to model all those jiggles in prices. 22 Buffett concluded, “This concept of volatility is useful for people 23 whose career is teaching, but it’s useless to us.” 24 Buffett believes that real risk comes from the nature of certain kinds 25 of businesses, by the simple economics of the business and from not 26 knowing what you’re doing. If you understand the economics and you 27 know the people, then you’re not taking much risk. 28 For example, Buffett noted that he’s willing to lose $6 billion in one 29 catastrophe, but Berkshire’s insurance business over time is not very 30 risky. Given time, the probabilities will play out. Similarly, if you own a 31 roulette wheel, you sometimes have to pay 35 to 1, but that’s okay. He’d 32 love to own a lot of roulette wheels. 33 Munger put in his two cents, “At least 50% of what is taught is twaddle, 34 but these people have very high IQs. We recognized early on that very 35 smart people do very dumb things, and we wanted to know why and 36 who so we could avoid them.” 37 38 Ethanol 39 40 Munger, ever the diplomat, weighed in on ethanol: “I think the idea of 41 running vehicles on corn is one of the dumbest ideas I’ve ever seen. Gov-

164 2007 ernments under pressure do crazy things, but this is among the craziest. 1 Raise the cost of food so you can run these autos around? You use up 2 just about as much hydrocarbons making ethanol as it produces, and its 3 cost doesn’t even factor in the permanent loss of topsoil. I love Nebraska 4 to the core, but this was not my home state’s finest moment.”* 5 6 7 Giving His Fortune Away 8 9 Buffett provided a very interesting summary of his $30 billion (and 10 growing) gift to the Bill and Melinda Gates Foundation and to some 11 other foundations run by his children. 12 Buffett said he always felt that he would compound money at a rate 13 higher than average, and it would have been foolish to give away a 14 significant portion of that capital. He also thought his wife would have 15 been the one giving it away, but things didn’t work out that way. 16 The idea of finding talented people to do what they do best is one of 17 Buffett’s driving principles. 18 He noted that when he and Suzie had a baby, they hired an 19 obstetrician—he didn’t try to do it himself. When his tooth hurts, he 20 doesn’t turn to Charlie. 21 Similarly, when it came time to giving his money away sensibly, he 22 turned to Bill and Melinda Gates, people who are smart, energetic and 23 passionate. He wanted to give the claim checks to someone who could 24 follow generally what he would do himself if he were to do it. 25 Buffett added that as far as he’s concerned, he hasn’t given up any- 26 thing. He hasn’t changed his life. He couldn’t eat any better or sleep 27 any better, so he really hasn’t given up anything. Someone giving up a 28 trip to Disneyland to make a donation is the one making a real sacrifice. 29 30 31 More Wisdom from Charlie 32 We have often recommended to our friends and clients George Clason’s 33 classic, The Richest Man in Babylon, so we were delighted to hear Charlie 34 speak of it. 35 He said that he read the book when he was young and that the book 36 taught him to under-spend his income and invest the difference. 37 Lo and behold, he did this, and it worked. 38 39

* Munger is not alone in questioning the wisdom of the ethanol program. The July 15, 2007, 40 Des Moines Register featured a headline story debating the future of ethanol subsidies. 41

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21 He got the idea to add a mental compound interest as well. So he 22 decided he would sell himself the best hour of the day to improving his 23 own mind, and the world could buy the rest of his time. 24 He said it may sound selfish, but it worked. 25 He also noted that if you become very reliable and stay that way, it 26 will be very hard to fail in doing anything you want. 27 28 29 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

166 1 2008 2 3 4 5 Venue: Qwest Center 6 7 Attendance: 31,000 8 9 Details About This Year: 10 11 • The Qwest Center on the Berkshire weekend has become 12 part meeting, part circus. There were country western 13 singers, live bulls, speed boats, antique cars and an entire 14 manufactured home from Clayton Homes. 15 • Some 25 Berkshire companies, from Justin Boots to Fruit 16 of the Loom to GEICO insurance, sold their wares in the 17 show room. 18 19 • Nebraska Furniture Mart had record sales of $7.5 million 20 during the event. 21 22 Fortune 500 Ranking: 11th 23 24 Stock Price: $141,685 25 One dollar invested in 1964 would now be worth $14,454. 26 27 Berkshire’s per-share book value has grown from $19.46 to 28 $70,530 (a rate of 20.3% compounded annually). 29 The S&P 500 compounded at 10.3% annually for the same 30 period. 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2008’s Notes 22 23 24 Buy the Business 25 26 Asked how not to be an investment lemming, Buffett suggested reading 27 his old standby, The Intelligent Investor by Benjamin Graham (especially 28 chapters 8 and 20), which changed his life. 29 Always remember that when you are buying a stock, you are really 10 buying part ownership of a business. 11 Buffett, after working at his grandfather’s grocery store, learned the 12 importance of hard work. However, his grandfather was very negative 13 about the stock market. Buffett stopped listening to him at that point.* 14 If Buffett were teaching business school, he would make it shockingly 15 simple. Teach 1) How to Value a Business, and 2) How to Think About 16 Market Fluctuations—that the market is there to serve you, not influence 17 you.” That would be it. Professors fill the time with all sorts of formulas. 18 Just as the priesthood of Biblical scholars would not have much to 19 do if the masses simply followed the 10 Commandments, so do business 20 school professors need something to teach and impress the students. 21 On the stock market, Buffett noted that the market represents 22 thousands of businesses. So it should not matter where the stock market 23 goes in the short run. He would be happy with his stocks if the market were 24 closed several years. 25 If you were buying a farm, for example, you would look at the farm’s 26 production over time versus the purchase price. You would not be trad- 27 ing farms based on short-term swings in agricultural prices. 28 Munger: “I have nothing to add.” 29 Buffett: “He’s been practicing for months.” 30 31 32 Future Returns: Lower Expectations 33 Buffett noted that he will be very happy with a 10% total return on his 34 stock portfolio. 35 He predicted (for the umpteenth time) that Berkshire’s future returns 36 will not even be close to the returns it has earned in the past. Given 37 Berkshire’s size, it must look at companies with $50 billion market caps 38 to move the needle. He concluded that “we’ll have decent results but 39 not indecent results.” 40 41 * Luckily for all Berkshire shareholders.

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Munger added, “We’re happy making money at a reduced rate and 1 suggest you do the same.”*† 2 3 Good Managers: We Cheat 4 5 Buffett noted that he cheats when it comes to finding good managers. 6 He simply buys the ones who are already running great companies. 7 If he were shown 100 MBAs, Buffett asserted that it would be impos- 8 sible for him to rank how they will actually perform as managers. 9 He simply finds decades-long records of excellent performance. 10 Then he seeks to retain them in a way that maintains their enthusiasm 11 for the work. 12 Buffett asks whether the manager loves the money or loves the 13 business. If they love the business, they’ll be a good fit for Berkshire. 14 In sum, Buffett looks for .400 hitters that can work for decades. He 15 joked that Mrs. B (founder of Nebraska Furniture Mart) left at age 103 16 and died the next year. He hopes that’s a lesson for his managers. 17 18 Ethics 19 20 Buffett said he’s very proud of how the Berkshire managers, as a group, 21 have behaved over the years. 22 To maintain clarity, Buffett sends a letter every two years to the 23 managers, asking who their successors would be and reminding them to 24 be sure not to lose a shred of reputation for the company.‡ 25 He suggests the “newspaper” standard: behave as if your actions will 26 be on the front page of the local newspaper. Berkshire has no budgets 27 or earning goals, which eliminates some of the perverse pressures that 28 infect most other large companies.§ 29 30 Hedging the Dollar: Going International 31 Buffett warned years ago that the U.S. dollar was at risk with our ever- 32 expanding trade deficit. 33 34 * Note the steady increase in equities in Berkshire’s Cash/Bond/Equity Ratio (See Appe- 35 dix II). † Berkshire has been active in the stock market, accumulating 8.6% (about $4 billion) of 36 Kraft Foods and adding to its stakes in Burlington Northern, Wells Fargo, U.S. Bank, John- 37 son & Johnson and Carmax. ‡ We recall how Buffett famously spoke about employee ethics at the congressional hearings 38 of the Salomon scandal: “Lose money for the firm, and I will be understanding. Lose repu- 39 tation for the firm, and I will be ruthless.” § In past meetings, Munger has referred to “earnings management” as evil as it pressures 40 managers to do irrational things. 41

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21 Given that there has been no meaningful change in U.S. economic 22 policies, Buffett continues to be bearish about the dollar. 23 As a result, Buffett is happy to earn profits in currencies other than the 24 U.S. dollar. That can happen through stock ownership (Coca-Cola earns 25 80% of its profits overseas) or through the direct purchase of foreign 26 companies. He’s actively looking to do more of the latter. 27 Buffett is heading to Europe soon to tout the virtues of family- 28 controlled companies selling to Berkshire. ISCAR in particular has 29 opened Buffett’s eyes to the possibilities overseas. ISCAR opened a plant 10 in China last year and its CEO, Eitan Wertheimer, is accompanying 11 Buffett on his swing through Europe. 12 ISCAR, by the way, has exceeded Buffett’s very high expectations. He 13 noted that both the financial performance and the personal relationships 14 have made it a “dream acquisition.” 15 Buffett wants more family owners who, when they feel the need to 16 monetize their business, will think of Berkshire Hathaway. 17 That was the case recently for the Pritzkers and Marmon Group. It 18 was the case a couple of years ago with the Wertheimers and ISCAR. 19 Munger noted that Germany has a particularly evolved civilization, 20 especially in terms of inventiveness and engineering. For example, in 21 the printing business, to an amazing degree, the best equipment is 22 German-made. 23 Buffett reflected how he lost big time on Dexter shoes. Twenty years 24 ago, the U.S. made one billion pair of shoes annually. 25 He quipped that our shoe-wild culture made the U.S. a nation of 26 Imelda Marcos’. Now, while we still buy shoes, the U.S. makes no shoes. 27 All shoes are made abroad today, especially in China. 28 Buffett noted how China is now unleashing its potential in a more 29 open society. The talent was always there. It was just suppressed for so 30 long. 31 32 Municipal Bond Dislocations 33 34 In his annual shot at modern portfolio theory, which claims that mar- 35 kets are always efficient, Buffett described what happened in the munic- 36 ipal bond market in early 2008. 37 Once in a while, Buffett brings props, and this year’s was a set of 38 municipal bond bid sheets. 39 He noted that there were some $330 billion of auction rate securities 40 (ARS) weekly. Voilà—long-term funding with short-term rates. Good 41

170 2008 as long as it works. But when credit markets seized up in February, so 1 did the ARS market. Chaos ensued. 2 Buffett noted that Los Angeles County Museum bonds that yielded 3 4% in January suddenly were priced to yield as high as 10% in mid- 4 February. Now, the bonds are back to a 4% yield. 5 He also noted that during the panic, different bonds of the same 6 issuer yielded anywhere from 6% to 11% at the same time! So much 7 for the efficient market. It was a short-lived but very obvious opportu- 8 nity for Buffett, and Berkshire acquired $4 billion of municipal bonds 9 during the period. 10 Munger noted how quickly the opportunity came and went. Hedge 11 funds had to dump because of margin calls. If you cannot think fast and 12 act resolutely, it does you no good. Like men spear fishing, you may wait 13 a long time, and when opportunity comes, you must act. 14 15 16 Berkshire Hathaway Assurance 17 18 In a remarkable turn of events, Berkshire recently entered the municipal 19 bond insurance industry as the mortgage crisis infected the other 20 primary players. 21 Buffett provided an update, noting that Ajit Jain started up Berkshire’s 22 municipal bond insurance subsidiary at the end of last year. 23 Buffett proudly announced that in a matter of months, BHA 24 (Berkshire Hathaway Assurance) already has collected premium volume 25 of $400 million, which may be more than all other municipal bond 26 insurers—combined! It’s done 278 transactions, mostly secondaries, 27 with just 30 people in the office. The Berkshire-insured bonds are trading 28 at a premium to those of any other bond insurer. 29 Buffett said that the premiums represent coverage that only pays if 30 the primary insurer cannot pay. And Berkshire is getting better than 2% 31 when the original insurance cost 1%. 32 Munger shared that once, when he was asked what was Berkshire’s 33 single best investment, he answered, “The fee for the corporate recruiter 34 that brought us Ajit Jain.” 35 36 37 Succession 38 Buffett announced that the board has the names of several potential 39 successors and reviews succession plans at each board meeting. 40 41

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21 Munger noted that Berkshire still has a rising young man in one 22 Warren Buffett. 23 Buffett wryly pointed out that the term “aging management,” so 24 often used to describe Berkshire’s top brass, refers to all managers. 25 Furthermore, given that he and Charlie average 80 years between 26 them, they are aging at the rate of just 1.25% per year. Meanwhile, a 27 50-year-old manager is aging at a 2% rate and, therefore, is a much 28 riskier bet. 29 Munger, on what Warren wants said at his funeral: “That’s the oldest 10 looking corpse I’ve ever seen.” 11 12 Concentration 13 14 Munger and Buffett were in complete agreement about the benefits for 15 the professional investor of loading up on your best ideas. 16 Buffett claimed that concentration is a good thing in investing, 17 noting that he has had 75% of his non-Berkshire net worth invested in 18 a single idea numerous times. It would be a mistake not to have 50% 19 of your net worth in a really good situation. The big mistake is having 20 500% of your net worth in things. Long-Term Capital Management had 21 25 times its net worth up, so it couldn’t play out its hand when things 22 went against it.* 23 Munger rued that elite schools teach that the secret of investment 24 management is diversification. They have it backasswards he asserted. 25 Non-diversification is the key. 26 27 Oil 28 29 The danger, according to Buffett, isn’t that we will run out of oil, as is 30 sometimes heralded by the press, but that daily production will level out 31 and then slowly decline over time. 32 The world now produces 87 million barrels per day, the most ever, 33 and yet we are probably at the lowest surplus capacity ever as demand 34 marches ever higher. If we are at peak production, and it looks like we 35 are, the world will have to adjust. 36 Munger noted that it is stupid to use our limited supply of hydrocar- 37 bons as fast as we are. 38 Munger believed that we need to use the sun—there is no other 39 alternative. 40 41 * Almost weekly, we are reading of blowups of hedge funds levered 10:1, 20:1, and more.

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1 Ethanol Update 2 Munger weighed in with his usual sunny assessment: “Corn to motor 3 fuel is one of the dumbest ideas for the future of the world I’ve ever 4 seen. It’s stunningly stupid. The idea is probably on its way out.” 5 6 7 Investment Bank Follies 8 Munger observed that Enron shocked the nation with its gross folly 9 and misbehavior. That brought us Sarbanes-Oxley, which turned out to 10 be like trying to shoot an elephant with a pea shooter. The convulsion 11 underway now makes Enron look like a tea party. We will have more 12 regulation, and it won’t work perfectly for everyone. 13 Buffett felt that the Fed did the right thing with the Bear Stearns 14 bailout. Bear would have failed, and the sorting out of some $14.5 15 trillion of derivative contracts with thousands of counterparties would 16 have been a spectacle of unprecedented proportions with another big 17 investment bank or two folding within a few days. These firms never 18 dreamt that the world would stop lending to them. 19 Buffett asserted that investment banks and big commercial banks 20 are too big to manage the way they have been going. It works most of 21 the time, so you don’t see the risk day to day. And if you’re a 62-year-old 22 executive, you don’t worry too much about the very long run. What 23 you need is a CEO with risk aversion in his DNA and the ability to resist 24 employees who want to copy others to make money. 25 26 27 OFHEO Spells Awful 28 Regarding the difficulty of regulating complex financial enterprises, 29 Buffett observed that OFHEO (Office of Federal Housing Enterprise 30 Oversight) oversees two incredibly important entities, Fannie Mae and 31 Freddie Mac. 32 These two accounted for 40% of mortgage flow a few years back and 33 perhaps some 70% today. 34 OFHEO, with a staff of 200, existed solely for the purpose of watching 35 these two companies. And what happened were two of the greatest 36 accounting misstatements in history, billions and billions of dollars, 37 while these 200 people had their jobs. They went two for two. 38 Buffett concluded that when you combine “too big to manage” with 39 a government that deems them “too big to fail,” you get interesting 40 outcomes. 41

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21 Munger was more direct, calling it crazy that the government would 22 allow the banks to get too big to fail, a product of a culture of greed and 23 overreaching. Overconfidence in algorithms played a part as well. 24 Munger called it demented to let derivative trading end up this way 25 and regretted that so few spoke against it. 26 27 GURF: Good Until Reached For 28 29 Munger noted that so much of derivative accounting was not real profits. 10 And he coined a new accounting term, GURF: “good until reached 11 for.” Many investment banks carried assets that went “poof” when it 12 came time to sell them. There were no bids. 13 He asserted that the accounting failed us and that accounting 14 should be more like engineering.* 15 Buffett recounted how, in the dark days of the Salomon Brothers 16 scandal, its traders were doing business with Marc Rich—who had fled 17 the country for securities fraud! Yet the traders resisted orders to stop 18 trading with him because they were making money at it. Buffett had to 19 issue a specific directive to stop it. This is the sort of thing that happens 20 in a corporate culture of greed. 21 Munger intoned, “There is much that happens in the bowels of 22 American business that you don’t want to know about.” 23 24 Thinking About Risk 25 26 Buffett noted that it’s important to think about risks, including those 27 that have never happened before. The investment banks all had mod- 28 els, they had weekly risk committee meetings and they still didn’t have 29 a clue. 30 Buffett opined that “a chief risk officer is an employee that makes 31 you feel good while you do dumb things.” 32 At Berkshire, Buffett is the chief risk officer, and they spend a lot of 33 time thinking about what could hit them out of the blue. 34 Munger said one can see how risk adverse Berkshire is. It behaves 35 in a way where no one will worry. There’s a double layering of safety 36 around risk. 37 While the crisis originated in the mortgage area, the troubles have 38 spread to other areas. In fact, Buffett said he couldn’t remember such 39

40 * GURF reminds us of Bob Rodriguez’s “to whom” securities, as in, when it comes time to 41 sell, “to whom” will you sell them?

174 2008 shock waves and the exposure of weakness of other practices like this 1 one. Stupid things were done, and now the price must be paid. 2 And he predicted, eventually, we will see it all again, just in a differ- 3 ent form. Some combination of wanting to get rich, leverage and belief 4 in the tooth fairy will generate another bubble in time. 5 Munger noted that this was a particularly foolish mess. He asked 6 if folks remembered that Internet-based grocery delivery business, 7 Webvan, which he thought was a simply asinine idea. Well, he asserted, 8 that idea was a lot smarter than the ideas cooked up in the mortgage 9 industry. 10 Buffett summed up that he could have more leverage at Berkshire, 11 but for what? Why expose the company to ruin and disgrace for an 12 extra percentage point of return? You cannot farm-out risk manage- 13 ment. Buffett willingly accepts lower returns for being able to sleep well, 14 whatever may come.* 15 16 17 Fair Value Accounting 18 Buffett allowed that accounting for asset values is a tough thing, though 19 he still strongly favors fair value versus cost. 20 The trouble with fair value can occur when the market produces 21 prices that makes no sense. 22 He talked about CDOs (collateralized debt obligations), which were 23 aggregations of tranches of thousands of different mortgage claims. 24 They were so complicated that there could be 15,000 pages to read 25 to understand all the mortgages and tranches involved. 26 As if that wasn’t complicated enough, there are also CDOs squared, 27 which might be a security that comprises 50 CDOs. At 15,000 pages 28 per CDO, one would have to read some 750,000 pages to understand 29 one CDO squared. 30 When you start buying securities made of tranches of other instru- 31 ments, nobody knows what they’re doing. It was madness. Forcing 32 people to mark things to market (“fair value”), valuing things like these 33 CDOs at a 10 cent market price versus the cost of 100 cents, helps to 34 keep management a little more honest. 35 Munger also took a shot at Alan Greenspan, suggesting Greenspan 36 had overdosed on Ayn Rand—adopting the belief that if things happen 37 in a free market, they must be okay. 38 39

* Ironically, this is the mindset that has produced among the very highest average rates of 40 compounding over the past four decades. 41

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21 Munger emphatically disagreed, saying that some things should be 22 forbidden: “If we had just banned the phrase ‘this a financial innovation 23 that reduces risk,’ we would have prevented a lot of trouble.” 24 25 CDS Trouble? 26 27 When asked about CDS (credit default swaps), a $60 trillion national 28 market, Buffett felt the CDS market was not a big risk to tumble into 29 chaos. 10 A CDS is insurance against a company going bankrupt. While corpo- 11 rate default rates will rise, most of the CDS market is a zero-sum game. 12 The losses of some will be matched by the gains of others. 13 In contrast, when the subprime mortgages went south, real dollars 14 were lost. 15 With the Fed stepping in to bail out Bear Stearns, Buffett believed 16 the odds for a CDS calamity now are low. 17 Munger concurred. Could we have a big time mess out of CDS? Yes. 18 But the stupidity is not as bad as in the mortgage market where skid-row 19 bums were swept up and given easy term mortgages. 20 What Munger did believe was bizarre was that CDS contract holders 21 actually have a perverse incentive: they make money when corporations 22 fail. So there could be manipulation to create corporate failures to 23 collect on contracts. 24 Munger believed it was insane for regulators to allow this. It is illegal 25 to buy life insurance on people you don’t know as it creates a moral 26 hazard (if they die, you get rich). He concluded that the CDS market 27 is the product of a major nutcase bunch of proprietors and regulators. 28 Buffett tallied, “Charlie 1, Invisible Hand 0.” 29 30 Keep It Simple 31 32 Munger asserted that Berkshire has lower due diligence expense than 33 any other large corporation. And they have less trouble than any other 34 large corporation. 35 At Berkshire, they think like engineers, looking for big margins of 36 safety. If you need an accountant to tell you about a deal, you should be 37 the accountant and let him run the business. 38 Buffett noted that this simplicity is a big advantage. Mars came to 39 Berkshire because they knew no lawyers were needed. The folks at Mars 40 knew that at Berkshire, a deal’s a deal, and the check will clear. 41

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1 Branded Food Companies 2 Berkshire has long been invested in branded food companies and 3 recently took a more than 8% stake in Kraft Foods. 4 Buffett observed that big food companies are good businesses. They 5 earn good returns on tangible assets. 6 Good brands like See’s, Coke, Mars, Wrigley’s are tough to compete 7 with. 8 Coke now provides 1.5 billion servings a day worldwide. Since 1886, 9 Coke has been delivering “happiness” and “refreshing” associations. 10 These associations get implanted in people’s minds. 11 Good branded products are often a good investment. 12 13 14 Keep It Simple II 15 Buffett allowed that one of their success secrets has been to focus only 16 on those things that they figure out. 17 If it’s a “no go,” Buffett will cut off a proposal in mid-sentence (a 18 technique he says he learned from Charlie). If he can figure it out, he 19 can make a decision in five minutes. 20 A fascinating point: Buffett claims he could spend five months more 21 on the idea, and it wouldn’t add value to his decision. 22 Munger chimed in that they have a good “blotter out” system. They 23 don’t waste time on certain things.* 24 25 26 China Olympics 27 Buffett was in favor of going ahead with the Olympics, believing it is 28 a mistake to start deciding which of the 200 countries are worthy to 29 participate. 30 He noted that the U.S. didn’t allow women to vote for 120 years and 31 that blacks, at one time, were considered three-fifths of a person. 32 Munger was even more pointed, saying that distressed persons 33 should ask themselves, “Is China more or less imperfect over the 34 decades?” 35 He believes China is clearly on the right track and that it is a mistake 36 to take what you like least about something and then obsess about it. 37 38 39 * Less information, when it’s the right information, is a key to good decision-making. 40 41

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21 Bargains in Banks? 22 23 Buffett noted that the size of a bank means little to him. What really 24 counts is the culture. 25 He wants a bank CEO who has risk controls in his DNA. 26 While places like Wells Fargo, U.S. Bancorp and M&T Bank are not 27 immune from problems, they are immune from institutional stupidity. 28 Too many banks do crazy things by trying to do what is popular. As 29 Maury Cohen once said, “There are more banks than bankers.” 10 Munger noted that smaller banks are probably a good place to pros- 11 pect for investment value. 12 Buffett feigned great excitement: “That’s wildly bullish coming from 13 Charlie! I’m gonna buy that stuff as soon as I get out of here.” 14 15 Nuclear Proliferation 16 17 Buffett noted that one of the greatest risks to civilization continues to 18 be nuclear proliferation. 19 A given percentage of the world’s 6.5 billion people will be psychotic. 20 Thousands of years ago, the worst the demented few could do was 21 to throw rocks. With the advance of technology came bows and arrows, 22 then guns and cannons and, today, nuclear devices. 23 He believes it is paramount to minimize the risk and that not much 24 progress has been made. We should do everything possible to reduce 25 access to materials. 26 As Albert Einstein warned in 1945 with the advent of the A bomb, 27 “This changes everything in the world except how men think.” 28 Buffett said he hoped that this issue will be at the top of the next 29 U.S. administration’s agenda. 30 31 Savings Rate 32 33 Somewhat surprisingly to us, Buffett suggested that the fact that the 34 U.S. savings rate has turned negative is not necessarily a big negative for 35 the economy. 36 He noted that the economic value of the United States has been 37 increasing for decades even without a high savings rate. With a per capita 38 GDP of $47,000, we’re so rich we may not need to save as much. 39 With imports exceeding exports, the world is doing the savings for 40 us. China, with a much higher savings rate, will grow faster than us, and 41 it probably needs to do so.

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1 Dividends 2 No meeting would be complete without the perennial “When are you 3 going to pay a dividend?” question. 4 Buffett noted it has been better to retain the cash at Berkshire, where 5 it can automatically compound. If you need cash, you can sell stock and 6 pay capital gains tax at a lower rate than a dividend would be taxed. 7 Munger kidded that Warren has always planned to pay a dividend in 8 the manner of St. Augustine: “God give me chastity, but not yet.” 9 10 11 Corporate Compensation 12 Buffett admitted that there isn’t much the individual investor can do. 13 What is needed is for the half-dozen largest institutional owners, 14 in egregious cases, to withhold their votes and make statements about 15 excessive compensation. Big shots do not like to be embarrassed. The 16 press can help, too. An effective pressure is needed to check the self- 17 interest of management. 18 Munger reflected that in England, class warfare resulted in a 90% 19 income tax rate. While it proved to be totally counterproductive, it 20 showed how the politics of envy can ruin an economic system. 21 Munger believes CEOs taking compensation have a moral duty not 22 to take the last dollar. Like Supreme Court justices, they should choose 23 to be underpaid. 24 Buffett noted, “Envy is the worst of the seven deadly sins. It’s the 25 only one that makes you feel worse, and the other party feels nothing. 26 Gluttony—that has at least some temporary upside. As for lust—I’ll let 27 Charlie speak to that.” 28 29 30 Pharma 31 Berkshire expanded its position in Johnson & Johnson and added 32 shares of Sanofi in 2007. 33 Buffett admitted that he doesn’t know much about the drug pipe- 34 lines, and in five years it will all be different anyhow. 35 In aggregate, he believes pharma is doing something enormously 36 important, and overall, the group should have decent profits. A group 37 approach should provide a reasonable result over five years. 38 Munger deferred, “You have a monopoly on our joint knowledge of 39 pharmacology.” 40 Buffett quipped, “He gets cranky late in the day.” 41

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21 Keys to Good Health 22 Buffett joked that good health starts with a balanced diet: some Coca- 23 Cola, some See’s Candy, some Wrigley’s gum and a Mars bar. 24 Seriously, he noted the importance of a good mental attitude, to 25 love what you do and to do it with other people who love what they do. 26 He said he feels blessed in so many ways, especially with great partners 27 and great managers. It would be crazy to focus on the minuses. 28 He also noted that he was lucky to find his passion so early in life. 29 He recalled reading his dad’s books on investing as a boy and how that 10 turned him on. (He joked that was before Playboy was invented.) 11 He pointed out that it is a terrible mistake to sleepwalk through life, 12 to just go through the motions. Ideally, you have a job that you would 13 do for free. 14 Surprisingly, he claimed that when he went to work for Ben Graham 15 at the age of 24, he never even asked what his salary would be. 16 He also noted that getting the right spouse is essential. 17 He told the story of the man who spent 20 years looking for the perfect 18 woman before he finally found her. Unfortunately, she was looking for 19 the perfect man. 20 21 22 Benefits of Public Speaking 23 In a revealing aside, Buffett admitted that years ago he was terrified of 24 public speaking. He got physically ill at the thought. 25 He said he even signed up for a $100 Dale Carnegie course but 26 cancelled the check when he got home. 27 Later, he did a communication course in Omaha. Doing it with others 28 in the same boat helped him to “get outside of himself.” He’s very glad 29 he did it, noting that effective communication is under taught, and 30 recommended that many could benefit by forcing themselves to learn 31 public speaking at an early age.* 32 33 34 Number One Investment 35 As he has counseled on numerous occasions, Buffett suggested the best 36 investment one can make is in oneself. 37 He noted that few people get the maximum horsepower out of life. 38 Potential exceeds realization for so many. 39

40 * Throwing a party for 31,000 . . . yes, it is clear that young Warren has come a long, long 41 way with his stage fright.

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When he speaks to students, he suggests they adopt the mindset of 1 someone who is picking one car for the rest of their lives. How would 2 they treat it? They would read the manual carefully, change the oil twice 3 as often and clean up the rust spots. Well, each of us gets one mind and 4 one body for life. How will you treat yours? 5 Buffett admitted that the focus has been on the mind at Berkshire. 6 He and Charlie didn’t bother to work too hard on the body. 7 Munger also suggested that it is very important to learn how to avoid 8 being manipulated by lenders and vendors. 9 He strongly recommended Robert Cialdini’s book, Influence, for 10 the task. He also recommended Cialdini’s newest book, Yes, noting that 11 Cialdini is the rare social psychologist who can connect the world of 12 theory and daily life. 13 14 15 Read 16 Buffett reflected that he devoured books from an early age. He spends 17 much of his day reading books, annual reports and newspapers. 18 Munger noted that different people learn in different ways. He too 19 has always been an avid reader. With books, he likes that you can learn 20 just what you want to learn and at the speed of your choosing. 21 Buffett concluded that if you read 20 books on a subject you are 22 interested in, you are bound to learn a lot. 23 24 25 Legacy 26 Buffett hopes that in the long run, Berkshire will provide decent perfor- 27 mance for shareholders and maintain its unique culture. 28 Buffett hopes it will be seen as the best home in the world for family 29 businesses. 30 Munger sees Berkshire deserving to be even more of an exemplar 31 and sees it having even more influence on other corporations. 32 Buffett concluded with this quip: “We also hope that Berkshire will 33 have the oldest living managers in America.” 34 35 36 37 38 39 40 41

181 1 2009 2 3 4 5 Venue: Qwest Center 6 7 Attendance: 35,000 or so 8 9 Details About This Year: 10 11 • The highlight of this year’s movie was a tongue-in-cheek 12 skit where Buffett becomes a fl oor salesman for Nebraska 13 Furniture Mart. After a miserable year of investing in 2008, 14 the board suggests Buffett might help the company more 15 by selling a few more mattresses. The new best-selling 16 mattress is the “Nervous Nellie” with a special “night deposit” 17 compartment under the mattress for storing important 18 items. A shopper tries out the mattress and notes that “it 19 bounces back slow.” Once the sale is made, Buffett hurries 20 to remove his valuables from under the mattress, including 21 some vintage Playboys. 22 23 Fortune 500 Ranking: 13th 24 25 Stock Price: $96,629 26 One dollar invested in 1964 would now be worth $7,812. 27 28 Berkshire’s per-share book value has grown from $19.46 to 29 $84,487 (a rate of 20.3% compounded annually). 30 The S&P 500 compounded at 8.9% annually for the same period. 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2009’s Notes 22 23 24 Negative Treasury Yields 25 26 Buffett opened the meeting with an overhead.* The overhead was of a 27 trade ticket dated December 18, 2008, where Berkshire sold a $5 mil- 28 lion Treasury bill due in April of 2009 for more than its maturity value: 29 $5,000,090.97. 10 This means the buyer was willing to accept a negative yield. 11 Extraordinary. 12 Buffett quipped that the ticket was, in effect, an ad for the Nervous 13 Nellie mattress and added that we may not see such a thing again in our 14 lifetimes. 15 16 First Quarter Earnings 17 18 Buffett gave a heads up on first quarter earnings, sharing that Berkshire 19 operating earnings were $1.7 billion down from $1.9 billion a year ago. 20 He sees Berkshire’s insurance and utility operations doing well 21 for 2009 as they are not all that economically sensitive. The retail and 22 manufacturing subsidiaries have been hit hard by the recession. 23 He noted that MidAmerican Energy’s $1 billion of operating 24 earnings would be reinvested in utility operations. 25 Float bumped up from $58 billion to $60 billion due to a deal with 26 Swiss Re. 27 Cash ended the quarter at $23 billion, though cash has since dropped 28 to $20 billion as Berkshire invested $3 billion in a Dow Chemical 29 convertible preferred. 30 31 Debt? Equity? How About Both? 32 33 You want yield? How about something in the double digits? 34 You want appreciation? How about equity participation in some of 35 the biggest companies in the world? 36 Well, that’s what Buffett has done with his special deals. 37 Buffett upped his “other” category in investments with deals com- 38 bining both yields and equity kickers with Goldman Sachs ($5 billion of 39 40 * We always take special note when Buffett goes to visuals. 41

184 2009 a 10% preferred and warrants to buy 43 million shares at $115/share), 1 General Electric ($3 billion of a 10% preferred and warrants to buy 135 2 million shares at $22.25/share) and Wrigley ($6.5 billion total—$4.4 3 billion in 11.45% notes and $2.1 billion of 5% preferred). 4 We note also that preferred dividends are tax-preferenced for 5 corporations, so in the case of Goldman and GE, that 10% preferred 6 dividend is equal to nearly a 14% interest coupon on an after-tax basis 7 to Berkshire.* 8 This is why we would guess that while Buffett and Munger agreed 9 that the opportunities of 2008 were great, though not as compelling as 10 the 1974–75 bear market when PEs were 4 (though interest rates were 11 higher then), they were referring to the general market, not the unique 12 opportunities Buffett was able to create during this meltdown. 13 Summarizing 1974, Munger declared, “I knew I’d never get another 14 trip to the counter like that.” 15 Buffett said, as with hamburger, he’d rather pay ½ X than X, so he 16 liked the lower prices. 17 With stocks down 40% and interest rates down, stocks and bonds 18 had to be more attractive. 19 He noted that the corporate bond market was very disorganized. 20 For Berkshire’s life insurance companies, they barreled into good 21 quality corporate bonds yielding 10% or better with great call protection. 22 23 24 Financial Literacy 25 Buffett allowed that financial literacy is a tough sell in a world of calcu- 26 lators. Few can actually do the math anymore. Add in credit cards, and 27 you’ve made it easy for people to do silly things. 28 Munger chimed in with an anecdote about going to Vegas for his 29 honeymoon back in 1952 at the Flamingo. There, he saw very well- 30 dressed people who had traveled for miles to do something dumb with 31 negative probabilities, and he thought to himself, “What a world of 32 opportunity!” 33 Munger added that states legalize gambling with lotteries, effectively 34 encouraging the populace to bet against the odds. 35 36

* Again, this is the best of all worlds—double-digit yields AND equity participation rights. 37 And Buffett isn’t done yet. Subsequent to year-end, Berkshire acquired $3 billion Swiss 38 francs worth of a 12% convertible note with Swiss Re and invested $3 billion in an 8.5% con- vertible preferred of Dow Chemical. All in, that’s over $20 billion in high yield securities 39 with equity kickers. Amazing. 40 41

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21 Banks 22 23 Buffett and Munger were both complimentary of the government’s 24 actions in the midst of crisis and are optimistic for the recovery of the 25 banking system. 26 Buffett asserted that mid-September, we were at the brink of a total 27 meltdown throughout the financial system. There was that one week- 28 end where Lehman went down, AIG went down and Merrill Lynch 29 would have gone down if not acquired by the Bank of America. 10 Under such pressure, overall, he believed the government did a 11 good job, particularly in guaranteeing the safety of bank deposits and 12 money market funds. 13 Buffett spoke especially well of Wells Fargo, calling it a fabulous bank 14 with advantages that the other large banks do not have. In particular, 15 Wells Fargo has the lowest cost deposit base, making it the low-cost 16 producer in the business. 17 Buffett provided that Wells Fargo will come out of this way stronger 18 than it went in. 19 In a fascinating aside, Buffett shared that he was teaching a class 20 the day Wells Fargo went under 9. Usually, he refuses to answer the old 21 “name a stock to buy” question, but on that day, he said that “if I had to 22 put all my net worth in one stock, I’d buy Wells Fargo.” 23 Wells Fargo has a fabulous business model. With Wachovia, it picked 24 up the fourth largest deposit base in America. 25 Wells Fargo will be much better off in a couple of years because this 26 debacle happened. 27 28 Efficient Market Jab 29 30 Buffett and Munger do their level best each year to debunk the efficient 31 market hypothesis that dominates academic thinking. 32 Buffett noted that investing is really all about laying out cash now to 33 get more back later. 34 Buffett joked that in 600 B.C., Aesop, who was a very smart man, 35 though he didn’t know it was 600 B.C., he couldn’t know everything— 36 said, “A bird in the hand is worth two in the bush.” That’s really it. 37 Munger noted that a lot of spreadsheets and fancy math can lead to 38 false precision and worse decisions. 39 He allowed, “They teach the fancy math in business schools because 40 . . . well, they gotta do something.” 41

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Buffett chimed in that if you taught the “bird in the hand” maxim, 1 you would not get tenure. Rising in the priesthood requires complexity. 2 Buffett added that this false precision only arises with very high 3 IQs. You only need an IQ of 120 or so to be a good investor. In fact, he 4 suggested, if you have a high IQ, keep your 120 and sell the rest. Higher 5 math can lead you astray. 6 7 The Housing Bubble 8 9 Buffett noted that housing prices had risen for so long that there became 10 an almost total belief that housing prices would never fall. They could 11 only go up. Thus, a $20 trillion asset class, housing, out of the nation’s 12 $50 trillion in assets, became increasingly levered up. And the blame is 13 shared by all players. 14 Buffett pointed out that it was Congress that presided over the two 15 largest mortgage entities in the world, Fannie Mac and Freddie Mac, 16 and both are in receivership. 17 As for the rating agencies, especially Moody’s, in which Berkshire 18 owns a 20% stake, Munger noted that they are good at fancy math and, 19 as with the man with the hammer, treated each problem like a nail. 20 Going forward, Buffett believed the rating agencies are good busi- 21 nesses: there are few competitors, they affect a large segment of the 22 economy and they don’t require much capital (though they are still 23 very much attackable). 24 Buffett noted that the biggest surprise may have been that so many 25 of these AAA toxic creations ended up in the hands of the creators 26 themselves. They drank their own Kool-Aid. Stupidity ran wild, and 27 “everyone else was doing it” became the primary rationale. It’s hard to 28 stop once there is such widespread industry acceptance. 29 30 Real Estate 31 California volumes are up for real estate transactions, especially in the 32 lower to mid-priced homes, so Buffett sees some stability coming to 33 parts of the real estate market. 34 The new mortgages going on the books each day are much better 35 in quality than the old ones they are replacing. Low interest rates are 36 helping. 37 Buffett laid out the big picture brilliantly: 38 There are about 1.3 million new households created each year. 39 Maybe a bit less right now with the recession. 40 41

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21 During the bubble, we were building two million new homes annually, 22 which far outstripped the household formation rate. 23 The current total excess in homes is about 1.5 million. The building 24 rate has plunged to about 500,000 units annually. 25 So if we continue to build homes at that reduced rate, we can sop 26 up about 800,000 of the excess housing inventory annually for a couple 27 years, and supply and demand will roughly come back into balance. 28 Buffett quipped that we could take care of the overhang tomorrow 29 by blowing up 1.5 million homes or accelerate household formation by 10 having 14 year olds start marrying. 11 However, what is happening is that we’re producing less, and even- 12 tually, the excess inventory will get absorbed. 13 In sum, housing is more affordable, mortgage rates are low, payment 14 terms are more sound . . . we’re on the road to healing. 15 16 Four Investment Managers 17 18 Buffett has four investment managers, inside and/or outside Berkshire, 19 and each of the four did no better than the S&P 500’s 37% decline 20 in 2008. 21 Buffett added that he’s tolerant of that as “I didn’t cover myself with 22 glory.” 23 Munger added that practically every investment manager he regards 24 highly got creamed last year. 25 Furthermore, they don’t want a manager at Berkshire that thinks 26 he can jump into cash and back into the market. They have excluded 27 those types.* 28 29 Warrenomics 101 30 31 Buffett loves to teach college students. 32 Buffett noted that he had eight sessions last year with students from 33 49 different universities. 34 His two courses, if he were to run a business school, would be 1) 35 How to Value a Business, and 2) How to Think About Markets. That 36 would be it. 37 In valuing businesses, it is important to understand the language of 38 accounting, to stay within your circle of competence, and to focus on 39 what is meaningful and sustainable. 40 41 * For Corey and me, this news was a nice balm for our bruised egos.

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In thinking about markets, it is important to remember that markets 1 are there to serve you, not instruct you. The key here is emotional stabil- 2 ity, to have an inner peace about your decisions. It is important to think 3 for yourself and to make good decisions over time.* 4 It is simple, but not easy. 5 The key with markets is that you cannot allow yourself to be forced 6 to sell (from using too much leverage) and that you must not sell in a 7 panic mode, emotionally pulling the rug out from under yourself. 8 Munger added that there is so much that is false and nutty in modern 9 banking, investing and academia that the most one can hope for is to 10 reduce the nonsense. If someone has an IQ of 150 but thinks it is 160, 11 it leads to disaster. 12 Buffett imagined himself an economics teacher, professing the effi- 13 cient market hypothesis: “Everything is priced properly.” And mused, 14 “What do you do for the rest of the hour?” And this is the stuff of Nobel 15 Prizes! 16 Buffett concluded with Max Planck’s observation of the inexorable 17 evolution of science despite the strong resistance to new ideas by even 18 the best and brightest of his peers: “Science advances one funeral at a 19 time.” 20 21 22 Replace Ajit? 23 Ajit Jain heads up BH Reinsurance and has done wonders, building 24 float to an incredible $24 billion as of year-end 2008. What would 25 Berkshire do without him? 26 Buffett noted that the authority here goes with the person, not the 27 position. 28 While he’s happy to give his pen to Ajit, signing for major deals, he 29 would not do so with anyone else. 30 He recounted the story of how Mutual of Omaha back in the 1980s, 31 the largest health and accident association at the time, got into property 32 and casualty insurance. By handing its pen to insurance brokers, Mutual 33 of Omaha lost half of its net worth in a very short time—a huge scandal. 34 In sum, if Ajit were gone, some of what BH Reinsurance does would 35 not be replaced. 36 Munger added that Berkshire is not looking for mismanagement. 37 While they like businesses that can withstand some folly, some fabulous 38 things are one off. That’s the case with Ajit. 39 40 * So focus on the process, not the outcome. 41

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21 What Matters at Berkshire 22 23 Buffett asserted that Berkshire was cheaper at the end of 2008 than it 24 was at the end of 2007. The investments are worth more than what they 25 are carried for. And the non-insurance operating earnings may suffer 26 for a bit but long term will do very well. 27 Munger noted that 2008 was a bad year for a float business.* 28 However, long term, the fact that Berkshire can have so much float 29 at a cost of less than zero is a great advantage. The key is to focus on 10 what matters. 11 According to Munger, what matters at Berkshire is that the property 12 and casualty business is probably the best in the world, the utility subsid- 13 iary is the best, ISCAR is the best at what it does, etc. 14 Munger emphasized that it is not easy to get into these positions. 15 16 17 GEICO 18 19 Perhaps no world-beating subsidiary is hotter right now than GEICO, 20 the low-cost provider of auto insurance. 21 Buffett noted that the economic downturn changed consumer 22 behavior like ringing a bell. Everyone is a bargain shopper now. 23 That has hurt at American Express, where the average ticket is down 24 10%. It has helped at GEICO, where the phone is ringing off the hook. 25 Thousands are coming to the website every day to see if they can save 26 money. 27 In the first four months of 2009, GEICO has added 505,000 policy- 28 holders. The competitive advantage GEICO has built over the past 29 decade is paying off hugely. 30 Buffett sees market share going to 8.5% by year-end. That’s up from 31 7.2% at the beginning of 2007. 32 Incredible! 33 And each policyholder has significant value—effectively an annuity 34 paying, on average, around $1,500 annually for a policy they must have 35 if they want to drive—and Americans love to drive. 36 Buffett quoted Marshall Fields: “We waste half of the money we 37 spend on advertising . . . the problem is we just don’t know which half.” 38

39 * We believe he’s referring to that 15:1 leverage factor—just as it has turbo-charged 40 Berkshire’s up-market returns, it leverages the losses incurred in a down market. 41

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From a paltry $20 million ad budget when Berkshire took full control 1 of GEICO in 1995, Buffett has amped up the annual ad budget to $800 2 million—far more than State Farm or Allstate.* 3 He wants everyone in the U.S. to have in mind that there’s a good 4 chance to save money at GEICO. 5 He related that to Coca-Cola, which, since 1886, has advertised to 6 associate Coke with moments of pleasure and happiness all around 7 the world. 8 And that share of mind is paying off for GEICO—with the economic 9 downturn, thousands more are checking to see if they can save even 10 $100 with GEICO. 11 Munger noted that in effect, GEICO is earning $800 million pre-tax 12 (the ad spend) that never shows in the earnings. 13 Buffett agreed, saying GEICO could probably go to a maintenance 14 advertising level of, say, $100 million and maintain the present policy- 15 holder count for many years. 16 17 18 Infrastructure: Build the Grid 19 Munger nearly elbowed Buffett out of the way to answer a question on 20 whether the U.S. should be spending more on infrastructure. “YES” was 21 his answer. 22 He went on to say that there is one big no brainer that would hugely 23 improve U.S. industry and commerce, and that is to build a nationwide 24 electricity grid. We have the technology and know-how, and it would be 25 100% likely to make the system better.† 26 27 28 Derivatives 29 30 Buffett asserted that the use of derivatives caused leverage to run wild, 31 straining an already fragile economic system and causing problems to 32 pop up in unexpected places. 33 After 1929, Congress decided it was very dangerous to let people 34 borrow against their securities. The Federal Reserve instituted margin 35 requirements of 50%. Derivatives totally went around these regulations 36 of the markets. 37 38 * We haven’t seen recent numbers, but GEICO outspent the entire rest of the auto insur- ance industry combined on advertising for most of the past decade. 39 † Munger said much about the grid at the Wesco Financial meeting as well. 40 41

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21 In addition, while normal securities settle in three days or less, keep- 22 ing counterparty risk to minimum, derivative contracts can have very 23 long settlements. These unsettled contracts pile up over time, adding 24 to the risk in the system. (Buffett recommended reading John Kenneth 25 Galbreath’s The Crash.) 26 Munger believed the deeper problem was that the derivatives dealer 27 was not only the croupier at the gambling table, but was also playing the 28 game itself against his clients with an informational advantage. 29 He concluded that society does not need this sort of thing. 10 11 Berkshire Derivatives 12 13 Buffett has written derivative contracts on both equity markets and on 14 high yield bond markets, which has caused quite a stir. 15 The equity puts raised $4.9 billion in cash, which Berkshire will hold 16 for the duration of the contracts, and the contracts do not require Berkshire 17 to post much (if any) collateral. 18 In effect, it’s much like writing long tail catastrophe reinsurance 19 where Berkshire creates that much coveted “float.” 20 The high yield bond contracts are experiencing higher than expected 21 default rates, so Buffett is not doing so well with those and may end up 22 losing some money. 23 24 The Berkshire Advantage 25 26 Buffett noted that the Berkshire culture and business model are very 27 difficult to copy. 28 Shareholders are high grade with an average turnover of 20% a year, 29 versus 100% for the average publicly traded large company. 30 They run the business without teams of lawyers and bankers. Man- 31 agement is decentralized and incentives are rational. The culture is 32 constantly reinforced as the managers see that it works. 33 In contrast, Munger opined that many corporations are run stupidly, 34 forcing things down from headquarters, worrying about quarterly profits. 35 For companies selling to Berkshire, Buffett noted that it is import- 36 ant that “it is known that we like allocating cash flows. Our reputation is 37 that we buy to keep, and people can trust us on that.” 38 Buffett noted one of his standard management questions is, “What 39 would you do differently if you owned 100% of the company?” 40 Answering the question for himself, he said he wouldn’t change a 41 thing at Berkshire.

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1 Copy Berkshire 2 Buffett noted there are things that Berkshire does that the average 3 investor cannot copy. 4 5 1. Float—Berkshire has that $58 billion interest-free loan. 6 2. Berkshire makes direct purchases and deals of its own design. 7 8 3. Berkshire sometimes buys whole companies. 9 Beyond that, Buffett shared that he did copy Ben Graham by studying 10 Graham Newman reports years ago. “Coat-tailing” was the term. 11 Munger concluded that it is quite smart to follow very good investors 12 around. 13 14 15 Inflation 16 Buffett said it is certain we will have some inflation over time. For the U.S. 17 and governments throughout history, this is the classic way of reducing 18 the cost of external debt. Inflate and pay the world back with cheaper 19 dollars. 20 Buffett noted that the Chinese, the largest holder of government 21 bonds, will suffer the most with devaluation as it is fixed-dollar investors 22 whose notes are worth less at maturity. 23 Buffett also chided politicians who constantly refer to how much all 24 of this government bailing-out is costing the taxpayers. The taxpayers 25 have yet to pay one cent more than in years past! 26 Buffett guaranteed that the dollar will buy less over time, and that is 27 happening with all other currencies as well. All major nations are elect- 28 ing to run major deficits in the face of the economic crisis. 29 Buffett was emphatic: “You can bet on inflation.” 30 Munger reflected that when he was growing up in Omaha, a postage 31 stamp was 2 cents and a hamburger was a nickel. And yet, he has lived in 32 the most privileged era of history. 33 Buffett added that a Coke was 5 cents with a 2-cent deposit—so it 34 really hasn’t gone up that much. Meanwhile, a newspaper was a penny, 35 but now costs a $1 and loses money. 36 The best protection against inflation, according to Buffett, is your 37 own earning power. If you constantly increase your earning power, 38 you’ll be sure to get your share of the economic pie. 39 The next best thing is to own wonderful businesses, especially those 40 that have low capital requirements. For example, Coca-Cola requires 41

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21 little capital to grow and is sure to get its percentage of income, however 22 it is measured, whatever the currency. 23 Munger summed up, “A young man should become a brain surgeon 24 and invest in Coke instead of government bonds.” 25 26 Newspapers 27 28 Buffett loves newspapers, reading at least five a day. However, he said that 29 most newspaper companies today are not a buy at any price. What was 10 an absolutely essential business 30 years ago is now a business looking 11 at unending losses. 12 Buffett said Walter Annenberg invented a term, “essentiality,” and that 13 newspapers once had that for advertisers and customers. Over time, that 14 essentiality has eroded, and there appears to be no end to that erosion. 15 At Berkshire’s Buffalo News, Buffett said the unions have been very 16 cooperative, and it can still make a little money. At the Washington Post, 17 there is a good cable business and a very good education business but 18 no answers yet for the newspaper. 19 Munger said it was a national tragedy to lose such an important sinew 20 of the civilization. The newspaper, with its desirable editorial influence, 21 kept government honest. 22 23 Retail and Manufacturing 24 Buffett again said he looks for housing supply and demand to return 25 to equilibrium in a couple of years. Business for Berkshire’s housing- 26 related products will recover at that point. 27 As for retail, Buffett sees a big change in consumer behavior going 28 for the low-priced products, and he suspects it will last quite a long time. 29 He wryly noted that for years, government has asked people to save 30 more while the savings rate drifted down to zero. Now, government 31 wants people to spend more, and the savings rate has jumped up to 32 about 4%–5%. 33 In commercial real estate, the 5% cap rates of recent years look silly 34 now. Vacancies are up. Shopping centers are suffering. Real estate could 35 be tough for quite a period. South Florida in particular he expects to be 36 flat for a long time due to huge oversupply. 37 38 Share Repurchases 39 40 Buffett noted that corporate America as a whole has not added value 41 with its stock repurchases.

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Back in the 1970s and 1980s, stocks were cheap—clearly well-below 1 intrinsic value—and very few corporations repurchased shares. 2 Then, during the last 10 years, buying stock became the thing to do. 3 Many companies had stock buyback programs at high to even silly prices. 4 Buffett estimated that 90% of the buyback activity in the last five 5 years was mostly herd behavior. 6 Now, with stock prices dramatically marked down, many at less than 7 half the prices at which repurchases were made, there are few buybacks 8 going on. 9 10 Opportunity Cost 11 12 Buffett noted that calibrating opportunity costs last year got a little crazy 13 with prices and intrinsic values changing so fast. 14 He shared that Berkshire got lots of calls and ignored most of them, 15 but interestingly, even the calls he chose to ignore were helpful in cali- 16 brating the more promising ones.* 17 For example, Goldman Sachs called on a Wednesday. The time for 18 that transaction was NOW—it wouldn’t be there a week later. So in a 19 chaotic market, Berkshire was able to put large sums to work fast. 20 The Constellation Energy offer (which “failed,” though Berkshire 21 took home a $1 billion profit), $5 billion in Goldman Sachs preferred 22 and warrants, $3 billion in GE preferred and warrants, etc. 23 Buffett noted that he hadn’t had a flurry of activity like this in a long 24 time. 25 26 The New PE at BYD 27 Munger was very excited about Berkshire’s attempt to acquire 10% of 28 BYD, a Chinese manufacturer. 29 He noted that BYD is no startup, with $4 billion of revenue and hav- 30 ing already pulled off miracles in becoming a world leader in lithium 31 batteries and a major player in cellphone components. 32 Now, the company aims to take on the auto world from a standing 33 start by building electric cars. It already has the best-selling car model in 34 China and makes each of the parts itself. 35 Munger seems especially excited by the fact that BYD has 17,000 engi- 36 neering graduates—the top of the class in a country of 1.3 billion people.† 37 38 * Who can match Buffett’s flow of information? 39 † The thought occurs to us that Munger may be on the verge of a new analytic device—the PE ratio—that is, Price to Engineers. We noted last year that Munger gave us the “GURF” 40 asset accounting idea—“good until reached for.” 41

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21 Lithium batteries are needed in every utility function. To harness the 22 power of the sun, we will need batteries. BYD is the sweet spot, Munger 23 concluded. 24 Buffett quipped, the Irish banks were my big idea and BYD was 25 Charlie’s. He’s the winner!* 26 27 28 Moody’s Downgrade 29 Buffett admitted to being irritated with the Moody’s downgrade of 10 Berkshire from AAA to AA. 11 Buffett claimed it makes little difference in Berkshire’s borrowing 12 costs, and there remains no stronger credit than Berkshire, having 13 always conducted its affairs so that no one worries about getting their 14 insurance checks well into the future. 15 Munger noted that at least Moody’s showed considerable indepen- 16 dence in making the change.† And he predicted the next change by 17 Moody’s in the Berkshire rating will be in the other direction. 18 Buffett quipped that as Charlie has told him before, “In the end, 19 you’ll see it my way because you’re smart and I’m right.” 20 21 22 Utility Investments 23 24 MEC is now the largest wind utility in the nation. 25 Iowa is No. 1 in wind power with some 20% of its power wind-generated. 26 The wind blows 35% of the time, so this is not base capacity. 27 Overall, MEC is a net exporter of energy for Iowa. Berkshire is a big 28 taxpayer, so it can use the 1.8 cents per kilowatt/hour tax credit. They 29 are putting in wind power in the Pacific Northwest and are looking to 30 do more. 31 Munger noted that he’s very proud that MEC is a leader in the field. 32 Buffett noted that he wished that he had been able to purchase 33 Constellation Energy. 34 The day David Sokol heard CEG was in trouble, facing bankruptcy, 35 he called Buffett with an idea to make an offer. That very evening, Sokol 36 and Greg Abel were in Baltimore with an all-cash offer. So Berkshire 37 went from an 11 a.m. phone call by Sokol to an in-person bid that night! 38

39 * Berkshire lost a few hundred million dollars on Irish banks last year. 40 † Berkshire owns 20% of Moody’s. 41

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Munger added that Berkshire once bought a pipeline in two hours. 1 Dynergy had purchased the Northern Natural Gas pipeline from Enron, 2 and then Dynergy itself went down. To close the deal, Berkshire needed 3 FERC approval, so Buffett agreed to do whatever FERC said to do 4 post-deal. 5 Buffett noted that while it’s the shareholders you need to please in 6 most deals, it’s the regulators you need to please in utility transactions. 7 8 9 China 10 Munger weighed in with praise for Chinese economic policy: 11 China has one of the most successful economic policies in the world. 12 Growth is so significant and important to China that it amounts to just a 13 trifle if the dollar declines. Their goal has been to make it very hard to 14 compete with them all over the world. That’s exactly what they’ve done 15 and what they should do. 16 17 18 Gen Re 19 Buffett announced that Gen Re is working well after a terrible start. 20 When Berkshire bought it in 1998, Gen Re’s premier reputation was 21 not reality. It was an enormous mess. 22 Thanks to Tad Montross and Joe Brandon, the operations have been 23 turned around. Now Buffett feels terrific about its future. 24 Munger noted that it is important sometimes to turn lemons into 25 lemonade, and while it wasn’t pretty or pleasant, Joe Brandon was the 26 one brilliant hero in the transaction. 27 28 29 Insurance 30 Buffett said they have marvelous insurance businesses. 31 His worst-case estimate was that Berkshire could lose 3%–4% of a 32 major industry loss. 33 For example, Hurricane Katrina amounted to about a $60 billion 34 loss, while Berkshire lost less than $3 billion. 35 In a $100 billion event, Buffett guessed Berkshire would now pay 36 around $3 billion to $4 billion.* 37 38

* Again, we wonder how Berkshire can have 6%–7% market share in reinsurance and yet 39 have only 3–4% exposure in a catastrophe. 40 41

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21 Swiss Re: A Four-Course Meal 22 23 In another exciting tale of fast action, Buffett related how Swiss Re was 24 under extreme pressure last year during the crisis. 25 Buffett met with them in Washington D.C. to hammer out a deal 26 that met their needs and that was good for Berkshire. 27 Buffett emphasized that Swiss Re’s problems were ones of capital 28 adequacy, not underwriting standards. 29 Berkshire agreed to a quota share arrangement where it will receive 10 20% of Swiss Re’s property casualty reinsurance business over five years. 11 Earlier in 2008, Berkshire had purchased 3% of Swiss Re. Then, in 12 February of this year, Berkshire invested $3 billion Swiss francs in a 12% 13 note that is callable at 120% of par for two years and in three years is 14 convertible at $25 francs/share. The notes are senior to Swiss Re equity 15 of $20 billion. 16 Buffett said the odds are good that the note will get called, which 17 would not make him happy. 18 Then, in addition to all that, Berkshire did a $2 billion Swiss franc 19 adverse loss cover with Swiss Re. That pushed Berkshire’s float to just 20 over $60 billion at quarter end. 21 So to summarize, Berkshire bought shares of Swiss Re, wrote a 20% 22 quota share contract, invested in a 12% convertible note, and provided 23 an adverse loss cover. That’s a lot of bites from one apple! 24 25 Hope for the World 26 27 Buffett offered that there is always a lot wrong with the world, but it’s the 28 only world we got. Fortunately, over time, people do better and better. 29 For all its flaws, the capitalist system works, unleashing human poten- 30 tial. Consider that there were 35,000 people at the Berkshire meeting— 31 that would have been 10% of the entire population of the U.S. in 1790. 32 Buffett allowed that we’ll have bad years in capitalism. There were 33 six panics in the 19th century. While we have had these interruptions, 34 we have grown at a great clip overall. 35 The standard of living increased 7 to 1 in the 20th century. At one 36 time, a black man was considered three-fifths of a person, and women 37 couldn’t vote for our first 130 years. We were wasting human potential. 38 Our kids and grandkids will live better and better. 39 Buffett repeated that he hopes to grow 2% or so faster than the S&P 40 500 in intrinsic business value. And that’s a far cry from outperforming 41 the market by 10% annually in his partnership days.

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However, Munger beamed that Berkshire’s best days of contributing 1 to civilization are ahead. 2 He noted that mankind is getting close to solving the technical prob- 3 lem of our time—solar power. Cheap, clean, storable power will change 4 the world. 5 Munger said, “As I get closer and closer to my death, I get more 6 cheerful about the future I won’t see.” 7 He talked about the potential of solar power as the final break- 8 through. It would solve the main technical problems of humankind. 9 He’s excited that MEC and BYD will participate. If we have enough 10 clean energy, we can do all sorts of things. 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

199 1 2010 2 3 4 Venue: Qwest Center 5 6 Attendance: 40,000 7 8 Details About This Year: 9 • Munger and Buffett answered shareholder questions for 10 nearly six hours. 11 12 • Highlights from this year’s movie included: 13 • An extended Burlington Northern Santa Fe tribute. 14 • The annual GEICO employee rock video featuring 15 Buffett doing an Axl Rose impersonation. 16 17 • “Warren the Whip” coming in from the bullpen 1 18 (wearing number “ ⁄16”) to bail out the Red Sox in the 19 bottom of the ninth against the Yankees—a spoof 20 where they squeezed in a mention of nearly every one 21 of the 70 some companies that Berkshire owns. 22 • Corey and Daniel also attended the Wesco Financial annual 23 meeting. We have added some comments of Munger’s from 24 that meeting as well. 25 26 Fortune 500 Ranking: 11th 27 • Berkshire now ranks in the top 10 by revenue. Adding the 28 revenues of the recently acquired Burlington Northern, 29 Berkshire’s revenues in 2009 would have been about $126 30 billion. That would place Berkshire just ahead of AT&T at 31 No. 7. 32 33 Stock Price: $99,238 34 35 One dollar invested in 1964 would now be worth $8,022. 36 Berkshire’s per-share book value has grown from $19.46 to 37 $95,453 (a rate of 20.2% compounded annually). 38 The S&P 500 compounded at 9.3% annually for the same period. 39 40 41

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21 Highlights From 2010’s Notes 22 23 24 First Quarter Earnings: Recovery Picking up 25 Buffett opened the meeting with a slide showing Berkshire had a first 26 quarter profit of $2.2 billion versus $1.7 billion a year ago, noting that 27 the economic recovery has been picking up steam. 28 Buffett was especially pleased to see a surge in heavy industry, where 29 there’s no inventory fill. 10 For example, BNSF railroad cars in use have jumped significantly. ISCAR 11 metal-working tools, which are used on assembly lines around the world, 12 have had a sharp uptick. Marmon Group was seeing improved sales. 13 Buffett added that the slide did not show earnings per share as a 14 matter of principle, noting that the practice too often leads to a fudging 15 of the numbers. 16 He cited a Wall Street Journal article, where a Stanford study looked 17 at nearly half a million earnings reports to the tenth of a penny over a 18 27-year period.* 19 What they found is that the earnings numbers seldom ended in a fourth 20 of a cent. The study concluded that the vast majority of companies were 21 gaming the numbers, so they could round up!† 22 The study went on to suggest that this fudging was a good leading 23 indicator for companies that would later have accounting problems. 24 Buffett concluded that this is not good for enterprise. 25 Asked if he had anything to add, Munger said, “I agree with you.” 26 Buffett quipped, “He is the perfect vice chairman.” 27 28 Goldman Sachs 29 30 Anticipating a round of questions about the SEC’s investigation of 31 Goldman Sachs, Buffett had an extensive reply ready to go. 32 He noted that as he understood the transaction in question (called 33 “Abacus”). It was no different from many transactions Berkshire has 34 done over the years. For every buyer, there is a seller on the other side. 35 In particular, one of the parties in the transaction, ACA, was a bond 36 insurer, so it was active in the business of handling these mortgage 37 packages. These were hardly innocent parties.‡ 38 39 *“Quadraphobia” from February 13, 2010. † Hence the article’s title. 40 ‡ A Wall Street Journal story on Jan. 8, 2008, indicated ACA had capital of $425 million and 41 credit default swaps outstanding of $69 billion—hardly a risk-averse group.

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Buffett displayed a slide showing an $8 billion municipal bond package 1 with bonds from a number of different states that Berkshire had agreed 2 to insure for a $160 million premium. 3 Buffett noted that he came to that conclusion with his own analysis. He 4 did not care who was on the other side of the transaction. If it makes sense 5 and the premium is high enough, he’ll take the deal. And he wouldn’t 6 dream of coming back later to cry “unfair” if he took a loss on the deal. 7 Regarding Goldman, Buffett lavished praise on Goldman CEO 8 Lloyd Blankfein. 9 Munger agreed, saying, “There are plenty of CEOs I’d like to see 10 gone—Blankfein is not one of them.” 11 However, Munger also noted that every business should decline 12 some business—that we should aspire to a higher standard than merely 13 what is legal. 14 Buffett did have advice for Blankfein on how to handle crisis: “Get it 15 right. Get it fast. Get it out. Get it over.” 16 He added that the SEC suit is actually a plus for Berkshire because 17 it most likely delays the point at which Goldman can call Berkshire’s $5 18 billion 10% preferred at 110% of par. That preferred pays Berkshire 19 $500 million a year, or $15 every second. Every extra “tick” between 20 now and the calling of the preferred is another $15 for Berkshire. Tick, 21 tick—while he sleeps—tick, tick on weekends—tick, tick . . . 22 Buffett loves this investment. 23 Buffett threw in another slide of the tombstone of a 1967 $5.5 million 24 8% bond due November 1, 1985, of Diversified Retailing (though it 25 only had one store!). 26 He noted that two of the most important underwriters were not 27 listed—Gus Levy of Goldman Sachs and Al Gordon of Kidder Peabody. 28 Each agreed to take $350,000 of the deal on the condition that they be 29 left out of the tombstone! 30 Buffett was grateful for their help 43 years ago.* 31 32 33 Financial Regulation 34 Munger doubted that anyone in Congress has actually read the 1,550-page 35 bill for financial regulation. 36 However, he sees a clear need to make the investment banking system 37 less permissive. Reduce the allowed activities. Reduce the complexity. 38 Reinstitute Glass Steagall. 39 40 * And he clearly has a long memory when it comes to his friends. 41

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21 Similarly, the savings and loan industry stayed out of trouble for 22 years with its narrow charter. As soon as the charter was loosened, major 23 trouble ensued. 24 He lamented, “Give humans a chance and they’ll go plum crazy.” 25 At the Wesco Financial meeting, Munger used the analogy of a soccer 26 referee. If one team has an extraordinarily good soccer player, it’s in the 27 best interests of the other team to knock the crap out of him to slow him 28 down. You need the referee to keep things civil. 29 Likewise in the competitive world of investment banking, with every- 10 one so aggressively trying to outdo everyone else, it creates a system 11 where eventually everyone goes blooey. 12 He added that the investment banks will push back hard. Like a 13 diver with an air hose, they do not want anyone stepping on their air 14 hose. They will defend it as if their lives depend upon it. So it will take 15 stern measures. 16 He concluded that if he were a benevolent despot, he would make 17 Paul Volker look like a sissy. 18 19 Derivative Reform 20 21 Buffett clarified some lobbying he had recently done to have one element 22 of the financial regulation bill revised regarding collateral for existing 23 derivative contracts. 24 It appeared the bill might retroactively require hundreds of companies 25 to post additional collateral without proper compensation. 26 As Buffett put it, “If I sell you my house unfurnished, that’s one 27 price. If you later want it furnished, well, then you need to pay me 28 more.” 29 He noted that Berkshire had just been shown a contract that 30 had two prices, $7.5 million with no collateral and $11 million fully 31 collateralized. 32 Munger concluded that the provision in the bill was of dubious 33 constitutionality and was both unfair and stupid. 34 35 Greece and the Dollar 36 37 Currencies worldwide appear to be in a race to the bottom. 38 Buffett noted that events in the world over the last few years make 39 him more bearish on all currencies holding their value over time. 40 He emphasized that there is no possibility of U.S. default—because 41 it prints its own currency and can simply print more money. Greece,

204 2010 however, is in a more awkward spot. While Greece is sovereign in terms 1 of its own budget, it cannot print its own money as it is part of the euro- 2 zone. This is a test case for the durability of the euro. 3 Munger noted that in the past, the U.S. was conservative, which gave 4 it wonderful credit. 5 Munger pointed out that credit status helped us fund World War II 6 and, then, in one of the greatest foreign policy decisions in all history, 7 funded the Marshall Plan to help reconstruct Germany and Japan. Now, 8 our government has pushed credit too hard for too long. Greece is just 9 the start of an interesting period where we see what happens when 10 government blows it by pushing too hard for too long. 11 Buffett chimed in that running a budget deficit of 10% of GDP is not 12 sustainable. How the world weans itself off of huge deficits in country 13 after country will be an interesting movie. 14 Munger added that unfunded promises are miles bigger than the 15 reported problem. It can work out as long as the economy grows. If 16 growth stops, you have a very difficult problem. 17 18 Higher Inflation 19 20 With the above observations, it follows that it is likely we will have higher 21 inflation in our future. 22 Buffett noted that since 1930, the dollar has depreciated by over 23 90%, yet the U.S. has done okay. Prospects for significant inflation have 24 increased around the world. The medicine for the crisis—massive doses 25 of debt—was okay, but continuing to run high deficits as a percentage of 26 GDP diminishes the value of the currency over time. 27 Both Buffett and Munger are betting on higher, and maybe a lot 28 higher inflation in the years to come.* 29 30 Biggest Global Challenge 31 32 As in years past, Buffett noted that the biggest challenge to civilization 33 is a massive nuclear or bio-chemical attack. 34 Over 50 years, the probability of such an attack occurring is high. 35 Over one year, the probability is low. 36 Buffett noted that throughout history, there has been incredible 37 progress, with lots of hiccups, in the state of mankind. The U.S. has 38 been remarkable in unleashing human potential like no other country. 39

* We note how Buffett has responded to this situation. He’s fully invested in businesses and 40 equities. 41

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21 Buffett imagined that a farmer in 1790 probably dreamed of a tool 22 that would shorten the work day from 12 hours to 10. At that time, the 23 U.S. had a fraction of the population that China had, and look how well 24 we have done. 25 He noted that the Berkshire crowd was probably no smarter than 26 folks 200 years ago, but boy do we live better. 27 28 Succession 29 10 Buffett once again assured shareholders that succession plans are in order. 11 A new CEO would be ready at any time on short notice. 12 Munger assured shareholders that he is quite optimistic that the 13 culture of Berkshire will last a long, long time after the founder is gone. 14 Buffett noted that the culture at Berkshire now is strongly self- 15 reinforcing. 16 He added that it’s really tough to change an existing culture. A plus 17 for Berkshire is that the culture has been engrained, evolving since 18 1965 as Buffett added more and more complementary companies. 19 20 Capital-Intensive Businesses 21 22 Buffett said this is the number one question he would ask of himself: 23 why is Berkshire investing in capital-intensive businesses? 24 Berkshire’s hallmark has been to find companies that gushed cash and 25 required little or no capital reinvestment—companies like See’s Candy. 26 As that cash flow got funneled to Omaha, it was then Buffett’s job to 27 reinvest in the next cash machine. 28 However, as Berkshire grew, Buffett found it more and more dif- 29 ficult to put those billions of dollars of cash flow to work. So Buffett 30 shifted gears. 31 Starting with MidAmerican Energy in 1999, Buffett saw the appeal 32 of companies that could reinvest all the cash they generated, assuming 33 they could do so at decent returns. 34 Owning a utility like MEC fit the bill. MEC has invested every dime 35 of its cash generation back into its utility businesses, mostly at regulated 36 rates of return in the 11%–12% range. Not brilliant, but the investment 37 has worked out very decently. 38 With that experience in his pocket, Buffett was ready for another. 39 Berkshire recently closed on the acquisition of Burlington Northern 40 Santa Fe, another highly capital-intensive business where he expects low 41 double-digit rates of return on investment.

206 2010

In the first quarter 10-Q, Berkshire estimates that the two subsidiar- 1 ies will have capital expenditures of $3.9 billion for 2010. 2 3 Debt versus Equity 4 5 Buffett noted that the analytical hurdle for buying a bond requires 6 answering the question, “Will the company go out of business?” while 7 buying an equity requires answering the more difficult question, “Will 8 the company prosper?” 9 This is why Berkshire bought the 15% notes of Harley Davidson 10 rather than the stock. 11 He had no question the company would stay in business, quipping, 12 “You have to like a business where the customers tattoo your name on 13 their chests!” 14 But gauging Harley’s long-term prosperity was much more difficult, 15 especially during the throes of the crisis. 16 Surprisingly (to us, anyway), Buffett added that had Goldman 17 offered him a non-callable 12% instead of a callable 10% plus warrants, 18 he would have taken the 12%. 19 Buffett added that Berkshire has some $60 billion of liability in 20 insurance with some exposures lasting as long as 50 years, so Berkshire 21 will never have all its money in stocks. 22 Munger piped in that Berkshire is investing as a fiduciary, so it is 23 constrained in how aggressively it buys equities. 24 Though, Munger added, investing in the equities of distressed 25 companies can be a very promising area. 26 27 Ajit 28 Buffett annually sings the praises of Ajit Jain, who heads up Berkshire’s 29 National Indemnity reinsurance unit. 30 In the annual report, Buffett joked, “If Charlie and I and Ajit are 31 ever in a sinking boat—and you can only save one of us—swim to Ajit.” 32 Jain has been a key player in expanding Berkshire’s insurance float 33 far beyond what Buffett thought possible many years ago. 34 Three years ago, Ajit took over huge liabilities from Lloyds, a contract 35 that brought Berkshire a $7.1 billion premium. 36 Last year, Ajit negotiated a life insurance contract that could 37 produce $50 billion of premium for Berkshire over the next 50 years. 38 So while Buffett doubted that Berkshire’s $63 billion of float will 39 grow much in the years to come, he allowed that there could always be 40 the float-expanding deal. 41

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21 Buffett shared that Ajit runs a staff of 30 in a way that makes the 22 Jesuits look liberal in what they allow the members to do. It’s one 23 disciplined operation. 24 If Ajit weren’t there, it would be a huge loss for Berkshire, but Berkshire 25 could still do some of the large deals it has become famous for. 26 27 Learning Money Lessons 28 29 Buffett noted that people do crazy things from time to time, and it is not 10 a function of IQ. You cannot modify the madness of mankind. 11 On a personal basis, Buffett emphasized how important it is to form 12 good financial habits early in life. 13 He noted that he and Charlie got lucky. They grew up in households 14 that taught the basic money lessons. It is far more important to get the 15 elementary ideas than those that come with an advanced degree. 16 Munger added that McDonald’s has been a great educator for 17 the American workforce. It teaches folks to show up on time, do their 18 work efficiently and so on. It’s had an enormous effect on training the 19 country. 20 Buffett also plugged a cartoon series seeking to train kids about 21 money called “The Secret Millionaires Club.” 22 23 Taxes 24 25 Buffett has been criticized for suggesting higher taxes are in order for 26 the wealthy while he has avoided estate taxes by gifting his Berkshire 27 shares to charity. 28 Buffett welcomed people to follow his example. It does avoid taxes, 29 and likely, the money will do a lot of good. 30 Munger added that Warren, as will we all, will ultimately pay a tax of 31 100%—when we die we leave it all. 32 On a national scale, the government budget equals some 25%–26% 33 of GDP, with roughly 15% from tax revenues and 10% from deficit 34 financing. 35 Buffett said that reducing the deficit will need to involve some balance 36 of lower expenditures and higher taxes. 37 38 NetJets 39 40 Buffett admitted making a mistake with NetJets, buying too many planes 41 at too high a price.

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He gave Davis Sokol enormous credit for turning things around and 1 getting the operating costs more in-line with revenue. 2 He added, this isn’t the first mistake he’s made. 3 Berkshire was in textiles for 20 years even though he knew it was a 4 bad business. He joked, “I finally woke up. I was Rip Van Winkle.” 5 Munger gave the episode some context. 6 He said, if you have 30 businesses with historically successful man- 7 agers and that works 95% of the time, then you will have one case that 8 doesn’t work so well. 9 And in the case of NetJets, the franchise is fine—what was lost were 10 past profits. Overall, this is a very good system. 11 12 13 BYD 14 At the Wesco Financial meeting, Munger gushed that he’ll be surprised 15 if they ever find another business as good as BYD. He noted that David 16 Sokol was key in enrolling him into looking at it. 17 BYD had a track record of rare accomplishment, so this was no 18 startup. 19 He was especially impressed with the founder, Wang Chuanfu (who 20 was recently crowned China’s richest man due to the sharp rise in BYD’s 21 stock price). Munger asserted that BYD will work out well as it solves 22 significant world problems with its batteries and electric cars. 23 He added that with Burlington Northern, MidAmerican and now 24 BYD, that adds a fair amount of engineering to Berkshire, which he likes. 25 In his younger days, Munger shared how he lost a bundle in a venture 26 capital investment—they lost their main inventor to another company, 27 and then their oscilloscope was obsolesced by the new technology of 28 magnetic tape. And that soured him on technology ventures ever since. 29 Until BYD. 30 Munger suggested that BYD illustrates their ability to keep learning 31 at Berkshire. 32 33 34 Compensation 35 Buffett shared that Berkshire owns more than 70 different businesses, 36 so it needs a variety of compensation arrangements. 37 For example, Burlington Northern requires lots of capital and See’s 38 Candy requires none. 39 Each business has its own key measures of building business value. 40 What Buffett wants to pay for is widening the moat. 41

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21 Munger noted that GE and many other large companies have 22 centralized personnel departments for such things. Imposing policy 23 from headquarters can build resentment. Berkshire is the opposite— 24 totally decentralized management. 25 Munger mused that it is amazing how simple it’s been, how well it 26 has worked and how little time it takes. 27 28 Allowable Returns 29 10 Utility returns are based on returns on equity averaging between 11%– 11 12%, depending on the state regulators. Berkshire is almost certain to 12 earn that rate as demand for power is unlikely to fall off much. 13 Railroads are riskier as they are more sensitive to the economy. How- 14 ever, it serves society to have railroad investment exceed depreciation. 15 That common interest suggests Berkshire will earn decent returns 16 on Burlington Northern, and there will be much needed investment in 17 the railroad over the next 30 years. 18 Munger observed that the railroads have been hugely successful in 19 a regulated system. They’ve been totally rebuilt over the past 50 years, 20 and the average train has doubled in both length and weight. 21 22 Insurance Risks 23 24 Buffett shared that earthquakes and hurricanes are the two biggest 25 catastrophe risks. 26 Currently, rates are soft, so Berkshire has been doing less business. 27 Berkshire is willing to take on a maximum risk of $5 billion. Katrina was 28 $3 billion, and 9/11 was $2 billion. 29 Berkshire is deliberately seeking big overall losses on occasion when 30 everyone else is trying to avoid them. That’s a big competitive advantage. 31 Buffett said it’s actually close to a permanent advantage that gets 32 wider every year. 33 By taking the other guy’s desire to smooth earnings, Berkshire 34 gets big premiums up front and books larger, though lumpier, earnings 35 over time. 36 37 Speculation 38 39 “Speculators may do no harm as bubbles on a steady stream of enterprise. 40 But the position is serious when enterprise becomes the bubble on a 41

210 2010

whirlpool of speculation. When the capital development of a country becomes 1 a by-product of the activities of a casino, the job is likely to be ill-done.” 2 3 Buffett kicked off an extended discussion on the nature of specu- 4 lation with this quote from chapter 12 of John Maynard Keynes’ The 5 General Theory of Employment, Interest and Money. (Buffett added that he 6 thought Keynes’ chapter 12 was the best description of the way capital 7 markets function.) 8 Wall Street has always been partly a casino operation, as well as a 9 socially important operation in the raising and allocating of capital. 10 However, this casino element became unbalanced with the advent of 11 options and derivatives. 12 According to Buffett, Pandora’s box was opened in 1982 when 13 Congress approved the creation of S&P 500 contracts. 14 It changed the game. 15 Now anyone could buy the index and ignore real companies. The 16 casino was then officially opened to all. 17 In addition, the contracts received preferred tax treatment, 60% long- 18 term gain and 40% short-term gain, regardless of the holding period. 19 Buffett wrote Congressman Dingell that year, suggesting that 95% of 20 the trading in these contracts would be gambling. 21 Munger noted how it was crazy and that Warren was the only one to 22 write in opposition of the bill. Munger concluded, quoting Bismarck, 23 “You shouldn’t watch two things—sausage making and legislation 24 making.” 25 26 Municipal Bonds 27 28 Asked about the possibility of municipal bond defaults, Buffett noted 29 that Harrisburg, PA had recently defaulted. 30 The real key, according to Buffett, was correlation—could a contagion 31 break out where many municipalities defaulted at the same time? For 32 bond insurers, the amount of liabilities is extraordinary relative to the 33 capital backing them. 34 Buffett also noted that the government bailed out GM, so how could 35 it not also come to the aid of a troubled state? The problem is a moral 36 hazard: if the undisciplined are not punished for it, then why should 37 others be disciplined? 38 Munger concluded that it is wise to invest in places that are prosperous 39 and disciplined—integrity still matters. 40 41

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21 Buy American Update 22 23 Buffett was asked about his famous New York Times article from October 24 2008 entitled “Buy American. I Am.” 25 Buffett noted that he writes very seldom, and he was pretty premature 26 on that one. Yet he knew that stocks would be better than bonds or cash 27 over the long run. 28 Even after the market rally, he said he would rather own stocks than 29 bonds for the next 10 or 20 years. 10 Munger was less sanguine, saying that equities were the best of a 11 bad lot of opportunities and that he sees a long period of dull returns 12 ahead. 13 14 Energy 15 16 Buffett observed that there are 500,000 producing wells in the U.S. and 17 that we’ve really exploited what took millions of years to create. It has 18 contributed significantly to the world’s prosperity. 19 Buffett said not to give up on humans’ abilities to solve problems. In 20 fact, leaving aside the nuclear and bio-chemical threats, this is a great 21 time in history to be born. 22 Munger noted that the world is less dependent on oil than in the 23 past. In the 1850s, the technology of the day needed oil to get ahead. 24 Today, oil is not so essential. 25 He cited physicist Freeman Dyson (the Templeton Prize winner in 26 2000), who points out that the world going off oil is not that dire— 27 we may go from 85 million barrels/day to 55 million barrels/day over 28 the next 50 years. Munger concluded that if it doesn’t bother Freeman 29 Dyson, then it shouldn’t bother you. 30 Munger asserted that solar power is coming because it is so obviously 31 needed. However, he wouldn’t buy solar panels yet as they will get 32 cheaper in the future. 33 He continues to be concerned about ethanol, calling the use of fossil 34 fuel and water to grow corn to make ethanol a “stunningly stupid idea.” 35 He is optimistic that we will build a smart electric grid eventually. 36 Munger believes our energy problems are solvable, and that the right 37 answer may end up being counterintuitive. 38 39 Kraft 40 41 Berkshire owns 8.8% of Kraft.

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Buffett did not like the price Kraft paid to acquire Cadbury’s. Nor 1 was he happy about Kraft’s tax-inefficient sale of DiGiorno Pizza to 2 Nestlé’s to raise cash for the deal. 3 He did say Kraft is selling for considerably less than its constituent 4 parts. The present price is below the value of very good businesses, such 5 as Kool-Aid and Jell-O. 6 Munger opined that many top U.S. business leaders think they 7 know too much and dream of running easier businesses with less 8 competition. 9 He recalled Xerox buying Crum and Foster (an insurance company)— 10 no tough Japanese to compete with in the insurance business. It was just 11 an awful deal. 12 Munger went on to add that Berkshire avoids a small subset of 13 stupidities by not having around an army of sales folks pushing deals. 14 15 16 Integrity 17 Munger asserted that the financial crisis was formed by a lack of integrity 18 in management. 19 Munger poignantly quoted Pope Urban about Cardinal Richelieu: 20 “If there is a god, he has much to answer for. If there is no god, he has 21 done rather well.” 22 Buffett added that the “everyone is doing it” factor is tough to handle. 23 For example, when the Accounting Standards Board (as instructed 24 by the Senate) allowed options to be treated otherwise, 498 of the S&P 25 500 opted for otherwise. CEOs surrendered, “I have to do it if everyone 26 else is doing it.” The situational ethics problem is huge. 27 Buffett recommended that the key to handling it is to create a struc- 28 ture that minimizes the weaknesses in human nature. 29 Munger added that much bad behavior is subconscious, and the 30 cure is to have folks bear the consequences of their decisions. Seen 31 from this perspective, Wall Street is an irresponsible and immoral 32 system. 33 Munger lamented, “Who do you see apologizing? People think they 34 did fine.” 35 36 37 Fear and Opportunity 38 Buffett repeated his old mantra that successful investing requires the 39 right temperament—to be greedy when others are fearful. If you get 40 scared yourself, then you won’t make a lot of money in securities. 41

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21 Munger shared that he developed courage after hardship. Maybe 22 it’s a good idea to get your feet wet in some failure. 23 Buffett suggested that most people would invest better with no daily 24 quotations. Buy a good business, and hold it for a long, long time. 25 Munger concluded with a joke. The man says, “Would you still love 26 me if I lost all our money?” The wife replies, “Yes, I will love you always, 27 and I would miss you terribly.” 28 29 The Electronic Record 10 11 Asked why he is on TV so much, Buffett responded that he likes having 12 the electronic record, so there is no chance of him being misquoted or 13 misunderstood.* 14 If he’s on Charlie Rose, he knows the record will be permanent and 15 will be exactly what he said. 16 17 0% Interest Rates 18 19 Buffett wryly noted that while it is called an easy money policy, it isn’t 20 so easy on the people that have the money. It has been tough on savers. 21 Meanwhile, purchasing power is being eaten away by inflation. 22 He asserted that it won’t work forever to have huge budget deficits 23 and 0% rates. 24 By the way, he added that if this goes badly, don’t blame the Fed, 25 blame Congress. 26 Munger agreed that it is enormously depressing. Stocks are up, in 27 part, because the savings rates are so low. It cannot last. 28 29 Making It In Business 30 31 Buffett quoted Emerson, “The power that resides within you is new in 32 nature.” 33 He shared how Rose Blumkin, who never went to school, was a force 34 of nature, turning a $500 investment into a $400 million business sitting 35 on 78 acres called the Nebraska Furniture Mart. 36 He remembered visiting Mrs. B at her home once, and she had 37 green sales tags hanging on the furniture. Buffett quipped that he said 38 to himself, “Forget Sophia Loren, this is my kind of woman!” 39

40 * In this year’s Berkshire annual report, Buffett cited how badly misquoted he was by the 41 media after last year’s annual meeting.

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Buffett shared that there’s nothing like following your passion. 1 That’s the common factor with all of Berkshire’s excellent managers— 2 they love what they do. 3 Buffett also shared some of his classic bits of wisdom about growing 4 wealth. Spend less than what you make. Know and stay within your circle 5 of competence. The only businesses that matter are the ones you put your 6 money in. Keep learning over time. Don’t lose. Insist on a margin of safety. 7 Munger suggested making it your practice that you go to bed each 8 night wiser than when you got up. You may rise slowly, but you are sure 9 to rise. 10 Munger reminisced that the only business course he ever took was 11 accounting. 12 As a little boy he saw a man who hung out at the club all day. He 13 asked his dad why. His dad explained that the man was very successful 14 in business because he had no competition—he rendered dead horses. 15 Munger said he has been interested in business ever since. 16 In Omaha, many businesses have come and gone, but he said you 17 could predict that Kiewit would be a success because they worked hard 18 and were disciplined. 19 20 Causes for Optimism 21 22 Long noted for being a bit of curmudgeon, Munger may have surprised 23 the crowd with a list of things he is quite optimistic about: 24 1. The main problems of civilization are technical and solvable, all 25 with energy, with huge benefits for civilization. 26 27 2. Berkshire’s culture will continue to work for years to come. 28 3. He likes to see people rising rapidly from poverty, and that is 29 happening in China and India. 30 31 4. Maintain low expectations—that is the key to happiness. 32 Munger finished with a flourish, “Seeing as I’ll be optimistic when 33 I’m nearly dead, surely the rest of you can handle a little inflation.” 34 35 36 Pragmatism 37 Asked about their theory for life, Munger seized the microphone and 38 said, “Pragmatism! Do what suits your temperament. Do what works 39 better with experience. Do what works and keep doing it. That’s the 40 fundamental algorithm of life—REPEAT WHAT WORKS.” 41

215 1 2011 2 3 4 5 Venue: Qwest Center 6 7 Attendance: 40,000 8 9 Details About This Year: 10 11 • This year’s movie included a GEICO employee rock video 12 featuring Buffett rapping and break-dancing (obviously, a 13 stunt double). There was a hilarious special edition of “The 14 Offi ce,” featuring both Buffett and Munger, where one 15 Offi ce employee said, “I’m just like Buffett. I save. I invest. 16 And my kids ain’t gettin’ diddly-squat.” 17 • Munger and Buffett handled questions from the throng of 18 shareholders for six hours. 19 20 • It is an impressive learning experience—even more so when 21 one considers that “Professors” Buffett and Munger (ages 80 22 and 87, respectively) are as sharp as ever. 23 24 Fortune 500 Ranking: 7th 25 26 Stock Price: $120,475 27 One dollar invested in 1964 would now be worth $9,739. 28 29 Berkshire’s per-share book value has grown from $19.46 to 30 $99,860 (a rate of 19.8% compounded annually). 31 The S&P 500 compounded at 9.4% annually for the same period. 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2011’s Notes 22 23 24 First Quarter Earnings: A Look at What the Numbers Mean 25 26 Buffett has long been the accounting teacher. 27 In four decades of annual reports, Buffett has covered many nuances 28 of accounting convention versus a practical picture of business reality. 29 The message throughout: Look not what at the numbers are but 10 what the numbers mean. 11 So we took it as highly significant that “Professor” Buffett opened 12 this year’s meeting with no less than four overhead slide projections. 13 The first of which showed Berkshire’s first quarter net operating 14 profit of $1.6 billion versus $2.2 billion a year ago—$821 million of 15 insurance underwriting losses obscured a decent increase in operating 16 profits ex-insurance. 17 Other than the residential construction area, Buffett was positive 18 about the slow but steady improvement in the economy. In particular, 19 Berkshire’s purchase of the BNSF railroad was proving to be a real win- 20 ner with its competitive advantages becoming more and more evident 21 as fuel prices increase. 22 What the numbers mean: With the exception of residential construc- 23 tion and some catastrophe losses, Berkshire’s businesses are rolling. 24 Slide two showed Berkshire’s estimate of its losses incurred from the 25 recent catastrophes of flooding in Australia ($195 million), the earth- 26 quake in New Zealand ($412 million) and the earthquake in Japan 27 ($1,066 million) which came to $1,673 million. 28 Berkshire estimates that $700 million of that total came from its 25% 29 quota share arrangement with Swiss Re. 30 Buffett noted that historically, Berkshire experiences losses totaling 31 some 3%–5% of total catastrophe losses (which was true with Katrina).* 32 For perspective, Buffett noted that the New Zealand quake caused 33 $12 billion in insured damages. Thus, New Zealand, with a population 34 of five million people—just one-sixtieth of that of the U.S.—suffered a 35 catastrophe on a per capita basis that was 10 times Katrina in scale. 36 Buffett warned that the third quarter (hurricane season) is usually 37 the worst for catastrophe losses, so 2011 might well go down as one 38 of the worst years in history for such losses. 39 * So here’s a really good unasked question: how can Berkshire have some 10% of the world 40 reinsurance market and yet consistently participate in only a fraction of that percentage of 41 the losses when catastrophe strikes?

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Slide three showed the phenomenal policy growth ongoing at GEICO, 1 which added 218,422 policies in the first quarter of 2010 and added 2 another 319,676 policies the first quarter of 2011. 3 Buffett values each policyholder at $1,500 (about 1x premiums), so 4 GEICO added nearly $500 million of value in the first quarter. Goodwill 5 accounting does not reflect this increase in value. 6 Buffett noted that GEICO’s intrinsic value has grown to over $14 billion 7 now, and GEICO continues to gain market share every day. 8 Buffett joked that if just 66 shareholders would sign up with GEICO 9 in the convention hall, that would add $100,000 of value for Berkshire 10 and help pay for the annual meeting.* 11 What the numbers mean: GEICO’s growing intrinsic value is much 12 greater than what the accounting reports. 13 Slide four touched on an accounting convention called “other than 14 temporary impairment.” It makes little sense, but the fact was that 15 Berkshire took a mark down of Wells Fargo stock purchased at higher 16 prices and a deduction of $337 million on the income statement due to 17 this convention. Meanwhile, Berkshire’s $3.7 billion of unrealized gain 18 on its other shares of Wells Fargo was ignored. 19 What the numbers mean: Ignore income or losses from investments 20 in calculating Berkshire’s operating earnings. 21 Buffett summed up the slides, decrying the news headlines that 22 report the “all important number,” which could easily be the “all deceptive 23 number.” Instead, investors should focus on gains in operating earnings, 24 gains in book value and gains in intrinsic value. 25 For the first quarter of 2011, Berkshire showed progress by each 26 measurement. 27 28 29 The Sokol Issue: Inexcusable and Inexplicable 30 As widely reported, David Sokol resigned from Berkshire recently and 31 left controversy in his wake. 32 At the center of the storm were questions about Sokol’s purchases 33 of shares of Lubrizol, contact with Citigroup—Lubrizol’s investment 34 35

* Here’s another area of inquiry. Advertising does more than bring in new policyholders, 36 building advantages in customer retention, brand and share of mind. So this is oversimplified. 37 However, we note that GEICO is spending $225 million per quarter in advertising—so that’s about $700 per new policyholder for the first quarter. If GEICO can average a 94 combined 38 ratio (6% margin) on a $1,500 average premium, that’s $90 profit per year per shareholder. 39 That means it may take Berkshire about eight years to get its money back just on the ad spend. So what are the features (which no doubt include float creation) that make this 40 business so darn valuable? 41

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21 banker, and a meeting with Buffett where Sokol pitched the idea that 22 Berkshire should buy Lubrizol. 23 Buffett reminisced that it was 20 years ago that he endured the Salomon 24 Brothers scandal. That scandal, even after all these years, Buffett still 25 describes as “inexcusable” and “inexplicable.” His guess is that he may 26 well say the same about this one 20 years from now. 27 Buffett noted that Sokol did nothing to hide the trades he made, so 28 there was no deception there. 29 He also noted that a decade ago, he offered an incentive bonus plan 10 to Sokol where, if certain extreme goals were met, Sokol would get $50 11 million, and his junior partner, Greg Abel, would get $25 million. 12 Sokol agreed with the proviso that the bonus be split equally, $37.5 13 million each. 14 So here was part of what Buffett found so inexplicable—here’s a 15 man of such great integrity voluntarily giving up $12.5 million of bonus 16 and then, with Lubrizol, the same man acting in a seemingly suspect 17 way for a profit of a mere $3 million. 18 Munger’s one word explanation for Sokol’s actions, “hubris.” 19 There was anger from some shareholders about a lack of outrage 20 in Berkshire’s initial press release, which conveyed praises for Sokol’s 21 contributions as well as regrets for his resignation. 22 Munger conceded that the press release was not the most cleverly 23 written in the history of the world. 24 At the same time, he held firm that it doesn’t serve to make decisions 25 in anger. He quoted Berkshire board member Tom Murphy: “You can 26 always tell a man to go to hell tomorrow if it’s such a good idea.” 27 28 The Lubrizol Deal 29 30 Buffett noted that Lubrizol is a low-cost provider of fuel additives, a $10 31 billion market. 32 It has a good-sized, sustainable moat with lots of patents, number- 33 one market share and regularly works with customers (primarily the 34 major oil companies) to develop new additives. 35 Buffett compared it to ISCAR, which “shines up tungsten into tools 36 and a durable competitive advantage.” 37 Munger noted that Lubrizol and ISCAR are sister companies where 38 their markets are small enough that they were not worth attacking. 39 Buffett also noted that by spending $9 billion on the Lubrizol acqui- 40 sition, Berkshire had used up a good chunk of the estimated $12 billion 41 after-tax earnings he expects to come in this year.

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1 Succession: Independent Chairman 2 Buffett shared that on his demise, Howard Buffett will likely become 3 the independent chairman as he will represent a large block of stock 4 and receive little or no compensation. 5 By separating the chairman and the CEO positions, Berkshire can 6 more easily correct mistakes with CEOs that don’t work out. Fire one, 7 hire another if need be. 8 Buffett quoted the Bible, “The meek will inherit the earth,” but then 9 noted the next question is, “Will they stay meek?” Thus, it is critical to 10 separate the chairman and CEO positions. 11 12 13 1776–2011 14 One longtime shareholder asked Warren how he can be so infernally 15 happy when we have so many problems. 16 Buffett answered that he is indeed enthused about America. Since 17 1776, America has been the most extraordinary economic story in the 18 world. 19 If you had been told that following Aug. 30, 1930, the day Warren 20 was born, the market would crash, 4,000 banks would fail, the Dow 21 would sink to 32 (32!!!), there would be 25% unemployment, a dust 22 bowl, the grasshoppers would take over . . . you might think we were in 23 big trouble. 24 Instead, despite all those problems, since 1930, the average standard 25 of living in America has increased 6 for 1. 26 In contrast, Buffett observed that you can look at entire centuries in 27 world history where nothing happened. The economic growth of America 28 has been an incredible achievement. 29 Many have underestimated the resilience of our republic. 30 Buffett said his father-in-law-to-be, Doc Thompson, was very anti- 31 New Deal. He called young Warren over for a pre-marital talk, which 32 made Buffett very nervous. 33 He said that Doc went on for a two-hour rant about the certain failure 34 of the politics of the day and then concluded with this advice for young 35 Warren: “You’re going to fail, but it’s not your fault. Susie would have 36 starved anyway. The Democrats are taking us to communism.” 37 In 1951, the two men Warren admired most, his father and Ben Graham, 38 both advised him against starting in the investment business at that 39 time. The Dow at 200 (200!!!) was much too high. Better to park your- 40 self on the sidelines for a while. 41

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21 We’ve had the Civil War . . . 15 recessions . . . it certainly has not been 22 a straight line of progress, but the power of capitalism has been amaz- 23 ing. Stimulus has helped our recent problems, but what will really bring 24 us out of recession is capitalism. And the world has caught on. 25 Buffett predicted that in the next 100 years, we will have 15 to 20 26 lousy years and that we’ll be so far ahead of where we are now that it will 27 be beyond belief. 28 Munger, in his characteristically sunny way, concluded that “Europe 29 had the Black Death where one-third of the population died. The world 10 will go on.” 11 12 Inflation Hedges 13 14 Buffett declared the best inflation hedge is a company with a wonderful 15 product that requires little capital to grow. 16 As a test, he invited each of us to look at our own earning ability. 17 In inflation, your compensation can go up without any additional 18 investment. 19 As a business example, Buffett noted that when See’s Candy was 20 purchased in 1971, it had the revenues of $25 million and sold 16 million 21 pounds of candy annually with $9 million in tangible assets. Today, See’s 22 sells $300 million of candy with $40 million of tangible assets. Berk- 23 shire needed to invest only $31 million to generate a more than 10-fold 24 increase in revenues. 25 In aggregate, Buffett noted that Berkshire has earned $1.5 billion in 26 profits at See’s over the years. 27 See’s inventory turns fast, has no receivables and has little fixed 28 investment—a perfect inflation hedge. 29 Buffett allowed that if you have tons of receivables and inventory, 30 that’s a lousy business in inflation. 31 The railroad and MidAmerican Energy both have these undesirable 32 characteristics, but that is offset by their utility to the economy and sub- 33 sequent allowable returns. 34 Buffett rued that there simply aren’t enough “See’s Candys” to buy. 35 Buffett added that being an investor has made him a better busi- 36 nessman and that being a businessman has made him a better investor.* 37 Munger noted that they didn’t always know this inflation-business 38 element, which shows how continuous learning is so important. 39 40 * We concur. 41

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1 Well Fargo/U.S. Bancorp 2 Buffett asserted that both banks are among the best, if not the best, 3 large banks in the country, with Wells Fargo being about four times 4 larger than U.S. Bancorp. 5 Buffett predicted that banking profitability will be less than it was 6 in the early part of this century due to reduced leverage, which is good 7 for society. 8 Significantly, Buffett said he thought that, by far, we’ve seen the worst 9 of the banking crisis. Loan losses will continue to come down. Banks 10 should be conservatively run given that they get very cheap money with 11 an implicit federal guarantee. 12 Buffett noted that the FDIC since 1934 has bailed out 3,800 banks, 250 13 of which were in the last couple years, and all the money came from other 14 banks. The FDIC has been a well-designed mutual insurance company. 15 16 17 The Three Categories of Investment 18 Asked about commodities, Buffett noted that when he took over Berk- 19 shire, the stock traded for three-quarters of an ounce of gold. At $1,500 20 an ounce, gold has a long ways to go to catch up to Berkshire’s $120,000 21 per share stock price. 22 Then he outlined three categories of investment: 23 24 Category 1—Investments denominated in a currency. 25 26 Buffett pulled out his wallet, took out a one dollar bill and 27 read out loud, “In God We Trust.” He noted this is false ad- 28 vertising. What it should say is, “In Government We Trust.” 29 God isn’t going to do anything about that dollar. 30 The point is that any currency investment is a bet on how 31 government will behave. Almost all currencies have declined 32 over time. Unless you get paid really well, these investments 33 don’t make much sense. 34 35 Category 2—Investments that don’t produce anything 36 but you hope to sell at a higher price. 37 Gold, for example. Buffett reprised his gold thought exper- 38 iment, where if you took all the gold in the world, you could 39 make a 67-foot cube weighing 175,000 metric tons. You 40 41

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21 could then get a ladder and sit on top of it, fondle it, polish 22 it. But that cube isn’t going to do anything. You are simply 23 betting someone will buy it higher. 24 He cited Keynes Chapter 12—“The State of Long Term 25 Expectation” from The General Theory of Employment, Interest 26 and Money—that such investing amounts to a beauty contest 27 where you are betting not on whom you believe to be the 28 prettiest contestant, but who others will believe is beautiful. 29 The self-effacing Buffett reminded us that he tried to do 10 that with silver and proved to be 13 years too early. 11 12 Category 3—Investments in assets that produce 13 something. 14 This is a play on what you think that asset will produce over 15 time. 16 For example, with a farm, one can make a rational cal- 17 culation on its value. Success will be determined on cash 18 produced. You don’t care about the quote the next day or 19 month. You are looking to the business for your return. 20 This is the basis for Berkshire’s investments in ISCAR and 21 Lubrizol. 22 23 Buffett noted that rising prices create their own excitement. 24 The neighbor gets rich. He owns gold. You know the neighbor’s not 25 that smart . . . yet he’s doing better than you. Pretty soon, you own 26 gold. 27 Munger added that gold is a peculiar investment in that it only works 28 if everything goes to hell. 29 Buffett joked that $100 billion of gold is produced annually, much 30 of it taken out of the ground in South Africa to be shipped to the New 31 York Fed, where it will be put back into the ground. 32 All the gold in the world is currently worth about $8 trillion. With 33 that amount of money, you could buy all the farmland in America, 10 34 Exxon Mobils and still have $1 trillion to $2 trillion of walking-around 35 money. 36 Buffett concluded that he will bet on good businesses to outperform 37 gold. 38 39 40 41

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1 Conglomerates 2 Buffett conceded that Berkshire is, indeed, a conglomerate. At their 3 best, conglomerates enable the tax efficient transfer of cash from businesses that 4 cannot use the money intelligently to those that can. Berkshire is a very rational 5 conglomerate. 6 The word “conglomerate” got a bad rap from the 1960s Ponzi 7 schemes of Gulf and Western (Charles Bluhdorn), LTV (Jimmy Ling), 8 etc., where there was an unspoken conspiracy and where stock was 9 issued like confetti to buy real assets. It ended badly, and the word 10 “conglomerate” left a bad taste. 11 12 Legacy 13 14 When asked what he’d like to be known for, Buffett quipped, “Old age.” 15 Munger said that what Warren most wanted to be said at his funeral 16 was, “That’s the oldest looking corpse I ever saw.” 17 In a more serious vein, Munger mused that he’d like something like, 18 “Fairly won, wisely used,” on his tombstone. 19 Buffett thought perhaps he’d go with “Teacher.” 20 He acknowledged that he loves teaching, and he’s grateful for the 21 great teachers he’s had, including his father, Ben Graham, and Tom 22 Murphy, among others. 23 24 Currency Debasement 25 Buffett noted that from his birth in 1930 to today, the dollar has depre- 26 ciated by 16 to 1 (i.e., $1 today buys what 6 cents bought then). Yet infla- 27 tion did not destroy us. 28 Some subsidiaries of Berkshire earn their money in other currencies. 29 Coca-Cola receives 80% of its profits in non-dollar earnings. 30 Munger observed that Greece is an awful situation. People there, while 31 wonderful in many respects, do not want to work or to pay taxes. He 32 quoted Adam Smith, “A great civilization has a good deal of ruin in it.” 33 Despite these concerns, Buffett concluded that if he had a choice, 34 he would be born in the U.S. today over any other place in the world. 35 36 37 Lower Expectations 38 Buffett shared his usual advice that the average investor would do fine 39 to simply buy shares of an index fund over time. 40 41

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21 Munger asserted that he’d definitely rather own Berkshire over an 22 index fund. 23 He also predicted that the next 50 years will not be as good as the 24 last 50 years for skilled investors. 25 Buffett averred that Berkshire’s mission was to increase earning 26 power and intrinsic value with 100% alignment with shareholders. That 27 is what they think about each day. Luck has helped, but there is no way 28 Berkshire will compound at rates anywhere close to when it was working 29 with smaller sums. 10 Munger said he was confident Berkshire will outperform U.S. indus- 11 try in aggregate. 12 He suggested that reduced expectations are the best defense for the 13 investor. He added that lowering expectations was how he got married— 14 “My wife lowered her expectations.” 15 Buffett immediately quipped, “And he lived up to them!” 16 17 Trust 18 19 Given the Sokol situation, Buffett had a number of questions around 20 rules and compliance. 21 Buffett reiterated his desire that employees honor both the spirit 22 and letter of the law. However, with 260,000 employees at Berkshire, a 23 number roughly equal to the households in Omaha, not all will match 24 the rules. 25 Buffett noted that you can have all the rules and records in the 26 world, and someone can still go off and trade in some cousin’s name. 27 Munger shared that it is fun to be trusted and to have much self- 28 respect. In his view, an attitude of trust was the best compliance. 29 He noted that you can find huge compliance departments on Wall 30 Street, and that is where the biggest scandals occur. 31 32 The Economy 33 34 Buffett observed that we have had the foot to the floor with both monetary 35 and fiscal policy in America, and this will go on for an extended period. 36 He noted that many people think of our “fiscal policy” as having 37 passed a “stimulus bill.” 38 Buffett suggested we look past the words. Forget the “stimulus bill.” 39 What is really happening is that we have a 10% deficit, which is gigantic. 40 We’re taking in 15% of GDP and spending 25% of GDP. That is huge 41 stimulus.

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Residential construction has flattened to 500,000 units per year, so 1 the crazy excesses of the boom are getting worked out.* 2 When that ends, we’ll see employment pick up much more than 3 most people think. Construction has a ripple effect through many 4 ancillary businesses. 5 Buffett stuck with the prediction he made in the annual report, that 6 we’ll see improvement in residential construction by year-end. 7 Munger added that one advantage of buying into cyclical industries 8 is that many people don’t like them because the earnings are so unpre- 9 dictable. At Berkshire, they don’t mind having lumpy earnings over a 10 business cycle. 11 For example, Berkshire just bought the largest brick company in Ala- 12 bama. Nobody’s bidding on Alabama brick when there are no customers. 13 Buffett chimed in that See’s Candy loses money eight months of the 14 year. Yet we know that Christmas will come, so there’s no reason to look 15 at one losing month and panic. Over the next 20 years, there will be 16 some lousy years, some great ones and plenty of okay ones. 17 As for Berkshire’s other businesses, he says that steady improvement 18 is widespread. Railcar loadings peaked at 219,000, bottomed at 150,000 19 and are now running at 190,000. ISCAR has seen month-by-month 20 improvement. 21 22 Financial Reform: Or the Lack of It 23 24 Munger felt it was a huge mistake not to learn more from the subprime 25 mortgage debacle. 26 In his view, we haven’t throttled the sin and the folly of asinine and 27 greedy behavior. He would take an ax to the financial sector, whittling 28 it down to a more constructive size. He would change the tax system to 29 discourage trading, so that securities would trade more like real estate. 30 He asserted that the lack of contrition on Wall Street for the debacle 31 makes Sokol look like a hero. 32 Buffett piped in, “He’s warming up!” 33 Then Buffett noted the inanity of a tax system where a six-second 34 trade in an S&P 500 futures contract results in 60% of the profit being 35 taxed as long-term capital gain. 36 Munger concluded that having a system where hedge funds are 37 taxed at rates less than those for professors of physics or taxi-cab drivers 38 is demented. 39

* Average construction runs around 1.2 million units per year. Bubble year construction ran 40 around two million units per year. 41

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21 Munger noted that past panics and the depression started on Wall 22 Street with great waves of speculation and bad behavior. This last 23 mess should have caused a 1930s-type reaction (like the Securities Act 24 of 1934). It hasn’t, so Munger confidently predicted that we’ll have 25 another debacle. 26 Munger asserted that it was really stupid not to have done more, that 27 part of the stupidity was in the way finance and economics are taught 28 at the universities and that finance attracts the same sort of people who 29 are attracted to snake charming. 10 Buffett quipped, “If there’s anyone else we forgot to insult, just pass 11 their names up.” 12 13 BYD 14 15 While BYD trades roughly double Berkshire’s cost in the shares, the 16 stock is down some 80% from its high. 17 Munger was unconcerned, noting that a company trying to move as 18 fast as BYD will have delays and glitches. In trying to double auto sales 19 each for six years, BYD did it for five years and then had a glitch. 20 Overall, Munger asserted that he’s quite encouraged. 21 In a rare and sweet role reversal, Buffett muttered, “I have nothing 22 to add.” 23 24 Too Big to Fail 25 26 Buffett acknowledged that there are institutions in the world that 27 governments should properly save. Europe is in the process of deciding 28 whether whole countries are “too big to fail.” 29 Buffett suggested that this problem will always be with us, so our best 30 tactic is to reduce the propensity to fail. 31 One measure he proposed was that those institutions that put society 32 at risk and fail should leave the CEO and spouse dead broke. The board 33 should also suffer severe penalties. If society needs to save you, you 34 should have very painful penalties. 35 Musing on the miserable case of Fannie Mae and Freddie Mac, Buffett 36 called them “too big to figure out!” 37 38 Great Insurance Companies 39 40 Buffett got quite enthusiastic discussing Berkshire’s insurance empire. He 41 called GEICO, now the third largest auto insurer, a fabulous company.

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GEICO debuted the idea of selling direct (without an agent) way 1 back in 1936, and few have been able to copy it. 2 Meanwhile, Ajit Jain built Berkshire’s reinsurance business from 3 scratch. 4 Buffett loves Ajit, claiming that he cannot think of any decision 5 Ajit has made that he’d have done any better. Ajit is as rational as any- 6 one Buffett has met, loves what he does, is very creative and unfailingly 7 thinks of Berkshire first. 8 Interestingly, Buffett claimed later in the meeting that Berkshire spent 9 its first 15 years in reinsurance not making money. It wasn’t until Ajit 10 came along that reinsurance became a real profit center for Berkshire. 11 Berkshire’s Gen Re unit, with Tad Montross, runs a disciplined busi- 12 ness, and Berkshire’s smaller insurance units have unusual franchises. 13 And it all started when Berkshire bought National Indemnity for 14 $7 million in 1970. Now, in that same building, they run an insurance 15 company with the largest net worth of any in the world and some $66 16 billion of float. 17 Munger noted that Berkshire has a number of best-in-class companies. 18 BNSF is certainly one of the best railroads in the world. MidAmerican 19 Energy is top-ranked among utilities. 20 Munger concluded that it’s not all bad to be world-class in your main 21 businesses. 22 Buffett noted that the high-speed rail proposal in California came 23 with an estimated cost of $43 billion, a cost that would be sure to go up. 24 Meanwhile, Berkshire paid about $43 billion for BNSF and got 25 22,000 miles of track, 6,000 locomotives, 13,000 bridges (anyone want to 26 buy a bridge?). So the replacement value of BNSF is huge. The country 27 will always need railroads. It’s a terrific asset to own. 28 29 30 Costco 31 Munger, a board member of Costco, made his annual assertion that 32 Costco (the $80 billion membership warehouse club retailer) is the best 33 in the world in its industry. 34 It’s a meritocracy that takes it as its extreme ethical duty to pass 35 along savings to its customers, which, in turn, creates ferocious 36 customer loyalty. 37 Costco has a store in Korea that will do $400 million in revenue— 38 something that one would think cannot exist in retail, yet there it is. 39 Costco has the right ethics, diligence and management to continue 40 its winning ways—quite rare. 41

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21 Munger observed that it’s a problem to prevent success and wealth 22 from creating your demise. General Motors was the most success- 23 ful company in the world at one time and then became a victim of its 24 success with large unionization and very tough competition eventually 25 wiping out the shareholders. 26 Munger asserted that if he taught business school, he would do the 27 full sweep of the history of a business. 28 Buffett joked that he and Charlie were hijacked by terrorists who 29 decided to shoot the capitalists. They allowed them one last request. 10 Charlie said, “I would like to give once more my presentation on the 11 virtues of Costco with slides.” The terrorists reluctantly agreed. Then 12 they asked Warren for his last request. Buffett said, “Shoot me first.” 13 14 Cash in Treasures 15 16 Buffett agreed that investment choices for short-term money are lousy 17 right now. However, he emphasized that he doesn’t mess around with 18 short-term money. 19 Basically, at Berkshire, cash is always in Treasuries. While it may 20 be irritating that they pay virtually nothing, Berkshire will not reach for 21 another 10–20 basis points. 22 “It’s a parking place, and we want our car back when we’re done 23 parking,” Buffett declared. 24 Buffett shared how critical it was when panic hit in 2008 that 25 Berkshire has the money to do deals. It was not in a money market fund 26 or commercial paper. 27 Munger noted that he’s seen a lot of people struggle stupidly to 28 reach for an extra 10 basis points. 29 He noted that they were able to buy pipelines because they could 30 agree to a deal on Friday and produce the cash on Monday. 31 Buffett added that the seller was worried about going bankrupt 32 the next week. Buffett concluded that “if panic breaks because Ben 33 Bernanke has run off with Paris Hilton, we’re ready.” 34 35 Learning 36 Munger noted that we’re here to go to sleep each day smarter than 37 when we woke up. 38 Buffett shared how he lived in the Omaha Public Library for four 39 years.* 40 41 * Buffett is reported to have read every investment book in the library.

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He also noted that his Dale Carnegie course in 1951 cost him $100, 1 and the value was incalculable as the value of good communication 2 skills so dramatically enhanced his life. 3 So Buffett’s big point was to develop yourself. Find your passion, and 4 improve your skills. 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

231 1 2012 2 3 4 5 Venue: CenturyLink Center (renamed from “Qwest”) 6 7 Attendance: 35,000 8 9 Details About This Year: 10 11 • The meeting lasted six hours. It was an impressive 12 accomplishment that “Professors” Buffett and Munger (ages 13 81 and 88, respectively) were still going strong. 14 • After the weekend, Buffett was pleased to announce that 15 Berkshire shareholders spent $35 million at “The Berkshire 16 Mall” on everything from See’s Candy to Borsheim’s jewelry. 17 That was an average of $1,000 per attendee. 18 19 Fortune 500 Ranking: 7th 20 21 Stock Price: $114,813 22 23 One dollar invested in 1964 would now be worth $9,282. 24 Berkshire’s per-share book value has grown from $19.46 to 25 $114,214 (a rate of 19.7% compounded annually). 26 27 The S&P 500 compounded at 9.2% annually for the same period. 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2012’s Notes 22 23 24 Sovereign Debt Crisis 25 26 Munger and Buffett agreed that the sovereign debt mess is the big 27 question of the moment and tough to answer. There have been many 28 failures throughout history. 29 Buffett noted that the wealth doesn’t go away—the farms, the factories 10 and labor remain. Rather, the wealth gets reallocated. It’s a big realloca- 11 tion of wealth. He compared the ECB’s trillion euro bailout to giving a 12 guy with a margin account more debt. 13 Munger observed that it is dangerous to go low on fiscal virtue, para- 14 phrasing St. Augustine, “Everyone wants fiscal virtue but not quite yet.” 15 He recommended we follow the Roman example where two-thirds 16 of the Punic Wars were paid off before the war was over. 17 He concluded that we need more sacrifice, more patriotism and 18 more civilized politics. 19 20 Banks 21 22 Buffett asserted that American banks are in far better position than Eu- 23 ropean banks. They have taken most of the abnormal losses, buttressed 24 capital in a big way and have “liquidity coming out of their ears.” 25 Munger noted that we have a full federal union, so we can print 26 money. He’s comfortable with the U.S. system. 27 Buffett agreed, noting that it’s night and day. The U.S. Fed and 28 Treasury had the power to do whatever it took. In contrast, 17 countries 29 in Europe surrendered their sovereignty with respect to currency. As 30 Henry Kissinger once said, “When I want to call Europe, what number 31 do I dial?” 32 Regarding European banks, Buffett called the ECB coming up with 33 1 trillion euro ($1.3 trillion in U.S. dollars—an amount equal to one- 34 sixth of all bank deposits in the U.S.) a huge act. Because European 35 banks have less in deposits and rely more on wholesale funding, they 36 needed to build more capital but have done little to do so. He noted 37 one Italian bank had at least had a rights offering. 38 Munger noted that Canada kept to the old standards and had almost 39 no trouble. We departed from sound decency and participated in 40 folly with lots of disgraceful behavior and suffered enormous damage. 41 Similar things happened in Ireland and Spain. Greenspan was wrong

234 2012 with his laissez-faire policies. It is the duty of government to step on bad 1 behavior. Once we were in it, we had to nationalize. 2 Buffett admitted buying some JP Morgan for his own account. His 3 favorite bank is Wells Fargo, which he buys exclusively for Berkshire, 4 which now owns over 400 million shares.* 5 6 Chief Risk Officer 7 8 Buffett noted that the role of the chief risk officer (CRO) must not be 9 delegated. He has seen risk management group reports ignored too 10 many times. 11 Buffett noted that he is the CRO at Berkshire and that role along 12 with capital allocation and the selection of managers, are his primary 13 duties. The two basic risks he analyzes are excessive leverage and insur- 14 ance risk. 15 Munger averred that not only has risk management been delegated, 16 it has been stupidly done. 17 He characterized “value at risk” as one of the dumbest ideas ever put 18 forward. 19 Buffett agreed that PhDs who should know better got hooked on 20 their fancy math, which may not be applicable to human behavior. 21 Munger related the story of how Sandy Gottesman (who founded 22 the investment advisory firm First Manhattan and joined the Berkshire 23 board in 2003) fired a man who was his top producer. The man said, 24 “How can you fire me?” Gottesman replied, “I’m a rich old man, and 25 you make me nervous.” 26 Buffett assured shareholders that no one at Berkshire makes him 27 nervous. 28 29 Special Deals 30 Buffett acknowledged that he cold-called Bank of America CEO Brian 31 Moynihan to offer the preferred with warrants deal ($5 billion of 6% 32 preferred with 700 million 10-year warrants to buy common stock at 33 $7.14 a share). 34 They had never talked before. However, Moynihan knew Buffett had 35 1) the ability to commit and 2) large sums available. 36 Buffett asserted that Berkshire will still have this advantage after he 37 is gone. 38 39 * Wells Fargo is now Berkshire’s largest position after Coca-Cola and is becoming just as dominant as Coke in its own way. Wells made 34% of the mortgages originated in the first 40 quarter, more than triple the share of the closest competitor. 41

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21 While the next CEO might not have Warren’s Rolodex, he will still 22 have these unique Berkshire deal advantages. 23 Buffett emphasized that the impact of special deals is peanuts com- 24 pared with the long-term impact of buying great businesses for Berkshire. 25 26 Insurance 27 28 A question on surprisingly higher than expected mortality on Berkshire’s 29 Swiss Re life insurance business got Buffett going on one of his favorite 10 topics. 11 Buffett noted that surprises like this are why Berkshire’s overriding 12 principle is to reserve conservatively. GEICO is short tail business and has 13 had redundancies in reserves year after year. While Gen Re was under- 14 reserved when Berkshire bought it in 1998, reserves are developing well 15 now under the management of Tad Montross. 16 Munger inserted, “It’s inevitable that some contracts work out worse 17 than expected. Why would anyone buy insurance if that weren’t the 18 case?” 19 Buffett noted that after 9/11, it was very difficult to assess insurance 20 damages. For example, what counts as business interruption? 21 Similarly, with the tsunami in Japan, does a U.S. auto parts company 22 have a case for business interruption? These sorts of issues take years to 23 sort out and argue, again, for reserving conservatively. 24 Pricing the reinsurance of catastrophes is very difficult. It’s hard to 25 detect a series of random events from what might constitute a long-term 26 trend. 27 Buffett’s tactic is to assume the worst and price from there. 28 In the last few months, Berkshire has written far more business in 29 Asia, New Zealand, Australia, Thailand, etc. 30 As he noted last year, Buffett pointed out that the second quake in 31 New Zealand caused $12 billion of insured damage in a country of five 32 million people. On a per capita basis, this was the equivalent devasta- 33 tion of 10 Hurricane Katrina’s. 34 Events like this are why Buffett insists that Berkshire keep at least 35 $20 billion in cash. 36 Buffett is very pleased with GEICO’s continued success, asserting 37 that GEICO is worth $15 billion more than what it is carried for on the 38 books.* 39

40 * Buffett said last year that he would value GEICO at $1,500 per policyholder. With over 10 41 million policyholders now times $1,500 per, that would equal $15 billion.

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GEICO is hitting on all cylinders. In 1995, GEICO had 2% of the 1 market. Under Tony Nicely’s superb management, GEICO now has 2 nearly 10% of the market. 3 Buffett admitted, “Gen Re was off the tracks when we bought it—lots 4 of ‘accommodation business’ emphasizing growth over profitability.” 5 Joe Brandon refocused the underwriting discipline, and Tad Montross 6 has followed through. Now, the business is right-sized, and the culture 7 is good, as are prospects for decent long-term growth, creating a terrific 8 asset for Berkshire. 9 In valuing Gen Re, Buffett would calculate intrinsic value as a com- 10 bination of net worth and float. 11 In valuing GEICO, he would also include its significant underwriting 12 profits for the next 10–20 years and its significant growth prospects. 13 14 Float 15 16 When Berkshire’s float reached $40 billion, Buffett started talking 17 about how it was unlikely float would grow much more. Now, float is 18 $70 billion. 19 Ajit Jain has found innovative ways to create more float. However, 20 some of the business, such as retroactive insurance, runs off by nature. 21 He credited Ajit Jain for working miracles for Berkshire over the 22 years and doing a spectacular job of managing the “melting ice cube” 23 that is Berkshire’s float. 24 In addition, because Berkshire’s companies write profitably, Berk- 25 shire gets the economics of float at a bargain rate. As long as Berkshire 26 underwrites at a profit, people are actually paying Berkshire to hold this $70 27 billion of float. 28 Munger concluded that property casualty insurance is not a terribly 29 good business. You have to be in the top 10% to do well. Berkshire prob- 30 ably has the best in the world. To have something that is very good and 31 not growing much is okay. 32 33 Running Berkshire 34 Munger suggests that it’s an illusion that there is vast control at the 35 average corporate headquarters. One of the beauties of Berkshire, he 36 contends, is that it doesn’t require much control from headquarters. 37 Buffett’s key to motivating Berkshire’s managers is giving them 38 room to paint their own paintings. 39 Buffett joked that if someone told him to use more red than blue, 40 he’d likely tell them where to stick the paintbrush. 41

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21 He likes painting his own canvas and getting applause for doing 22 well. So he seeks managers who are wired in the same way, giving them 23 the paintbrushes and compensating them well for good performance. 24 In addition, Berkshire managers don’t have to talk to shareholders, 25 lawyers, reporters, etc., so they can focus on their businesses. 26 Buffett concluded that his focus is on not taking away something 27 that’s already good, a sort of negative art. 28 Munger noted how rational this approach is versus the percentages 29 and quota arrangements dreamed up by human resource departments. 10 Regarding compensation consultants, he suggested prostitution would 11 be a step up for them. 12 Buffett quipped, “Charlie’s in charge of diplomacy at Berkshire.” 13 14 Valuation 15 16 Buffett confessed that he’d prefer that Berkshire would trade just once 17 a year at a fair value that he and Charlie would come up with. This is 18 how some private companies do it. 19 However, public markets can do strange things. 20 Buffett reminded us that Berkshire issued stock in the mid-1990s 21 when it was overpriced. Surely a first for any public offering, on the 22 prospectus Buffett and Munger stated that they would not buy the stock 23 at the price, nor would they recommend that their families buy shares. 24 Buffett confirmed that the intrinsic value of Berkshire is signifi- 25 cantly higher than the book value, so he is very comfortable about the 26 idea of buying in shares at 1.1 times book. He would love to buy tens of 27 billions of dollars in at 110% of book, consistent with maintaining his 28 cash cushion of $20 billion. Such a move would be certain to increase 29 intrinsic value per share, so doing it on a big scale would be an obvious 30 winner. 31 Buffett noted that Berkshire nearly completed a $22 billion deal 32 recently, suggesting there is plenty to do in the world of adding value in 33 ways other than buying in shares. 34 Buffett noted he has seen the stock cut in half four times and that 35 the beauty of stocks is that they can sell at silly prices sometimes. 36 Buffett was definitive, “It’s how we got rich.” 37 As he has in years past, Buffett asserted that The Intelligent Investor 38 chapters 8 (Mr. Market) and 20 (Margin of Safety) give you all you need 39 to know. Build into your system that stocks get mispriced. 40 In the next 20 years, Berkshire will be significantly overvalued and 41 undervalued at different points. The stock market is the most obliging

238 2012 of money-making entities. Armed with the right system, the rules are 1 stacked in your favor. 2 In valuing the operating businesses, Buffett said he would love to 3 buy the group for 10 times pre-tax earnings or maybe even more. 4 5 6 Natural Resources 7 Buffett observed that cheap natural gas has been a huge plus for the 8 trade deficit. The U.S. energy picture has changed a lot in three years. 9 Buffett noted that there has been a remarkable decrease in elec- 10 tricity usage as kilowatt hours used declined 4.7% in the first quarter. 11 In addition, with natural gas at $2 per mcf (thousand cubic feet) and 12 oil at $100 a barrel, that creates a 50/1 ratio of oil to gas pricing, some- 13 thing he didn’t think was possible. Now natural gas is supplanting coal 14 at these low prices. 15 Munger called the using up of our natural gas reserves “idiotic.” He 16 would use up our less precious thermal coal first. That would be rational 17 and exactly the opposite of what we are doing. 18 He asserted that we would have been better off to keep oil and gas, 19 the hydrocarbons that are the single most precious resource of the U.S., 20 in the ground over the last 50 years. 21 In his usual understated manner, Munger summed up his point: 22 “Energy independence is stupid. We want to conserve it and use the 23 other fellow’s resources.” 24 Buffett joked, “This is Charlie’s version of saving up sex for old age.” 25 Munger retorted, “But we’re going to use the oil!” 26 27 28 Business School 29 Buffett and Munger took their annual shot at modern portfolio theory 30 and the business schools that teach it. 31 Buffett noted that business schools focus on one fad after another, 32 usually mathematically based. 33 Buffett said if he ran a business school he would have just two courses: 34 1) How to Value a Business and 2) How to Think About Markets. 35 He noted that Ray Kroc had no need to know the option value of 36 McDonald’s, but thought long and hard about how to make better fries. 37 Buffett concluded, “If you think about business and buy businesses 38 for less than they’re worth, you’re going to make money.” 39 Munger added that valuing a very long-term option on a business 40 you understand does not fit the Black Sholes option pricing model. 41

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21 It makes no sense. However, the accounting profession wanted some 22 standardized way of valuing them. And they got one. 23 24 The Buffett Rule 25 Buffett took pains to note that his idea of having the rich pay more taxes 26 applied to only the 400 largest incomes, which now average $270 million 27 each—131 of that group paid taxes at less than a 15% rate. 28 This compares to 1992, where the 400 largest income earners averaged 29 $45 million and just 16 paid less than a 15% rate. 10 Buffett’s point is that a group that has done so well over the last 11 two decades should be paying taxes at least at the same rate they did 20 12 years ago. 13 For himself, Buffett said he has no tax planning, no gimmicks. 14 He earned between $25 million and $65 million the last few years. 15 And he had the lowest tax rate in his office at about 17%. 16 17 MidAmerican Energy 18 19 Buffett said MEC has done a lot with wind power, thanks to a 10-year 20 subsidy of 2.2 cents per kilowatt hour. Otherwise, the economics would 21 not work. 22 MEC owns half of two large solar projects as well. Both solar and 23 wind need subsidies to develop. In addition, given that wind is unpre- 24 dictable, you can never count on wind power for your base load. Wind 25 will always be supplementary. 26 MEC CEO Greg Abel noted that with solar incentives, they will 27 recover 30% of the construction cost. Since Berkshire is a full tax payer, 28 it derives full benefit from these tax incentives. 29 In contrast, Buffett asserted that 80% of utilities cannot reap full tax 30 benefits because they wipe out their taxable income with depreciation. 31 Buffett noted the MEC is capital intensive, and a reasonable expec- 32 tation for return on investment with this utility would be 12%. 33 Buffett surprised us a bit, saying that MEC may have enormous oppor- 34 tunities in the next 15 years to invest, perhaps as much as $100 billion. 35 36 Systemic Risk 37 With regard to systemic risk, Buffett noted that his first rule is to play 38 tomorrow. That means not going broke no matter what happens. So 39 keep plenty in reserves, and go low on debt.* 40 41 * Again, at Berkshire, that reserve number is now $20 billion in cash.

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If that is handled, then you can invest. 1 Buffett claimed that in 53 years, he and Charlie had never had a 2 discussion about buying a business that included a talk about macro 3 affairs. “If it’s a good business at a good price, we buy it. There is always 4 going to be bad news out there.” 5 He said he bought his first stock in 1942, when we were losing the war! 6 Buffett reminded attendees that it was during the swoon in 2008 7 that he wrote his “buy stocks” op-ed piece for the New York Times. 8 Buffett concisely summed up, “We look to buy value. We don’t look 9 to headlines.” 10 11 12 Railroads 13 Buffett noted that railroads have improved their position over the last 14 15–20 years. 15 Railroads are an extremely efficient and environmentally friendly 16 way to move goods. The assets cannot be duplicated for probably six 17 times what they are selling for. 18 Buffett noted that he expects BNSF to spend far more than its 19 depreciation over the next 10 years and anticipates a good return. 20 With the sums Berkshire is working with, he’s satisfied to earn a 12% 21 return on capital, especially with Berkshire’s low cost (or no cost) float. 22 It takes the railroad one gallon of diesel fuel to move one ton 500 miles. 23 Trucks cost three times more. Railroads move 42% of all intercity traffic 24 now, offering very powerful economics compared to the cost, conges- 25 tion and emissions of moving by roads. BNSF will spend $3.9 billion to 26 improve and expand its systems, all this year and without a check from 27 the government. 28 Munger allowed that BNSF has had some breaks with technology 29 and the oil boom in North Dakota. And while it will have some bad 30 breaks, too, averaged out, BNSF is a terrific business with terrific man- 31 agement. 32 33 34 Berkshire Investment Managers 35 Buffett has been pleased with Todd Combs and Ted Wechsler, the two 36 hedge fund managers hired to manage a portion of Berkshire’s portfolio. 37 He feels he hit a homerun with both. 38 Buffett allowed that each could make more money elsewhere— 39 though, he joked, they do have access to the free Coke machine in the 40 office. 41

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21 They receive $1 million a year plus 10% of the amount by which their 22 portfolio beats the S&P on a three-year rolling basis. To encourage 23 teamwork, 80% of the bonus is each man’s own effort and 20% is on 24 that of the other. 25 Berkshire had a similar arrangement with Lou Simpson, who ran 26 the portfolio at GEICO for many years. 27 Buffett reported that the arrangement is working better than he 28 hoped, and he added $1 billion to each portfolio. So they are each 29 managing $2.75 billion now. 10 11 Newspapers 12 13 Asked about Berkshire’s acquisition of the Omaha World Herald, Buffett 14 noted that 50 years ago, newspapers were the primary source. Now, so 15 much information is free and immediately online. To survive, newspapers 16 must be primary in something. In addition, newspapers need to shift to 17 paid subscriptions on the web, so they don’t give their products away. 18 One strategy Buffett put forward was for newspapers to focus on 19 being a primary source for the local community market. In this way, 20 Berkshire is making some money in Buffalo with Buffalo News. 21 Buffett shared that Berkshire may buy more newspapers.* 22 While the economics are not as good as they once were, newspapers 23 still have a role to play.† 24 25 Shrinking Businesses 26 27 Talk of newspapers led to a discussion of how it is more profitable to 28 own growing businesses, though shrinking businesses can generate a lot 29 of cash. Berkshire has owned its share of them. 30 In fact, Buffett noted, Berkshire started as a New England textile 31 mall. Then Berkshire got into retail with Diversified Retailing, a Balti- 32 more department store, with Sandy Gottesman in 1966. And Charlie 33 presided over a company‡, whose sales went from $120 million in 1967 34 to $20,000 today. 35 Buffett concluded that they were “masochistic” in those days. Munger 36 added, “Ignorant, too.” 37

38 * Berkshire bought 63 newspaper properties this week from Media General. 39 † In April, it was reported that Berkshire bought $85 million of Lee Enterprises debt for 65 cents on the dollar from Goldman Sachs. Lee is a premier publisher of local news through 40 49 daily newspapers and 300 weekly papers. 41 ‡ Probably Blue Chip Stamps.

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1 Avoiding Mistakes 2 Buffett suggested that investors stay away from businesses they don’t 3 understand well. 4 You want to be able to have a decent idea of what the business will 5 look like in 5–10 years—then wait for a crazy price. 6 Avoid new issues—the insiders are selling their company, so it’s 7 ridiculous to think that an IPO will be the cheapest thing to buy in a 8 world of thousands of stocks. The IPO sellers pick the time to sell. So 9 don’t waste five seconds on it. 10 Use filters so that you don’t waste time on unproductive ideas. Avoid 11 big losses. 12 Munger said to avoid issues with a large commission attached. Instead, 13 look at things other smart people are buying. 14 Buffett recalled eagerly reading the Graham Newman reports years 15 ago just for that reason. 16 Think about playing tomorrow. Avoid the worst-case mistakes. 17 On the other hand, Buffett admitted that he and Munger both have 18 instincts to do big things. 19 Don’t dwell too much on mistakes. Learn from other people’s mistakes. 20 Buffett noted their constant study of others’ disasters has helped 21 them enormously. Read the stories of financial follies. 22 23 No Dividend 24 25 Buffett noted that as long as each dollar retained creates a dollar or 26 more of value, retaining profits is the way for Berkshire to go. 27 If people need income, Buffett suggested just selling off a few shares 28 each year. 29 Buffett concluded, “We paid out 10 cents a share in the 1960s, and it 30 was a big mistake. We’ll think about a dividend when we’re older.” 31 32 Remembering What Can Go Wrong 33 An interesting aside, Buffett said that in 1962, with an art budget of $7, 34 he made copies of seven financial days of crisis. 35 One was in May 1901—the Northern Pacific Corner. E.H. Harriman 36 of the Union Pacific Railroad and JP Morgan each owned over 50% of 37 the stock. Harriman was trying to take control of Northern Pacific to 38 get railroad access to Chicago. The stock went from 170 to 1,000 in one 39 day, squeezing the shorts. Margin calls ensued. A brewer committed 40 suicide by diving into a vat of beer. 41

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21 Buffett concluded that he never wanted to die in a vat of beer. 22 Munger added that there’s a lot of false confidence on Wall Street. 23 Risk on Wall Street may be measured with Gaussian curves, but the fat 24 tails are not fat enough! 25 26 Barriers to Entry 27 28 “We buy barriers to entry. We don’t build them,” declared Munger. 29 Buffett concurred, noting that some industries just don’t have 10 them—you just have to keep running really fast. 11 However, if he had $30 billion to knock the Coca-Cola brand off the 12 shelf, he couldn’t do it. 13 To further his point, Buffett took note of how Richard Branson’s 14 Virgin Cola came and went, joking that a brand is a promise, but he’s 15 not sure what the promise was with Branson’s product. 16 Buffett also declared that no one will ever build another railroad. 17 Munger noted that all it takes is one competitor to ruin a business. 18 Buffett remembered owning a gas station at 30th and Ruddick in 19 Omaha that suffered from the daily competition of a Phillips 66 station 20 across the street. 21 22 Plutocracy 23 24 With $48,000 in per capita GDP, America is a rich nation. However, far 25 too much compensation has gone to the top executives over the last 20 26 years. The tax code has encouraged this trend. 27 Buffett mused that this could be the natural progression in democ- 28 racy, to move toward plutocracy.* 29 Society needs some mitigating factors. 30 Munger recalled that when he went to Boston for the first time, 31 Mayor Curley was running the city . . . from the penitentiary! Boston 32 politics have been littered with egregious behavior. 33 34 Taxes and Tapeworms 35 36 Asked about the U.S. corporate tax rate, Buffett replied that the top 37 rate is 35%, while 13% is the average rate actually paid. You can write off 38 100% of most fixed asset purchases. 39

40 * “Plutocracy”—from the Ancient Greek “ploutos” (meaning “wealth”) and “kratos” (meaning 41 “power”).

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However, he asserted, corporate profits, balance sheets and liquidity 1 are not the problem. 2 Corporate taxes equal just 1.2% of GDP. 3 Meanwhile, medical costs equal 17% of GDP, a seven-point disad- 4 vantage to the rest of the world. Medical costs are the tapeworm of 5 American industry. 6 Munger opined that it is time for a value-added tax. It is logical to 7 tax consumption to equalize the trade deficit, and it creates a steadier 8 income stream. 9 10 11 How Are You Feeling? 12 With the recent announcement of his prostate cancer, Buffett answered 13 the inevitable question: “I feel terrific. I love what I do. I work with 14 people I love. I have more fun every day. And I have a good immune 15 system.” 16 Munger joked, “I resent all this sympathy for Warren. I probably 17 have more prostate cancer than he does. I just don’t know it because I 18 don’t let them test for it.” 19 20 21 Long-Term Outlook 22 Buffett declared that if the population grows 1% per year and GDP 23 grows 2.5% per year, by the standard of 1,000 years ago, this would be a 24 remarkable achievement. We would quadruple real GDP per century, 25 remarkable for a country that already has such a high standard of living. 26 Buffett noted that in his lifetime, real per capita GDP has increased six- 27 fold. We are unbelievably rich, hugely abundant. Folks in the 1930s would 28 have thought such growth nearly impossible. The country is not a mess. 29 The outlook is terrific. The system still works. Even after the incredible 30 crash 2008/2009, business has proven to be extraordinarily resilient. 31 Munger was less bullish. He said he’d settle for 1% real (net of infla- 32 tion) growth in GDP with a mature economy such as ours with a big social 33 safety net and emerging competition. Expectations are too high. 34 35 36 Berkshire’s Future 37 Munger noted that the first $200 billion was hard. The next $200 billion 38 will be easy now that Berkshire has momentum, people and culture in 39 place. Munger said that he hopes the Munger family will stay with this 40 heirloom. 41

245 1 2013 2 3 4 5 Venue: CenturyLink Center 6 7 Attendance: 45,000 8 9 Details About This Year: 10 11 • During the six-hour shareholder meeting, “Professors” 12 Buffett and Munger (ages 82 and 89, respectively) were still 13 going strong. 14 • The quality of questions in the Q&A was signifi cantly 15 improved by having a panel of three journalists and a panel 16 of three analysts (including short seller Doug Kass) ask a 17 majority of the questions. 18 19 Fortune 500 Ranking: 5th 20 21 • In terms of market value, Berkshire now trails only Apple, 22 Exxon Mobil and Google for the title of America’s most 23 valuable company. 24 25 Stock Price: $134,102 26 One dollar invested in 1964 would now be worth $10,841. 27 28 Berkshire’s per-share book value has grown from $19.46 to 29 $134,973 (a rate of 19.7% compounded annually). 30 The S&P 500 compounded at 9.4% annually for the same period. 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2013’s Notes 22 23 24 GEICO 25 26 We have talked often of the big getting bigger and the strong getting 27 stronger with the way the global economy is unfolding. 28 Well-run companies with winning business models are taking market 29 share from the less well-run. Those companies with scale can more easily 10 deal with the increasing regulation and complexity of modern society. 11 We love the little guy, but the way to bet has been on the big. GEICO 12 is getting big fast. 13 GEICO has always had a winning business model—selling auto 14 insurance direct. By cutting out agents, GEICO has a lower cost delivery 15 system, and low-cost providers usually win in commodity-type businesses. 16 Buffett wrote his Columbia grad school thesis on the company. 17 In the 1970s, GEICO got into trouble, and Buffett took advantage of 18 a weak stock price to buy a lot of the stock. 19 Berkshire’s percentage ownership of GEICO continued to grow as 20 CEO Jack Byrne bought in the shares aggressively. Then, in 1995, Berk- 21 shire bought in the portion of GEICO it didn’t already own at around 22 three times book value. 23 At the time, the price seemed rich. However, Buffett realized that 24 GEICO, as a public company, was limited in how aggressively it could 25 grow the business. With GEICO fully owned by Berkshire, Buffett could put 26 the pedal to the metal. GEICO’s advertising budget soon exceeded the 27 ad spend of the rest of the auto insurance industry combined. That nationwide 28 branding created a share of mind that has led to exceptional growth 29 in market share. 30 Since 1995, GEICO’s share of the personal-auto market has grown from 31 2.5% to 9.7%. And business is accelerating. 32 At the annual meeting, Buffett was virtually giddy with delight about 33 the gains at GEICO in both the closure rate and the persistency (renewal) 34 rate. 35 High and rising closure rates add significant value as GEICO already 36 added over 470,000 new policyholders for the year and might exceed one 37 million new policyholders to date, which Buffett estimated would account 38 for two-thirds of all new auto policies written in 2013. This is astonishing. 39 In addition, GEICO has enjoyed a meaningful increase in its renewal 40 rate for existing policyholders (“persistency”) as well. Buffett called this 41

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“pure gold.” Any business where people send you a check year after year 1 certainly has appeal. 2 Buffett went on to say that each policy has a mathematical value of 3 about $1,500. So if GEICO does add one million new policyholders this 4 year, that would create an additional $1.5 billion of intrinsic value for 5 Berkshire—none of which shows up directly on the income statement 6 or the balance sheet, but clearly increases the value of GEICO over what 7 it is carried for on the books.* 8 9 10 Auto Insurance Primer 11 Asked about Progressive’s new “Snapshot” product, Buffett launched 12 into a lecture on the essentials of the business. 13 He noted that insurance underwriting involves figuring out the 14 probability of a person generating a claim—i.e., having an accident. 15 GEICO asks a lot of questions to help it calculate this probability, 16 and Progressive uses its Snapshot tool to help them assess the same 17 thing. 18 To help explain, he used an example from the life insurance indus- 19 try, noting that someone who is 100 years old is more likely to die next 20 year than someone who is 20. With auto insurance, figuring out who’s 21 more likely to have an accident involves looking at many more variables 22 and that every company does it its own way. 23 He went on to explain that if you’re a 16-year-old male, you are more 24 likely to have an accident than he is. This isn’t because he’s a better 25 driver but because the 16 year old will drive a lot more and also will be 26 trying to impress his girlfriend. 27 “That doesn’t work for me anymore, so I’ve given up.” 28 Effectively if your risk-selection process treats 16 year olds like 82 29 year olds, you’re going to get horrible underwriting results. 30 Buffett added a story that Progressive’s Peter Lewis had shared with 31 him. When Lewis started Progressive, it was a tiny little mutual company 32 without much capital that underwrote motorcycle policies. The first 33 reported loss was some guy who was redheaded, so Lewis decided not to 34 insure redheads! 35 GEICO’s ability to sell insurance at a price considerably below the 36 competition’s, as shown by the large numbers of people moving to it, 37 38 * This growth suggests that GEICO will pass Allstate this year as the No. 2 auto insurer in the nation, trailing only the longtime king of auto insurance, State Farm. Quite a ride since 39 1995. 40 41

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21 and write at a large underwriting profit shows that GEICO’s system is 22 working well. 23 He added that since it has been doing this for decades and has many 24 policyholders, its underwriting is extremely credible.* 25 Buffett finished by saying that they’re watching Snapshot but are 26 quite happy with the current system. 27 Munger concluded in his usually understated way: “Well, obviously, 28 we’re not going to copy the oddball things every competitor does when 29 we’ve got an operation that’s working so well.” 10 11 Berkshire Reinsurance 12 13 Ajit Jain has built a remarkable reinsurance business for Berkshire 14 Hathaway, and recently, his operation made two important decisions. 15 Buffett discussed how Ajit’s division signed a deal where they would 16 participate in 7½% of all business in the entire London market. He also 17 noted that Berkshire had a similar arrangement with Marsh on some of 18 the business there before, but never across the board like this. 19 The second decision was to hire four well-known insurance people 20 from AIG to write commercial insurance. These are people that reached 21 out to Ajit in the past. Buffett believed this could make Berkshire a very 22 significant factor worldwide in the commercial insurance business, 23 perhaps in the billions. 24 While they have made acquisitions of insurance businesses in the 25 past, Buffett said that it’s really better to build than buy if you can find 26 the right people and the right mindset. In effect, Berkshire will be able 27 to build a very large commercial business at essentially book value and 28 won’t pick up any bad habits from other companies. 29 Munger observed that the reinsurance business is usually not very 30 good for most people. The key to Berkshire’s success with reinsurance 31 is the unique way it is run. 32 Buffett concluded that they have “the right people, capital like no 33 one else and can write business without spreading things out.” 34 35 Reinsurance Primer 36 37 Buffett emphasized several times that Berkshire is “an unusually ratio- 38 nal place.” It has been a benefit that he and Charlie did not have outside 39 influences pushing them in unwanted directions.

40 * The mantra for insurance underwriting is that data must be credible and reliable. Large 41 amounts of data are required to achieve this.

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Insurance in particular should be conducted as a rational activity. 1 One problem some insurers have is that they have pressure from Wall 2 Street to increase premiums every year. 3 In contrast, Berkshire will walk away when the pricing is inadequate. 4 He recalled that at one time, National Indemnity contracted by 80% 5 because pricing was inadequate.* 6 Buffett added that if Berkshire does something stupid, it’s not 7 because of outside influences. 8 In contrast, most managers, especially if they have little vested in- 9 terest in a company they are running, would have a hard time resisting 10 what Wall Street wanted them to do. They wouldn’t want to be subjected 11 to media criticism and other unwanted pressure. 12 Buffett noted that Berkshire wrote a lot of catastrophe insurance 13 in the U.S. when prices were right. Now, the prices aren’t right, so they 14 aren’t writing it. Buffett concluded, “We haven’t left the market. The 15 market left us.” 16 He went on to compare this to refusing to buy Internet stocks in the 17 late 1990s. Referring to it as a “social proof or bandwagon effect,” he 18 added that it’s hard to resist this pressure when people around you are 19 making a bunch of money and friends and the media are questioning 20 why you aren’t doing it. 21 Berkshire’s advantage is that they don’t have such pressures—“we 22 just don’t give a damn.” 23 Munger added that the Bible says things like, “You can’t covet your 24 neighbor’s ass,” for a reason. 25 Borrowing from past comments, he finished with, “Even worse, envy 26 is the one sin that’s no fun.” 27 Buffett chimed in, “Gluttony is a lot of fun (while reaching for a piece 28 of peanut brittle). Lust has its place, too, but we won’t get into that.” 29 Buffett acknowledged that hedge funds have recently entered the 30 reinsurance market in a big way. He opined that it is a product that is 31 easily sold to investors. 32 Buffett huffed, “Anything Wall Street can sell they will. You can 33 count on that.” Munger added, “They’ll throw in a lot of big words, 34 too.” 35 Adding a life lesson to the discussion, Buffett emphasized “that you 36 can’t afford to go along with the crowd in investment or insurance or a lot of 37 things.” 38 39

* We recall that National Indemnity subsequently did business hand over fist during the 40 next hard market. 41

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21 He recounted that if you own a gas station and the guy across the 22 street sells below cost, you’ve got a huge problem. In insurance, if 23 the guy across the street is selling below his cost, the standby costs are 24 reasonable and aren’t backbreaking. 25 Effectively, Berkshire can just wait for better days and better pricing 26 to come along. 27 Buffett, once again, praised his insurance managers saying that Berk- 28 shire was very lucky to get such great people—such as Ted Montross 29 at General Re, Ajit Jain, Don Wurster, and Tony Nicely at GEICO. 10 He went on to conclude that they like it at Berkshire because they 11 are not pressured to do dumb things. 12 Munger agreed, “With our cranky methods, we probably have the 13 best insurance operation in the world. So why change?” 14 15 BNSF Railroad 16 17 Buffett reported that the railroad is doing very well. Figures displayed at 18 the start of the meeting showed gains in railcar loadings of 3.8% versus 19 a gain for all other U.S.-based railroads combined of just 0.3%. 20 Buffett noted that there is a significant difference. 21 It’s helped that a lot of oil was found close to their tracks. “What 22 better place to find oil!” he quipped. 23 In fact, Buffett talked with oil producers in the Bakken oil play, and 24 he sees increasing rail usage for a long time. He added that oil moves 25 faster by rail than by pipeline.* 26 Burlington Northern Santa Fe CEO Matt Rose said that they’re moving 27 about 650,000 barrels of crude a day. He thinks it will be 750,000 by year 28 end and could go up to 1.4 million in the years ahead. 29 Buffett added perspective, noting that the whole country produced 30 just five million barrels a day not too long ago. This is a lot of oil, and it’s 31 not just the Bakken. There’s shale developments and more unfolding.† 32 In terms of BNSF’s coal franchise, they look for it to stay about 33 where it is today. With some track dedicated to coal, there could be 34 some loss of value over time. Business will fluctuate depending upon 35 natural gas prices and the EPA. Some generating capacity can go in 36 either direction. 37 * An engineer friend at MidAmerican Energy tells us oil can only move about 30 miles per 38 hour max without causing undue corrosion. The rail can go twice as fast, though it has a bit 39 more handling risk. † Kinder Morgan recently proposed a pipeline from Texas to the West Coast to supply 40 refiners there. Refiners have declined to sign up, preferring the new-found flexibility of oil 41 by rail.

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1 BNSF versus the New Normal 2 Asked about Bill Gross’ concept of lower future returns dubbed “the new 3 normal,” Buffett stressed that he and Charlie don’t pay any attention 4 to macro forecasts. 5 He noted that people talk all the time about future and macro issues, 6 but they don’t know what they’re talking about. It’s not very productive. 7 Buffett profoundly noted, “To ignore what you know to listen to someone 8 else who doesn’t know, doesn’t make sense.” 9 Buffett went on to say that he does know that BNSF will be carry- 10 ing more and more carloads, and there will be no substitute. There will 11 be only two railroads in the West, so BNSF has incredible replacement 12 value. 13 He suggested that people will do very well owning good businesses if 14 they don’t pay too much for them. 15 Munger demurred, saying that he believes that it’s conceivable that 16 the next 10 years may be no better than the last 10. 17 18 ISCAR 19 20 Just prior to the meeting, it was announced that Berkshire would buy the 21 final 20% of ISCAR held by the Wertheimer family for about $2 billion. 22 Buffett noted that the relationship with the Wertheimer family 23 would continue, comparing ISCAR to Sandvik.* 24 Buffett noted that Sandvik is very good, but ISCAR is much better. 25 The advantage is in brains and incredible passion for the business. 26 When Seth Wertheimer started the company around 1951, here was 27 this 25 year old buying tungsten, the raw material for cutting tools, from 28 China along with everyone else. Then he’s selling to customers using 29 machine tools all over the world, basically heavy industry. 30 He had no advantage doing business from Israel. Yet he’s getting 31 tungsten from miles away, selling to customers miles away, and he’s 32 competing with well-run companies like Sandvik. 33 How did he do it? 34 He had some incredibly hard-working and talented people who con- 35 stantly improved the product and worked to make customers happier. 36 And they haven’t stopped doing this. 37 Buffett concluded that ISCAR is one of the world’s greatest compa- 38 nies, and he feels very fortunate to be associated with its management. 39

* Sandvik is a Swedish company that owns Sandvik Tooling and Seco Tools—major ISCAR 40 competitors. 41

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21 Heinz 22 23 Buffett said the $23 billion deal came about at the airport in Boulder, 24 Colorado, when 3G Capital Partners’ Jorge Paulo Lemann asked if 25 Buffett would be interested in joining him on a deal to buy Heinz. Since 26 he respected both Heinz and Jorge Paulo, Buffett said, “I’m in.”* 27 In a week or so, Buffett said he received a term sheet on the deal, 28 and he didn’t need to change anything on it. In all respects, Buffett said 29 it was an absolutely fair deal to both parties. 10 Buffett acknowledged that they paid a bit more than they wanted 11 to, as always, and wouldn’t have done the deal without 3G. He added 12 that they believe the people of 3G are both classy and are extraordinary 13 managers. 14 While each party has invested $4.1 billion in equity, 3G wanted more 15 leverage in the deal, so Berkshire agreed to invest $8 billion in that 9% 16 preferred. 17 18 Too Big to Succeed? 19 20 Asked whether Berkshire was morphing into an index fund, Buffett ac- 21 knowledged that as Berkshire gets bigger, it gets harder to move the needle, 22 and returns, although satisfactory, will not be as good as in the past. 23 However, Berkshire’s success will also depend on opportunities pro- 24 vided by turbulent markets like 2008, when size and a lot of capital gave 25 them an advantage. 26 Thanks to Charlie’s prodding, they have paid up for good busi- 27 nesses. 28 Buffett added that if you buy a great business for what appears to be 29 a high price, it’s seldom a mistake. 30 Munger attempted to do Buffett one better and noted that the 31 record of holding companies that got really big is not good. He added 32 that Standard Oil was pretty much the only one that got “monstrously 33 big and continued to do monstrously well.” 34 Even with that backdrop, he added that Berkshire has a better system 35 than most others. 36 Buffett added that they have been buying some very good businesses, 37 and in fact, eight of them would be on the Fortune 500 as standalone 38 entities . . . 8½ counting their 50% stake in the Heinz acquisition. 39 40 * He’s known Jorge Paulo for years from being on the board of Gillette together. 41

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1 The Dollar 2 Buffett declared that he thinks the dollar will be the world’s reserve 3 currency for some decades to come. 4 While China and the U.S. will be the world’s economic super powers, 5 he thinks it extremely unlikely that any currency will supplant the U.S. 6 dollar. 7 Munger acknowledged that having the reserve currency is an advan- 8 tage. However, if the U.S. dollar were displaced as the world’s reserve 9 currency, so be it. 10 Munger noted that it is in the nature of things that sooner or later 11 the leader is no longer the leader. As Keynes said, “In the long run, 12 we’re all dead.” 13 Buffett joked, “This is the cheery part of the section.” 14 Munger continued, “Well, if you stop to think about it, every great 15 civilization of the past has passed the baton.” 16 17 18 Corporate Profits as a Percentage of GDP 19 20 Buffett was reminded of a 1999 Fortune article where he wrote that one 21 would have to be wildly optimistic to think that corporate profits as 22 a percentage of GDP could be much above 6% for a sustained period. 23 Today, corporate profits are greater than 10% of GDP. 24 Buffett said that people should take with a grain of salt complaints 25 of high corporate taxes. 26 He noted that business has done much better since the 2008 melt- 27 down than private citizens and noted how employment levels have not 28 recovered. 29 Buffett’s best guess is that profits as a percentage of GDP will trend 30 downward from here but that GDP will keep growing, so it’s not anything 31 terrible. 32 Munger noted that it is important to recognize that stocks are owned 33 by many pension funds that support the masses in some way. So though 34 the figures show that there is an income gap, it doesn’t mean that the 35 world has become more unequal and that the two figures aren’t auto- 36 matically correlated. 37 He said he likes Warren’s idea that the rich should pay more but 38 would prefer to see a lower corporate tax rate. 39 Buffett concluded, “He’s the Republican, and I’m the Democrat.” 40 41

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21 The Huge Fed Experiment 22 23 Asked about the Fed buying $85 billion per month of mortgage secu- 24 rities and treasuries and what the long term risks might be, Munger 25 replied, “The basic answer is I don’t know.” Buffett added that it really 26 is uncharted territory. 27 However, as the Hunt brothers found out when they were buying 28 silver, it’s a lot easier to buy things sometimes than to sell them. 29 He noted the Fed’s balance sheet is up around $3.4 trillion. This is 10 somewhat balanced out by banks with huge reserve positions. He pointed 11 out that Wells Fargo has $175 billion at the Fed earning effectively 12 nothing. 13 Buffett noted that he has a lot of faith in Bernanke, though he does 14 wonder if Bernanke is affected by the fact that his term is expiring. 15 Buffett quipped that maybe Bernanke’s advice to his successor to 16 help him bring down the Fed’s balance sheet by a few trillion will be 17 to tell him to read a few of the speeches he gave at George Washington 18 University. 19 On a serious note, Buffett warned that this does have the poten- 20 tial to be quite inflationary. He also speculated that some of the Fed 21 members were probably disappointed that they haven’t seen more 22 inflation. 23 Turning to the market, Buffett predicted that the impact on the 24 market will not be when the Fed starts selling. It will be when the market 25 senses that the Fed has changed course—stopped buying in securities. 26 He called this the shot that might be heard around the world. He 27 speculated that this wouldn’t necessarily be cataclysmic, but that this 28 change will cause investors to reevaluate their investments—especially 29 those that made their decisions based on low interest rates. 30 Munger took a shot at the field of economics, adding that the econ- 31 omists thought they knew the answers, but have been surprised by the 32 outcome. He added that with their track record, maybe they should be 33 more cautious in their behavior. 34 He recommended that they reevaluate their belief that they won’t 35 get us into trouble when they print lots of money. 36 Upon prodding by Buffett, Munger indicated that he is worried 37 about inflation and that the next century will be harder, but that he 38 won’t be here to see it. 39 Buffett joked, “Charlie says he won’t be here to see it. I reject such 40 defeatism.” 41

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1 Effects of ZBIR 2 Moving into a tutorial on interest rates, Buffett observed, “Interest rates 3 are to asset prices sort of like gravity is to the apple.” 4 When there are very low interest rates, there is a not much of a grav- 5 itational pull on asset prices. People behave differently today, when 6 money costs virtually nothing, versus the early 1980s when Volker was 7 trying to stem inflation and rates were 15%. 8 Buffett continued, “Interest rates power everything in the economic universe.” 9 He added that part of paying a bit more for Heinz included being 10 able to borrow money so cheaply. 11 He noted that interest rates will change, but when they change can- 12 not be predicted, as was the case in Japan for 20 plus years. 13 He surmised that asset prices were higher because people believe 14 that interest rates will stay low. Relating the interest rate environment to 15 bonds, he added that when the 30-year Treasury bond is 2.8%, it makes 16 houses very attractive. 17 Noting that it’s been a smart policy, Buffett ventured that selling $85 18 billion a month will be much more than buying $85 billion a month. 19 He concluded that it is like watching a good movie because he doesn’t 20 know how it’s going to end. 21 Munger noted that Berkshire has this enormous float* that is worth 22 less than it used to be because of the low rates. So Berkshire would 23 benefit in that regard if and when rates rise. 24 Buffett emphasized that at Berkshire, they never stretch for yield. At the end 25 of first quarter, Berkshire had about $49 billion in short-term Treasuries 26 earning basically nothing. If short-term interest rates got back up to 5%, 27 that would bring Berkshire a couple of billion dollars of pre-tax earn- 28 ings, though it would have lots of other effects on all their businesses. 29 30 31 Flim-Flam 32 A favorite meeting moment came when Buffett was comparing two 33 multi-level marketing companies, Pampered Chef and Herbalife (which 34 has been very publicly shorted by hedge fund manager Bill Ackman). 35 The claim by the short sellers is that Herbalife loads product up 36 on unsuspecting people that they can never sell, and that is sort of the 37 main business. 38 39 * $73 billion. 40 41

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21 In contrast, Buffett contended that Berkshire’s Pampered Chef is fo- 22 cused on selling to the end user through thousands of parties every week. 23 Munger nailed it: “I think there is likely more flim-flam in selling magic 24 potions than in selling pots and pans.” 25 Buffett joked, “At our age, we’re in the market for magic potions!” 26 27 1-800-brk-deal 28 29 There is no doubt that Buffett’s reputation and deal acumen have re- 10 sulted in some remarkable deals for Berkshire. Will his successor be so 11 successful? 12 Buffett noted that his successor will have even more capital to work 13 with, and that will be especially valuable at turbulent times. Being able 14 to say “yes” very quickly to large deals sets you apart from every other 15 investor. “Berkshire is the 800 number when there is a panic in the markets” 16 Buffett further noted that this happens occasionally, as it did in 2008 17 and 2011. Using one of his favorite metaphors, Buffett pointed out that 18 when the investment tide goes out, you will see who has been swimming 19 naked. Adding dryly, “Those naked swimmers will call Berkshire.” 20 Interestingly, Buffett was asked about what he would do when one 21 of those quick investment decisions made in February of 2009 comes 22 due in 2014. Berkshire invested $300 million in a five-year 15% Harley 23 Davidson note. 24 Buffett joked that they would like to just not answer the mail and 25 keep getting the 15%. He further noted that it will be a sad day when it 26 comes due. 27 He indicated that they were able to make the decision quickly be- 28 cause he believed they would not go broke. 29 Concluding his thoughts on Harley Davidson, Buffett said, “Any com- 30 pany that gets its customers to tattoo ads on their chests can’t be all that bad.” 31 Munger observed that in the early days, Buffett was successful be- 32 cause he has no real competition. Interestingly, by moving into a field 33 where Berkshire is a great home for businesses that don’t want a home 34 office overseeing everything they do, he has moved into an area where 35 there isn’t a lot of competition. 36 Buffett affirmed that Berkshire gets the calls that no one else gets 37 because they have the money and the willingness to act immediately. 38 Interestingly, Buffett noted that this area becomes more and more 39 Berkshire’s own as Berkshire gets bigger and bigger. 40 Munger spoke about Berkshire’s competitive advantages. In his 41 mind, those include the ability to stay sane when others are crazy.

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Another advantage he talked about was living by a corporate gover- 1 nance golden rule where they treat subsidiaries as they would want to be 2 treated. Noting how rare that was in corporate America, he noted that it 3 attracts businesses to Berkshire. 4 He opined that by Berkshire positioning itself in a less competitive 5 space, it has become quite unusual. “This is a very good idea . . . I wish 6 I’d done it on purpose.” 7 Buffett shared the story of a business owner that was thinking about 8 selling his business. 9 He was concerned that if he sold it to competitors, they would fire 10 the people that helped him build the business. They would come in like 11 Attila the Hun. If he sold to some private equity firm, they’d load it up 12 with debt and resell it later on, at which point the Attila the Hun sce- 13 nario would play itself out again. 14 So when he thought about it, he wasn’t interested in selling to Berk- 15 shire because it was so attractive, but because Berkshire was the last man 16 standing. 17 It turned out to be a wonderful acquisition for Berkshire. His people 18 stayed, and he continues to do what he loves doing. 19 Buffett concluded, “Our competitive advantage is that we have no 20 competitors.” 21 Buffett also added that he thought one of the advantages was that 22 Berkshire has a shareholder base that’s different, where Berkshire looks 23 at shareholders as partners. The owner/managers want shareholders to 24 get the same result they get. 25 26 Energy Management 27 28 On the subject of their work habits, Munger offered a fascinating insight. 29 By accident, he and Buffett have ideal habits for what they do. 30 For example, they didn’t know when they started out about modern 31 psychological evidence that you shouldn’t make important decisions 32 when you’re tired and that difficult decisions are tiring. 33 He joked that they didn’t know important decision-making was 34 helped by consuming lots of caffeine and sugar.* 35 Munger offered up that because they both live on auto–pilot, they 36 don’t waste energy on the ordinary things that come up every day. He 37 said this is an ideal way to do what they do. 38 He further commented that he has never seen Buffett tired, that he 39 sleeps soundly and that his lifestyle works ideally for what he does. 40 * Cherry Coke and See’s peanut brittle were present at the meeting. 41

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21 Newspapers 22 23 Buffett stated that Berkshire has been buying papers at very low prices 24 compared with current earnings and must do so because the earnings 25 will go down. 26 In addition, Buffett noted that his recent newspaper purchases have 27 some tax benefits. Buffett said he expects at least a 10% after-tax return 28 with declining earnings over time. In terms of scale, it doesn’t move the 29 needle at Berkshire. 10 Altogether, Buffett estimated that they have $100 million in pre-tax 11 earnings from their newspaper holdings. 12 Interestingly, although the group is below the threshold for reporting, 13 he said he would report the results of the newspaper group annually. 14 Munger deadpanned, “I think I hear you saying that this is an excep- 15 tion, and you like doing it.” 16 17 Biggest Threat 18 19 As in past years, Buffett asserted that health care costs are the biggest 20 threat to American competitiveness. We’re spending something like 21 17% of GDP on health care, while our rivals are paying around 10%. 22 He compared it to a raw material cost where U.S. industry pays 23 about 7% more than global competitors. It’s just like having a raw 24 material or something of the sort that costs you more. Yet because any 25 one company cannot control the cost, it’s a big disadvantage. 26 Munger eagerly addressed this issue and offered up that the “grossly 27 swollen securities and derivatives markets” don’t really help competi- 28 tiveness. 29 He added that Cal-Tech and MIT graduates doing derivative trading 30 was a “perfectly crazy outcome in terms of the country.” 31 He agreed with Buffett about health care, but finds this other issue 32 more revolting. 33 Warren concluded, “Charlie is very Old Testament.” 34 35 Advice for Life 36 37 Munger declared that he and Warren are basically old fashioned. 38 He thinks the key to life is that the old virtues still work, like plug- 39 ging along and staying rational. 40 Warren recommended doing what turns you on. Munger agreed, 41 saying he’d never done anything really well that he didn’t like to do.

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Buffett reminisced that he and Charlie both started at the same 1 grocery store, and neither of them is in the grocery business today. 2 Munger joked that the young Buffett was in no danger of being pro- 3 moted, either, even though his family owned the store. 4 Buffett interjected, “Grandpa was right, too!” 5 Buffett went on to say that he’s been lucky—lucky to live in this 6 country, lucky to find things he liked to do early in life. 7 He said, “It’s so much fun running Berkshire. It’s almost sinful.” 8 Munger joked, “You found a way to atone for your sins from having 9 so much fun—you’re giving all the money back.” 10 Buffett shot back, “You give it all back whether you want to or not.” 11 12 13 Timing 14 Bill Gross recently made comments that his generation of investors 15 owed a lot of their success to the timing of their birth. Buffett agreed 16 that there was no question that being born male and in the U.S. was a 17 huge advantage. 18 Spinning a story he first related in a 1979 Fortune article, he talked 19 about his dad being in the securities business. And since his dad had no 20 one to call on after the crash, he stayed home in the afternoons. “And 21 there was no television . . . so here I am. I feel lucky the crash of 1929 22 came along.” 23 He related that the crash turned people off to the market for an 24 entire decade and that business was horrible. 25 Buffett noted that we had a similar sort of decade up to 2010 for 26 stocks. 27 He allowed that the 1950s were a favorable environment for invest- 28 ing, with low competition for ideas, and that he would have made more 29 money if had he been born five years earlier and probably made less if 30 he’d been born 15 to 20 years later. 31 Buffett said he envies the baby being born today in the United States. 32 That’s the luckiest individual ever. He opined that the baby will do better 33 in all sorts of different ways than when he was born. Just as we live far 34 better than people like John D. Rockefeller, the person born today will 35 live far better than we do. 36 Munger noted that the competition for investment ideas in Buffet’s 37 early career was much weaker than it is today. However, that does not 38 mean that there’s nothing to be done ahead in the world of investing. 39 Buffett bragged up Charlie a bit, noting that in 2008 and 2009, there 40 were thousands and thousands of high IQ, investment professionals. 41

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21 And Charlie invested the cash at Daily Journal (of which Munger is chair- 22 man of the board) in equities at X that are now worth 3X-4X.* 23 Munger observed that Buffett was drowning in opportunities when 24 they first met, but what he lacked was money. 25 Buffett finished with the punchline: “Now we’ve got the money and 26 no ideas.” 27 28 Solar Power 29 10 Munger confidently predicted that there will be more solar generation 11 in deserts than on rooftops. Berkshire’s big solar operations get very fa- 12 vorable terms and are located in the desert, so Berkshire will do fine. 13 However, he’s skeptical about rooftop panels harming Berkshire’s 14 utilities. He suspects there’s some twaddle in that area. 15 MidAmerican Energy CEO Greg Abel added that while the cost of 16 installing rooftop solar has come down, there are tariffs protecting the 17 utilities. 18 19 Banks 20 21 Asked about Dodd Frank, Buffett noted that the higher the capital ratio, 22 the lower the return on equity. Overall, he thinks that U.S. banks are 23 much stronger than they’ve been in 25 years. For the most part, the old 24 bad loans are gone, and the new ones are much better. 25 He added that our banking system is far stronger than Europe’s. 26 Buffett declared that he’s not worried about the banking system or 27 a housing boom causing the next bubble. It will be something else. He 28 noted we will always have bubbles because it is the nature of capitalism 29 to go to excess. That’s what humans do. But the next bubble will come 30 in some other way. 31 Buffett said he feels very good about investments in Wells Fargo, 32 U.S. Bank and M&T Bank. Their earnings should be decent over time, 33 but their returns on equity will be lower than they were seven or eight 34 years ago because of Dodd Frank. 35 Munger noted that he’s a little less optimistic about the banking system 36 long term than Warren. He still does not see why massive derivative 37 books should be mixed up with deposits that are insured by this country. 38 Buffett agreed. 39

40 * We’ll brag up Warren here. As we noted earlier, Berkshire has put to work over $100 bil- 41 lion since 2008.

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Munger concluded, “The more bankers want to be like investment 1 bankers instead of bankers, the worse I like it. I can’t say more. I’m in 2 enough trouble on this subject already.” 3 Buffett joked, “I can see the journalists just licking their chops waiting 4 for Charlie to throw a thunderbolt. He’s unusually restrained today.” 5 6 7 Succession Plan: The Culture 8 There were yet again a number of questions concerning the succession 9 issue. Andrew Ross Sorkin asked the question, “Is Ajit your successor”? 10 To which Buffett replied after pausing for a moment, “I noticed you 11 started with the A’s. You’ll have just as much luck with the B’s.” 12 Buffett said he and the board think about succession all the time. He 13 added that it is the number one thing discussed at board meetings and 14 that the board “solidly” agrees with who the successor is. 15 The important thing will be to preserve the culture and that picking 16 the right CEO will be the key to that. Buffett believes the culture has 17 been intensified year after year and that any type of foreign behavior will 18 be “cast out” The wrong sort of person would be rejected like “foreign 19 tissue.” 20 Around succession, Berkshire has thought about “what can go wrong.” 21 When indelicately asked by the short seller Doug Kass about Howard 22 Buffett’s qualifications to be the non-executive chairman on the board, 23 Buffett reflected that the intention of the position is to solely look af- 24 ter the culture of Berkshire, and no one is more committed to that than 25 Howard. 26 When asked about the complexity brought on by the multiple number 27 of companies he oversees, Buffett allowed that his successor may orga- 28 nize things in a somewhat different way. However, Berkshire will con- 29 tinue to leave its CEOs running their businesses, with capital allocation 30 decisions being made in the home office. 31 Buffett joked that if his successor really went crazy, he might hire 32 one more person at headquarters. 33 Munger noted that managing this structure would be unwieldy if 34 Berkshire had an imperial headquarters that forced its will on the subsid- 35 iaries, but pointed out that Berkshire doesn’t operate like that. Conclud- 36 ing, “If your system is decentralization to the point of abdication, what 37 difference does it make how many subsidiaries you have?” 38 Munger, ever inverting the topic for insight, noted that if what they 39 were doing was too hard, it would be impossible. But it isn’t. 40 Buffett joked, “I’ll have to think about that a little.” 41

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21 Munger continued, suggesting that if 50 years ago, someone would 22 have said that Buffett would manage a huge firm like Berkshire from 23 Omaha, Nebraska, with a tiny office staff, people would have said it 24 could never work. But it has. 25 Munger concluded, “I want to say to the many Mungers out there, 26 don’t be so stupid as to sell your shares.” 27 Buffett quipped, “That goes for the Buffetts, too.” 28 29 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

264 1 2014 2 3 4 5 Venue: CenturyLink Center 6 7 Attendance: 40,000 8 9 Details About This Year: 10 11 • Corey took copious notes alone this year while Daniel stayed 12 home under the weather. 13 • Buffett and Munger had special edition Heinz ketchup 14 bottles for sale. The Buffett version sold for $2.00 each, while 15 the Munger version sold for just $1.50. They joked that they 16 will be keeping track to see who sells more ketchup. 17 18 • Nebraska Furniture Mart did over $40 million of business 19 during this week. That’s 10% of the store’s annual sales. 20 • The shareholder meeting was six hours long. “Professors” 21 Buffett and Munger (ages 83 and 90, respectively) were still 22 going strong. 23 24 Fortune 500 Ranking: 5th 25 26 Stock Price: $177,953 27 28 One dollar invested in 1964 would now be worth $14,386. 29 Berkshire’s per-share book value has grown from $19.46 to 30 $146,386 (a rate of 19.4% compounded annually). 31 32 The S&P 500 compounded at 9.8% annually for the same period. 33 34 35 36 37 38 39 40 41

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21 Highlights From 2014’s Notes 22 23 24 Five Things You May Have Missed 25 26 We have long noticed the paradox of craziness that surrounds Warren 27 Buffett: no investor gets more media attention, and yet so little under- 28 standing flows out of that attention. 29 We suppose it’s a problem of the short attention span/instant grati- 10 fication culture bouncing off the wisdom of the ages. 11 In any case, now that the media frenzy over the Berkshire meeting has 12 died down, we check in with our observations on the annual gathering. 13 Here’s what seems big to us and what few seem to have really noticed: 14 15 1. Berkshire is more invested in equities than any time 16 since 1997 (and less invested in fixed income than any 17 time since 1995). 18 19 How’s that for a headline? 20 In all our post-meeting reading, we did not see this point 21 made. 22 To all those wringing their hands about an imminent 23 bear market, apparently Buffett didn’t get the notice. This 24 is especially noteworthy as Buffett was so cash-heavy during 25 the “lost decade.” 26 He most decidedly is not all in all the time. So the fact 27 that he is leaning so decisively toward equities is worthy of 28 note. 29 In addition, while the investment portfolio has shifted 30 over the last decade from being the centerpiece of the Berk- 31 shire empire to merely a part of the whole, it still represents 32 his thinking about the opportunity costs of various asset 33 classes over time. 34 He clearly believes equities are the superior choice to 35 bonds and cash at this time. That’s a point worth noting. 36 37 2. Buffett is touting Berkshire’s value. 38 39 This is a complete about-face. 40 For decades, we well remember Buffett and Munger 41 downplaying Berkshire’s value and low-balling expectations

266 2014 for future growth year after year after year. You could almost 1 hear the violins in the background. 2 In recent years, Buffett has been more upfront about 3 what makes Berkshire so remarkable and hinting at what 4 those values might be. 5 This year Buffett did a “shout out” on Berkshire’s value. 6 He was quite direct that Berkshire’s plan to buy back 7 shares at 120% of book value is nothing less than a not-so- 8 subtle hint to own Berkshire from the master himself. 9 To put some numbers on that, first quarter equity of $230 10 billion equates to $93 of book value per “B” share—120% of 11 that would be $112. With the “B” shares at $126, they are sell- 12 ing at just 12% above the price at which Buffett would buy in 13 large amounts of stock—a value differential that Berkshire’s 14 growth will close within the year. 15 After years of low-balling Berkshire, Buffett is fairly 16 screaming to whoever will listen to notice the value here. 17 18 19 3. Buffett loves banks. 20 It’s well-known that Buffett likes Wells Fargo. It’s less well- 21 known that Buffett likes banks. 22 For example, what is Berkshire’s fifth-largest equity 23 holding? 24 Come on now, make a guess. 25 The Big Four get plenty of press: Wells Fargo, Coca-Cola, 26 American Express and IBM. 27 What’s number five? 28 If you don’t know, don’t feel bad. We asked several of our 29 friends who study Berkshire, and they did not know. 30 The answer: Bank of America. 31 Assuming exercise of the warrants, the shares were worth 32 $10.9 billion at year-end and $12 billion at the end of the 33 first quarter. 34 Between Wells Fargo, Bank of America, U.S. Bancorp, 35 Bank of New York Mellon and M&T Bank, Buffett has a $40 36 billion investment in U.S. banks. 37 This is a huge position and, thus, worth close inspection. 38 For all the hand-wringing about increased regulation, in- 39 creased capital requirements, ongoing lawsuits and narrow 40 interest rate spreads, something must be very right about 41

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21 banking and/or these particular banks for Buffett to have 22 his largest sector weighting in banks. 23 We would add that Buffett knows banks, having pur- 24 chased the Illinois National Bank of Rockford in 1969. 25 In the 1977 Berkshire report, Buffett proudly took note 26 of Gene Abegg’s able management in building a bank whose 27 rate of earnings to assets was about three times that of most 28 large banks. 29 10 4. Buffett is happy. 11 12 Over the years, we have found Buffett’s general level of en- 13 ergy and enthusiasm remarkable. 14 However, some years are more difficult than others, and 15 that shows up in a more somber demeanor at the meeting.* 16 This year, we report that we have seldom seen him happier. 17 We believe a big contributor is that Berkshire is hitting on 18 all cylinders. Every one of his major investments and import- 19 ant hires of the last decade is working out and—in certain 20 cases—working out very well. 21 The man is on a roll. 22 23 5. Berkshire is a smooth-running capital 24 allocation machine. 25 26 Allocation of capital is the key to future returns in the busi- 27 ness world. Never before has the world seen an allocation 28 machine like Berkshire Hathaway. 29 Generating in the neighborhood of $20 billion a year in 30 growing cash flow, Berkshire will easily generate more than $230 31 billion of cash in the next decade, an amount equal to its current 32 equity value. 33 In other words, what Berkshire does with its excess cash 34 over the next decade will match or exceed in scale every- 35 thing Buffett has done over the last 50 years. 36 Buffett knows full well he may or may not be around to 37 preside over these allocation decisions, so the more capital 38 allocation can be mechanized or delegated in a good way, 39 40 * The Salomon scandal and the year David Sokol stepped down come to mind. 41

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the better. And Buffett has done this to an absolutely stun- 1 ning degree over the last 15 years. 2 Perhaps, in years to come, this transition will be seen as 3 his greatest work. 4 5 Let’s take a closer look at what he has created. 6 7 8 Berkshire Hathaway: Allocation Machine 9 There are essentially five things public corporations can do with a dollar 10 earned: reinvest in the business, acquire other businesses or assets, pay 11 down debt, pay dividends, and/or buy in shares. 12 Deciding how much to allocate to each of these five areas ideally is 13 driven by “opportunity cost.” 14 In other words, each extra dollar should go where it gets the best 15 risk-adjusted return over the long run compared to all other competing 16 opportunities. 17 Warren Buffett, more than anyone else we know, has brought the 18 art of capital allocation to the forefront of American business thinking. 19 For years, he and Charlie Munger have noted that American business 20 managers promoted to CEOs were much like the world-renowned vio- 21 linist who finally makes it to Carnegie Hall and then is told to play the 22 piano. 23 After years of mastering accounting or just-in-time production or 24 sales and marketing, the rising manager is suddenly in charge of some- 25 thing he’s had no training for: capital allocation. 26 Not surprisingly, the overall record of capital allocation in American 27 business has not been good. 28 Back in the 1980s, we hardly ever heard companies speak of this 29 function. Today, it has become commonplace (though execution still 30 can and often does leave much to be desired). 31 For example, according to a recent Wall Street Journal, corporate 32 spending on share buybacks rose 23% last year to $477 billion and divi- 33 dend payments increased 14% to $1.3 trillion, while capital spending is 34 expected to climb 6% this year to $650 billion. 35 That’s a great little summary and not the sort of thing one read in 36 the paper 30 years ago. 37 For years, Buffett has modeled a rational, intelligent and sometimes 38 inspired approach to capital allocation. 39 40 41

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21 In this year’s annual report, Buffett was quite specific as to how the 22 allocation went for 2013 at Berkshire: 23 24 Reinvesting in the businesses 25 26 Here is where the biggest changes have occurred. 27 Prior to 1998, Berkshire owned little in the way of operat- 28 ing businesses that could reinvest large amounts of cash. In 29 fact, Buffett distinctly preferred low-capital, high cash flow 10 businesses, so he could reinvest the cash flow himself. 11 Since then, however, Berkshire has been on a buying 12 spree of capital-heavy businesses, highlighted by his “Pow- 13 erhouse Five”: MidAmerican Energy, Burlington Northern 14 Santa Fe, ISCAR, Lubrizol and Marmon Group. 15 Exhibiting a remarkable flexibility of mind, Buffett totally 16 shifted gears. After years of buying low-capital, high cash 17 flow businesses, Buffett has assembled a group of businesses 18 that can guzzle cash. 19 Berkshire subsidiaries spent a record $11 billion on plant 20 and equipment during 2013. 21 BNSF alone plans to invest $5 billion in 2014. 22 When current projects are completed, MidAmerican 23 Energy will have spent $15 billion on renewable energy. 24 From a standing start in 2004, MidAmerican now pro- 25 vides 7% of the nation’s wind generation capacity and, when 26 projects are completed, an even larger share of the nation’s 27 solar capacity. 28 In addition, Berkshire spent $3.5 billion buying the por- 29 tions of Marmon Group and ISCAR that it did not already own. 30 We speculate here, but note that Berkshire bought in the 31 shares of GEICO that it didn’t already own in 1995. Buffett 32 then put the pedal to the metal on the ad budget such that 33 GEICO outspent the rest of the auto insurance industry 34 combined! 35 We cannot help but wonder if the success of that capital 36 intensity applied at the right time with the right company 37 informed Buffett’s more recent purchases and capital invest- 38 ment policies. 39 Being able to think and invest very long term and not 40 worry about current earnings or Wall Street analysts can be a 41 major competitive advantage in certain businesses.

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1 Acquire other businesses 2 Here Buffett continues to be on a tear. 3 4 • The Basic Deal: Buffett has long loved to buy control of good 5 companies. In fact, Buffett said at the meeting that he 6 much prefers to buy operating businesses that can add to 7 Berkshire’s earnings power versus marketable securities. 8 Last year, Berkshire spent $18 billion to acquire NV En- 9 ergy and a major interest in Heinz (with 3G Capital Part- 10 ners). Just prior to the meeting, Berkshire announced 11 the $2.9 billion acquisition of Alta Link, which operates 12 power transmission services for about 85% of Alberta. 13 • The Fancy Deal: Buffett has long been famous for cutting 14 special deals that only he and Berkshire could dream up. 15 Debt with warrants attached. Insurance quota shares. 16 Double-digit convertible preferred issues. Berkshire cut 17 a couple of interesting, tax-advantaged deals last year: a 18 swap of Washington Post shares for a TV station in Miami 19 and Berkshire shares, and a swap of $1.4 billion of Phil- 20 lips 66 shares for full ownership of the energy firm’s 21 pipeline-services business. 22 23 • The Bolt-On Acquisition: Berkshire’s smaller subsidiaries 24 have the green-light to grow by intelligent acquisition. 25 Last year, $3.1 billion was invested in bolt-on acquisitions 26 at Berkshire subsidiaries. 27 • The Portfolio: Once the crown jewel of Berkshire, the 28 $211 billion portfolio of cash, bonds and equities is now 29 merely a part of this burgeoning empire. However, Buf- 30 fett added Ted Wechsler and Todd Combs to the team in 31 recent years, with each now running portfolios of over 32 $7 billion. Buffett clearly likes what these two are do- 33 ing and hints they have also contributed to some of the 34 other deals mentioned here. 35 36 37 Pay down debt 38 Years ago, Buffett taught that the time to borrow money is 39 when money is cheap. Debt is cheap now, so the question 40 really might be, “Why doesn’t Berkshire borrow more?” 41

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21 Buffett said he prefers to keep the balance sheet super 22 strong (with a minimum of $20 billion in cash). This unques- 23 tionable strength creates a durable competitive advantage 24 for the insurance subsidiaries.* 25 26 Pay dividends 27 28 Berkshire has famously not paid dividends. 29 However, Buffett did suggest during the meeting that 10 in the “not too remote future,” Berkshire’s cash generation 11 might be so substantial, that would be a question to revisit. 12 “May you live until Berkshire pays a dividend” may not 13 be so long. 14 15 Buy in shares 16 17 Berkshire has implemented this remarkable authorization to 18 buy in shares at 120% of book value. 19 While few shares have been repurchased to date, it cre- 20 ates a floor under the price. 21 Interesting note: Buffett mused during the meeting that 22 when Berkshire bought BNSF, it paid 70% of the cost in cash 23 and the remainder in stock. He would have been wise to 24 have bought those shares back in on the open market. 25 One other point here, a number of Berkshire’s investees 26 repurchase shares, increasing Berkshire’s percentage owner- 27 ship over time—yet one more form of “automatic” capital al- 28 location for Berkshire. 29 30 In Summary 31 32 There you have it. The Berkshire Hathaway Allocation Ma- 33 chine is no longer dependent on Buffett’s next idea. 34 The Powerhouse Five can reinvest cash to grow their own 35 operations for years to come. Smaller subsidiaries can do 36 bolt-on acquisitions. Wechsler and Combs are on the hunt 37 38

39 * We note that a sly old favorite of ours, Leucadia National, did just that, raising $3.3 billion 40 on a variety of bond issues last year. Borrow money when money is cheap, indeed. 41

272 2014 for bargains in both the stock market and in the world of 1 deal making. 2 And nearly all of this capital allocation capacity has been 3 created by Buffett in just the last 15 years. 4 A remarkable achievement. 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

273 1 2015 2 3 4 Venue: CenturyLink Center 5 6 Attendance: 40,000 7 Details About This Year: 8 9 • Berkshire celebrated 50 years under Buffett’s management. 10 • Buffett joked that they expanded transportation beyond 11 planes, trains and automobiles as Justin Boots brought two 12 big steers and Wells Fargo brought a stagecoach to parade 13 down to The CenturyLink Center at 6:30 a.m. 14 15 • The annual movie included Buffett as “The Berkshire Bomber” 16 going toe-to-toe with boxer Floyd Mayweather in a Rocky-style 17 bit. It included cameos from Steve Wynn and Charlie Rose. 18 Buffett talked trash to Mayweather. Munger said, “Mayweather’s 19 people asked me fi rst, but I was too busy.” At the start of the 20 fi ght, they ask Buffett if he’s going to fi ght with his glasses on, to 21 which he responds, “Damn right I will!” They both swing, and 22 just as they’re about to hit each other, the screen goes blank. 23 • Also in the movie was an interview with Buffett’s associates 24 from the early days, Gladys Kaiser and Bill Scott. Buffett 25 and Scott talked about the acquiring of Berkshire and the 26 partnership days. Kaiser remembered that 1991 was an awful 27 year, the year of the Salomon Brothers scandal, and that 28 Buffett was totally focused: “That was quite a responsibility. 29 You saved their behind.” 30 Fortune 500 Ranking: 4th 31 32 • Berkshire now trails only Wal-Mart, Exxon Mobil and Chevron. 33 Stock Price: $226,000 34 35 One dollar invested in 1964 would now be worth $18,270. 36 Berkshire’s per-share book value has grown from $19.46 to 37 $146,186 (a rate of 19.4% compounded annually). 38 The S&P 500 compounded at 9.9% annually for the same period. 39 40 41

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21 Highlights From 2015’s Notes 22 23 24 Berkshire Hathaway: Capital Allocation Machine 25 26 “The lack of skill that many CEOs have at capital allocation is 27 no small matter: After ten years on the job, a CEO whose company 28 annually retains earnings equal to 10% of net worth will have 29 been responsible for the deployment of more than 60% of all the 10 capital at work in the business.” 11 –1987 Berkshire letter 12 13 Intelligent capital allocation is the essence of sound wealth-building. 14 In last year’s review, we noted how dramatically Buffett has reshaped 15 Berkshire into a capital allocation machine over the last 15 years. As it is 16 now configured, the future compounding of Berkshire’s value depends 17 less on Warren Buffett than at any other time in Berkshire’s history. 18 When considering how poorly capital gets allocated in the main, 19 Berkshire stands out even more as one exceptional story. 20 What we didn’t realize until this year’s Berkshire Hathaway annual 21 report is how strongly capital allocation affected Berkshire from the 22 very beginnings. 23 Buffett celebrates Berkshire’s 50th year under his command with a 24 terrific annual report, including excerpts from old annual reports, buy- 25 out term sheets and other historical notes. 26 In fact, Buffett notes that it was a buyback announcement that 27 initially attracted him to Berkshire. It was not the business, but the re- 28 allocation of capital that drew Buffett to the stock.* 29 30 BNSF 31 32 Buffett put up a slide of Berkshire’s quarterly earnings. He noted there 33 was nothing particularly remarkable except that BNSF did much better 34 than last year in both earnings and other performance measures. 35 Buffett admitted that the railroad got behind last year early in the year, 36 so Berkshire spent a lot of money to get things the way they should be. 37 Those expanded efforts have paid off. Burlington Northern has 38 gained market share and improved earnings. 39

40 * See Appendix I for Buffett’s telling of the story and our analysis of his capital allocation 41 moves in those early days. It is really quite spectacular.

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1 Clayton Homes 2 A question came about a Seattle Times story alleging predatory lending 3 practices at Berkshire subsidiary Clayton Homes. 4 Buffett was prepared with his response, saying that there were some 5 important mistakes in the article and claimed that Clayton’s lending 6 practices are exemplary. 7 So began an interesting lecture on lending and manufactured housing. 8 Buffett asserted that mortgage problems in 2008 and 2009 hap- 9 pened in large part because the mortgage holder and the mortgage 10 originator became “totally divorced.” 11 Mortgage originators sold the loans to investment bankers who 12 sliced and diced the loans into derivative products where the eventual 13 buyers often didn’t really know what they owned. 14 The default rates in those years was far, far higher for $800,000 and up 15 homes than they were for loans at Clayton. In contrast, Clayton retains 16 nearly all of the mortgages that it originates. Clayton has retained over 17 $12 billion of mortgages on some 300,000 homes. 18 It is not in Clayton’s interests to sell a house where the buyer defaults 19 since that will be loss for the company as well as for the customer. 20 That is not true of most mortgage originators, though there has 21 been some talk to have originators retain 3% or so of the mortgages 22 they originate, so they have some skin in the game. 23 Buffett acknowledged that manufactured housing covers the lower 24 end of the market in terms of FICO scores (620 or below). He said 70% 25 percent of homes that sell for $150,000 or less are manufactured and 26 that the average payment is about $670 a month. 27 So the challenge is to lend to people in a way that they are likely to 28 make the payments and keep their homes. 29 For Clayton, about 3% of these mortgages default. 30 The primary reasons for mortgage default are loss of job, divorce 31 and death. 32 However, 97% don’t default. 33 Without the financing Clayton and others make available, they 34 wouldn’t be able to own such a home. 35 Buffett said the Clayton home on display in the Century Link audi- 36 torium goes for $69,500. Land usually costs about $25,000. So for a total 37 of $95,000, someone could get into a home with appliances, a couple of 38 bedrooms, and 1,200 square feet of space. 39 Buffett noted that there were mistakes in the Seattle Times story, which 40 alleged that Clayton’s average profit was $11,600 per home sold. Buffett 41

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21 said he knew that was nonsense. He read the affidavit about three times, 22 and nowhere in the affidavit was that statement made. 23 What was in the affidavit was a comment on gross profit, not net 24 profit. In the case of Clayton, the gross profit is around 20%, while the 25 net profit margin is about 3%. 26 An interesting aside, Buffett shared that they have had absolutely no 27 complaints about Clayton’s lending standards. However, Buffett admitted 28 that he gets letters of complaint about other subsidiaries on a regular basis. 29 Buffett added that Clayton is regulated by each state in which it has 10 financing, so it is regulated by nearly every state. 11 In the last three years, Clayton has had 91 compliance examinations 12 by the state. In those 91 examinations, the largest fine Clayton paid was 13 $5,500, and the largest refund was $110,000.* 14 Buffett concluded that he is proud: “Clayton put over 30,000 people, 15 at a very low cost, into very good homes last year. And a very high per- 16 centage of those people are going to have those loans paid off in 20 17 years and have a home that was a real bargain.” 18 Munger mused that while Clayton has around 50% of the manufac- 19 tured housing market, he’s surprised the market isn’t bigger since it’s 20 such an efficient way to build houses. 21 22 3G Capital Partners 23 24 Buffett also came prepared for questions about his partnership with 3G 25 Capital Partners. 26 The question was about 3G’s style of reducing the number of workers 27 at companies it takes over. 28 Buffett noted that the 3G people are successful business builders and 29 buyers. They seek to run their businesses efficiently, and that includes 30 reducing headcount when there are considerably more people in the 31 business than are needed. After reducing expenses, 3G businesses have 32 done well. 33 Buffett observed that Burger King is now outperforming its compet- 34 itors by a significant margin. Burger King’s most recent acquisition, Tim 35 Horton’s, is already showing marked improvement. 36 Munger pointed out that the alternative to having your company 37 right-sized is what eventually happened in Russia. He quoted the Russian 38 worker who said, “Everyone has a job, and it all works out. They pretend 39 to pay us, and we pretend to work.” 40 41 * Buffett did his homework.

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Buffett noted that the railroad business after World War II had 1.6 1 million people employed in the business, and it was a lousy, undercapi- 2 talized industry. Today, the rail industry has less than 200,000 employees, 3 and the industry is much larger, more efficient and far safer. No one is 4 claiming today that it would be better to run the railroads with 1.6 million 5 folks. “Efficiency is required over time in capitalism.” 6 Buffett concluded, “I tip my hat to what the 3G people have done.” 7 8 9 Van Tuyl 10 Asked about Berkshire’s recent acquisition of Van Tuyl, Buffett noted 11 that it is a very productive auto dealer. 12 Renamed Berkshire Hathaway Automotive, the unit is one of the 13 largest dealership groups in America, with over $9 billion in revenue 14 and 81 independently operated dealerships in 10 states. 15 Some dealers, such as Carmax, have gone to a more transparent 16 model with less negotiation. 17 Buffett noted that Van Tuyl will adapt to what the customer wants. 18 However, the negotiated model is still predominant. 19 Munger shared that negotiating for cars has been the primary 20 model for his entire lifetime, and he’s amazed that this hasn’t changed 21 more. 22 Buffett assured shareholders that Van Tuyl would be fine however 23 things unfold, though he wouldn’t be surprised if things don’t change 24 that much in 10 to 15 years. Overall, there are 17,000 dealers in the 25 country, and Berkshire plans on buying more of them through Van Tuyl 26 in the years to come. 27 Interestingly, Buffett does not see any scale advantages to owning 28 auto dealers. Most dealerships work on local considerations. 29 Buffett does not see Berkshire getting into the car finance business. 30 Wells Fargo is the largest auto finance company with a cost of funds 31 around 12 basis points, so it has an unbeatable advantage. 32 Munger concluded that Van Tuyl has “a system of meritocracy, 33 where the right people have a significant ownership.” It reminds him of 34 the Kiewit company in Omaha, another very successful culture. 35 36 37 Filters 38 Asked for five or six criteria for choosing an investment, Munger asserted 39 that Berkshire does not have a one-size-fits-all system. Each industry 40 is different. Also, they keep learning. 41

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21 Buffett observed that they do have filters. A key one is whether they 22 have a good idea of how the business is going to do over the next five 23 or 10 years. That filter eliminates many businesses from consideration. 24 Another filter is people. Buffett wants people to run the business the 25 same way after selling to Berkshire as they ran it before selling to Berk- 26 shire. That filter also eliminates a lot of deals. 27 Buffett concluded, “I can’t give you five criteria. Maybe Charlie has 28 kept them from me.” 29 10 IBM 11 Asked whether IBM wasn’t a cigar butt, similar to those textile mills of 12 the 1960s, Munger said “no.” 13 He noted that IBM has been rare in its ability to adapt to technological 14 change. Munger sees IBM as “a very admirable enterprise bought at a 15 reasonable price.” 16 Buffett chimed in that he finds it interesting when he gets asked 17 questions about investments Berkshire owns and that people think he 18 would want to talk them up. Either Berkshire or the investee companies 19 may be buying more shares in the future, so why would they want the 20 price to go up? 21 Buffett concluded, “Wall Street thinks it’s better if price goes up the 22 next day even if you’re planning on buying more shares in. Charlie, do 23 you have any idea why?” 24 Munger replied, “Warren, if people weren’t so often wrong, we wouldn’t 25 be so rich.” 26 27 Building the Insurance Businesses 28 29 In building Berkshire’s insurance empire, Buffett allowed that he had 30 many pieces of luck. Three in particular: visiting Lorimar Davidson of 31 GEICO, buying National Indemnity and hiring Ajit Jain. 32 Buffett claimed the education he received from just four hours with 33 Davidson was better than any university course he could have taken. 34 That’s when he realized insurance was something that he liked and 35 understood. That understanding prepared him to buy National Indem- 36 nity when it came up for sale and, of course, prepared Buffett to buy 37 a major position in GEICO and eventually the entire company in the 38 decades to follow. 39 Buffett has often said that Jack Ringwalt had five minutes every year 40 when he wanted to sell his company, National Indemnity. In 1967, Buffett 41

280 2015 got that call and jumped on it. National Indemnity became the base on 1 which Buffett would build Berkshire’s insurance empire. 2 In the mid-1980s, Ajit Jain walked in on a Saturday volunteering his 3 services even though he hadn’t worked in the insurance business. 4 Buffett marveled at his good fortune for this trifecta and shared that 5 the real key was being open to ideas as they came along. 6 Munger noted that the real key is that Berkshire bought wonderful 7 businesses. 8 9 10 Culture 11 Buffett asserted that Berkshire’s culture runs deep. 12 He shared that Berkshire had just closed on a transaction in Ger- 13 many, Detlev Louis Motoradvertriebs GmbH, a motorcycle apparel 14 and accessories retailer. Mrs. Louis and her husband lovingly built the 15 business over 35 years. Her husband died a couple of years ago, and she 16 came to Berkshire because she wanted to sell to Berkshire. 17 It is essential for Berkshire to have a culture that runs throughout 18 the entire company as well as the shareholders. 19 Buffett was pleased that 97% of shareholders voted against having a 20 dividend and in favor of having management invest the cash. 21 Buffett observed that the culture gets reinforced and becomes 22 self-selecting over time. Buffett believes that this culture has become 23 institutionalized and has no doubt that it will continue long after he 24 and Charlie are gone. 25 Munger did note that Berkshire’s rate of gain will slow: “There 26 are worse tragedies in life than having Berkshire’s compounding slow 27 down—that’s inevitable. “ 28 Buffett quipped,” Name one.” 29 Culture comes from the top according to Buffett. The leader must 30 be consistent, communicate well, and reward proper behavior and 31 punish misbehavior. Since it takes time, it’s actually easier to inherit the 32 culture you like. 33 Buffett concluded that one of his core values at Berkshire is to always 34 strive to treat people the way you would want to be treated. 35 Munger’s insightful conclusion, “I think one thing that we have 36 done that’s worked best is that we were always dissatisfied with what 37 we already knew, and we wanted to know more. We kept learning, and 38 that’s what made it work.” 39 40 41

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21 Brands 22 23 Asked about Berkshire being long on sugar consumption for the past 50 24 years and changing consumer tastes, Buffett countered that Coca-Cola 25 has a very wide moat. 26 With 1.9 billion 8-ounce daily servings of Coca-Cola products con- 27 sumed worldwide, the company is still a force. And it will need to adjust 28 to the changing preferences of consumers. 29 However, much like negotiated auto sales, Buffett said he just 10 doesn’t see anything revolutionary happening here. He predicted that 11 20 years from now more Coke will be consumed than today. 12 In a startling admission, Buffett declared that he estimated one- 13 quarter of all the calories he has consumed over the last three decades 14 came from Coca-Cola. 15 He joked, “If I would’ve been eating broccoli and Brussels sprouts 16 my whole life, I don’t think I would’ve lived this long.” 17 Buffett shared that while there are shifts in preferences over time, 18 it’s remarkable how durable some brands can be. Coke started in 1886. 19 Heinz ketchup came out in 1870. 20 Buffett reiterated that a strong brand is really powerful, though you 21 do have to build them and promote them. 22 He marveled that Gillette bought the rights to radio advertising for 23 the 1939 World Series for $100,000. “Think about how many people 24 heard those commercials.” 25 26 Macro Factors & Predictions 27 28 Buffett noted that he would have never predicted five years of zero inter- 29 est rates. “We’re operating in a world that Charlie and I don’t understand.” 30 Munger wryly noted, “If we failed to predict what happened before, 31 why would anybody ask us what our prediction was for the future?” 32 Fortunately for shareholders, macro predictions are not essential to 33 the Berkshire process. 34 Buffett took pains to emphasize that he and Charlie had never, 35 to the best of his memory, ever turned down an acquisition based on 36 macro factors. 37 As examples, Buffett noted that See’s Candy and BNSF were pur- 38 chased during difficult times in the economy. 39 He said the real key is to be able to figure out what the average prof- 40 itability of the business will be over the long term and how strong the 41 business moat may be.

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Buffett’s punch line, “We think that any company that has an econo- 1 mist has one employee too many.” 2 3 The Railroad 4 5 Regarding concerns about railcar safety, Buffett noted that BNSF, as 6 a common carrier, is required to carry certain dangerous substances, 7 such as ammonia and chlorine. 8 The government develops the rules for these issues, and rail is the 9 most logical way to transport many of these substances. 10 BNSF leads the industry in safety, and overall, Buffett believes that 11 rail has gotten significantly safer over the years. 12 13 Renewable Energy 14 15 Solar’s cost per megawatt hour has plummeted from $315 in 2009 16 down to $128 today. The energy cost of wind per megawatt hour is 17 $85.48, down from $96.09. Renewable energy costs are becoming more 18 competitive. 19 Greg Abel, CEO of Berkshire Energy Group, said that by the end of 20 2016, 58% of power in Iowa will be from wind. 21 22 All In 23 Winding up, Buffett noted that all of his and his families’ net worth is 24 in BRK. 25 Munger noted that Berkshire is only lightly levered and that “it’s 26 crazy to sweat at night.” 27 Buffett quickly clarified, “Over financial things.” 28 Buffett concluded that with $60 billion in cash, Berkshire would be 29 ready and willing to act if some economic turbulence creates an oppor- 30 tunity.* 31 32 33 Stock Market and Interest Rates 34 There was a very good question about valuations. 35 36 * True to his word, Buffett was ready to act with that $60 billion in cash. In August, Berkshire 37 agreed to its biggest acquisition ever, buying Precision Castparts (PCP), an aerospace parts company, for $32.4 billion in cash, or $235/share. Berkshire expects to fund the deal using 38 about $23 billion of its cash and another $10 billion of borrowed money. 39 Buffett wasn’t shy about saying how much he likes Precision Castparts CEO Mark Donegan: “The guy is fantastic. He’s as in love with his company as I am with Berkshire, and that’s 40 saying a lot.” 41

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21 One ratio that Buffett is known to track is the total market cap to 22 GDP. Recently, it was at 125%, which is a level approached in 1999 23 during the Internet bubble. 24 Another number that Buffett has mentioned is the ratio of corporate 25 profits to GDP. 26 From 1951 to 1999, that number ranged from 4.5% to 6%. More re- 27 cently, that number has been up over 10%. 28 Should investors be concerned about these numbers and the market? 29 Buffett replied that those percentages suggest that American busi- 10 ness is doing very well, though that might be a concern for society. The 11 valuation picture is very much affected by our zero-based interest rate 12 structure. Clearly, stocks are worth far more when government bonds 13 yield 1% than when they yield 5%. 14 Munger noted that people have limited alternatives with bonds pay- 15 ing so little. This has pushed stocks to higher prices than they would 16 reach otherwise. 17 Buffett added that the question is how long will these low rates 18 continue? In Japan, this has gone on for decades. Or will we get back to 19 normal? If rates go back to a more normal level, stock prices are high. If 20 rates stay low, then stocks look “very cheap.” 21 Buffett concluded, “Now I’ve given you the answers, and you can 22 take your pick.” 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

284 1 2016 2 3 4 5 Venue: CenturyLink Center 6 7 Attendance: 40,000 8 9 Details About This Year: 10 11 • Professors Buffett and Munger presided over the fi rst-ever 12 live-streaming of the Berkshire meeting via Yahoo Finance, 13 creating a global audience. 14 • The live streaming decreased attendance by about 10%. 15 16 Fortune 500 Ranking: 4th 17 18 • Berkshire now trails only Wal-Mart, Exxon Mobil, and Apple. 19 20 Stock Price: $197,800 21 One dollar invested in 1964 would now be worth $15,983. 22 23 Berkshire’s per-share book value has grown from $19.46 to 24 $155,501 (a rate of 19.2% compounded annually). 25 The S&P 500 compounded at 9.7% annually for the same period. 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

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21 Highlights From 2016’s Notes 22 23 24 Just Getting Started 25 26 Buffett, clearly in a good mood, opened with a few quips. 27 Buffett claimed, “Charlie gets the girls. Every mother tells her 28 daughter, ‘If choosing between two old men, pick the older one.’” 29 Noting he had a great grandchild in the audience, Buffett said, “If 10 you hear crying, it’s just his mother explaining my views on inherited 11 wealth.” 12 13 Slides 14 15 Slides matter. Buffett only shows slides when he has something he wants 16 to convey. 17 With the first slide, he gave a snapshot of Q1 results. With the sec- 18 ond slide, he showed the impressive growth in Berkshire’s after-tax op- 19 erating earnings since 1999. 20 Slide One: While first quarter net earnings were up from $5.2 bil- 21 lion to $5.6 billion, operating earnings dipped to $3.7 billion from $4.2 22 billion. 23 Buffett added some color: Insurance underwriting profits fell by 24 half due to hail storms and catastrophe losses. Railroad earnings were 25 down due to lower car loadings. Manufacturing earnings were up with 26 the addition of Precision Castparts and Duracell. Net earnings were 27 boosted some $900 million by investment and derivative gains. 28 Slide Two: This was the more significant slide. Buffett showed the 29 per-share after-tax annual operating earnings since 1999, the year of 30 the MidAmerican Energy acquisition. 31 Those earnings have risen steadily from $0.67 to $17.36 for 2015. 32 This shows how operating earnings have grown substantially. Further- 33 more, Berkshire has done it with no corporate budgets, no quarterly 34 earnings projections—focusing instead on adding sustainable and 35 growing earnings power. 36 The chart also shows the development of Berkshire’s realized invest- 37 ment gains and losses. They are, of course, erratic, bumping from $0.89 38 in 2000 to a loss of $4.65 in 2008, to a gain of $6.73 in 2015. 39 Overall, realized investment gains and income totaled $32.39 for 40 the period. 41

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Consider this: One year’s operating earnings ($17.36 for 2015) 1 equaled 50% of the entire 17 years’ worth of realized gains and income. 2 This slide reveals how significantly Berkshire has shifted from simply 3 being an investment company to being an operating earnings power- 4 house with a portfolio of investments. 5 6 7 Precision Castparts 8 The $32 billion purchase of aerospace parts maker Precision Castparts 9 (PCP) marks the largest deal in Berkshire’s history. 10 Buffett noted that the most important asset was CEO Mark Donegan. 11 Buffett called Donegan one of the most extraordinary managers that 12 he’s come across—one of a kind. 13 In addition, Buffett saw some advantages for PCP as part of Berk- 14 shire: Donegan could now spend 100% of his time on engines versus 15 quarterly earnings calls, bank line negotiations, and so on. Donegan 16 wouldn’t even have to come to Omaha to make a $1 billion acquisition. 17 Buffett concluded that Berkshire had taken Precision’s most valuable 18 asset, Donegan, and made it even more valuable. 19 Munger stressed that operating PCP requires superior management. 20 This is a departure from the early years at Berkshire when they 21 owned cheap stocks and easy-to-operate companies. Now, they’ve 22 learned to find great managers, which creates an opening to own more 23 complex businesses. 24 With aerospace components, quality and reliability are enormously 25 important. The contracts run many years, so customers don’t just take 26 the low bid. PCP has an unparalleled reputation for quality.* 27 28 29 30 * Corey and I had a 20-minute chat with Donegan at the PCP booth in The Berkshire Mall. 31 Donegan echoed Buffett’s comments, sharing that the first thing he does every morning 32 now is thank Berkshire for buying the company. He’s more than happy to never do another earnings call. He also walked us through how he does plant inspections, constantly asking, 33 “Why do we do this?”—always challenging his team to make processes more efficient. 34 What struck us most was Donegan’s intensity. Our sense is that Donegan runs a hard- charging meritocracy. Those who are self-motivated, hard-working, and achievement- 35 oriented love working for him. If you’re looking for a slower-paced job, don’t apply here. 36 We see two primary game-changers with PCP having access to Berkshire’s capital: 1) PCP can now do acquisitions more aggressively, and 2) PCP can invest more readily in the long- 37 term development of parts contracts—once a contract is won, it may pay out over seven 38 years or more. Both uses of capital can ding short-term earnings for a public company and deter a manager from making a great long-term investment. 39 Donegan is thrilled to no longer have that headache. 40 41

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21 Happiness 22 23 Buffett’s formula for happiness is simple: “Do what I like with people I 24 like.” He noted that he learned early in life that his favorite employer 25 was himself. It avoids aggravation. 26 Munger shared that he’s as fascinated at age 92 as he’s been in any 27 period of his life. 28 While he wishes he had wised up sooner, Munger also saw the bless- 29 ing in it: “At age 92, I still have lots of ignorance left to work on.” 10 11 Reinsurance 12 13 Buffett had something of a prediction: Reinsurance will not be as good 14 the next 10 years as the last 10 years, in part, due to ultra-low interest rates. 15 Europe has negative yields! The whole idea of float is to invest in pos- 16 itive returns. 17 However, Berkshire is better situated than most. Its capital cushion 18 and unrelated operating income give it more flexibility with investing 19 the float. Berkshire also has more flexibility in modifying business mod- 20 els. All other reinsurance companies are tied to a different business 21 model. 22 Munger allowed that lots of new capacity and heavy competition will 23 make for slower going. Additional competition has come from offshore 24 insurance companies. He groused that such companies are really invest- 25 ment operations seeking friendly tax jurisdictions. 26 In sum: Supply is up while demand is not. 27 28 GEICO 29 A question: Progressive Direct had a 95.1 combined ratio, while GEICO 30 came in at 98.0.* What gives? 31 Looking at the question from a bigger perspective, Buffett noted 32 that driving has become much safer over time. In the mid-1930s, there 33 were 32,000 fatalities per year, or 15 fatalities per 100 miles driven. To- 34 day, that ratio is down to 1 fatality per 100 miles. Last year had about 35 32,000 deaths—the same number as in the 1930s, but with 15x more 36 miles driven. 37 After years of declines, Buffett reported that last year both frequency 38 and severity increased suddenly and substantially. There was more driving 39

40 * The combined ratio is a measure of insurance profitability. Under 100 is profitable, so the 41 lower the better.

288 2016 and more distracted driving. GEICO needed to adjust its premiums ac- 1 cordingly and will do better in 2016. This accounts for the elevated 2 combined ratio. 3 Buffett continues to like GEICO’s model, noting that it has ex- 4 ceeded Progressive’s market share in every state. He mused that, if he 5 lives to 100, he might even see GEICO surpass State Farm. 6 Munger observed that it is not a tragedy for someone else to have 7 a good quarter. 8 GEICO’s market share has increased fivefold since Berkshire 9 bought it. 10 11 12 Amazon 13 14 Buffett admitted that Amazon is a huge development. What it has ac- 15 complished in a relatively short time is remarkable. Amazon’s created a 16 big advantage with its intense focus on developing millions of satisfied 17 customers. You’re not going to beat them. 18 GEICO was slow to change to the Internet because the phone 19 worked so well. However, Buffett has been amazed how fast inquiries 20 for GEICO migrated from the phone to online. Adaptation to the Inter- 21 net by the American public has been amazing. 22 If you have a good business, plenty of folks will try to take it from 23 you. Overall, Buffett sees Berkshire as well-situated with its diversified 24 collection of businesses. 25 Munger suggested that, on balance, Berkshire has been helped by 26 the Internet. 27 28 29 Coca-Cola 30 Challenged with being “long sugar,” Buffett responded that he con- 31 sumes 700 Coca-Cola calories per day of his daily target of roughly 2,800 32 calories. He elects to get 700 calories per day in a way that makes him 33 feel good when he consumes them. 34 Coca-Cola delivers over 1.9 billion 8-ounce servings per day. That’s 35 693 billion servings a year. That’s 100 8-ounce servings per capita for 7.4 36 billion people. 37 Buffett finds it spurious to lay obesity all on Coke. The key lies in 38 making the choice not to consume more calories than you can use. 39 Buffett likes fudge, peanut brittle. He said that he wished he had 40 a twin who only ate broccoli. He knew he’d be happier than that twin. 41

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21 Talking about health, Buffett spoke about life expectancy, noting 22 there are now 10,000 men and over 45,000 women over age 100. 23 Buffett joked that, if he really wants to live longer, he should get a 24 sex change—he’d be 4.5 times more likely to get to 100. 25 In an effort to improve public discourse, Munger weighed in with 26 Munger’s Law: You can’t list the detriments without listings the benefits. 27 Munger suggested it would be like cancelling air travel because 100 28 people died in a crash. Buffett likes peanut brittle and flavored drinks. 29 People should be free to choose to do what they like. 10 In classic understated Munger fashion, he asserted, “To say the detri- 11 ments without including the benefits is immature and stupid.” 12 Later, Munger went even further by suggesting that if you disagree 13 with someone, you should understand their side better than they do 14 before you open your mouth. 15 16 17 Renewables 18 19 Buffett explained that the federal government has encouraged the de- 20 velopment of renewable energy with a 2.3 cents/kilowatt hour pro- 21 ducer tax credit. 22 This subsidy has the benefit of reducing carbon emissions world- 23 wide. The cost of the tax credit is borne by the citizenry in the form of 24 lower tax revenues. To the degree renewables replace coal and natural 25 gas, the benefits accrue not only to the citizenry but also to the whole 26 world. 27 Since Berkshire has large taxable income and lots of capital, Berk- 28 shire will continue to have a large appetite for renewable energy devel- 29 opment. 30 Buffett noted that Berkshire Energy also features very low utility 31 rates. In Iowa, where competitor Alliant (which hasn’t pursued renew- 32 ables) will need a rate increase, Berkshire won’t need one until 2029. 33 He added that Iowa regulators have been marvelous to work with and 34 very encouraging of renewables. 35 Munger summed up that Berkshire is doing more than its share and 36 is charging lower rates. 37 He noted that the Nebraska Public Power District, a co-operative, 38 was very proud of its record. Today, power is cheaper across the river in 39 Council Bluffs, Iowa, which is becoming a tech haven. Google and the 40 like gobble up electricity with their massive server farms, so they are 41 locating there.

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1 Derivatives and Discontinuities 2 Buffett warned that derivatives still pose a danger. 3 The great danger is when there are discontinuities that cause the sys- 4 tem to stop such as World War I, September 11, 2001, and October 19, 5 1987 (Black Monday). 6 Buffett noted that a major cyber, nuclear, or biological attack is a 7 near certainty that will happen at some point. At times like that, there 8 can be enormous gaps in positions. 9 Buffett noted that Berkshire would only do derivatives on a collater- 10 alized basis. The Gen Re derivative book is still in run-off after a decade 11 of benign market conditions. 12 Buffett still sees derivatives as a potential time bomb in the system. 13 Munger summed: “We’d prefer that derivatives were illegal.” 14 15 Float 16 17 Buffett loves the idea of increasing float, which has grown to $88 billion. 18 With $50 billion in treasuries and another $8 billion coming from 19 the call of its Kraft Heinz preferred, Berkshire will be at around $60 bil- 20 lion in cash. 21 Low rates are a problem for everyone with fixed-dollar investments. 22 However, Buffett noted again, that Berkshire has so much capital and 23 so many sources of earnings power that it can use its float in ways other 24 insurers cannot consider. 25 Munger: “I’ve got nothing to add.” 26 Buffett: “He’s now at full strength.” 27 28 29 Railroads 30 With rail stocks down some 35% in the stock market, Buffett was asked 31 if the rails were in secular or cyclical decline. 32 Buffett admitted that a decline in the usage of coal was likely sec- 33 ular. However, the recent decline in coal orders was overstated due to 34 high inventories by utilities. The high inventories resulted in the utili- 35 ties temporarily under-ordering. 36 Overall, Buffett was unabashed, saying, “We love Burlington North- 37 ern Santa Fe.” 38 Buffett suggested not to mark the progress of the business by the ups 39 and downs of the stock market. He concluded, “It’s a very good busi- 40 ness, and we’ll hold it forever.” 41

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21 Later on, Buffett shared that railroad depreciation was understated 22 and that Berkshire would have to spend more to keep the railroads in 23 shape. In 2015, Berkshire invested $5.7 billion versus $3.4 billion of de- 24 preciation as part of its catch-up effort. 25 BNSF does more gross revenue ton-miles than any other railway in 26 North America. However, the composition of those revenues is shifting. 27 With coal, there will be no expansion. With the Bakken, it’s a sen- 28 sible investment but will be less busy going forward. With intermodal, 29 BNSF will be looking to grow. 10 11 Basic Advice 12 13 Buffett complimented Andy Hayward and his “Secret Millionaires Club” 14 series for helping thousands of kids learn how to handle money, make 15 friends, and become better citizens. 16 Buffett reminded folks that to buy a stock is to buy part ownership 17 of a business. Don’t get hung up on daily price quotes. Instead, think 18 about business performance and what you would pay for the business, 19 just as you would a farm. 20 Munger added, while it’s difficult, to look for people you can trust in 21 dealing with investments. 22 Buffett assured that American business will be fine over time. Don’t 23 be envious. Follow your own course. 24 25 Nevada Solar Policy 26 27 A controversial decision by the Nevada Public Utility Commission came 28 up for discussion. 29 The commission decided to stop a rebate experiment that allowed 30 roof-top solar homeowners to sell back to the grid at a subsidized rate. 31 In effect, 99% of the homeowners were subsidizing the 1% who had 32 roof-top solar by paying an inflated price for their power. 33 Buffett seemed to agree with the decision. 34 He pointed out that the key question is, “Who pays the subsidy?” In 35 this case, it wasn’t right for the 99% to buy at the inflated price to the 36 benefit of the 1%. However, if the entire society benefits, society should 37 pick up the tab. 38 Greg Abel weighed in, affirming that Berkshire is strongly in favor 39 of renewables, but at a market rate not a subsidized rate. Abel noted 40 that, by 2019, 76% of Berkshire’s coal-fired plants would be retired, re- 41 placed by solar.

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1 Education in America 2 Buffett noted that monopoly and bureaucracy were widespread in higher 3 education in America. If you want more financial efficiency in educa- 4 tion, you’re howling at the wind. 5 Munger concurred, noting that a rich society has an obligation to the 6 young as well as the old. Endowments have gone up, yet there are no tu- 7 ition reductions, no increase in students. The only thing up are the pro- 8 fessors’ salaries. For too many schools, the purpose of the endowment is 9 to make a bigger endowment. 10 Munger stopped himself: “I’ve made all the enemies I can afford.” 11 12 Buffett: “That never slowed him down in the past.” 13 14 Trump or Clinton? 15 Buffett claimed that Berkshire will do fine with either candidate. 16 Despite 50% taxes for many years, price controls, regulations, and 17 more, American business has done extraordinarily well over the last 200 18 years. America is a remarkably attractive place to do business. GDP per 19 capita is up six-fold in his lifetime. 20 While aggregate output is very good, the distribution of that output 21 can fall short. 22 Munger noted that GDP figures understate the real advantages the 23 system has given our citizens—advantages that don’t translate easily 24 into monetary figures. 25 Buffett challenged those who think this is a bad time to be born. 26 They are wrong. Consider the pace of innovation. With phones alone, 27 there are numerous choices that were not available just 20 years ago. 28 29 30 Bank Profitability 31 Buffett noted you can change the profitability of banking totally with 32 capital requirements. With a 100% capital requirement, you could not 33 make any money. With a 1% capital requirement, you add too much 34 risk to the system. 35 New, tougher capital requirements for banks are sure to make large 36 banks less profitable, though less risky. 37 Wells Fargo is Berkshire’s largest single marketable security. Buffett 38 likes it extremely well with its huge base of very cheap deposits. Unfor- 39 tunately, Wells has to lend it out at cheap rates currently, but Buffett ex- 40 pects the spreads will work in their advantage eventually. 41

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21 Activists 22 23 Buffett believes Berkshire’s willingness to repurchase shares will keep 24 its stock price at a reasonable approximation of fair value. Breaking up 25 Berkshire is an unlikely event. 26 Munger noted that worry about activists is good for Berkshire. If a 27 company is being attacked, Berkshire makes a great ally. 28 29 Sequoia Fund 10 11 After its embarrassing over-concentration in Valeant, the Sequoia Fund 12 came up for discussion. 13 Buffett reminisced that he was the father of the fund. 14 When he closed the Buffett Partnership in 1969, the partners wanted 15 to know what to do. Buffett suggested putting some money into munici- 16 pal bonds and then suggested just two managers: Sandy Gottesman and 17 Bill Ruane—two terrific people with talent and integrity. 18 Gottesman took on individual clients. Ruane started the Sequoia 19 Fund for clients with more modest means and did a fantastic job up to 20 his passing in 2005. 21 With Valeant, despite objections by the board, the managers took an 22 unusually large position.* The primary Sequoia manager involved is no 23 longer at the fund. The Valeant business model was enormously flawed 24 and had been touted to Berkshire. 25 Buffett shared that the Valeant debacle illustrates a principle of Pe- 26 ter Kiewit: “If you need a manager, look for someone with intelligence 27 and energy and integrity. If they don’t have the last one, then be sure 28 you don’t have the first two. If they have no integrity, I want them dumb 29 and lazy.” 30 Buffett noted that they have seen certain things over and over. 31 Valeant had elements of a chain letter scheme. Many Wall Street things 32 seem to have that element. 33 Buffett believed that the team at Sequoia going forward were able 34 people. Munger agreed. Sequoia, as it was reconstituted, is reputable. 35 The problem is fixed. As for Valeant, Munger called it a sewer and said 36 those who created it deserved what they got. 37 38 39 40 * At one point, Valeant comprised 30% of the fund. 41

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1 Bet Update 2 Buffett gave an update on his bet with Protégé Partners that the S&P 3 500 would outperform a selection of hedge funds over the decade be- 4 ginning with 2008. 5 As of year-end 2015, the score was S&P 500 up 65%, Protégé’s hedge 6 funds up 22%. 7 Buffett is driving home his point about the extreme compensation 8 of hedge fund managers: Getting 2 and 20 for just breathing!* Taken in 9 aggregate, the returns of all managers must be average. With the hedge 10 funds, you get average less the terrific expenses. 11 In addition, you have consultants charging fees. If the consultants 12 just say, “Buy an S&P 500 Index fund and sit for 50 years,” they wouldn’t 13 be able to charge much. The hyperactive traders and their “helpers” 14 are, in aggregate, a tax on the system. 15 In sum, you can skip the fees and get the performance of American 16 industry by owning an S&P 500 Index fund. 17 This is not new. Buffett mentioned Fred Schwed’s classic from 1940, 18 Where Are the Customers’ Yachts?† 19 Buffett asserted that far more money is made on Wall Street with 20 selling talent than with investing talent. 21 Munger shared, again, that finding people you trust is difficult—like 22 finding a needle in a haystack. 23 Buffett reiterated that he only had two recommendations in 1969: 24 Gottesman and Ruane. 25 That was it. 26 27 28 Culture 29 Buffett was pleased to assert that the Berkshire board, managers, and 30 shareholders clearly recognize and embrace the Berkshire culture. It 31 works, and there’s not a lot of competition. 32 Buffett noted that the main problem is Berkshire’s size. To a signifi- 33 cant degree, size is the enemy of performance. 34 Munger claimed he was more optimistic, predicting that Berkshire’s 35 culture will surprise everyone with how well it works. So much power in 36 37 38 * 2% of asset fee plus 20% of the profits. † Classic line from the book: “They told me to buy this stock for my old age. It worked won- 39 derfully. Within a week I was an old man.” 40 41

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21 place with so little turnover. Great tenure with people who are not in it 22 for the money. 23 Buffett noted that Berkshire selects board members with (1) busi- 24 ness savvy, (2) shareholder orientation, and (3) special interest in Berk- 25 shire. 26 He asserted that they have the best board they could have. All Berk- 27 shire board members have bought stock in the open market. There are 28 no stock options. He lamented that board members too often get op- 29 tions just for breathing. 10 Buffett suggested we take note of the Christmas picture in the an- 11 nual report. He hopes it’s exactly the same next year. It’s a remarkable 12 group. No committees. No makeshift work groups. A cooperative effort 13 by all. 14 15 Berkshire Buybacks 16 17 When asked about Berkshire’s 120% of book value buyback authori- 18 zation, Buffett allowed that the stock didn’t trade to buyback levels, so 19 none was purchased. 20 Although, he loves the idea as the surest way to make money is to 21 buy dollar bills for less than a dollar. 22 Over time, the buyback is a backstop for ensuring that a no-dividend 23 policy results in a greater return than paying out a dollar. It’s probable, 24 but not certain, to work out. 25 Buffett noted that Berkshire’s intrinsic value has widened from 26 book value. He mused that, if Berkshire gets to $100-120 billion in cash, 27 maybe they’ll need to move up the threshold. 28 Munger noted that buybacks are fashionable, sold by consultants, 29 and often destroy value. 30 Buffett chimed in that most buybacks are done at any price, which 31 makes no sense. Very rarely do you see metrics to govern the prices 32 paid. Buybacks above intrinsic value destroy value. 33 Buffett: “A full wallet is like a full bladder. One could get the urge 34 very quickly to pee it away.” 35 36 Nebraska Furniture Mart 37 38 Buffett shared that NFM’s new store in Dallas had so much initial vol- 39 ume that they couldn’t keep up. It took a while to get deliveries up to 40 standard. 41

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Dallas is already their largest store and will be a $1 billion store be- 1 fore long. 2 NFM is bringing prices and variety that Dallas hasn’t seen before. 3 4 5 Beware CNBC 6 Cyber, nuclear, biochemical, and chemical attacks, that is. 7 In a sobering digression, Buffett shared that CNBC is his handle for 8 the world’s greatest problems. Buffett warned that something of the sort 9 will happen. It’s just a matter of time because a percentage of the popu- 10 lation comprises psychotics, megalomaniacs, and religious fanatics. 11 And the problem is growing. There are more of them when the 12 world population is 7.4 billion versus 3 billion. 13 Also, we have innovated beyond bows and arrows, and spears, so 14 the potential damage has increased. In 1945, with the dropping of the 15 bomb in Japan, we unleashed a power like the world had never seen. 16 That bomb was a popgun compared to what we can do now. 17 Buffett recommended visiting the Union of Concerned Scientists 18 website for further study on the issues. 19 Buffett sees this as overwhelmingly a government problem and a pri- 20 ority for each president. 21 He suggested you could argue that, if Hitler hadn’t been so anti- 22 Semitic, pushing out all the scientists, he would have had the bomb. 23 It was Leo Szilard who got Einstein to co-sign a letter to FDR that con- 24 vinced the president to move ahead with the Manhattan Project. One 25 side or the other was going to get it. 26 Referencing 9/11 and the anthrax letter, Buffett noted that the ca- 27 pacity for damage is horrific. And we still don’t know just what to do 28 about it. It’s a tough problem. 29 Again, he warned, anything that has a 99.9% chance of not happen- 30 ing eventually will happen. 31 32 33 Get the Details 34 Asked how he does it, Buffett shared that he and Charlie read a lot. 35 What matters most to him are micro factors, as opposed to the 36 macro factors that so often get all the attention. He loves to know all 37 the details of a business. 38 Buffett reminisced that, in 1972, See’s Candy had 140 shops. You 39 could look at each shop, see how it did in year one, year two, year three. 40 41

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21 It was very interesting. You never know when some fact might pop up 22 as useful. 23 Buffett compared it to baseball, where every move was interesting, 24 and then, suddenly, you get a double steal. 25 26 Free Cash Flow Outlook 27 28 A question about free cash flow turned into a lovely ramble about the 29 value of good mentors. 10 Buffett started with walking through Berkshire’s deferred tax item 11 (about $21 billion on some $60 billion of unrealized appreciation), 12 float ($88 billion), and depreciation. 13 He allowed that Berkshire will outspend depreciation at both Bur- 14 lington Northern Santa Fe and Berkshire Hathaway Energy for years 15 and year to come. 16 Buffett noted that annual operating earnings (about $17 billion) 17 and additions to float would equal Berkshire’s net new cash available. 18 That torrent of cash flow to allocate allows for a lot of mistakes. 19 The goal, again, is to add each year to the normalized per-share 20 earnings power of the company. 21 Munger quipped that the key is not to be at the mercy of standard 22 stupidities. If so, you’ll do well. 23 He noted that Warren’s gift is that he thinks ahead of the crowd. He 24 thinks in such a clear way. 25 Buffett quoted Yogi Berra: “You can see a lot just by observing.” 26 Buffett said they see very smart people do very dumb things. Rich 27 people leveraging up and other self-destructive behaviors. 28 Munger chimed in, saying that what is required is the proper tem- 29 perament of opportunism combined with patience coupled with trying 30 to behave well. 31 He cited the preacher who, for his grandfather’s eulogy, said, “None 32 envied the man’s success so fairly won and so wisely used.” It’s not just 33 about being smart, but also about doing things in a good way. 34 Then came a reminiscence of mentors gone by. 35 Munger mentioned that Warren’s uncle Fred was one of the finest 36 men he ever met. 37 Buffett mentioned his four aunts who each reinforced good quali- 38 ties in him. 39 Munger joked that he wished Warren would have had more aunts so 40 that he’d have done even better. 41

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Munger remembered Warren’s grandfather Earnest working them 1 hard at the Buffett family grocery store and then giving them lectures 2 on self-reliance. 3 Buffett summed up that they were very lucky to have such people 4 around. 5 6 7 Acquisitions: Quality of the Business + Quality of 8 the People 9 Buffett said what matters most with an acquisition is whether you have a 10 fix on the basic economics of the business. 11 He argued that typical due diligence does not get at the real risks. 12 He could think of at least a half-dozen mistakes made, none of which 13 could have been prevented by a checklist. It’s all about the future eco- 14 nomics. 15 For example, if you give a manager $1 billion for a business he once 16 owned 100%, will he behave in the future as he has in the past? It’s a 17 hugely important question that’s not on a checklist. 18 Munger concurred, noting that the essence of it all is the quality of 19 the business and the human quality of the management. Neither can be 20 assured by “due diligence.” 21 Munger said he didn’t know anyone who’s done a better job with ac- 22 quisitions than Berkshire. 23 Buffett added that he likes to show trust and that trust usually comes 24 right back. That keeps things moving. 25 In addition, Buffett has found that really able people can handle so 26 much. There’s no limit to what talented people can do. 27 He noted that Berkshire’s managers have added billions of dollars 28 of value to Berkshire over the years. 29 Munger pointed out that the obverse is true: “Not only are the most 30 able easy to trust, the unable you cannot fix. You’re forced to use our 31 system if you have your wits about you.” 32 33 34 3G Capital Partners and Cost Cutting 35 3G Capital Partners has come under fire for its cost-cutting approach 36 with Kraft Heinz. 37 Buffett defended 3G, citing Tom Murphy, CEO of Cap Cities, who 38 said the best approach is to never hire a person you don’t need, so you 39 never have to lay anyone off. 40 41

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21 Buffett suggested that all kinds of companies have people not doing 22 much. He’d let go of the staff economist and the investor relations de- 23 partment, for example. 24 His impression is that 3G is extremely intelligent about staffing. In 25 packaged foods, volume trends are not good, so some cutting is needed. 26 Munger noted that reducing sales volume at times can be quite in- 27 telligent. Just as you may need to lose excess staff, there may be times to 28 lose some customers. 29 He concluded that a lean staff is always better. 10 Buffett noted that, when sloppy thinking appears in one area, sloppy 11 thinking appears elsewhere. He recommended reading Barbarians at the 12 Gate for a lesson on how a great business can get sloppy. 13 14 Van Tuyl 15 On Berkshire’s $4.1 billion acquisition of auto deal Van Tuyl, Buffett 16 noted that $1 billion of securities came with the deal, so take $1 billion 17 off the price! In addition, the economics are good, and the CEO, Jeff 18 Rachor, is first class. 19 20 NIRP (Negative Interest Rate Policy) 21 22 Buffett observed that, while going from 0% to -0.5% interest rates is no 23 different than going from 4.0% to 3.5%, it feels different. 24 What’s most dramatic is that we’ve had 0% interest rates for so long. 25 That leads folks to pay much more for businesses than when rates are, 26 say, 15%. 27 Aesop’s rule of a bird in the hand is worth two in the bush is being 28 re-written as a bird in the hand is worth 9/10 of a bird in the bush. 29 Munger noted that we’ve never had NIRP before. All the Keynesians 30 have been mired in stasis over Japan for 25 years. 31 Munger noted that his advantage is that he knows he doesn’t under- 32 stand it. 33 Munger: “If you’re not confused, you haven’t thought about it 34 correctly.” 35 Buffett: “I’ve thought about it correctly then.” 36 37 Compensation 38 39 Munger noted the importance of proper incentives. You get what you 40 reward for. Reward for silliness, and you will get silly outcomes. 41

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Buffett shared that GEICO uses just two variables that apply to its 1 20,000 employees’ laddered bonus program: (1) growth in policies in 2 force and (2) profitability of seasoned business. 3 Buffett noted this approach allows for the expensive nature of first- 4 year policies. It’s simple, everyone understands it, and it aligns the goals 5 of the owners with the goals of the staff. 6 Munger took his annual shot at compensation consultants. 7 Munger asserted that it is important not to just reward profits. Banks 8 and insurance companies can show huge profits on paper before di- 9 saster appears. This was a major cause of the subprime mortgage deba- 10 cle. Accountants allowed lenders to merely use past loan experience to 11 lend. It was insane—and no one is ashamed. The very greedy CEO en- 12 lists others in the industry to make a pyramid, so it doesn’t look like he’s 13 in it for himself. Stock options get re-priced at low prices. 14 Munger stopped himself, summing up that intelligent compensa- 15 tion is not as complicated as the world makes it. 16 17 18 Restructuring 19 A question about restructuring hit a nerve. 20 Munger retorted, “Would you kill your mother to get the insurance 21 money?” 22 He noted that Berkshire had never had a restructuring charge and 23 was never going to start. 24 Buffett said that the key is that their accounting numbers are conser- 25 vatively stated. The one understatement on the Berkshire balance sheet 26 was the low depreciation at BNSF, which has been openly discussed. 27 28 29 Final Quote 30 Munger: “I think if you see the world accurately, it’s bound to be humor- 31 ous because it’s so ridiculous.” 32 33 34 35 36 37 38 39 40 41

301 1 2017 2 3 4 5 Venue: CenturyLink Center 6 7 Attendance: 40,000 8 9 Details About This Year: 10 11 • Despite the meeting being live-streamed, which reduces 12 the need to travel to Omaha, for the second year in a row, 13 physical attendance was as big as ever. 14 • One reason for the large turn-out may be that, last year, 15 Warren added an extra shopping day by having The 16 Berkshire Mall open on Friday. This year, shareholders/ 17 shoppers were ready. The place was packed. Past record sales 18 fi gures for the annual event were probably handily exceeded 19 by this year’s eager treasure hunters. 20 21 • The festivities began with a one-hour movie. One vignette 22 was a Munger clip from the Daily Journal meeting where he 23 talks about being a nerd and dating. He gets a date with a 24 blond goddess, inadvertently sets her on fi re, and douses 25 her with Coke. He encourages fellow nerds to persevere. 26 His version of an inspirational speech, we suppose. 27 28 Fortune 500 Ranking: 2nd 29 • Berkshire now trails only Wal-Mart. 30 31 Stock Price: $244,121 32 33 One dollar invested in 1964 would now be worth $19,726. 34 Berkshire’s per-share book value has grown from $19.46 to 35 $172,108 (a rate of 19% compounded annually). 36 37 The S&P 500 compounded at 9.7% annually for the same period. 38 39 40 41

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21 Highlights From 2017’s Notes 22 23 24 First Quarter Earnings 25 26 Buffett opened the meeting with a review of the first quarter earnings. 27 While the review was relatively short, in a sense, it was a lecture unto 28 itself. It illustrated so many elements of the Berkshire model. 29 For the quarter, per-share earnings were $4,060 versus $5,589 a 10 year ago. 11 However, it is not what the numbers are but what they mean that matters. 12 The key question is always, “Did intrinsic value grow?” Buffett clearly 13 believed the answer was “yes,” making it a good quarter from his per- 14 spective. 15 First, he proudly noted that GEICO had added over 748,000 new 16 policyholders since the beginning of the year.* 17 Competitors increased their rates. Loss costs have increased sharply 18 in the industry,† and some competitors decided to slow down taking 19 on new business. Acting more like a cheetah than a lizard, GEICO’s re- 20 sponse was to accelerate its new-business efforts. 21 Buffett regards each policyholder as a lifetime stream of premiums. 22 Each policy is worth something like $2,000 to Berkshire. Thus, GEICO 23 added some $1.5 billion of intrinsic value to Berkshire in just the last 24 four months.‡ 25 Second, Buffett noted that Berkshire’s float had hit a new high of 26 $105 billion, thanks primarily to a deal with AIG where Berkshire re- 27 ceived a $10.5 billion premium for taking on 80% of substantially all of 28 AIG’s U.S. commercial long-tail exposures for accident years 2015 and 29 prior. 30 It’s good for AIG, allowing them to unload a troublesome book of 31 business that was depressing earnings.§ It’s also good for Berkshire, who 32 gets lots of money up front (float) to work with in exchange for paying 33 out claims over many years. 34 By highlighting these two events, Buffett was teaching the share- 35 holders several essential lessons: 36 For one, focus on intrinsic value growth, not reported earnings. 37 Again, it’s not what the numbers are but what they mean that matters. 38 39 * For comparison, GEICO added 707,000 policies in 2015 and 974,000 in 2016. † Largely due to “distracted driving.” Texting is dangerous. 40 ‡ 748,000 x $2,000 per policy. 41 § AIG is currently in the sights of activist Carl Icahn.

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Each business will have a couple of unique factors that are essential 1 in evaluating its progress. Often, those unique factors are not immediately re- 2 flected in the reported earnings. In our short-attention-span world, analysts 3 and the media so often focus on reported earnings and look no deeper. 4 With GEICO, one of those essential factors is the policyholder 5 count. Buffett is telling us that. Another is the combined ratio, which 6 reflects the profitability (or lack thereof) of those policies over time. 7 There’s also the generation of float. 8 With GEICO, these are the things that matter—and they are all 9 growing in a good way. In particular, growth in policyholders has accel- 10 erated. 11 For the Berkshire insurance operation, the growth of no- or low-cost 12 float is primary. Adding $10.5 billion of float (an 11% increase in one 13 fell swoop) is a major addition to intrinsic value. If the float comes with 14 little or no cost, it acts much like equity. 15 No wonder Buffett is delighted with the AIG deal. 16 Another lesson is how Berkshire’s laser focus on long-term intrinsic 17 value growth and comfort with lumpy earnings puts it at a major advan- 18 tage compared to its publicly traded peers. 19 In the case of GEICO, competitors are ceding market share to shel- 20 ter profit margins. 21 Under pressure from analysts, shareholders, and other constituen- 22 cies, public companies are often driven to forgo the long-term, rational 23 decision in favor of short-term gratification. 24 In the case of AIG, with Carl Icahn breathing down its neck, the 25 company is ceding 80% of its pre-2016 U.S. commercial book to im- 26 prove the optics of its quarterly earnings. 27 This dynamic has created tons of value for Berkshire over the years. 28 Third, it highlights the value of momentum and share of mind for 29 GEICO. 30 GEICO has long been the low-cost operator in auto insurance. In ad- 31 dition, GEICO management has invested heavily to make the company 32 ever more efficient. 33 To top it off, after years of massive marketing, GEICO has also cre- 34 ated a large share of mind. Who doesn’t know where they might save 15% on 35 their auto insurance? 36 When companies raise prices, consumers shop. GEICO immediately 37 and successfully responded to this ripple in the market by putting the 38 pedal to the metal on its new-business efforts. 39 Fourth, it highlights the value of Berkshire’s Fort Knox balance 40 sheet and reputation for fiscal soundness. 41

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21 When an insurance company cedes a book of business to a reinsurer, 22 it is still on the hook if the reinsurer fails to pay. 23 AIG had 10.5 billion reasons to only do that deal with Berkshire. No 24 other company could have done that AIG deal. 25 So again, quarterly earnings were down. Digging deeper, Buffett 26 let us know that it was a good quarter for growing intrinsic value. And 27 that’s what counts at Berkshire Hathaway. 28 29 Driverless Cars 10 11 Buffett noted that driverless cars were a threat to both GEICO and the 12 railroads. 13 Safer roads would bring down economic loss costs, which would 14 mean fewer premium dollars for GEICO. Safer trucks would provide 15 stiffer competition for the railroads. 16 However, Buffett added that he thinks it’s all a long way off. 17 Munger: “I think that’s perfectly clear.” 18 Buffett: “Finally, approval after all these years.” 19 20 21 Technology 22 A question about technology turned into a fascinating revelation on 23 Buffett’s investments and non-investments in this arena. 24 For one, Berkshire sold some IBM. Buffett admitted that he has been 25 wrong on IBM. He thought it would do better over the last six years. 26 For another, Berkshire has recently accumulated an $18 billion 27 stake in Apple. Buffett explained that, while Apple obviously has prod- 28 ucts with lots of technology built into them, the big question is, ”What 29 will its customers do over the years ahead?” 30 Munger noted that Buffett’s purchase of Apple suggests that either 31 he is crazy or he is learning, most likely the latter. 32 33 The Technology Age 34 35 Buffett rocked the meeting by declaring that people don’t appreciate 36 how much the world has changed. 37 He noted that the five largest companies in the U.S. by market cap 38 (excluding Berkshire)—some $2.5 trillion of market value—now repre- 39 sent 10% of the whole market. 40 These five companies (Alphabet, Amazon, Apple, Facebook, Micro- 41 soft) require no equity capital to run them. None.

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It’s a very different world. It used to be that growing and earning 1 larger and larger amounts of money required large reinvestments of 2 capital. Not so with these top five, which generate almost infinite returns 3 on capital. 4 Buffett mused that Andrew Mellon would be baffled. In his world, 5 growth could only come with more capital. More trucks. More factories. 6 More plant and equipment. Our capital system was built on real tangi- 7 ble assets with innovation. 8 Munger cautioned that venture capital has been chasing this trend 9 hard and has lost lots of money doing it. Only a few will win big.* 10 11 Google 12 13 Munger asserted that they have no advantages in technology. That they 14 weren’t smart enough to figure out Google when it was right in their laps. 15 Buffett agreed that they were very close-up on Google. They knew 16 GEICO was paying $10 a click, and they were happy to do it. Further- 17 more, Google had no incremental cost. The owners even came to see 18 Buffett before the IPO. 19 Buffett confessed: “I blew it.” 20 Munger added that they saw Wal-Mart as a total cinch and blew that 21 one too.† 22 23 Amazon 24 While Berkshire also does not own Amazon, Buffett saw this as less of 25 a miss. 26 He noted that it is difficult to predict winners in new areas. Even more 27 amazing is when a person builds two major businesses from a standing 28 start, as Jeff Bezos of Amazon has done with retail and the cloud. 29 Buffett noted that Bezos laid out his vision in the 1997 annual re- 30 port.‡ Even knowing what his plans were, the successful execution of 31 them would have been a long shot. 32 Munger observed that what Amazon has done was very difficult and 33 not at all obvious. Missing Google was worse. 34 Munger concluded that Jeff Bezos is a different species. 35 36 * What we hear Buffett saying, in a sense, is that as huge as the “FANG” type stocks have 37 been, they are still underappreciated. From this, we infer that these stocks may still not be fully valued as people do not understand just how radically different their capital models are 38 from past models. 39 † Munger is a long-time board member of Costco, so he knows big-box retailing. Why has Berkshire never taken a meaningful stake in Costco? 40 ‡ He also recommended checking out the Charlie Rose interview of Bezos. 41

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21 Indexing 22 23 Buffett had John Bogle, who was turning 88 years old, stand up for rec- 24 ognition. 25 Buffett joked that, in two years, Bogle would be eligible for an exec- 26 utive position at Berkshire. 27 He praised Bogle for his lifelong championing of the idea of index 28 funds. 29 Later in the meeting, Buffett discussed his big bet with a fund of 10 funds back in 2007. 11 He reviewed his reasoning that a fund of hedge funds, which charge 12 2 and 20,* in aggregate, simply could not beat the index. By definition, 13 a large group of aggregated returns will be average. Subtract large fees 14 and the result must be worse than average. 15 Buffett asserted that it’s the sales culture of Wall Street that’s perpet- 16 uated the scheme. 17 Munger joked that a hedge fund manager was asked, “Why do you 18 charge 2 and 20?” The manager replied, “Because I couldn’t get 3 19 and 30.” 20 21 The Wells Fargo Error 22 23 In a response to misdeeds at Wells Fargo, Buffett noted that Berkshire 24 benefits from decentralization. However, with hundreds of thousands 25 of employees, there is no question that, somewhere, a few are behaving 26 inappropriately. 27 Berkshire leans heavily on principles of behavior rather than loads 28 of rules. He claimed that a culture that self-selects is better than a 1,000- 29 page manual. 30 Buffett sends a letter every other year to all the managers with the 31 “Salomon pledge”: “Lose money for the firm and I will be understanding. Lose 32 one shred of reputation for the firm and I will be ruthless.” 33 With Wells Fargo, Buffett observed that there were three errors, but 34 one of them, in particular, dwarfed the others. 35 One error was to inadvertently incentivize bad behavior. In addition, 36 as with any strong sales culture, there is a risk of pushing too hard. But 37 the giant error here was that, when the program runs off the rails, the 38 CEO must act. 39 40 * 2% of the assets plus 20% of the profits. 41

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Buffett recalled the Salomon scandal. Paul Moser of Salomon was 1 flim-flamming the Treasury auctions with phony bids. The then-CEO, 2 John Gutfreund, got the news and said he’d take care of it. He didn’t. 3 In fact, Gutfreund compared the infraction to a “traffic ticket.” Then 4 Moser did it again. The pyro-maniac had lit another fire. That’s when 5 things imploded for Salomon. This “traffic ticket” nearly brought down 6 the enterprise. 7 There are times when the CEO must act. 8 With Wells Fargo, the top brass underestimated the impact of fraud- 9 ulent account openings. The fines totaled $185 million, not an amount 10 that seemed all that offensive. It was a huge miss. The CEO did not act. 11 Buffett revised Ben Franklin: “An ounce of prevention is worth a ton of cure.” 12 13 Ideal Buy 14 15 Buffett said he knows a great deal when he sees it. 16 Although every situation is unique, in general, he loves a competi- 17 tive advantage that can last for decades, talented and eager managers 18 who fit the Berkshire culture, and of course, a good price. 19 Buffett reviewed how buying See’s Candy in 1972 was a watershed 20 moment. 21 They paid $25 million net for an entity earning $4 million pre-tax 22 that has since generated $2 billion of pre-tax earnings. 23 See’s Candy was special then, and it’s special now. However, for a 24 slightly higher price, they would not have bought it. 25 Munger: “We were young and ignorant.” 26 Buffett: “Now we’re old and ignorant.” 27 28 29 Continuous Learning—Early Stupidity Helped Us 30 One of Buffett’s annual themes is the value of learning. He noted that 31 life properly lived is learning, learning, learning all the time. 32 He observed that being wrong is when he learns the most. 33 Munger chimed in that there’s nothing like personal painful expe- 34 riences to help you learn. 35 He added that they had a lot of early experiences fixing horrible 36 businesses and that it helps to have your nose rubbed in it. 37 Buffett agreed that their early stupidity really helped them. 38 Munger put it more graphically, “Painful experience is a lot like eating 39 cockleburs. It really gets your attention.” 40 41

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21 Buffett added that if you want to be a good evaluator of a business, 22 run a lousy business for a while. You can see how awful it can be and that 23 having a high IQ doesn’t help.* 24 25 Durable Competitive Advantage 26 27 Asked about some of his more challenged investees (such as American 28 Express, Coca-Cola, Wells Fargo, and the airlines), Buffett reminded 29 us that these companies were not purchased because they would never 10 have problems or competition, but because they had durable competitive 11 advantages. 12 In the case of American Express, he noted that the Platinum Card is 13 doing very well. 14 Berkshire is now the largest holder of four of the largest airlines— 15 while the industry has its problems, it also has some strengths. 16 There is also a judgment on the ability of management to ward off 17 competitors. 18 Buffett noted National Indemnity, purchased in 1968 for $8 million, 19 has become a huge asset for Berkshire after years of warding off ma- 20 rauders. 21 He summed up that what you want is an economic castle with a very 22 wide moat and an honest, talented knight to handle marauders. 23 Munger: “I have nothing to add.” 24 Buffett: “We’ll cut his salary if he doesn’t participate.” 25 26 Airlines 27 28 Remarkably, Buffett very clearly laid out his rationale for Berkshire’s 29 airline investments. Seldom does he lay out his cards so directly. 30 Operating at 80% of capacity in seats/miles, Buffett sees it as very 31 likely that revenues per passenger mile will rise for the next 5–10 years. 32 Surprisingly, the airlines are earning higher returns on capital than 33 UPS or FedEx. 34 35 36 * We can’t help but feel a little vindication. In 1986, one of my questions was whether owning the Berkshire textile mills, while an 37 economic mess, did add value to Berkshire by lessons learned and showing Buffett’s pa- 38 tience and loyalty with owned businesses. Buffett made a joke about my question, I blushed, and I don’t remember what he said after that. 39 In any case, at this year’s meeting, they clearly made the case that those early mistakes 40 were formative in building the Berkshire compounding machine. 41

310 2017

In addition, the airlines are buying in lots of stocks at very low multi- 1 ples. Even if business proves to be flat, the stocks will be worth more on 2 a per-share basis in years to come. 3 Buffett cautioned that it’s no cinch. Will pricing be rational or sui- 4 cidal? What will happen with oil prices? While labor relations seem 5 more stable, there is a shortage of pilots. 6 Munger noted that the railroads were terrible for decades and de- 7 cades. Then things changed, and they got good. 8 Buffett summed up that the keys will be operating margins, fewer 9 shares, and the intensity of pricing competition.* 10 11 12 Intrinsic Business Value 13 Buffett noted that intrinsic business value can only be calculated in ret- 14 rospect: cash generated between now and judgment day discounted 15 back to the present at an appropriate interest rate. 16 While book value is a starting point, even 120% of book† under- 17 states Berkshire’s intrinsic business value. 18 Going back to 2007, Buffett estimated that Berkshire has com- 19 pounded at about 10% a year. Going forward, Buffett mused that it will 20 be tough to achieve that rate of growth with interest rates so low. 21 The one statistic Buffett would want to know for the future would 22 be, “What will the interest rates be over the next 20 years?” 23 Buffett’s guess is that rates will be somewhat higher in the next 20 24 years. If so, maybe 10% a year for Berkshire will be achievable. If rates 25 stay low, Berkshire will likely do less than that. 26 However, Buffett affirmed that Berkshire is built to last. 27 He asserted that the chances of Berkshire having a terrible return 28 are as low as you can find. And the chances of Berkshire having a sensa- 29 tional return are also as low as you can find. 30 Munger noted that size is the anchor of performance, and they are 31 proving it.‡ 32 Munger also asserted that Berkshire’s collection of businesses is su- 33 perior to those of the S&P 500, on average. 34 Buffett agreed, noting that Berkshire’s culture is significantly more 35 shareholder-oriented than that of the companies in the S&P 500. 36 37 * Again, Buffett teaches us that every industry has a few essential variables. These are the 38 ones for his airline bet. † Berkshire’s stock buyback hurdle. 39 ‡ Although, size also has its advantages: Only Berkshire was big enough to do the AIG deal. 40 41

311 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Berkshire’s owner-oriented culture and mindset are distinctly different 22 from most public companies, which are subject to all sorts of pressures. 23 Buffett went even further: “There’s nothing I can think of that 24 would break Berkshire.” 25 Berkshire has such a wide variety of earnings streams. In every way, 26 Berkshire is structured to handle stresses.* 27 Munger insightfully concluded: “A lot of people are trying to be bril- 28 liant. We’re just trying to stay rational. That’s a big advantage. Trying to 29 be brilliant is dangerous.” 10 11 Tax Cuts 12 13 Regarding the proposed tax cuts, Buffett observed that effects can vary 14 widely. 15 For Berkshire’s regulated businesses, returns are regulated, so all 16 benefits would flow through to the customers. For other businesses, the 17 gains may be competed away. For monopolies, all the benefits would 18 flow to the corporate bottom line. 19 History shows that overall benefits would be split between businesses 20 and consumers. 21 22 Risk Averse 23 24 Munger noted that, if things went to hell in a handbasket, Berkshire 25 would do much better. While he doesn’t wish adversity on anyone, Berk- 26 shire benefits from times of chaos. 27 Buffett noted that, when the world is fearful, people have a hard 28 time believing things will get better. Berkshire has no such trouble. 29 Buffett’s trust that things will recover, time and again, has allowed 30 him to put lots of money to work in troubled times. And when fear hits, 31 things can happen faster than you can believe. 32 As an example, Buffett noted that, in 2008, with $2.5 trillion in 33 money market funds, $750 billion flowed out in a week. 34 As a cute aside, Buffett recalled that his Aunt Katie, who lived to age 35 97, lived simply and owned $200 million worth of Berkshire stock. Yet 36 she would write to Warren every 3–4 months: “Sorry to bother you, but 37 am I going to run out of money?” He would write back: “Dear Katie, It’s 38 * Buffett often brings up this diversification of earnings streams. It’s what allowed the Berk- 39 shire Insurance Group to show a profit after Hurricane Andrew. He’s also been building this 40 diversification into the utility subsidiaries and operating businesses. 41

312 2017 a good question. Because if you live 986 years, you’re going to run out 1 of money.” 2 He concluded: “There’s no way in the world, if you’ve got plenty of 3 money, that it should become a minus in your life.” 4 5 6 Capital Allocation 7 For his successor, Buffett emphasized that proven capital allocation 8 abilities would be the key. 9 Buffett estimated that Berkshire will need to allocate some $400 10 billion over the next decade. That far exceeds all the money put into 11 Berkshire to date. Clearly capital allocation will need to be the foremost 12 talent. 13 Buffett noted that such a person would need a “money mind.” Even 14 someone with an IQ of 140 can have a very different mind where they 15 do poorly at investing. It takes a money mind to think well about money 16 and investing. 17 18 19 Precision Castparts 20 Buffett has been pleased with this acquisition, noting that the company 21 has a strong position in the aerospace industry and extraordinary man- 22 agement. 23 Buffett noted that Precision Castparts (PCP) earnings are under- 24 stated to the extent that there is $400 million of annual amortization 25 from the purchase. 26 Buffett loves the long-term prospects for aircraft parts and that they 27 are unlikely to be digitally replaced. He noted, “There will be no 3-D 28 printing of aerospace parts.” 29 Overall, Buffett believes PCP has a great future.* 30 31 32 * We anticipated that part of the appeal of PCP was its ability to make acquisitions, and PCP has done two deals already. 33 PCP CEO Mark Donegan told Corey that he loves working for Warren. Presumably, 34 when Donegan sees a deal worth doing, all he has to do is pick up the phone and call Omaha. 35 In addition, Berkshire gives Donegan the freedom to invest in developing long-term 36 aerospace contracts. While such aerospace parts cycles are expensive upfront, they can cre- ate very long-term, lucrative earnings streams. 37 Back when PCP was a public company, the lumpy earnings process caused Donegan 38 plenty of headaches working with shareholders, bankers, and analysts. Now, working at Berkshire, he is free to build long-term intrinsic value without undue concern for short- 39 term turbulence in profit cycles. 40 41

313 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Productivity 22 23 Buffett fielded several questions about 3G Partners and its aggressive 24 cost-cutting ways. The discussion quickly expanded to an overview of 25 productivity. 26 As he did in the 2016 Berkshire annual report, Buffett reflected on 27 the history of productivity improvement. 28 He noted that, without it, we’d still be living as we did in 1776. Eighty 29 percent of the American working population was on farms 200 years ago. 10 Farming, steel, retail—all these areas have always been getting more 11 productive. America is a story of constantly finding better ways to do things. 12 With Kraft Heinz, 3G found it could run things with fewer people. 13 Buffett asserted that 3G was fair in severance. 14 Munger chimed in that he would not care to be a subsistence farmer, 15 nor does he miss the elevator operator. While it’s unpleasant for those 16 involved, productivity and change are part of life. 17 He noted that textiles, Berkshire’s original business, were headed 18 for oblivion. While it wasn’t fun, it was pro-social for textile production 19 to move where it could be more efficiently done. Berkshire’s mills were 20 closed, and 2,000 people were let go. 21 Munger agreed that there is nothing wrong with improving pro- 22 ductivity. However, he did allow that, just because you’re right, doesn’t 23 mean you should always do it. 24 With artificial intelligence, Buffett observed that more change will 25 be coming. Almost certainly it will cause less employment in certain ar- 26 eas while being good for society overall. 27 Buffett offered a thought problem: Let’s say one person could push 28 a button and the entire U.S. GDP would be produced 150 million work- 29 ers would be without jobs. It would be an enormously disruptive trans- 30 formation and pro-social eventually. 31 Munger discerned that it is a matter of how fast people adapt. 32 When air conditioning came along, acceptance was immediate. No one 33 wanted to go back to being stinky and sweaty in the South. 34 He wrapped up the topic by opining that change will continue, but 35 it won’t happen that quickly—so people don’t need to worry so much. 36 37 Berkshire Hathaway Energy: Wind and Solar 38 39 Buffett is proud of Berkshire’s large investments in wind and solar and 40 has a large appetite for more. He said that, if there were a $5 billion solar 41 project, they would look at it.

314 2017

Iowa has proved to be a bonanza for wind projects. In 2016, wind 1 generated 55% of all megawatt-hours sold to Iowa retail customers. New 2 projects are underway that will take that figure to 89% by 2020. 3 Buffett concluded that Iowa is terrific for wind and California is ter- 4 rific for solar. 5 One of the keys is that Berkshire pays lots of taxes, so the tax subsi- 6 dies for wind and solar have real value to Berkshire. 7 In contrast, most public utilities (1) don’t have much cash after divi- 8 dends to invest and (2) don’t pay much real tax, so the tax subsidies are 9 of little or no value. 10 Buffett said that Greg Abel has done a sensational job. 11 Berkshire Hathaway Energy’s prices are 21%–33% lower across the 12 states they serve. 13 While utilities in the Midwest region produce power on average for 14 9.7 cents per kilowatt, MidAmerican Energy is getting it done for just 15 7.1 cents. 16 Buffett predicted that in the next 10 years, Berkshire will have sig- 17 nificantly more money invested in utility systems and that Berkshire is 18 the buyer of choice with utility commissions. 19 20 21 Opportunities 22 Munger suggested that you must fish where the fish are. China has lots 23 of fish. In the U.S. market, there are too damn many boats. 24 25 26 Healthcare 27 Corporate tax rates are down over the past 50 years. Meanwhile, health- 28 care costs have soared. Buffett reported that, in 1960, corporate taxes 29 were 4% of GDP and healthcare costs were 5% of GDP. Today, corpo- 30 rate taxes are 2% and healthcare is 17% of GDP. 31 Buffett labeled medical costs the tapeworm of American economic compet- 32 itiveness. The rest of the world spends 5%–10% of GDP on healthcare, 33 mostly with socialized medicine. 34 Munger piped in that there is much in medical care that he doesn’t 35 like. Too much chemo for the almost dead, doctors doing too many un- 36 necessary surgeries. 37 He asserted that it is not moral. However, vested interests are hard 38 to change. We are in love with our lifesaving technologies. The system is 39 crazy, and the costs are wild. 40 Munger predicted present trends will only get worse. 41

315 UNIVERSITY OF BERKSHIRE HATHAWAY

21 Looking Back and Looking Ahead 22 23 A local audience member, born in 1965, said that Buffett had run Berk- 24 shire Hathaway his entire life. Looking back all those years, the 52 year 25 old was interested in hearing a memory from Berkshire’s first annual 26 meeting. 27 Continuing on, the local man said he’d asked Buffett in 2011 what 28 he would like to be known for 100 years from now. Now, in 2017, he’d 29 like to know the same for Munger. 10 Munger responded with one answer to this man’s two-part question. 11 Munger recalled that his earliest memory of the meetings was 12 Buffett’s answer to this age-old question of legacy, “They asked him 13 what he wanted said at his funeral, and he said, ‘I want them to all be 14 saying that’s the oldest looking corpse I ever saw.’” 15 Buffett quipped, with a laugh at his often-told joke, “That may be 16 the smartest thing I ever said.” 17 Then, becoming earnest, Buffett shared that his ideal legacy is very 18 simple. What he really likes is teaching. He’s been teaching both for- 19 mally and informally all his life. He’s also had some of the greatest 20 teachers one could imagine. So he figures that, if somebody thought he 21 did a decent job of teaching, he’d feel very good about that. 22 Munger concluded: “And to make the teaching endurable, it has to 23 have a bit of wise-assery in it. And that we’ve both been able to supply.” 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

316 1 2 3 4 5 6 7 8 9 10 APPENDICES 11 12 A 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 APPENDIX I: 1 2 IN THE BEGINNING . . . 3 4 THERE WAS CAPITAL 5 6 ALLOCATION 7 8 A 9 10 11 12 13 14 15 16 17 18 The story of Buffett’s takeover of Berkshire Hathaway begins with cap- 19 ital allocation. 20 It was the company’s massive buyback proposal at the 1962 share- 21 holders’ meeting that caught Buffett’s attention. This at a time when 22 buybacks were virtually nonexistent. 23 We thought the whole thing was fascinating, so here’s Buffett’s tell- 24 ing of the story in the 2014 Berkshire annual report: 25 26 “On May 6, 1964, Berkshire Hathaway, then run by a man 27 named Seabury Stanton, sent a letter to its shareholders 28 offering to buy 225,000 shares of its stock for $11.375 per 29 share. I had expected the letter; I was surprised by the price. 30 Berkshire then had 1,583,680 shares outstanding. About 31 7% of these were owned by Buffett Partnership Ltd. (“BPL”), 32 an investing entity that I managed and in which I had virtu- 33 ally all of my net worth. Shortly before the tender offer was 34 mailed, Stanton had asked me at what price BPL would sell 35 its holdings. I answered $11.50, and he said, “Fine, we have 36 a deal.” Then came Berkshire’s letter, offering an eighth of a 37 point less. I bristled at Stanton’s behavior and didn’t tender. 38 That was a monumentally stupid decision. 39 Berkshire was then a northern textile manufacturer, 40 mired in a terrible business. The industry in which it operated 41

319 A PPENDI X I: IN THE BEGINNI N G . . .

21 was heading south, both metaphorically and physically. And 22 Berkshire, for a variety of reasons, was unable to change 23 course.”* 24 “That was true even though the industry’s problems had 25 long been widely understood. Berkshires’ own Board minutes 26 of July 29, 1954, laid out the grim facts: ‘The textile industry 27 in New England started going out of business forty years ago. 28 During the war years this trend was stopped. The trend must 29 continue until supply and demand have been balanced.’ 10 About a year after that board meeting, Berkshire Fine 11 Spinning Associates and Hathaway Manufacturing—both 12 with roots in the 19th Century—joined forces, taking the 13 name we bear today. With its fourteen plants and 10,000 14 employees, the merged company became the giant of New 15 England textiles. What the two managements viewed as a 16 merger agreement, however, soon morphed into a suicide 17 pact. During the seven years following the consolidation, 18 Berkshire operated at an overall loss, and its net worth 19 shrank by 37%. 20 Meanwhile, the company closed nine plants, sometimes 21 using the liquidation process to repurchase shares. And that 22 pattern caught my attention. 23 I purchase BPL’s first shares of Berkshire in December 24 1962, anticipating more closings and more repurchases. The 25 stock was then selling for $7.50, a wide discount from per- 26 share working capital of $10.25 and book value of $20.20. 27 Buying the stock at that price was like picking up a discarded 28 cigar butt that had one puff remaining in it. Though the 29 stub might be ugly and soggy, the puff would be free. Once 30 that momentary pleasure was enjoyed, however, no more 31 could be expected. 32 Berkshire thereafter stuck to the script: It soon closed 33 another two plants, and in that May 1964 move, set out to 34 repurchase shares with the shutdown proceeds. The price 35 that Stanton offered was 50% above the cost of our original 36 purchases. There it was—my free puff, just waiting for me, 37 after which I could look elsewhere for other discarded butts. 38 * Charlie Munger once referred to textiles as “congealed electricity,” so the move of pro- 39 duction to the TVA southern states was inevitable. In his classically understated way, he con- 40 cluded that the New England textile business was a “totally doomed, certain-to-fail business.” 41

320 A PPENDI X I: IN THE BEGINNI N G . . .

Instead, irritated by Stanton’s chiseling, I ignored his 1 offer and began to aggressively buy more Berkshire shares. 2 By April 1965, BPL owned 392,633 shares (out of 1,017,547 3 then outstanding), and at an early-May board meeting, we 4 formally took control of the company. Through Seabury’s 5 and my childish behavior—after all, what was an eighth of 6 a point to either of us?—he lost his job, and I found myself 7 with more than 25% of BPL’s capital invested in a terrible 8 business about which I knew very little. I became the dog 9 who caught the car. 10 Because of Berkshire’s operating losses and share repur- 11 chases, its net worth at the end of fiscal 1964 had fallen to 12 $22 million from $55 million at the time of the 1955 merger. 13 The full $22 million was required by the textile operation: 14 The company had no excess cash and owed its bank $2.5 15 million. (Berkshire’s 1964 annual report is reproduced on 16 pages 130-142.) For a time I got lucky: Berkshire immediately 17 enjoyed two years of good operating conditions. Better yet, 18 its earnings in those years were free of income tax because 19 it possessed a large loss carry-forward that had arisen from 20 the disastrous results in earlier years. 21 Then the honeymoon ended. During the 18 years fol- 22 lowing 1966, we struggled unremittingly with the textile 23 business, all to no avail. But stubbornness—stupidity?—has 24 its limits. In 1985, I finally threw in the towel and closed the 25 operation.” 26 27 28 A Tutorial on Capital Allocation 29 While Buffett grills himself for buying a dying textile business out of 30 pique for Stanton Seabury’s chiseling, we think he doth protest too 31 much. 32 In truth, Buffett’s maneuvers in the years to follow constituted an 33 amazing exercise in aggressive capital reallocation. 34 Here are the numbers: In 1964, the year before Buffett took control, 35 Berkshire’s per-share book value stood at $19.46 with per share earn- 36 ings of $0.15. At year-end 1969, Berkshire’s per-share book value was $43.18, 37 up 120%, with per share earnings of $8.07. 38 How the heck did Buffett do that with a dying textile business? 39 Let’s take a look. 40 41

321 A PPENDI X I: IN THE BEGINNI N G . . .

21 Buybacks 22 23 At the time of purchase, Berkshire was undergoing a dra- 24 matic buyback program. 25 In 1964, Berkshire bought in 469,602 shares, leaving 26 1,137,778 shares outstanding, a 29% cap shrink! 27 Furthermore, this was done at an average price paid of 28 $11.32 share, far below book value. 29 Massive per share value was being created by shrinking 10 the capitalization at very low prices. 11 Under Buffett’s command, Berkshire bought in an addi- 12 tional 120,231 shares to further shrink the cap. In all, Berk- 13 shire’s share count went from 1,607,380 in 1964 to 1,017,547 14 in 1969, a 37% reduction.* 15 16 Hidden Value 17 As of 1964, Berkshire had $5 million of “tax loss carry-overs.” 18 With the accounting rules of the day, this asset was not 19 included in the calculation of book value. In addition, this 20 asset could be especially valuable at the time since the top 21 corporate tax was 48%. 22 We estimate this asset added over $2 per share of value as 23 Berkshire used up the tax loss carry-overs within a few years, 24 sheltering a significant portion of earnings from taxes. 25 26 Investments 27 28 Buffett created cash for investment through additional asset 29 sales and reductions in inventory and overhead. 30 He invested in securities that appreciated significantly, 31 liquidating the portfolio during 1968 and 1969. 32 He reported net per share earnings from the gains on 33 those sales of $2.20 ($1.49 from the parent and $0.71 from 34 insurance subsidiaries) in 1968 and $4.16 ($3.87 from the 35 parent and $0.29 from insurance subsidiaries) in 1969, add- 36 ing a total of $6.36 of after-tax value. 37 38

39 * Compare this to just over 1.6 million shares outstanding today. Berkshire has had little 40 share expansion over the past 50 years. 41

322 A PPENDI X I: IN THE BEGINNI N G . . .

Acquisitions 1 2 In 1967, Berkshire bought National Indemnity for $8.4 million, 3 which became the base for building Berkshire’s insurance 4 empire. 5 As of the 1969 report, Berkshire was moving into surety, 6 workmen’s compensation and reinsurance. 7 In 1969, Berkshire purchased The Illinois National Bank 8 and Trust Co. of Rockford, Illinois. 9 10 Earnings and Earnings Power 11 With these two new lines of business, Buffett transformed 12 Berkshire’s earnings power. 13 Of those $8.07 of per share earnings in 1969, $4.66 came 14 from operations: $0.79 from the textile operation, $2.31 15 from the insurance subsidiaries and $1.56 from the banking 16 operation.* 17 The key to note here is that the bulk of Berkshire’s future 18 earning power was no longer in the textile operation but in the insur- 19 ance, banking and investment operations. 20 Note that the $43.18 book value in 1969 represented a far 21 better company, more diversified, with more earning power 22 and better growth prospects than the $19.46 book value 23 of 1964, so the increase in intrinsic per share value was even 24 greater than the 120% increase in per-share book value. 25 Despite its beginnings in the ill-fated textile industry, Buf- 26 fett’s ability to re-allocate resources transformed Berkshire 27 Hathaway into a dynamically growing juggernaut within just 28 five years. 29 30 31 32 33 34 35 36 37 38

* Again, $4.16 of those earnings represented non-recurring gains from the liquidation of 39 the investment portfolio. 40 41

323 APPENDIX II: 1 2 THE 3 4 SPECTACULAR GROWTH 5 6 IN POPULARITY 7 8 A 9 10 11 12 13 14 15 16 17 As Buffett’s fame and wealth have grown, so has the frenzy around his 18 once humble meetings: 19 20 • In the 1970s, Berkshire’s annual meetings consisted of a half 21 dozen shareholders in a local coffee shop. 22 • In 1980, there were only 13 people at the meeting. 23 24 • In 1984, Corey, my now partner, was newly employed in the audit 25 department at Berkshire and joined a few dozen of the faithful at 26 the Red Lion Inn. 27 • My first meeting was in 1985. The meeting was moved to the Joslyn 28 Art Museum to handle the “crowd.” There were about 300 in 29 attendance. 30 31 • In 1989, the year’s meeting was delayed 15 minutes as over 1,000 32 people squeezed in. Buffett noted, “A lot more people turn out to 33 talk about their money than to look at old paintings.” 34 • In 1994, attendance continued to grow with 3,000 shareholders 35 squeezing into the Orpheum Theater. Buffett mused that the 36 only place large enough to hold next year’s meeting might be the 37 local race track, AK-SAR-BEN. He remarked that in moving from 38 a temple of culture (the Joslyn Art Museum) to an old vaudeville 39 theater, then on to a den of gambling, Berkshire was sliding down 40 the cultural scale. 41

325 A PPENDI X II: THE SPECTA CULAR GROW T H I N POP U LAR I T Y

21 • In 1997, a throng of 7,700 stakeholders filled AK-SAR-BEN’s 22 auditorium. 23 • In August 2001, 10,000 plus fans were in attendance at the 24 currently titled CenturyLink Center. 25 26 • By 2003, attendance nearly doubled with a packed-to-the-rafters 27 event with 19,000 in attendance. 28 • In May 2008, with 31,000 of Warren’s closest friends in town, 29 Buffett had now taken over Omaha. 10 11 • May 2013 was the largest attendance by far: 45,000 of Warren 12 Buffett’s friends joined him at the CenturyLink Center. 13 • In 2016, Professors Buffett and Munger presided over the first- 14 ever live-streaming of the Berkshire meeting via Yahoo Finance, 15 creating a global audience. The live streaming decreased 16 attendance by about 10%. 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

326 APPENDIX III: 1 2 LESSONS FROM THE 3 4 BERKSHIRE MALL 5 6 A 7 8 9 10 11 12 13 14 15 16 One of the secrets to the explosion in meeting attendance has been the 17 festive shopping event that Buffett shrewdly added in the mid-1990s. 18 Ever the entrepreneur, Buffett realized the spending power of his 19 shareholder base. The weekend began morphing into a target-marketing 20 retail bonanza for Berkshire subsidiaries. They have since capitalized 21 on the huge attendance numbers by rolling out “The Berkshire Mall.” 22 Today, Berkshire’s shareholders head en masse to the ground floor 23 of the CenturyLink Center. And there awaits a mini-mall comprising 24 booths of subsidiaries selling their goods. 25 The mall shamelessly plugs as many Berkshire enterprises as can be 26 fit into the showroom. These have included the following: 27 28 • Benjamin Moore Paints • Kirby vacuum cleaners 29 • Borsheim’s Jewelry • Larson-Juhl custom framing 30 31 • Clayton Homes • M&T Bank 32 • Cort Business Furniture • Nebraska Furniture Mart 33 • Dairy Queen • Pampered Chef 34 • Fruit of the Loom • Quikut knives 35 • GEICO insurance • See’s Candy 36 37 • Ginsu Knives • Shaw Carpets 38 • H.H. Brown shoes • World Book 39 • Justin Boots 40 41

327 A PPENDI X III: LESSONS F ROM THE BE R KSHIR E MALL

21 If that weren’t enough branding, purchases and free handouts are 22 taken home in shopping bags featuring the Coca-Cola logo. Cartoon 23 caricatures of Buffett festoon as many of the products as possible— 24 including boxers, T-shirts and even competing ketchup bottles. 25 This is not gimmickry, though. Far from it. 26 In 2008, Nebraska Furniture Mart did a record of $7.5 million in 27 sales during the event. An amount considered a great year for most 28 retail outlets. In 2012, Buffett proudly announced that Berkshire 29 shareholders spent $35 million on everything from See’s Candy to 10 Borsheim’s jewelry, an average of $1,000 per attendee. And in 2014, 11 Nebraska Furniture Mart did over $40 million of business the week of 12 the meeting—equivalent to 10% of its annual sales. 13 Not only is Buffett enabling Berkshire shareholders to do their part 14 to augment the company’s sales, but the mall also functions as a great 15 teaching aid. The mall educates shareholders on how Berkshire has 16 become a powerhouse collection of operating businesses. 17 In a not-so-subtle way, it’s as if Buffett is tacitly shouting to the public 18 that Berkshire outgrew being primarily an investment holding company 19 years ago. 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

328 1 2 APPENDIX IV: 3 4 CASH/BOND/STOCK 5 6 RATIOS 7 A 8 9 10 11 12 13 14 15 16 17 18 Percentage Allocation 19 Securities 20 Investment Cash with Equities and 21 Portfolio and Cash Fixed Other 22 Year (in millions) Equivalents Maturities Investments 23 1979 $615 5% 30% 65% 24 1980 $764 8% 24% 68% 25 26 1981 $911 8% 22% 70% 27 1982 $1,162 5% 16% 79% 28 29 1983 $1,516 5% 14% 81% 30 1984 $1,710 10% 18% 72% 31 1985* $2,676 38% 18% 44% 32 33 1986 $3,288 9% 34% 57% 34 1987 $4,666 5% 44% 51% 35 1988 $5,639 5% 32% 63% 36 37 1989 $8,263 2% 34% 64% 38 39 *In 1985, cash swelled due largely to the buy-out of General Foods by Philip Morris, and 40 the 1998 General Re Corporation merger shifted the percentage in equities from 76% to roughly 55%. 41

329 A PPENDI X IV: CASH/BOND/STOCK RAT I O S

21 Percentage Allocation 22 23 Securities 24 Investment Cash with Equities and Portfolio and Cash Fixed Other 25 Year (in millions) Equivalents Maturities Investments 26 27 1990 $8,994 3% 34% 63% 28 1991 $12,283 6% 19% 75% 29 1992 $14,948 8% 14% 78% 10 11 1993 $16,487 11% 13% 76% 12 1994 $18,355 2% 15% 83% 13 1995 $26,362 10% 6% 84% 14 15 1996 $35,537 4% 18% 78% 16 1997 $47,548 2% 22% 76% 17 1998 $74,589 18% 29% 53% 18 1999 $73,565 5% 41% 54% 19 20 2000 $77,086 6% 43% 51% 21 2001 $72,471 7% 51% 42% 22 2002 $80,494 13% 50% 37% 23 24 2003 $95,589 33% 27% 40% 25 2004 $102,929 39% 22% 39% 26 2005 $115,615 34% 23% 41% 27 28 2006 $125,715 30% 20% 49% 29 2007 $141,217 27% 20% 53% 30 2008 $122,025 20% 22% 58% 31 2009 $145,982 19% 22% 59% 32 33 2010 $147,772 24% 23% 53% 34 2011 $153,909 22% 20% 58% 35 2012 $176,331 24% 18% 58% 36 37 2013 $211,308 20% 13% 67% 38 2014 $228,906 25% 12% 63% 39 2015 $236,803 26% 11% 63% 40 41 2016 $244,531 29% 9% 62%

330 APPENDIX V: 1 2 ON CURATING 3 4 THIS BOOK 5 6 A 7 8 9 10 11 12 13 14 15 16 Whereas this is a historical document, the original newsletters are not 17 reprinted here exactly as they were sent out to clients. Instead, these are 18 the curated highlights of the original text. 19 This was done because these newsletters were never conceived to be 20 reprinted in one volume. Therefore, many redundancies exist from one 21 year to the next. Understandably, such repetition would be tiresome to 22 the reader. So, wherever possible, redundancies have been removed. 23 Those original newsletters have also been edited. As this is a histori- 24 cal document, I have preserved many typos. However, as Corey and I as- 25 sembled this collection, some errors were so glaring that we could not 26 help ourselves. So light editing was done. Stylistic changes were made. 27 Nothing of note was omitted. All the information is the same. 28 29 30 31 32 33 34 35 36 37 38 39 40 41

331 ACKNOWLEDGMENTS 1 2 A 3 4 5 6 7 8 9 Daniel Pecaut 10 Huge thanks to my partner and best friend, Corey Wrenn, who has been 11 so instrumental in my understanding of Berkshire. Thanks, Corey, for 12 the copious notes you took which, along with my notes, were the raw 13 material for this book. Attending these meetings with you at my side has 14 been an absolute blast. Thank you for believing in me, especially when I 15 didn’t believe in myself. Your support has been invaluable. 16 Thanks also to our clients at Pecaut & Company. Without you, these 17 newsletters would never have been written. Many of you have been with 18 us through so many ups and downs of the markets—and of life itself. We 19 deeply appreciate our relationship with you. 20 I want to acknowledge my gratitude to Austin Pierce for having the 21 vision to see the possibility of this book. You inspired me to take it from an 22 idea and turn it into a reality. I wouldn’t have done it without you, Austin. 23 An even bigger thank you to my assistant, Shelby Pierce, who actually 24 started this whole thing by introducing me to her husband, Austin. 25 Shelby supports me each and every workday with an indefatigable work 26 ethic and sunny disposition. Everyone should have a Shelby in their life. 27 Thanks to Gayle Rupp, our long-time administrator at Pecaut & 28 Company, who keeps things running smoothly so I can do crazy proj- 29 ects like this book. We have a great team at work, and I appreciate their 30 support day in and day out. 31 Thanks to our beta readers: David Aycock, Dan Boyle, Helen Burstyn, 32 Frank Franciscovich, Andrew Henshon, Phil McLaughlin, Mary Pecaut, 33 and Robert Roy. Your feedback has made this a far better book. I’m 34 deeply grateful to all of you. 35 Deep gratitude to my parents, Dick and Dottie, who taught me so 36 many of life’s lessons and created an environment of love and curiosity 37 for our family to grow in. While they’re no longer alive, their voices of 38 teaching and encouragement still resonate. 39 Thanks go to my children, John, Charlie, and Danielle, who’ve 40 helped me grow in a thousand ways. Until recently, I always thought 41

333 ACK NOWLED GMENTS

21 what I wanted for them most was to be happy. Now I see what I’ve really 22 wanted for them is to take 100% responsibility of their own lives. And 23 they have. I couldn’t be happier for them. 24 Most of all, great love and thanks to my wife, Kay, my high school 25 sweetheart and greatest teacher. She has loved me and supported me 26 throughout. She doesn’t care that much about money. She does care 27 that I show up with integrity, generosity, and love. 28 Big thanks to Warren Buffett and Charlie Munger. We couldn’t have 29 done this book without you. Thanks for the last three decades. See you 10 next year. 11 12 Corey Wrenn 13 14 I would like to thank my partner and dear friend Daniel Pecaut for believing 15 in and welcoming me into the Pecaut and Company family 24 years 16 ago. I believe he is one of the finest individuals I have ever known. He 17 is an excellent writer, teacher and investor. I have learned and continue 18 to learn much from him. 19 I would also like to thank our clients who are like family to me. It has 20 been a privilege and honor to have worked with and for them over all 21 these years. 22 I feel incredibly lucky to have worked with the many faces at Pecaut 23 and Company, including Dick Pecaut. Dick was smart, had an encyclo- 24 pedic memory, was quick-witted, and passionate about investing. 25 I am very grateful to Gayle Rupp, who my family refers to as my right 26 hand. She shows an amazing attention to detail, is a tireless worker, and 27 someone I have counted on for over 25 years. 28 I would like to also acknowledge Shelby Pierce. She brings youthful 29 energy and a joyful spirit to Pecaut and Company. She is outstanding 30 and, remarkably, manages Daniel and me effortlessly. 31 Thank you for your hard work on this book, Austin Pierce. You have 32 a unique skill set and an ability to herd an unruly crew to a final desti- 33 nation. 34 I am very grateful for all the paths I crossed at Berkshire. It is an 35 incredible organization filled with brilliant, talented and focused indi- 36 viduals. Those who worry about succession there clearly don’t under- 37 stand how deep the bench is. It was an honor to work there. 38 I am exceedingly grateful for my mother, who single-handedly raised 39 a gaggle of children. She built a successful business that served her 40 customers—with $0 of beginning equity with elbow grease and sheer 41 determination. She was loved by anyone who crossed her path, by her

334 ACK NOWLED GMENTS employees and her customers. I learned the art of dealing with people, 1 integrity and making the most of every situation from her. 2 I am extremely grateful for my three daughters and son-in-law. Each 3 has unique strengths, talents, and gifts that helped me to become, 4 in many ways, the man I am today. I love them all dearly and am very 5 proud of the paths they have chosen. 6 Finally, I am humbled by and over-the-top grateful for my beloved wife 7 Lisa who has always believed in me. Supporting me through the highs 8 and the lows, she is the glue that holds our family together. Je t’aime 9 ma chérie. 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41

335 INDEX 1 2 A 3 4 5 6 7 8 A Asia, 134 9 “A” shares, 54, 70, 74 AT&T, 81 10 Abegg, Gene, 268 Auction rate securities (ARS), 170–171 11 Abel, Greg, 118, 123, 196, 220, 240, Auto insurance. See GEICO 262, 283, 292, 315 Avoiding mistakes, 243 12 ACA, 202 13 Accounting, xxiv, 34, 39, 66, 113, B 14 137–138, 188 “B” shares, 54, 70, 267 15 abuses of, 51, 82, 93, 107, 124, 148, Bank of America, 186, 235, 267 16 202 Bank of New York Mellon, 267 for derivatives, 106, 116, 119, 125, Banks, 25, 186, 234–235, 262–263, 17 138, 155–156, 174 267–268 18 fair value, 175–176 bargains in, 177 19 option, 66, 114 corporate profits of, 292 20 subprime mortgages and, 158 derivatives and, 262 21 Accounting Standards Board, 213 investment banks, 173, 203–204 22 Ackman, Bill, 257 Barings PLC, 50 Activists, 294 Barriers to entry, 244 23 Adjusted book value, 73 Bear Stearns, 155, 173, 176 24 Adverse loss cover, 198 Belrich Oil, 94 25 Advertising, 190–191, 194, 219, 248, Berkshire Energy Group, 283 26 270 Berkshire Hathaway. See Specific topics 27 Aesop, 186 Berkshire Hathaway Assurance AIG, 132, 186, 250, 304–306, 311 (BHA), 171, 189 28 Airline industry, 12, 33, 63, 79, 81, 98, Berkshire Hathaway Energy, 314–315 29 163, 310–311 Berkshire Mall, xxii, 287, 327 30 Allen, Woody, 48 Bernanke, Ben, 256 31 Allstate, 249 Berra, Yogi, 68, 298 32 Alta Link, 271 Beta, in MPT, 164 33 Alter, Jon, 157 Bezos, Jeff, 307 Amazon, 289, 307 BHA. See Berkshire Hathaway Assur- 34 American Express, 51, 72, 86, 310 ance 35 Annenberg, Walter, 194 Bill and Melinda Gates Foundation, 36 Annual reports, 46, 49–50, 55, 57, 165 37 113 Biographies, 13 38 Apple, 306 Biotech, 79 Aristotle, 65 Black Monday, 150, 155, 291 39 ARS. See Auction rate securities Black Sholes option pricing model, 40 Asbestos, 95, 103–104 239–240 41

337 INDE X

21 Blankfein, Lloyd, 203 Burlington Northern Santa Fe 22 Bluhdorn, Charles, 225 (BNSF), xix–xx, 169, 206–207, 23 Blumkin, Rose, 214 229, 241, 252–253, 270 BNSF. See Burlington Northern coal and, 291 24 Santa Fe dangerous substance safety by, 283 25 Board of directors, xxv market share of, 276 26 CEOs and, 146, 159 return on equity of, 210 27 executive compensation and, 31, Business acquisitions, 48, 112–113, 28 159 170, 271, 323. See also Good busi- of Salomon Brothers, 105 nesses; Specific companies 29 Bogle, John, 308 competitive advantage for, 258–259 10 Bolt-on acquisitions, 271 dollar decline and, 157–158 11 Bonds, 102, 160 filters for, 65–66, 279–280 12 cash/bond/stock ratios, 329–330 of good businesses plus manage- 13 derivatives for, 192 ment quality, 299 14 government, 36 ideal buys for, 309 junk, 16–17, 124, 127, 156 100% ownership in, 44–45, 168 15 municipal, 170–171, 203, 211 value calculations for, 161–162 16 zero-coupon, 16, 75 waiting for fat pitch in, 109, 118 17 Bond-stock ratio, 71–73 Business cycle, predictions of, 11 18 Bonuses, 123 Business moat, 37, 50–51, 55, 80–81, 19 Book value, 33 209, 220, 282, 310 Borsheim’s, 58, 80 Business risk, 63–64 20 BPL. See Buffett Partnership Ltd. Buybacks, 56, 296, 322 21 Brady, Nick, 150 BYD, 195–196, 209, 228 22 Brandon, Joe, 102, 197, 237 Byrne, Jack, xix, 248 23 Brands, xviii, 17, 80, 177, 282 24 vs. generics, 37–38 C 25 market share of, 37 Cadbury’s, 213 vs. retail, 96 California, 93–94, 135, 187, 229, 315 26 Branson, Richard, 244 Capital allocation, 32, 43, 268–270, 27 Buffalo News, 99, 161, 242 313, 319–323 28 Buffett, Howard, 221, 263 Capital Cities/ABC, 4, 24, 58 29 Buffett, Warren, xi–xvi. See also Specific Capital gains, taxes on, 65, 71, 73 30 topics Carmax, 169 advice from, 260–261, 292 Carry trade, 132, 138, 157 31 energy of, 259 Cash, 75–76, 143, 206–207 32 happiness of, 268, 288 for business acquisitions, 271 33 legacy of, 225 vs. dividends, 179, 243, 272 34 misquotations of, 214 in Treasury bills, 230 35 philanthropy of, 165 Cash flow, 33, 36, 80, 106, 206 36 popularity of, 325 free, 298–299 predictions by, 282–283 IBV and, 17 37 prostate cancer of, 245 Cash/bond/stocks ratios, 329–330 38 track record of, 2–3 Catastrophe coverage, 42, 66–67, 197, 39 Buffett Partnership Ltd. (BPL), 154, 210, 218, 236 40 319–321 CDOs. See Collateralized debt obliga- 41 Burger King, 278 tions

338 INDE X

CDS. See Credit default swaps Competitive advantage, 43, 56, 64, 97, 1 CEG, 196 190, 258–259, 310 2 CEOs, 31, 106–107, 137 Concentration, 172 3 board of directors and, 146, 159 Conglomerates, 225 executive compensation and, Conseco, 112 4 123–124, 145, 159, 179 Constellation Energy, 195, 196 5 Chief investment officer (CIO), 154 Consumer credit, 159 6 Chief risk officer (CRO), 235 Consumer Price Index (CPI), 150 7 China, 170, 177, 193, 197 Corporate governance, 146 8 Christopher, Doris, 115 Corporate jet, 17, 43 9 Cialdini, Robert, 181 Corporate profits, 159. See also Profit CIO. See Chief investment officer margins 10 Clason, George, 165–166 of banks, 292 11 Clayton Homes, 113–114, 147–148, GDP and, 255, 284 12 277–278 Corporate taxes, 132, 244–245, 255, 13 Clinton, Hillary, 292 315 14 Clipper Fund, 132 Correlations, 116 CNBCs. See Cyber, nuclear, biological of management quality, 139 15 and chemical hazards with municipal bonds, 211 16 Coal, 239, 291 of risk, 135 17 Coca-Cola, 21, 62, 66, 72, 108, 148–149 Cort, 89 18 barriers to entry with, 244 Costco, 96, 151, 229–230 19 business castle of, 51 CPI. See Consumer Price Index 20 business moat of, 81, 282 The Crash (Galbreath), 192 durable competitive advantage of, Creative accounting, 107 21 310 Credit contractions, 156–157 22 focused management at, 59 Credit default swaps (CDS), 176 23 vs. generics, 37 CRO. See Chief risk officer 24 health consequences of, 289–290 Crowe, Jim, 116 25 independent thinking at, 122–123 Crum and Foster, 213 inflation and, 193–194 Currency markets, 10, 36, 132, 223. See 26 look-through earnings of, 30 also Dollar 27 market share of, 18, 83 Cyber, nuclear, biological and chemi- 28 as permanent holding, 24 cal hazards (CNBCs), 297. See also 29 product liability of, 95 Nuclear, chemical and biological 30 See’s Candy and, 67 hazards 31 share of mind by, 83, 86, 177 Wells Fargo and, 235 D 32 world markets for, 24, 30, 36, 170 Dairy Queen, 95, 118 33 Cohen, Maury, 177 Dale Carnegie course, 180, 231 34 Collateralized debt obligations Davidson, Lorimar, 280 35 (CDOs), 175 Day trading, 87, 148 36 Combined ratio, for GEICO, 288–289, Debt, 184–185 305 business risk of, 63 37 Combs, Todd, 241, 271 CDOs, 175 38 Commodity businesses, 63, 146–147 vs. investment, 207 39 Compensation. See Executive compen- national, 51–52 40 sation paying down, 271–272 41

339 INDE X

21 Debt, (cont’d) Dynergy, 197 22 sovereign debt crisis, 234 Dyson, Freeman, 211 23 systemic risk and, 240 Deferred taxes, 56, 73, 298 E 24 The Defining Moment: FDR’s Hundred Earnings before interest, taxes, de- 25 Days and the Triumph of Hope preciation and amortization 26 (Alter), 157 (EBITDA), 114 27 Department of Justice, U.S., 88 fraud with, 106 28 Depreciation, 210, 240, 292, 298 Earnings power, 20, 323 EBITDA, 106, 114 Earthquakes, 135, 210, 218, 236 29 Derivatives, 42, 173, 291 EBITDA. See Earnings before interest, 10 accounting for, 119, 125, 138, taxes, depreciation and amorti- 11 155–156, 174 zation 12 banks and, 262 Economic forecasting, 3–4 13 for bonds, 192 Economic Value Added (EVA), 48 14 at General Re Corporation, 106, Education, 136, 292. See also Learning 128, 156 Effective rationality, 89–90 15 informational advantage in, 192 Efficient market theory, 26–27, 16 leverage in, 128, 155–156, 191–192 186–187 17 at Long-Term Capital Management, Einstein, Albert, 177, 297 18 150 Eisner, Michael, 58 19 predictions on, 150 EJA. See Executive Jet Aviation reform for, 204 Electric grid, 191, 211 20 risk of, 50, 119, 125 Electronic herd, 132, 156 21 at Salomon Brothers, 38, 125, 150 Electronic record, 214 22 Detlev Louis Motoradvertriebs GmbH, Emerson, Ralph Waldo, 214 23 281 Employee incentives, 128. See also Ex- 24 Dexter shoes, 159, 170 ecutive compensation 25 DiGiorno Pizza, 213 Energy companies, 94, 118, 211. See Discontinuities, derivatives and, 291 also Specific companies 26 Discount rate, 36, 124 Enron, 107, 119, 197 27 Disney, 58 Envy, with executive compensation, 28 Diversification, 57–58, 172 145, 179 29 Diversified Retailing, 242 Equity coupons, 33–34 30 Dividends, 115, 179, 185, 243, 272 Errors of omission. See Opportunity Dodd Frank, 262 cost 31 Dollar, as reserve currency, 255 Ethanol, 146–147, 164–165, 173, 32 Dollar decline, 133–134, 150 211 33 business acquisitions and, 157–158 Ethics, 169, 213, 229 34 inflation and, 151, 193–194, 225 EVA. See Economic Value Added 35 trade deficit and, 169–170 Eveillard, Jean-Marie, xiii, 119 36 Donegan, Mark, 283, 287, 313 Executive compensation, 66, 88, 209– Dow Chemical, 184 210, 220, 242. See also Stock op- 37 Downsizing, 59, 278–279 tions 38 Driverless cars, 306 board of directors and, 31, 159 39 DuPont, 115 CEOs and, 123–124, 145, 159, 179 40 Durable competitive advantage, 310 envy with, 145, 179 41 Duracell, 109, 286 at GEICO, 123, 300–301

340 INDE X

management quality and, 158–159 G 1 short-term focus on, 136–137 Galbreath, John Kenneth, 192 2 Executive Jet Aviation (EJA), 82 Gambling, 161–162. See also Specula- 3 tion F with derivatives, 192 4 Fair value accounting, 175–176 in stock market, 50 5 Fairness, 65, 115 Gates, Bill, 54–55, 58 6 Fannie Mae (FNM), 138, 173–174, GDP 7 187, 228 corporate profits and, 255, 284 8 FDIC, 223 growth of, 63, 78, 92, 115 9 Fear, 213–214 health care costs and, 260 Fed, 256 market cap to, 284 10 Federal deficit, 140, 205, 208 per capita, 115, 178, 244 11 FERC, 197 GE. See General Electric 12 Ferguson, Ron, 74 GEICO, xviii–xix, 64–65, 68, 79–80, 13 Fields, Marshall, 190 103, 108, 228–229, 280 14 Filters, 65–66, 243, 279–280 100% ownership of, 55 Financial literacy, 185 advertising for, 190–191, 219, 270 15 Financial sector, 51. See also Banks buybacks of, 56 16 reform of, 226–227 combined ratio for, 288–289, 305 17 regulation of, 203–204 competitive advantage of, 190 18 First Executive Life, 25 driverless cars and, 306 19 First Normandy, 105 executive compensation at, 123, 20 Flightsafety International, 63 300–301 Float, 291, 304 float of, 64, 67 21 of GEICO, 64, 67 focused management at, 59 22 of General Re Corporation, 72–73, growth of, 219, 248–250, 304 23 79, 102 Internet and, 80, 289 24 of insurance companies, xviii, xix, market share of, 190, 237 25 56–57, 92, 102–103, 237, 305 as permanent holding, 24 interest rates and, 257 Progressive and, 288–289 26 of NI, 102, 112, 207–208 General Electric (GE), 185 27 railroads and, 241 General Motors (GM), 137–138, 230 28 of Swiss Re, 198 General Re Corporation, 70–76, 86, 29 FNM. See Fannie Mae 197, 229, 237 30 Focused management, 59 derivatives at, 106, 128, 156 31 Food companies, 95, 113, 177 float of, 72–73, 79, 102 Fortune, xx, 33, 88, 117, 119, 159, 261 The General Theory of Employment, Inter- 32 Franchises, 67 est and Money (Keynes), 211, 224 33 Franklin, Ben, 21, 131, 309 Generics, 37–38 34 Fraud, 105–106, 174, 308–309 Germany, 170, 281 35 Freddie Mac (FRE), 51, 138, 173–174, Gillette, 30, 36, 37, 59, 62, 72, 282 36 187, 228 Glass Steagall, 203 Free cash flow, 298–299 GM. See General Motors 37 Friends, 109, 120 Gold, 134, 223–224 38 Fruit of the Loom, 108, 123 Goldfarb, Jack, 108 39 Furniture business, 89. See also Goldman Sachs, 184–185, 195, 202– 40 Nebraska Furniture Mart 203, 242 41

341 INDE X

21 Good businesses, 20–21, 32, 58–59, 62, Herbalife, 257–258 22 66, 270 High-speed rail, in California, 229 23 cost structure of, 97–98 Holland, John, 108 inflation and, 222 Holowesko, Mark, 36 24 insurance companies as, 228–229 Homestore.com, 89 25 management quality and, 299 Horton, Tim, 278 26 Good health, 81, 103, 180–181 Housing bubble, 134–135, 148, 27 Good until reached for (GURF), 174, 187–188 28 195 Huggins, Chuck, 123 Google, 307 Hunt brothers, 256 29 Gordon, Al, 203 Hurricanes, 149, 197, 210, 218 10 Gottesman, Sandy, 154, 163, 235, 242, 11 294 I 12 Government bonds, 36 IBM, 87, 280 13 Graham, Benjamin, xvi, xviii, 109, 117, IBV. See Intrinsic business value 14 180, 221 Icahn, Carl, 305 The Intelligent Investor by, 2, 39, 164, Identical twins, 120 15 168, 238 Illinois National Bank of Rockford, 16 on market timing, 32 268, 322 17 value investment and, 20 Income tax, 46, 73, 179, 321 18 Grant’s Interest Rate Observer, 75 Independent thinking, 46, 122–123 19 Greece, 204–205, 225 Index funds, 83, 107, 225–226, 254, Greed, 6, 95, 174, 213 295, 308 20 Greenspan, Alan, 44, 150, 175, Inflation, 3, 39 21 234–235 Coca-Cola and, 193–194 22 Gross, Bill, 253 CPI and, 150 23 Guinness, 30, 36 dollar decline and, 151, 193–194, 24 GURF. See Good until reached for 225 25 Gutfreund, John, 12, 309 federal deficit and, 205 GDP growth and, 92, 115 26 H hedges for, 10–11, 222 27 Habits, 129, 208 interest rates and, 257 28 Hair triggers, 124, 132, 141 protection from, 122 29 Happiness, 120, 268, 288 stock market and, 78 30 Harley Davidson, 207, 258 Influence (Cialdini), 181 Harriman, E. H., 243 Information technology, 46, 78–79 31 Hayward, Andy, 292 Informational advantage, in deriva- 32 Hazen, Paul, 25 tives, 192 33 Health care costs, 34, 260, 315 Infrastructure, 191 34 Hedge funds, 251, 295 Initial public offerings (IPOs), 54, 87, 35 FNM and FRE as, 138 105, 147, 243 36 hair triggers at, 132 Institutional blindness, 21 investment managers of, 241–242 Insurance companies, 17, 27. See also 37 municipal bonds and, 171 Reinsurance; Specific companies 38 Heider, Charlie, 119 building empire of, 280–281 39 Heinz, 254, 257, 271, 282 catastrophe coverage at, 42, 66–67, 40 Helzberg, Barnett, 48 197, 210, 218, 236 41 Helzberg’s, 48 cost structure of, 98

342 INDE X

data requirements for, 250 learning for, 116–117, 163–164, 181, 1 earthquakes and, 135, 210, 218, 236 230–231, 309–310 2 float of, xviii, xix, 56–57, 92, 102–103, in self, 103, 139, 180–181 3 237, 305 to sell at higher price, 223–224 as good businesses, 228–229 in technology, 306–307 4 hurricanes and, 149, 197, 210, 218 temperament for, 125–126, 213–214 5 NCBs and, 135 value, 2, 20, 33, 36–37 6 profit margins for, 154 Investment banks, 173, 203–204 7 reserve of, xviii, xix Investment managers, 188 8 risk of, 108, 116, 235 of hedge funds, 241–242 9 stock market and, 251 Iowa, wind power in, 315 terrorism and, 104–105 IPOs. See Initial public offerings 10 Integrity, in stock market, 213 ISCAR, 144, 146, 157, 170, 220, 253, 11 Intel, 64 270 12 The Intelligent Investor (Graham), 2, 39, 13 164, 168, 238 J 14 Interco, 25 Jain, Ajit, 171, 189, 207–208, 229, 237, Interest rates, 107 250, 251, 280, 281 15 IBV and, 311–312 Japan, 89–90, 107, 300 16 inflation and, 257 Johns Manville, 100 17 NIRP, 300 Johnson & Johnson, 169, 179 18 reinsurance and, 288 JP Morgan, 235, 243 19 returns on equity and, 63 Junk bonds, 16–17, 124, 127, 156 20 stock market and, 283–284 0%, 214 K 21 Internet Kansas Bankers Surety, 67 22 day trading on, 148 Kass, Doug, 263 23 GEICO and, 80, 289 Kellogg’s, 96 24 IPOs for, 87 Keough, Don, 24 25 newspapers and, 161, 242 Keynes, John Maynard, 211, 224, 255 profit margins and, 87 Keynesian economics, 89, 107, 300 26 retail and, 80 Kiewit, Peter, 294 27 trap of, 95–96 Kissinger, Henry, 234 28 Intrinsic business value (IBV), 3, 17, Kraft Foods, 169, 177, 211–212 29 49–50, 55 Kroc, Ray, 239 30 buybacks and, 56, 296 31 interest rates and, 311–312 L St. Petersburg Paradox and, 124 Labor costs, 98 32 stock options and, 59–60, 66, 107 Last in, first out (LIFO), 151 33 Investment, 109–110 LastBestChance.org, 135 34 in assets that produce something, Lawyers, 78, 95, 124, 238 35 224 LBO, 17, 25 36 capital allocation and, 322 Learning, 116–117, 163–164, 181, categories of, 223–224 230–231, 309–310 37 concentration in, 172 Lee Enterprises, 242 38 in currency, 223 Lehman Brothers, 186 39 vs. debt, 207 Lemann, Jorge Paulo, 254 40 fear in, 213–214 Leucadia National Corp, 112, 163 41

343 INDE X

21 Leverage Maxwell, Robert, 105 22 in derivatives, 128, 155–156, 191–192 McDonald’s, 62, 239 23 as inflation hedge, 10 McLane, 113 risk of, 127–128, 175, 235 MEC. See MidAmerican Energy 24 Levitt, Arthur, 82 Media business, 25–27, 149 25 Levy, Gus, 203 Merrill Lynch, 186 26 Lewis, Peter, 249 Michaelis, George, xiii, 17, 20, 21 27 LIFO. See Last in, first out Microsoft, 51, 54–55, 88 28 Ling, Jimmy, 225 MidAmerican Energy (MEC), 94, 118, Liquor, 30 184, 196, 229, 240, 270 29 Lloyd’s of London, 38 cash from, 206–207 10 Long-Term Capital Management, 119, executive compensation at, 123 11 132, 150, 157, 172 inflation and, 222 12 Look-through earnings, 30 solar power and, 262 13 Loomis, Carol, 37 Minuit, Peter, 13 14 Louis Harris & Associates, 62 Modern portfolio theory (MPT), 32, Lower expectations. See Modest expec- 45, 57–58, 151, 164, 170–171, 15 tations 239–240 16 Lubrizol, xix, 219–220, 270 Modest expectations, 159–160, 168–169, 17 Lynch, Peter, 81 225–226 18 The Money Masters (Train), xiii 19 M Monopolies, 87, 292, 312 Management evaluation, 43 Montross, Tad, 197, 229, 237, 251 20 Management quality, 81, 139, 145–146, Moody’s downgrade, 196 21 169, 299 Moser, Paul, 309 22 business acquisitions and, 66 Moynihan, Brian, 235 23 executive compensation and, MPT. See Modern portfolio theory 24 158–159 M&T Bank, 177, 262, 267 25 Manhattan Project, 297 Munger, Charlie, xi, xiii, xiv, xv–xvi, Manufactured housing, 113, 147–148 260–261. See also Specific topics 26 Margin accounts, 128 Municipal bonds, 170–171, 203, 211 27 Market, 64 Murphy, Tom, 220 28 Market cap, 63, 79, 168, 284 Mutual of Omaha, 116, 189 29 Market risk, 64 30 Market share N of BNSF, 276 National debt, 51–52 31 of brands, 37 National Indemnity (NI), xviii, 55, 71, 32 business moat and, 81 119–120, 229, 251, 280–281, 322 33 of Coca-Cola, 18, 83 durable competitive advantage of, 34 of GEICO, 190, 237 310 35 of Gillette, 109 employee incentives at, 128 36 of NetJets, 113 float of, 102, 112, 207–208 Market timing, 32, 44 Natural gas, 239 37 Marmon Group, 170, 270 Natural resources, 239 38 Mars, 176 NCBs. See Nuclear, chemical and bio- 39 Marshall, Ira, 117 logical hazards 40 Math, 79, 89, 96, 126, 164, 185–187, Nebraska Furniture Mart (NFM), xiv, 41 235, 239 xxii, xxiii, 169, 214, 296–297, 327

344 INDE X

Negative interest rate policy (NIRP), predictions on, 18, 96–97 1 300 value investment and, 35–36 2 Nestlés, 213 Payment-in-kind (PIK) bonds, 16 3 NetJets, 79, 82, 98–99, 113, 208–209 PCP. See Precision Castparts Nevada Public Utility Commission, PE. See Price earnings ratio 4 292 Pecaut, Dick, xi 5 New York Times, 211, 241 Pension funds, 34, 75, 93, 255 6 Newman, Mickey, 108 Per capita GDP, 115, 178, 244 7 Newspapers, 49, 161, 194, 242, 260 Permanent holdings, 24 8 Newton, Isaac, 126 Petro China, 157 9 NFM. See Nebraska Furniture Mart Pharma, 179 NI. See National Indemnity Philadelphia and Reading Coal and 10 Nicely, Tony, 237, 251 Iron (P&R), 108 11 NIRP. See Negative interest rate policy Philip Morris, 37 12 Non-executive chairman, 31 PIK. See Payment-in-kind bonds 13 Northern Natural Gas pipeline, 197 Planck, Max, 189 14 Northern Pacific, 243 Plutocracy, 244 Nuclear, chemical and biological haz- PNC Bancorp, 51 15 ards (NCBs), 135, 205–206, 291 Ponzi schemes, 225 16 Nuclear proliferation, 177 Portfolio insurance, 150, 155 17 Nuclear terrorism, 135–136 POSCO, 157 18 NV Energy, 271 P&R. See Philadelphia and Reading 19 Coal and Iron 20 O Pragmatism, 215 Office of Federal Housing Enterprise Precision Castparts (PCP), 283, 286, 21 Oversight (OFHEO), 173–174 287, 313 22 Oil, 172, 211, 239, 241, 252 Predictions, 11, 48–49, 126–127, 23 O’Loughlin, James, xi 282–283 24 Olympics, in China, 177 by CEOs, 137 25 Omaha World Herald, 242 on derivatives, 150 100% ownership, 44–45, 55, 168 economic forecasting, 3–4 26 OPM. See Other people’s money on interest rates, 257 27 Opportunity cost, 65, 94, 117–118, on past performance, 18, 96–97 28 126, 151, 195 technology and, 80 29 Optimism, 215 Preferred stock, 48, 50 30 Option accounting, 114 Price earnings ratio (PE), 107, 195–196 31 Option trading, xii Pricing power, 132 Other people’s money (OPM), 44–45 Pricing umbrella, 37 32 Ovarian lottery, 65. See also Identical Pritzkers, 170 33 twins Proctor and Gamble, 42 34 Overpayment Product liability awards, 94–95, 103–104 35 for good businesses, 62 Profit margins 36 market risk and, 64 GDP growth and, 92 for insurance companies, 154 37 P Internet and, 87 38 Pampered Chef, 115, 257–258 Program trading, 11 39 Parity of concern, 114 Progressive, 249–250, 288–289 40 Past performance Progressive income tax, 46 41

345 INDE X

21 Projections. See Predictions Risk, 174–175 22 Protégé Partners, 295 business, 63–64 23 Public speaking, 180 correlations of, 135 Purchase goodwill, 73 CRO for, 235 24 of derivatives, 50, 119, 125 25 Q of insurance companies, 108, 116, 26 Quality of GDP, 115 235 27 of leverage, 127–128, 175, 235 28 R Rockefeller, John D., 261 Rachor, Jeff, 300 Rodriguez, Bob, xiii, 132, 160 29 Railroads, 241, 279, 291–292. See also Rose, Matt, 252 10 Burlington Northern Santa Fe RTC. See Resolution Trust Corp 11 depreciation of, 210, 292 Ruane, Bill, 154, 294 12 driverless cars and, 306 Russell, Bertrand, 52, 122 13 high-speed, 229 14 Rate of change, 37 S Reading, 13, 26, 36, 57, 113, 126, 163, Salomon Brothers, 11–12, 31, 49, 51, 15 180–181, 194, 230 145 16 Real estate derivatives at, 38, 125, 150 17 housing bubble in, 134–135, 148, fraud at, 105 18 187–188 Sam’s Club, 96 19 as inflation hedge, 10 Sandler, Michael, 132 retail and, 80, 194 Sandvik, 253 20 subprime mortgages in, 158 Sanofi, 179 21 The Real Warren Buffet: Managing Cap- Santulli, Rich, 82 22 ital, Leading People (O’Lough- Sarbanes-Oxley, 173 23 lin), xi Savings and loans (S&Ls), 25 24 Reichardt, Carl, 25 Savings rate, 178, 194 25 Reinsurance, 38, 42–43, 82, 229, Schwed, Fred, 295 250–252, 288. See also General Re Scott, Walter, 81 26 Corporation; Swiss Re SEC, 82, 145, 202–203 27 catastrophe coverage and, 236 “The Secret Millionaires Club,” 208, 28 hedge funds in, 251 292 29 Reinvestment, 270, 307 Security Analysis (Graham), 2, 109 30 Renewable energy, 283, 290. See also See’s Candy, xviii, 18, 67, 206 Solar power; Wind power executive compensation at, 123 31 Renewable Fuels Association, 147 vs. generics, 38 32 Reserve currency, 255 inflation and, 122, 222 33 Resolution Trust Corp (RTC), 163 pricing power of, 132 34 Restaurant business, 62 product liability of, 95 35 Restructuring, 301 share of mind of, 86 36 Retail, 80, 96, 98, 194. See also Specific Self, investment in, 103, 139, 180–181 companies Sequoia Fund, 294 37 Returns on equity, 63, 147, 210 ServiceMaster, 17 38 Rich, Mark, 174 Share of mind, 58, 81, 83, 86, 177, 191, 39 The Richest Man in Babylon (Clason), 219, 248, 305 40 165–166 Share turnover, 152 41 Ringwalt, Jack, 55, 108, 119–120, 280 Silver, 147

346 INDE X

Simpson, Lou, 242 Swiss Re, 184, 197, 198, 236 1 S&Ls. See Savings and loans Systemic, 240–241 2 Smith, Adam, 225 Systemic risk, 240–241 3 Snapshot, 249–250 Szilard, Leo, 297 Social Security, 139–140 4 Software. See Information technology T 5 Sokol, David, 118, 123, 196, 209, Tax credit, for renewable energy, 290 6 219–220 Tax loss carry-overs, 322 7 Solar power, 199, 211, 262, 283, Taxes, xxiv. See also Corporate taxes 8 314–315 on capital gains, 65, 71, 73 9 by MEC, 240 corporate profits and, 159 Nevada Public Utility Commission deferred, 56, 73, 298 10 and, 292 on dividends, 115, 185 11 Sorkin, Andrew Ross, 263 federal deficit and, 208 12 Source Capital, 20 fraud with, 106 13 Sovereign debt crisis, 234 gambling as, 161–162 14 S&P 500, xx–xxi, 83, 211, 295 income, 46, 73, 179, 321 Speculation, 87, 147, 148, 210–211 at MEC, 240 15 St. Petersburg Paradox, 124–125 per capita GDP and, 244 16 Stanton, Seabury, 319–321 progressive income tax, 46 17 State Farm, 68, 249 proposed cuts in, 312 18 Stimulus bill, 226 tapeworms and, 244–245 19 Stock market, 4, 24–25, 169 unit trusts and, 54 20 bond-stock ratio, 71–73 Technology, 51, 80, 86–87, 306–307. cash/bond/stock ratios, 329–330 See also Internet 21 crash of, in Japan, 89–90 BNSF and, 241 22 derivatives in, 192 at IBM, 280 23 fraud in, 105 information, 46, 78–79 24 gamble of, 50 nuclear proliferation, 178 25 insurance companies and, 251 terrorism and, 151–152 integrity in, 213 Telecommunications, 81 26 interest rates and, 283–284 Temperament, for investment, 125–126, 27 long-term rate of return for, 78 213–214 28 OPM in, 44–45 Templeton, John, xiii, 6–7, 12, 46, 110 29 railroads on, 291 10-year returns, 140 30 risk in, 243–244 Terrorism. See also Cyber, nuclear, bi- 31 10-year returns in, 140 ological and chemical hazards; Stock options, 34, 59–60, 66, 88, 106– Nuclear, chemical and biological 32 107 hazards 33 Stock repurchases, 194–195, 294, 321 insurance companies and, 104–105 34 Stock valuation, 74 nuclear, 135–136 35 Stocks splits, 38 technology and, 151–152 36 Stocks-as-bonds analysis, 33 TESCO, 157 Subprime mortgages, 158 Thompson, Doc, 221 37 Succession planning, 145, 169, 171–172, 3G Capital Partners, 254, 271, 278–279, 38 206, 221, 263–264 299–300, 314 39 Successor businesses, 12 “Too big to fail,” 228 40 Sugar, 30, 95, 259, 282, 289 Total market cap to GDP, 284 41

347 INDE X

21 Trade deficit, 12–13, 16, 133–134, Wang Chuanfu, 209 22 169–170, 239 Washington, D.C., 135 23 Trademarks, 51 Washington Post, 21, 24, 133, 194, 271 Train, John, xiii Watson, Tom, 146 24 Treasury bills, 184, 230, 257 Webvan, 96, 175 25 Trump, Donald, 292 Wechsler, Ted, 241, 271 26 Trust, 226 Wells Fargo, 25, 51, 169, 177, 219, 223, 27 Twain, Mark, 49 262, 267 28 Twentieth Century Industries, 67, 105 Coca-Cola and, 235 durable competitive advantage of, 29 310 10 U Union of Concerned Scientists, 297 in financial crisis, 186 11 Union Underwear, 108 fraud at, 308–309 12 Unions, 99 Wertheimer, Eiton, 143, 146, 157 13 Unit trusts, 54 Wertheimer, Seth, 253 14 U.S. Bancorp, 177, 223, 267 Wesco Financial, xiv–xv, xix, 38, 45, 67 U.S. Bank, 169, 262 Wheeler, Munger & Co., xvi 15 Where Are the Customers’ Yachts? 16 USAir, 50, 98, 163 Utility sector, 196–197 (Schwed), 295 17 in California, 93–94 Whitman, Marty, xiii 18 Wind power, 196, 314–315 19 Winters, David, 128 V Wonderful companies. See Good busi- 20 Valeant, 294 nesses 21 Value investment, 2, 20, 33, 36–37 World Book, 11–12, 161, 327 22 Value-added tax, 245 World markets, 24, 30, 36, 170 23 Van Tuyl, 279, 300 Wrigley’s, 81, 177, 185 Venture capital, 95, 209 Wurster, Don, 251 24 Virgin Cola, 244 25 Volatility, 45, 64, 164 X 26 Volker, Paul, 133, 204, 257 Xerox, 213 27 28 W Y 29 Wachovia, 186 Yes (Cialdini), 181 30 Wagoner, Richard, 137 Wall Street Journal, xvi, 70, 117, 202 Z 31 Wal-Mart, 96, 113, 117, 126, 145, 151 Zero-coupon bonds, 16, 75 32 33 34 35 36 37 38 39 40 41

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