Wesco 2003 Annual Meeting

Charlie Munger, Pasadena CA

*** OPENING COMMENTS ***

This group is the hard core cultists. Most have actually been to the Berkshire meeting [last Saturday], sat through hours and hours of questions, and now here they are again. Some are doing it with other people's money, but many are doing it with their own money. If you've traveled this far, you're hard core.

Why do people come? Partly, I'm sure out of respect for the long-term record of compounding money at high rates. But also there's the cast of mind that helped create the record. I'm very sympathetic to people who share our twists of mind. If you're Warren Buffett and Charlie Munger, you're lonely. The whole of academia, business and economics believe a lot of things we don't believe at all, and conversely don't believe a lot of things we do believe.

Critique of the Efficient Market Theory and Institutional Money Managers

They used to criticize us bitterly, but stopped doing that when criticized by their heirs[?]. There's a world in academia where markets are perfectly efficient, where nobody knows if one company is better than another at any time, where value is dictated based on price. Then, it can never make any sense for a company to buy back its own stock. But if you say, "I can point to you many situations in which a stock was selling for 1/5th of its value, so why shouldn't a company buy it back?", some purists still won't change their minds. A corollary of this says that you can never find a price that is rational to buy a stock that you know a lot about.

It makes it hard for Warren and I to go on every year. We don't really care actually. [Laughter] In what other profession do the leading practitioners differ so much from the leading theorists? [Laughter] Hopefully this is not true in surgery, engineering and so forth.

Institutional money managers hire consultants who hire other consultants. They put money in venture capital, little companies, big ones, growth, value, etc. One thing that's sure is that at the end of the year, you've spent a lot on the consultants and frictional costs. Berkshire and Wesco never have and never will [behave this way].

20 Punches

Warren said at the Berkshire meeting (or maybe it was to the press afterward?), that he often tells business school students that if he gave them a card that only had 20 punches for a lifetime, and each time they made an investment they would use up one punch, and that after 20 punches there would be no more, then on average, with those rules, you'll die a lot richer. But people can't grasp this; they don't know what to make of it. But I believe it's true -- you'll do better over a lifetime [following the 20-punch way of thinking], assuming you're a smart, disciplined person. This room is filled with people who followed that advice. But that is absolute apostasy in academia.

How many different things has Wesco done since Blue Chip Stamps? [A major acquisition that Wesco made under Munger and Buffett's leadership in the 1970s.] We've only bought two or three companies and made a few big stock purchases. We've probably made a significant decision every two years. But nobody manages money this way. For one thing, clients won't want to pay you. [Laughter]

But our theory is that getting a real chance to invest at rates way better than average is not all that easy. I'm not saying it's not moderately easy to beat the indices by half a percentage point every year, but the moment you seek higher returns, is a very rarified achievement. The only way we know how to do this is to make relatively few investments of size.

What you can know if that if you spread your capital over a large number of securities, this will lead to average returns. Why anyone would pay a lot of money to learn what is so obvious is beyond me. [Laughter] I'm serious, people get paid to teach this! [Laughter]

It's not so bad to have one's money scattered over three wonderful investments. Suppose you were a real estate investor with a 1/3 interest in the best apartment complex in town, the best mall, and the best [I missed what he said -- another type of real estate investment]. Would you feel like a poor, undiversified investor? No! But as soon as you get into stocks, people feel this way. Partly, people need to justify their fees.

Envy is a Really Stupid Sin

Then there's the chasing of the investment return rabbit. What if you had an investment that you were confident would return 12% per annum. A lot of you wouldn't like that -- especially if you've done better -- but many would say, "I don't care if someone else makes money faster." The idea of caring that someone is making money faster [than you are] is one of the deadly sins. Envy is a really stupid sin because it's the only one you could never possibly have any fun at. [Laughter] There's a lot of pain and no fun. Why would you want to get on that trolley? [Laughter]

Options and Circle of Competency

We have a theory that you go through life in an orderly way. It gives us extra options. There's an obvious doctrine in life that all individuals and companies have to make decisions based on opportunity costs -- that's how all people make decisions. If you're married, you can keep [your spouse] but you always have the option to say, "I can do better elsewhere." Now you don't say this… [Laughter]

Most people have options: what job to take, school to go to, and so forth. One should measure investment opportunities this way. The more attractive things are, the higher the bar is. Berkshire has raised the opportunity bar by looking at stocks, bonds, private companies, public companies, etc. We have more opportunities by operating in a wider range.

The danger is that you have more risk of operating outside of your circle of competency. I don't think we're ever gone outside our circle of competency. We find things across a fairly wide range that we think is within our circle of competency. If you can widen your range and broaden your circle of competency, then you'll be a better investor.

Focus Investing

I remember when Warren was buying American Express when the company was suffering from a scandal [the 1963 Salad Oil Scandal]. Warren said to me, "I can't find anything else that's nearly as attractive." So, he asked his partners [this was before Berkshire, when he was managing the Buffett Partnership] to change the partnership agreement [which, I assume, prevented him from putting too much of the partnership into one position] and put 40% of his capital into American Express. When was the last time you saw a mutual fund do this [I'm not sure if he meant investing so heavily in one stock, or changing the contract with investors to take advantage of an opportunity]? It happens, but it's rare. To me, it's the most ordinary common sense, but it's not the most conventional wisdom of the time.

I know value investors who [I missed this]. There's a graduate of Stanford Business School who can compound money at 25% per annum so why does he need to invest other people's money, and he's now a very rich man. Warren operated out of a sun porch [in his house] for years.

Unattractive Investment Environment

At Wesco, we're in a state of arrest. We have way more capital than we're using. We have some investments in bonds that went up $20 or $30 million [over the past year], but this is not fun, watching and waiting, for people who have an action bias. Too much action bias is dangerous [however], especially if you're already rich.

In terms of the general climate, I think it's pretty miserable for anyone who likes easy, sure money. Common stocks may be reasonably fairly valued, but they are not overwhelming bargains. Interest rates are really low. When you get five-year rates under 3%, it starts getting really unpleasant for people who are used to better results. But I don't think this is a tragedy. If things get really bad, like Japan, then things will be very unpleasant. Think of how you'd like to run a big university under those circumstances. I don't think that will happen here -- I think we're a better place in terms of investing.

But the world can throw you a lot of surprises. Who would have predicted the World Trade Center, interest rates where they are, life insurers in Japan insolvent because they agreed to pay 3% interest per annum.

A New Way to Measure Returns

Think of professional money management. A typical fund might do well, the money comes in, and then there's a big collapse. If you took into account the negative results at the end, with the big money in the fund, the overall result would be negative. If I were running the world, I'd require all people running mutual funds and investment funds to report results in two ways: the current way and per dollar year. The big funds would really look terrible because they took in really a lot of money and then collapsed. If you took venture capital, which did well with a small amount of capital, and then took in a huge amount of capital [and lost most of it], they'd have trouble shaving in the morning.

[To understand what Munger is talking about, consider a fund with $100 that has a spectacular year and doubles to $200, a 100% return. Money of course pours in (let's say $800), chasing this performance, such that the fund grows from $200 to $1,000. Then, the fund falls by 50% the next year to $500. The fund's IRR (internal rate of return) is 0% (a +100% year followed by a -50% year), yet investors have lost a massive amount of capital: a $100 gain in the first year, followed by a $500 loss in the second year.]


*** COMMENTS ON BERKSHIRE HATHAWAY ***

Berkshire Without Buffett

I said to my fellow directors of Berkshire quite recently, when we were discussing Berkshire in his [Buffett's] absence, "It's hard to believe that he's getting better with each passing year." It won't go on forever, but Warren is actually improving. It's remarkable: most almost-72-year-old men are not improving, but Warren is.

If he were gone, we couldn't invest the money as well as Warren, but the place is drowning in money -- we have great business pounding out money. If the stock went down, Berkshire could buy it back. There's no reason to think it will go to hell in a bucket, and I think there's reason to believe it could go on quite well. The people at MidAmerican Energy are quite formidable. I'd be horrified if it isn't bigger and better over time, even after Warren dies. And I can't imagine Ajit not being one of the jewels of the insurance business in the world as far as the eye can see.

If your problem is that eventually all things crest, then you're right. The loss of dominance rate is 100%. Every great civilization that was dominant eventually passed the baton. Similarly, the greatest companies of yore are not the great companies of hence. I like looking back and seeing who would have predicted what happened to [formerly great companies like] Kodak, Sears and General Motors.

Sure, vicissitudes come to all places, but I think Berkshire is structured so that it's unlikely to fall back the way GM has. GM basically transferred the enterprise value to the employees instead of the shareholders. That is not the Berkshire culture. We want employees to be esteemed, get rich and enjoy life, but we're not in business of deliberately transferring the company from shareholders to employees.

At GM, they tried to get by each year without a calamity [e.g., a strike] by giving [whichever union whose contract was due for renegotiation] a lot, which they then had to give to the other unions. Do this over 40 years and at the end there's nothing left for shareholders. That's not the culture at Berkshire.

Will it ever fail? I suppose it will. [I believe he was referring to Berkshire, not GM, in the context of his earlier comment, "Every great civilization that was dominant eventually passed the baton."]

Berkshire and Wesco's Stock Prices Relative to Intrinsic Value

We like the stocks of both Berkshire and Wesco to trade within hailing distance of what we think of as intrinsic value. When it runs up, we try to talk it down. That's not at all common in Corporate America, but that's the way we act.

At Berkshire, there's been a deafening silence [on what we think of the stock price]. Berkshire is trading in a reasonable way given our environment and opportunities, which is why we've been silent. We are in no distress at all about the current value of the stock, and we're the type who feel uncomfortable if the stock gets too high or too low.

I have yet to see a shareholder who needs to get out not be able to sell it. So far, we haven't had any crisis of liquidity. If there were a crisis of liquidity, there's someone around who has plenty of liquidity. [E.g., Buffett/Berkshire] [Laughter]

There have been two times that my Berkshire stock holdings have fallen by more than 50%. So what? Warren has always said that if you're not prepared to experience a 50% quotational loss, you shouldn't be in stocks.

Intrinsic Value of Berkshire vs. Wesco

[He gave two explanations -- I missed them -- and concluded:] Either way you calculate it, Berkshire has way more value per dollar of book value [than Wesco].

Berkshire's Advantages in Super Cat Insurance Underwriting

If it could easily be done, just by manipulating rules of statistics, like life insurance, then everyone would have done it and there wouldn't be much profit in it. But what you point out -- what everyone doesn't like about it -- is what we like about it. For example, there have been lots of earthquakes but the average actuary says that after 50 years without an earthquake, it means that one is now less likely. But we think that maybe pressure is building up, making it more likely not less. We try to take into account all of these factors.

There is a close collaboration between Warren and Ajit Jain. I've known both a long long time and if there are two better people on this earth to do this [super cat underwriting], I don't know who they are. We can't guarantee results, but they've done fine -- in fact, more than fine.

Sometimes they will do things where it's a straight Pascalian calculation -- the odds are x and we get paid at a rate that give us better odds than Las Vegas. The reason other people won't do it is because if they're wrong, it'll be a big money loss, but Berkshire can handle a big number loss. I'm quite comfortable watching those two people do it. I wish I could do it, but I can't. It's reasonable heuristics by two tough, sharp-minded men.

Event Arbitrage Investing and Berkshire's Junk Bond Investments in 2002

We haven't been doing much event arbitrage in recent years. In earlier years we did a fair amount, but now it's rare. The equivalent is we bought something around $10 billion of junk bonds last year, and $7 billion are left around. It's sort of similar to event arbitrage that Warren used to do in his earlier days. I don't think you'd find the recent records in event arbitrage are very good compared to the results we've had.

Warren calculated that over the past 60 years, if you combined Ben Graham's record and his, they generated returns of 20% per annum on event arbitrage. Ben Graham called them "Jewish Treasury Bills."

[Graham was Jewish. Here's the full story: When Buffett graduated from Columbia Business School, he offered to work for Graham at his investment firm, Graham-Newman, for free. Graham turned him down, even though Buffett was his only student to ever receive an A+ grade, because he only hired Jews. (This was not unusual at the time, as Wall Street had a number of all-Jewish firms to balance the many all-white, male, Christian firms.) Buffett returned to Omaha and worked as a stock broker (and occasionally wrote research reports on companies like GEICO) until Graham contacted him years later in 1954, after he had decided to open up the firm to non-Jews. Buffett took the job for two years, until Graham shuttered the firm in 1956, and then went back home to Omaha to open his own partnership. Incidentally, it was at Graham-Newman that Buffett met another legendary investor, Walter Schloss, who was also a junior analyst there.]

Now, that way of investing [event arbitrage] has gotten fashionable [today] because some money will be coming in even if world goes to hell in a hand basket. You can amuse yourself with that calculation as much as you want, but we tend not to do that. I suppose we could if the right opportunity came along. For one thing, its hard to do with a lot of capital.

The junk bonds are an interesting case. When we were buying [last year], the mutual [bond] funds were getting net redemptions and had to sell. Even under those conditions, we only got $8 or $10 billion invested. Now, the mutual funds have net inflows and you can't buy anything.

More on Bonds

Warren's doing most of the work on Berkshire's bond portfolio. I scarcely look at them.

We normally don't talk about what we are or aren't investing in, but I can't help saying that we don't own tobacco bonds. As for the WPPSS bonds, we bought every bond that traded, but we could only buy $300 million. It's hard to invest large sums of money.

[According to Of Permanent Value: The Story of Warren Buffett (a wonderful 1,490 page tome for true Berkshire junkies), "Buffett quietly bought $139 million worth of Projects 1, 2, and 3 of Washington Public Power Supply System bonds in 1983 and 1984…Buffett explained how WPPSS had defaulted on $2.2 billion worth of bonds issued to help finance Projects 4 and 5. That stigma stained other projects and Buffett was able to buy the bonds at a steep discount."]

Berkshire's SQUARZ deal in 2002

Warren has a big motor and there isn't enough going on at Berkshire with a tiny pile of assets and an insufficient number of large businesses [laughter] so when he sees a mispriced security, so he's willing to issue it. Personally, I wouldn't issue it. But it's one of Warren quirks. Remember the LIONS [a security Berkshire issued long ago]? We only have to put up with this every 20 years. To Warren, the appeal is that it could be done. I think the mere fact of borrowing money at a negative interest rate turned him on [because] not many people are able to do that. Just call it an intellectual quirk.

Berkshire's Acquisition Strategy

We've bought business after business because we admire the founders and what they've done with their lives. In almost all cases, they've stayed on and our expectations have not been disappointed.

Buying Stock vs. Entire Companies

We do both, but we get tax advantages by buying whole companies rather than stocks -- very significant ones. Also, if we buy a company, we can change management, dividend policy, etc. if we need to.

We'll pay more per share for 100% of a company than 3%, but practically everyone else will too.

Why Did Berkshire Bid for Burlington Industries?

That's very easy: Burlington has a segment that relates to Shaw. Shaw does flooring and carpets [so there's a part of Burlington that] would fit in nicely with Shaw. What wouldn't fit in, we were will to buy for the price we offered. It was a peculiar add-on thing. We haven't suddenly decided that textiles are the thing.

The judge was willing to have us give the company a put [for an inadequate fee]. In our world, puts are worth a lot of money. There was a perfectly reasonable judge, but we're perfectly reasonable too, so we walked.

A Change in Dividend Tax Policy Wouldn't Change Us

[At the Berkshire meeting, Warren did talk about dividends. It [making dividends tax-free] wouldn't change us. Our long-stated policy is that as long as we think that, over an extended period of time, we think we can create more than $1 of value for every $1 retained, then we'll retain it. If that changes, we'll shell it out.

Would Corporate America change if dividends could be distributed tax free? Sure. For one thing, people would think the law might change [and therefore rush to pay out dividends before they became taxable again].

Failing to Buy Wal-Mart Stock

Wal-Mart was an $8 billion sin. What happened is that we started to buy it and the price started to go up and we're naturally so cheap that we stopped buying. It's not $8 billion we lost, but $8 billion we didn't gain. We keep doing this. We haven't done this hundreds of times, but our sins of omission have cost us a lot in terms of opportunity. I wish I could tell you we won't do this again. We do find things to actually do and they tend to work out well. If we only could have been 5% smarter, our shareholders would be a lot better off.

Costco and Wal-Mart

Costco [Munger is on the Board] and Wal-Mart are two of the most admirable retailing operations in the history of the world. In fact, Wal-Mart has the best retailing record in the history of the world. It was started by a guy in his 40s and he hasn't been dead that long. There's a similar story at Costco. Costco would be worth a lot more money if there weren't any Wal-Mart [Laughter]. Sam Walton talked to Sol Price about buying what is now Costco, but those two titans never got together. We screwed up by not buying Wal-Mart stock, and Wal-Mart screwed up by not paying whatever price Sol Price wanted.

Future Relationship With Wal-Mart

Obviously based on past history, with Garan and McLane, we trust Wal-Mart. [Wal-Mart accounts for more than 85% of Garan's sales.] We admire Wal-Mart. How could you have a good value system and not admire Wal-Mart?

[When asked about Berkshire expanding its relationship with Wal-Mart to put Dairy Queens in Wal-Mart, sell GEICO insurance, knives, etc. through Wal-Mart, Munger replied:] I wouldn't get carried away with two transactions. Wal-Mart has perhaps the best buying systems on earth. They won't be buying from us because they like us. We wouldn't want it any other way. I wouldn't expect any fast flood of products into Wal-Mart.


*** COMMENTS ON BERKSHIRE HATHAWAY AND WESCO HOLDINGS ***

McLane

Obviously we like the manager [of McLane, Grady Rosier] a great deal, and obviously we trust Wal-Mart to stay with us as a major customer. Obviously we think it's a good buy at the price we paid. What more can I say? It's not some business that's going to grow at fantastic rates forever and ever, partly because one of its main products is tobacco. But we didn't pay for a business that's going to grow forever and ever. We like buying decent businesses at fair prices.

You should think of a business like McLane not as a normal merchandising business -- it's a logistics business like FedEx or UPS. It's a super-slick, super-efficient system for carrying out a logistics function. I think Wal-Mart sold it because they're the best in the world at retailing and they want to concentrate at what they're best at. I would too.

Clayton Homes

We wouldn't have bought Clayton Homes if the family members weren't there and weren't planning to remain. With reference to the price, the entire industry worked itself into a disastrous collapse with vast oversupply of used units, big financial losses, etc. Even Clayton has felt the effects of this calamity. We think Berkshire will help make Clayton stronger. We agree that Clayton is the jewel of the industry. We're buying at period of maximum distress. We think it's okay for Berkshire and okay for Clayton shareholders.

A lot of people wouldn't be interested because they can't stand taint. There's nothing wrong with Clayton, but the whole industry is tainted. We're willing to do things like that all of the time. Our triple A credit rating won't hurt Clayton [Laughter]. Everything you like about Clayton's culture -- does it seem that inconsistent with Berkshire's culture?

I've always felt that manufactured housing should have a bigger place in our society. It might morph into something different. Houses are built in many places in a very inefficient way.

CORT Business Services

CORT [which Wesco acquired in January 2000] has been clobbered by the big dot-com decline. The whole temporary office business in the country had a huge boom. Law firms, accounting firms, venture capital firms, etc. all expanded. When they went bust, rental firms went bust. In that business, we caught a big recession.

We're having a similar recession in NetJets in that used jets have gone down in price. CORT and NetJets are losing a lot of money. Do I think CORT is going to fail? No. Net Jets? No. There are vicissitudes in life. In fact, we're buying other furniture rental companies. Some people vote with their feet; we vote with our wallets. Was our timing great in buying CORT? No, it was terrible.

Asbestos and Berkshire's Investment in USG

Obviously, so far at least, USG has not been one of our happiest moments. Everyone in American has underestimated how much asbestos could cost. One reason is that an awful lot of money goes to people who haven't been hurt -- way more than half goes to lawyers and experts and those who haven't been hurt. They [the country] did it a lot better when they had [a settlement] for black lung [disease] for coal miners. They simply put a tax on coal and all the money didn't go to lawyers and people who weren't sick.

In my judgment, the common stock of USG won't go to zero, but how well it will work out on the plus side, from zero to infinity, I'll leave you to figure out.

Won't Talk About Investments

[When asked to comment on Berkshire's investment in Mueller Industries (NYSE: MLI; a manufacturer of brass, copper, plastic and aluminum products; Mueller also owns a short-line railroad and various natural resource properties in the western United States), Munger replied:] We ordinarily don't talk about the reasons for making particular investments. We don't want people following us into particular stocks. It's sort of like asking, "What are you buying tomorrow?" We tend not to answer those questions.


*** INVESTMENT ADVICE ***

Attractive Investment Opportunities Tend to Be Ephemeral

A lot of opportunities in life tend to last a short while, due to some temporary inefficiency. If you're Berkshire, you can get a few billion dollars out, but most institutions would miss it -- they would have to meet with trustees, lawyers, etc. By the time they were done, they'd have missed it. In this environment, you have to be present and ready to act. Look at some of our recent acquisitions. They faced default and needed money by Monday, and it was Friday afternoon. It was an ephemeral opportunity. For each of us, really good investment opportunities aren't going to come along too often and won't last too long, so you've got to be ready to act and have a prepared mind.

Cigar-Butt Investing and the Value of Meeting With Management

I don't think Warren would think it [cigar-butt investing] was useless -- he just doesn't want to do it. [Laughter] And he trained under Ben Graham, who said, "Just look at the facts. You might lose an occasional valuable insight, but you won't get misled." If you sit down and talk to the key manager for an hour and you're a smart person, I think that could be a significant plus. But a smart person might be right 60% of the time and, for the balance, be misled. If you have some specific questions that the management is going to answer, obviously that would be helpful.

Warren reads a lot of what people have written. He just doesn't want to do it [spend a lot of time talking to managements]. There's a good argument that at a certain level of skill, you're better off without it, especially if you're Warren Buffett. But even he finds it helpful.

I remember a few years ago, Warren met with a CEO and afterward said he thought the CEO wasn't very shareholder friendly and was the biggest horse's ass. So we didn't invest and the stock compounded at 15% per annum for 20 years.

Views on Ben Graham's Ideas

The idea of a margin of safety, a Graham precept, will never be obsolete. The idea of making the market your servant will never be obsolete. The idea of being objective and dispassionate will never be obsolete. So Graham had a lot of wonderful ideas. Warren worshipped Graham. He got rich, starting essentially from zero, following in the footsteps of Graham.

I liked Graham, and he always interested and amused me. But I never had the worship for buying the stocks he did. So I don't have the worship for that Warren does. I picked up the ideas, but discarded the practices that didn't suit me. I don't want to own bad businesses run by people I don't like and say, "no matter how horrible this is to watch, it [the stock] will bounce by 25%." I'm not temperamentally attracted to it.

[For more on Graham, read his classics: The Intelligent Investor [the single greatest book on investing, in my opinion] and Security Analysis. Another book I recommend on Graham is The Rediscovered Benjamin Graham. Finally, my friend Rich Rockwood wrote a nice piece on Graham's thinking recently, Invest the Buffett Way.]

Deworsification and Circle of Competence

95% of American managements, the minute they get out of their chosen activities, why shouldn't they just slaughter themselves? I think most managements are nice people, but their general powers of capital allocation are inadequate. And the people advising them, the investment bankers, etc., they will mislead you 95% of the time. The consequences for the utilities that tried to diversity were lethal.

Why are we different? We're working harder at trying to be rational. If you don't work hard at it, and just float along, you will fall victim to the folly of the crowd -- and there will always be folly of the crowd. I wish people would learn more from this than I think they will.

A Shareholder Case Study

[A shareholder stood up and said he first discovered Buffett and Munger and bought Wesco stock in 1984, and kept buying more -- and also added Berkshire stock -- despite Munger talking down Wesco all the time. Munger replied:] If I was steering you toward Berkshire rather than Wesco, then I hope I didn't hurt you. [Laughter]

The man who just spoke is teaching by providing an example of what I was talking about earlier. Here's a guy who is acting like he has 20 punches in life. He likes these guys [Buffett and Munger], gets to know them better, doesn't ask a consultant if he should buy a burlap bag manufacturer in India -- he just kept buying what he knows and has confidence in.

[Munger then asked the shareholder:] How many investments have you made in which you had as much confidence as you had in us?

Shareholder: "Maybe 10."

Munger: "A typical rich shareholder, which means he probably doesn't have a chauffer."

Shareholder: "I drive a '94 Buick."

Munger: "They won't teach this in all of the finance departments. Maybe you should give all of the money back." [Laughter]

Investing Taught at Business Schools

There are a handful of business school professors who teach investing properly. Jack McDonald of Stanford Business School, for one. He comes to the Berkshire meetings. I've taught in his class and Warren has come to his class. There are others.

Reforming academia, except accidentally by having a view that catches on, isn't something I try. It's amazing how difficult it is to change ideas, no matter how wrong they are.

Neither Warren nor I has ever thought for two seconds about beta. But every business school teaches this [concept]. Maybe if we had a few more hundreds of billions of dollars, people would pay attention to us. [Laughter]

Competitive Threat from China

If you're in any business of a manufacturing nature that China can do well, after you consider transport, then you're in the crosshairs of a very formidable opponent.

Why didn't we recognize this with the shoe business? Well, as a German philosopher once said, "Too soon old and too late smart."

Comments on Philip Fisher

Phil Fisher believed in concentrated investing and knowing a lot about your companies -- it's in our playbook, which is partly because we learned from him.

[For more on Fisher, I recommend his books: Common Stocks and Uncommon Profits [one of the all-time great books on investing, in my opinion], Conservative Investors Sleep Well, and Developing an Investment Philosophy.]

Recommended Reading for Investors

I think the business publications, beAlign Centercause they digest so much so well, are a good resource. There's a lot of brainpower on the staffs of Fortune, Forbes and The Wall Street Journal.


*** RISKS IN THE FINANCIAL SYSTEM ***

Derivatives

It's easy to see [the dangers] when you talk about [what happened with] the energy derivatives -- they were kerflooey. When they [the companies] reached for the assets that were on their books, the money wasn't there. When it comes to financial assets, we haven't had any such denouement and the accounting hasn't changed, so the denouement is ahead of us.

We tried to sell Gen Re's derivatives operation and couldn't, so we started liquidating it. We had to take big markdowns. I would confidently predict that most of the derivative books of [this country's] major banks cannot be liquidated for anything like what they're carried on the books at. When the denouement will happen and how severe it will be, I don't know. But I fear the consequences could be fearsome. I think there are major problems, worse than in the energy field, and look at the destruction there.

Consumer Credit

Consumer credit has been a gold mine -- it's like selling heroin to addicts. There are a lot of fiscalaholics [a new Mungerism] who will probably find some way to pay their bills. Some banks understood this and made a great deal of money.

What I said last year was that it made me nervous, that constant pushing of consumer credit. I didn't say when [a blow-up might occur], but it still makes me nervous.


*** COMMENTS ON OTHER ECONOMIC MATTERS ***

The Banking Industry, Past and Future

The banking industry has been a gold mine. I think Warren and I blew it -- we should have invested a lot of money in banks. While we did well in it, we should have been heavier in it. The amount of money made in banking has been awesome. And [this despite the fact that] the people who made the money -- how shall I say it -- have been moderately skillful. [Laughter] [I think he said something here about one being able to make a lot of money in banking even if one is "a perfect ass."] [Bankers have been like] a duck sitting on a pond and they raised the pond. By borrowing short and lending long, one can make a lot of money. It's so easy that people are tempted to do more and more.

Can it go on forever? A wise economist once said, "If a thing can't go on forever, it will eventually stop." My guess is that the extremes are over. Banking has been a marvelous business, but I wouldn't think it would continue to get better and better and it might even get a lot worse.

Pension Fund Consultants

I'm glad you asked, as it gives me a chance to talk about a deeper reality. [Laughter] Let's compare pension fund consulting with bass fishing. You can go on the bass fish tour and catch bass and get prizes. Or you can go into the business of selling tackle and giving advice to bass fisherman. They are two different businesses. The people who choose the latter wouldn't be very good at catching bass. That's how Warren and I view things. We want to win the bass fishing tour, whereas pension fund consultants sell tackle. We're not interested in selling tackle, we're interested in catching bass.

Housing Boom

We've had a boom in housing that has been almost unprecedented in the country, and it keeps going on despite setbacks in certain places. It's partly due to interest rates being so low, and partly because everyone who previously bought [houses] did so well. But in some places, like Silicon Valley, prices got so high that they've come down. I don't know a lot about the housing price market. I wouldn't have predicted that a little house in Palo Alto would be worth $3.5 million. It took a good educational system and being amidst the Silicon Valley boom.

Having failed to predict accurately [what would happen in the housing industry] in the past, I don't know why, based on a clear lack of competency, why I should predict anything now. Ordinarily, [my advice is to] buy housing when you need it, and don't try to time the market.

*** ADVICE ON LIFE AND OTHER (MUNGER'S WORLDLY WISDOM) ***

Approach to Life

We've tried to do that [convey our philosophy] in everything we've ever done and said. But you can't say: "Please dispense all wisdom in one sentence." We're just not up to it. Other people have tried. If you want it short, try Buddha, who said: "I only teach one thing: I teach the cause of human sorrow and how to avoid some of it." (This isn't word for word, but some of it.)

That's my approach: Go around figuring out what doesn't work and then avoid it -- and when you get the sorrow, how to handle it. I think this is a very rational approach to the human condition. If you want to avoid sorrow, you gotta know the cause of sorrow. There are certain ways of improving life that have a certain outcome.

If it's trite, it's right. That's not totally true, but mostly true.

How to Get Rich

We get these questions a lot from the enterprising young. It's a very intelligent question: you look at some old guy who's rich and you ask, "how can I become like you, except faster?" [Laugher] My answer is that I did it slowly, inch by inch, taking losses mentally when they occurred. If you want to do it with fast rapidity, then you're talking to the wrong man, but I know my way works.

If you don't just want to play tiddlywinks, I say welcome to the pool. Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. You may not need Zsa Zsa Gabor or a Lamborghini or a lot of other things you think you need now. Slug it out one inch at a time, day by day, at the end of the day -- if you live long enough -- most people get what they deserve.

It's so simple. What's the best way to get a good spouse? The best single way is to deserve a good spouse because a good spouse is by definition not nuts. [Laughter] It's the same with the responsibilities in life.

Iraq and Afghanistan

As for Iraq and Afghanistan, your guess is as good as mine. But I will say that it's very easy to shrink from something unpleasant and conclude we don't really need it. At least I admire the ability to suffer now in the hopes of making something better. I'm skeptical of the approach that never finds it necessary to suffer now to make it better. There's a lot to be said to seeking ways to suffer now to make things better. That's the way it is in investing -- sacrifice now in the hopes of something better. Now whether it will actually turn out better [in the Middle East], your guess is as good as mine, but I kind of like the fact that we tried.

[For more on this, see my two columns, Iraq and Investing and Weathering Iraq's Storm.]

Don't Change the Dividend Tax Policy

I think in a democracy, you have to kind of work to keep appearances not too unfair. The way to do this is to keep the reality not too unfair. I think that to some cab driver working seven days a week and paying taxes at a 40% rate, that someone at the country club paying zero tax would be unacceptable. Look what happened when American Airlines executives took part of their compensation and made it secure. The resentment among the workers, who were being asked to sacrifice, was overwhelming -- and I think rightly so.

I think if you make it [e.g., become wealthy], then you have a duty not to mess up the system. I think Corporate American has been terrible at setting an example. If you rise in life, you have to behave in certain way. You can go to a strip club if you're a beer-swilling sand shoveler, but if you're the Bishop of Boston, you shouldn't go. [Laughter]

Opinion on a Temporary Wealth Tax

The wealth tax has existed in the past. For example, immediately after WW II, to recover from the war, Germany instituted a temporary wealth tax and people cheerfully paid it. In this country, I think that once people got accustomed to it, it would stay [e.g., politicians would make it permanent].

Estate Taxes

I like the idea of retaining gift and death taxes, but as for the guy who builds up a good business worth $5 million and wants to pass it to his children, I think the death tax should be zero. But for people who really strike it big, I think there should be an intergenerational tax.

Intergenerational Tensions

If the growth rate of the country goes to zero, then of course we'll have intergenerational tensions. If it continues to grow at 2% -- per capita real growth of 2% per annum -- then we won't, and Social Security will be okay.

Don't Invest Part of Social Security in Stocks

People grew accustomed to stocks doing well. A lot of people behind these schemes thought stocks would yield very high returns over a long period of time. I don't have any gospel from god that stocks will yield 8-10% real returns over a long period. But I do have faith that if government gets involved, it will gum it up. I don't want trustees appointed by the government voting shares of the common stocks in America. Leave it well enough alone.

Common stocks are valued in 2 ways: 1) rational estimates based on future use value [e.g., as Buffett has said in the past: future cash flows that the underlying businesses will generate from now until kingdom come, discounted back to the present at an appropriate rate]; 2) in the hopes that they will go up because people want to buy them. Like bonds and Rembrandts. Once you have government buying stocks every year like [they are] Rembrandts, God knows what would happen. This doesn't appeal to me at all. I'm afraid of it, afraid of the politics, and I don't believe the numbers of those projecting them. By the way, the numbers of those proposing this idea three years ago now look silly. What would happen to the morale of this country if [we invested Social Security into stocks and then what's happened over the past 20+ years in Japan happened here? Imagine that the] government of Japan had put [their] Social Security into common stocks. For a while, stock prices went up and everyone felt good, consumers and politicians spent more, etc., and then stocks declined by 80%. I think they'd be in even worse shape. The more anything sounds like easy free money, the less I tend to believe it.

Giving Money Away

I don't like to think of bequests, not because it reminds me that I'm going to die, but because I find it very hard to figure out what to do with money. Some people like to have people come up to them asking for money, but I don't.

I know a lot of people who like to remain anonymous when they give away money, and you may think that this is a becoming modestly, but mostly it's because they're afraid someone else will ask them for more money.

Charities Cooperating More

In terms of getting all charities in the world to act together, I can't get all of my children to act together, and they've been in my house and under my control.

View of Liberal Art Faculties

[Every year, Munger takes a shot at what he believes are clueless, disconnected-from-reality liberal art faculties at major universities. This year was no exception:] I think liberal art faculties at major universities have views that are not very sound, at least on public policy issues -- they may know a lot of French [however]. [Laughter]

The Importance of Reading

In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time -- none, zero. Now I know all kinds of shrewd people who have done well by staying in a narrow area. But investing requires broad knowledge.

You'd be amazed at how much Warren reads -- at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out. [Laughter]

Recommended Reading

A Matter of Degrees, by physicist named Segre, is a perfectly marvelous book. Not a book you can go through at 90 mph, but if you parse through it slowly, you'll get a lot out of it. You'll get a lot of hours per dollar if you use it right.

How much GNP per capita there is really matters. It multiplied by seven times in a single century [in the U.S.] -- a lot by previous history of man. I certainly recommend the Carnegie biography by the Grinnell guy -- I forget his name [he was referring to Andrew Carnegie by Joseph Frazier Wall], but it's the definitive biography. It's a very interesting story. Carnegie started in absolute poverty and had only 4 1/2 years of grade school in a one-room schoolhouse with only one teacher for 170 or 180 students. From this beginning came Carnegie Steel and all of his eccentricities. He was married at 51 and was a virgin -- it was a different world. [Laughter]

It's very interesting -- the past is strange. People behave differently there. [Laughter] The way labor was treated was really something. People did dangerous work, had no Workman's Comp, insurance or pensions, companies could arbitrarily slash their pay by 40%, etc. And that was only 100 years ago. It makes you think how different the world will be 100 years from now.

Johnson, Adams and Franklin Biographies

Yes, I've read the whole Johnson biographies [Robert Caro's trilogy: The Path to Power, Means of Ascent, and Master of the Senate] and I've read the Adams biography [John Adams by David McCullough] and the various Franklin biographies.

Sure, Franklin was quite old when he was ambassador to France. This was after he was world famous and rich, and he was more self-indulgent than when he was young and making his way in the world. But he was a very good ambassador and whatever was wrong with him from John Adams's point of view [I'm sure] helped him with the French. [Laughter] I think Franklin was a marvelous steward. I'm willing to take the fellow as he averaged out. And certainly I'm in favor of old people having a little enjoyment. [Laughter]

Wesco 2002 Annual Meeting

Charlie Munger, Pasadena CA, 2002

*** COMMENTS ON BERKSHIRE HATHAWAY AND WESCO
***

Berkshire's competitive advantages in reinsurance

"I do think we get some advantage in reinsurance because people trust our willingness and ability to pay, so it's not a commodity. I think we have some special talents. That being said, I think it's dangerous to rely on special talents -- it's better to own lots of monopolistic businesses with unregulated prices. But that's not the world today. We have made money exercising our talents and will continue to do so."

"I'm glad we have insurance, though it's not a no-brainer, I'm warning you. We have to be smart to make this work."

Outlook for Berkshire's insurance operations

"The overall result is that we're going to do pretty well -- meaning in the top 10% [of the industry] -- because we do different things. In New Jersey, when they capped rates, we said we were going to withdraw from the market, and we did. We're one of the only corporations in America to run off its derivative book. We had hoped to sell it, but that didn't work out. We're willing to do some unpleasant things."

"Generally speaking, we're mildly optimistic about our insurance operations." [This is Munger-speak for "I'm quite enthusiastic about our insurance operations."]

Berkshire's future outlook

"It's a finite and very competitive world. All large aggregations of capital eventually find it hell on earth to grow and thus find a lower rate of return."

"Personally, I think Berkshire will be a lot bigger and stronger than it is. Whether the stock will be a good investment from today's price is another question. The one thing we've always guaranteed is that the future will be a lot worse than the past."

Types of businesses Berkshire buys

"A lot of things we do are fairly basic. Bricks have been around since Babylon. Their consumption is regular and predictable. Our brickyards dominate their region."

"We tend to buy things -- a lot of things -- where we don't know exactly what will happen, but the outcome will be decent."

Would Berkshire ever invest in Level 3?

"We have the same problem as everyone else: it's very hard to predict the future [of Level 3]. Could we invest in it? Sure, it's conceivable. After all, we're in the electricity distribution business in the UK and the generating and distribution business in Iowa. We have a history when things are really horrible of wading in when no-one else will."

Berkshire's culture

"Berkshire's culture could go on for a long, long time because we've decentralized power to people who deserve it."

"For many of our shareholders, our stock is all they own, and we're acutely aware of that. Our culture [of conservatism] runs pretty deep."

Share price

"We don't like our stocks [Berkshire and Wesco] to get too high -- only deservedly high -- so we tend to throw deserved bits of cold water on them. For example, in the prospectus for the Berkshire B shares, we said we wouldn't advise anyone to buy our stock. People bought it anyway, but we tried to dampen it."

Share buybacks

"If only you people thought a lot less of us, there would be more opportunity to buy back Wesco and Berkshire shares."

Bonds

"Berkshire owns bonds in two ways:

1) Through our insurance operations. Mainly mortgage backed, with some government and a little junk.

2) Through our finance subsidiary. Interesting little things. I call it the 'miscellaneous Warren Buffett account.' As long as he's doing it, I'm OK with it. We've made a few hundred million [dollars] with little risk or fuss."

Comments on Wesco

"Wesco's insurance operations are decent, but small."

"Wesco's business has come up some in the past year or two."

Berkshire's insurance accounting

"Generally speaking, we think we're more conservative than most insurers. Nevertheless, in certain periods, we've discovered that our reserves were not adequate. But over time, we'll not only try to be more conservative, we will be."

Will Berkshire be in the S&P 500?

"If Berkshire were owned by institutions, it would already be in the S&P 500. But Berkshire's loyal shareholders would cause a price spike if it were added to the S&P 500 [because of all the index funds that would have to buy the stock], which would be an embarrassment. Sooner or later it will be in, but not tomorrow."

History of Buffett's investing philosophy

"Warren Buffett came to investing at the knee of Ben Graham, who ran a Geiger counter over the detritus of the 1930s. Stocks were ridiculously cheap. Graham bought companies that were quite mediocre on average, but made 20% when their stock bounced."

"Warren trained under this system and made money, so he was slower to come to the idea I learned that the best way to make money is to buy great businesses that earn high returns on capital over long periods of time."

"We're applying Graham's basic ideas, but now we're trying to find undervalued GREAT companies. That concept was foreign to Ben Graham."

"Warren would have morphed into a great investor without Ben Graham. He is a greater investor than Graham was. Warren would have been great had he never met anyone else. He would have excelled at any field that required a high IQ, quantitative skills and risk taking. He wouldn't have done well at ballet though."

Differences between Buffett, Munger and Simpson

"Not very much."

[Lou Simpson, who manages GEICO's investment portfolio, was in the audience, so Munger asked him to address this question. He said:] "The big difference between you and Warren and my situation is the difference is size. We're $2.5 billion, whereas you and Warren are many times more, so we have an advantage in looking at smaller situations. If we find a $200-$250 million position, we can invest and make a difference."

Munger: "It does make a difference. Maybe Lou is just smarter. His returns have been better [over the past few years]."


*** COMMENTS ON BERKSHIRE HATHAWAY HOLDINGS ***

Gen Re

"Gen Re misguessed its reserves -- almost every insurer in America did -- which is why we took a big loss."

"Gen Re always tried to do it right [reserve properly]. Losses crept up on everybody. You'd think that under Berkshire, their reserving, which was always very good, would be more conservative, consistent with Berkshire's culture."

"At Warren's level, we operate through the CEO of Gen Re, who has to tinker with the culture. It's a good culture, but with the world so tough, we need to improve it a bit."

Munger's role in the purchase of Gen Re

"That thing was very far along before I ever heard of it. There will be more of this as the years go on."

Finova

"Finova is a run-off situation. It's not going to run off as well as it would have before 9/11 happened, but it will work out fine. We'll make hundreds of millions. It's a blip in the history of Berkshire."

American Express

"American Express has had some things that didn't work out. Am I satisfied by what we know at American Express? Yes. We never expected them to handle their investments the way we'd handle ours. But we're big boys. We're not depressed about American Express."

USG

"[Our investment in] USG obviously hasn't worked out very well. It wasn't just asbestos -- the market for wallboard went to hell. We missed that too. What can I say? It reminds me of a story about a man who had a wife and three kids. He conceived an illegitimate child with a woman he'd just met. When asked why he did it, he said, 'It seemed like a good idea at the time.'"


*** INVESTMENT ADVICE ***

Becoming a good investor

"If you're going to be an investor, you're going to make some investments where you don't have all the experience you need. But if you keep trying to get a little better over time, you'll start to make investments that are virtually certain to have a good outcome. The keys are discipline, hard work and practice. It's like playing golf -- you have to work on it."

Investing mental models

"You need a different checklist and different mental models for different companies. I can never make it easy by saying, 'Here are three things.' You have to derive it yourself to ingrain it in your head for the rest of your life."

Circle of competence

"There are a lot of things we pass on. We have three baskets: in, out and too tough. A lot of stuff goes into the 'too tough' basket. We can't do that if it's a problem at a Berkshire subsidiary company, but if we don't own it, we just pass."

"I don't know how people cope [trying to figure everything out]."

"We have to have a special insight, or we'll put it in the 'too tough' basket. All of you have to look for a special area of competency and focus on that."

Buying into stock declines

"Over many decades, our usual practice is that if [the stock of] something we like goes down, we buy more and more. Sometimes something happens, you realize you're wrong, and you get out. But if you develop correct confidence in your judgment, buy more and take advantage of stock prices."

*** COMMENTS ON VARIOUS COMPANIES, INDUSTRIES AND OTHER ECONOMIC MATTERS ***

Freddie Mac

"We held that stock for a great many years, and of course made a great deal of money."

"Warren and I get nervous with vast amounts of leverage unless we're 100% confident that risk-taking won't creep into the culture."

"It reminds me of a guy running a company who fired his top producer. The guy asked him, 'Why are you firing me? I'm your top producer.' To which he responded, 'You make me nervous. I'm a rich old man. Why should I be nervous?"

Lloyd's

"At present, Lloyd's is greatly improved. Lloyd's had become a sewer. Ethics became terrible, easy money, three-hour lunches with drinks... The culture got quite bad and it degenerated into huge underwriting losses."

"It's way better now, but not totally reformed. The jury's still out."

Moody's

"Most of the bonds Berkshire buys, Warren picks. He doesn't need Moody's, nor does he look at their rating. But he believes Moody's provides a useful service."

Influence of board members (or lack thereof)

"Joe Rosenfeld -- a marvelous human being and great friend -- was asked to be on the board of Northwestern Bell. He said it was the last thing they ever asked him. That's typical. Sometimes a CEO asks for advise when a board has expertise, but they generally make their own decisions and use their staff. Averaged out, the CEO decides what he wants to do and the board says yes."

"We have very little influence [on the boards Warren and I serve on]. There's an occasional exception if someone has very high regard for us."

Risks of financial institutions

"The beauty of a financial institution is that there are a lot of ways to go to hell in a bucket. You can push credit too far, do a dumb acquisition, leverage yourself excessively -- it's not just derivatives [that can bring about your downfall]."

Consumer credit

"My method for a nation growing is Germany after World War II -- no consumer credit, but high growth."

"In the U.S. today, we push consumer credit harder year after year. There are occasional blow-ups like Providian. Could we have a big national blow-up? Yes. It tends to be self-correcting."

"Once you get used to growing each year by goosing consumer credit 5%, what do you do when you've reached the limit?"

"I don't like it. I don't like thinking up ads to get people to use their credit card more. But it's not illegal and maybe the world's even better for it. It's not my temperament though."

The wealth effect

"The wealth effect is the extent to which consumer spending is goosed upward due to increases in stock prices. Of course it exists, but to what extent? I made a speech a while back in which I said that the wealth effect is greater than economists believe. I still say this."

"The wealth effect is one driver of economic assumption, but not the only one. The government in two years has gone from back-to-back surpluses to increasing spending 10% each year. Also, the decline in interest rates has led to an increase in housing values, which makes people feel richer. So, there are countervailing effects."

"Look at Borsheim's. When Level 3 [a widely held stock in Omaha] crashed 97%, there was a big effect [on Borsheim's sales]. There are also more homes for sale [in Omaha]."

"So many people try to predict macroeconomic factors by looking at only one factor. You need to look at all the factors."

Risk of the unexpected

"A lot of things happen that you can't predict. Who would have predicted the war on terrorism, government spending increasing 10% each of the past two years, etc.?"

"We try to run our companies so there's no chance of going back to Go. I think we're way more aware of that possibility [the risk of going back to Go], but that's no guarantee [that it can't happen to us]. In our insurance underwriting, we put in more clauses [limiting our risk] and are more aware of aggregate risks."

Expect the unexpected (Japan example)

"Warren has said that over 40 years, a lot of surprising things will happen."

"What's interesting in Japan is that every life insurance company is essentially insolvent because they promised to pay 3%. Who'd have thought that this could lead to insolvency, but interest rates went to zero and stayed there for years. They tried to invest in equities, but got negative returns. Can you imagine 13 years with negative equity returns and interest rates below 1%?"

"Is it inconceivable that it could ever happen here? I don't think so. Strange things happen."


*** CRITIQUES OF ACCOUNTANTS AND INVESTMENT BANKERS ***

Wall Street's ethics (or lack thereof)

"Generally speaking, ethics on Wall Street have been imperfect throughout my lifetime. In the old days, brokers would sell old ladies very conservative utility stocks with a big mark-up."

"Underwriting standards were better then. Now, what can be sold, will be sold. It's terrible."

"With First Boston, under the Mellons, there are just some things they wouldn't do."

"It's always hard. Some guy needs to pay his kid's tuition and at the end of the month, let's say he's behind on his quota and there's Suzi's account. Lo and behold, there's some activity."

"The ethics of Wall Street will always average out to mediocre at best."

"I don't think you get a lot of credit in life for not committing adultery with the Virgin Mary."

"Analysts as shills were always present, but it reached extremes in the dot-com boom because there was so much money at stake. Wall Street firms can't make money trading stocks for two cents per share, but can make so much money doing deals."

"If you set up incentives to reward A, and then say you want B, you'll give people schizophrenia."

"This doesn't mean there aren't some wonderful, intelligent people on Wall Street -- there are, like those in this room -- but everyone I know has to fight their own firm [to do the right thing]."

Critique of legal and accounting firms

"I think there's plenty wrong with the legal profession. Plenty of law firms take business they shouldn't. Accounting has this problem in spades. All have clients they shouldn't have. All the leading law and accounting firms aren't quick enough to decline or kick out bad clients."

"Too many law and accounting firms get roped into shady things. For example, tax shelters, with their contingency fees and secrecy, are a total abomination. The troubles are contagious -- they spread."

"Lawyers have gotten away with murder. The rule of thumb now is to defend anyone, using any means, and not get sued. This is changing however. Now, people are being more careful. This tendency to pull back is good."

"I never have the least interest in defending miscreants and helping them misbehave. But the general view is that it's wonderful what Johnny Cochran did."

"They say the second-happiest day for a defense lawyer is winning an acquittal of an innocent man."

Derivatives

"Originally, there were interest rate swaps. If you did them naked, you could lose or make an enormous amount. But there wasn't enough money for traders, so they adopted mark-to-market accounting. Everyone caved, adopted loose [accounting] standards and created exotic derivatives linked to theoretical models. As a result, all kinds of earnings, blessed by accountants, are not really being earned. When you reach for the money, it melts away. It was never there."

"The accountants have written 800 pages of rules on this."

"If you're the least bit venal, you can do what Enron did. Even if you're not, your employees will still [get you in trouble with derivatives]."

"It [accounting for derivatives] is just disgusting. It is a sewer, and if I'm right, there will be hell to pay in due course. All of you will have to prepare to deal with a blow-up of derivative books. To me, it's always been obvious it [the accounting for derivatives] is ridiculous."

"It's a crazy idea for people who are already rich -- like Berkshire -- to be in this business. It's a crazy business for big banks to be in."

[On this topic, here's an excerpt from the 5/20/02 Business Week:

"Critics say FASB's nitpicking hit bottom with Financial Accounting Standard No. 133, which governs accounting for financial derivatives and hedging. Launched in 1992, the standard is based on a simple principle: Futures, swaps, options, and other derivatives should be carried on books at their market value. But revaluing derivatives every quarter can create wide and unpredictable swings in corporate earnings. To avoid that, FASB carved out exceptions for hedging deals, forward contracts for materials, insurance policies, and other special cases. 'The exceptions are legitimate,' says FASB member John M. 'Neel' Foster, 'but once you start down that path, it's hard to stop.' The result: FAS 133 and its supporting documents weigh in at 800 pages--and it's still a work in progress."]


*** COMMENTS ON EDUCATION AND PROPER THINKING ***

Fooling oneself

"The ethos of not fooling yourself is one of the best ethoses you could possibly have. It's powerful because it's so rare."

Mental models

"Generally speaking, you need to have appropriate mental models and a checklist to go through each of them. If 2-3 items are not on the checklist, and you're a pilot, you might crash."

"It [this approach] is perfectly obvious. But how many of you were taught to think this way at university?"

[One person in a room of perhaps 200 raised his hand and, when asked which university he attended, said "MIT."]

Munger snorted and said: "This wasn't rehearsed. This underscores the importance of science. If you have kids or grandkids, make them take science [classes]. Can you imagine the kind of nonsense we'd get from the head of the poetry department at Amherst?"

Personal computer use

"Do I use a computer? Not so far. I just had a computer installed, but so far it's dark. I don't every type. As for the future? We'll see."

"I'm a big follower of Thomas Hunt Morgan [in 1933, he won the Nobel Prize in Physiology or Medicine]. While at Cal Tech, he banned the Frieden calculator, which everyone used for all sorts of calculations. Why? I walk along the river and pick up gold. So why should I do placer mining? I'm willing to do placer mining if need be, but I'm hoping to go to my grave without doing so."

"Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

Importance of science

"I think scientific literacy is terribly important…Habits of the mind formed from science are so valuable."

"I once spoke at one of New York's great Catholic girls schools, and they require every student to take physics."

"Even if you're not a scientist, you can pick up on the big ideas like thermodynamics. A lot of people haven't bothered to learn thermodynamics, and that's a big mistake. I recall a utility that invested in a scheme to create energy from seawater. [Anyone with even a rudimentary knowledge of science would know that] this violates the laws of thermodynamics."

Inner-city schools

"Center-city school systems are a disaster. The schools are dealt a difficult hand, but many schools have shown not an impossible one."

Universities

"There's a lot wrong [with American universities]. I'd remove 3/4 of the faculty -- everything but the hard sciences. But nobody's going to do that, so we'll have to live with the defects. It's amazing how wrongheaded [the teaching is]. There is fatal disconnectedness. You have these squirrelly people in each department who don't see the big picture."

"This doesn't just happen in academia. Companies can get balkanized. Look at what happened at Arthur Andersen and Enron. They weren't all bad people, but their cultures were dysfunctional. It's easy to create such a culture, in which you have good people but terrible results. Many areas of government are dysfunctional. Universities are complicit. They don't feel guilty about the product they're producing."

"We have the best universities in the world. They are strong in the hard sciences, but if you go to business, law, sociology…"


*** ADVICE ON LIFE AND OTHER ***

Terrorism risk and immigration policy

"Our handling of the terrorism risk has been insanely sloppy. Can you imagine that someone with an Arabic name, who was Arabic looking, took lessons on flying big jets in which he didn't want to learn how to take off or land, and no-one asked any questions?! But it's the human condition. It's what bureaucracies do."

"I would be in favor of foolproof national identity cards, and wouldn't worry about due process with immigrants -- I'd really be more rigorous. But we're a democracy, and we'll muddle through."

"Canada's [immigration policies are] worse. They should have a banner that says, 'Welcome Terrorists!'"

"It's sad that we need an event like 9/11 to wake up."

Books

"Ice Age [only available in the UK; will be published in the U.S. later this year] is one of the best books I've ever read. I've spent thousands of dollars buying copies for my friends. If you don't like Ice Age, then you have some limitations."

"I also recommend How the Scots Invented the Modern World: The True Story of How Western Europe's Poorest Nation Created Our World and Everything in It. It's amazing how one million poor people with a lousy climate and no resources had such a large and constructive influence on the world. I tried to figure it out and couldn't. This professor did that. It's a wonderful book."

Wesco 2001 Annual Meeting

Charlie Munger, Pasadena CA, 2001

*** Wesco and Berkshire Hathaway ***

Using Wesco as a vehicle for small investments

I asked Munger the following question: "Mr. Munger, an hour ago someone asked me what Wesco was worth. I threw up my hands and said, 'I don't know. With $1 billion in cash and a $2 billion market cap, Wesco's future returns will be largely dependent on how that cash is allocated.' Can you tell us how you plan to invest that money? In particular, you and Mr. Buffett have been saying for a long time that Berkshire Hathaway's increasing size is an anchor on the percentage rate of return it will be able to generate in the future. You have also said that certain investors with smaller pools of capital could generate very high rates of return. So why don't you use Wesco as your vehicle to do smaller investments, such as those that Mr. Buffett sometimes does in his personal portfolio?"

Munger replied, "Warren spends 70 hours a week thinking about investing, and we're not talking about large sums [in his personal portfolio]. He does these investments to amuse himself when he's not playing bridge."

"Even with the amount of money that Wesco has makes it very hard to play this game. You just have to have a prepared mind and be able to move rapidly."

" It took us months of buying all the Coke stock we could to accumulate $1 billion worth -- equal to 7% of the company. It's very hard to accumulate major positions."

Competitive advantages

"We don't have automatic competitive advantages. We're seeing some more insurance volume, mainly from General Re, and Cort and Precision Steel have momentum, but we have to find future advantages through our own intellect. We don't have enough critical mass and momentum in place at Wesco, so investors are betting on management."

"We have one slight edge that helps us: there's a lot of human love in building at least some businesses and some people who own businesses love them. They don't want to sell to a financial buyer who will dress it up and strip it down. When we buy a company, we don't tinker with winning businesses. So, for some sellers such as Justin, Berkshire Hathaway was the only acceptable buyer."

"If you want a culture like ours, I don't know anywhere to get it if not here. In that sense, we're stronger than we were years ago because we're better known. I don't think GE is going to catch us in this area."

"So, we may well have a competitive advantage buying decent businesses at decent prices. But they won't be fabulous businesses and fabulous prices. There's too much competition and money out there, with many buyout specialists. Debt is tight right now, which helps us. Berkshire wouldn't have been able to buy Johns Manville were it not for this."

Wesco's history

"Wesco had a market capitalization of $40 million when we bought it [in the early 1970s]. It's $2 billion now. It's been a long slog to a perfectly respectable outcome -- not as good as Berkshire Hathaway or Microsoft, but there's always someone in life who's done better."

Berkshire buying Wesco outright

"It's a historical accident [that Wesco is only 80.1% owned by Berkshire and that its stock continues to trade], due to complicated tax reasons. I suspect that it will eventually become wholly owned by Berkshire, but it's hard to do when you people maintain this enthusiasm [for the stock]."

Berkshire's future returns

"Warren said [at the Berkshire annual meeting] that he hoped to do modestly better than the market. 15% would be a hell of a number, so the target is the 6-15% range."

"You're in the same boat we are."

Buffett's decision making

"Warren is amazingly quick to say both yes and no."

Cort

"Cort will keep growing, both via acquisitions and expanding in its current markets. It will do pretty well. It's like Enterprise Rent-A-Car. They both have a terrific culture, service and incentive system."

"Cort has good relationships with its suppliers. Capitalism works better when there's trust in the system."

General Re

"It's one of the best reinsurance operations in the world. It has a strong distribution network and culture -- a culture of intelligence and discipline. It sees reinsurance opportunities that Berkshire doesn't. They have a huge advantage being there for so long. Gen Re's competitive advantage is that it's smarter and sees more opportunities."

"I don't think its returns in the future will be as good, but a 2-3%/year advantage is a lot over time."

"Reinsurance is interesting. A lot of people get into the business because of the money. Then, reinsurance brokers -- who are very well paid and can make dumb ideas look good -- pitch them business. Boy, is this dangerous! Very smart people can make very dumb investments. Even GEICO and Gen Re get caught sometimes."

Insurance reserves

"In the past, we've under-reserved, but more often been overly conservative. Consequently, Berkshire and especially Wesco have been reversing some reserves."

Insuring against natural disasters

"No-one wanted to write California earthquake coverage [as Berkshire did]. We're like that."

"We don't think because it's never happened that it won't. There's no actuarial science, it's rough judgment. We just try to be conservative."

Wesco's and Berkshire's inefficient tax structure

"We don't have any miraculous way of avoiding taxes at Wesco and Berkshire. With float, we get some tax benefit."

[Munger said something about some of the most foolish behavior he's ever seen was a result of trying to avoid paying taxes.]

"What a terrible, inefficient thing it is to own real estate and securities in a Section C Corporation [like Wesco and Berkshire]. The enormous taxes we paid when we sold Freddie Mac last year is an example of this. If we were a partnership, you wouldn't have had to pay this. It's very hard."

"We drifted into this structure by accident. We bought a doomed textile mill [Berkshire Hathaway] and a California S&L [Savings & Loan; Wesco] just before a calamity. Both were bought at a discount to liquidation value. It turned out wonderful for many people in this room -- Wesco's market cap has grown from $40 million to $2 billion -- but it was dumb. They structure is terribly inefficient and bad. It's much better when we buy wholly owned businesses like Precision Steel."

Why not franchise See's candy stores?

"It takes almost no capital to open a new See's candy store. We're drowning in capital of our own that has almost no cost. It would be crazy to franchise stores like some capital-starved pancake house. We like owning our own stores as a matter of quality control."

Walter Scott, Level 3 Communications, and Berkshire's investment in electricity

"Walter Scott has one of the best business records ever. People put a lot of money in new fiber optic networks, and now there is a bloodbath that has driven Level 3 stock down. I don't think it means that Walter Scott is any less of a businessman."

"Berkshire's electricity investment [in Mid-American Energy] was in a total system in Iowa and a distribution system in Britain. It's doing perfectly fine. I would not extrapolate these results to new capacity in a new field [such as Level 3]. Ours is a much more conservative investment."

"Electricity is a HUGE field. It's enormously stupid to run short of electricity. There's an opportunity to make reasonable returns and we're going to try."

Finova

"We're never done anything like this before, so there's no model. We think our offer is a good example for the creditors of Finova -- an honorable, intelligent transaction. It's fair to bondholders -- we're the largest -- and leaves some room for the stock to come back. It brings in good management with the right incentives. Of course there will be some complaints, but I'd be surprised if someone else comes in with the same offer."

"I wish every place in which we had a junk bond investment, someone came forward with an offer like ours."

Auto insurance pricing

"I think auto insurance is getting some rate increases. It was almost too good a business over the last 6-7 years."

Conservative nature

"We don't feel some compulsion to swing. We're perfectly willing to wait for something decent to come along." "We're rich in relation to the business that we're doing."

Future returns from equities

"In certain periods, we have a hell of a time finding places to invest our money. We are in such a period."

"In Warren's Fortune article [11/22/99], he described the last two 18-year periods. During the first period, the market was essentially flat. The most recent one has been a marvelous period. Warren said that in the nature of things, double-digit returns couldn't go on and on and on. Therefore, individual shareholders and pension funds should reduce their expectations. My guess is that he'll be right for a long period ahead. There will be way lower returns over the next 15-18 years."

"The normal expectancy of the average investor -- for example, the pension funds of AT&T or IBM -- is 6% for a long time."

"With stocks yielding 1.5% and trading at 4-5x book value, it's not as much fun as it was buying Coke and Gillette at much lower prices relative to their valuations."

Recent stock market decline

"What you've recently seen is just a tea party. If you, like me, lived through 1973-74 or even the early 1990s… There was a waiting list to get OUT of the country club -- that's when you know things are tough. If you live long enough, you'll see it."

Purchase vs. pooling for acquisitions

"The problem is that the exact same transaction is treated differently. That's crazy. The proposal to require that all acquisitions be done using purchase accounting is perfectly reasonable. Berkshire made a mistake buying Dexter Shoes. When we found out, we wrote it down and took a charge against earnings. The difference is that we didn't say it was a one-time or unusual charge -- we just took it against earnings."

Retailing and Costco

"If I were teaching at business school, I'd take people through retailing because it's easy to understand. Retailing is pretty simple. There are four or five strategies."

"I'm a director of Costco. It's easy to understand. In the history of the world, few companies have succeeded on a 12% mark-up. They make it up with high volume. Costco has the right culture. They promote from within. It's a wonderful place to work."

"I think that Costco is a better operator in the warehouse club format than Sam's. Both companies will do well in the future, but I predict that Costco will do better."

"I don't know why schools don't teach this, but I'd teach a lot of things differently."

State Farm

"State Farm is one of the very richest insurance companies in the world. It's an honorable, old fashioned, high-grade place. They have integrity and skill. In condominium insurance, for example, they're the best. They're in Indiana, don't have elaborate compensation schemes, no stock options, and no high-falutin' advisors -- and they've blown by competitors. We admire them."

"They're enormously rich, so if they decide to keep a lid on auto insurance, I can't predict when they might stop. We [at GEICO] have a better model though."

Demutualization

"Are policy holders treated fairly [when an insurance company demutualizes]? The ordinary answer is 'No.' What a surprise."

How to detect bad reserving

"If [an insurance company's] combined ratio is wonderfully regular, then it's probably crooked. It's also a bad sign if a company is consistently under-reserving."

"Sometimes you can tell by the people that the numbers are good. For example, George Joseph of Mercury General is a genius and you know his numbers are right."

Wrigley

"Wrigley is a great business, but that doesn't solve the problem. Buying great businesses at advantageous prices is very tough."

Financial industry

"The financial industry has become so big. We keep pushing it further and further and further. For example, we now lease new autos for 36 months and guarantee a high residual value. How much further can you push consumer credit? We don't like it. We don't like pushing credit to extremes. We don't like daisy chain stock promotion. However, one of Berkshire's largest holdings is American Express, so we think it has a great future."

Medicare and HMOs

"The cost was projected to be X, but was actually 10X. People forgot that effects have effects. Incentives have super-effects. [Notes are sketchy here.] The original system was on a cost-plus basis. For example, a test was not reimbursed in a doctor's office, but was at a hospital, so doctors referred patients to the hospital to have the test. It was great for doctors and hospitals, but bad for patients and taxpayers."

"So then the system switched to DRGs [whereby providers were reimbursed a fixed amount for a certain disease/problem], which controlled costs somewhat. Then, there was a switch to HMOs, which did control costs. People who hate HMOs should realize that it was a needed response to a totally out of control system."

"Yes, HMOs have an incentive to deny needed care -- this kind of behavior is just unspeakable -- but no-one ever gives HMOs credit for preventing unnecessary, harmful procedures that doctors would otherwise do."

The decline of family-controlled businesses when family foundations take over

"Don't confuse correlation and causation. Almost all great records eventually dwindle. Those you mention [Reader's Digest, Kellogg] would have dwindled, even without family ownership."

"I think the foundation at Berkshire [Buffett's stake in Berkshire will pass to the Buffett Foundation upon his death] will be a plus because there will be a continuation of the culture. We'd still take in fine businesses run by people who love them."

Money managers

"We have a number of high-IQ individuals -- an enormous group compared to the past, 4-5 times as many -- devoting extraordinary time to beating the market. They have new vehicles: hedge funds, LBO funds, venture capital, international investing, etc. In the nature of things, some will succeed. But I don't think the mass of people's results, even pretty sound, glued-together people, will be very high."

"It's natural that you'd have more brains going into money management. There are so many huge incomes in money management and investment banking -- it's like ants to sugar. There are huge incentives for a man to take up money management as opposed to, say, physics, and it's a lot easier."

"I think it's inevitable but terrible -- a disaster for the wider civilization. I'm somewhat ashamed… That I've profited from being shrewd with money is not by itself satisfying to me. To atone, I teach and try to set an example. I would hate it if the example of my life caused people to pursue the passive ownership of pieces of paper. I think lives so spent are disastrous lives. I think it's a better career if you help build something. I wish I'd built more, but I was cursed at being so good at stock picking. 'The man is the prisoner of his talents.' You can laugh, but I'll bet this room is full of people who are prisoners of their talents. It tends to be the human condition."

Asbestos litigation

"This is one of the most interesting things on the current scene. It affects you as both citizens and investors."

"Asbestos had many wonderful qualities. But when the health risks became clear, the companies that were major users of asbestos such as Johns Manville covered it up and were rightly hit with damages through the tort system. But other companies only used small amounts -- for example, in brake pads or a bit in USG's paste. Because of a tiny bit of asbestos in brake pads, Ford has set aside $1.7 billion to pay claims. There was a gain to society and the risk was low. It's not clear to me the damage from these uses."

"The claims bar quickly drove into bankruptcy anyone who behaved like Johns Manville, and then went after companies that didn't know they did anything wrong."

"The tobacco companies caused almost all of this."

"Now there is a whole class of people filing claims who have no symptoms. This accounts for way more than half the money being paid out. You could argue that it was a mistake to pay these claimants."

"It's coming from companies on an extortion basis. There are judges in Texas who are in the pockets of the plaintiff's bar, and there are compliant juries. It's turning the courts into an extortion system."

"Isn't it interesting that the only brand names that plaintiffs can remember are the brands of the only two solvent companies?"

"Is it good for society that lawyers, workmen, etc. are lying, that junk science is accepted? It's a national disgrace. I don't know where it will stop."

"I regard what's happening to USG as a dishonorable mugging of an honorable place. I don't think they should be driven out of business, but I don't want to make predictions about this."

"Is the system sound when obvious fraud goes on on a massive scale? I would say no. And it spreads. You get what you reward for. That's why the claims keep coming and coming and coming. If you want ants, put sugar on the floor."

Later, another shareholder asked if he'd been too harsh on this topic. That set Munger off again:

"I wasn't harsh enough! Once you've got people benefiting from the system and use the money to influence judges and politicians [you've got a real mess]. It creates a situation that's very hard to fix. It would have been relatively easy to prevent if we'd had the will, but now it will be hell to fix. As Ben Franklin once said, 'An ounce of prevention is worth a pound of cure.'"

The decline of public schools

"There's a similar situation with schools. In Omaha years ago, there was an influx of poor minorities and white flight. It was obvious that Omaha Central High School was tipping toward 100% low-income minority students. If this happened, there would be no good high school in Omaha for minorities. This happened everywhere else. But in Omaha, a group of blacks demanded that there be an anti-black quota at Omaha Central, which passed and saved the school. It's a wonderful story, but the tragedy is that it only happened in Omaha."

"If you let it go, I don't see how you can reverse a lot of this stuff."

Estate tax

"Personally, I'm against the estate tax at its current rate, with its rapid rise to 55%. It hits owners of auto dealers, plumbers, etc. I think the exemption should be raised. [Since this appears likely to happen,] out of our crazy democratic system, we're going to get a reasonable outcome.

"I have no problem with this rate [for estates] in the hundreds of millions of dollars. I have no problem personally with the estate tax."

California energy crisis

"The California energy crisis is a disgrace -- to schools, executives, both political parties. There's enough disgrace to go around. We richly deserve this miserable result, which is due to extreme stupidity and indifference. [Quit beating around the bush, Mr. Munger. Tell us what you really think!] We are like the canary in a coal mine for other states, which are saying, 'Boy, have these guys done us a favor!' It's ABC basic what needs to be done: decrease pollution, increase conservation, and have the right incentives in the rates."

"In modern academia, there's no shame. People are taught Beowolf, but can't think their way out of a paper sack."

Investing abroad

"We don't feel any compulsion to go abroad because of any strategic considerations. We haven't taken the advice of any financial planner that I'm aware of. We have more comparative advantage buying in the U.S. because we're well known. There's no master plan. We're individual opportunity driven."

Mental models

"If you have the right mental equipment from the right education, you know it. We [at Berkshire and Wesco] have experienced people with the right models. You don't want to be the patient of a surgeon who's doing his first complicated procedure."

"My speech about mental models using Coke as an example was a failure. People had to read it two or three times before it sunk in, and even then it only sunk in if people already half knew it."

Prediction of interest rates

"Neither Warren nor I has ever made a dime in this area."

John Train

Asked to comment on John Train's books (The Money Masters, etc.), Munger said, "He's a gifted writer with moderate insights into the investment process."

Damn Right (biography of Munger by Janet Lowe)

"I didn't want it done. I felt that the disadvantages outweighed the advantages. I like to keep private. But once it became clear that she would write it with or without me, it was obviously the right decision to cooperate. I got to like Janet Lowe -- she's a very high-grade person. The book gave me the chance to spread some of my ideas without having to do the work. One idea is that whenever you think something or some person is ruining your life, it's you. A victimization mentality is so debilitating. I love spreading this stuff around. Just because it's trite doesn't mean it isn't right. In fact, I like to say, 'If it's trite, it's right.'"

Munger's writings

"For you masochists, I taught a course at Stanford Law School recently and compiled some readings. Copies are available in boxes at the front of the room."

The booklet, privately printed by Munger, is entitled "Some Investment-Related Talks and Writings Made or Selected by Charles T. Munger." A copy of the entire package, in .pdf format, can be downloaded by right-clicking here and selecting Save As (this is a large file: 3,446 KB).

1) "The Great Financial Scandal of 2003, An Account by Charles T. Munger." Unlike the other readings in this booklet, I don't believe this has ever been published before. It details a hypothetical financial scandal in 2003, triggered by dishonest accounting, especially for options, at an imaginary tech company called Quant Tech (which appears to be a bit of Cisco, IBM and the like). To read it, click here.

2) "11/10/00 Talk of Charles T. Munger to Breakfast Meeting of the Philanthropy Round Table." Munger rails against --among other things -- "common-stock-price-related 'wealth effects'" and foundations and other investors "wasting 3% of assets per year in unnecessary, nonproductive investment costs." To read it, click here.

3) "Investment Practices of Leading Charitable Foundations, Speech of Charles T. Munger on October 14, 1998 to a meeting of the foundation financial officers group." Munger continues railing against the investment practices of foundations -- lessons that apply to nearly all investors. To read it, click here.

4) "Mr. Buffett on the Stock Market," 11/22/99. A reprint of Buffett's Fortune magazine article, in which Buffett presciently warns investors about the tech bubble and argues that stock market returns for the foreseeable will be in the mid-single digits. To read it, click here.

5) Munger's 1994 presentation to the USC Business School on "Investment Expertise as a Subdivision of Elementary, Worldly Wisdom." The transcript is from the 5/5/95 Outstanding Investor Digest. In this speech, Munger talks about the importance of mental models and argues that "you're got to hang experience on a latticework of models in your head" to be a successful investor and thinker.

6) A transcript of last year's Wesco annual meeting, published in the 12/18/00 edition of Outstanding Investor Digest. My notes from that meeting are available at http://www.fool.com/boringport/2000/boringport00051500.htm.