4. Buffett and Munger on Modern Academic Finance Revised

Extract from 1987 Annual Report of Berkshire Hathaway Whenever Charlie and I buy common stocks for Berkshire's insurance companies (leaving aside arbitrage

purchases, discussed later) we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay. We do not have in mind any time or price for sale. Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate. When investing, we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.

Our approach makes an active trading market useful, since it periodically presents us with mouth-watering opportunities. But by no means is it essential: a prolonged suspension of trading in the securities we hold would not bother us any more than does the lack of daily quotations on World Book or Fechheimer. Eventually, our economic fate will be determined by the economic fate of the business we own, whether our ownership is partial or total.

Ben Graham, my friend and teacher, long ago described the mental attitude toward market fluctuations that I believe to be most conducive to investment success. He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail, Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

Even though the business that the two of you own may have economic characteristics that are stable, Mr. Market's quotations will be anything but. For, sad to say, the poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead for both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is uninteresting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic- depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning or everything will turn into pumpkins and mice: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful. If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence. Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market, you don't belong in the game. As they say in poker, "If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy."

Ben's Mr. Market allegory may seem out-of-date in today's investment world, in which most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising "Take two aspirins"?

The value of market esoterica to the consumer of investment advice is a different story. In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace. In my own efforts to stay insulated, I have found it highly useful to keep Ben's Mr. Market concept firmly in mind.

Extract from 1988 Annual Report of Berkshire Hathaway

Efficient Market Theory

The preceding discussion about arbitrage makes a small discussion of “efficient market theory” (EMT) also seem relevant. This doctrine became highly fashionable - indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben’s; he had 1929-1932 to contend with.)

All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.

Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one’s curiosity.

Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.

Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

Berkshire Hathaway’s AGM for 1993

Comments on Risk

Shareholder: There appears to be inconsistencies between your view of risk and the conventional view.Derivatives are dangerous. And yet you feel comfortable playing derivatives through Salomon. Betting on hurricanes is dangerous. And yet you feel comfortable playing with hurricanes through insurance companies. So it appears that you have some view of risk that’s inconsistent with what would appear on the face of it to be conventional view of risk.

Buffett: We do define risk as the possibility of harm or injury. Therefore, we think it’s inextricably would up in our time horizon for holding an asset. If you intend to buy XYZ Corporation at 11:30 this morning and sell it out before the close today, that’s a very risky transaction in our view -because we think that 50% of the time, you’re going to suffer some harm or injury. On the other hand, given a sufficiently long time horizon . . .

For example, we believe that the risk of buying something like Coca Cola at the price we paid a few years ago is close to nil -given our prospective holding period. But if you asked me to assess the risk of buying Coca-Cola this morning and selling it tomorrow morning, I’d say that that’s a very risky transaction.

As I pointed out in the annual report, it became very fashionable in the academic world -and it spilled over into the financial markets -to define risk in terms of volatility of which beta is a measure. But that is no measure of risk to us.

The risk in terms of our super-cat business is not that we lose money in any given year. We know we’re going to lose money in some given day. That’s for certain. And we’re extremely likely to lose money in some years. But our time horizon in writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon of investment, we think that it is not a risky business.

And it’s a whole lot less risky than writing something that is much more predictable. It’s interesting to us that using conventional measures of risk, something whose return varies from year-to-year between +20% and +80% is riskier than something that returns 5% a year every year. We think the financial world has gone haywire in terms of how they measure risk.

We’re perfectly willing to lose money on a given transaction - arbitrage being one example and a given insurance policy being another. But we’re not willing to enter into any transactions in which we think the probability of a number of mutually independent events of a similar type has an expectancy of loss.

And we hope that we’re entering into transactions where our calculations of those probabilities have validity. Todo so, we try to narrow it down. There are a whole bunch of things that we just don’t do because we don’t think we can we can write the equation on them.

Basically, Charlie and I are pretty risk averse by nature. But if we knew it was an honest coin and someone wanted to give us 7 to 5 odds or something of that sort on one flip, how much of Berkshire’s net worth would we put on that flip? It would sound like a big number to you. It wouldn’t be a huge percentage of Berkshire’s net worth, but it would be a significant number. We’ll do things where the probabilities favour us.

Munger: We try to think like Fermat and Pascal as if they’d never heard of modern finance theory. I really think that a lot of modern finance theory can only be described as disgusting.

Comments on Cost of Capital

Shareholder: What is Berkshire’s cost of capital?

Buffett: That questions puzzled people for dozens of years. So I’ll let Charlie handle it. . .

Munger: I find the way that subject is taught at most business schools incoherent. I’m usually the one who asksthat question and gets the incoherent answers. I don’t have a good answer to what I consider a stupid question.

Buffett: We’re better at stupid answers to good questions.

Munger: What’s the cost of capital at Berkshire when we keep drowning in a torrent of cash we have to reinvest?

Buffett: There are really only two questions. And they get to the same issue. However, you needn’t have a mathematical answer. The first is: “When you have capital is it better to keep it or return it to the shareholders?” And the answer is it’s better to return it to shareholders when you can’t achieve more than $1 of value for each $1 of capital retained. That’s test # 1.

So our minimum cost of capital is measured by our ability to create more than $1 of value for every $1 retained. If we’re keeping $1 bills that would be worth more in your hands, then we’ve failed to exceed our cost of capital . . .

And once we think we can -if you pass that threshold-the question becomes:“How can we do it to the best of our ability?” Then you simply look around for the thing you feel most certain about which promises the greatest return.

With all of the stuff I’ve seen in business schools, frankly, I’ve not found any way to improve on that formula.

A trouble you may have is that many managements could be reluctant to distribute money to shareholders because they rationalize that they will do better than they actually will. Almost any management that wants to retain money will rationalize it and say: “We’re going to do wonderful things with it.” That’s a danger.

But I doubt the problem would be solved by hiring a bunch of consultants to arrive at a cost of capital -because the consultants would know the conclusion management wants. “Whose bread I eat, his song I sing.”

That’s why in the annual report, in the ground rules, I suggest making checks on the validity of managerial projections. And the check on it is whether after three of four years the dollars retained have created more than that much value in increased market value sot shareholders.

If they hadn’t the presumption would be strong that management should pay out more cash to shareholders.

Comments on Academic Finance

Buffett: What you really want a course on investing is how to value a business. That’s what the game is about. If you don’t know how to value a business, you don’t know how to value a stock. And if you look at what’s being taught, I think you see very little of how to value a business.

And the rest of it is playing around with numbers or Greek symbols of something of that sort. But that doesn’t do you any good. In the end, what you have to decide is whether you’re going to value a business at $400 million, $600million or $800 million -and then compare that with the price. That’s what investing is. And I don’t know any other kind of investing to do.

And that just isn’t taught. And the reason why it isn’t taught is because there aren’t teachers around who knowhow to teach it. They don’t know themselves. And since they don’t, they teach that nobody knows anything -which is the efficient market theory. . .

It’s fascinating to me how the really great universities operate in this respect. . . You get in the finance department because you sign on to whatever the present group thinks. And if they think the world is flat, you better think the world is flat too. And your students better answer that the world’s flat when they get the question on their exams.

I would say that, generally speaking, finance teaching in this country is kind of pathetic.

Comments on Risk

Shareholder: Wall Street often evaluates the riskiness of a particular security by the volatility of its quarterly or annual results -and likewise, measures money managers’ riskiness by their volatility. I know you guys don’t agree with that approach. Could you give us some detail about how you measure risk?

Buffett: We regard volatility as a measure of risk to by nuts. And the reason its used is because the people that are teaching want to talk about risk -and the truth is that they don’t know how to measure it in business. Part of our course

on how to value a business would also be on how risky the business is. And we think about that in terms of every business we buy.

Risk with us relates to several possibilities. One is the risk of permanent capital loss. And the other risk is that there’s just an inadequate return on the kind of capital we put in.

However, it doesn’t relate to volatility at all. For example, ourSee’sCandy business will lose money-and it depends on when Easter falls -in two quarters each year. So it has this huge volatility of earnings within the year. Yet it’s one of the least risky businesses I know. You can find all kinds of wonderful businesses that have great volatility in results. But that doesn’t make them bad businesses.

Similarly, you can find some terrible businesses with very low volatility. For example, take a business that did nothing. It’s results wouldn’t vary from quarter to quarter. So it just doesn’t make any sense to equate volatility with risk. Charlie, do you want to add anything on that?

Munger: Well, it raises an interesting question which is, “How can a professoriate that is so smart come up with such silly ideas and spread them all over the country?” That’s a very interesting question . . . But I’ve been waiting for this craziness to pass for several decades now. I do think it’s getting dented some, but it’s not passing. . .

Buffett: If somebody starts talking to you about beta, zip up your pocketbook.

Shareholder: Mr. Munger, at last year’s meeting, you said you didn’t feel that the concept of cost of capital made economic sense. Would you explain why you feel this way and what would you replace it with, if anything?

Munger: First, obviously, considerations of cost are important in business. And obviously, opportunity costs which is a doctrine of economics, but really a doctrine of lifesmanship -are also very important. We’ve always had this kind of basic thinking. Of course, capital isn’t free. And of course, you can figure out the cost of capital when you’re borrowing money -or at least you can figure out the cost of loans.

But the theorists had to develop a theory for what equity cost. And there they went absolutely bonkers. They said if you earned 100% on capital because you had some marvelous business, your cost of capital was 100% -and,therefore, you shouldn’t look at any opportunity that delivered a lousy 80%. That’s the kind of thinking t hat came out of the capital asset pricing models and so forth that I’ve always considered inanity.

What is Berkshire’s cost of capital? We have this damn capital. It just keeps multiplying and multiplying. What is its cost? You have perfectly good, old-fashioned doctrines like opportunity cost. And at any given point of time when we consider an investment, we have to compare it to the best alternative investment we have at that time.

So we have perfectly good old-fashioned ideas that are very basic to use but that weren’t good enough for these modern theorists. So they invented this ridiculous mathematics which concluded that the companies that made the most money had the highest costs of capital. Well all I can say is that’s not for us. . .

Buffett: What you find in practice, of course - the test used by most CEOs -is that the cost of capital is about ••• of 1% below the return promised by any deal that the CEO wants to do. It’s very simple.

When we have capital around, we have three questions - leaving aside whether we want to borrow money - which we generally don’t want to do. First, “Does it make more sense to pay out to the shareholders than to keep it within the company?” The sub-question on that is, “If we pay it out, is it better off to do it via repurchases or via dividend?”The test for whether we pay it out in dividends is, “Can we create more than a dollar of value within the company with that dollar by retaining it rather than paying it out?”

And you never know the answer to that. But so far, the answer, as judged by our results, is, “Yes, we can.” And we think that prospectively we can. But that’s a hope on our part. It’s justified to some extent by past history, but its not a certainty.

Once we’ve crossed that threshold, then we ask ourselves, “Should we repurchase stock?” Well, obviously, if you can buy your stock at significant discount from conservatively calculated intrinsic value and you can buy a reasonable quantity, that’s a sensible use for capital.

Beyond that the question becomes, “If you have the capital and you think that you can create more than a dollar,how do you create the most value with the least risk?” And that gets to business risk. It doesn’t get to any calculations of volatility. I don’t know the risk in See’s Candy as measured by its stock volatility -because the stock hasn’t been outstanding since 1972.

Does that mean that I can’t determine how risky a business See’s is because we don't have a daily quote on it?No. I can determine it by looking at the business, the competitive environment in which it operates and so on.

So once we cross the threshold of deciding that they can deploy capital so as to create more than a dollar of present value for every dollar retained, then it’s just a question of doing the most intelligent thing you can find. And the cost of every deal that we do is measured by the second best deal that’s around at a given time -including doing more of some of the things we’re already in.

And I have listened to the cost of capital discussions at all kinds of corporate board meetings and everything else. And I’ve never found anything that made very much sense in it -except for the fact that it’s what they learnt in

Munger: The current freshman economics text which, incidentally, is sweeping the country, has it right in practically the first page. And it says, “All intelligent people should think primarily in terms of opportunity cost.” And that’s obviously correct.

But it’s very hard to teach business based on opportunity cost. It’s much easier to teach the capital assets pricing model where you can just punch in the numbers and out come numbers. And therefore, people teach what is easy to teach instead of what is correct to teach.

It reminds me of Einstein’s famous saying. He said, “Everything should be made as simple as possible, but no more simple.”

Buffett: Write that down.

Extract from 1993 Annual Report of Berkshire Hathaway We define risk, using dictionary terms, as “the possibility of loss or injury.” Academics, however, like to define

investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks -that is,their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the "beta" of a stock -its relative volatility in the past -and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.

For owners of a business -and that's the way we think of shareholders -the academics' definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market -as had Washington Post when we bought it in 1973 -becomes "riskier" at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?

In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor.There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you,whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor.That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing,or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock,consequently, we would not be disturbed if markets closed for a year or two. We don't need a daily quote on our 100% position in See's or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?

In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful. The primary factors bearing upon this evaluation are:

1. The certainty with which the long-term economic characteristics of the business can be evaluated;

2. The certainty with which management can be evaluated, both as to its ability to realize the full potential of the business and to wisely employ its cash flows;

3. The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

4. The purchase price of the business;

5. The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.

These factors will probably strike many analysts as unbearably fuzzy, since they cannot be extracted from a database of any kind. But the difficulty of precisely quantifying these matters does not negate their importance nor is it insuperable. Just as Justice Stewart found it impossible to formulate a test for obscenity but nevertheless asserted, "I

Is it really so difficult to conclude that Coca-Cola and Gillette possess far less business risk over the long term than, say, any computer company or retailer? Worldwide, Coke sells about 44% of all soft drinks, and Gillette has

more than a 60% share (in value) of the blade market. Leaving aside chewing gum, in which Wrigley is dominant, I know of no other significant businesses in which the leading company has long enjoyed such global power.

Moreover, both Coke and Gillette have actually increased their worldwide shares of market in recent years. The might of their brand names, the attributes of their products, and the strength of their distribution systems give the man enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection. As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: “Competition may prove hazardous to human wealth.”

The competitive strengths of a Coke or Gillette are obvious to even the casual observer of business. Yet the beta of their stocks is similar to that of a great many run-of-the-mill companies who possess little or no competitive advantage. Should we conclude from this similarity that the competitive strength of Coke and Gillette gains them nothing when business risk is being measured? Or should we conclude that the risk in owning a piece of a company-its stock -is somehow divorced from the long-term risk inherent in its business operations? We believe neither conclusion makes sense and that equating beta with investment risk also makes no sense.

The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie. But it's quite possible for ordinary investors to make such distinctions if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness.Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases,a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.

In many industries, of course, Charlie and I can't determine whether we are dealing with a “pet rock” or a “Barbie.” We couldn't solve this problem, moreover, even if we were to spend years intensely studying those industries.Sometimes our own intellectual shortcomings would stand in the way of understanding, and in other cases the nature of the industry would be the roadblock. For example, a business that must deal with fast-moving technology is not going to lend itself to reliable evaluations of its long-term economics. Did we foresee thirty years ago what would transpire in the television-manufacturing or computer industries? Of course not. (Nor did most of the investors and corporate managers who enthusiastically entered those industries.) Why, then, should Charlie and I now think we can predict the future of other rapidly-evolving businesses? We'll stick instead with the easy cases. Why search for a needle buried in a haystack when one is sitting in plain sight?


Shareholder: There appear to be inconsistencies between your view of risk and the conventional view. Derivatives are dangerous. And yet you feel comfortable playing derivatives through Salomon. Betting on hurricanes is dangerous. And yet you feel comfortable playing with hurricanes through insurance companies.

So it appears that you have some view of risk that’s inconsistent with what would appear on the face of it to be the conventional view of risk.

Buffett: We do define risk as the possibility of harm or injury. Therefore, we think it’s inextricably wound up in your time horizon for holding an asset. If you intend to buy XYZ Corporation at 11.30 this morning and sell it out before the close today, that is a very risky transaction in our view – because we think that 50% of the time, you’re going to suffer some harm or injury. On the other hand, given a sufficiently long time horizon…

For example, we believe that the risk of buying something like Coca-Cola at the price we paid a few years ago is close to nil – given our prospective holding period. But if you asked me to assess the risk of buying Coca-Cola this morning and selling it tomorrow morning, I’d say that that’s a very risky transaction.

Buffett: As I pointed out in the annual report, it became very fashionable in the academic world – and it spilled over into the financial markets – to define risk in terms of volatility of which beta became a measure. But that is no measure of risk to us.

The risk in terms of our super-cat business is not that we lose money in any given year. We know we’re going to lose money in some given day. That’s for certain. And we’re extremely likely to lose money in some years. But our time horizon in writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon of investment, we think that that is not a risky business.

And it’s a whole lot less risky than writing something that is much more predictable. It’s interesting to us that using conventional measures of risk, something whose return varies from year-to-year between +20% and +80% is riskier as it’s defined than something that returns 5% a year every year. We think the financial world has gone haywire in terms of how it measures risk.

Buffett: We’re perfectly willing to lose money on a given transaction – arbitrage being one example and any given insurance policy being another. But we’re not willing to enter into any transactions in which we think the probability of a number of mutually independent events of a similar type has an expectancy of loss.

And we hope that we’re entering into transactions where our calculations of those probabilities have validity. To do so, we try to narrow it down. There are a whole bunch of things that we just don’t do because we don’t think we can write the equation on them.

Basically, Charlie and I are pretty risk-averse by nature. But if we knew it was an honest coin and someone wanted to give us 7-to-5 (odds) or something of the sort on one flip, how much of Berkshire’s net worth would we put on that flip? It would sound like a big number to you. It wouldn’t be a huge percentage of (Berkshire’s) net worth, but it would be a significant number. We’ll do things where the probabilities favor us.

Munger: We try to think like Fermat and Pascal as if they’d never heard of modern finance theory. I really think that a lot of modern finance theory can only be described as disgusting.

Buffett: You may have trouble believing this, but Charlie and I never have an opinion about the market because it wouldn’t be any good and it might interfere with the opinions we have that are good.

If we think a business is attractive, it would be very foolish for us not to take action on it because of something we thought the market would do or anything of that sort – because we just don’t know. And to give up something we do know that is profitable for something we don’t know and won’t know just doesn’t make any sense to us.

And it just doesn’t really make any difference to us. I bought my first stock around April of 1942 when I was 11. We were in the middle of World War II at the time. And our prospects didn’t look all that good. They really didn’t. We weren’t doing all that well in the Pacific at that time – although I’m not sure that I factored that into my purchase of three shares. And just think abut everything that’s happened since; the advent of atomic weapons, major wars, a President resigning, inflation and all kinds of other things.

To give up what you do well because of guesses about what’s going to happen I some macro way just doesn’t make any sense to us.

Buffett: The best thing that could happen from Berkshire’s standpoint – and I’m not wishing it on anyone – is to have markets go down a tremendous amount. If you asked us next month whether Berkshire would be better off if the whole stock market were down 50% or where it is now, we’d tell you that we would be better off if it were down 50%. We’re going to be buyers of things over time. If you’re going to be a buyer of groceries over time, you’d like grocery prices to go down. If you’re going to be buying cars over time, you’d like car prices to go down.

We buy businesses. We buy pieces of businesses – stocks. And we’re going to be much better off if we can buy those things at an attractive price than if we can’t.

We don’t have anything to fear. What we fear is a long, sustained irrational bull market. As Berkshire Shareholders – unless you own your shares with borrowed money or might be selling them in a very short period of time – you’ll be better off if stocks get cheaper because it means we can do more intelligent things for you than we could otherwise.

Buffett: We have no idea what’s going to happen. And we wouldn’t care what anyone thinks – least of all us. Munger: If you’re an agnostic about macro factors and, therefore, devote all of your time to thinking abut the

individual businesses and the individual opportunities, it’s a way more efficient way to behave – at least with our particular talents and lack thereof.

Buffett: If you’re right about the businesses, you’ll end up doing fine.

Buffett: We don’t know and we don’t think about when something will happen – we think about what will happen. It’s not so difficult to figure out what will happen. It’s impossible in our view to figure out when it will happen. So we focus on what will happen.

Coke in 1890 or thereabouts – the whole company – sold for $2,000. Its market value today is $50-odd billion. Somebody could have said to the fellow who was buying it in 1890. “We’re going to have a couple of great World Wars. There’ll be a panic in 1907. All of these things are going to happen. Wouldn’t it be better to wait?”

We can’t afford that mistake.


To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.

From Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger

In 1996, Charlie Munger was invited by Cardozo School of Law in New York City, to moderate a debate on research of one Professor William Bratton of the Rutgers-Newark School of Law. Bratton’s research dealt with the corporate decision to pay dividends to stockholders rather than reinvest profits. Munger soon nailed Bratton with what he considered a flawed assumption in the research.

Munger: I take it that you believe that there is no one-size-fits-all dividend policy and that you’re with the professor (Jill E. Fisch of Fordham University School of Law) who said yesterday that there wasn’t any one-size-fits all scheme for corporate governance?

Bratton: On that simple proposition I am entirely in concord with Professor Fisch.

Munger: But you say there is some vaguely established view in economics as to what is an optimal dividendpolicy or an optimal investment?

Bratton: I think we all know what an optimal investment is.

Munger: No, I do not. As not as these people use the term.

Bratton: I don’t know it when I see it . . . but in theory, if I knew it when I saw it this conference would be about

me and not about Warren Buffett. [Laughter from the audience] Munger: What is the breakpoint when a business becomes

suboptimal in an ordinary corporation or when an

investment becomes suboptimal?

Bratton: When the return on the investment is lower than the cost of capital?

Munger: And what is the cost of capital?

Bratton: Well, that’s a nice one [Laughter] and I would . . .

Munger: Well, its only fair, if you’re going to use the cost of capital, to say what it is?

Bratton: I would be interested in knowing, we’re talking theoretically.

Munger: No, I want to know what is the cost of capital in the model.

Bratton: In the model? It would just be stated.

Munger: Where? Out of the forehead of Joe or something?

Bratton: That is correct. [Laughter]

Munger: Well, some of us don't find this too satisfactory. [Laughter]

Bratton: I said, you’d be a fool to use it as a template for real world investment decision making. [Laughter]

They’re only trying to use a particular perspective on human behavior to try to explain things.

Munger: But if you explain things in terms of unexplainable subconcepts, what kind of an explanation is that

[Laughter]

Bratton: It’s a social science explanation. You take it for what’s it worth.

Munger: Do you consider it understandable for some people to regard this as gibberish? [Laughter]

Bratton: Perfectly understandable, although I do my best to teach it. [Laughter]

Munger: Why? Why do you do this? [Laughter]

Bratton: It’s in my job description. [Laughter]

Munger: Because other people are teaching it, is what you’re telling me. [Laughter]


Shareholder: Do you differentiate between types of businesses in your discounted cash flow analysis given that you use the same discount rate across companies? For example, when you value Coke and GEICO, how do you account for the difference in the riskiness of their respective cash flows?

Buffett: We don’t worry about risk in the traditional way – for example, in the way you’re taught at Wharton. It’s a good question, believe me. If we could see the future of every business perfectly, it wouldn’t make any difference to us whether the money came from running street cars or selling software because all of the cash that came out – which is all we’re measuring – between now and Judgement Day would spend the same to us.

Therefore, the industry that earned it means nothing to us except to the extent that it may tell you something about the ability to develop the cash. But it doesn’t tell you anything about the quality of the cash. Once it becomes distributable, all cash is the same.

Buffett: When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know – that it’s risky for us. It may not be risky for someone else who understands the business.

However, in that case, we just give up. We don’t try to predict those things. We don’t say, “Well, we don’t know what’s going to happen.” Therefore, we’ll discount some cash flows that we don’t even know at 9% instead of 7%. That is not our way to approach it.

Once it passes a threshold test of being something about which we feel quite certain we tend to apply the same discount factor to everything. And we try to only buy businesses about which we’re quite certain.

Buffett: As for the capital asset pricing model type reasoning with its different rates of risk adjusted returns and the like, we tend to think of it – well, we don’t tend to think of it. We consider, it nonsense.

But we think it’s also nonsense to get into situations – or to try and evaluate situations – where we don’t have any conviction to speak of as to what the future is going to look-like. I don’t think that you can compensate for that by having a higher discount rate and saying, “Well, it’s riskier. And I don’t really know what’s going to happen. Therefore, I’ll apply a higher discount rate.” That just is not our way of approaching it. Charlie?

Munger: Yeah. This great emphasis on volatility in corporate finance we regard as nonsense…. Let me put it this way. As long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are the favorable odds. We figure the volatility over time will take care of itself at Berkshire.

Buffett: If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll make more money in a business where we know what the end game will be if it bounces around a lot.

For example, See’s may lose money in eight months in a typical year. However, it makes a fortune in November and December. If it were an independent, publicly-traded company and people reacted to that and therefore made its stock very volatile, that would be terrific for us. We could buy it in July and sell it in January – because we’d know it was nonsense.

Well, obviously, things don’t behave quite that way. But when we bought The Washington Post, it had gone down 50% in a few months. Well, that was the best thing that could have happened. It doesn’t get any better than that. Its businesses were fundamentally very non-volatile – a strong, dominant newspaper and TV stations – but it was a volatile stock. That’s a great combination in our view.

When we see a business about which we’re very certain whose fortunes the world thinks are going up and down – and so its stock behaves with great volatility – we love it. That’s way better than having a lower beta. We actually prefer what other people call “risk.”

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Shareholder: It would be very helpful to know the correlation coefficient between Berkshire and the S&P 500. If you have it, would you let us know, what it is? If not, would you consider calculating it?

Buffett: Well, it could be calculated, but I don’t think that it would have much meaning. We don’t think anything that relates to trading volume, historical stock price, relative strength – any of that sort of thing – does….

And bear in mind that I used to eat all that stuff up back in my teens. I used to make calculations based on that stuff all the time. And I prepared charts based on it, etc. But it has no place in the operation today.

Plus, it would be an historical correlation. What was doable by us in the past is not doable today. As I said in the annual report my best decade ever in terms of relative performance – by far – was the 1950s. I don’t think it was because I was a lot smarter then. I’m willing to accept that. But I had some edge – probably near 30% per year.

But I was working with far less money then. So it has no relevance today whatsoever. And it would be misleading to publish it, make calculations based on it etc.

Buffett: I don’t know exactly what you’d find in terms of the correlation between Berkshire and the S&P. But I know you’d find a lot of correlation between Berkshire’s intrinsic value and that of Coke and a few stocks like that.

But I don’t think that’s particularly useful information. We have no objection to anyone making the calculation, but it wouldn’t be something with any utility to us. And therefore, we don’t want to put it out to shareholders and risk giving some of them the impression that it does.

Buffett: We don’t pay any attention whatsoever to beta or any of that sort of thing. It just doesn’t mean anything to us. We’re only interested in price and value. That’s what we’re focusing on all the time. To us, any kind of market movements have no meaning whatsoever.

I really don’t know what Berkshire is selling for today. It just doesn’t make any difference. I can’t tell you t\what it was selling for on May 4th, 1983 or May 4th, 1986. And I don’t care what it sells for on May 4th, 1998.

I do care what it sells for 10 years from now. That’s what counts. And that’s where all of our focus is.

Buffett: We do believe the S&P 500’s returns have some meaning because it’s an alternative in which people can invest. And they don’t need us to buy the S&P. Therefore, unless we exceed the S&P return over time, what are we contributing? That’s the way we add value. So we think shareholders should hold us accountable.

And actually, we might prefer they didn’t because the pretax return of the S&P 500 is a mighty tough comparison for a taxpaying entity like Berkshire. Charlie?

Munger: Warren and I provide you with the data and we publish it in the form and on the time schedule which we would want were we in your position – in other words, if we were the passive shareholders. And we don’t think correlation coefficients would help us.

One of the pleasant things about dealing with Warren all these years, incidentally, is that he’s never talked about a correlation coefficient. If the correlation isn’t so extreme that you can see it with the naked eye, he doesn’t bother.

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Shareholder: In this era when departments of institutions of higher learning refer to you as an anomaly, preach the efficient market hypothesis and say that one can’t outperform the market, where does one go to find a mentor like you found in Ben Graham?

Buffett: I understand the University of Florida has instituted some courses – actually, Mason Hawkins (of Southeastern Asset Management) gave them a significant amount of money to finance ‘em. And I believe they’re teaching something other than efficient markets there.

Also, there’s a very good course at Columbia that gets a lot of visiting teachers to come in. I go in there and teach occasionally – as do a number of other practitioners….

I think the efficient market theory is less holy writ in universities today than it was 15 or 20 years ago – although there’s still a lot of it taught. However, I think you can find more diversity in what is being offered now than you could 10 or 20 years ago. And I’d recommend looking into those two schools.

Buffett: But the hard-form efficient market theory has been quite helpful to us…. If you had a merchant shipping business and all of your competitors believed the world was flat, you’d have a huge edge – because they wouldn’t take on cargo going to places where they think they’d fall off the earth. So we should be encouraging the teaching of hard-form efficient market theories at universities.

It amazes me, I think it was Keynes who said, “Most economists are most economical about ideas – they make the ones they learned in graduate school last a lifetime.”

What happens is that you spend years getting your Ph.D. in finance. And (in the process), you learn theories with a lot of mathematics that the average layman can’t do. So you become sort of a high priest. And you wind up with an enormous amount of yourself in terms of your ego – and even professional security – invested in those ideas. Therefore, it gets very hard to back off after a given point. And I think that to some extent that’s contaminated the teaching of investing in the universities, Charlie?

Munger: I’d argue the contamination was massive…. But good ideas eventually thrive.

Buffett: I’ve always found the word ‘anomaly’ interesting because Columbus was an anomaly I suppose – at least for awhile. What it means is something the academicians can’t explain. And rather than reexamine their theories, they simply discard any evidence of that sort as anomalous.

On the other hand, Charlie and I believe that when you find information that contradicts your existing beliefs, you’ve got a special obligation to look at I – and quickly Charlie says that one of the things Darwin did whenever he found anything that contradicted any of his cherished beliefs was that he would write it down immediately – because he knew that the human mind was so conditioned to reject contradictory evidence that unless he put it down in black and white very quickly, his mind would push it out of existence….

Munger: …I did find it amusing: One of these extreme efficient market theorists explained Warren for many years as an anomaly of luck. And this theorist finally got all the way up to six sigmas – six standard deviations – of luck. But then, people began laughing at him because six sigmas of luck is a lot.

So what did he do? Well, he changed his theory. Now, he explains, Warren has six or seven sigmas of skill.

Buffett: I’d rather have the six sigmas of luck actually.

Munger: The one thing he couldn’t bear to leave was his six sigmas.

Shareholder: Both of you have said you don’t think business valuation is being taught correctly at universities. As a student at Columbia Business School, that troubles me because I’ll soon be joining the ranks of those teaching business valuation. My question is do you have any counsel about … teaching techniques…?

Buffett: I was lucky. I had a sensational teacher in Ben Graham. We had a course there – in fact, there’s at least one fellow in the audience who attended it with me – and Ben made it terribly interesting. Basically, what we did when we walked into that class was value companies.

Ben had various little games he would play with us. For example, sometimes he would (give us a whole bunch of figures about Company A and Company B and) have us evaluate them. And only after we’d finished the exercise would we learn that (Company) A and (Company) B were the same company at different points in its history.

And he played a lot of little games to get us to think about what the key variables were and how we could go off track. For example, on one occasion, Ben met with Charlie and me and nine or so other people down in San Diego in 1968. And he gave all of us a little true/false test. We all thought we were pretty smart – and we all flunked.

That was his way of teaching us that a smart man playing his own game and working at fooling you could do a pretty good job at it.

Buffett: But if I were teaching a course on (investing), there would simply be one valuation study after another with the students trying to identify the key variables in that particular business and … evaluating how predictable they were – because that’s the first step. If something isn’t very predictable, you should forget it – (because) you don’t have to be right about every company. You (just) have to make a few good decisions in a lifetime.

But the important thing is that when you do find one where you really do know what you are doing, you must buy in quantity…. Charlie and I have made a dozen or so very big decisions relative to net worth, although not as big as they should have been. And in each of those, we’ve known that we were almost certain to be right going in.

They just weren’t that complicated. We knew we were focusing on the right variables, that they were dominant, et. And even though we couldn’t carry the figures out to five decimal places or anything like that, we knew – in a general way – that we were right about ‘em.

That’s what we look for – a fat pitch. And that’s what I would entry to teach students to do.

Buffett: I would not try to teach them to think (that) they could do the impossible. Charlie?

Munger: Yes. If you plan to teach business valuation the way people teach real estate appraisal so that after completing your course your students will be able to take any company and give you an appraisal of that company incorporating its future prospects relative to its market place, then I think you’re attempting the impossible.

Buffett: Yeah. On the final exam, I’d probably take an internet company and (ask), “How much is it worth?” And anybody that gave me an answer, I’d flunk…. It’d make grading papers easy too.

Munger: Finance properly taught should be taught from cases where the investment decisions are easy. And the one that I always cite is the early history of the National Cash Register Company. It was created by a very intelligent man who bought all the patents, had the best sales force and the best production plants. He was a very intelligent man and a fanatic, all of whose passions were dedicated to the cash register business.

And of course the invention of the cash register was a godsend to retailing. You might even say that the industry was the pharmaceuticals of a former age.

And if you read an early annual report when Paterson was the CEO of National Cash Register, an idiot could tell that here was a talented fanatic – very favorably located. Therefore, the investment decision was easy.

If I were teaching finance, I’d want to use maybe 100 cases like that. That’s the best way to teach the subject.

Buffett: Incidentally we have that annual report. What year was it – 1894 or so< It’s really a classic. Paterson not only tells you why his cash register’s worth 20 times what he’s selling it for, but he also tells you that you’re an idiot if you want to go into competition with him.

Munger: No intelligent person could read this report and not realize that this guy couldn’t lose.


Shareholder: Mr. Buffett, many in the academic community either call you lucky or a statistical outlier. Mr. Munger, I’m not sure what they call you.

Buffett: (Buffett laughs.) You’re free to speculate on what they call him.

Shareholder: I know why you don’t like to forecast the equity markets. But maybe you’d dare to forecast the evolution of the debate between proponents of the efficient market theory and value investors. Do you think there’ll ever be a reconciliation… (between the two)? And as an addendum, are your designated successors outliers, too?

Buffett: Well, we like to think they are. And they may be more outliers than we are….

To me it’s almost self-evident if you’ve been around markets for any length of time that the market is generally fairly efficient. It’s hard to find inefficiently priced securities. There are times when it’s relatively easy. But right now it’s difficult. So the market is fairly efficient in its pricing between asset classes – and it’s fairly efficient in terms of evaluating specific businesses.

But being fairly efficient does not suffice to support an efficient market theory approach to investing or all of the

offshoots that have come off of that in the academic world. Buffett: So if you’d been taught efficient market theory and adopted it for your own 20 or 30 years ago – or even 10

years ago (it probably hit its peak about 20 years ago) – then it would have been a terrible, terrible mistake. It would have been kind of like learning that the earth is flat. You would have had the wrong start in life.

Nevertheless, it became terribly popular in academia. It almost became a required belief in order to hold a position. It was what was taught in all of the advanced courses. And a mathematical theory that involved other investment questions was built around it – so that if you went to the center of it and destroyed that part of it, it really meant that people who’d spent years and years and years getting Ph. Ds. found their whole world crashing around them.

Buffett: It’s been discredited in a fairly significant way over the last decade or two. You don’t hear people talking about it the same way you did 15 or 20 years ago. I don’t know exactly how much it’s holly writ still. I certainly get the impression as I go around talking to business schools that its far less regarded as unquestioned dogma than it was 15-20 years ago.

The University of Florida now has some courses in valuing businesses. The University of Missouri is putting one in. And the high priests of efficient market theory probably aren’t in as much demand for seminars, speaking engagements and all of that as they used to be.

Buffett: But it’s very interesting. It’s hard to dislodge a belief that becomes the dogma of a finance department. It’s so challenging to them. At age 30 or 40, they have to go back and say, “What I’ve learned up to this point and what I’ve been teaching students and all of that is silly.” That doesn’t come easy to people. Charlie?

Munger: Well, Max Planck, the great physicist, said that even in physics the old guard really didn’t accept the new ideas. New ideas prevail in due course because the old guard fades away clinging to asininities of the past. And that’s what’s happened to the hard-core efficient market theorists. They’re an embarrassment to the scene – and they will soon be gone.

People who think the market is reasonably efficient – or roughly efficient – of course, are absolutely correct. And that will stay with us for the long pull.

Buffett: However, thinking it’s roughly efficient does nothing for you in academia. You can’t build anything around it. What people want are elegant theories. And roughly efficient just doesn’t work.

Buffett: Investment is about valuing businesses…. That is all there is to investment. You sit around and try to figure out what a business is worth. And if it’s selling below that figure, then you buy it. But you virtually can’t find a course in the country on how to value businesses. You find all kinds of courses on how to compute beta or whatever it may be because that’s something instructors know how to do. But they don’t know how to value a business. So the important subject doesn’t get taught.

And it’s tough to teach. I think Ben Graham did a good job of teaching it at Columbia – and I was very fortunate to run into him many decades ago. But if you ask the average Ph.D. in finance to value a business, he’s got a problem. And if he can’t value it, I don’t know how he can invest in it.

Buffett: Therefore, it’s much easier to take up efficient market theory and say there’s no sense in trying to think about valuing businesses because everybody knows everything about them anyway. If the market’s efficient, it’s valued them all perfectly anyway.

But I’ve never known what you talk about on the second day I that course. You walk in and you say, “Everything’s valued perfectly” – and “Class dismissed.” So it puzzles me. But I encourage you to look for the inefficiently priced.

Berkshire, incidentally, was inefficiently priced for a long time. It wasn’t on the radar screen…. If you’d asked an academic how to value it, they wouldn’t have known what to look at exactly.

Charlie Munger’s Comments at Wesco Financial’s 2003 Annual Meeting

Critique of the Efficient Market Theory

They used to criticize us bitterly, but stopped doing that when criticized by their heirs[?]. There's a world in academia where markets are perfectly efficient, where nobody knows if one company is better than another at anytime, where value is dictated based on price. Then, it can never make any sense for a company to buy back its own stock. But if you say, "I can point to you many situations in which a stock was selling for 1/5th of its value,so why shouldn't a company buy it back?", some purists still won't change their minds. A corollary of this says that you can never find a price that is rational to buy a stock that you know a lot about. It makes it hard forWarren and I to go on every year. We don't really care actually. [Laughter] In what other profession do the leading practitioners differ so much from the leading theorists? [Laughter] Hopefully this is not true in surgery, engineering and so forth.

Investing Taught at Business Schools

There are a handful of business school professors who teach investing properly. Jack McDonald of StanfordBusiness School, for one. He comes to the Berkshire meetings. I've taught in his class and Warren has come to his class. There are others. Reforming academia, except accidentally by having a view that catches on, isn't something I try. It's amazing how difficult it is to change ideas, no matter how wrong they are.

Neither Warren nor I has ever thought for two seconds about beta. But every business school teaches this[concept]. Maybe if we had a few more hundreds of billions of dollars, people would pay attention to us.[Laughter]

Charlie Munger’s Comments at Wesco Financial’s 2004 Annual Meeting

Munger: We have had very little effect upon the nation’s economics departments and business schools. And these are, by and large, staffed by very smart people who are trying to think carefully and do right. However, they just don’t get it.

It’s odd. We may misjudge academia generally – misjudging it as being worse than it probably is – because the part of it that interfaces with us is bonkers people with bonkers ideas like beta and modern portfolio theory.

And none of this stuff makes any sense at all to us.

Munger: We’re looking for competitive advantages that are as enduring as possible. And we’re trying to buy shares for less than they’re worth – or even to pay a fair price for them if we admire what we see.

I think academia is defective in creating basic doctrine in our field partly because if you believe like us, you’ve got nothing new to teach. You come in and speak your two sentences – but what do you do the rest of the semester? In contrast, with their doctrines, they have all these mathematical formulas and what have you so they can test students to make sure they’ve memorized them, etc. But rewarding people for spouting back formulas that don’t work in real life is a disastrous way to educate people.

Munger: Stanford Business School is very interesting. Jack McDonald thinks a lot the way we do. He’s probably the single most popular professor in the Stanford Business School. And he carries twice the normal teaching load year after year. He gets voted year after year among the top, or at the very top, in terms of popularity with the students.

Well, the school can hardly wait for Jack to get old enough to leave. He’s totally out of step with modern academia – the business school version. I’m not inventing these stories – it’s reality that is so ridiculous.


Let me end this section by telling you about one of the good guys of Wall Street, my long-time friend Walter Schloss, who last year turned 90. From 1956 to 2002, Walter managed a remarkably successful investment partnership, from which he took not a dime unless his investors made money. My admiration for Walter, it should be noted, is not based on hindsight. A full fifty years ago, Walter was my sole recommendation to a St. Louis family who wanted an honest and able investment manager.

Walter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North Carolina School of the Arts. Walter and Edwin never came within a mile of inside information. Indeed, they used “outside” information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When Walter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.

Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.

I first publicly discussed Walter’s remarkable record in 1984. At that time “efficient market theory” (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to over-perform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.

And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory.

Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.

Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on over-performing, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.

Maybe it was a good thing for his investors that Walter didn’t go to college.


Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.


The Basic Choices for Investors and the One We Strongly Prefer

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.

• Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments – and indeed, rates in the early 1980s did that job nicely. Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.

Under today’s conditions, therefore, I do not like currency-based investments. Even so, Berkshire holds significant amounts of them, primarily of the short-term variety. At Berkshire the need for ample liquidity occupies center stage and will never be slighted, however inadequate rates may be. Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.

Beyond the requirements that liquidity and regulators impose on us, we will purchase currency-related securities only if they offer the possibility of unusual gain – either because a particular credit is mispriced, as can occur in periodic junk-bond debacles, or because rates rise to a level that offers the possibility of realizing substantial capital

gains on high-grade bonds when rates fall. Though we’ve exploited both opportunities in the past – and may do so again – we are now 180 degrees removed from such prospects. Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”

• The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

• Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Whether the currency a century from now is based on gold, seashells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See’s peanut brittle. In the future the U.S. population will move more goods, consume more food, and require more living space than it does now. People will forever exchange what they produce for what others produce.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.

4. Buffett and Munger on Modern Academic Finance Revised

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