A Perverse Use of Antitrust Law.

by Charles T. Munger. September 2000.

As best I can judge from the Microsoft antitrust case, the Justice Department believes that any seller of an ever-evolving, many-featured product--a product that is constantly being improved by adding new features to every new model--will automatically violate antitrust law if: (1) it regularly sells its product at one all-features-included price; (2) it has a dominant market share and (3) the seller plays "catch-up" by adding an obviously essential feature that has the same function as a product first marketed by someone else.

If appellate courts are foolish enough to go along with the trial court ruling in the Microsoft case, virtually every dominant high-tech business in the United States will be forced to retreat from what is standard competitive practice for firms all over the world when they are threatened by better technology first marketed elsewhere.

No other country so ties the hands of its strongest businesses. We can see why by taking a look at America's own history. Consider the Ford Motor Co. When it was the dominant U.S. automaker in 1912, a small firm-a predecessor of General Motors-invented a self-starter that the driver could use from inside the car instead of getting out to crank the engine. What Ford did in response was to add a self-starter of its own to its cars (its "one-price" package)-thus bolstering its dominant business and limiting the inroads of its small competitor. Do we really want that kind of conduct to be illegal?

Or consider Boeing. Assume Boeing is selling 90 percent of U.S. airliners, always on a one-price basis despite the continuous addition of better features to the planes. Do we really want Boeing to stop trying to make its competitive position stronger-as it also helps travelers and improves safety by adding these desirable features-just because some of these features were first marketed by other manufacturers?

The questions posed by the Microsoft case are: (1) what constitutes the impermissible and illegal practice of "tying" a separate new product to a dominant old product, and (2) what constitutes the permissible and legal practice of improving an existing one-price product that is dominant in the market.

The solution, to avoid ridiculous results and arguments, is easy. We need a simple, improvement-friendly rule that a new feature is always a permissible improvement if there is any plausible argument whatever that product users are in some way better off.

It is the nature of the modern era that the highest standards of living usually come where we find many super-successful corporations that keep their high market shares mostly through fanatical devotion to improving one-price products.

In recent years, one microeconomic trend has been crucial in helping the United States play catch-up against foreign manufacturers that had developed better and cheaper products: our manufacturers learned to buy ever-larger, one-price packages of features from fewer and more-trusted suppliers. This essential modern trend is now threatened by the Justice Department.

Microsoft may have some peculiarities of culture that many people don't like, but it could well be that good software is now best developed within such a culture. Microsoft may have been unwise to deny that it paid attention to the competitive effects of its actions. But this is the course legal advisers often recommend in a case such as this one, where individuals' motives at Microsoft were mixed and differed from person to person. A proper antitrust policy should not materially penalize defendants who make the government prove its case. The incumbent rulers of the Justice Department are not fit to hold in trust the guidance of antitrust policy if they allow such considerations of litigation style to govern the development of antitrust law, a serious business with serious consequences outside the case in question.
While I have never owned a share of Microsoft, I have long watched the improvement of its software from two vantage points. First, I am an officer and part owner of Berkshire Hathaway Inc., publisher of the World Book Encyclopedia, a product I much admire because I know how hard it was to create and because I grew up with it and found that it helped me throughout a long life.

But despite our careful stewardship of World Book, the value of its encyclopedia business was grossly and permanently impaired when Microsoft started including a whole encyclopedia, at virtually no addition in price, in it software package. Moreover, I believe Microsoft did this hoping to improve its strong business and knowing it would hurt ours.

Even so, and despite the huge damage to World Book, I believe Microsoft was entitled to improve its software as it did, and that our society gains greatly--despite some damage to some companies--when its strong businesses are able to improve their products enough to stay strong.
Second, I am chairman and part owner of Daily Journal Corp., publisher of many small newspapers much read by lawyers and judges. Long ago, this corporation was in thrall to IBM for its highly computerized operation. Then it was in thrall to DEC for an even more computerized operation. Now it uses, on a virtually 100 percent basis, amazingly cheap Microsoft software in personal computers, in a still more highly computerized operation including Internet access that makes use of Microsoft's browsers.

Given this history of vanished once-dominant suppliers to Daily Journal Corp., Microsoft's business position looks precarious to me. Yet, for a while at least, the pervasiveness of Microsoft products in our business and elsewhere helps us--as well as the courts that make use of our publications--in a huge way.

But Microsoft software would be a lousy product for us and the courts if the company were not always improving it by adding features such as Explorer, the Internet browser Microsoft was forced to add to Windows on a catch-up basis if it didn't want to start moving backward instead of forward.

The Justice Department could hardly have come up with a more harmful set of demands than those it now makes. If it wins, our country will end up hobbling its best-performing high-tech businesses. And this will be done in an attempt to get public benefits that no one can rationally predict.

Andy Grove of Intel, a company that not long ago was forced out of a silicon chip business in which it was once dominant, has been widely quoted as describing his business as one in which "only the paranoid survive." If this is so, as seems likely, then Microsoft should get a medal, not an antitrust prosecution, for being so fearful of being left behind and so passionate about improving its products.

Charles T. Munger is vice chairman of Berkshire Hathaway Inc. and chairman and part owner of Daily Journal Corp.

A version of this article appeared in the Washington Post on September 1, 2000.

How We Can Restore Confidence

By Charles T. Munger
Wednesday, February 11, 2009; A19

Our situation is dire. Moderate booms and busts are inevitable in free-market capitalism. But a boom-bust cycle as gross as the one that caused our present misery is dangerous, and recurrences should be prevented. The country is understandably depressed -- mired in issues involving fiscal stimulus, which is needed, and improvements in bank strength. A key question: Should we opt for even more pain now to gain a better future? For instance, should we create new controls to stamp out much sin and folly and thus dampen future booms? The answer is yes.

Sensible reform cannot avoid causing significant pain, which is worth enduring to gain extra safety and more exemplary conduct. And only when there is strong public revulsion, such as exists today, can legislators minimize the influence of powerful special interests enough to bring about needed revisions in law.

Many contributors to our over-the-top boom, which led to the gross bust, are known. They include insufficient controls over morality and prudence in banks and investment banks; undesirable conduct among investment banks; greatly expanded financial leverage, aided by direct or implied use of government credit; and extreme excess, sometimes amounting to fraud, in the promotion of consumer credit. Unsound accounting was widespread.

There was also great excess in highly leveraged speculation of all kinds. Perhaps real estate speculation did the most damage. But the new trading in derivative contracts involving corporate bonds took the prize. This system, in which completely unrelated entities bet trillions with virtually no regulation, created two things: a gambling facility that mimicked the 1920s "bucket shops" wherein bookie-customer types could bet on security prices, instead of horse races, with almost no one owning any securities, and, second, a large group of entities that had an intense desire that certain companies should fail. Croupier types pushed this system, assisted by academics who should have known better. Unfortunately, they convinced regulators that denizens of our financial system would use the new speculative opportunities without causing more harm than benefit.

Considering the huge profit potential of these activities, it may seem unlikely that any important opposition to reform would come from parties other than conventional, moneyed special interests. But many in academia, too, will resist. It is important that reform plans mix moral and accounting concepts with traditional economic concepts. Many economists take fierce pride in opposing that sort of mixed reasoning. But what these economists like to think about is functionally intertwined, in complex ways, with what they don't like to think about. Those who resist the wider thinking are acting as engineers would if they rounded pi from 3.14 to an even 3 to simplify their calculations. The result is a kind of willful ignorance that fails to understand much that is important.

Moreover, rationality in the current situation requires even more stretch in economic thinking. Public deliberations should include not only private morality and accounting issues but also issues of public morality, particularly with regard to taxation. The United States has long run large, concurrent trade and fiscal deficits while, to its own great advantage, issuing the main reserve currency of a deeply troubled and deeply interdependent world. That world now faces new risks from an expanding group of nations possessing nuclear weapons. And so the United States may now have a duty similar to the one that, in the danger that followed World War II, caused the Marshall Plan to be approved in a bipartisan consensus and rebuild a devastated Europe.

The consensus was grounded in Secretary of State George Marshall's concept of moral duty, supplemented by prudential considerations. The modern form of this duty would demand at least some increase in conventional taxes or the imposition of some new consumption taxes. In so doing, the needed and cheering economic message, "We will do what it takes," would get a corollary: "and without unacceptably devaluing our money." Surely the more complex message is more responsible, considering that, first, our practices of running twin deficits depend on drawing from reserves of trust that are not infinite and, second, the message of the corollary would not be widely believed unless it was accompanied by some new taxes.

Moreover, increasing taxes in some instances might easily gain bipartisan approval. Surely both political parties can now join in taxing the "carry" part of the compensation of hedge fund managers as if it was more constructively earned in, say, cab driving.

Much has been said and written recently about bipartisanship, and success in a bipartisan approach might provide great advantage here. Indeed, it is conceivable that, if legislation were adopted in a bipartisan way, instead of as a consequence of partisan hatred, the solutions that curbed excess and improved safeguards in our financial system could reduce national pain instead of increasing it. After the failure of so much that was assumed, the public needs a restoration of confidence. And the surest way to gain the confidence of others is to deserve the confidence of others, as Marshall did when he helped cause passage of some of the best legislation ever enacted.

Creating in a bipartisan manner a legislative package that covers many subjects will be difficult. As they work together in the coming weeks, officials might want to consider a precedent that helped establish our republic. The deliberative rules of the Constitutional Convention of 1787 worked wonders in fruitful compromise and eventually produced the U.S. Constitution. With no Marshall figure, trusted by all, amid today's legislators, perhaps the Founding Fathers can once more serve us.

The writer, a Republican, is vice chairman of Berkshire Hathaway Inc., which owns 21 percent of The Washington Post Co.'s common stock.

Munger speaks with Kiplinger's Steven Goldberg

2005

Why has Berkshire done so well?

Just remember that we had a long run and an early start, particularly in Warren's case. It's much easier for me to talk about Warren than myself, so let's talk about Warren. Not only did he have a long run from an early start, but he got very smart very young -- then continuously improved over 50 years.

Buffett was a student of Ben Graham, the father of security analysis. He was buying deep value stocks -- "cigar butts" -- until you got involved.
If I'd never lived, Warren would have morphed into liking the better businesses better and being less interested in deep-value cigar butts. The supply of cigar butts was running out. And the tax code gives you an enormous advantage if you can find some things you can just sit with.

There are a whole lot of reasons, and Warren was a natural for always just getting smarter. The natural drift was going that way without Charlie Munger. But he'd been brainwashed a little by worshiping Ben Graham and making so much money following traditional Graham methods that I may have pushed him along a little faster in the direction that he was already going.

How do you work together?
Well, it's mostly the telephone and as the years have gone on, and I've passed 80 and Warren is 75, there's less contact on the phone. Warren is a lot busier now than he was when he was younger. Warren has an enormous amount of contact with the operating businesses compared to what he had early in his career. And, again, he does almost all of that by phone, although he does fly around some.

What are your work styles like?
We have certain things in common. We both hate to have too many forward commitments in our schedules. We both insist on a lot of time being available almost every day to just sit and think. That is very uncommon in American business. We read and think. So Warren and I do more reading and thinking and less doing than most people in business. We do that because we like that kind of a life. But we've turned that quirk into a positive outcome for ourselves.

How much of your success is from investing and how much from managing businesses?
Understanding how to be a good investor makes you a better business manager and vice versa.

Warren's way of managing businesses does not take a lot of time. I would bet that something like half of our business operations have never had the foot of Warren Buffet in them. It's not a very burdensome type of business management.

The business management record of Warren is pretty damn good, and I think it's frequently underestimated. He is a better business executive for spending no time engaged in micromanagement.

Your book takes a very multi-disciplinary approach. Why?
It's very useful to have a good grasp of all the big ideas in hard and soft science. A, it gives perspective. B, it gives a way for you to organize and file away experience in your head, so to speak.

How important is temperament in investing?
A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success.

How should most individual investors invest?
Our standard prescription for the know-nothing investor with a long-term time horizon is a no-load index fund. I think that works better than relying on your stock broker. The people who are telling you to do something else are all being paid by commissions or fees. The result is that while index fund investing is becoming more and more popular, by and large it's not the individual investors that are doing it. It's the institutions.

What about people who want to pick stocks?
You're back to basic Ben Graham, with a few modifications. You really have to know a lot about business. You have to know a lot about competitive advantage. You have to know a lot about the maintainability of competitive advantage. You have to have a mind that quantifies things in terms of value. And you have to be able to compare those values with other values available in the stock market. So you're talking about a pretty complex body of knowledge.

What do you think of the efficient market theory, which holds that at any one time all knowledge by everyone about a stock is reflected in the price?
I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don't think it's totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It's efficient enough, so it's hard to have a great investment record. But it's by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

What would a good investor's portfolio look like? Would it look like the average mutual fund with 2% positions?
Not if they were doing it Munger style. The Berkshire-style investors tend to be less diversified than other people. The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasizes feeling good about not having your investment results depart very much from average investment results. But why would you get on the bandwagon like that if somebody didn't make you with a whip and a gun?

Is finding bargains difficult in today's market?
We wouldn't have $45 billion lying around if you could always find things to do in any volume you wanted. Being rational in the investment world at a time when other people are losing their minds -- usually all it does is keep you out of something that causes a lot of trouble for other people. If you stayed away from the mania in the high-tech stocks at its peak, you were saved from disaster later, but you didn't make any money.

Should people be investing more abroad, particularly in emerging markets?
Different foreign cultures have very different friendliness to the passive shareholder from abroad. Some would be as reliable as the United States to invest in, and others would be way less reliable. Because it's hard to quantify which ones are reliable and why, most people don't think about it at all. That's crazy. It's a very important subject. Assuming China grows like crazy, how much of the proceeds of that growth are going to flow through to the passive foreign owners of Chinese stock? That is a very intelligent question that practically nobody asks.

What do you think of the U.S. trade and budget deficits -- and their impact on the dollar, which Berkshire is still betting against?
It's not at all clear exactly from some objective bunch of economic data just where the dollar ought to trade compared to the Euro. Who in the hell knows? It's clear that you can't run twin deficits on the scale that the U.S. has forever. As [economist] Herb Stein said, "If something can't go on forever, it will eventually stop." But knowing just when it's going to stop is a very difficult matter.

Is there a bubble in the real estate?
When I see people going to some old flea-bitten old condo and the list price is $1.8 million, and they decide to put it on the market for $2.2 million, and five people start bidding for it, and they sell it for $2.7 million, I say that's a bubble. So there are some bubbly places in the economy. I am amazed at the price of real estate in Manhattan.

So there is some bubble in the game. Is it going to go back to really cheap houses in good neighborhoods in good cities? I don't think so. So I think there will be huge collapses in some places, but, on average, I think that good houses in good places are going to be plenty expensive in future years.

Is there a bubble in energy stocks?
When it gets into these spikes, with shortages and uproar and so forth, people go bananas, but that's capitalism. If the price of automobiles were going up 40% a year, you'd have a boom in auto stocks. But if you stop to think about it, of the companies that you could have bought in, say, 1911, to hold for a long time, one of the very best stocks would have been Rockefeller's Standard Oil Trust. It became almost all of today's integrated oil companies.

How do you feel most corporate citizens behave in the U.S.?
Well, I disapprove of the way most executive compensation is arranged in America. I think it goes to gross excess. And I certainly don't like phony accounting that takes part of the real cost of running the business and doesn't run it through the income account as a charge against the reported earnings. I don't like dishonorable, lying accounting.

Do you think the stock market will return its long-term annualized 10% in the next decade?
A good figure for rational expectation would be no higher than 6%. I think it's unreasonable to assume that the world is going to try to arrange itself so that the inactive, asset-owning class is going to get a much higher share of the GDP than it normally gets. When you start thinking that way, you get into these modest figures. The reason the return has been so good in the past is that the price-earnings ratio went way up.

Ibbotson finds 10% average returns back to 1926, and Jeremy Siegel has found roughly the same back to 1802.
Jeremy Siegel's numbers are total balderdash. When you go back that long ago, you've got a different bunch of companies. You've got a bunch of railroads. It's a different world. I think it's like extrapolating human development by looking at the evolution of life from the worm on up. He's a nut case. There wasn't enough common stock investment for the ordinary person in 1880 to put in your eye.

What do you see for bonds?
The bond market has fewer opportunities now. The short-term rates are the same as the long-term rates, and the premium interest rate you get for taking risk is lower than it ought to be, given the risk. By definition, that's a world in which bond investment is much tougher to do with great advantage.

What do you expect in terms of returns for Berkshire Hathaway?
We have solemnly promised our shareholders that our future returns will be considerably below our previous returns.

But annual reports have been saying that year after year after year.
But lately we've been better at doing what we have long predicted.

What happens to Berkshire after the two of you?
Well, the world will go on and, in my opinion, Berkshire will still be a strong, rich place and with a central culture that will be shrewd and risk-averse. But do I think that we will get another person better than Warren to come in and replace Warren? I think the odds are against it.

Chatting with Charlie: The Mark Twain of Finance

PRESS-SHY CHARLIE MUNGER, vice chairman of Berkshire Hathaway, generally appears in public only once a year, sipping Cokes at a table with Warren Buffett, fielding shareholder questions at the company’s annual meeting in Omaha, Nebraska. Directors’ College attendees enjoyed a rare private session with Munger to kick off their second day. By turns witty and provocative, Munger, a Harvard-educated lawyer, left no doubt where he stands on issues of corporate governance.

ON NEWSPAPERS
“For years I have read the morning paper and harrumphed.There’s a lot to harrumph about now.”

ON ACCOUNTING STANDARDS
“Proper accounting is like engineering.You need a margin of safety.Thank God we don’t design bridges and airplanes the way we do accounting.”

ON THE ARGUMENTS AGAINST EXPENSING STOCK OPTIONS
“Quoting Demosthenes,‘For what each man wishes,that he also believes to be true.’I would rather make money playing a piano in a whorehouse than arguing that no cost is incurred when employees are paid in stock options instead of cash.I am not kidding.”


ON THE TRANSPARENCY OF MODERN FINANCIAL REPORTING FOR TRADING DERIVATIVES
“No CEO examining books today understands what the hell is going on.”


ON ENRON
“I think Enron is the first shoe to drop. There’s a kind of Gresham’s Law,where bad conduct drives out good conduct.”

ON INDIVIDUAL GREED
“It’s amazing the way people have sold out. It’s insane.”

ON ACCOUNTING FIRMS
“Accounting has steadily degraded over the past 30 years,and accounting firms have sold out time after time.”

Banks: Evil and Folly

Friday, 1 May 2009

Warren Buffett's long-time partner Charlie Munger tells CNBC "evil and folly" on the part of the banks and bankers have "helped create a catastrophe for everyone."

In a taped interview with Becky Quick today, Munger worries about the future. "It will be politically hard to remove from the system the evil and folly that helped create the mess, because the people who make a lot of money out of the system as it is have a lot of political power and they don't want it changed."

He does think, however, that thanks to some "stunningly correct and stunningly effective" government policies, we're now on the right path economically.

In a separate interview with Bloomberg TV, Munger says he supports a "100 percent" ban on credit-default swaps.

Here's the CNBC video clip and transcript of Becky's report on her conversation with the usually quiet Munger:

BECKY: Trish, thank you very much. Charlie Munger is a man who doesn't speak very often. Certainly doesn't speak to cameras even when he's here at the shareholders' meetings. He tends to have limited answers. Warren Buffett tends to take the stage. But when Charlie Munger speaks, you should listen up. He almost always says something worthwhile. He's the vice chairman of Berkshire Hathaway. He has been Warren Buffett's partner for many decades. We got the change to catch up with him just a few minutes ago and talk to him about what he sees out there. Remember earlier this morning we were playing sound from Warren Buffett from last night. Warren Buffet is saying right now we've made it through Pearl Harbor, the economic Pearl Harbor that he first told CNBC about last fall, but he says right now we are still in the war. This morning speaking with Charlie Munger, we asked him about the same comments, where he thinks we are in this economy. Listen up.

MUNGER (on tape): Some of the policies are stunningly correct and stunningly effective. For instance, nationalizing Fannie Mae and Freddie Mac and promptly allowing all the sound loans in the country to be redone at low interest rates was a marvelous idea. It's been promptly executed. I think the people who did that deserve enormous credit.

BECKY: Again, that's Charlie Munger talking about the path we're on right now. He says as far as he sees things, he thinks we are on the right path economically right now. Now, as to how we got on this path, he says this has been a horrible mess. He says we got here through evil and folly that created catastrophe. Very big words. You ask who he's talking about. The bankers? He says absolutely. Listen to what he says about the banks.

MUNGER (on tape): Evil and folly have crept into our system at steadily increasing amounts. And finally it helped create a catastrophe for everyone, created the biggest economic threat since 1930s. The conditions of the '20s and '30s gave us Adolf Hitler. That was really serious, and this one's not that serious, but it's the most serious we've had since that one. And it will be politically hard to remove from the system the evil and folly that helped create the mess, because the people who make a lot of money out of the system as it is have a lot of political power and they don't want it changed.

BECKY: All right. Again, Charlie Munger, if you've ever followed his career, you know he's incredibly different than his partner Warren Buffett. Buffett talks a lot, Charlie not so much. Warren Buffett has been someone who has supported Democratic candidates including Barack Obama during his run for the presidency. Charlie has always been someone who has had Republican leanings. But when you ask him now what he thinks about the situation, he says he thinks that people should get behind the president and this administration. He thinks that anything like the divisive partisan politics should be set aside now because there's too much at stake. Now, that's not to say Charlie agrees, Mr. Munger, agrees with everything that the administration is doing right now. In fact, if you ask him about cap and trade, well he has delicate thoughts on that. Listen in.

MUNGER (on tape): Well, I think it would be monstrously stupid to do it right now. It would be a huge shock to the economy, and it wouldn't accomplish very much. Given the fact that the vast majority of the pollutionists, or, rather, the CO2 is coming from a place like China. It would almost be demented if we would rush into cap and trade right now in the middle of this economic crisis.

BECKY: Yes, Mr. Munger has never been someone who minced words. When he thinks something's a dumb idea he says just that. We talked to him about a lot of things. Ethanol, what he sees with the economy, and some of these other administration plans. More on all of these things coming up today in the "Closing Bell." By the way, more of that interview Monday morning on "Squawk Box" as well. But those are some quick thoughts from Charlie Munger, who will be joining Warren Buffett right here in the Qwest Center tomorrow morning answering questions from shareholders.

Monday Interview: Man on the money with Buffett

Wesco Financial’s Pasadena headquarters are a blur of earth tones and cloudless sky. Bathed in southern California sun, the offices hold a glow befitting the gilded career of the company’s chairman, Charlie Munger.

Mr Munger, best known as business partner to Warren Buffett, head of Berkshire Hathaway, is settled deep into his chair. His lips stretched to a thin smile, the 85-year-old billionaire peers through thick glasses.

Over the years, generations of investors, chief executives and journalists have wondered why Mr Munger has stayed happily in the background for almost half a century as Mr Buffett forged a reputation as the world’s greatest stock-picker.

Warren is peculiar, and I’m peculiar,” says Mr Munger, who is also Berkshire’s vice-chairman. “We’ve got our own peculiar operating model. Nobody else operates the same way or stays in the game in a major corporation as long as we have, so we’ve got a different model. And we like it that way.

Working 1,500 miles apart – Mr Buffett remains in his hometown of Omaha, Nebraska – the two “intellectual pals” have built up a stellar record by sticking to the basic principles of value investing: they buy companies in industries they understand, with managers they trust, at cut-rate prices. “We think all intelligent investing is value investing,” he says. “What the hell could it be if it wasn’t value?

While Mr Buffett’s mentor, the economist Benjamin Graham, is considered the father of value investing, it is Mr Munger who is credited with helping Mr Buffett evolve beyond buying stocks for no other reason than that they were cheap.

That worked fine in the period after the 1930s,” Mr Munger says. “I don’t think it works nearly as well now. Too many people are doing it.

Many of Berkshire’s holdings, from longtime investments such as Coca-Cola and Wells Fargo to last year’s purchase of General Electric’s preferred shares, are blue-chip companies considered the best at what they do.

The strategy sounds simple enough, but Mr Munger says few investors practise it. “You can’t believe the way that conventional wisdom invests money,” he explains. “They tend to rush into whatever fad has worked lately. In my opinion, a lot of them are going to get creamed.

There are no regular meetings at Berkshire, no corporate-speak or standard management memorandums that help define the cultures of so many companies.

The legally required meetings for corporate governance, we do those,” Mr Munger says. “Everything else is ad hoc.

Mr Munger has been known to seize hold of a conversation and not let go until his views on a given subject – and possibly the interviewer – are exhausted. But on this afternoon, he is practically beaming.

When Warren talks about tap dancing to work, he’s not kidding,” he says. “His spirits lift as he goes through the office door. And I’m the same way.

In keeping a stake in the hands of public shareholders and a portfolio of its own investments, Wesco maintains an unusual place within the Berkshire empire. Mr Buffett initially agreed to keep the company as a standalone entity to honour the request by the Casper family, the previous owners who had sided with Berkshire in a takeover battle for the former savings and loan company.

Wesco is a historical accident,” Mr Munger says of the holding company whose assets include an insurer, a steel manufacturer and a furniture-rental business. “It should’ve been folded into Berkshire long ago.

It is unlikely Berkshire, which owns 80 per cent of Wesco, will acquire the remaining stake unless the stock price falls relative to Berkshire’s. “Warren’s never going to issue stock that isn’t fair to Berkshire shareholders, so we’re hooked by reason of our popularity,” Mr Munger explains. “But it is a ridiculous outcome and it costs $2m (€1.4m, £1.2m) a year in extra administration costs. We hate it, but we can’t fix it.

Like Berkshire, Wesco’s annual meetings, held each spring in Pasadena, have inspired a devoted following among its investors. But while the carnival atmosphere of Berkshire’s event in Omaha has earned it the moniker “a Woodstock for capitalists”, Wesco’s gathering is an intimate performance in a small club. And Mr Munger’s terse soundbites, his trademark at the Omaha meetings, give way in Pasadena to extended monologues on the economy, government policy and his favourite target this year, the financial services industry.

The public is furious with Wall Street,” he says. “Everyone who is in a position to observe this says they’ve never seen this much fury to one particular industry.

Is it justified?

Absolutely.”

A voracious reader, Mr Munger’s conversations and writings are peppered with references to philosophers, psychologists and inventors whose works and life stories he has studied. He speaks directly, in a tone that can, at times, both alienate and educate.

Like Mr Buffett, Mr Munger was raised in Omaha. He attended the University of Michigan, enlisted in the Army Air Corps and, after the second world war, earned a degree from his father’s alma mater, Harvard Law School. He considered joining his father’s practice in Omaha before setting his sights on southern California, where he had studied meteorology during the war.

Mr Munger was back in Omaha in 1959 when a family friend arranged a lunch with Mr Buffett, then a young local investment manager. The pair hit it off immediately and thus began a lifelong friendship.

By the early 1960s, Mr Munger had opened a law practice with four others and found success as a part-time investor in both businesses and commercial real estate. As his relationship with Mr Buffett flourished, he eventually stopped practising law to focus on deals.

While they no longer speak daily, rarely will more than a week pass between conversations. They still frequently send one another documents and books to read. And while they often disagree, Mr Buffett once told the Financial Times that they had “never had an argument”.

We are having a huge amount of fun understanding how the world works,” Mr Munger says.

Mr Munger has amassed a great fortune in part because of his association with Mr Buffett, but as his annual meetings attest, he has also built a loyal following of his own.

He’s got a real fan club, but for good reason,” Mr Buffett has said. “I’m a member, too.

Mr Munger is in turn quick to praise Mr Buffett, who is looking to rebound from Berkshire’s worst year. As an investor, Mr Munger insists, his partner has continued to improve.

He never would have bought into BYD [the Chinese electric car battery maker],” Mr Munger said. “He’s changed. He learns.

Longtime Berkshire disciples and friends alike might say Mr Munger has had something to do with that.

“There’s no successor to Charlie,” Mr Buffett says. “You’re not going to find anyone like him.”

The Philanthropy Round Table

11/10/00 TALK OF CHARLES T. MUNGER TO BREAKFAST MEETING OF THE PHILANTHROPY ROUND TABLE

I am here today to talk about so-called “wealth effects” from rising prices for U.S. Common stocks.

I should concede, at the outset, that “wealth effects” are part of the academic discipline of economics and that I have never taken a single course in economics, nor tried to make a single dollar, ever, from foreseeing macroeconomic changes.

Nonetheless, I have concluded that most PhD economists under appraise the power of the common-stock-based “wealth effect”, under current extreme conditions.

Everyone now agrees on two things. First, spending proclivity is influenced in an upward direction when stock prices go up and in a downward direction when stock prices go down. And, second, the proclivity to spend is terribly important in macroeconomics. However, the professionals disagree about size and timing of “wealth effects”, and how they interact with other effects, including the obvious complication that increased spending tends to drive up stock prices while stock prices are concurrently driving up spending. Also, of course, rising stock prices increase corporate earnings, even when spending is static, for instance, by reducing pension cost accruals after which stock prices tend to rise more. Thus “wealth effects” involve mathematical puzzles that are not nearly so well worked out as physics theories and never can be.

The “wealth effect” from rising U.S. stock prices is particularly interesting right now for two reasons. First, there has never been an advance so extreme in the price of widespread stock holdings and, with stock prices going up so much faster than GNP, the related “wealth effect” must now be bigger than was common before. And second, what has happened in Japan over roughly the last ten years has shaken up academic economics, as it obviously should, creating strong worries about recession from “wealth effects” in reverse.

In Japan, with much financial corruption, there was an extreme rise in stock and real estate prices for a very long time, accompanied by extreme real economic growth, compared to the U.S. Then asset values crashed and the Japanese economy stalled out at a very suboptimal level. After this Japan, a modem economy that had learned all the would-be-corrective Keynesian and monetary tricks, pushed these tricks hard and long. Japan, for many years, not only ran an immense government deficit but also reduced interest rates to a place within hailing distance of zero, and kept them there. Nonetheless, the Japanese economy year after year, stays stalled, as Japanese proclivity to spend stubbornly resists all the tricks of the economists. And Japanese stock prices stay down. This Japanese experience is a disturbing example for everyone, and, if something like it happened here, would leave shrunken charitable foundations feeling clobbered by fate. Let us hope, as is probably the case, that the sad situation in Japan is caused in some large part by social psychological effects and corruption peculiar to Japan. In such case our country may be at least half as safe as is widely assumed.

Well, grant that spending proclivity, as influenced by stock prices, is now an important subject, and that the long Japanese recession is disturbing. How big are the economic influences of U.S. stock prices? A median conclusion of the economics professionals, based mostly on data collected by the Federal Reserve System, would probably be that the “wealth effect” on spending from stock prices is not all that big. After all, even now, real household net worth, excluding pensions, is probably up by less than 100% over the last ten years and remains a pretty modest figure per household while market value of common stock is probably not yet one third of aggregate household net worth, excluding pensions. Moreover, such household wealth in common stocks is almost incredibly concentrated, and the super-rich don’t consume in proportion to their wealth. Leaving out pensions, the top 1% of households probably hold about 50% of common stock value and the bottom 80% probably hold about 4%.

Based, on such data, plus unexciting past correlation between stock prices and spending, it is easy for a professional economist to conclude, say, that, even if the average household spends incrementally at a rate of 3% of asset values in stock, consumer spending would have risen less than ½% per year over the last ten years as a consequence of the huge, unprecedented, long lasting, consistent boom is stock prices.

I believe that such economic thinking widely misses underlying reality right now. To me, such thinking looks at the wrong numbers and asks the wrong questions. Let me, the ultimate amateur, boldly try to do a little better, or at least a little differently.

For one thing, I have been told, probably correctly, that Federal Reserve data collection, due to practical obstacles, doesn’t properly take into account pension effects, including effects from 401(k) and similar plans. Assume some 63-year-old dentist has $1 million in GE stock in a private pension plan. The stock goes up in value to $2 million, and the dentist, feeling flush, trades in his very old Chevrolet and leases a new Cadillac at the give-away rate now common. To me this is an obvious large “wealth effect” in the dentist’s spending. To many economists, using Federal Reserve data, I suspect the occasion looks like profligate dissaving by the dentist. To me the dentist, and many others like him, seem to be spending a lot more because of a very strong pension-related “wealth effect”. Accordingly, I believe that present day “wealth effect” from pension plans is far from trivial and much larger than it was in the past.

For another thing, the traditional thinking of economists often does not take into account implications from the idea of “bezzle”. Let me repeat: “bezzle”, B-E-Z-Z-L-E.

The word “bezzle” is a contraction of the word “embezzle”, and it was coined by Harvard Economics Professor John Kenneth Galbraith to stand for the increase in any period of undisclosed embezzlement. Galbraith coined the “bezzle” word because he saw that undisclosed embezzlement, per dollar, had a very powerful stimulating effect on spending. After all, the embezzler spends more because he has more income, and his employer spends as before because he doesn’t know any of his assets are gone.

But Galbraith did not push his insight on. He was content to stop with being a stimulating gadfly. So I will now try to push Galbraith’s “bezzle” concept on to the next logical level. As Keynes showed, in a naive economy relying on earned income, when the seamstress sells a coat to the shoemaker for $20, the shoemaker has $20 more to spend and the seamstress has $20 less to spend. There is lalapaloose effect on aggregate spending. But when the government prints another $20 bill and uses it to buy pair of shoes, the shoemaker has another $20 and no one feels poorer. And when the shoemaker next buys a coat, - the process goes on and on, not to an infinite increase, but with what is now called the Keynesian multiplier effect, a sort of lalapaloosa effect on spending. Similarly, an undisclosed embezzlement has stronger stimulative effects per dollar on spending than a same-sized honest exchange of goods. Galbraith, being Scottish, liked the bleakness of life demonstrated by his insight. After all, the Scottish enthusiastically accepted the idea of pre-ordained, unfixable infant damnation. But the rest of us don’t like Galbraith’s insight. Nevertheless, we have to recognize that Galbraith was roughly right.

No doubt Galbraith saw the Keynesian-multiplier-type economic effects promised by increases in “bezzle”. But he stopped there. After all, “bezzle” could not grow very big, because discovery of massive theft was nearly inevitable and sure to have reverse effects in due course. Thus, increase in private “bezzle” could not drive economies up and up, and on and on, at least for a considerable time, like government spending.

Deterred by the apparent smallness of economic effects from his insight, Galbraith did not ask the next logical question: Are there important functional equivalents of “bezzle” that are large and not promptly self-destructive? My answer to this question is yes. I will next describe only one. I will join Galbraith in coining new words, first, “febezzle”, to stand for the functional equivalent of “bezzle” and, second, “febezzlement”, to describe the process of creating “febezzle”, and third “febezzlers” to describe persons engaged in “febezzlement”. Then I will identify an important source of “febezzle” right in this room. You people, I think, have created a lot of “febezzle” through your foolish investment management practices in dealing with your large holdings of common stock.

If a foundation, or other investor, wastes 3% of assets per year in unnecessary, nonproductive investment costs in managing a strongly rising stock portfolio, it still feels richer, despite the waste, while the people getting the wasted 3%, “febezzelers” though they are, think they are virtuously earning income. The situation is functioning like undisclosed embezzlement without being self-limited. Indeed, the process can expand for a long while by feeding on itself. And all the while what looks like spending from earned income of the receivers of the wasted 3% is, in substance, spending from a disguised “wealth effect” from rising stock prices.

This room contains many people pretty well stricken by expired years --- in my generation or the one following. We tend to believe in thrift and avoiding waste as good things, a process that has worked well for us. It is paradoxical and disturbing to us that economists have long praised foolish spending as a necessary ingredient of a successful economy. Let us call foolish expenditures “foolexures”. And now you holders of old values are hearing one of you own add to the case for “foolexures” the case for “febezzlements” --- the functional equivalent of embezzlements. This may not seem like a nice way to start a new day. Please be assured that I don’t like “febezzlements”. It is just that I think “febezzlements” are widespread and have powerful economic effects. And I also think that one should recognize reality even when one doesn’t like it, indeed especially when one doesn’t like it. Also, I think one should cheerfully endure paradox that one can’t remove by good thinking. Even in pure mathematics they can’t remove all paradox, and the rest of us should also recognize we are going to have to endure a lot of paradox, like it or not.

Let me also take this occasion to state that my previous notion of 3% of assets per annum in waste in much institutional investment management related to stocks is quite likely too low in a great many cases. A friend, after my talk to foundation financial officers, sent me a summary of a study about mutual fund investors. The study concluded that the typical mutual fund investor gained at 7.25% per year in a 15-year period when the average stock fund gained at 12.8% per year (presumably after expenses). Thus the real performance lag for investors was over 5% of assets per year in addition to whatever percentage per year the mutual funds, after expenses, lagged behind stock market averages. If this mutual fund study is roughly right, it raises huge questions about foundation wisdom in changing investment managers all the time as mutual fund investors do. If the extra lag reported in the mutual fund study exists, it is probably caused in considerable measure by folly in constant removal of assets from lagging portfolio managers being forced to liquidate stockholdings, followed by placement of removed assets with new investment managers that have high-pressure, asset-gaining hoses in their mouths and clients whose investment results will not be improved by the super-rapid injection of new funds. I am always having trouble like that caused by this new mutual fund study. I describe something realistically that looks so awful that my description is disregarded as extreme satire instead of reality. Next, new reality tops the horror of my disbelieved description by some large amount. No wonder Munger notions of reality are not widely welcome. This may be my last talk to charitable foundations.

Now toss in with “febezzlement” in investment management about $750 billion in floating, ever- growing, ever-renewing wealth from employee stock options and you get lot more common- stock-related “wealth effect”, driving consumption, with some of the “wealth effect” from employee stock options being, in substance, “febezzle” effect, facilitated by the corrupt accounting practice now required by law.

Next consider that each 100-point advance in the S&P adds about $1 trillion in stock market value, and throw in some sort of Keynesian-type multiplier effect related to all “febezzlement”. The related macro-economic “wealth effects”, I believe, become much larger than is conventionally supposed.

And aggregate “wealth effect” from stock prices can get very large indeed. It is an unfortunate fact that great and foolish excess can come into prices of common stocks in the aggregate. They are valued partly like bonds, based on roughly rational projections of use value in producing future cash. But they are also valued partly like Rembrandt paintings, purchased mostly because their prices have gone up, so far. This situation, combined with big “wealth effects”, at first up and later down, can conceivably produce much mischief. Let us try to investigate this by a “thought experiment”. One of the big British pension funds once bought a lot of ancient art, planning to sell it ten years later, which it did, at a modest profit. Suppose all pension funds purchased ancient art, and only ancient art, with all their assets. Wouldn’t we eventually have a terrible mess on our hands, with great and undesirable macroeconomic consequences? And wouldn’t the mess be bad if only half of all pension funds were invested in ancient art? And if half of all stock value became a consequence of mania, isn’t the situation much like the case wherein half of pension assets are ancient art?

My foregoing acceptance of the possibility that stock value in aggregate can become irrationally high is contrary to the hard-form “efficient market” theory that many of you once learned as gospel from your mistaken professors of yore. Your mistaken professors were too much influenced by “rational man” models of human behavior from economics and too little by “foolish man” models from psychology and real-world experience. “Crowd folly”, the tendency of humans, under some circumstances, to resemble lemmings, explains much foolish thinking of brilliant men and much foolish behavior --- like investment management practices of many foundations represented here today. It is sad that today each institutional investor apparently fears most of all that its investment practices will be different from practices of the rest of the crowd.

Well, this is enough uncredentialed musing for one breakfast meeting. If I am at all right, our - present prosperity has had a stronger boost from common-stock-price-related “wealth effects”, some of them disgusting, than has been the case in many former booms. If so, what was greater on the upside in the recent boom could also be greater on the downside at some time of future stock price decline. Incidentally, the economists may well conclude, eventually, that, when stock market advances and declines are regarded as long lasting, there is more downside force on optional consumption per dollar of stock market decline than there is upside force per dollar of stock market rise. I suspect that economists would believe this already if they were more willing to take assistance from the best ideas outside their own discipline, or even to look harder at Japan.

Remembering Japan, I also want to raise the possibility that there are, in the very long term, “virtue effects” in economics--- for instance that widespread corrupt accounting will eventually create bad long term consequences as a sort of obverse effect from the virtue-based boost double-entry book-keeping gave to the heyday of Venice. I suggest that when the financial scene starts reminding you of Sodom and Gomorrah, you should fear practical consequences even if you like to participate in what is going on.

Finally, I believe that implications for charitable foundations of my conclusions today, combined with conclusions in my former talk to foundation financial officers, go way beyond implications for investment techniques. If I am right, almost all U.S. foundations are unwise through failure to understand their own investment operations, related to the larger system. If so, this is not good. A rough rule in life is that an organization foolish in one way in dealing with a complex system is all too likely to be foolish in another. So the wisdom of foundation donations may need as much improvement as investment practices of foundations. And here we have two more old rules to guide us. One rule is ethical and the other is prudential.

The ethical rule is from Samuel Johnson who believed that maintenance of easily removable ignorance by a responsible office holder was treacherous malfeasance in meeting moral obligation. The prudential rule is that underlying the old Warner & Swasey advertisement for machine tools: “The man who needs a new machine tool, and hasn’t bought it, is already paying for it”. The Warner & Swasey rule also applies, I believe, to thinking tools. If you don’t have the right thinking tools, you, and the people you seek to help, are already suffering from your easily removable ignorance.