Like every year, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) were on stage answering questions from shareholders for five and half hours. There were more than 40,000 attendees and it was hard to find a seat in the arena. Everyone was amazed by their knowledge and wisdom. In the meantime, you have to admire their energy at the ages of 85 and 91. Here are the notes from the Q&A session.
Of course, a picture:
Until recently, I considered BRK an ethical company benefiting society through (BRK cos) BNSF and Acme Brick. Those ethics called into question, in wake of a highly critical Clayton Homes story and involvement with 3G in Tim Horton's takeover. You and Charlie have made many statements about upholding Berkshire's ethical standing ... your efforts years ago to keep Berkshires textile mills running exemplify that. I cannot make a moral case for Clayton and 3G. How do you do that?
Buffett: Important mistakes were made in reporting on Clayton's business practices. If you look back at the housing bubble, in fact maybe the greatest cause was the fact that the mortgage holder became totally divorced from the mortgage originator and the homebuilder.
The originator packaged and secured the loans so people around the world had no connection to the original transaction. You had these two parties with no connection to the actual outcome of whether it was a good mortgage or not. At Clayton, unlike virtually anybody, we offer mortgages to all the buyers of our homes. We have retained roughly $12 billion of mortgages on 300,000 homes. When a mortgage goes bad, two people lose: the person that owns the house loses and the person that owns the mortgage loses. This results in a net loss to both parties.
There's been much talk in terms of changes in mortgage rules to get the originators to keep some skin in the game ... just so they would have an interest in these mortgages. Clayton keeps 100% of these mortgages made through Clayton.
Reality is that many borrowers for manufactured housing don't qualify with a traditional FICO score so they're riskier borrowers.
About 3 percent of the mortgages default ... when they do, we lose money and the person that bought the house loses money. But 97 percent don't and most of those people wouldn't be living in these kinds of housing without the financing that Clayton and others make available.
The rate of failed mortgages made through Clayton is minimal; without the lending efforts made through the organization, these people wouldn't be enjoying home ownership in the first place.
If we make a mistake, it hurts them, and it hurts us.
The average gross profit margin on Clayton homes was roughly one-fifth the average sales price of the home. Citing an affidavit and running some math, Buffett said the difference between gross profit and profit is key here. The reporters made a mistake in conflating these two terms.
The gross margin as stated in the affidavit was correct, but the reporter cited this as a profit margin, which was about one-sixth of the cited gross margin of 20%.
I make no apologies whatsoever about Clayton's lending terms. ... I have not received one call from any party in connection with a Clayton home. Moreover, we are, at Clayton, we are regulated in almost every state in which we have financing, which is practically every state. In the last three years, we have had I think 91 examinations by the states. They look at our practices and make sure they conform to laws. In those exams, I think the largest fine we've had has been $5,500.
They encourage FHA loans in many cases, especially since many borrowers have a FICO score below 625. The average principal and interest is around $625 a month.
Clayton has behaved, in my book, extraordinarily well.
More than four years ago, the company said they wouldn't do 30-year mortgages either – another sticking point in the critical story.
Munger: I don't know about the mortgage practices of Clayton, but I do know we've sold an enormous number of houses ... Personally, I've always wondered why manufactured houses don't have a bigger share of the market.
We can't make lending to poor people who buy houses 100% successful for everybody.
Buffett: Loss of job, death, divorce happens to owners of high-priced houses, too, but it affects people living near the edge more. Default rate on mortgages in 2008-9 was many, many times higher than that on Clayton homes.
Question About 3G:
Buffett: The 3G people have been successful in building marvelous businesses and ... after they have reduced the employee head count needed, these businesses have done extraordinarily well. I don't know of any company that has a policy that says we're going to end up with a lot more employees we need ... I hope our Berkshire companies aren't being run with more people than we need.
(Buffett discussed the railroad industry after World War II. It had 1.6 million people, and capital was hard to come by. Now, the industry has less than 200,000.)
Efficiency is required over time in capitalism, and I really tip my hat to what the 3G people have done.
Question on Van Tuyl Group automobile: There is a movement toward fixed prices, lower-pressure sales. If the market requires a new way of selling, what does this mean for a sales culture that has long done things in a different way?
Buffett: This "new" model has been tried before. When they actually get into it, however, it seems to break down. I don't think there will be any problem at all if the world goes in that direction ... but I wouldn't be surprised if the system is pretty much the same five or 10 years from now.
Buffett to Munger: Do you think you'll be negotiating on a car the next time you go to buy?
Buffett: It happens when you buy jewelry, when you buy a home. When people are dealing with a big-ticket item, a lot of people's natural tendency is to negotiate, and they'll do so if they think it's built into the system.
Shareholder: Can you name at least five characteristics of a company that gives you confidence to predict its earnings 10 years into the future?
Buffett: Charlie, I want to hear five.
Munger: We don't have a one-size-fits-all approach. What we did 10 years ago, we hope we're doing that better now, but there's no formula to help you.
Buffett: The considerations are often tilted toward the things that would influence them to NOT act on a potential deal rather than things that would influence them to predict how well a company will perform in the future. We don't have a list like that. If we do, Charlie has kept it from me.
Question for Charlie: You broke Warren of his cigar-butt habits. Did you try to talk him out of buying IBM?
Munger: No. The company has been dominant in various instances over its life, and the company has a history of successfully adapting to different circumstances. I think IBM (NYSE:IBM) is a very credible company. It's still an enormous enterprise and I think it's still a very admirable enterprise.
Buffett: "We have no interest in encouraging other people into buying the investments we own. Why would we want a stock to go up if we're going to be a buyer next year and the year after that? If we talked our book about our holdings, we'd be saying pessimistic things since our four biggest investments are all buying back stock.
Munger: If people weren't wrong so often, we wouldn't be so rich.
Question about BRK’s insurance success, which has become "astoundingly large." Does Buffett agree that success is not repeatable today?
Buffett: I have had many, many, many pieces of luck, but three extraordinary pieces of luck in the insurance business. One was getting someone to spend 4 hours with a 20-year-old kid to explain the industry to him. That was just pure luck. I had no idea I would run into him in Washington nor that he would spend time to sit down with me. The next stroke of luck was when we were able to purchase National Indemnity. Right place, right time.
The next was a meeting with Amit Jain. How lucky can you get? The odds are very much against being able to pull off a trifecta like that in the future. You couldn't expect to have three lucky events like that happen again.
Shareholder question from Lawrence from Germany: You are heralded for your integrity. How can investors judge the state of Berkshire's culture long after these two are gone?
Buffett: I think you will be very pleased with the outcome. I think BRK's culture runs as deep as any large company's could.
A few days ago the company closed on a transaction in Germany. The owners had spent 35 years or more building a retail business ... It's a vital part of Berkshire to have a clearly defined, deeply embedded culture that pervades the company.
Once Charlie and I aren't around, it will be so clear that it's not a force of personality, that it's institutionalized.
Munger: As I said in the annual report, I think BRK is going to do fine after we're gone. In fact it will do a lot better ... but at any rate, it will be never again at the rate it did in early years. There are worse tragedies in life.
Buffett: Name one.
Munger's repartee reinforces the value of his few words.
Over the last 50 years, BRK shareholders have been long on sugar consumption (see: See's Candies, Coca Cola(NYSE:KO) ). But what are the true costs of greater sugar consumption as embodied in things like higher healthcare costs? Have we reached the inflection point of human behavior as consumers see the effects of sugar consumption? What news would it take to convince you we have?
Buffett: I think you will see all the food and beverage companies adjust to consumer demands. Twenty years from now, there will be more Coca-Cola cases consumed than there are now by some margin.
Fortune decades ago said the good times for Coca-Cola were over. I sit here as somebody who, over the last 40 years, one-quarter of the calories I've consumed have come from Coca-Cola. I think there's a lot to be said about being happy with what you're doing. If I were eating nothing but broccoli and Brussel's sprouts the whole time, I don't think I would've lived as long.
Munger: The way I look at it is sugar is an enormously helpful substance. It prevents premature hardening of the arteries, and the way I look at it is that if I consume more, I'm just avoiding a few more months in a nursing home.
Buffett: The same brands that went through Philip Morris and were spun out as Kraft are still terrific brands with considerable staying power.
Heinz ketchup came out in the 1870s and Coca-Cola came out in 1880s. It's a pretty good bet people will still be liking the same things (in the future).
Will getting more auto dealerships present a significant growth opportunity in the future of the company's automobile business?
Buffett: I don't think you widen profit margins by having 1,000 dealers versus having (fewer). The focus will be more on building and establishing a local presence, since people tend to know who are the dealers locally.
Munger: Van Tuyl has a system of meritocracy where the right people get the power and ownership, and it reminds him a lot of the Kiewit Corp. here in Omaha, where the right people are in power.
Following up on culture ... elaborate on building that.
Buffett: Obviously, it's much easier to do if you inherit a culture you like and it's easier in smaller firms, I think.
I don't think if Charlie and I were around (a company) for 10 years that we could accomplish much of anything. It seems to be more what you do rather than what you say. People see how those above them behave and they move in that direction. They don't all move that way ... we have 340,000 people working for us, and I guarantee you there's a number of them doing something they shouldn't be doing.
I didn't like making 30-year mortgages at Clayton, so I said five years ago we wouldn't be making them anymore. Similar decrees handed down regarding sales practices at Kirby, the vacuum sales business.
Of the millions of claims settled by GEICO, it's not often where two people involved in the accident agree, but we try to behave as if our positions are reversed.
Munger: I think the one thing that we did that worked best of all: we were always dissatisfied with what we already knew, and we wanted to know more. If Warren and I had stayed frozen in time, (Berkshire) would have been a terrible place.
Shareholder concerns regarding two indicators: the level of the total stock market's market cap relative to GNP and corporate profits as a portion of GNP. If that number was between about 4% and 6.5%, that was a good place. Now it's about 10.5% per the Fed. Response?
Buffett: The facts are that American business has prospered incredibly. The first comparison is very much affected by the fact we live in an interest rate environment that Charlie and I would have thought was almost impossible not too many years ago.
Profits are worth more when government bond yield is 1% vs. 5%. Charlie talked of opportunity costs, and that comes into play when you compare buying government bonds against buying stocks.
We're living in a world that has incredibly low interest rates and the question is how long will those prevail? If we get back to normal interest rates, stocks will look like they're priced very high, and vice versa.
Munger about the pair's relative inability to accurately predict the current rate environment: Why would anybody want our predication now?
Buffett: We think any company that has an economist certainly has one employee too many.
Concerning capital expenditures in the rail industry, what impact will safety measures like tank car regulations have on BNSF?
Buffett: The interests of our railroad and our tank car manufacturer and leasing operations might diverge in a few ways ... but obviously we have an interest in developing safer cars. As a common carrier, we have to carry chlorine (and other dangerous products) that we'd rather not carry ... but we do carry them. It's up to the government to regulate things that are potentially dangerous and how they're transported. Both rail and pipelines have their disadvantages. Meanwhile, the railroad's safety measures improve year after year.
Munger: Big and successful companies like BNSF have a lot of engineers and a lot of information/experience about how to do this. You'd be out of your mind to think these big companies are doing this without understanding how to do it safely.
Buffett: BNSF has the best safety record among its peers, and so does Berkshire Hathaway Energy, where safety statistics have gotten way better under current management.
Question: What advice would you give to someone who's trying to network with influential people but lacks access to the alumni network of a top business school?
Munger: I'll take that one. I think you should do the best you can.
Buffett: Charlie’s very Old Testament about this kind of thing. He didn't get past Genesis.
Munger: I never had any business school training. Why should you have it?
Buffett: The schools used to talk about efficient market theory ... Imagine paying $30-40k a year to hear that.
Question: One risk to BRK and BNSF appears to be a large railroad accident. What about a worst-case scenario of an accident in a more populous setting?
Buffett: BRK's reinsurance unit went to four major railroads and offered very high limits. Maybe as high as $5-6 billion excess. If you had the exact wrong circumstances, the possibility always exists that that could happen. There are things that have very small probabilities but if we run trains millions and millions of miles year after year, something will happen.
So you run trains slower in urban areas as has been instituted when transporting crude oil. You can always be safer, but you'll never be perfectly safe.
I don't anticipate buying 5,000 new rail cars. The Marmon operation has taken on a new facility that will work hard to apply the retrofit mandate, likely at three shifts, in addition to building new (safer) rail cars.
Question about intercompany transactions among insurance companies, which have been numerous within Berkshire Hathaway in recent years: It seems like a lot more activity than normal, so what's the purpose of these movements and why now?
Buffett: Like a lot of things at Berkshire, the 'Why now?' portion is answered simply because we just got around to it. In some cases, shifts have been made because it makes more sense to have money invested in fewer main pockets of capital. It really makes life a little easier in terms of managing money by having most of the funds concentrated in National Indemnity.
The general approach is to keep the companies loaded with more capital than any of us could foresee ever needing.
Question from shareholder from Minneapolis: What is AIIB’s (Asian Infrastructure Investment Bank) influence on future multinationals?
Buffett: I’ll hand that to Charlie, who knows more about it than I do.
Munger: I know less than you.
Question: What about the dollar as a reserve currency for the world?
Buffett: I think the probability is very high.
Munger: I'm probably more nervous than most people about printing a lot of money ... but I'm happier when we print money and use it to improve infrastructure than when we spread it around from a helicopter.
Several subsidiaries are being renamed to include the Berkshire name, a practice that was previously restricted due to potential for reputational damage. Will Fruit of the Loom become Berkshire Undergarments?
Buffett: If it does, we won't make them pay a royalty. We're losing naming rights to some companies over time. I've said these companies could use it but also that if I started hearing of any abuses (of the name) that we would yank it. We had no idea we wanted to take Berkshire Hathaway into becoming a household name and adding value because of it.
Dealers within Van Tuyl will have the option to use the Berkshire Hathaway name, but misuse means I'd get on top of them faster than if they weren't using the company's name.
Munger: It would be crazy to start selling BH peanut brittle instead of See's.
Question regarding renewable energy storage, like what Elon Musk debuted earlier this week: How long do you believe it will be before distributed generation becomes a threat to utilities?
Buffett: Distributed energy has been something we've paid a lot of attention to; the best defense is to have very low-cost energy. People that have adopted solar in our territories have been miniscule. But huge improvements in storage would make a difference in a lot of ways.
Munger: Obviously we'll use a lot more renewable energy because the fossil fuels aren't going to last forever. I grew up in this part of the world, and we have 20% of BH Energy utilities energy coming from wind. It's not a threat; it's a huge benefit to humanity and I think it'll be a huge benefit to Berkshire. What the hell would we do if the fossil fuels ran out and we didn't have the sun? With disruption comes opportunity.
Berkshire Hathaway Energy CEO Greg Abel: The company just announced 10th project in Iowa, which takes it beyond 4000 MW wind there. That's about 56% of energy provided to customers coming from renewables.
With that, $18 billion committed to renewable energy, which includes retirement of coal facilities in Indiana.
Question from a Chicago/Berkeley, California shareholder, a first-timer to Omaha: Looking back on the last 50 years, what was the most memorable failure, and how did you deal with it?
Buffett: Back in the mid-1990s I looked to the shoe business in Dexter, Maine, and paid $400 million for something that was destined to go to $0 in a few years. I didn't figure that out.
I paid for some transactions in BRK stock – maybe the only instance in which I felt good about the share price going down.
I would say almost any time we've issued shares, it's been a mistake, wouldn't you say, Charlie?
Munger: Of course.
Buffett: We've had our own net worth and our families' net worth and our friends and partners put net worth into the partnership. We've been very, very cautious about what we've done. So there have been times we could have stretched a little harder and pushed a bit more. But taking a 1 percent chance isn't something I could live with.
Munger: It's obviously true if we would have used the leverage a lot of successful operators did, we would have become a lot bigger. But it's crazy to sweat in life.
Buffett: Over financial things.
Munger: Over financial things.
Next question about high rates of inflation and the consequences for Berkshire relative to other large companies, from a Maine shareholder.
Buffett: So far, I've been wrong. I would not have predicted you could have five to six years of close to zero rates and now we're seeing negative rates in Europe.
Very large, uncontrollable deficits are scary. So far, nothing bad has happened except for the fact that people who have saved and put their money in short-term savings instruments have gotten killed. It's still hard for me to see if you toss money from helicopters that, eventually, you won't have inflation.
When Poland issues bonds at negative interest rates, that wasn't in my list of forecasts a couple of years ago.
I think BRK, in almost any environment, will probably do better than most big companies. It's always prepared for anything, and it's also prepared to act, which gives it an added advantage over big companies. The company is sitting on $60 billion right now. I would rather have $20 billion and make a $40 billion acquisition, but it's positioned well to weather problems.
Munger on macroeconomic trends: We're just swimming all the time and we'll let the tide take care of itself. The problem with macroeconomic predictions is that people make them long enough, and they start to believe they know something.
Question regarding regulators deeming BRK's reinsurance business too big to fail.
Buffett: There are two aspects: A European group that looks at insurers through a more general scope ... and one that's more relevant in the U.S., the Financial Stability Oversight Committee, which deems certain financial institutions systemically important. This includes not only big banks, but also GE, Prudential, Metropolitan.
Exxon is large; Apple and Walmart, too. But the definition on a non-bank systemically important non-bank excludes Berkshire Hathaway. We don't come remotely close to that (definition).
Question: So could its failure devastate the U.S. financial system?
Buffett: No one has ever approached me about such a designation.
During the last time of trouble we were about the only party supplying help to the financial system and we'll always conduct ourselves in a way (where) the problems of others can't hurt us in a significant way. It's a moot question.
Munger: There's still too much risk in high finance and the idea that Dodd-Frank has removed it permanently is nonsense. I think our competitors don't like it that they deserve regulation and we don't.
Buffett on Dodd-Frank: My understanding is that (Dodd-Frank) actually weakens the power of regulators to take the power they took, and those powers were needed, in my view, to keep things from going into utter chaos.
Buffett on key figures weighing in on the state of economic affairs in troubling times: We've all seen what happens when regulatory leaders make proclamations about the state of markets, and this has been an important method to prevent runs on banks in times of trouble.
Question: What's the overall strategy with efforts of online insurance offerings?
Buffett: We will find out what the consumer wants, but we are experimenting with online workers comp. We believe in experimenting at Berkshire, and we've got the know-how.
The nature of the insurance business has changed significantly since Leo Goodman and his wife were stuffing envelopes in GEICO's early days in the 1930s. The world moves on and the key is to save people money and give them good service.
Question: After all these years of interviews and meetings, what's the one question you've never been asked that you'd like to answer now?
Buffett: I think I've been asked almost all of them and many of them, time after time after time. Charlie, do you have anything you're dying to be asked?
Buffett (pushing back against assertion that 3G and Berkshire are at odds concerning employment philosophies): I think better of the 3G method of operation than I do of our few operators that have excess people. I would never advocate running a business at a loss where it's going to continue. The same goes for having excess people around. You'll see our attitude best reflected in our Omaha office that has 25 people.
Munger: We're getting by with practically nothing.
This is Part I. Part II is here.