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

37. Berkshire Annual Meeting 2005: Part II: Points 9-16 for Wisdom & Fun (of Learning)

Wisdom & Fun 9. On Insurance: I think about this a lot – it’s my job to think about the absolute worst-case scenario. No matter what happens, we’ll be OK.

Managing Insurance Risk

We are doing some things in insurance that have some correlations. For example, we have insured a lot of things in California and if you have the right earthquake at the right time, not only could National Indemnity and GEICO incur losses, but See’s and Wells Fargo would as well. And we used to own Freddie Mac [which would get hit as well].

I think about this a lot – it’s my job to think about the absolute worst-case scenario. No matter what happens, we’ll be OK.

The most likely mega-cat is a hurricane. In Long Island, there’s huge exposure [by the entire insurance industry]. The last big hurricane hit there in the 1930s [and insurance is being priced accordingly]. But everything that can happen will happen.

The most powerful earthquake in U.S. history – 9.0 – was in New Madrid, Missouri.

It’s Berkshire’s job to be absolutely prepared for the very worst. A few years ago, we didn’t have nuclear/chemical/biological risk exclusions [in our insurance policies] – we had huge risk, but it’s gone now.

We wrote a policy for $500 million in excess of $2.5 billion, not caused by a nuclear/chemical/biological attack, on a major international airport. There was a cap of $1.6 billion for business interruption, so there would have to be more than $900 million of property damage [before we’d have to pay anything].

We insured the [NCAA basketball] Final Four against being cancelled (not moved or postponed), excluding nuclear/chemical/biological attacks. We would have paid $75 million [in this event]. We also insured the Grammy’s in a similar way. We’re OK with losing a lot of money, as long as we’re being paid appropriately for the risk.

Nuclear/chemical/biological attacks are excluded from virtually all of our policies. We write it only when we’re specifically getting paid for it.

Munger: We care more about thinking about things that have never happened. Think of a 60-foot tidal wave hitting California. Can you imagine?

Is there any other company that has attacked [reducing the insurance risk of] nuclear/chemical/biological attacks as well as us?

Buffett: No-one has attacked it more vigorously than we have. It’s Armageddon here every day. (Laughter)

My aunt, who died last year, had everything she had in Berkshire [stock. With investors like this,] it would be crazy to take any risks to jeopardize this [company] to make an extra $100,000 or add a point to the track record. Maybe if I had a 2/20 [incentive fee structure; 2% management fee and 20% promote], I’d behave differently, but I sure hope not.

Wisdom & Fun 10. On Europe: Europe isn’t doing as badly as you might think. Its growth rate is lower than ours, but our population is expanding a lot faster, so on a per capital basis, the gap is not as wide as you’d think.

Comments on Investing in Europe

One disadvantage to buying a stock in the UK is that you have to report your holding once you reach the 3% level. So, for a stock with a $5 billion market cap, we’d have to report [and likely run the stock up] once we’d acquired only $150 million. But in the past, we’ve owned Guinness, which is now owned by Diageo, so this is not an overwhelming disadvantage. We’d be very comfortable owning many UK companies.

Incidentally, contrary to what’s been reported, we do not have to report a 5% position within 10 days [referring to reports in The Wall Street Journal and elsewhere that Berkshire would have to file on its recently disclosed purchase of Anheuser-Busch stock if it held more than 5% of the shares outstanding].

Munger: Recently we’ve preferred the currencies of socialized Europe over the U.S. dollar. A queer occurrence…

Buffett: I remember when I’d come back from Europe and couldn’t wait to convert my euros back to dollars.

Europe isn’t doing as badly as you might think. Its growth rate is lower than ours, but our population is expanding a lot faster, so on a per capital basis, the gap is not as wide as you’d think.

COMMENTS ON BERKSHIRE HATHAWAY HOLDINGS

Berkshire’s Stock Holdings

We’re at the lowest percentage of public holdings ever [relative to all of Berkshire’s assets], except for when we were winding down [in the early 1970s].

We’re not unhappy with our public holdings like Coke, Wells Fargo and Moody’s, but would we buy more? Well, we’re not, so there’s your answer. But due to taxes, the size of our positions, etc., we’re not selling either.

We’re not in an attractive time.

Munger: It’s not a permanent state of affairs, but it’s not going away.

We will still put large amounts of money to work at good rates, whereas now we’re only able to invest small amounts – where small is still billions.

Wisdom & Fun 11. Avoid Credit Card Debt

Best Investments Ever (and Avoid Credit Card Debt)

See’s was very important to us to learn about [running a] business, and to provide cash for a lot of other things.

[Also,] buying the first half of GEICO for $40 million, given what we’ve gotten out of it and its future potential. (We later paid $2 billion for the 2nd half.) GEICO still has enormous possibilities for growth.

In the past I’ve touted the American Express card – well today, I’m going to tout the GEICO credit card. That being said, I advise you to pay off your credit card. It’s a terrible mistake to get hooked on revolving credit at high interest rates.

I met with 21 groups of students last year and what I tell them is, even if you don’t remember anything else I say, please don’t get hooked on credit card debt.

GEICO is a great, great business model, run by a superb person and businessman, Tony Nicely.

Munger: The search expenses that brought us Ajit Jain – I cannot think of a better investment.

This is a good life lesson: getting the right people into your system is the most important thing you can do.

Anheuser-Busch

Most of the time, our actual decision [to buy] takes about two seconds. In the case of Anheuser-Busch, I bought 100 shares 25 years ago so that I would get the annual reports (you get the annual reports a little quicker if you own the stock in your own name). So, I’ve been reading the company’s annual reports for 25 years. Recently, beer sales have been flat. Wine and spirits are growing, at the expense of beer, and Miller has been rejuvenated to some degree. So, Anheuser-Busch has been experiencing very flat earnings; they’ve had to spend more to maintain share and even do a bit of promotional pricing. They are going through a period that is certainly less fun for them than was the case a few years ago.

It’s been a fascinating industry over the past 50 years. Omaha used to be a brewing town and Storz beer had 50% of the local market, but then the national brands took over.

Anheuser-Busch will have a strong position for a long time. The beer business is not going to grow significantly in the U.S., but worldwide beer is popular in a great many places, and Anheuser-Busch has a very strong position. I would not expect the earnings to do much for some time, but that’s fine with us.

Munger: In our situation, it’s rare that we can buy into a good company – we almost need a little unpleasantness.

Buffett: That’s true for Berkshire too.

In beer, you don’t see the rise of generic brands, as we’ve seen in so many other categories. But beer consumption per capita is going nowhere.

Americans drink about 64 ounces of liquid per day. 27% of that is soda (11 ounces are Coke products), beer is about 10% and, despite the rise of Starbucks, a fine company, coffee has gone down and down over time.

Wisdom & Fun 12. Giant Companies Dominating The Beer Industry Will Be The Norm

Munger: There used to be hundreds of brewers. I think the trend toward giant companies [dominating the beer industry] is permanent.

Buffett: Schlitz used to be the #1 brand of beer.

There’s a great book on the history of the beer industry [he didn’t give the title, though mentioned it was written by a Wall Street Journal reporter. Most likely it is Travels with Barley: A Journey Through Beer Culture in America, by Ken Wells.]

PetroChina

We bought it a few years ago, investing $400 million. It was my first investment in a Chinese stock.

I read the annual report. They produce 3% of the world’s oil, about 80% as much as Exxon Mobil. Last year, it earned $12 billion in profit – only maybe five US companies earned as much last year.

The total market value when I bought it was around $35 billion, so I paid only three times last year’s earnings. The company does not have unusually large amounts of leverage and – this is unusual – has a stated policy of paying out 45% of its earnings in cash, so that’s a 15% cash yield [based on last year’s earnings, since Berkshire bought it at 3x those earnings].

The Chinese government owns 90% and we own 1.3%, so if we vote with them, together we control the business. (Laughter)

Unfortunately, we don’t own the same shares [as the Chinese government]. [We own another class of shares such that] we had to report our interest [in the company] at 1.3%. We would have liked to buy more, but the price jumped up [after our ownership stake was disclosed].

Munger: It would be nice if this [finding really cheap stocks] happened all the time. Unfortunately, it doesn’t.

Buffett: I simply read the annual report. I had no contact with management nor did I attend any management presentations. I just sat in my office and invested $400 million, which is worth $1.2 billion today.

I also looked at Yukos, the big Russian oil company [at the time I bought PetroChina] and compared the two at the time. PetroChina was far cheaper and I thought the economic climate was likely to be better in China. Yes, there was risk of tax laws or ownership rights changing, but the price was ridiculous.

HomeServices of America

We don’t think the way homes are bought and sold will change very much. Some will disagree, but we don’t think the internet will change this. [Buying and selling a home] is the biggest financial decision most people will make] and people will continue to want to have a 1-on-1 relationship with a real estate broker. [It also will be] a local business, so we’ve retained the local identities.

It’s almost certain that we’ll be a lot bigger [in this business] in 5-10 years. It depends on how many acquisitions we make, but we’re a good buyer and owner.

Munger: As to whether we’d prefer to buy brokerages or real estate, obviously we like brokerages better.

Use Bill Gates to Invest in Tech Stocks?

Charlie and I put money in things we understand and think we’ll know what it’ll look like in 5, 10 or 20 years. Bill being on the board doesn’t change this. I’ll listen to any idea of his and, in fact, our investment ideas overlap quite a bit. I still wish I’d bought Microsoft when I’d first met him. (Laughter)

COMMENTS ON FINANCIAL COMPANIES AND RISKS IN THE FINANCIAL SYSTEM

Comments on Financial Companies

Wisdom & Fun 13. Financial companies are more difficult to analyze than other companies.

Financial companies are more difficult to analyze than other companies. They can report whatever earnings they want – it’s an easy game to play. For banks, earnings depend on loans and the reserves set aside. It’s easy to change and manipulate the reserves.

With a company like WD-40 or a brick company, the financials are easy to analyze. But with financial [companies] it’s tough, especially when you throw in derivatives.

There were very high grade, financially sophisticated people who were on the boards of the GSEs [Government-Sponsored Enterprises, such as Fannie Mae and Freddie Mac] and they were not negligent, but it’s very tough [to detect the shenanigans that went on].

Charlie and I were on the board of Salomon and Charlie was on the audit committee, and [it’s just impossible to evaluate thousands of transactions]. You’ll just have to accept that with insurance companies, banks and other financial companies – it’s just a more dangerous field to analyze.

With GEICO it’s easier because the statistics are quite accurate – it’s short-tailed insurance. It’s not like asbestos.

I wouldn’t fault the ratings agencies. Even the big-name auditors didn’t catch it.

Munger: Where you have complexity, by nature you can have fraud and mistakes. You’ll have more of that than in a company that shovels sand from a river and sells it. This will always be true of financial companies, including ones run by governments. If you want accurate numbers from financial companies, you’re in the wrong world.

Bad Accounting and Derivatives

Any accounting that gives people a rationale to reduce reserves even further is bad. There’s such a tendency to reduce reserves for long-tailed [insurance] policies – to understate them – especially if the CEO is retiring or options are vesting.

In derivatives, both sides book a profit; this is especially true of traders who are on commission.

We’re three years into unwinding Gen Re’s derivatives book and you would not believe the complexity. Most of it was marked to market, so you’d think it would only take a few days to unwind.

I don’t think any regulator or auditor [has any hope of getting a handle on any big derivatives book].

Munger: The stupid and dishonest accountants allowed the genie of totally inappropriate accounting to descend on derivatives books. And once this has happened – people get status, etc. – it’s impossible to get it back into the bottle.

The housewife preparing her toast in the morning just isn’t worried about a derivatives blowup.

The people with vested interests in the status quo are very powerful. If you’re going to try to fix this, you’re going to have a very interesting life.

Wisdom & Fun 14. Big consumer debt load and trade deficit could cause some financial market distress – there are great investment opportunities in dislocations – but the country will survive.

Also, Don’t Be That Guy: I knew a guy who had $5 million and owned his house free and clear. But he wanted to make a bit more money to support his spending, so at the peak of the internet bubble he was selling puts on internet stocks. He lost all of his money and his house and now works in a restaurant.

Risks in the Financial System

I think our currency will weaken, but I’m not the Armageddon type. I think most of our citizens will be better off in 10 or 20 years.

I’m concerned about our political leadership, but as Peter Lynch once said, “Invest in businesses any idiot could run because someday one will.” (Laughter) We’ve had all sorts of bad Presidents, but have still done well. Our real GDP per capital rose seven-fold in the last century, which is remarkable.

Sure, the big consumer debt load and trade deficit could cause some financial market distress – there are great investment opportunities in dislocations – but the country will survive.

Eventually the country will do fine, but there’s a significant possibility of a chaotic situation.

Munger: We don’t have any great record making macroeconomic predictions. It’s obvious that we could have some kind of convulsion however.

Buffett: Far greater sums in one asset class after another are on a hair trigger. We’re piling up huge financial assets at intermediaries, which lend themselves to huge dislocations. We’ve turned over huge amounts of money to people who want to beat the S&P in the short term, and while they may appear to be independent, their actions are not independent. They can all try to head to the exits at the same time. But if you’re selling, you must find a buyer. The only way to sell a burning seat in the theater is to find someone else to buy it.

Munger: There’s way heavier leverage by hedge funds and [others] today.

I knew a guy who had $5 million and owned his house free and clear. But he wanted to make a bit more money to support his spending, so at the peak of the internet bubble he was selling puts on internet stocks. He lost all of his money and his house and now works in a restaurant.

It’s not a smart thing for the country to legalize gambling [in the stock market] and make it very accessible.

Buffett: Is there anyone we’ve forgotten to offend? We don’t want to miss anyone. (Laughter)

Risks in the Global Financial System

Charlie and I are not as on board on this, so I’ll answer it and then Charlie can share his thoughts.

We have a $618 billion trade deficit and an even larger current account deficit. As large as we are, something will change [for the worse] and the longer it goes on, the worse it will be. Most economists say a soft landing is likely, but they don’t say what this [will look like]. How the numbers come down is quite significant. Paul Volcker has expressed apprehension about [the likelihood of] a soft landing.

There’s as high a percentage as there’s ever been fn money on a hair trigger – in foreign exchange, stocks, bonds, the carry trade… When people go to bed at night – an electronic herd – that can sell billions of dollars at the press of a key. I think this is at an all-time high. An exogenous event, like Long Term Capital Management – and it will happen – could trigger a stampede.

If you hold dollars, you can’t get rid of them. You can’t sell them to the U.S., because you’d get dollar-denominated assets in return. And you can’t sell them to another country, like France [I forget the reason he gave].

[He read a quote from Paul Volcker’s recent article in the Washington Post and concluded:] The situation is dangerous and intractable and is at an all-time high. But I can’t predict the timing.

I would say that what’s going on with the trade deficit will have serious consequences. But in the last Presidential race, neither candidate addressed it, which is understandable. 90% of the American people can’t define “current account” and it’s hard to describe in three minutes. And it’s not the kind of issue that Betty [the average American voter], when she’s making her toast in the morning, asks herself, “Gee, that trade deficit is really unsettling me today.”

Charlie has a different view. Charlie?

Munger: If anything, I’m a little more repelled by the lack of virtue in how we as a nation run our financial affairs. Look at consumer credit… Things could get a lot worse.

Buffett: How do you think it will end?

Munger: Badly.

Buffett: We’re like an incredibly rich family. We sit on the porch of our huge farm – so big that we can’t even see the end of it – and each year, we consume 6% more than the farm produces. To pay for this, each year we sell or mortgage a little bit of the farm that we can’t see, so we don’t even notice. We’re very, very rich and the rest of the world is happy to buy from us or lend to us, so each year they take a piece of our valuable assets – and they work very hard.

But we will have to service this. If it goes on for a long time, our children will pay. We’re sending $2 billion per day [overseas right now].

[What will cause a crisis? I don’t know.] Does it reach a tipping point, or will there be an exogenous event?

I have a hard time conceiving of any scenario in which the dollar appreciates.

Munger: The counter-argument is: what does it matter if foreigners own 10% of us over time, if the pie grows by 30%? [But I don’t buy this. Taken to its logical extreme,] what if we had no manufacturing and our only businesses were hedge funds?

Imagine that if, instead of fighting the Revolutionary War, we’d instead agreed to give Britain 3% of our GDP each year. This might have looked good in 1776, but not to future generations. It’s like taxation without representation.

Compliments for AIG

Munger: I’ll go out on a limb and say the following about AIG: I think that whatever comes out, they will find a lot that was right about AIG. There’s a lot of ability in that place.

Buffett: Oh yeah. Hank Greenberg was the #1 man in insurance. He built an incredible business. He took nothing and built the leading property and casualty insurer in the world.

Wisdom & Fun 15. Be Careful Of Leverage & Derivatives

Hedge Funds and Private Equity Funds

There’s no doubt that there’s far more money looking a deals now than in the past. They’re willing to pay up to buy good but mundane businesses that we’ve historically bought and had success with. Now it’s not just private equity funds getting in – hedge funds are too.

There’s been a bit of a change in the past few weeks, as it’s gotten a little harder to borrow money, but overall, we can’t compete, which makes us feel distress.

But it won’t go on forever. In the near term, we are not positioned favorably at all, but you’d be amazed at just how fast things can change. Things happen to change the landscape. At least three times in my career, there’s been so much money sloshing around. It was so bad in 1969 that I closed my partnership. But only four years later, it was the best time to be a buyer in my entire life.

1998 Crisis

In 1998, there were incredible opportunities. Just like today, there were a lot of smart people with 150 IQs running around with lots of money, but there was a panic. For example, there was a 30 basis point difference in the yields of on-the-run and off-the-run 30-year Treasuries. Literally, a 29 1/2-year traded 30 basis points higher than a 30-year because of the slight liquidity difference. You could have made a lot going long one and short the other. You wouldn’t have thought this kind of thing was possible, but it happened.

The high-yield market went crazy as well. In the span of only 14 months, you had yields go from 25%-60% to 7%. [Buffett put up the following chart:]

Company Yield in late 2002 Yield later # of months elapsed

Williams 75.4% 7.0% 14

Dynegy 62.7% 6.0% 14

Qwest 54.1% 8.5% 14

Crown Cork & Seal 48.5% 4.4% 17

[I missed a few in here]

Corning 28.3% 4.4% 12

Tyco 26.5% 4.7% 6

We didn’t own all of these.

Fannie Mae, Freddie Mac and Other Highly Leveraged Financial Institutions

The GSEs were a very logical development. For a fee, which used to average 25 basis points, they would allow someone 3,000 miles away to buy a mortgage [or portfolio of mortgages] and not worry. The GSEs were looked at as government guaranteed, so investors didn’t worry.

They became all about leverage – they could access capital at a low rate and built a huge carry trade [borrow at low short-term rates and lend at higher long-term rates]. Then they got carried away when they promised high rates of steady growth. It was madness – you can’t do that. If you lend for 30 years to someone who can repay in 30 seconds, as a practical matter you can’t perfectly handle that risk. So, they first enlarged their portfolios and then engaged in financial shenanigans.

[I have written many columns about accounting shenanigans in: Corporations Favor Fudge, Where Has Corporate Integrity Gone?, More Earnings Shenanigans, IBM’s Accounting Tricks, Lessons from the Enron Debacle, Lessons from Lucent’s Cash Flow, Stocks to Avoid, More Stocks to Avoid, Another Financial Scandal? and Accounting for Non-Paying Customers.]

It boggles the mind how, with good auditors and board members, they misrepresented billions of dollars. They now have $1.5 trillion of mortgages and the Federal government is on the hook – markets believe it and it is – because two companies wanted earnings per share to go up. They acted like the two largest hedge funds in history.

People are now seeing the consequences of the government issuing a guarantee. Congress should be paying a lot of attention to this. You can’t shut them down, but you can increase capital requirements and capital ratios. You could put them into run-off mode. There are plenty of other mortgage guarantee providers. It would not be the end of the world at all if the GSEs were put into run-off mode.

Munger: I think their problems are due in part to their large derivatives books, which were sold to hem by silver-tongued salesman. As many of you know, I believe there’s much wrong with derivative accounting and don’t believe the full penalties have yet been paid.

Buffett: If you can have a $5 billion mismark in one direction and a $9 billion mismark in the other direction [as was the case with Freddie and Fannie, respectively], I would say we’ve come a long way from Jimmy Stewart in “It’s a Wonderful Life”.

Wisdom & Fun 16.  The best investment you can make is in your own abilities. If you own your own business in America [and you run it well, you’ll do fine].

INVESTMENT ADVICE

Invest in Yourself

It’s hard for individual investors to successfully pick stocks or time the market. The best investment you can make is in your own abilities. Anything you can do to develop your own abilities or business is likely to be more productive than investing in foreign currencies.

If you own your own business in America [and you run it well, you’ll do OK].