Stockholders' Questions Answered at Berkshire's Annual Meeting

This past weekend, I attended the Berkshire Hathaway (BRK.A) meeting in Omaha Nebraska. I was able to go thanks to my friend Dave, who is a shareholder in Berkshire. I am not a Buffett-ologist, but I am a big admirer and fan, not only because he is perhaps the greatest investor on the planet, but also because he, from what I understand, is a genuinely decent human being. In an industry where ethics is an option for too many, there may not be a better role model than Warren Buffett.

The following are Buffett’s and Munger’s thoughts about the subjects asked by the crowd. The opinions are Buffett’s unless specifically ascribed to Charlie Munger.

Residential construction
It will struggle for some time.

Private equity
It will be some time before disillusionment with returns from private equity sets in. But it will happen.

Investing abroad
They have nothing against investing abroad. However, in Germany and the UK, a purchaser of stock must report to the regulatory authorities when it has accumulated a 3% position in a company. Berkshire has to take significant stakes to effect returns, and it does not like others knowing what it is doing. The 3% threshold makes its moves more transparent. The 1997 collapse in Korea saw valuations in that country similar to the U.S. in 1932.

Management compensation
CEOs are overpaid. However, there are more problems with having the wrong manager than having the wrong compensation system. Unlike negotiations with unions, the lack of intensity in the negotiating process for executive pay drives up executive compensation. Most managements want tail-waging cocker spaniels on the compensation committee, not dobermans. Compensation is driven by envy. Envy is the “dumbest” of the seven sins because, unlike the other seven sins such as gluttony and lust, there is no upside to envy. Envy just makes you feel bad, unlike gluttony and lust where there is an upside. Charlie Munger noted that all this excess was causing envy and resentment.

Derivatives
We will have something like 1998. They don’t know when or what it will look like, but it could be bigger than the collapse of Long Term Capital Management. Derivatives make margin regulations a joke and will bring chaos.

Accounting for derivatives
According to Charlie Munger, most of the accounting profession doesn’t know how stupidly it is behaving, especially regarding accounting for derivatives. By marking to market derivative positions, traders are being paid for profits that may or may not materialize, and increasing risk in the financial system as returns relative to risk are asymmetric for the trader. The aggregate balance sheet for all derivatives almost certainly doesn’t balance. In some cases, profits on different sides of the same trade are being accounted for differently, creating the illusion that profits are higher than they actually are. Traders will game the system to make its trade benefit itself as opposed to presenting an accurate reflection of profitability.

Corporate profits
Corporate profits today are extraordinary and not sustainable. Over time, corporate profits have averaged 4%-6% of GDP. Today it is 8%, and that will come down. Much of today’s profits are being derived from the financial sector.

Human fallibility
People have a hard time thinking about what hasn’t happened in the past. Thus, they tend to incorrectly discount events in the future. On desired hurdle rates, it is amazing how gullible big investors, such as institutions, are. They are willing to believe and invest with people who will tell them what they want to hear, even if those people cannot deliver the stated hurdle rate.

Shorting
They have no problem with shorting. People will pay you money to borrow your stock, giving you “found” money. Then, you have a constituency that must eventually buy back your stock. It even offered to have a special meeting just for the shorts because shorts generally have a much harder time than other investors.

Gambling
Gambling is a tax on ignorance. It is disgusting that governments prey on the weaknesses of its citizens. Charlie Munger stated that casinos use egregious tricks to harm people, and you will never find a gambling stock owned by Berkshire.

Valuation
There is no single easy method of determining intrinsic value according to Charlie Munger. You need to use several methods. Experience plays a big part. However, the correct theoretical valuation metric is discounted cash flow.

Global warming
There is enough evidence to suggest global warming is occurring. General Re is taking it seriously. Charlie Munger chimed in, however, that “you’d have to be a pot-smoking journalism student to believe global warming is a threat to the existence of mankind.” What matters are the dislocations that will occur due to global warming, not global warming itself. People generally like it warmer. After all, people aren’t moving from Southern California to North Dakota.

Asset allocation
If he were head of a $10 billion endowment , and his choices were stocks, bonds or cash, Buffett would be 100% in stocks if his time frame was 20 years. However, they believe future returns will be tempered. They do not have high expectations for equities over the next 20 years but, equities will earn more than the 4.75% you will receive from bonds. There will be a severe dislocation at some time. It does not believe in traditional asset allocation, i.e. 60% equities, 30% bonds and 10% cash. You should invest entirely in stocks, bonds or cash. According to Charlie, opportunity cost is what you want to base your investment decisions on.

Their silver trade
“I bought it too early, I sold it too early. Other than that, it was a perfect trade. That shows you how much we know about silver. I’m flattered you asked because no one asks us our opinion on silver anymore.” Commodity prices are determined by supply and demand, not conspiracy theories.

Asset size and investment strategy
If he were working with a small fund, he would be investing totally differently. According to Charlie Munger, the area where you should look for investment ideas when you are young is in inefficient markets.

Subprime mortgages
If unemployment doesn’t rise significantly and if interest rates don’t go up very much, the subprime market will not have a broad effect on the economy.

Real Estate
In some parts of the country, it will take a few years before the real estate market rights itself.

Managed futures
Berkshire would not limit itself to such a narrow product, or any such narrow products. Products like this are created to be sold to the public. Charlie Munger stated that the annual return would be from lousy to negative, and Warren agreed.

Volatility as a measure of risk
Volatility is not a measure of risk. The people who teach risk in universities do not understand risk. Beta does not measure risk. Warren gave the example of farmland in Nebraska in the early 1980s, which he purchased at $600 an acre. Two years earlier, it was selling for $2000 an acre. However, when farmland was selling at $2000 an acre, its beta was lower. Thus, according to financial theory, farmland was less risky at $2000 an acre than it was at $600 an acre. Volatility as a measure of risk is nonsense.

Volatility arises from certain types of businesses and not knowing what you are doing. Using volatility as a measure of risk was useful for people who wanted a career in teaching. According to Charlie, 50% of financial theory as taught in universities is “twaddle.” Very smart people do very dumb things. They want to know who those people are and avoid them. People who talk about volatility being an accurate reflection of risk are crazy. You would have to believe in the tooth fairy to believe that Gaussian equations are a measure of risk in capital markets.

Investing and meeting management
When buying marketable securities, they will invest without meeting management. They will read a lot, particularly annual reports, industry reports, etc. When they receive dishonest messages in the corporate literature, they avoid those companies. If consultants or PR firms write the message, "why invest with someone who is responsible with your capital but won’t talk to you once a year," then they will meet with management before they buy a whole company. A good business can override bad management.

Hedge fund fees
They are very suspicious of people who overcharge their clients simply because it can.

Heroes
According to Charlie Munger, “You are not restricted to picking living people as your heroes. Some of the best people are dead.”

Ethanol
Charlie Munger stated: “I think the idea of running cars on ethanol in one of the dumbest ideas I’ve ever heard,” and “I’m a Nebraskan to the core, but this isn’t my state’s finest moment.”

Railroads
The competitive position of the railroads has improved over the past 20-25 years. Rising fuel prices hurt the truckers four times more than the rails. There is not much capacity coming on. It was a terrible business 30 years ago when it was regulated, but now it is getting better. It will never be a great business but returns on capital are improving as it requires a lot of CAPEX.

At 3:15, Berkshire had put aside time to deal with a proxy issue regarding Petro-China’s involvement in Sudan. Even though the SEC did not require the proxy be tabled, Buffett chose to put it on the agenda so that the dissidents could express their concerns, once again demonstrating Buffett’s class. Could you imagine Bob Nardelli doing the same at a Home Depot annual meeting? I wanted to stay and listen to the debate, but I had a plane to catch.

Comments

[jorge.lobl]

Thank you for these brief but concise insights. Hope you caught your plane. You are lucky Dave is such a good friend..... maybe he did not have a plane to catch and he would be so kind and brief you (and us) on the Petro China debate ?

And you are so right about Mr. Buffet .. if we had a few Presidents, Prime Ministers and others like him, what a different world we would have!!! I have great admiration for him.
Jorge

[TAK]

I was present at the meeting in 2007. I wanted to make one point of clarification on his response to the question about hedge fund fees.
While Mr. Buffet has historically railed against aggregious fees in the industry - he made a very specific and important departure from his normal "script" when answering this question last April.
At the 2007 meeting, Mr. Buffet took a slightly softer stance than normal on the issue of fees. He proposed that one look at returns NET of all fees charged by the manager. If those net returns were consistent with a mandate set by the client, and were managed by (in his words) "good stewards of capital" - then the fee in those returns was probably justified.
I believe this is one of the best responses to the fee question I have heard in a while.