Today I offer a compilation of the questions and answers that I think are the most interesting from the 1995 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting.
1. On charging managers a high rate for incremental capital they employ.
Warren Buffett (Trades, Portfolio): The questions about incentive arrangements we have with managers or other situations, where we either advance capital to a wholly owned subsidiary or withdraw it, usually, that ties in with the compensation plan.
And we want our managers to understand just how highly we do value capital. And we feel there’s nothing that creates a better understanding than to charge them for it.
So, we have different arrangements. Sometimes it’s based a little on the history of the company. It may be based a little bit on the industry. It may be based on interest rates at the time that we first draw it up.
We have arrangements depending on those variables and perhaps some others and perhaps just, you know, how we felt the day we drew it up, that range between 14% and 20%, in terms of capital advanced.
And sometimes we have an arrangement where, if it’s a seasonal business where, for a few months of the year, when they have a seasonal requirement, we give it to them very cheap at LIBOR.
But, beyond that, we start saying, “Well, that’s permanent capital,” so we charge them considerably more.
Now, if we buy a business that’s using a couple hundred million of capital, and we work out a bonus arrangement, and the manager figures out a way to do the business with less capital, we may credit him at a very high rate -- same rate we would use in charging him -- in terms of his bonus arrangement.
So, we believe in managers knowing that money costs money. And I would say that, just generally, my experience in business is that most managers, when using their own money, understand that money costs money.
But sometimes managers, when using other people’s money, start thinking of it a little bit like free money. And that’s a habit we don’t want to encourage around Berkshire. By sticking these rates on capital, we are telling the people who run our business how much capital is worth to us.
And I think that’s a useful guideline, in terms of the decisions they’re making, because we don’t make very many decisions about our operating business. We make very, very few. I don’t see capital budgets, in most cases, from our 100%-owned subsidiaries. And if I don’t see them, no one else sees them.
2. Question on American Express (AXP, Financial):
Warren Buffett (Trades, Portfolio): Obviously, even though you mentioned they’re in a number of businesses, by far, the key, the most important factor in American Express’ future for a great many years to come will be the credit card.
And that is a business that has become, and will forever, probably, become ever more competitive. I followed it since I think I met Ralph Schneider at the Diners’ Club in the late 1950s.
And American Express entered into the credit card business out of fear. They were worried about what the credit card was going to do to their traveler’s check business. Traveler’s check business had been originated back in 1890-something, I believe.
And that was, in turn, building off of the old express business where, I think, it was Henry Wells and William Fargo, they would chain themselves to the express boxes as they delivered them to the West.
And they decided that maybe issuing traveler’s checks would a little easier than carrying all this stuff around. So the traveler’s check was evolved out of the express business.
And the credit card business with American Express arose out of fear of particularly Diners Club at the time. They were all terrified of Diners Club, which got the jump on everybody. And they became enormously successful with it. And the American Express card, as you know, had a terribly strong position in what they called the “travel and entertainment” part of the card business. And of course, the banks entered in on a big scale. And Visa’s been enormously successful.
So, the card has a strong franchise in certain areas, like the corporate card. Although people like First Bank System are very aggressive in going after them there. But the card has a significant franchise, but it does not have the breadth of franchise that it had many years ago.
For a while, it was “the” card. And now it’s “the” card in certain areas, but nothing like as broad an area as before.
It has certain, very important, advantages and economic strengths and it has some weaknesses. And you have to suss those, in deciding where it’ll be in the year 2000 or 2005. And we think that the management of American Express thinks well about the question of how you keep the card special in certain situations. And they’ve reacted to the merchant backlash for higher discount fees, I think, in an intelligent way.
So, we’ll see how it all plays out. IDS, which has now been renamed, is a very big part of American Express. It accounts for close to a third of their earnings. But the real key will be how the card does over time.
3. Question on how many years of earnings he goes through:
Warren Buffett (Trades, Portfolio): If we are buying all of them, we’re trying to look at businesses in terms of what kind of cash can they produce. If we’re buying part of them, we’ll look at what kind of cash will they produce.
4. Charlie Munger (Trades, Portfolio) on the basic fundamental economics rules to follow:
The honest lord is low agency cost. And the microeconomic business advantages are, by and large, advantages of scale. You can have scale of intelligence. In other words, you can have a lord with enough extra intelligence that has a big advantage.
There are two different kinds of agency costs. One, the guy favors himself at the expense of the shareholders, and the other is he’s done foolish things. Or he’s not trying to favor himself, he just is foolish by nature. Either way, it’s very costly to you, as the shareholder. So, you have to judge those two aspects of human character, and they’re terribly important.
5. Question on whether Buffett considers book value in investment evaluation and whether Buffett uses Ben Graham’s formula:
Warren Buffett (Trades, Portfolio): Book value is not a consideration, virtually, not a consideration at all. The best businesses, by definition, are going to be businesses that earn very high returns on capital employed over time. So by nature, if we want to own good businesses, we’re going to own things that have relatively little capital employed compared to our purchase price. That would not have been Ben Graham’s approach.
It probably takes more business experience and insights, to some degree, to apply Phil Fisher’s approach than it does Graham’s approach. The only problem is, you may be shut out of doing anything for a long time with Ben’s approach, and you may have a lot of difficulty in doing it with big money. Ben felt you could read his book sitting out here in Omaha and apply – buying things that were statistically cheap, and you didn’t have to have any special insights about business or consumer behavior, or anything of that sort.
6. Example of early Buffett "cigar butts:"
Charlie Munger (Trades, Portfolio): Well, I can remember when you bought one membership in some duck club that had oil under it, when you were young.
Warren Buffett (Trades, Portfolio): Yeah, that was a company called Atled —
Charlie Munger (Trades, Portfolio): When you get down to one duck club membership, well, you’re really scavenging for cigar butts.
Warren Buffett (Trades, Portfolio): Not a bad cigar butt. There were 98 shares outstanding. It was the Delta Duck Club. And the Delta Duck Club was founded by a hundred guys who put in 50 bucks each, except two fellows didn’t pay, so there were only 98 shares outstanding.
They bought a piece of land down in Louisiana, and one time somebody shot downward instead of upward, and oil and gas started spewing forth out of the ground. So, they renamed it Atled, which is Delta spelled backwards, which sort of illustrated the sophistication of this group.
And a few years later, at $3 a barrel oil, they were taking about a million dollars a year in royalties out of the place. And the stock was selling at $29,000 a share, and it was earning $10,000 a share. No, it was earning about $7,000 a share after tax, about 11,000 pretax, and it had about 20,000 a share in cash. And it was a long-lived field.
So, you know, I use that sometimes as an example of efficient markets, because somebody called me and offered me a share of it, and those things, you know — is that an efficient market or not?
You know, 29,000 for 20,000 of cash, plus 11,000 of royalty income at 25 cent gas and $3 oil? I don’t think so.
7. Why is there just one Borsheim Store?
Warren Buffett (Trades, Portfolio): Well, it’s an interesting question about both the Borsheims and the Nebraska Furniture Mart. They’re owned historically by the same family. It was Mrs. B.’s sister’s family that bought Borsheims, but, in effect, started it virtually from scratch.
Both of those institutions offer this incredible selection, low prices brought about by huge volume, low operating costs, and all of that.
Operating multiple locations, you would get some benefit, obviously, from the name and the reputation. But you would lose something, in terms of the amount of selection that could be offered.
There’s $50 million-plus at retail of jewelry at Borsheims’ one location. Well, when someone wants to buy a ring, or a pearl necklace, or something of the sort, they can see more offerings at a place like that than they possibly could at somebody who is trying to maintain inventory at 20 or 50 locations.
Similarly, that gives us a volume out of a given location that results in operating costs that, again, can’t be matched if you have an enormous number of locations.
So, I think those businesses tend to be more successful in that particular mode as one-location businesses.
Now, a Helzberg’s will be bringing merchandise to people all over the country at malls. And they will do — through that mode of operation, they perform that exceptionally well.
But Borsheims can’t be Helzberg’s, and Helzberg’s can’t be Borsheims. They’re both going for two different — in a sense, two different customers, to some degree. Sol Price, Charlie’s friend who started the Price Club, the first big wholesale club, said that part of his success was due to figuring out the customer he didn’t want. I think that’s right, isn’t it?
You have to figure out what you’re good at and who you really can offer something special to. Borsheims offers something very special to people, but in part, it comes about through being at one location.
You can see more of almost any kind of jewelry you want there than you’re going to see virtually any place in the world. And that will bring people there, or it will bring male people there.
8. On acquisition of Helzberg Diamonds:
Warren Buffett (Trades, Portfolio): It [Helzberg Diamonds] is in its position in the jewelry industry, it tends to compete with Zales or Gordon’s, but it does a far, far better job. Their sales, per store, on roughly equivalent square footage, will be very close to double what competitors achieve. It’s got a magnificent morale, and organizational structure. And the people – Barnett was very generous with people in making the sale. He took it out his own pocket to treat people right because they’d done such a terrific job over the years.
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