If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef. Likewise,if you are going to buy a car from time to time but are not a car manufacturer, should you prefer higher or lower car prices ? These questions, of course, answer themselves.
But now for the final exam: If you expect to be a net saver during the next five years,should you hope for a higher or lower stock market during that period ? Many investors get this one wrong. Even though they are going to be net buyers of stocks for years to come they get elated when stock prices rise and depressed when they fall.
In response to a question from Barbara Kiviat of Time on how he and Munger control their emotions, Buffett replied: "[It] comes about from having an investment philosophy grounded in the idea that a stock is a piece of a business. If you look at it that way, there's no reason to get excited whether some analyst is recommending it or the company is splitting the shares two-for-one, or whatever. The only way to drive the extraneous thoughts out of your mind is to have a philosophy. And for us that philosophy comes from Benjamin Graham and The Intelligent Investor, especially chapters 8 and 20. It's not very complicated stuff."
"You have to have the right temperament. I tell the students who come visit me that if you have more than 120 or 130 I.Q. points, you can afford to give the rest away. You don't need extraordinary intelligence to succeed as an investor. You need a philosophy and the ability to think independently...It doesn't make any difference what other people think of a stock. What matters is whether you know enough to evaluate the business," he opined.
"You should be able to write down on a yellow sheet of paper, 'I'm buying General Motors at $22, and GM has  million shares for a total market value of $13 billion, and GM is worth a lot more than $13 billion because _______________." And if you can't finish that sentence, then you don't buy the stock. [Note: Buffett mentioned GM for illustrative purposes only.] All this requires some temperamental detachment from other people's behavior. Both Charlie and I have a natural instinct in that direction. We value our opinions more than others' -- perhaps to an extreme!"
Kiviat followed up by asking whether they mind being regarded as "a bastion of calm" by others. Buffett simply stated, "I think they're probably right," while Munger was more loquacious: "Not only are they right, but it's a huge advantage to us to get the reputation of being wiser and stronger than other places. Would any of you object to being considered wiser and stronger when you're trying to get anything in life? The key is not to be seduced by crazy ideas, but instead just stick to the fundamentals year after year. Academia doesn't get too interested in us -- we're too simple. What would the professors do? A great many of the formulas [they use to analyze securities and markets] are dead wrong. They exist purely to give the intellectual class something to do. We don't do anything just exercise our intellectual proclivity for mathematical formulas."
Then Buffet said one of the most remarkable things I've ever heard him say: "There's no reason we should become fearful if a stock goes down. If a stock goes down 50%, I'd look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50% over the next month."
Look at that sentence again. What Buffett is actually saying is that most people's emotions work backwards: They get greedy when stock prices go up and fearful when they go down. Instead, if you are a true investor, you should shop for stocks the same way you shop for anything else: Look for sale prices, and never regard falling prices as inherently bad news. Instead, falling prices create the opportunity to buy even more of something that was already worth owning.
In that single sentence Buffett captured the difference between investing and speculating: An investor, like Buffett, wants the price of a stock to fall below the value of its underlying business so he can buy even more and hold for as long as possible. A speculator (like Jim Cramer) only wants the price of a stock to go up, with no regard for the value of the underlying business at all, so he can sell as fast as possible. To the investor, the market's opinions do not matter. To the speculator, they are the only thing that matters.
When a Korean journalist asked whether Berkshire would buy any other Korean companies in addition to its existing holding in steelmaker Posco, Buffett revealed that he had bought "a number of" Korean stocks for his personal portfolio "a few years ago," when "that stock market got about as cheap as any market I've seen in my lifetime."
But most Korean stocks are too small to have a significant impact on Berkshire's portfolio, so Buffett and Munger don't expect to put much money there. Nevertheless, "Korea represents sound value," said Munger, and Buffett added: "It's one of the better stock markets in the world."
Later, in answering a question about whether the credit crisis has turned regional bank stocks into good values, Buffett said: "It's hard to get much conviction on how [the management] will behave and whether they tell the truth. There's a lot of leeway [in the accounting procedures and the reported financial statements]. Talking to the CEOs isn't very useful. When they're lying, they believe it themselves a lot of the time. I want to see how people behave in different situations."
In short, Buffett is not bullish on regional banks. Munger, however, was more upbeat: "For somebody who's very diligent, you've identified a prospecting territory that has some promise. It wouldn't necessarily work for us [because BRK needs to buy very large blocks of stock], but it might work for others."
Buffett wasn't done criticizing the impervious financial statements of US banks: "If you had $1 million," he retorted to Munger, "it would be easier to go through a manual of Korean stocks than to select a few good American banks." This time Munger agreed: "I'd take the Korean stock market so much faster than the American banks that it'd make your head spin."
I don't think, by the way, that Buffett and Munger were trying to say that the Korean stock market is a steal. They were, instead, merely pointing out that investors need to think for themselves and to cast a wide net. If you run out today and buy a bunch of Korean stocks without researching them first, you're not following Buffett and Munger's advice, you're violating it.
A Chinese reporter asked whether Berkshire will be buying more stocks in China now that its market has fallen by almost half, and what the next year will hold for Chinese investors. Buffett's answer held a lesson for investors based anywhere. "We're not in the business of forecasting what the market will do in the next year," said Buffett. "But if a market goes down, we like that. There's no way Charlie and I get upset when stocks go down. We like it, because falling prices give us the opportunity to buy more good businesses at better prices."
"We don't predict stock prices," he went on to day. "All we know is, the lower they go, the more interesting they get. I think it was Agatha Christie, who was married to an archeologist, who said: 'I don't mind getting older, because the older I get, the more interested my husband becomes in me.' Well, the lower stock prices go, the more interested we get in them...We are not looking at any stocks in China now, but China will always be on our radar screen."
Asked how he evaluates financial stocks when so many have balance sheets complicated by derivatives, Buffett said: "There are some that I can't value. I probably couldn't value them even if I worked there, even if I were in charge, and even if I had a year to do it. It's just too complicated [with such large positions in complex derivatives]....Most of them, I'm agnostic. I guess that means I don't trust them. When you're buying stock in a financial institution, you should have a reason to be quite comfortable with the risk-assessment capabilities of the people in charge...to have a real fix on the people running the institution. We can't do that with a lot of [banks]. We just can't figure out what they're doing most of the time.... [the accounting doesn't] really spell out where the institution stands. So you'd better know more about the people running it than any set of figures can give you."
Buffett added that not long ago, he read the 270-page 10-K annual report of a bank he was curious about. "After a couple of hours," he said, "I had about 25 pages marked with big question marks that I couldn't answer." (This raises the obvious question: If Warren Buffett can't understand the financial statements of big banks with derivatives, who can?)
Munger summed up the complexity of derivatives this way: "Wall Street is always going to go where the money is and not worry about the consequences. First they invent things they shouldn't sell to anybody, then they end up selling them to their grandmothers."
Munger commented later, "Many of the present troubles were richly deserved. A lot of financial institutions behaved with a combination of stupidity and over-reaching, and that's not a good combination. I think the world is right to exact a large penalty. Capitalism wouldn't exist without failure."
Added Buffett: "Capitalism without failure is like Christianity without hell. These institutions not only brewed the Kool-Aid but drank it. [Some of the banks and mortgage companies] were like an arsonist who got caught in the house after he set it on fire."
Munger's final word on the subject: "In some of these institutions, the main product is not banking, it's testosterone."
(Fortune) -- In a presentation he made to students at the Wharton School earlier this month and a subsequent interview with Fortune, Warren Buffett shared his thoughts on everything from the economy to the credit crisis and the Bear Stearns bailout.
In this Web exclusive, we present further excerpts from his talk with the students, in which the megabillionaire offers his insights on judging managers, buying businesses, what metrics - if any - he relies upon, and why he views his job as similar to painting the Sistine Chapel.
Q: You said before that one of the things you look for in businesses you're buying is good managers who are honest, capable, and hard-working. To me, that's a hard judgment to make if you haven't known him for long on a personal level. How do you go about figuring that out about somebody, and how long does it take you to make that evaluation?
WB: Well, almost always, we're buying businesses where the managers come with it, so I do have a record [I can judge]. If I had to pick out the five people in this group here who would be the best managers, I wouldn't know how to do it. I mean, you all have great IQs, you have great academic records. You've all shown the energy to get into school and push hard and all that. So you'd have all these attractive qualities.
Can I pick out the five best? I don't think I can do it. What I can do, when I've seen somebody run a business for 20 years, is decide whether they're going to keep behaving in the future as they have in the past, if I keep the conditions that caused them to behave that way in the past. So when I buy a business - it's the biggest question I ask myself if I decide it's a good business - is "Do they love the money, or do they love the business?" Now, if they love the business, we can do business. If they love the money, we can't.
Now, let's say they love the business, as our managers do. They sell me a business for a billion dollars and can hardly wait to get to work in the morning.
In that situation, I'm the only guy that can mess it up. I can take that out of them. I can't put it into them. But I say to myself, "Why do I go to work in the morning?" I've got enough money. I've got Social Security now, even. [Laughter] I'll make it, you know? The kids won't get much, but that's their problem. So I say, "Why do I go to work in the morning?"
Well, there are two reasons. I love painting my own painting. I come down to the office, I get on my back, and I start painting. And I think I'm in the Sistine Chapel. It's my painting. Now, if somebody says, "Use more red paint instead of blue. Paint a seascape instead of a landscape," I would hand them the brush in five seconds and I'd say-I'd say a few other things, too - but I'd say, "Do your own painting. I'll go paint what I want to paint." I get to do my own painting. And then I get applause - if I deserve it. And I like that. I like having the painting admired, and I like to get to paint my own painting. That's so much more important to me than getting my golf score down three strokes or beating somebody at shuffleboard or something. I mean, it is the ultimate pleasure.
Now, if that turns me on, why won't it turn on these people who have built their own businesses? They have spent their life creating a wonderful painting. Now, for one reason or another, maybe tax reasons, maybe sibling reasons, who knows what, they need to sell it, they need to monetize it.
They come to me, and they know that at Berkshire they're going to keep the brush, they're going to keep doing the painting, and I have to look at them and decide whether they are people that really care about their painting or care about the money. [One giveaway is] if they auction the business. We've never bought a business at an auction. Never. Anybody that wants to auction off their family or auction off the creation of a lifetime, that's not what we want.
I tell people you've got two choices. You've spent a lifetime building this business. Or maybe your father built the business and you carried it on. Maybe your grandfather. You've given up vacations sometimes. You worked on weekends and all these things to create this really incredible painting that you're bringing to me. Now, if they want to auction it, they're not for me.
I tell them they have two choices. They can sell it to us, and it'll be in the Metropolitan Museum of Art. We'll have a wing for their painting. People will come and admire it, which they do. And they will say, "That's one hell of a painter." And you get to keep painting. Or you can take this marvelous painting and you can sell it to a porn shop. [Laughter] And he'll take the thing and he'll make the boobs a little bigger, something like that. And put it in the window. And a guy will come over in a raincoat a few years later, and he'll buy it, post it in his window, and it'll become a piece of meat, basically. We get the ones who care about having in it the Metropolitan Museum.
I got a fax almost three years ago on a Wednesday from a fellow I'd never met about a company I'd never heard of. This fellow named Peter Liegl ran Forest River over in Elkhart, Indiana. He sent me a couple pages, and said, "This is the sort of thing it looks like you're generally interested in."
I called him up that day. I said, "Pete, send me the last few audits. FedEx it, and I'll call you tomorrow afternoon." Never met him, never heard of the company. (It's a recreational vehicle company.) So I got in on Thursday morning, and I called him that afternoon. I said, "Pete, here's what I'll do. And if it works for you, fine." I'd never met the guy, but I could still tell by just the way he presented it and his thinking on it. And he said, "Fine. I'll come over next week with my wife and daughter, who own the stock."
And they came over late in the afternoon. I said to him, "Pete, what kind of salary would you like"; this is a company that did a billion seven last year. That's not the way they teach you to do it in business school, but I don't want anybody working for me that has a compensation system they're unhappy with. These people don't need me. They've got all the money they need. I'm going to [invest] hundreds and hundreds and hundreds of millions of dollars [in their businesses]. And he said, "I don't know." And I said, "Well, just tell me because I want you to be happy. You have to run this thing." "Well," he took a little while, "Well," he said, "I looked at the proxy statement, you make $100,000. I wouldn't want to make more than you do." So that became his salary.
Then I said, "You should get paid for exceeding the figures [on which I'm basing the decision to buy the company]. So," I said, "I want you to have a percentage interest in future earnings above this level," which we worked out. But he offered $100,000 and I offered the percentage above that. He has run the business magnificently since then. I've never been to Elkhart, Indiana. I've never seen this place. I hope it's there. [Laughter] Pete may have some 11-year-old kid in there that says, "What figure shall we send Warren?" [Laughter] The guy has done a remarkable job.
If I told Pete whether he should build a new plant, whether he should bring out a new model, whether he should change dealer firms, he'd tell me to take a hike. You know, why shouldn't he tell me to take a hike? He doesn't need the job. As long as that thing is a lot of fun for him, he's going to keep running it. And he'll run it for a long time.
[I get offered all] kinds of deals from LBO operators. I would just love to bet against the projections of every one that they give me. They hand me these books, which I don't even want to look at, but they hand me the books, and of course they always just project like that [points upward like a graph that only increases]. I would just love to make a career out of betting against the figures presented in those books, but I don't get a chance to do that. If you ever get a chance to short investment banker books, that would be a great activity.
Q: When you purchase a subsidiary, you've mentioned that you allow them to reinvest capital if they're able to go above a certain hurdle rate. So I was wondering how you decide what the cost of capital should be on a risk-adjusted basis.
WB: Well, we don't think about cost of capital or risk-adjusted. I mean, we don't want to take any risk, and we don't. That doesn't mean we don't do things that are wrong and all that, but we are not doing anything that risks real losses.
You know, GEICO spends 800 million on advertising. I may spend $200 million that's wrong this year at GEICO or something. But I recognize the things that I can't further refine. What we do with capital is we just look for the best thing we can do at any given time. I mean, in the end, we're going to retain everything.
We don't want to do anything that doesn't create more than a dollar's worth of value for every dollar expended. And we'll do the best we can. And as I said earlier [regarding stock holdings], we would have sold the thing to do something that offered even better opportunity. We won't do that with businesses at Berkshire. That's a pledge I make to people. If they sell me the business, it's going to stay in the Metropolitan Museum forever. I may make a mistake.
If it's going to permanently lose money, I reserve the right to sell it, and if it has labor problems, I reserve the right to sell it. That's in the back of the annual report every year. They've been there for 20-plus years, those principles. But we believe in them. We follow through on them. So we won't dump a business that way. But about 200 million a week comes in to me every week. I like it, too. [Laughter] And it's my job to figure out how to allocate that.
The smaller capital expenditures, or even fairly large ones at the subsidiaries, they just do them themselves. They don't need me, because if some guy comes in to me and talks about something in the yarn plant or something in Georgia, what the hell do I know about it? I mean, they can always present it in a way that makes it look good. If I say the internal rate of return we demand is 15.83, it'll be 15.84. I mean, you just can bet on it. I've never seen a project that doesn't meet your hurdle rate, you know, if they really want to do it. We don't go through those charades. And it saves my time, saves their time.
If we get into bigger deals, then I get involved. Buying businesses of any size and things of that sort. But we just look for the most intelligent thing. And our cutoff point is where we don't think we're creating more than a dollar of value for every dollar we lay out. Marketable securities, to some extent we just look for the things we think have the best expectancy, but we're not buying - there isn't one security that I've got in the portfolio that I look at as-in terms of risky - in the sense of permanent capital loss. They can go down 50%.
Berkshire Hathaway (BRKA, Fortune 500) stock itself has gone down 50% three times since I bought the first stock in at 7 3/8. In 1974 it got cut in half. In 1987 it got cut in half. In 1998, 2000 or so it got cut in half. So that doesn't make any difference. I mean, I just don't worry about it. I worry about permanent loss of capital. I worry about making the right businesses. I worry about keeping the managers happy. Everything else pretty much takes care of itself.