Tutelage 1. Tough investment climate. Apartment yield @ 4% yield it doesn’t include replacing the carpets. Bonds of strong corporations are 4% yield, Corporate equities@ 2% pa, growing 4% per year. It is not at all impossible that brilliant investors get bad results in the future.
CM: Testing, can you hear in back? Mr Denham has an announcement.
Denham: We ask you not to use your video recorders, thanks.
CM: Welcome to the 49th annual meeting of shareholders of Wesco Corp. Please register to vote at entrance. Anyone wishing to speak, state name, wait for microphone. List of shareholders, 96% of outstanding proxies received. Election of directors? All in favor?
[Aye]. Motion is carried.
Six nominees are elected. There will be a long Q&A preceded by Socratic solitaire conducted by the Chairman. Meeting is adjourned.
We now begin Q&A, starting with a long game of Socratic solitaire. During questions, do not ask what we are buying or selling. Any other question is fair game, but we don’t agree to answer them.
Because many of you have come from such a long distance, I will talk before I take your questions. I will address two topics, general investment climate [and learnings from Berkshire Hathaway]. We normally avoid [discussing the general investment climate] like the plague. Most assets are priced to a level where it is hard to get excited. It is hard to get 4% yield on a nice apartment, and it doesn’t include replacing the carpets. Bonds of strong corporations are 4% yield. Corporate equities are paying 2% pa, growing 4% per year. Such a world isn’t the one that made all of you able to come to the meeting. Last generation has been in hog heaven – some bumps, but it had easiest time getting ahead. In the eighteen years that preceded hog heaven, the purchasing power of Yale’s endowment went down 60%. They were getting real investment return of 0%, negative. It is not at all impossible that brilliant investors like Yale get bad results in the future.
People are used to laying money aside and investing in standard fashion, and become quite comfortable. It is easy to forget that this isn’t guaranteed. Many have recognized this, but for those running pensions it is difficult [to adjust down assumptions] —like the agony of raising taxes or not looking good as CEO of a company. Some of them wonder if they have signed up for something too hard when running a defined pension plan. That crowd doesn’t want to go to a 4-5% assumption, because the pain of the money needed to correct the plan is large. Bonds pay 4%, so they go to alternative investments with profit sharing. They solve the problem by giving ‘reasonable return’ and sell hedge funds and venture capital fund, mid-stage, late stage, private equity, etc etc etc. They do complex trading strategies, private equity in Africa. They buy timber.
Evidently that machine didn’t like the remark. People go into alternatives, and this has worked very well so far. A lot of university endowments have done it – and that is game we are in. If natural return is 5%, getting it to 9% is very unlikely to work well long term. It’s going to be difficult for people to have high real returns from deferring consumption.
Tutelage 2. If you get rich because of a fluke, note that it won’t necessarily continue. Also, easier to get happiness by reducing expectations instead of seeking extreme results.
The reason my generation did so well was kind of a fluke, and won’t necessarily continue. There will be lots of chicanery in future. Many claim alpha – but really they are just taking earthquake risk. At end of year, when there is no earthquake, they take the money. This is a dishonorable way to invest. It is always easier to get felicity by reducing expectations instead of seeking extreme results.
Tutelage 3. (In Derivatives) There is a lot of Gresham’s law here, where the bad practice drives out the good.
We have plenty of scandals coming. Lots of rot has gotten into system. It has caused unpleasantness. What is next? I suggest the derivative trading books of the world are next. The accounting allowed in derivative books has been god awful. The morals and intelligence has been god awful. ‘I’ll be gone and you’ll be gone’ is phrase they use.
What is buried in those books is dangerous, with clearance risks with optimistic assumptions that the accountants allowed. I was at Salomon when interest rate swap accounting was changed. They had a matched book. They were making $7mil, 25m over 18m. Both sides wanted to mark trades profitably. They couldn’t retain derivative traders if they didn’t have bad accounting. There is a lot of Gresham’s law here, where the bad practice drives out the good.
Tutelage 4. (Recipe For Systemic Financial Disaster) The engineering mindset that everything must withstand great stresses was thrown out for ‘if music is playing, you gotta dance’.
If you run a good bank, and testosterone bank around corner pressures you, there are tremendous pressures to conform. Everyone starts replicating. If every university puts 2% into timber, that can go on a long time. But it is self-fulfilling. When it comes to the unwind, when they all want to get out. A lot of things rely on momentum. Valuations make everyone look good for a while.
We have seen consequences in this mortgage meltdown, not pretty. The amount of knavery and folly revealed in last eighteen months has been unbelievable. I will ask a question, then I will attempt to answer it. Why did this happen? Greed, envy, and terrible accounting was part of it. There was a general lack of conservatism. The engineering mindset that everything must withstand great stresses was thrown out for ‘if music is playing, you gotta dance’. I don’t feel compulsion to dance, to join the crowd.
Tutelage 5. Understanding Arithmetic Is Good But Understand Sheep As Well
One of my favorite stories is boy in Texas, when the teacher asked the class the following question. There are nine sheep in pen, and one jumps out, how many are left? Everyone got it right, and said eight are left. The boy said none are left. The teacher said you don’t understand arithmetic, and he said ‘no you don’t understand sheep’. Sam Goldwin had a saying – ‘include me out’ – it is one of my favorite expressions.
Tutelage 6. Systems (& Decision Makers) have to be responsible. People who are making decisions must bear results of decisions. In Rome, the builder and designer stood under the bridge when the scaffolding was removed. In parachutes, you pack your own chute.
People were distributing stuff that they wouldn’t buy themselves. It is the structure of the modern world. Favorite philosopher: Frankl. He said the systems have to be responsible. People who are making decisions must bear results of decisions. In Rome, the builder and designer stood under the bridge when the scaffolding was removed. In parachutes, you pack your own chute. Capitalism works that way too. At a restaurant, owner is bearing the consequences. If he slips, he doesn’t do well. Frankl would be pleased with restaurant business, and not pleased with investment banking. They sell, take the money, go home – it doesn’t work. And people wouldn’t get by if accountants didn’t bless it. When I was at Salomon, I was on the audit committee. A group came and said that we want to change our accounting, and where our credit is terrible – we want to report automatic profits – ie, to buy counterparties out cheaply because they want to sell. I told them that ‘You will have that accounting over my dead body’. I won that battle, but I lost the war.