7) You and Charlie Munger believe that the easiest person in the world to fool is yourself. Have you been fooling yourself by remaining committed to certain buy and hold doctrines, especially considering they are alluring because you have to work less since good investments work for you.
People believe what they want to believe. Everyone rationalizes their actions. A partner like Charlie can point it out to me. If we have a strength, it is that we think things through and we have the advantage of having each other. We are not influenced by other people. Charlie would say we are successful because we are rational and do our own work.
Paraphrasing Keynes’, “The difficulty lies not in the new ideas but in escaping from the old ones,” Mr. Buffett remarked: The problem is not holding onto the new [ideas]. The problem is escaping from the old. Darwin claimed he had to write down new ideas constantly. His mind would race to find new ideas. But if he did not write down his new findings within 30 minutes his subconscious would wipe them out and revert to old beliefs.
8) What do you believe is the top thing that will affect our great country’s competitiveness in the future and what would you advise be done to address it? (can follow up with health care and social security/pension gap)
One of the biggest problems facing the country is weapons of mass destruction. But there isn’t much that can be done about the problem (there will always be terrorists).
The trade deficit, of which current account deficit accounts for 90%, is the biggest economic problem facing the U.S. It is very complicated and not covered sufficiently in the debate. Social security and Healthcare are two issues tied in with the issue of the trade deficit. When there is no trade deficit, there is no net holding by foreigners. Currently government redistributes 22% of the US output to social security and healthcare. And these issues are eternal intra-family political squabbles over the redistribution between those who are producing and those who are not producing? Trade Deficit is a transfer of ownership or IOU on converted ownership, representing $1.8BN of outflow to foreign countries. It can’t be easily addressed. If the trade deficit continues at the current rate for the next 6-10 years, foreigners will have a permanent call on 3% of the output.
Can we afford this? Potentially yes. Foreign aid administered after the Marshall Plan post-WWII can be appropriate. However this is an accumulated burden to be paid by future generations because their “parents” didn’t want to pay for it. This could play a significant factor in future financial market disruption. “When someone fires in the theater on the stage” with significant amount of assets held by foreigners, along with other things happening at the same time, the trade deficit could be the #1 problem in the next financial event.
On healthcare, you have to rationalize healthcare demand when healthcare costs become higher and higher. The demand structure under the current system is not sustainable. We need to reframe some of the expectations of people and reframe what is the appropriate level of healthcare provisions. For example: Should we keep everyone alive for their last 3-6 months? Should people get the maximum amount of care to keep healthy? Government needs to ration it through government policy and people’s willingness to wait.
9) Is there a significant portion of the value you generate from the portfolio derived through active investment (e.g., influence on management decision, etc.) If so, what do you think of the role and probability of long-term success of an investment manager with little influence over management decisions, i.e, a passive investor? Has passive investing lost some of its appeal for you because you have been personally disappointed with the management of major American corporations? If so, what implications does that have for America?
In short, Charlie and I do not and should not have a significant impact on the management of our companies. You would be surprised how little impact we have on management. They [CEOs] all have different batting stances and know what style works for them. There would be no point for us to tell them to alter their stance as you can still be a good hitter even if you stand different to the next man – we hire them as they are good hitters.
In terms of our influence on the CEO’s of our public holdings – we are “toothless tigers”. We do not control the company and do never threaten to sell our stakes if our advice is not taken, therefore we are very much toothless tigers. We are holders of the stock for the long-term and therefore do not gain from short-term increases in the price. Moreover, we actually prefer for the price to go down in the near term so we can buy more stock and increase our stake in the company. However, the disclosure rules make it increasingly difficult for us to build up stakes in companies. For instance, we rarely invest in the UK as there is a 3% disclosure rule so we can not build a meaningful stake before it becomes public. So historically, we performed much better when the disclosure requirements were less stringent and they have been increased steadily over time. Our investment in PetroChina was another example of disclosure rules costing us hundreds of millions of dollars. We had to announce our ownership at a 1% level, after which the price shot up.
Stockholders should be able to think and behave like owners. The three things that a shareholder in a public company should focus on are: do you have the right CEO? does she/he overreach? are they too focused on acquisitions or empire building and stop thinking on a per share basis? Institutional owners need to focus on these three aspects.
Both Charlie and I say we would make a lot more money if we were anonymous. You’d be surprised how little impact we have on management. They’re all different individuals with their own egos, money, and even control. You’d be surprised how much we don’t steer them. We have very little influence on their investments, but it doesn’t matter because we don’t buy and sell. We don’t gain anything from the stock price going up. Piggybacking doesn’t do much.
It’s a big minus to operate in a public arena where people are not likely to follow. I still have 99% of my net worth in Berkshire, but I try to buy some on my own anonymously — I do much better that way.
We ask for confidential treatment in some areas, but the SEC doesn’t allow that often. Passive investor role: big institutional owners should act and behave like owners. The big thing to worry about is whether the company has the right CEO and if it does, does the CEO overreach even if he’s a good manager? The only people who can stop that are the directors and owners…and the directors will only stop it if the owners make a case. CEOs will sometimes do things uneconomic to satisfy primal urges. My instinct is that the institutional investors behave better than they did 10 years ago.
10) I am also from Omaha. When I tell people at school about your frugal financial approach, they are stunned. What is your specific philosophy about wealth? And how do you think this discipline has contributed to your success running Berkshire?
Mr. Buffett feels he was lucky to be born in the US (he won the ovarian lottery). He believes that he’s wired in a way that works well in a capitalistic society: he has the innate ability to allocate money. He believes that society has enabled him to earn this money and so he believes that the money should go back to society eventually. He believes in a graduated income tax. Society has contributed to his wealth so they should benefit.
He discussed the effect wealth has on an individual and the effect it has had on his life: It means that he can do whatever he wants to do. He has the luxury to make choices. But, he has no desire to be a greenskeeper- to own a 20 acre property which requires him to devote time to organizing and maintaining it. Further, spending the next 4yrs building a house doesn’t appeal to him. He won’t find a house where he’d be happier than the one he’s live in since ’58-59. He has no interest in owning a large yacht- he views this as more of a hassle than anything else. He prefers to use his wealth to do what he wants to do with the people he wants to do it with. He likes his life. He likes the people he works with- nobody has left Berkshire voluntarily in 15 yrs. He won’t buy a business owned by someone he doesn’t like.
If one were to ask Charlie why they were successful, he would respond that it was due to “rational decision making” and being able to not depend and focus on what someone else thinks is important. Also stressed that he was very lucky to be born in the country that he was. Likened it to a lottery with a 1 in 50 chance. This is because he is “wired in a way to be very effective” in a large economy where capital allocation skills are needed and highly rewarded. He illustrated the counter example with a quote from Gates saying that if he were born a few thousand years earlier he “would be an animal’s lunch”.
As for the trappings of wealth, he believes he already lives the life he wants to live. He cautioned against backing into certain behaviors simply because that was what other rich people do. For example, he does not want to own a large boat as he simply does not derive enough utility out of it to justify the bother that would entail from owning and maintaining one. As it stands, he does benefit from his wealth in that he has the “ultimate luxury”, that is to do what he wants to do everyday and he’s having more fun than most 74 year olds. He doesn’t want to build a bigger house and he gets to work with people he likes. Apparently, they like him too as none of the 18 people who work with him at Berk HQ has left in 15 years. He also will not do a deal simply for the money as it would be as perverse as someone already very wealthy marrying for the money. What money has ultimately given him is the power to choose because the luxury to choose is what being wealthy is all about.
Mr. Buffett continued and discussed the middleweight boxing match he watched on PPV at $54.95. He didn’t think twice about the cost of it. He talked about how in the not too distant past the fight would have been limited to people at Madison Square Garden whereas the boxers there stood to gain the benefit from an audience of millions because of what society as a whole has enabled. Therefore he is, and he believes so should the boxers, be in favor of progressive taxes. That is they are able to make extraordinary incomes because of society and should be willing to contribute a greater share to maintaining it.
11) It is clear that you would never resort to earnings smoothing etc for Berkshire. But you do sell insurance products that have helped other companies smooth their earnings, or at least make their problems look less severe. Is there a contradiction in this?
The whole idea of insurance is that you pay a premium each year to protect for a disaster every 20 years. The nature of the product is smoothing earnings. You personally do this with your auto insurance. You pay $400 (or $350 if you call Geico!) to protect yourself. Sometimes companies have used it incorrectly, but this is not inherent in the insurance product. If you get into “no risk transfer” deals with insurance you can get called on it. Berkshire Hathaway has written the two biggest retroactive insurance deals. One when White Mountain bought One Beacon and the other when ACE bought Cigna. Each paid ~$1.5 billion to reduce charges for old bad cases. Berkshire Hathaway was much better equipped to handle the risk than ACE or White Mountain (who were both stretching to pay for the deals). All of our policies are finite. There have been some cases of policies with zero risk transfer in the U.S., but they were very limited in the last five years because auditors must now sign off that there is adequate risk transfer and it is not just for accounting purposes. Generally, there is an understanding and a long relationship between the primary insurer and the reinsurer. If the reinsurer gets killed, the primary does not take the business elsewhere. They just build that experience into next year’s quote. This is less prevalent now because it is less client orientated and more transaction oriented because of the introduction of brokers. There is no more relationship development, just a focus on the lowest price.
12) At our investment management conference a few weeks ago, one panel featured the CIOs from Barclays Global Investors, State Street and Vanguard, and we collectively discussed the use of derivatives in modern portfolio management. We understand you dealt with unknown exposures in a past acquisition, but wonder if you think in this environment certain institutions have the risk control and discipline to use derivatives to effectively mitigate their risks.
Berkshire uses derivatives. There is nothing evil about them per se. It is very hard to control risks without derivatives. But all mismarks on contracts are in the trader’s favor, never our favor. These days, there is no money in plain vanilla stuff – the margins are too squeezed – so you get people writing very sophisticated derivatives.
Berkshire is still unwinding many of its positions. General Re had 23,000 contracts 3 yrs ago and 3000 are left. Derivatives are very tough for management. In situations like 9/11, with losses of unknown magnitude, anyone with big equity and big derivatives portfolio (when you don’t know what’s behind the derivatives) is in trouble. A big downgrade on the company would have followed with margin postings, etc. – trouble…
Another issue with derivatives is that the incentives of the guy writing the derivates are not aligned with the company. For example. one of the highest paid guys at Gen Re was the guy that wrote complicated contracts – and those contracts were not necessarily good for the company. Finally, the problem with large derivatives portfolios is that they tend to be directly related to equity positions that company has. This interdependence means that billions of dollars on your balance sheet are dependent on others performance (other equity performance) – not on your own company performance.
“Derivatives are like AIDS – its not who you slept with, but who they slept with”
Go to Part 1 , Part 2 , Part 3