Munger: Low Opinion of Forecasts

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With enough cushion from his investments, Burkle didn't have to get a full-time job. He put together a plan to buy Kroger's Southern California Market Basket chain, which was dealing with unfunded pension liabilities. When he returned to Munger, lugging three notebooks with five-year plans to justify the deal, Munger was uninterested in Burkle's work.

``He said, `What are these for?''' Burkle recalls. ``He said, `Manage to the opportunity, not to the plan.'''

`Low Opinion of Forecasts'

Munger confirms the story. ``I have a low opinion of forecasts made in investment banking projections, so I don't generally read them,'' he says. ``If I tossed them aside, that would be typical.'' Munger declines to comment otherwise on Burkle's career. ``I know what I read in the paper,'' he says.

Source

Charlie Munger on how he'd make Volckler look like a sissy

Munger was interviewed by Robert Lenzner of Forbes.

On Berkshire Hathaway
"Smart people can sense when the market price is a little ahead of itself and when it's a little behind. I sold 2,000 shares to my children at $70,000 a share. Having a market price that is split 50-to-1 and being in the S&P 500 index we can easily handle selling 1% of the shares every year (for Buffett's gifts to the Gates Foundation). Ben Graham (legendary investment guru) said if it's a good investment it's likely to be a good speculation. We're going into a sound proposition on the expectation it will last for our lifetime. We have a lot of smart people at Berkshire. We have extreme centralization at headquarters where a single person (Buffett) makes all the capital allocation decisions, and we have decentralization among our operations without a big bureaucracy. That's the Berkshire Hathaway model."

Charlie and Warren
"We find the same things humorous. That's why we get along so well. It's hard to tell who is wittier. My humor is Jewish humor. Maybe I'm part Jewish."

"How would you make Paul Volcker look like a sissy if you regulated Wall Street?"
I would economically restrain what investment banks and banks do more than he would. I would separate derivatives from the basic bridges of civilization. We don't want civilization contaminated by extreme speculation. I'd ban all the derivatives trading except for metals and commodities. The new stuff is a marvelous gambling game. It swamps any commercial transactions that are needed. Gambling does not become wonderful just because it pertains to commerce. It's a casino. You shouldn't be able to use $500,000 to do a $5 million trade.

"If I were the Lee Kwan Yew (formidable former Singapore leader) I'd make finance far less attractive to go into. I'd raise taxes, maybe put a Tobin (Yale economist) tax on all transactions. If Warren was the benevolent despot of the U.S., these things (derivatives) would have never existed. Warren wrote a letter in 1982 objecting to the creation of the S&P 500 derivative contract. Its message: This is going to do more harm than good. He tried to prevent it from happening. I think he believes civilization would be better if they didn't exist. Still, Warren has great difficulty not buying a mispriced item in the financial market. We bought derivatives even though we didn't believe in their existence.

On Wall Street
"Wall Street has too much wealth and political power. The system is dysfunctional for our country. There's more honor in investment management than in investment banking. I'm terribly conflicted. I hate it that bright young people are going into finance when all the Chinese are going into engineering. If we don't make substantial changes in the system we'll have another big mess."

On Human Nature
"I'm used to people with very high IQs knowing how to recognize reality, but there's a huge human tendency where it may be instructive to think that whatever you're doing to succeed is all right. These people say to themselves: I need it and I want it, therefore I must have it. I come from a culture that sees reality better. Lehman under Dick Fuld was pathological, operating like a boiler room. It reminds me of a quote from the Mikado: 'I have a little list of those who will not be missed.'"

On the acquisition of Chinese electric car maker BYD and Iscar, an Israeli machine tool manufacturer.
"BYD and Iscar are the first two technology companies ever acquired by Berkshire and a break with the past. I enlisted the help of Dave Sokol (chairman of MidAmerican Energy, a subsidiary of Berkshire and favorite to succeed Buffett as CEO) to convince Warren it was a good investment. (Berkshire owns 10%, the limit for a foreign interest. BYD is trying to solve the engineering and production problems useful to civilization. BYD has 16,000 engineers and its founder, Wang Chuanfu (the wealthiest Chinese entrepreneur with $5.1 billion in BYD shares) is behaving like the Thomas Edison of today.

On Himself
"I went where there was dumb competition (investment management). We do so well in spite of being so stupid. That's why there's hope for you!"

Source

Wesco 2010 Annual Meeting

Notes from: The Inoculated Investor

The plan is to follow the procedure from last year and then talk about interesting issues. Regarding his general observations, he is flabbergasted that so many people came to Pasadena after going to Omaha. He thought we would have had our fill of his opinions but apparently there are “addicts” out there. Wesco is a quiet enterprise. It has a $2B market cap, up from $20M at the time they started buying back stock. That is a failure in comparison to Berkshire Hathaway (BRK), but compared to other companies it looks alright.

The failure rate of S&Ls has been very high and they are one of the only survivors. Why is the casualty rate of S&Ls in California so high? They tried to live off of a modest spread between their loans and their costs of debt. Relying on a small spread is a tough way to live if you are ambitious. If you are determined to grow 10-20% per year in assets and earnings, what you will tend to do in order to achieve this goal will lead to ruin. Ultimately, competitors drop loan standards and you either fire people to cut your overhead [due to lack of business] or you lower your own standards as well. Most people follow this race to the bottom, a process that destroys the entire industry. This was what the Greeks called a tragedy-- you could see it coming but you couldn’t escape it. At the bottom tick just about everyone in Wall Street could have gone under unless the government had saved them. This whole process leads to a competitive deterioration of asset quality and leads the system to ruin. This is an obvious dynamic.

Why hasn’t mankind developed a system to prevent this ruin? What happens is that active people get rich and powerful and they buy the favor of politicians and then auditors go along. At the depths of the crisis, it was deadly serious. We were on the edge of something that could have taken the whole civilization into severe difficulty. We gave up the stupidity after WWII. We took our money to our enemies and helped them recover. This was one of the best decisions ever made. It worked out beautifully. This did not happen after WWI and that’s how Hitler rose. That certainly did not turn out well.

Why can’t we do something smart like the Marshall Plan in finance? What happened is that all our elites failed us, especially academic elites. Faulty risk control mechanisms were taught in business schools and eventually law schools adopted the belief that everything is based on a Gaussian distribution. This turned out to be very wrong, despite the high all the IQ people analyzing the financial markets. Why do some people make good decisions and other smart people make bad decisions? Some bad choices come from incentives inherent in our civilization. People start to want to spread and dominate. How do you remain in the minority who stays sane when everyone else is going crazy? You have to skeptical of common wisdom and keep your head when everyone else is losing theirs.

Who else failed us? The academic types thought that diversification was the secret to success. Diversification may be a way of avoiding disaster but does not represent a path to success. A person is not much of a teacher if all he or she can do is prevent disaster. This is why he calls it de-worsification. BRK owns things they know a lot about [instead of blindly].

The concept of beta or volatility is asinine. It isn’t always bad ideas that cause bad outcomes but good ideas taken to excess. Obviously if you own very volatile stocks your returns can be volatile day to day. The main problems in life can only be solved when you know what works, what doesn’t and why.

Very high IQ people coming out of b-schools are basically useless to us, aside from their own idiosyncratic virtues. These people often tell him and Warren that what they learned in b-school was useless and they like the way Warren and Charlie think. Simple formulas are all that are taught but they are totally useless. B- schools have not done civilization a favor by making the matter easier to teach but useless. If he were running a business school, he would start off with a history of business. That system would steal cases from each of the sub-specialist’s repertoire so there would be a lot of cross-academic friction. However, he thinks it is useful to know why GM rose and then failed. He also thinks it would be beneficial to examine why railroads rose, struggled and why are they better investments now. Unfortunately, it is easier to teach beta, which he equated to algebra; where you can plug in values and find an answer.

A friend of his went to a school that taught him how to reduce working capital by starving suppliers. They taught him to use simple algebra to squeeze suppliers. When he has tested on this material, he gave the calculation on the exam but told the teacher that it was asinine and that would never do that. We should all want to have a partnership with suppliers in which everyone trusts one another. He is a very prosperous guy and did well because he rejected the business school stupidity.

It is very important for students to be independent and to question what they learn.
Gilford Glazer [a longtime friend of his], came back from the war and went to HBS. But his father’s little machine shop needed attention and he asked them to defer acceptance for a year so he could help his father. After a year he contacted HBS and asked for another year. The guy from Harvard then asked him how many employees he had last year at this time. He answered 50. Then, when he asked him how many employees he had now, the answer was 900. The Harvard guy laughed and told him he didn’t need to go to business school. That kind of approach is no longer present at HBS. They were probably wiser then than they are now.

Gilford’s father gave him good advice when he came back from the war. As a general principle, he wanted to sell people things that are good for them. He didn’t want to operate casinos or sell drugs. He believed a firm should only do things that were good for customers and now he is a billionaire. A lot of the ethical approach of the elder Glazer is gone today. Competition takes things to excess.

Charlie then changed the subject to soccer. Soccer is a game that is very competitive and it is hard to win when the other team has a player that is unusually good. If you let the players do what they want to do they will work mayhem on that great player. Therefore, the soccer referee has to limit the mayhem. This is an important role in soccer. This is the role that government should take with investment bankers. You can’t expect competitive people like them to reign themselves in. It’s understandable that if you recruit these competitive people that it leads to too much aggression and ethical standards go down. Something like that has happened in investment banking.

At the end, Lehman (LEH) was pathological. The totally crooked and crazy operators who originated mortgages and then packaged them into securities were behaving in a way that Glazer’s father would not have recommended. In the end it does not work well for those who sell things that are bad for their customers. The disturbing thing is that most of these people think it is someone else’s fault. Hitler said when he was in that bunker that it was too bad that this happened. He believed that the problem was that the German people hadn’t appreciated their leader enough.
This is similar to what people on Wall Street think now.

There needs to be an adult in the room. But the government was not a good referee of mortgage originators. They had 200 people in OFHEO whose job it was to regulate Fannie and Freddie and right under their noses both went hopelessly insolvent and had phony accounting. Some of this was due to the desire at Fannie and Freddie to generate bonuses. In any case, you are not going to solve the problem by saying to these entities “do whatever you want because we have a regulator here to watch.” The regulator is likely to be co-opted or be subject to inertia.

The SEC failed us and let Madoff do what he did but they ignored it because it was difficult. Our problems cannot be solved by letting these people who failed regulate more. We should curtail the activities that are permitted. We need to limit what Goldman Sachs (GS) can do. We did that after the 1920s due to the wretched excess of the 1920’s. They passed a law that said commercial banks couldn’t do investment banking and for a long time the investment banks stayed out of trouble and maybe even were too cautions.

We don’t need the capital allocation process of our civilization mixed up with a casino. Commercial and investment banks should be separated. We should have commodity markets, but not within the banks. They should not be able to gamble on derivatives or agriculture hedging. The investment banks should be allowed to be an underwriter, sell securities to customers, get revenues from M&A, and run accounts for hedge funds. There is a lot of legitimate activity that can be done without scandal and trouble. Why do they have to do everything else? Munger would really curtail what is allowed to be done. Investment banks could spin off these businesses if they like. JP Morgan was reputable after Morgan Guaranty was split off. Unfortunately, nobody else believes this like Munger does.

It is very hard being up there in his 87th year. He said he feels a lot like George Burns. According to a story, they sent Burns 4 girls to sing to him on his birthday and he couldn’t handle it. He said that one of the girls will have to come back tomorrow.

We need the equivalent to the soccer referee--but not OFHEO. There needs to be legislation that says that insured deposit taking precludes you from engaging in other risky activities. If there is no formal legislation, you have what happened to LEH. All problems were solved by doubling down, the accounting gets wretched, you take things off the balance sheet and everything goes bonkers. This is dangerous for the rest of us.

Charlie thinks GS has the best morality and best wisdom of all of the banks. Accordingly, the government should not jump on the bank that is the best. The government just stumbled into this SEC investigation and it is not an appropriate response. He thinks the world would work a lot better off without this stuff [derivatives]. It worked well without them before.

He knows of a place where poker is played. There, the more complex the game, the easier it for the best players to beat the patsies. This is the same thing happen on Wall Street. People now want to be more like him instead of being engineers. When people are allowed to play complicated games they will clobber their own customers who are not as experienced.

When a guy is offering you free money then don’t listen to the rest of the sentence. This is the Munger rule. Korea and Mexico got caught up in buying derivative contracts. The carnage from the complex products has been terrible. It is a mistake to create products that rook your own customers. Who is going to be the wolf and who is the going to be the sheep? Just guess.

There are a lot of activities that we can do without in our current financial scene. But the vested interests in this stuff are just so big. The accountants are part of the problem here. There is a new accounting standard. Assets are good until you reach for them or actually need them. Derivative books are full of $400M holes. These books are full of assets that are being valued differently by each of the parties. We don’t need mark to myth accounting. Accountants learn too much math and too little sense. Over-reporting assets and earnings and under reporting assets and earnings are not the same. The real risk of over-conservatism is just about 0. The accounting changed because people wanted to write their assets up, not down.

He remembers when the Morgan Bank decided to go along with crowd in order to retain their traders. They had to go to looser accounting standards. This led them into further derivative trading and the books went nuts. There is a huge advantage to trading derivatives over the counter (OTC). If you are the only market maker and the other person wants to get out-- they have to come to you. Plus there is mystery in terms of pricing. Banks have unclear derivative transactions in the 100’s of billions of dollars on their books. It is like hydrogen and oxygen sitting next to each other on the sidewalk but people just continue to book profits and somehow believe they are actually earning them.

Is there an example of a prudent decision like the Marshall Plan after WW2? The George Washington of Singapore, Lee Kuan Yew, decided to marry the smartest girl in his class. Their son is now the PM of Singapore. He was a very practical man. He didn’t want people dying of Malaria so he drained all the swamps and didn’t care if a little fish went extinct. He didn’t like the drug problem and he looked around the world to solve the drug problem. He found the solution in US by copying the US Military’s policy. Any time you can be tested and if you fail you go to jail. If something was going to grow like cancer he would check it hard with the wrath of God. He turned a country with no resources or agriculture into a prosperous country, starting from 0 mph. We need to pay more attention in our country to the Singapore model.

They hate Lee Kuan Yew in liberal arts colleges. They hate that Singapore doesn’t allow free speech. But, time after time he has been successful and even the leaders of China came to Singapore and learned from Lee Kuan Yew. Charlie doesn’t care whether the cat is black or white, as long as it catches mice. In many respects the US is too damn permissive. We don’t step hard enough on things that can grow into trouble. If some of the silly accounting practices had been stopped, then none of this would have happened.

Take Enron, for example. The ability to record profits upfront on uncertain derivative contracts was insane. The SEC needs more sense and to learn to say no. People will always ask to be able to do the wrong things. If we don’t tell them no, we are going to continue to have trouble.

Not only do accountants have mathematical consistency that doesn’t make sense, they also follow the rules and then blindly conclude that they have the right answer. They created a rule based on past experiences at banks. After a long period during any boom, bad debt reserves at a bank go to $0 when they should go up. We should throw out that system and find one that makes more sense. To get consistency, the profession came up with a rule that when you are on the edge of bankruptcy (creditors are terrified), you have made a huge profit because you could theoretically buy your debt back at a large profit--if you had cash of course.

There is Alice and Wonderland and nut case accounting in the US. These people need to be thrown out and people who think more like Lee Kuan Yew need to be installed. Jamie Dimon of JP Morgan is actually complaining about this but he is the only one. Charlie takes his hat off to him but his derivative book needs to go away. He should not run a gambling parlor next to a legitimate business. Actually, in recent years, some of our banks actually bought casinos. “Why run a casino in drag when you can run a real casino?”

When it comes to casinos, maybe we should have these things but we should minimize them. Casinos work so well--no inventories and no accounts receivable. It’s like god gave you the ability to print money. But real casinos have huge CAPEX and asset requirements. On the other hand, on Wall Street they can create a casino without those requirements. How many of us could resist those temptations to print money?
Some people look at an 87 year old Chairman and worry about succession. Wesco is a historical accident— it should have been merged into BRK. People like this as a club and have bid the price too high for Buffett to be willing to buy it. He and Warren don’t like forcing people out in exchange for cash and hate to issue BRK stock for almost anything. So, the inevitable outcome has been delayed. Eventually the price will be right or such a minor blip to BRK that it will eventually be merged into BRK. This place has no logical future. “I have no idea why you like place. I was never all that popular in my youth.”

The BRK model--what is different about it? We have decentralization just short of abdication in terms of managing subsidiaries. They employ 28 people in Omaha. But, they have an extreme centralization of cash in Omaha. They allow businesses to buy things that will help their businesses but the cash for the most part comes to Omaha for Buffett to invest. Centralization is as peculiar as the decentralization. There is no big bureaucracy with central rules. People would rather work in small groups where they trust one another. Extreme de-centralization is good, on balance. Averaged out, it provides more benefit than harm. They get a ton of value from centralization of capital. The higher the opportunity cost, the better decisions will be. They can allocate capital to insurance companies or they can buy a whole company. He recently looked at a company in China that he rejected it immediately. He knew he liked BYD more and could buy more of that company instead. The opportunity cost consideration at headquarters leads to better capital allocation.

People now ask him, what the hell has happened to you? You are buying companies that are dependent on technology. BYD and Iscar are the primary examples. Up until recently, Charlie and Warren have shunned high tech. They like shops and roofing shingles more. They don’t want to look like Merck or GE and they have historically been different. Why are they doing this? Well, their past behavior was due to inadequacies. The change happened because they developed other models. You should have a lot of models in your head.

One of the models in his head is the Northern Pike model. Some businesses are like Northern Pike and come into the business world of stupid trout and gallop through the world like Genghis Kahn. Costco and Wal-Mart are examples of these types of companies. They have a models and systems that make them a great force.

He would never have bought Samsung previously because they surf on the edge of technology. Take Kodak, for example. They had the smartest people and the best patents and it almost went “blooey.” What about Xerox? They had great people and engineers but they had a near death experience. When you are a high tech company, when a game changing technology comes around, you fail (quoting Bill Gates). Because of this threat of failure they stayed out of this sector previously. But now they are in it. The answer is that some of the models got so powerful that they could make predictions that success would happen and the company would continue to grow. If he claimed he could press 800 pounds above his head, people would laugh. But if you saw him actually do it over and over again, you would start to believe that he could do it again. This is exactly what happened with BYD. They created miracles that kept on happening.

What has happened is that they have gotten confidence to enter places they hadn’t been before. They are clearly not going to do this very often. There are not that many BYDs. They don’t want to be the new Klenier Perkins of Southern California. He actually hates the venture capital business. When you bet on something like BYD, it is not just BYD. You are betting on something that is close to proven. It is fun to watch a business tackle the biggest problems we face in this world. Cheaper solar power and better batteries are holy grails. Mass production of better cars for people in China is a holy grail. The electric car has to be made for places where you can’t breathe the air. At every major university and every energy company they are trying to develop these technologies. How are some people in China in the lead? They have unique individuals and a unique culture. Chinese engineers just work harder than other. He thinks BYD will succeed and it will help us all if they do. We have to use more sunlight in order to solve power problems and pollutions problems. A better battery technology is part of that. He recently drove a BYD vehicle even though he usually drives Mercedes 500. This BYD car weighs more due to the weight of the battery. He foresees that there is going to be a car like the Mercedes that works on a battery,

Mercedes just signed a cooperation agreement with BYD. Why would they do that? The answer is that they have tested the battery. They can see the future coming and can see why it will work. The right people are getting together and if he lives long enough he will be driving a battery car. He does not advocate everyone get into technology, especially since he and Warren got rich following their old model. It is just safer. He thinks he is right about BYD even though it wasn’t how he came up. He can still learn even though he is 86.

* * *


Question 1: Referring Wall Street, are distorted incentives between banks and regulators the problem? There is a huge pay discrepancy between regulators and bankers. What happens when they finish public service and then move into the private sector? Should that be curtailed?

He thinks that the revolving door between Wall Street and the US government regulators is a big problem. Lee Kuan Yew of Singapore decided to pay civil servants more to get around this problem. Our main problem is not corruption-- it is cognitive inadequacy.

Question 2 (Whitney Tilson of T2 Partners): Jimmy Cayne and Alan Schwartz recently testified in front of Congress that there was nothing that they could have done to save Bear Stearns. Should we have these congressional hearings?

If you haul people in front of Congress, hanging onto any shreds of dignity, people will blame others instead. Congress does it in part because they are mad and they want drag people in there. It’s like putting a dog’s nose in it after it has an accident in the living room. Some people will even say that they just don’t remember.

Question 3: (David Winters of Wintergreen Fund) When do you anticipate insurance pricing to improving and to generate a greater float at BRK?

Odds are the float will not grow much. It may even decline. It is hard to increase float from the current levels. There have been some miracles in the past and they have a wonderful system to increase float, but it is unlikely.

Question 4: Should America get back to basics? The crisis is not forcing us to back to basics. We have lost sight of manufacturing and infrastructure. People seem to be missing the importance of these things. What does Charlie think?

Of course the county has more troubles now than we are used to. Certain forces look difficult to handle and we somehow can’t change things like education. That said, he is not overly pessimistic. People ask him, how can you be happy in California with the legislature? There are certified nuts on both sides of the aisle hating one another? It’s true that we have all of these troubles but we have a great climate and are getting an influx of Asian people. The truth is that when you get enough of a mess, you get a correction. The failure that’s bothering people so much looks like a ray of sunshine to Munger. People need to be provoked by a lot of failure. Maybe a partial dawn is coming while to some it looks like the end of the world. “I hope I’m
right.”

Question 5: How do you develop the temperament of the Berkshire mode?

That’s a very good question. Why do we have so much failure? Most people don’t understand the main model. Look at East Germany. People were caught under Communism. The best 5M people got to leave. The worst 17M stayed and of course that ruined even a great country Germany. This is true in the US’s urban cities. The best people have left and the problems can’t be fixed easily. You can’t fix brain cancer when you already have it. You need to protect against it by stepping on things before they get too bad. The whole EU has problems like East Germany now. You can’t blame Greece’s politicians. They acted based on the incentives in front of them. You better cope with the problems if they are in your face.

We would do better coping with complex systems if we thought about them more. Lee Kuan Yew thinks things through. The fact that it is unpleasant does not stop him. Affluence and poverty can both ruin children. Charlie recommends a much more rational and tough-minded approach. An ounce of prevention is not worth a pound; it is often worth a ton.

Question 6: Do we need for s smart electrical grid in the US? When it comes to Burlington North Santa Fe (BNSF), could the vast right of ways be used for building the grid? Would that be good for BRK shareholders?

He has ever heard anyone every suggest that. But, he can’t rule it out because they use the railways for pipelines now. The grid he has in mind has to be up in the air. He can’t imagine the BNSF grid full of utility towers. “Put me down as skeptical-- I don’t see any potential synergy.”

Question 7: BYD has a brilliant leader. What happens if he isn’t there?

There are inevitable risks but Charlie is accustomed to it dealing suck risks when it comes to Warren. [Charlie asked Wang Chuangfu to stand up and show how “frail” he was] BYD actually just moved their HQ into downtown LA. That is a good message since it doesn’t look anything like Wall Street.

Question 7: How do you retain good engineering mentality without succumbing to the dark side [relying too much on numbers and formulas]?

One big institution that has a low amount of paralysis by analysis is BYD. They are determined to be rational and they don’t like delays. Their culture is so different from what you see in places that suffer from paralysis from analysis. Unfortunately, India has copied our worst faults when they should be copying Singapore’s.

Question 8: In his relationship with Buffett, what did Buffett teach Charlie? [Buffett credited Munger with teaching him about a durable competitive advantage at the BRK Annual Meeting]

Buffett is a supportive and appreciative of his colleagues and says nice things. He gave him credit he does not deserve. Munger claimed that Buffett already he knew about competitive advantages. He didn’t need Charlie. They do so well in spite of being so stupid. “That’s why you are here. You think there is hope for all of you.”

Patrick Wolf, the chess player, came to Munger and complemented him. Munger said he certainly does not do better than Wolf. Munger just went where there was no or dumb competition. Wolf goes where the competition is the most intense. [Playing chess against 6 players at a time blindfolded]

Question 9: How do you determine bet size when you make investments? Do you use the Kelly Formula?

They don’t use any accounting formulas to determine the size of bets. The Kelly Formula only works when you make bets over and over again. They rarely make bets so the formula doesn’t make sense. Their problem is finding a way to make sensible bets that can make a difference. The formula makes sense for gambling, but not for their style of investing. It is a correct formula, but only for certain types of problems.

Question 10: In terms of the BNSF acquisition, are their incentives in management’s compensation to get their margins up [closer to where the competitor’s margins are]?

They don’t think they have to do one damn thing--they are going to let the CEO Matt Rose do whatever he wants. They are happy to let Matt think about such margin problems.

Question 11: Did he and Buffett share ideas before they formally got together?

He always had someone to discuss investments with. Even Einstein didn’t work in isolation. But he never went to large conferences. Any human being needs conversational colleagues. He had enough. He only needed one wife and few pals, at least when it comes to deep intellectual stuff.

Question 12: Excesses in the economy finally caused the blow up. Have they been worked out?

Of course they have not been worked out. What we think of as excesses are the air holes for a diver [meaning that they think they need excesses to survive]. People say to themselves: “I need it and I want it and I should have it.” Some people never get over that. If we don’t make substantial changes to the system we will have another big mess like the one we have had.

Question 13: What do you think of Central Banks’ behavior, especially printing money and changing collateral standards?

Greece is serious. Everyone knew that a Greece-like problem was a risk when forming the union. It’s amazing that it actually took so long. There is one problem that is very hard to fix: the EU doesn’t want to bail out everyone who has borrowed too much no matter how much trouble they get into. It is very awkward to have a member of the EU go under. In the old days, countries like Ireland got welfare from the EU and Ireland enjoyed a great surge, subsidized by the EU. There are terrible problems on each side; neither is attractive. He is glad he isn’t working on it because he has no idea how to solve it. Wisdom is in prevention. Wise people step on big troubles early. Civil servants drift along hoping that God will provide a solution and the problems inevitably get worse.

Question 14: You study people you admire. Who should we study?

There is a lot to learn from BRK. At a BRK meeting, one group of BRK managers said he had been successful following an 80/20 rule: focus on the best 20% of customers. Then, the next man came up with an even more profitable business. But, he specializes in the worst 20% in the world; the people that others wanted to get rid of. Both were correct following completely different strategies. If you are clever enough, you can do well going after what no one wants.

Question 15: In terms of BRK, the questioner wanted to invest but he is concerned about succession.

Speaking for himself, he has much of his net worth in BRK stock. He thinks it will be a great company for many years after they are long gone. He thinks that the culture is amazing and the businesses are great. Few enterprises have been created to need so little talent at the top. It has great momentum and the culture in place should last.

Question 16: Where would you start a circle of competency in investing?

Don’t go where the big boys have to be. You don’t want to look at the drug pipelines of Merck and Pfizer Go where there are inefficiencies in which you can get an advantage and where there are fewer people looking at the stocks. Go where the competition is low.

Question 17: A lattice work and a cross-disciplinary approach to thinking are very useful. The questioner claimed that his constraint is adding to the tool kit, meaning that it takes him longer to learn something as a result of using these frameworks. Is this inevitable or can you speed it up?

Charlie was born a lattice work thinker. He was continually curious. Learning was play, not work. This gives you an advantage. If you have his nature, just do what comes naturally. If you are different then you have to figure out your own damn solution.

Question 18: Why did the government have to step in this time [where it hasn’t to the same extent previously] to save the financial system?

It was way worse and the banks were going to go down like bowling pins. The process was just feeding on itself and stuff like this can get worse real fast. No one liked what was unfolding and no one wanted to see what could have happened without the extreme measures. Both the democrats and republicans figured out that something had to happen really fast. England showed us that we had to intervene in out banks and that that approach was better than the original TARP plan. We have wonderful leadership (singled out Hank Paulson) and he is grateful. The problems were very dangerous.

Question 19: Can you talk to the current state of the condo development next to Wesco HQ?

Charlie thanked the questioner for rubbing his nose in a financial failure. He said it’s good for him. He decided to help civilization in the hope that people who could afford anything would move in Pasadena and pay a lot of money. In spite of the bad market they are selling condos to the right type of people at a modest loss. They are selling to good people. They are behaving correctly and will continue to do so. Eventually each one of those condos will be worth more than these buyers paid for it. Eventually one condo will be for sale and there will be lots of bidders who take the price way up. It will be good for buyers, bad for Wesco.

Question 20: Some high percentage of Cal Tech students are going to work in finance after graduation. This may not be a bad thing because one day they could be running the place. What does Charlie think of that idea?

It is likely that random person from Cal Tech would do better than [former Lehman CEO) Dick Fuld. But the loss of engineers to finance and to a money grubbing exercise is a problem. They should be designing oil refineries and just because they are better than Fuld does not mean they should go into finance for a living.

Question 21: Can you talk about the state of the insurance market?

Generally speaking, the P&C business is tough. It has some of the problems of high finance when people try to maintain volumes and then eventually underwriting suffers. He would not look at this business as a good investment other than if you wanted to invest in BRK. They are tough minded and can make money in this space. This is not a good business for most other companies. It is very tough with a lot wrong with it. It is so easy to underpriced and under-reserve. It is tough to count on smart decision making at the top of a P&C company. It is even more difficult in the reinsurance business.

Question 22: How does he look at the potential BNSF return? Has he read any good books lately?

BRK is doing things based on opportunity cost of capital. They were getting poor returns on their money and what happened was that they thought the deal was good for BRK shareholders. It was better for BNSF shareholders but that isn’t a reason not to do it. CEO Matt Rose was a big addition to BRK. He is young and sound. They don’t estimate precise return figures.

They invest money and hope to make 10% pretax over a long period of time when they are buying equity. Generally, they hope that they will make that 10% but it’s not an iron rule. A rough range in the current return environment would include less than 10% pretax from here. This is not a hog heaven period. Interest rates are low and this is one reason stocks are up so much. This is not a world that should make all you people salivate. This world is difficult. There was a short bargain period. Some of us were paralyzed and others didn’t have the money. We are facing ordinary adult life now and it is not easy. Thus, we may be wrong about getting a 10% return from buying stocks now.

In terms of books, all the books about the Great Recession were interesting. He likes the John Paulson story and thinks it is going to create a lot of trouble in America because everyone wants to be him. This will cause everyone to invest in derivatives. He is a nice man but his influence is not positive. He said his own life is like this in that he feels like he is atoning for things that happened in the past. A lot of people who hope they can do well and take their chances regarding whether or not there is a job that suits them.

Question 23 Ryan Morris of Meson Partners: Regarding, the rate of change of business: over time the rate seems to be increasing. Evolution is getting faster. Accordingly, is it harder for a buy and hold strategy to work?

He doesn’t know what the next 20 years are going to hold. He has little personal reason to care about it. The rate of change that he thinks is interesting is that of China. There is no precedent of any place to grow as fast at this size as China.

These Communist leaders are so different from other communist leaders that he is optimistic. His kind of Communist has an engineering background. We [Americans] are too critical of them. We want them to have specific civil rights rules but China does not have to do it out way. They can do it their way and it is really working. It is not just cheap products. They are coming up the competency curve at a rate that has almost no precedent. No country has ever come up so fast from such a backward condition. People resent China’s cheap products. They need to foster more companies and people like BYD who are trying to make the world better and make actual product improvements. He thinks we are going to see a lot more of that from China. He has always liked the Chinese. The restaurant that he used to like so much in Omaha is still there. The Chinese have a great record of handling difficulty. That restaurant is the only business that is still there.

Question 24: At the BRK meeting he mentioned that solar was too expensive for his house. What about wind power?

He doesn’t 2nd guess people who run MidAmerican for investing in wind power. In general he is in favor of using more wind and sun power. He thinks solar costs are going to go down in the near future. He does not know if he is right but that’s what he thinks.

Question 25: How does Wesco increase its float? Can the relationship with BRK help in that process? Why was BYD made in BRK and not Wesco?

In regards to the BYD question, everything they do that is strategic involves BRK. That’s just the limitation of the conditions. Wesco is not a smaller, identical BRK.
When it comes to is insurance, there is no way for Wesco to increase its float in a magical way. It is not a fabulous company with great independent prospects. They bought Cort (rental furniture) at a bad time. They will do alright over time but it will be a long grind. People shouldn’t analyze Wesco as if were its own entity.

Question 26: The questioner decided to get his MBA. Based on what Charlie said today, he thinks it was a bad idea. Also, will he come and talk to his class?

The MBA label is helpful as long as you don’t fall for the wrong ideas. He did a talk one time to a business school class and it lives on pretty well. Warren spends a lot of time talking to students but Charlie doesn’t want to talk to b-school classes.

Question 27: If you are running less capital, would you look for small caps?

At BRK they can’t look at small caps b/c it is not practical. That is one of the things that is wrong with BRK. He told the questioner that he had the problem of being young and poor. Then, he said that if he were young and poor he would be looking for exploitable opportunities wherever they were.

Question 28 (Alan Schram of Wellcap Partners): Is Cort in just a cyclical decline or is the problem more severe? Will they have to write down the goodwill? Do you disagree with Warren about GS and the Abacus transaction?

He thinks Cort will do ok and be a halfway decent investment. He thinks that it will justify the price they paid. Having said that, they are becoming more dominant in the industry so maybe he is being too pessimistic.

Regarding GS, he just doesn’t like that derivatives are allowed all over the place. He thinks they do more social harm than social good. When they got mispriced Warren actually made some bets using those instruments even after writing a letter in 1982 saying that S&P derivatives were a bad idea [and calling them weapons of mass destruction in an annual report]. Despite that, he does not see Warren’s foray into derivatives as inconsistent.

Given a world of propriety derivatives, GS did not misbehave. They were just doing what other people were doing. The Abacus deal does have the disadvantage that it is hard to explain. The GS people did not think through how hard it would be to explain to the public. GS will change because Blankfein is a flexible man. They deserve their share of blame for urging the government to stop regulating. It was natural and everyone was doing it. When it comes to Wall Street, anything that transfers risk between consenting adults is OK. But all kinds of things that consenting adults want to do that should not be allowed. One of those is gambling with derivatives at investment banks. But, why is GS the poster boy for insensitivity? It is not fair based on what others were doing as well.

Question 29: What makes a good distribution business? The questioner referenced Coke (KO) and the decision to acquire its bottlers.

Charlie said that he doesn’t follow KO that closely. The original structure allowed the lower return businesses to be separated from the profitable concentrate business. In general, he does not like cosmetic changes like that. Thus, he welcomes changes to this model that reverse what was done. He added that the new CEO of Coke is the best one in a long time.

Question 30: Clayton Homes offers a high quality product. Post housing crisis, what are the growth prospects for Clayton?

Kevin Clayton is interested into taking that model upscale to other homes that get around the zoning issues that now exist in the US. Thinks there will be more Clayton style construction in the US going forward. This could take decades but Clayton will gain from what they are trying to do because of the expense of building custom homes. We will slowly get to that point.

Question 31: What are some good books for children interested in investing?

He is not sure that he believes that young children should be exposed to investing. For him, he understands reality better than others. When he is gone and they ask, how much did Charlie leave? The answer will be: I believe he left it all.
If you have the capacity to get wisdom and don’t use it then he regards that as a moral failure. That is a Confucian concept. This is why he likes the Chinese. They think similarly.

Question 32: Why do he and Warren read 5 newspapers a day? Will GS have to divest their businesses?

No bank is going to divest its operation unless it is forced to. So, it will depend on what Congress and the regulators decided to pursue.

He reads papers because they contain a lot of intelligence. He likes the Financial Times because it is the most intellectual. But he would read more if had the time. He skims until he finds something he likes and then he drills down. He likes all the newspapers he reads. He doesn’t know anyone who is wise in the practical world who reads no newspapers. Maybe young people will be good at looking at a little keyboard and multitasking. But he thinks they will do worse than him because multitasking is counterproductive. If young people didn’t embrace the modern world of multitasking, they would be banished from their social groups. “But what the hell? I have been banished by certain social groups.”

Question 33: Charlie spoke very highly of Singapore. Given the problems in the US, would he ever move to Singapore?

He would never leave the US. Singapore could be a good place for someone else. If crime tripled in the US them Singapore could get an influx of rich people from the rest of the world. He doesn’t know what is going to happen but he will still be here. He loves the US, despite the flaws.

Question 34: Why did BRK buy re-insures if it is a bad business?

Gen Re is a good business and is very respectable. These purchases are just portfolio investments and they seem sensible to him and Warren. It doesn’t change the idea that reinsurance is a bad business in which it is easy to make big mistakes.
Specifically, it is very hard to find these mistakes. You have to judge culture too. Reserves and culture are both important. All these things have to be judged when you are making an investment decision. It is much better to find a no brainer. He likes no brainers like Costco and BYD. But you don’t find that many. Therefore, if you are lucky to have enough money [like at BRK], then you have to make a lot of tough decisions when it comes to allocating money. Having said that though, he doesn’t feel bad for people with such problems [having too much money].

Question 35: In the US we have moved away from mark to market accounting. How do we deal with this in the future?

At the bottom tick, Wells Fargo (WFC) went down to as silly price. WFC is an admirable bank with a great model. They will certainly have a lot of work to do atoning for mistakes and cleaning up Wachovia. But, it is a good investment, even at the current price. That said, even the best banks seem to drift along with follies of their times and the people are WFC likely have a long list of mistakes. The truth is that they face it and fix it better than other banks.

We may be getting more changes in credit cards because they were issued to people who can’t handle them. If he were running a bank he would not give credit cards to “fiscaholics” He doesn’t like charging 30% to people who can’t handle credit. It offends him but maybe that is just him. [Charlie then asked people to raise their hands if they found such high rates offensive] Based on the response, there are a lot of people who feel that way. He hopes that the bankers are looking at all those people who feel the way he does.

Question 36: What else is he interested in China?

He is interested in knowing more about China but he is happy with BYD. It is hard to imagine finding anything that pleases him as much. He thinks he has had all the good luck he is entitled to in his life when it comes to China. He would be surprised if he ever finds a better company.

Question 37: What are the risks and opportunities at GEICO? Are there other auxiliary businesses they could get into?

They did not cover themselves in glory with the credit card initiative at GEICO. The difference is that they admit their mistakes and they get their noses rubbed in them. He hopes GEICO doesn’t find any other auxiliary investments like that.

Question 38: Based on his extensive criticism of accounting in the US, what should we tell our current accounting students?

The people who set the standards have to understand that huge changes are necessary in the interest of the country. Unfortunately, we are stuck teaching it the way it is because of the CPA test. To someone who teaches account, he said that they hold their noses and just teach it the same way. Accounting in a noble profession that has done wonders for the world. It is a wonderful profession and he hopes that people grow up to change the things that he detests.

Accountants are right to fear making businesses decisions. Thus, he would exempt accountants from liability except for outright fraud. But on the other side they would have to do a lot better at stopping fraud and being more sensible.

Video: Munger on Goldman and Lehman Brothers

In a taped interview today with CNBC's Becky Quick, Munger says Lehman's Richard Fuld was guilty of "megalomania" and "isolation." Lehman's spectacular collapse in September of 2008 helped deepen the credit crisis.

Transcript below in case CNBC removes this video at some point in the future.



Munger: Dick Flud would not be, for me, an exemplar of the best that can exist in investment banking. I would say that of all the investment banks, of size, that was the one where the behavior was the worst and it came right from the top.

Quick: Worse than Bear Stearns?

Munger: Yes

Quick: Why?

Munger: Megalomania, envy driven, poor cognition, isolation and of course its an interesting example of corporate governance, because you didn't have to be very wise to see the place had the wrong leaders and they had a board that did exactly nothing to fix their problem.

Quick: Do you think there is any chance that Flud didn't know what repo 105 was?

Munger: I have no way of judging that. But there was so much he didn't know or deliberately ignored that... there is enough sin and folly there already you don't have to find the last item.

Quick: Is Loyd Blankenfeld an example of the most ethical standards on Wall Street?

Munger: You know, i don't personally know Loyd the way Warren does but i am favorably impressed with him. And, that is not to say that Goldman didn't participate with its industry in urging permissive rules for investment banking that I think were socially undesirable. It's just human nature to do that. But with that one qualification, yes, I admire Loyd Blankenfeld

Munger on Goldman

Charlie Munger, Mr. Buffett's longtime business partner at Berkshire's helm who shares the stage with him at the meeting, will likely have some choice words for Wall Street.

While Mr. Munger thinks Goldman did nothing illegal, the firm was engaged in "socially undesirable" activities, he said in an interview after the SEC lawsuit was filed.

"They were very competitive in maximizing profits in a competitive industry that was permitted to operate like a gambling casino," Mr. Munger said. "The whole damn industry lost its moral moorings."

He added that he believes Goldman is "more prudent and ethical" than other big Wall Street banks.

Source

Charlie Munger: Turning $2 Million Into $2 Trillion

It is 1884 in Atlanta. You are brought, along with twenty others like you, before a rich and eccentric Atlanta citizen named Glotz. Both you and Glotz share two characteristics: first, you routinely use in problem solving the five helpful notions, and, second, you know all the elementary ideas in all the basic college courses, as taught in 1996. However, all discoverers and all examples demonstrating these elementary ideas come from dates transposed back before 1884. Neither you nor Glotz knows anything about anything that has happened after 1884.

Glotz offers to invest $2 million, yet take only half the equity, for a Glotz charitable foundation, in a new corporation organized to go into the non-alcoholic beverage business and remain in that business only, forever. Glotz wants to use a name that has somehow charmed him: Coca-Cola.

The other half of the new corporation’s equity will go to the man who most plausibly demonstrates that his business plan will cause Glotz’s foundation to be worth a trillion dollars 150 years later, in the money of that later time, 2034, despite paying out a large part of its earnings each year as a dividend. This will make the whole new corporation worth $2 trillion, even after paying out many billions of dollars in dividends.

You have fifteen minutes to make your pitch. What do you say to Glotz?

And here is my solution, my pitch to Glotz, using only the helpful notions and what every bright college sophomore should know.

Well Glotz, the big “no-brainer” decisions that, to simplify our problem, should be made first are as follows: first, we are never going to create something worth $2 trillion by selling some generic beverage. Therefore we must make your name, “Coca-Cola,” into a strong, legally protected trademark. Second, we can get to $2 trillion only by starting in Atlanta, then succeeding in the rest of the United States, then rapidly succeeding with our new beverage all over the world. This will require developing a product having universal appeal because it harnesses powerful elemental forces. And the right place to find such powerful elemental forces is in the subject matter of elementary academic courses.

We will next use numerical fluency to ascertain what our target implies. We can guess reasonably that by 2034 there will be about eight billion beverage consumers around the world. On average, each of these consumers will be much more prosperous in real terms than the average consumer of 1884. Each consumer is composed mostly of water and must ingest about 64 ounces of water per day. This is eight eight-ounce servings. Thus, if our new beverage, and other imitative beverages in our new market, can flavor and otherwise improve only 25 percent of ingested water worldwide, and we can occupy half of the new world market, we can sell 2.92 trillion eight-ounce servings in 2034. And if we can then net four cents per serving, we will earn $117 billion. This will be enough, if our business is still growing at a good rate, to make it easily worth two trillion dollars.

A big question, of course, is whether four cents per serving is a reasonable profit target for 2034. And the answer is yes, if we can create a beverage with strong universal appeal. One hundred fifty years is a long time. The dollar, like the roman drachma, will almost surely suffer monetary depreciation. Concurrently, real purchasing power of the average beverage consumer in the world will go way up. His proclivity to inexpensively improve his experience while ingesting water will go up considerably faster. Meanwhile, as technology improves, the cost of our simple product, in units of constant purchasing power, will go down. All four factors will work together in favor of our four-cents-per-serving profit target. Worldwide beverage-purchasing power in dollars will probably multiply by a factor of at least forty over 150 years. Thinking in reverse, this makes our profit-per-serving target, under 1884 conditions, a mere one fortieth of four cents or one tenth of a cent per serving. This is an easy-to-exceed target as we start out if our new product has universal appeal.

That decided, we must next solve the problem of invention to create universal appeal. There are two intertwined challenges of large scale: first, over 150 years we must cause a new-beverage market to assimilate about one fourth of the world’s water ingestion. Second, we must so operate that half the new market is ours, while all our competitors combined are left to share the remaining half. These results are lollapalooza results. Accordingly, we must attack our problem by causing every favorable factor we can think of to work for us. Plainly, only a powerful combination of many factors is likely to cause the lollapalooza consequences we desire. Fortunately, the solution to these intertwined problems turns out to be fairly easy, if one has stayed awake in all the freshman courses.

Let us start by exploring the consequences of our simplifying “no-brainer” decision that we must rely on a strong trademark. This conclusion automatically leads to an understanding of the essence of our business in proper elementary academic terms. We can see from the introductory course in psychology that, in essence, we are going into the business of creating and maintaining conditioned reflexes. The “Coca-Cola” trade name and trade dress will act as the stimuli, and the purchase and ingestion of our beverage will be the desired responses.

And how does one create and maintain conditioned reflexes? Well, the psychology text gives two answers: by operant conditioning, and (2) by classical conditioning, often called Pavlovian conditioning to honor the great Russian scientist. And, since we want a lollapalooza result, we must use both conditioning techniques – and all we can invent to enhance effects from each technique.

The operant-conditioning part of our problem is easy to solve. We need only (1) maximize rewards of our beverage’s ingestion, and (2) minimize possibilities that desired reflexes, once created by us, will be extinguished through operant conditioning by proprietors of competing products.

For operant conditioning rewards, there are only a few categories we will find practical:
  1. Food value in calories or other inputs;
  2. Flavor, texture, and aroma acting as stimuli to consumption under neural preprogramming of a man through Darwinian natural selection;
  3. Stimulus, as by sugar or caffeine;
  4. Cooling effect when man is too hot or warming effect when man is too cool.

Wanting a lollapalooza result, we will naturally include rewards in all the categories.

To start out, it is easy to decide to design our beverage for consumption cold. There is much less opportunity, without ingesting beverage, to counteract excessive heat, compared with excessive cold. Moreover, with excessive heat, much liquid must be consumed, and the reverse is not true. It is also easy to decide to include both sugar and caffeine. After all, tea, coffee, and lemonade are already widely consumed. And it is also clear that we must be fanatic about determining, through trial and error, flavor and other characteristics that will maximize human pleasure while taking in the sugared water and caffeine we will provide. And, to counteract possibilities that desired operant-conditioned reflexes, once created by us will be extinguished by operant conditioning employing competing products, there is also an obvious answer: we will make it a permanent obsession in our company that our beverage, as fast as practicable, will at all times be available everywhere throughout the world. After all, a competing product, if it is never tried, can’t act as a reward creating a conflicting habit. Every spouse knows that.

We must next consider the Pavlovian conditioning we must also use. In Pavlovian conditioning powerful effects come from mere association. The neural system of Pavlov’s dog causes it to salivate at the bell it can’t eat. And the brain of man yearns for the type of beverage held by the pretty woman he can’t have. And so, Glotz, we must use every sort of decent, honorable Pavlovian conditioning we can think of. For as long as we are in business, our beverage and its promotion must be associated in consumer minds with all other thing consumers like or admire.

Such extensive Pavlovian conditioning will cost a lot of money, particularly for advertising. We will spend big money as far ahead as we can imagine. But the money will be effectively spent. As we expand fast in our new-beverage market, our competitors will face gross disadvantages of scale in buying advertising to create the Pavlovian conditioning they need. And this outcome, along with other volume-creates-power effects, should help us gain and hold at least 50 percent of the new market everywhere. Indeed, provided buyers are scattered, our higher volumes will give us very extreme cost advantages in distribution.

Moreover, Pavlovian effects from mere association will help us choose the flavor, texture, and color of our new beverage. Considering Pavlovian effects, we will have wisely chosen the exotic and expensive-sounding name “Coca-Cola,” instead of a pedestrian name like “Glotz’s sugared, caffeinated water.” For similar Pavlovian reasons, it will be wise to have our beverage look pretty much like wine, instead of sugared water. And so we will artificially color our beverage if it comes out clear. And we will carbonate our water, making our product seem like champagne, or some other expensive beverage, while also making its flavor better and imitation harder to arrange for competing products. And, because we are going to attach so many expensive psychological effects to our flavor, that flavor should be different from any other standard flavor so that we maximize difficulties for competitors and give no accidental same-flavor benefit to any existing product.

What else, from the psychology textbook, can help our new business? Well, there is that powerful “monkey-see, monkey-do” aspect of human nature that psychologists often call “social proof.” Social proof, imitative consumption triggered by mere sight of consumption, will not only help induce trial of our beverage. It will also bolster perceived rewards from consumption. We will always take this powerful social-proof factor into account as we design advertising and sales promotion and as we forego present profit to enhance present and future consumption. More than with most other products, increased selling power will come from each increase in sales.

We can now see, Glotz, that by combining (1) much Pavlovian conditioning, (2) powerful social-proof effects, and (3) wonderful-tasting, energy-giving, stimulating and desirably-cold beverage that causes much operant conditioning, we are going to get sales that speed up for a long time by reason of the huge mixture of factors we have chosen. Therefore, we are going to start something like an autocatalytic reaction in chemistry, precisely the sort of multi-factor-triggered lollapalooza effect we need.

The logistics and the distribution strategy of our business will be simple. There are only two practical ways to sell our beverage: (1) as a syrup to fountains and restaurants, and (2) as a complete carbonated-water product in containers. Wanting lollapalooza results, we will naturally do it both ways. And, wanting huge Pavlovian and social-proof effects we will always spend on advertising and sales promotion, per serving, over 40 percent of the fountain price for syrup needed to make the serving.

A few syrup-making plants can serve the world. However, to avoid needless shipping of mere space and water, we will need many bottling plants scattered over the world. We will maximize profits if (like early General Electric with light bulbs) we always set the first-sale price, either (1) for fountain syrup, or (2) for any container of our complete product. The best way to arrange this desirable profit-maximizing control is to make any independent bottler we need a subcontractor, not a vendee of syrup, and certainly not a vendee of syrup under a perpetual franchise specifying a syrup price frozen forever at its starting level.

Being unable to get a patent or copyright on our super important flavor, we will work obsessively to keep our formula secret. We will make a big hoopla over our secrecy, which will enhance Pavlovian effects. Eventually food-chemical engineering will advance so that our flavor can be copied with near exactitude. But, by that time, we will be so far ahead, with such strong trademarks and complete, “always available” worldwide distribution, that good flavor copying won’t bar us from our objective. Moreover, the advances in food chemistry that help competitors will almost surely be accompanied by technological advances that will help us, including refrigeration, better transportation, and, for dieters, ability to insert a sugar taste without inserting sugar’s calories. Also, there will be related beverage opportunities we will seize.

This brings us to a final reality check for our business plan. We will, once more, think in reverse like Jacobi. What must we avoid because we don’t want it? Four answers seem clear:

First, we must avoid the protective, cloying, stop-consumption effects of aftertaste that are a standard part of physiology, developed through Darwinian evolution to enhance the replication of man’s genes by forcing a generally helpful moderation on the gene carrier. To serve our ends, on hot days a consumer must be able to drink container after container of our product with almost no impediment from aftertaste. We will find a wonderful no-aftertaste flavor by trial and error and will thereby solve this problem.

Second, we must avoid ever losing even half of our powerful trademarked name. It will cost us mightily, for instance, if our sloppiness should ever allow sale of any other kind of “cola,” for instance, a “peppy cola.” If there is ever a “peppy cola,” we will be the proprietor of the brand.

Third, with so much success coming, we must avoid bad effects from envy, given a prominent place in the Ten Commandments because envy is so much a part of human nature. The best way to avoid envy, recognized by Aristotle, is to plainly deserve the success we get. We will be fanatic about product quality, quality of product presentation, and reasonableness of prices, considering the harmless pleasure it will provide.

Fourth, after our trademarked flavor dominates our new market, we must avoid making any huge and sudden change in our flavor. Even if a new flavor performs better in blind taste tests, changing to that new flavor would be a foolish thing to do. This follows because, under such conditions, our old flavor will be so entrenched in consumer preference by psychological effects that a big flavor change would do us little good. And it would do immense harm by triggering in consumers the standard deprival super-reaction syndrome that makes “take-aways” so hard to get in any type of negotiation and helps make most gamblers so irrational. Moreover, such a large flavor change would allow a competitor, by copying our old flavor, to take advantage of both (1) the hostile consumer super-reaction to deprival and (2) the huge love of our original flavor created by our previous work.

Well, that is my solution to my own problem of turning $2 million into $2 trillion, even after paying out billions of dollars in dividends. I think it would have won with Glotz in 1884 and should convince you more than you expected at the outset. After all, the correct strategies are clear after being related to elementary academic ideas brought into play by the helpful notions.

How consistent is my solution with the history of the real Coca-Cola company? Well, as late as 1896, twelve years after the fictional Glotz was to start vigorously with $2 million, the real Coca-Cola company had a net worth under $150 thousand and earnings of about zero. And thereafter the real Coca-Cola company did lose half its trademark and did grant perpetual bottling franchises at fixed syrup prices. And some of the bottlers were not very effective and couldn’t easily be changed. And the real Coca-Cola company, with this system, did lose much pricing control that would have improved results, had it been retained. Yet, even so, the real Coca-Cola company followed so much of the plan given to Glotz that it is now worth about $125 billion and will have to increase its value at only 8 percent per year until 2034 to reach a value of $2 trillion. And it can hit an annual physical volume target of 2.92 trillion servings if servings grow until 2034 at only 6 percent per year, a result consistent with much past experience and leaving plenty of plain-water ingestion for Coca-Cola to replace after 2034. So I would guess that the fictional Glotz, starting earlier and stronger and avoiding the worst errors, would have easily hit his $2 trillion target. And he would have done it well before 2034.

This brings me, at last, to the main purpose of my talk. Large educational implications exist, if my answer to Glotz’s problem is roughly right and you make one more assumption I believe true – that most Ph.D. educators, even psychology professors and business school deans, would not have given the same simple answer I did. And, if I am right in these two ways, this would indicate that our civilization now keeps in place a great many educators who can’t satisfactorily explain Coca-Cola, even in retrospect, and even after watching it closely all their lives. This is not a satisfactory state of affairs.

Moreover – and this result is even more extreme – the brilliant and effect executives who, surrounded by business school and law school graduates, have run the Coca-Cola company with glorious success in recent years, also did not understand elementary psychology well enough to predict and avoid the “New Coke” fiasco, which dangerously threatened their company. That people so talented, surrounded by professional advisers from the best universities, should thus demonstrate a huge gap in their education is also not a satisfactory state of affairs.

Such extreme ignorance, in both the high reaches of academia and the high reaches of business, is a lollapalooza effect of a negative sort, demonstrating grave defects in academia. Because the bad effect is a lollapalooza, we should expect to find intertwined, multiple academic causes. I suspect at least two such causes.

First, academic psychology, while it is admirable and useful as a list of ingenious and important experiments, lacks intradisciplinary synthesis. In particular, not enough attention is given to lollapalooza effects coming from combinations of psychological tendencies. This creates a situation reminding one of a rustic teacher who tries to simplify school work by rounding pi to an even three. And it violates Einstein’s injunction that “everything should be made as simple as possible – but no more simple.” In general, psychology is laid out and misunderstood as electromagnetism would now be misunderstood if physics had produced many brilliant experimenters like Michael Faraday and no grand synthesizer like James Clerk Maxwell.

And, second, there is a truly horrible lack of synthesis blending psychology and other academic subjects. But only an interdisciplinary approach will correctly deal with reality – in academia as with the Coca-Cola company.

In short, academic psychology departments are immensely more important and useful than other academic departments think. And, at the same time, the psychology departments are immensely worse than more of their inhabitants think. It is, of course, normal for self-appraisal to be more positive than external appraisal. Indeed, a problem of this sort may have given you your speaker today. But the size of this psychology-department gap is preposterously large. In fact, the gap is so enormous that one very eminent university (Chicago) simply abolished its psychology department, perhaps with an undisclosed hope of later creating a better vision.

In such a state of affairs, many years ago and with much that was plainly wrong already present, the “New Coke” fiasco occurred, wherein Coke’s executives came to the brink of destroying the most valuable trademark in the world. The academically correct reaction to this immense and well-publicized fiasco would have been the sort of reaction Boeing would display if three of its new airplanes crashed in a single week. After all, product integrity is involved in each case, and the plain educational failure was immense.

But almost no such responsible, Boeing-like reaction has come from academia. Instead academia, by and large, continues in its balkanized way to tolerate psychology professors who mis-teach psychology, non-psychology professors who fail to consider psychological effects obviously crucial in their subject matter, and professional schools that carefully preserve psychological ignorance coming in with each entering class and are proud of their inadequacies.

Appendix D in Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger

Wesco 2009 Annual Letter to Shareholders

To Our Shareholders:

Consolidated net “operating” income (i.e., before realized investment gains shown in the table below) for the calendar year 2009 decreased to $54,073,000 ($7.59 per share) from $77,562,000 ($10.89 per share) in the previous year.

Consolidated net income decreased to $54,073,000 ($7.59 per share) from $82,116,000 ($11.53 per share) in 2008. The 2008 figure included realized after-tax investment gains of $4,554,000 ($.64 per share). No investment gains or losses were realized in 2009.

Wesco has four major subsidiaries: (1) Wesco-Financial Insurance Company (“Wes- FIC”), headquartered in Omaha and engaged principally in the reinsurance business, (2) The Kansas Bankers Surety Company (“Kansas Bankers”), owned by Wes-FIC and specializing in insurance products tailored to Midwestern community banks, (3) CORT Business Services Corporation (“CORT”), headquartered in Fairfax, Virginia and engaged principally in the furniture rental business, and (4) Precision Steel Warehouse, Inc. (“Precision Steel”), head- quartered in Chicago and engaged in the steel warehousing and specialty metal products businesses.

Consolidated net income for the two years just ended breaks down as follows (in thousands except for per-share amounts)(1):



This supplementary breakdown of earnings differs somewhat from that used in audited financial statements which follow standard accounting convention. The foregoing supplementary breakdown is furnished because it is considered useful to shareholders. The total consolidated net income shown above is, of course, identical to the total in our audited financial statements.

Insurance Businesses
Consolidated operating earnings from insurance businesses represent the combination of the results of their insurance underwriting (premiums earned, less insurance losses, loss adjustment expenses and underwriting expenses) with their investment income. Following is a summary of these figures as they pertain to all insurance operations (in 000s).


As shown above, operating income includes significant net investment income, representing dividends and interest earned from marketable securities. However, operating income excludes after-tax investment gains of $4.6 million realized in 2008. The discussion below will concentrate on insurance underwriting, not on the results from investments.

Wes-FIC engages in the reinsurance business. At the beginning of 2008, it entered into a retrocession agreement with National Indemnity Company (“NICO”), an insurance subsidiary of Berkshire Hathaway, Wesco’s 80%-owning parent. Under the contract, Wes-FIC has assumed 10% of NICO’s 20% quota-share reinsurance of Swiss Reinsurance Company and its principal property-casualty affiliates (“Swiss Re”). Under this agreement, which was enthu- siastically approved by Wesco’s Board of Directors, Wes-FIC assumed 2% of essentially all Swiss Re property-casualty risks incepting over the five-year period which began on January 1, 2008, on the same terms as NICO’s agreement with Swiss Re. Wes-FIC’s share of written and earned premiums under the contract were $294.1 million and $276.7 million for 2009 and $265.2 million and $183.2 million for 2008, representing very significant increases in Wes- FIC’s reinsurance activities. It is important to keep in mind that premiums assumed under the contract in each of the next three years could vary significantly depending on market conditions and opportunities.

For several years, through yearend 2007, Wes-FIC’s principal reinsurance activity consisted only of its participation in several pools managed by a subsidiary of General Reinsurance Corporation (“Gen Re”), another insurance subsidiary of Berkshire Hathaway. The arrangement became effective in 2001 and has covered domestic hull, liability and workers’ compensation exposures relating to the aviation industry. For the past three years, Wes-FIC has reinsured 16.67% of the hull and liability pools and 5% of the workers’ compensation pool. Since mid-2009 Wes-FIC has also been reinsuring 25% of an international hull and liability pool. Another subsidiary of Gen Re provides a portion of the upper-level reinsurance protection to these aviation risk pools on terms that could result in the Berkshire subsidiary having a different interest from that of Wes-FIC under certain conditions, e.g., in settling a large loss. Premium volume under these pools has approximated $35 million annually.

It is the nature of even the finest property-casualty insurance businesses that in keeping their accounts they must estimate and deduct all future costs and losses from premiums already earned. Uncertainties inherent in this undertaking make financial statements more mere “best honest guesses” than is typically the case with accounts of non-insurance-writing corporations. And the reinsurance portion of the property-casualty insurance business, because it contains one or more extra links in the loss-reporting chain, usually creates more accounting uncertainty than the non-reinsurance portion. Wesco shareholders should remain aware of the inherent imperfections of Wes-FIC’s financial reporting, based as it is on forecasts of outcomes over many future years.

Wes-FIC’s underwriting results have typically fluctuated from year to year, but have been satisfactory. When stated as a percentage, the sum of insurance losses, loss adjustment expenses and underwriting expenses, divided by premiums, gives the combined ratio. Wes- FIC’s combined ratios from reinsurance activities were 94.9% for 2009, 101.0% for 2008 and 93.9% for 2007, much better than average for insurers. We try to create some underwriting gain as results are averaged out over many years. We expect this to become increasingly difficult.

Float is the term for money we hold temporarily. Its major components are unpaid losses and unearned premiums, less premiums and reinsurance receivable, and deferred policy acquisition costs. As long as our insurance underwriting results are break-even or better, float costs us nothing. The new Swiss Re venture with NICO has significantly increased Wes-FIC’s float, from $76 million at the end of 2007, to $264 million at yearend 2009, thus providing additional opportunities for investment. We hope to see our float continue to increase, but we make no predictions.

Kansas Bankers was purchased by Wes-FIC in 1996 for approximately $80 million in cash. Its tangible net worth now exceeds its acquisition price, and it has been a very satisfactory acquisition, reflecting the sound management of President Don Towle and his team.

Kansas Bankers was chartered in 1909 to underwrite deposit insurance for Kansas banks. Its offices are in Topeka, Kansas. Over the years its service has continued to adapt to the changing needs of the banking industry. Today its customer base, consisting mostly of small- and medium-sized community banks, is spread throughout 29 mainly Midwestern states. Kansas Bankers offers policies for crime insurance, check kiting fraud indemnification, Internet banking catastrophe theft insurance, Internet banking privacy liability insurance, directors and officers liability, bank employment practices, and bank insurance agents professional errors and omissions indemnity.

Last year we reported that events in the banking industry, including a number of bank failures, caused us to become less confident in the long-term profitability of Kansas Bankers’ long-established line of deposit guarantee bonds. These bonds insure specific customer bank deposits above Federal insurance limits. After sustaining a loss of $4.7 million, after taxes, from a bank failure in the latter half of 2008, Kansas Bankers discontinued writing deposit guarantee bonds, and in September 2008 it began to exit this line of insurance as rapidly as feasible. The aggregate face amount of outstanding deposit guarantee bonds has been reduced, from $9.7 billion, insuring 1,671 institutions at September 30, 2008, to $33 million, insuring 10 institutions, currently. We believe that none of the banks whose deposits are currently insured are facing significant risk of failure.

This decrease in exposure to loss, of course, has caused a sharp decline in Kansas Bankers’ insurance volume, inasmuch as premiums from guarantee bonds not only approx- imated half of Kansas Bankers’ written premiums for 2008, but also represented the entirety of the business it had conducted in almost half of the states in which it was licensed to write insurance in 2008. The insurance business is highly competitive, with lengthy periods during which competitors offer coverages at prices we do not consider adequate. Kansas Bankers is now licensed to sell insurance in 29 states, down from 39 states one year earlier, with plans soon to withdraw from 4 more. We expect that Kansas Bankers will ultimately expand its premium volume, at prices deemed satisfactory.

When Wesco purchased Kansas Bankers, it had been ceding almost half of its premium volume to reinsurers. In 2009 it reinsured only about 1%. And, because it has also restructured the layers of losses reinsured, it is now better protected from the downside risk of large losses. Effective in 2006, insurance subsidiaries of Berkshire Hathaway became KBS’s sole reinsurers. Previously, an unaffiliated reinsurer was also involved. The increased volume of business retained comes, of course, with increased irregularity in the income stream. Kansas Bankers’ combined ratios were 140.2% for 2009, 111.6% for 2008 and 55.1% for 2007. Kansas Bankers’ business activities require a base of operations supported by significant fixed operating costs which do not lend themselves to downsizing in proportion to the recent decline in premium volume. We continue to expect volatile but favorable long-term results from the now much smaller business remaining in Kansas Bankers.

CORT Business Services Corporation (“CORT”)
In February 2000, Wesco purchased CORT Business Services Corporation (“CORT”) for $386 million in cash.

CORT is a very long-established company that is the country’s leader in rentals of high-quality furniture that lessees have no intention of buying. In the trade, people call CORT’s activity “rent-to-rent” to distinguish it from “lease-to-purchase” businesses that are, in essence, installment sellers of furniture.

However, just as Enterprise, as a rent-to-rent auto lessor in short-term arrangements, must be skilled in selling used cars, CORT must be and is skilled in selling used furniture.

CORT’s revenues totaled $380 million for calendar 2009, versus $410 million for calendar 2008. Of these amounts, furniture rental revenues were $312 million and $340 mil- lion, furniture sales revenues were $61 million and $62 million, and rental relocation revenues were $7 million and $8 million. CORT operated at an after-tax loss of $1.4 million for 2009 versus after-tax profits of $15.7 million for 2008 and $20.3 million for 2007. Headwinds from the “Great Recession” that began in 2008 have caused the shift from moderate profit to the small loss that occurred last year.

CORT has made several “tuck-in” acquisitions since its purchase by Wesco; most recently, the residential furniture rental division of Aaron Rents, Inc., purchased late in 2008. Earlier in 2008, CORT expanded its operations internationally, through the purchase of Roomservice Group, a small regional provider of rental furniture and relocation services in the United Kingdom, now doing business as CORT Business Services UK Ltd. Factoring out the effects of those acquisitions, CORT’s core revenues fell by almost 20% in 2009, reflecting the hammering caused by the severe economic recession. So far, CORT’s business has been melting away faster than CORT can fix it.

Shortly after its acquisition by Wesco, CORT started up a nation-wide apartment locator service, originally intended mainly to supplement CORT’s furniture rental business by providing apartment locator and ancillary services to relocating individuals. Paul Arnold, long CORT’s able CEO, and his management team, have devoted much effort in recent years, expanding CORT’s rental relocation services, and redirecting them toward the needs of businesses and government agencies who require a skilled and able partner to provide comprehensive and seamless relocation services for the temporary relocation of employees worldwide. These efforts had not yet gained traction when recession hit. CORT is now focusing its efforts more on cost containment than on expansion of services.

Under Wesco’s ownership, CORT has continuously undertaken to improve its competitive position. With several websites, principally, www.cort.com and www.apartment- search.com, professionals in more than 80 domestic metropolitan markets, affiliates servicing more than 50 countries, almost twenty-one thousand apartment communities referring their tenants to CORT, many ancillary services, and its entrée to the business community as a Berkshire Hathaway company, CORT is better positioned than previously to benefit from an economic turnaround if it occurs in due course. Near term, we expect more of the difficult business conditions of the recent past, but we do not expect another operating loss at CORT in 2010. Instead, we expect disappointing profits.

More details with respect to CORT are contained throughout this annual report, to which your careful attention is directed.

Precision Steel Warehouse, Inc. (“Precision Steel”)
The businesses of Wesco’s Precision Steel subsidiary, headquartered in the outskirts of Chicago at Franklin Park, Illinois, were pounded by the “Great Recession,” exacerbating a long-term reduction in demand resulting from movement of manufacturing outside the United States. Revenues were $38.4 million for 2009 versus $60.9 million for 2008. Sales volume for 2009, in terms of pounds sold, declined by one-third and represented less than half the annual volume that Precision Steel had sold thirty years earlier, when it was acquired by Wesco.

Precision Steel operated at an after-tax loss of $0.6 million in 2009 versus an after-tax profit of $0.8 million in 2008. These figures reflect after-tax LIFO inventory accounting adjustments increasing after-tax income by $1.5 million for 2009 and decreasing after-tax income by $0.7 million for 2008. Had it not been for the LIFO accounting adjustments, Precision Steel would have reported an after-tax operating loss of $2.1 million for 2009 versus after-tax operating income of $1.5 million for 2008. Moreover, the $2.1 million pre-LIFO-effect loss last year would have been about $0.5 million greater without after-tax profits from a couple of Precision Steel’s small businesses that are different from conventional steel warehousing.

We do not consider Precision Steel’s recent operating results to be a satisfactory investment outcome, particularly when one compares its recent performance with its after-tax operating earnings which averaged $2.3 million for the years 1998 through 2000. And, because of the ongoing recession, more difficulty for Precision Steel will surely lie ahead.

Apart from the recessionary-caused weakness, the general and ongoing decline in Precision Steel’s physical volume is a serious reverse, not likely to disappear in some “bounce back” effect once the economy recovers.

Terry Piper, who became Precision Steel’s President and Chief Executive Officer in 1999, has done an outstanding job in leading Precision Steel through very difficult years. But he has no magic wand with which to compensate for competitive losses among his best customers or from the weak economic conditions. He is redoubling his efforts to pare costs, which must be his response to conditions faced.

Tag Ends from Savings and Loan Days
All that now remains outside Wes-FIC but within Wesco as a consequence of Wesco’s former involvement with Mutual Savings, Wesco’s long-held savings and loan subsidiary, is a small real estate subsidiary, MS Property Company, that holds tag ends of appreciated real estate assets consisting mainly of the nine-story commercial office building in downtown Pasadena, where Wesco is headquartered. Adjacent to that building is a multi-story luxury condominium building which MS Property Company has recently built and is in process of marketing. For more information, if you want a very-high-end condominium, simply phone Chris Greco (626-585-6700). MS Property Company’s results of operations, immaterial versus Wesco’s present size, are included in the breakdown of earnings on page 1 within “other operating earnings.”

Other Operating Earnings (Loss)
Other operating earnings (loss), net of interest paid and general corporate expenses, amounted to ($6.9 million) in 2009 and ($0.4 million) in 2008. The 2009 figure includes a $6.2 million after-tax writedown of the book carrying value of a condominium building that was completed in the worst condominium market in decades. Other components of the other operating loss in 2009 were (1) rents ($4.1 million gross) principally from Wesco’s Pasadena office property (leased almost entirely to outsiders, including Citibank as the ground floor tenant), and (2) interest and dividends from cash equivalents and marketable securities held outside the insurance subsidiaries, less (3) general corporate expenses plus expenses involving tag-end real estate and real estate held for sale.

Consolidated Balance Sheet and Related Discussion
Wesco has unusual balance sheet strength, concentrated in security holdings of its insurance subsidiaries. These holdings, in turn, are concentrated in a few securities. Details can be found in Note 2 to the accompanying financial statements.

Wesco carries its investments at fair value. As a result, unrealized appreciation or depreciation, after income tax effect, is included as a component of shareholders’ equity and net worth per share.

Affected substantially by changes in market value of securities owned, Wesco’s yearend net worth per share has varied only slightly during recent tumultuous years. Figures are as follows:
2006 $337
2007 356
2008 334
2009 358

These results are not impressive. Moreover, if net worth per share had been computed at its low point in the recent stock market panic, stability implied by the foregoing figures would have been considerably lessened.

We repeat our standard warning. Business and human quality in place at Wesco continues to be not nearly as good, all factors considered, as that in place at Berkshire Hathaway. Wesco is not an equally-good-but-smaller version of Berkshire Hathaway, better because its small size makes growth easier. Instead, each dollar of book value at Wesco continues plainly to provide much less intrinsic value than a similar dollar of book value at Berkshire Hathaway. Moreover, the quality disparity in book value’s intrinsic merits has, in recent years, continued to widen in favor of Berkshire Hathaway.

The Board of Directors recently increased Wesco’s regular dividend from 391⁄2 cents per share to 41 cents per share, payable March 4, 2010, to shareholders of record as of the close of business on February 4, 2010. Shareholders can thank Director Elizabeth Peters for the recommendation that Wesco increase its next and future dividends to ensure that share- holders are paid in even pennies.

This annual report contains Form 10-K, a report filed with the Securities and Exchange Commission, and includes detailed information about Wesco and its subsidiaries, as well as audited financial statements bearing extensive footnotes. As usual, your careful attention is sought with respect to these items.

Shareholders can access much Wesco information, including printed annual reports, earnings releases, SEC filings, and the websites of Wesco’s subsidiaries and parent, Berkshire Hathaway, from Wesco’s website: www.wescofinancial.com.

Charles T. Munger
Dated: February 26, 2010


Wesco 1984 Letter to Shareholders
Wesco 1983 Letter to Shareholders