Berkshire AGM 1997 excerpts
You can pay too much even if a business is “wonderful”
WARREN BUFFETT: American business has done extraordinarily well in the last decade-plus. And that’s a huge plus for securities, because they just represent pieces of those businesses. Interest rates over the last 15 years have fallen. That’s a big plus for stocks. Anytime interest rates go down, the value of every financial asset goes up, in rational calculation.Both of those factors have combined in recent years to produce conditions that enhance the true value of American business. But those are pretty widely recognized now, and after a while — Ben Graham always used to say you can get in more trouble in investment with a good premise than with a bad premise, because the bad premise will shout out to you immediately as being fallacious, whereas with a good premise it’ll work for awhile. You know, businesses are worth more money if interest rates fall and stocks rise.
But then eventually the market action of the securities themselves creates its own rationale for a whole — for a large crop of buyers, and people forget about the reasons and the mathematical limitations that were implied in what they — in what got them excited in the first place. And after a while, rising prices themselves alone will keep people excited and cause more people to enter the game.
And therefore the good premise, after a while, is forgotten except for the fact that it produced these rising prices. And the prices themselves take over. He wrote about that and the connection with the 1920s when Edgar Lawrence Smith in 1924 wrote a fine book on why stocks were better than bonds. And that was sort of the Bible of the bull market of the ’20s, and it made sense, if you paid attention to a couple of the caveats which were in Edgar Lawrence Smith’s little book, which related to price. But people tend to forget about the importance of the price they pay as the experience of a bull market just sort of dulls the senses generally.
“Volatility is a huge plus to the real investor”
WARREN BUFFETT: Yeah. We don’t think in terms of — well, we think first in terms of business risk, you know. We — the key to [Benjamin] Graham’s approach to investing is not thinking of stocks as stocks or part of a stock market. Stocks are part of a business. People in this room own a piece of a business. If the business does well, they’re going to do all right as long as they don’t pay way too much to join into that business.
So we look at — we’re thinking about business risk. Now, business risk can arise in various ways. It can arise from the capital structure when somebody sticks a ton of debt into some business, and so that if there’s a hiccup in the business that the lenders foreclose. It can come about just by the nature of the — certain businesses are just very risky. Back in — when there were more commercial aircraft manufacturers, Charlie and I would think of making a commercial airplane, a big airliner, sort of as a bet-your-company risk because you would shove hundreds and hundreds of millions of dollars out into the pot before you really had customers.
And then if you had a problem with the plane, you know, that company could go. There’s certain businesses that inherently — because of long lead times, because of heavy capital investment — that basically have a lot of risk. And commodity businesses have risk unless you’re the low-cost producer, because the low-cost producer can put you out of business. Our textile business was not the low-cost producer. And we had a fine management, and everybody worked hard. We had cooperative unions, all kinds of things. But we weren’t the low-cost producer, so it was a risky business. The guy who could sell it cheaper than we could made it risky for us.
So there’s a lot of ways businesses can be risky. We tend to go into businesses that inherently are low-risk, and are capitalized in a way that that low risk of the business is transformed into a low risk to the enterprise. The risk beyond that is that even though you buy — identify — such businesses, that you pay too much for them. That risk is usually a risk of time rather than loss of principal, unless you get into a really extravagant situation.
But then the risk becomes the risk of you yourself. I mean, whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market.The stock market is there to serve you, and not to instruct you. And that’s a key to owning a good business, and getting rid of the risk that would otherwise exist in the market.
You mentioned volatility. It doesn’t make any difference to us whether the volatility of the stock market, you know, is — averages a half a percent a day or a quarter percent a day or 5 percent a day. In fact, we’d make a lot more money if volatility was higher, because it would create more mistakes in the market. So volatility is a huge plus to the real investor.
Ben Graham used the example of “Mr. Market,” which is the — and we’ve used it. I’ve copied it in the report. I copy from all the good writers. And Ben said, “You know, just imagine that when you buy a stock, that you — in effect, you’ve bought into a business where you have this obliging partner who comes around every day and offers you a price at which you’ll either buy or sell. And the price is identical.” And no one ever gets that in a private business, where daily you get a buy-sell offer by a party. But in the stock market you get it. That’s a huge advantage. And it’s a bigger advantage if this partner of yours is a heavy-drinking manic depressive. (Laughter)
The crazier he is, the more money you’re going to make.So you, as an investor, you love volatility. Not if you’re on margin, but if you’re an investor you aren’t on margin. And if you’re an investor, you love the idea of wild swings because it means more things are going to get mispriced. Actually, volatility in recent years has dampened from what it used to be. It looks bigger because people think in terms of Dow points and so they see these big numbers about plus 50 or minus 50 or something. But volatility was much higher many years ago than it is now. And you had — the amplitude of the swings was really wild. And that gave you more opportunity. Charlie?
CHARLIE MUNGER: Well, it got to be the occasion in corporate finance departments of universities where they developed the notion of risk-adjusted returns. And my best advice to all of you would be to totally ignore this development. Risk had a very good colloquial meaning, meaning a substantial chance that something would go horribly wrong. And the finance professors sort of got volatility mixed up with a lot of foolish mathematics.
To me, it’s less rational than what we do, and I don’t think we’re going to change. (Buffett laughs)
WARREN BUFFETT: Finance departments teach that volatility equals risk. Now, they want to measure risk, and they don’t know any other way. They don’t know how to do it, basically. And so they say that volatility measures risk. And, you know, I’ve often used the example that the Washington Post stock when we first bought it had gone — in 1973 — had gone down almost 50 percent from a valuation of the whole company of close to, say, 180 or 175 million, down to maybe 80 million or 90 million.
And because it happened very fast, the beta of the stock had actually increased and a professor would have told you that the stock — company — was more risky if you bought it for 80 million than if you bought it for 170 million. Which is something that I’ve thought about ever since they told me that 25 years ago, and I still haven’t figured it out. (Laughter)
We don’t know how to value Intel and Microsoft
WARREN BUFFETT: Yeah. Well, it will certainly work out to twice the return if Intel and Microsoft do twice as well as Coke and Gillette. I mean, it’s a question of being able to identify businesses that you understand and feel very certain about. And if you understand those businesses, and many people do, but Charlie and I don’t, you have the opportunity to evaluate them. And if you decide they’re fairly priced and they have marvelous prospects, you’re going to do very well. But there’s a whole group of companies, a very large group of companies, that Charlie and I just don’t know how to value.
And that doesn’t bother us. I mean, you know, we don’t know what — we don’t know how to figure out what cocoa beans are going to do, or the Russian ruble, or I mean, there’s all kinds of financial instruments that we just don’t feel we have the knowledge to evaluate. And really, you know, it might be a little too much to expect that somebody would understand every business in the world. And we find some that are much harder for us to understand. And when I say understand, my idea of understanding a business is that you’ve got a pretty good idea where it’s going to be in ten years.
And I just can’t get that conviction with a lot of businesses, whereas I can get it with relatively few. But I only need a few. As you’ve pointed out, you only need a few, six or eight or something like that. It would be better for you — it certainly would have been better for you — if we had the insights about what we regard as the somewhat more complicated businesses you describe, because there was and may still be a chance to make a whole lot more money if those growth rates that you describe are maintained.
But I don’t think they’re — I don’t think you’ll find better managers than Andy Grove at Intel and Bill Gates at Microsoft. And they certainly seem to have fantastic positions in the businesses they’re in. But I don’t know enough about those businesses to be as sure that those positions are fantastic as I am about being sure that Gillette and Coca-Cola’s businesses are fantastic. You may understand those businesses better than you understand Coke and Gillette because of your background or just the way your mind is wired. But I don’t, and therefore I have to stick with what I really think I can understand. And if there’s more money to be made elsewhere, I think the people that make it are entitled to it. Charlie?
CHARLIE MUNGER: Well, if you take a business like Intel, there are limitations under the laws of physics which eventually stop your putting more transistors on a single chip. And the 30 percent per annum, or something like that, you — I don’t think — those limitations are still a good distance away, but they’re not any infinite distance away. That means that Intel has to leverage its current leadership into new activities, just as IBM leveraged the Hollerith machine into the computer. Predicting whether somebody’s going to be able to do that in advance is just — it’s too tough for us.
Just takes 5 minutes to know if we’re interested in a company
WARREN BUFFETT: The five minute test is a — you know — Charlie and I have — we’re familiar with virtually every company of a size that would interest us in the country. I mean, if you’ve been around for 40 or more years looking at businesses, it’s just like if you were looking at — you know, studying baseball players every day. You get to know all the players after a while. And that’s the way it works. Then we have a bunch of filters we’ve developed in our minds over time. We don’t say they’re perfect filters. We don’t say that those filters don’t occasionally leave things out that should get through. But they’re very — they’re efficient.
And they work just as well as if we spent months and hired experts and did all kinds of things. So we really can tell you in five minutes whether we’re interesting in something, and — We’d never owned shares in FlightSafety but we’d been familiar with the company for at least 20 years, wouldn’t you say, Charlie?
CHARLIE MUNGER: Sure, I had a partner who bought a lot of it 20 years ago. Yeah.
WARREN BUFFETT: Yeah. But that’s true of almost any business. And we know — we’ve got a fix on what we don’t understand, and then we don’t care to know any more about them, particularly, although we’ll pick up a little as we go along, maybe. And then the ones that are — we’re capable of understanding, we’ve probably gotten about as far as we’ll get already. So we do know in five minutes. Now, when we do something with FlightSafety, before the purchase and even for somewhat — a little after the purchase — I’d never been — I’d never set foot on a piece — they have 40 or so training centers around the world — I’d never set foot on one of them.
International earnings in the United States
WARREN BUFFETT: Well, we have a number, well, at least several major businesses, three or four at least, five, six, I mean, as I count along, that derive very significant percentages of their earnings from international operations. Coca-Cola earns 80 percent or more from international operations. Gillette would earn two- thirds or more from international operations.So if you look to where earnings are coming from, we get a lot from international companies.They don’t have to be domiciled outside the United States.It’s a slight advantage to us to have them domiciled in this country.
For example, their dividends are treated better. We get better treatment on the dividends if they are domestically based rather than based someplace else, just because of the way the U.S. tax laws work. But if Coca-Cola were domiciled in Amsterdam, or Gillette were domiciled in London, they had the same basic businesses, we would be attracted to them to virtually the same degree we are as having them domiciled in Atlanta and Boston.
We look at businesses outside this country that are domiciled outside this country. Many don’t meet our size requirements. But that’s true here, too. We have to look at very big companies. But we have nothing against buying into companies that are domiciled — or even buying the entire business of a company — that’s domiciled outside the United States.We feel slightly less familiar with the tax laws and the corporate cultures, perhaps. But that would not be a huge factor in a great many countries. And, you know, we will keep looking. We need to look everywhere with the kind of money that we have available for investment.
Treasury bonds are yardstick to compare investments
WARREN BUFFETT: The risk-free rate is used merely to equate one item to another. In other words, we’re looking for whatever’s the most attractive. But in terms of present valuing anything, we’re going to use a number. And, obviously, we can always buy the government bonds. So that becomes the yardstick rate. It doesn’t mean we want to buy government bonds. It doesn’t mean we want to buy government bonds if the best thing we can find is only — has a present value that works out at a half percent a year better than the government bond. But it’s the appropriate yardstick, in our view, to simply use to compare across all kinds of investment opportunities, oil wells, farms, whatever it may be
“It’s not share of market. It’s share of mind that counts”
WARREN BUFFETT: You know, what you really — when you get into consumer products, you’re really interested in finding out — or thinking about — what is in the mind of how many people throughout the world about a product now, and what is likely to be in their mind five or ten or 20 years from now? Now, virtually every person on the globe — maybe, well, let’s get it down to 75 percent of the people on the globe — have some notion in their mind about Coca-Cola. They have — the word“Coca-Cola” means something to them. You know, RC Cola doesn’t mean anything to virtually anyone in the world, you know, it does to the guy who owns RC, you know, and the bottler.
But everybody has something in their mind about Coca-Cola. And overwhelmingly, it’s favorable. It’s associated with pleasant experiences.Now, part of that is by design. I mean, it is where you are happy. It is at Disneyland, at Disney World. And it’s at ballparks. And it’s every place that you’re likely to have a smile on your face, including the Berkshire Hathaway meeting I might add. (Laughter) And that position in the mind is pretty firmly established. And it’s established in close to 200 countries around the world with people. A year from now, it will be established in more minds. And it will have a slightly, slightly, slightly different overall position. In ten years from now, the position can move just a little bit more.It’s share of mind. It’s not share of market. It’s share of mind that counts.
Disney, same way. Disney means something to billions of people. And if you’re a parent of a couple young children and you got 50 videos in front of you that you can buy, you’re not going to sit down and preview an hour and a half of each video before deciding what one to stick in front of your kids. You know, you have got something in your mind about Disney. And you don’t have it about the ABC Video Company. Or you don’t even have it about other — you don’t have it about 20th Century. You know, you don’t have it about Paramount. So that name, to billions of people, including lots of people outside this country, it has a meaning. And that meaning overwhelmingly is favorable. It’s reinforced by the other activities of the company. And just think of what somebody would pay if they could actually buy that share of mind, you know, of billions of people around the world. You can’t do it. You can’t do it by a billion dollar advertising budget or a $3 billion advertising budget or hiring 20,000 super salesmen. So you’ve got that.
Now, the question is what does that stand for five or ten or 20 years from now? You know they’ll be more people. You know they’ll be more people that have heard of Disney. And you know that there will always be parents that are interested in having something for their kids to do. And you know that kids will love the same sort of things. And, you know, that — (Munger accidentally knocks over his microphone) — what’s? (Laughter) He emphasizes the key points when we get to those. (Laughter) But that is what you’re trying to think about with a consumption product. That’s what Charlie and I were thinking about when we bought See’s Candy.