Charlie Munger's 3 Categories of Investment: In, Out & Too Tough

36. Berkshire Annual Meeting 2005: Part I: Points 1-8 for Wisdom & Fun (of Learning)

Wisdom & Fun from Notes from 2005 Berkshire Hathaway Annual Meeting – April, 2005

Ref: http://www.tilsonfunds.com/brkmtg05notes.pdf

Wisdom & Fun 1. Acquisition Criteria – We look for people who have a passion for their business.

We look for people who have a passion for their business. We frequently buy businesses the owners still manage, where they are monetizing a lifetime of work. They often don’t want to sell but need to for estate planning or other reasons.They need to have a passion because we don’t have any employment contracts – because we don’t think they work – we don’t stand over them with whips, and they’re already rich. We just try not to kill or dampen their love for their business.

Wisdom & Fun 2. We also look for three things: intelligence, energy and integrity. Without integrity, You Want Them Dumb.

We also look for three things: intelligence, energy and integrity. If you don’t have the latter, then you should hope they don’t have the first two either. If someone doesn’t have integrity, then you want them to be dumb and lazy. (Laughter)

We look them in the eyes and ask, “Do they love the business or the money?” If someone wants to cash out, then we have a problem because we only have 16 people at Berkshire’s headquarters and can’t run it ourselves.

Munger: The interesting thing is how well it [our acquisition strategy/process] has worked over a great many decades, and how few people copy it. (Laughter)

Keys to Berkshire’s Success With Acquisitions

We criticize it [acquisitions], but then we do it. But we have different motivations.

We’ve been reasonably successful in having people run their businesses with the same passion as before we bought them.

Gillette, the oil companies, etc. all went out and bought a lot of businesses and tried to run them themselves. We’re under no illusions that we can do that. We think that having lots of Executive Vice Presidents, directives from headquarters, centralized Human Resources etc. can destroy the incentives of the people who’ve already gotten rich, and we’re counting on them making us rich.

The successor to me will come from Berkshire, knows our system, has seen that it works, and will be surrounded by people who believe in it. So it’s not going to be so hard to keep this train going down the tracks at 90 miles per hour.

Wisdom & Fun 3. if you’re going to provide minimal oversight, you have to buy carefully.

Munger: Our success has come from the lack of oversight we’ve provided, and our success will continue to be from a lack of oversight. (Laughter)

But if you’re going to provide minimal oversight, you have to buy carefully.

It’s a different model from GE’s. GE’s works – it’s just very different from ours.

Buffett: We are a conglomerate – and we hope to become more of a conglomerate.

We’re successful because of simplicity itself: We let people who play the game very well keep doing it. Our successor won’t change this. The big worry is that the culture is tampered with and there’s oversteering. But our board and owners won’t allow this.

Wisdom & Fun 4. We’ve Picked Great Managers By Only Picking Proven Winners

It would be tough to evaluate a class of MBAs and pick which ones would prove to be the best managers, just like it would be tough to pick the best golfer by watching them hit on the practice range.

We haven’t tried to evaluate, before they have a record, who will be superstar managers. Instead, we find people who’ve batted .350 for 10-50 years. We just assume we won’t screw it up by hiring them. We take people who play the game very well and allow them to play.

I recall a study that correlated business success with the age at which a manager started. It turns out that those who started young did best. Of course, if you work with what you have, you can develop over time, but a lot of it is wiring – I’ve come to believe more so than I did 4-5 years ago. I’ve never heard Charlie say anything dumb about business – except when he disagrees with me. (Laughter) And I’ve never heard [GEICO CEO] Tony Nicely say anything dumb about business, ever.

Munger: Part of it is intelligence, partly temperament. Rick Guerin, for example, wanted to be rich, he was smart and had the right approach [so I knew he would be very successful]. [Guerin was one of the Superinvestors of Graham and Doddsville that Buffett profiled is this speech.]

Buffett: It’s interesting to think about the odds that the NCAA basketball Final Four will be cancelled [referring to his comment elsewhere that Berkshire had written a $75 million policy on the Final Four being cancelled]. Some people like thinking about this. My dad wouldn’t let me be a bookie, so I went into investing.

Selling Businesses

We won’t sell a business just because it’s underperforming.

It’s Hard to Buy Businesses in the Current Environment

We are positioned very badly in terms of buying businesses. Berkshire will not do as well as long as this persists.

Munger: A lot of buying is fee motivated. Managers want to earn the extra fees on the extra assets. I have a friend who buys warehouses, but he stopped bidding recently because he’s always being outbid. Howard Marks sent a lot of money back to investors, which is the right way to behave [I assume he’s referring to one of the Principals of Oaktree Capital Management]

Buffett: Five or six years ago, I got a call from a well-known investor who asked me a lot of questions about reinsurance. He didn’t know much about the business, but he was considering buying a reinsurance company because, as he explained to me, he would have to send his investors’ money back to them if he didn’t invest it in the next few months, and he was earning 2% [annually] on it.

We [unlike this gentleman] have all of our net worth on the downside as well. If we have 2 and 20 [2% management fee and a 20% performance allocation] on the upside and nothing but a goodbye kiss on the downside…

The competition right now is tough, so our efforts to buy businesses are likely to be futile. But there are 1-2 deals we might get done…

Munger: I don’t think there’s any business that we’ve bought that would have sold itself to a hedge fund. There’s a class of businesses that doesn’t want to deal with private-equity and hedge funds…thank God. (Laughter)

Buffett: We don’t see any deals [recently] that we wish we’d made – this wasn’t true in the past – even if the price had been 10% lower. We’re in a different world right now…

Berkshire’s Asset Allocation

Munger: Berkshire doesn’t do much conventional asset allocation. We just search for good opportunities and don’t want to put up artificial barriers. In this sense, we’re totally out of step with modern portfolio management, but we think they’re wrong.

Buffett: Well over 80% of our assets are in the U.S.

Munger: When have you ever done a big asset allocation?

Buffett: Never. But if junk bonds had stayed low for longer, we could have invested $30 billion instead of $7 billion.

Wisdom & Fun 5. Our test has been whether, if we retain a dollar, will it be worth more than a dollar in present value. So far we’ve always passed this test.

Paying a Dividend

One reason not to pay a dividend is taxes, but we’ve always said that even if we could have paid a tax-free dividend, we would not have done so. Our test has been whether, if we retain a dollar, will it be worth more than a dollar in present value. So far we’ve always passed this test.

 

Wisdom & Fun 6. Something Will Go Wrong. Have The Right Incentives In Place. Don’t Spped Up The Pilot.

But it’s no fun sitting on $40 billion, which earned less than 1% last year after tax. The burden of proof will shift in the next few years. We always ask, “Can we use the money effectively within our business?” So far, the answer has been yes. This will be discussed at our board meeting on Monday.

What Can Go Wrong at Berkshire and the Importance of the Right Incentives

We don’t worry about our businesses. We have a diverse group of good businesses with great managers. What we worry about is something going wrong. We have 180,000 employees, so it’s guaranteed that something will go wrong. We know it will happen. We just try to have – we do have – the right incentives in place.

For example, when I get on a NetJets flight, even if I’m in a hurry, I don’t say to the pilot, “Hey, I’m in a hurry. Can you speed it up.” The last thing I want is a pilot rushing through his pre-flight checklist, etc.

But companies do this all the time in the way they incent people. They should not have a system that encourages a focus on quarterly earnings. Our managers have no quarterly budgets – I don’t know what our numbers are going to be next quarter. I’m also careful not to communicate anything to the contrary via body language.

Wisdom & Fun 7. Quarterly Expectations in Mpdern Capitlidm: It’s not the kissing cousin of evil; it’s the blood brother.

Insurance companies in particular can report pretty much any numbers that they want. With $44 billion of reserves, it would be easy to adjust the reserves to show whatever profit was desired.

Even if quarterly numbers weren’t tied to our managers’ compensation, if I went to Wall Street and promised X, the managers, who wouldn’t want to let me down, might play some games to achieve X.

Munger: What we don’t like in modern capitalism is the expectations game. It’s not the kissing cousin of evil; it’s the blood brother.

Buffett: People who predict precisely are either kidding themselves or others. We’ve seen people get their egos involved. And everyone in the organization knows what the CEO has promised in public. It’s setting up a system that sets up financial or psychological pressure for people to do things they probably don’t want to do. It’s a terrible mistake.

Berkshire’s Board and Corporate Governance

Munger: We’re out of step. We don’t feel the need to have directors from every diversity category and pay everyone $100,000-$200,000 per year.

Our directors are all rich, own Berkshire stock, and don’t have any company-provided Directors and Officers insurance coverage.

We’ve been waiting for our system to spread and we’ve been losing. (Laughter)

Buffett: The real issue is mediocrity – there are too many .240 hitters on boards. Businesses often settle for a notch or two above mediocrity – there are strong human instincts at work.

For many directors, the director’s fees are an important part of their [total annual] compensation, and they want to be recommended for other boards, so this makes it difficult to arrange a rump meeting to say, “The guy at the end of the table [the CEO] is no good.” This is mediocrity that is tough to combat.

We’ve been on boards and they can only tolerate a certain amount of obnoxiousness, so we have to ration it out. (Laughter) It’s hard to overrule someone [the CEO] and we’re likely to lose anyway. Occasionally we fire a bullet, but it often does no good.

We have real owners on our board – they bought it just like you. [In contrast,] the boards I’ve been on just hand me stock and stock options.

Independence is a state of mind. We think we have the best board in the country, but people who evaluate boards by a checklist disagree.

Wisdom & Fun 8. A director who gets $150,000 per year from a company and needs the money is not independent.

Munger: A director who gets $150,000 per year from a company and needs the money is not independent.

[The new law requiring a majority of independent directors] is typical government intervention.

Buffett: I’ve been on 19 boards and I’ve never seen a director who needs the money oppose an acquisition or executive compensation. They just don’t behave as if they own it.

Munger: Someone once said that no man who needs the salary that a politician receives should be allowed to hold office.

Buffett: One of our directors was asked to leave two compensation committees for having the temerity to question pay packages. They’re looking for Chihuahuas not Great Danes or Dobermans. (Laughter) I hope I’m not insulting any of my friends on compensation committees. (Laughter)

Munger: You’re insulting the dogs. [The biggest laugh of the day.]