Street Capitalist: Event Driven Value Investments

(Note: This is all paraphrased by me. Do not take any of this as an exact quotation, but rather a general idea of what was said here . I made this because these videos are difficult to share and take a while to sit through, so hopefully you will find this to be helpful.)

Q: How do you evaluate family business acquisitions? same as stocks?

A: When buying marketable securities use Benjamin Graham’s margin of safety

When buying businesses, you buy to keep. Margin of safety is in crossing the threshold of being virtually certain of buying a business with competitive advantage and a passion for the business. Margin of Safety is qualitative instead of quantitative when buying whole businesses. Ben Graham is very quant. focused, buying businesses is a much different. It is a look at the long-term economics and viability of the business.

Q: Any plan to buy stakes in Brazilian companies because of its new status as investment grade?

A: We would buy in any country as long as they understand risks well enough. Has to be a large enough criteria (75mm dollars pre-tax, etc) Would feel very comfortable owning a business in Brazil, owned the Brazilian Real.

Q: Anything you like in Germany? Strike a deal before the end of the week?

A: Guarantee not by end of the week. If lucky, run into two possible deals. We don’t buy when ready to buy — buy when the owner has a reason to sell. Advises owners not to sell their wonderful private businesses, don’t need a number put on it to validate it. Doesn’t call or pester owners to sell. I don’t go around delivering sales talks, wonderful businesses should be kept by owners until there is a reason to sell.

Q: Some bad feelings in Europe/Germany about American investors. Why should family businesses look to investors like yourself?

A: If they have a reason to sell, maybe no heirs, siblings don’t agree — this is a reason to sell. If it’s simply getting a best price, then they should auction it off. If they care about a business over decades and decades, and want it to be in a home where everything will continue as it has before, where they are dealing from great financial strength and never have to see Wall Street - Go to me. Berkshire Hathaway and its culture is what they’re buying into and it’s a very rare and hard to replicate culture. It’s large so a very big business can join. We’re a logical alternative.

Q: You are known to invest in American companies. Why look to Europe? Are you disappointed by American companies / American way of businesses? What is your criteria for investing in Swiss companies?

A: Not disappointed by US… I will probably buy a US company probably in a couple years. We’re in the minds of more owners in the US than in Europe. Trip to Europe is a move towards correcting that. I love buying Businesses in the US, but I love businesses in Switzerland too. The criteria for buying in Switzerland is exactly the same as buying that is listed in the annual report. Wherever they can buy they will buy.

Q: You speak about Europe but — Are you ready to invest in Eastern Europe? Are you happy?

A: Yes — I am happy. We don’t rule out any countries but smaller companies have less opportunities. Some companies we worry about the rule of law. I accept phone calls from a lot of companies I have not visited.

Q: Which sectors and companies do you like in Switzerland?

A: We don’t look for specific sectors. We look for businesses that I can understand. Where I have a high degree of confidence where I can see where they will be 5-10-20 years from now. I didn’t know that Google would come along. Anything rapidly changing I would not understand. I look at businesses that are reasonably easy to evaluate their products - how they will fit in the economic picture - how the economics will look. We’re looking for understandable businesses (like Nestle). But I don’t go out saying I’m looking for the steel industry, etc.

Q: You’ve been fairly critical in the past about how the US currency has been devalued and Handled. How much of your trip to Europe is about diversifying away from the USD?

A: Not really a factor but does not mean I ignore currency rates. I’m not here because of small differences in the euro. It’s not a big factor. I certainly feel that overtime — long period (10 years) I do not worry about them (Euro currencies) depreciating against the US dollar. If we don’t change the USD policies we will have weaker currency.

Q: Have you seen any challenges with EU Family businesses / Compared to US Businesses?

A: Same challenges, many diverse reasons. Bought twice when there was a successor issue that could hurt the family — I can solve the problem in a way that their solution cannot. There are all kinds of situations that can come up. I would guess that the reasons are diverse in Europe/Asia as they are here, in the US.

If you go 100 years - there will come a time when certain hatreds develop. I had one call some years back from a large family business where they were all hating each other.

I had a call from a young woman, a thousand miles from Omaha, I never met her. She said, “Mr. Buffett the family has some split — we feel that you’re the only person who can come here and solve this.” Then I said to her, “Tell me one thing, do you want to win, or do you want your bother to lose?” She paused and said “Don’t bother to come down.” I was not going to make a solution that could cause anyone to suffer. You get into situations where things break up sometimes. You get great results for family businesses but sometimes it comes to an end.

Q: You’ve teased biz schools for teaching arcane subjects (Option Pricing). What would you teach?

A: It wouldn’t keep all the professors permanently employed. It would teach

1. How to value a business.
2. How to think about the market.

As a general part of the curriculum, I would add two subjects not emphasized in business school. I think that the ability to communicate both orally and in writing is enormously important. All students I meet benefit immensely by working on those two skills. They would have a pay off that is enormously disproportionate that would pay off more than learning modern portfolio theory.

The way someone speaks or write can have an enormous impact. Those subjects are under-taught and can have an impact on all schools.

Q: You like real economy - real business. What do you think about what’s going on in the banks. What advice would you give to these bankers?

A: There are more banks than bankers. I think that the head of any bank or financial inst. needs to be the Chief Risk Officer. You have no biz in running a financial institution if you’re not looking at risks. Unless willing to take on CRO job, you shouldn’t be a CEO. We’re seeing the consequences of people not understanding the vehicles they’re sitting up and the risks they’re facing.

CDOs squared can be 750,000 pages just to understand one instrument. Designed to make money for the seller. Huge mistakes have been made by these institutions and they will make similar mistakes in the future. I’d buy a bank bank depending on banker.

Q:Some criticism towards SWFs. Is it fair? Have you ever looked at a Norwegian co.?

A: I’ve looked at one or two Norwegian cos. Not a lot I could put 500 mm in (minimum investment for marketable security). SWFs interesting. We’ll have them as we continue to force-feed dollars to the rest of the world. Not the best policy to blame these people when it’s us who push the dollars onto them.

Q: What will solve the food crisis? Will you invest in food cos like Nestle?

A: Some talk of speculators — does not look like a speculator situation. Prices of corn are largely dependent on supply/demand. If producing 86 million bb a day of oil and using 86 million — that is how supply and demand intersect. There has been a case to some degree of corn — part of the corn supply being used on fuel is spilling over, farmers may plant more corn because he sees the the affect on corn, affecting other crops. We’re likely to see higher prices over time if we follow the same policies. We don’t own any commodities, we use them in our businesses. All these factors (price increases) has a real affect on the consumer.

Q: How does it feel to be the richest man in the world? You still friends with Bill Gates?

A: Bill and I are extremely good friends. Nothing has changed. I’m giving away the stock as I go along so I wont stay there.

Q: Over the last few years, a number of energy industries have come to Switzerland. Would you own an energy company?

A: Sure. We can understand energy companies. I understand the energy business, we’ve bought stocks and natural gas pipelines. Frequently they’re large so I would not be reluctant.

Q: Why and how do you support Barack Obama? What do you do for the people from Burma and China who have been affected by natural disasters?

A: Before both Hillary and Barack were running I told I would support both of them. I told them that I’d hold more fundraisers for them. They are outstanding candidates. In terms of the philanthropic efforts, I’ve outsourced that to 5 foundations. Largest portion goes to Bill & Melinda Gates Foundation. Biggest so far has been health. A portion in there goes towards emergency type relief. In various crises in the past they’ve always contributed something. They handle that. My funds will end up being half what they dispense annually. They handle that. I support them.

Q: You bought a 3% stake in SwissRe. A 20% share in their PnC Business. Do you understand Cat Bonds, Longevity Bonds? What do you think of insurance securities?

A: I would prefer to write them for our own account. I’d rather take the risk myself and get paid the premium. There are plenty of people in that business who are good at it. Investment banks have been making cat bonds which is competition against Berkshire.

Q: We’re in Switzerland, the country of Luxury Goods. Would you be interested in buying something here?

A: Our Ben Bridge subsidiary is the largest seller of Rolex (I believe). We have 80-90 stores, Rolex is a significant portion of our business. Those are great companies (companies like Rolex). They know my phone no. but haven’t called.

Q: You keep telling us that you want the family owned businesses and want the family owners to call you. What phone number should they use?

A: 402-346-1400. I was a little bothered the other day, a letter came in that said Supreme Idiot - Berkshire Hathaway. I see all of my mail. Every phone call that comes in, people are asked what they are calling about. If people are calling about a serious idea, they have no trouble getting through to me or sending a fax. I bought half a dozen companies just starting with a fax. It’s easy to get through. You can call collect if you have a good deal.

Q: One of the most difficult tasks for you must be to find a guy who can get in and follow you?

A: There are three people we’ve identified. It’s all we (the board) talk about. The board knows. People on the board have almost 1/2 their net worth in berkshire stock. They care about it. My successor will be a lot better in certain things than I am. They will walk into a very well-defined culture. There will be a little bit of a problem in that people don’t know him yet. That will get overcome.

Sam Walton died 15 years ago, Walmart was Sam Walton, but Walmart isn’t Sam Walton. Walmart was institutionalized. Berkshire’s culture is institutionalized.

Q: A question about your charity activities and corporate activities. Suppose you have corporations that you invest in, that might not be impeccable in corporate governance. Can charity be a balance for a corporate governance flaw?

A: We on stock in companies where I don’t agree with everything, but my children don’t either. We can’t expect 100% adherence. We don’t feel a responsibility about that. If we have control over a company, we want it run in a way that you could describe it on the front of the paper and not feel embarrassed.

For businesses we own, I say keep following your own charitable policies, don’t check in with us. In my own case every share I own will go to charity. But it’s no sacrifice, but it’s what I believe should happen. I don’t believe it is my job to take the shareholder’s money to be allocated to whatever charity I believe in. They should allocate their own funds.

Q: Any calls from finance ministers that you didn’t show up to their countries?

A: No. No complaints either! I would be delighted to find the right business in any country. Europeans should feel comfortable about the US. US should feel comfortable about Europe. All of these countries believe in the right things. Wonderful businesses are built all over, no reason to rule one country off the list. I’d be equally to get a call from any company even one I haven’t visited. Call at 402-346-1400.

Is Starbucks the next AOL? Maybe.

Trading at levels last seen in 2003, Starbucks looks like they are in trouble. There is glorious talk about a turnaround for the brand, and a recent investment by Nelson Peltz seems to indicate that there is promise. However, so far, everything I have heard from the company does not seem to indicate what I would be looking for in a possible turnaround.

Starbucks is a little like AOL. AOL came onto the scene in the early 90’s and figured out how to turn the internet into a commodity for consumers. AOL brought the internet to the masses. But AOL did not change as fast as consumers preferences and when faced with new competitors.

In somewhat of the same way, Starbucks did a lot of the same things. They cannibalized the existing café market by opening up on block after block, driving small indie cafes out of business. As a result, more consumers became exposed to coffee. Cafes went from being havens for college students and older left-leaning adults, to symbols of suburbia where teens congregated to appear older and housewives went for their daily boost of caffeine before picking up the kids from soccer practice.

This ubiquity, allowed for people of all walks of life who were not normally associated with gourmet coffee consumption to actually try it and like it. For a while, this worked really well. But exposing the masses to a product that can be commoditized like coffee has its drawbacks, and that’s what I think we’re seeing at the moment.

Schultz mentions that companies are gunning for their consumer, and he’s right. By exposing consumers to coffee, Starbucks did the heavy lifting. They got consumers, to try a pricey product that may have been outside of their comfort zone. All this did though was create a new group of consumers for companies to go after, and they have. McDonalds is unrolling their iced coffee line and Dunkin Donuts has diversified into offering competitive iced drinks that deviate from normal coffee and appeal to the general population. We also know that Starbucks does not serve the best quality coffee, or provide the best experience (lack of real cups and plates). Each of these cases show how easily consumers of Starbucks can be poached to coffee outlets that better serve their needs.

This is precisely why my outlook for Starbucks, at least in its current form, is dim. Schultz is looking at things like bringing better tasting coffees, making the interior more friendly (smelling better, architecturally more welcoming), and bringing healthier options. I don’t buy that these things are enough. None of them are really a game changer and they don’t address some of the wide-scale problems that are affecting Starbucks.

McDonalds and Dunkin Donuts are about to extract an advantage by chipping away at the more working-class consumers who will be more cost sensitive. Cost sensitivity will remain highly important as consumers continue to come to grips with costlier gas and food and it will be tough for Starbucks to compete on this end. For consumers that are health conscious, Starbucks becomes an even more perplexing choice.

Starbucks does not benefit from geographic isolation, they are found on city blocks and corners that are usually filled with other offerings - from traditional fast food/casual dining outlets to places like Jamba Juice which will always appear to be more healthy because of the inherent emphasis on fruit. Then there will also be traditional food outlets that will remain more competitive as well. I know that the only reason I buy a muffin from Starbucks is because I want a sweet baked good, I’m sure many people share the same sentiment (which would also be why the breakfast sandwiches were removed in the first place).

This leaves going after tastier drinks (perhaps inspired from Italy) but again, this doesn’t help too much. Starbucks already offers a wide variety of easy to customize drinks, diluting any kind of effect that a new one may have.

So Starbucks might have to live with new entrants coming onto their turf, taking their customers. Especially competitors who may be able to specialize and cater towards the needs of certain niche groups in the market. This leaves only a few solutions, with no one solution looking like the best course of action.

First, Starbucks could pursue a plan where stores are better differentiated to fit the types of locations they’re in. A Starbucks near a college could offer cheaper drinks/promotions conducive to ordering multiple drinks, making it worthwhile to utilize Starbucks as a study spot. Starbucks in nicer neighborhoods could also reflect that, and could have things like real china to make the atmosphere more hospitable. Perhaps even some higher end coffees.

Regional tastes could be taken account also. For example, McDonalds is adept at catering towards not only national but also regional palettes. Sweet tea is big in the south, but Starbucks really has not offered any unique sweet tea to cater to, they instead offer their existing teas in an iced and sweetened form. Their stubbornness to cave to regional tastes seems reflected by their poor showings in international stores, and would be yet another strike against their one size fits all strategy.

Store differentiation works to an extent. To go further though, I think that an emphasis on franchising is needed. With Cap Ex rising 68% in two years, it must be understood that the current strategy is incorrect. A franchise driven model would help alleviate some of the burdens of running Starbucks and transfer much of the risk into the hands of budding entrepreneurs, after all, store openings are one of the company’s major costs. Shifting that aspect of the business out would allow the company to focus on products more which would also be helpful. The strong competitors that are appearing are all companies that are franchise driven, so it’s possible that they carry an advantage that Starbucks does not in this sense.

Nelson Peltz is a numbers savvy guy who likes good brands - see his purchases of Snapple, Tiffany Co., and Wendy’s. These brands had strong followings but poorly allocated capital, which he sought to change. My belief is that he might agree that franchising could be the way to go for Starbucks.

Finally, there needs to be a de-centralization of the company. If you read articles about Starbucks, you hear everything about the return of Howard Schultz. There’s even comparisons between Schultz and Steve Jobs, perhaps because both pay such close attention to the smallest of details regarding their products and services. Starbucks and Apple are two very different companies. Apple has become successful due to the iPod. It made consumers come over and try a product from a company that they had long forgotten. The iPod served then as a bridge to other Apple products, like their laptop line and iMacs.

Starbucks tries to do this, but in a bad way. You come in for a coffee drink and you are faced with products that bridge into the whole Starbucks “lifestyle”. What is this? CDs (a dying breed), teddy bears (???), and coffee to make at home (who wants to make coffee at home? isn’t this why you go to Starbucks in the first place?).

None of these products had much of a competitive advantage, making the Starbucks strategy very un-Apple. Furthermore, Apple’s products are simpler to group (mp3 players, phones, laptops, PCs, iTunes, operating system). The introduction of a new product line, like the iPhone for instance, has a tremendous effect on the company. I fail to see how the introduction of a fruity drink at Starbucks will have the same level of effect on Starbucks. Consumer preferences here are quite different, Apple caters to status and utility, Starbucks caters to individual palettes - which are extremely fickle.

So Howard Schultz is no Steve Jobs, and maybe the company should start reflecting that more. People think that the founders of companies can solve all of their problems, but just look at Jerry Yang at Yahoo if you want an example of a founder coming back and having trouble. So maybe it is time for stores to have more autonomy, so that decision making will come down from the top to the front-lines and create an environment for more innovation.

Still, even these ideas might not be enough and that’s the trouble with Starbucks. I used to think that Starbucks is a great business that I would love to own at a good price. Now, I’m not entirely sure about that. Howard Schultz is facing competitors who have been serving customers much longer than Starbucks has even existed - while also having to battle new insurgents entering the market. Good luck Mr. Schultz and shareholders at Starbucks, you’re going to need it.

1. For the week ending May 10, initial jobless claims climbed by 6,000 to 371,000.

2. Continuing claims for the week ending May 3 grew to 3.06 million (+28,0000)

3. Specifically, New York, Pennsylvania, and Wisconsin reported increases > 1,000 in claims

4. Conversely, New Jersey and Georgia reported a decrease > 1,000 in claims.

Overall, the unemployment insurance claims appear to be trending upwards YoY over the last three years. I feel that it will be important to keep an eye on these numbers, because there is a high likelihood for them to affect consumer spending. We know that it is consumer spending that affects the economy, but there have been mixed inputs as of late.The rebate checks ($600) were thought of to be a means of stimulating the economy by getting consumers to spend. But so far, this does not seem to be probable.

Retail Sales Data, via the Big Picture

Looking at the recent retail sale data, with this graph, we can see that the only places with an increase in retail spending were gas stations and groceries. This appears to be a shift away from discretionary goods to what is absolutely necessary. It will be difficult to see how consumers will be able to keep up. Just today oil hit $127 a barrel and recently data has come to show that consumer debt is only increasing.

I didn’t attend the annual meeting, but I have read through a few Q&As and was pretty happy about the questions and answers. What I’ve done here is used Peter Boodell’s notes from here: Berkshire Q&A Transcript by Peter Boodell and annotated them with some of my own thoughts.

There are only 9 of the questions listed here but you can read the rest at the link above. Peter Boodell did an excellent job so I suggest you read all of what he’s transcribed.

I’ve chosen to use the quotes that best resonated with me because some things I just felt were too clear/have been reiterated by Warren Buffett a thousand times (things like invest like buying a business).

Q16: Germany, fixed income markets at discounts. Will you take advantage?

WB: We have seen some important dislocations. I’ve brought some figures. Tax exempt money market funds [auction facilities]. $330b of them. Repricing of first grade muni’s every 7 days. LA County Museum of Art. Jan 24th: 3.1%. Jan 31st: 4.1%. Feb 7th: 8%. Feb 14th: 10%. Fell back down to 3% on Feb 21st. Now 4.2%. Somehow rates were much higher on Valentine’s day. Look at bid sheet of Citigroup. Repricing every 7 days. You would find same issue on several different pages. Same broker at same time on different pages quoting different prices. On one page we bid 11%, and someone else bid 6%. You found this in 1974, after LTCM. These are great times to make extra money. Auctions in esoteric securities. We have $4bil in it. We will have made some insignificant money in this for a few months. There may be opportunities that we can’t spot. If you have enough time you can figure out something that are really mispriced. We don’t play with that, just don’t have enough time. If you spend enough time you may find those that Charlie and I can’t find because we just can’t look at that many things.

CM: What is interesting is how brief these opportunities are. Some idiot bought muni’s, bought 20x what he could afford at incredible margin, those things were dumped on margin calls and suddenly got really mispriced. The dislocation was very brief, but very extreme. The moves are fast and short. You must think fast, resolutely. You have to be like man who stands by a stream and fish comes by once a year.

The Q&A here is most indicative of the idea that Berkshire does not operate on a consensus basis. Decision making is relegated to mostly Buffett with Munger consulting. The advantages here are huge, Berkshire is able to take quick, opportunistic investments in the market.

Other organizations might not be able to move so quickly and make big bets in areas that were seemingly dislocated. An example that comes to mind is the story about Goldman Sachs’ great sub-prime bets. The organizational structure at Goldman was arranged in a way where traders were able to quickly push ideas like that to the company’s top management and act quickly. Without that sort of structure there is a high likelihood that you would have missed out, and we saw that. Certain investment banks did not make the huge “short sub-prime” trades and suffered as a result.

What this indicates to me is that most value investors are probably best suited to acting mostly alone. The fact is, inherently many value investments arise out of highly contrarian situations. The decisions here are not easy to make in a group situation and make it easy for you to miss out.

Q20: Philadelphia, I’m 12 yrs. There are a lot of things they don’t teach you in school, what things should I be looking into?

WB: I’d read a daily newspaper. You want to learn about world around you. Bill Gates quit at letter P in World Book Encyclopedia. Just sop it up, and find what is most interesting to you. More you learn, the more you want to learn. It is fun.

CM: My suggestion is that the young person has already figured out how to succeed in life.

What I feel important to mention here is how Buffett says to learn about the world around you. A few investors that I speak to spend most of their time just reading the Wall Street Journal or Financial Times. I think that this is a good start but it does not give you a comprehensive view of the world. You can read more. Reading more seems to fit in with Charlie Munger’s Latticework of Mental Models. Most of the books Munger has recommended at past meetings typically come from science backgrounds where the c onnection is investing may not be immediately recognizeable.

Reading business publications will only help you to an extent. I could read thousands of books on value investing, but it would not necessarily help me. They all say mostly the same thing. Look for companies that are undervalued. Take a long term horizon. Maybe they’ll express some accounting concepts. But they don’t teach you enough to act in an uncertain world, and that’s the world we live in.

Buffett has referenced this idea a bit when he discusses the four CIO candidates. He says he is looking for someone wired in a way that they can perceive and deal with risks that we have never faced before and I believe this is where the lattice work of mental models really comes in to play.

Q26: New York City. American Express and Washington Post – big positions. How do you get confident enough?

WB: If we were running only our own money, 75% of net worth outside Berkshire has never been a significant amount. Several times I have had 75% of my non-Berkshire net worth in a situation. You will see things where it would be a mistake not to act. You won’t see them often, and the press and your friends won’t be talking about them.

CM: Sometimes I have had more than 100% in individual investments.

WB: You just had a good banker.

WB: Look at LTCM – they put 25x their money in things that had to converge – but couldn’t play out the hand. There are people in this room with more than 90% of their worth in Berkshire. I saw things in 2002 in junk bonds. You could have bought Cap Cities in 1974 – selling for 1/3 the property value, with best manager and in a good business. You could have put 100% in Coca-cola when we bought it and that wouldn’t have been a dangerous position.

CM: Students learn corporate finance at business schools. They are taught that the whole secret is diversification. But the exact rule is the opposite. The ‘know-nothing’ investor should practice diversification. Diversify– but it is crazy if you are an expert. If you only put 20% in the opportunity of a lifetime – you are a not being rational. Very seldom do we get to buy as much of any good idea as we would like to.

What is most important to takeaway here is the idea of concentration with respect to your positions. If you want to truly earn outsized returns you must concentrate your positions with ideas that you have high conviction in. If you look at most of the value investors out there, you’ll notice a huge wealth gap between Buffett and pretty much everyone else. A good answer for that is simply due to how they invest their wealth. Around 99% of Warren Buffett’s wealth is invested in Berkshire and Berkshire’s rise has been instrumental in the rise of his own wealth. There’s no other way around that.

Part of this has to do with good analytical work on your part. This means that doing your own analysis of a company, not relying on a random stock tip you pick up. If you put in the effort you should be able to be reasonably comfortable with a highly concentrated portfolio.

Mohnish Pabrai is a proponet of the 10 position portfolio, because he argues that when you exceed 10 positions the benefits of diversification fall, you end up being too diversified and it erodes on your returns. He also has a limit that no position can exceed 10% of Pabrai Funds, again, this is a pretty good idea. Pabrai targets for some of his investments to go totally to zero, but for others to go gain 100%, and for some to not move at all. So far this method has worked quite well and even with DFC becoming a zero, Pabrai funds has not faced massive redemptions like we’re seeing elsewhere, so things must be working.

The one caveat could be when you employ leverage. If you’re employing leverage whilst utilizing a highly concentrated portfolio, you can lock yourself into a death spiral due to volatility. The fact is, a concentrated portfolio will most likely swing widely in value on a month-to-month basis. But in the long term it should do great. Unfortunately, if you are employing leverage you run the risk of being at the mercy of a margin call and not the merits of your own investments.

Shareholder: What do you think of the food shortages we’re seeing right now?
Munger: Turning American Corn into motor fuel is one of the dumbest ideas i’ve ever seen. The idea is so monstrously dumb it is probably on its way out.

I’ve blogged about the Food Crisis before. It’s important, there is no way around it. As emerging market nations grow, they will have larger middle classes who are going to eat more food. Take China, India, or even Brazil. All of these countries are having larger middle classes as their consumption is appreciating in step. This creates a huge increase in demand for food.

Couple this with the supply aspect. Droughts are scattered around the world, we had a cyclone in Myanmar, and finally farmers are planting corn for ethanol which reduces the amount of space that’s left for other crops, which pushes them up in value as well. Certain areas are cutting their production of key cereal crops, like Saudi Arabia who used to produce 12% of the nation’s cereal crops. By abandoning that production, they’re going to fill the 12% by acquiring it from the global market, thus taking more off the table for other countries and helping push prices higher.

Q34: Idaho. Are investment banks too complicated? Risks unknown.

WB: Exceptionally good question. Answer probably yes in most places, though there are a few CEOs I respect a lot. Gen Re had 23k derivative contracts. I could have spent full time on that, and I probably still couldn’t have gotten my head around it all. And we had exposures that I thought were possible and heads of business units didn’t – I don’t want slim, I want none. I am Chief Risk Officer. If something goes wrong, I can not assign to committee. I think big investment banks and big commercial banks are almost too big to manage effectively in way they have elected to run their business. It will work most of time. You may not see the risk. A 1 in 50 year risk - it won’t be in interest of 62 year old executive who is retiring at 65 to worry about it. I worry about everything. Many CEOs say they didn’t know about what was going on. It’s easier to admit he doesn’t know what’s going on than to admit that he knew what was going on and let it go on. I’ve been asked for advice on regulation. Somehow press hasn’t picked up on this too much. OFHEO supervised Fannie and Freddie – activities had public element, and were semi-regulated. For 200 people it was their sole job to examine the books. They were 2 for 2 with 2 of biggest accounting scams in history of world. Person at top must have it in their DNA to see risks. In many ways, there are firms that in terms of risk are too big to manage. If too big to fail, there are interesting policy implications.

CM: It is crazy to allow things to get too big to fail, run with knavery. As an industry, there is a crazy culture of greed and overreaching and overconfidence trading algorithms. It is demented to allow derivative trading such that clearance risks are embedded in system. Assets are all “good until reached for” on balance sheets. We had $400m of that at general re, “good until reached for”. In drug business you must prove it is good. It is a crazy culture, and to some extent an evil culture. Accounting people really failed us. Accounting standards ought to be dealt with like engineering standards.

WB: Salomon was trading with Marc Rich who had fled country. They said they wanted to keep trading with him. Only by total directive could we stop it. I think Fed did right thing with Bear. They would have failed on Sunday night, and walked to a bankruptcy judge. They had 14.5tril of derivative contracts – not as bad as it sounds, but the parties that had those contracts would have been required to undo the contracts to establish the liability from the estate. The $400m at Gen Re we had took 4-5 yrs, at Bear it would have been 4-5hours. It would have been a spectacle. Two of witnesses said at testimony, ‘we understood we couldn’t borrow unsecured, but we didn’t understand we couldn’t borrow secured’. The world does not have to lend you money. If they don’t want to lend you money, an extra 10bps won’t make a difference. It depends on people’s willingness to lend you money which comes down to how other people feel about you. If you are dependent on borrowed money, you have to wake up every day worried about what world thinks of you.

I don’t think there is anything to add here, I just felt like their arguments were strong. Particularly Charlie Munger’s comments on trading algorithms and accounting. It was the overconfidence in financial models that lacked a proper future looking component that has gotten us into a tremendous amount of mess already. In terms of accounting, simply put, we’ve having billions of dollars seemingly evaporate from balance sheets per quarter. Or we have sketchy actions where banks offer financing to cover the amount needed to buy debt off of their balance sheets. These situations lead to a really slippery slope.

Q51: How do we better measure leverage and accounting of assets, integrity?

WB: It is a very tough thing. I still lean strongly towards fair value accounting – it is hard to use, but should we use cost? I think there are more troubles when you start openly valuing things at prices that don’t matter instead of best estimates even if inaccurate. I would stick with financials reporting assets at fair value. When you get into CDOsquared, the documentation is enormous. If you read a standard residential security – it consists of thousands of mortgages, then different tranches. Then take CDO and take junior tranches on a whole bunch of juniors – put them together and diversified in theory – a big error to start with. That was nuttiness squared. You had to read 15,000 pages to get a CDO, then 750k pages to evaluate one security in a CDOsquared. To let people use 100cents they paid vs. the 10cents it trades at in market is an abomination. Fair value discipline, mild as it may be, may keep managements from doing some stupid things. I lean toward the market value approach. When you get towards complex instruments, I don’t know how you value it. Charlie, back at Salomon I think you found one mismarked by $20m, right?

CM: A lot goes on in bowels of American industry which is not pretty. A lot of people got overdosed on Ayn Rand. They would hold that even if an axe murderer in a free market is a wise development. I think Alan Greenspan did a good job on average, but he overdosed on Ayn Rand that whatever happens in free market is going to be alright. We should prohibit some things. If we had banned the phrase, “this is a financial innovation which will diversify risk”, we would have been far better off.

Most of the points here are reiterated in my own comments above, but I’ll add one thing. This quote here is probably one of the main reasons I really love reading anything from Charlie Munger. He’s an investor who is attacking Ayn Rand. There seems to be this gross obsession with Ayn Rand that perversely affects the financial community.

A while back I did a post on the follies of Value Investors, and I discussed how some value investors obsess over a strict ideology on how they should invest that sometimes it clouds their judgement detrimentally. The Ayn Rand obsession is another case of that. An argument Munger makes repeatedly is not to become an extremist, someone who follows only one really strong version of some ideology. You can see it in his “man with the hammer” idea.

When you get swept up in a philosophy like Rand preaches, you run the risk of making mistakes because of your tunnel vision.

Q55: To win, first you must not lose. If corporate default rates escalate, will the credit default swap problem materialize as a threat to financial system? You are great pricer of risk. You must consider selling insurance without pricing appropriately. Is there a chance CDS market may eclipse subprime?

WB: CDS notional is about 60trillion, there are lots of double counting, etc, but no doubt it is a lot of money. They are swaps, or insurance against companies going bankrupt. We have written two types of derivatives, and we have insured a swap that pays to someone else in event of default on high yield indices. I think we will make significant money. I think there is no question that corporate default rate will rise. That has been included in price in writing this insurance. Will CDS market lead to chaos? Probably not, but if bear had failed you would have had chaotic conditions. A CDS is a payment by one party to another. When someone loses money on a loan, they’ve lost real money, but there is not a swap of dollars immediately when loan goes bad. In CDS, there is an exchange of cash. Whether counterparties fail — I don’t think it will happen. We’ve had enormous collateral payments from one firm to another in this recent crisis. Fairfax Financial made $1bil in CDS. This means another guy lost $1bil. They have been most volatile of instruments – and it really hasn’t created a problem in system. If Fed must step in, I don’t think it will be due to CDS. It may cause big losses, but will be matched by big gains by others. There is a problem of an overnight disruption in the system (bear, nuke bomb) – where discontinuity and collateral postings inadequate. At that time, large CDS exposure could exacerbate chaos to considerable degree.

CM: Could we have mess in CDS? Yes, but stupidity not as bad as sweeping bums off skid row to give them houses. There is an issue of insuring against outcome of losing money on $100mil bond issue, when you have $3bil of contracts on $100m bond issue – there are incentives to manipulate the smaller loss to make big collection on the larger position. It used to be illegal to buy life insurance on people you didn’t know, with big payoffs in event of their death. Why did we want enormous bets to be made in unregulated markets? We have a major nutcase bunch of regulators and proprietors in this field.

WB: Charlie 1 point, Invisible Hand 0 points.

I don’t think the credit default swap market is bad. It serves a real purpose like Munger says, as opposed to his example of using bums to collect insurance. The CDS market helps hedge risk for coporations, and while there is some counter-party risk, I don’t think it is as bad as people make it seem.

Also, I was happy to see Buffett mention Fairfax Financial Limited (FFH).

Q59: Jim James, MN. Will you share your influences on you, your educators?

WB: Biggest educator was father. It is important who you marry. Those are great teachers. Ben Graham. Dave Dodd. I devour books. Charlie likes Ben Franklin. My grandfather at the family grocery store. Most important job you have is to be the teacher to your children. You are the big great thing to them, you don’t get rewind button, you don’t get to do it twice, teach by what you do not what you say. By the time they get formal school they would have learned more from you than school. Provide warmth and food and everything else. It won’t change when they get to graduate school – and you get no rewind button. You teach with what you do, not what you say.

CM: Differing people learn in differing ways. I was put together to learn by reading. If someone is talking to me – it doesn’t work as well. With a book, I can learn what I want at speed that works. It works for my nature. For those people who are like me, welcome, it is a nice fraternity.

WB: Did you learn more from your father? Your father probably had more impact on you before your readings?

CM: Father did have an impact. He always took more than his share of work and risk – that was helpful. Conceptual stuff – I learned from books. Those authors are fathers in a different sense.

WB: If you keep reading books, you’ll learn a lot. If you read 20 books, you can learn a hell of lot. Having right parents is very lucky. If you get the right spouse, that’s just doubled down.

This goes back to my comments that I made earlier regarding Munger and the Latticework of Mental Models. I’ve seen that Buffett reads multiple newspapers every day (The Financial Times, USA Today, Omaha World Herald, and The New York Times)

I think it’s important to understand the existance of biases in the world, again, if you do not you run the risk of having tunnel vision and missing some of the parts of the equation. This is simple, if you read something that has a left-bias, maybe read something with a right-bias as well. Do not limit the perception you have of the world around you, it’s just a dumb thing to do. In an investing environment tunnel vision/acting only on biases can be devastating. It’s important to be open-minded but also confident in yourself so you can make the right decisions and employ concentration.

Q61: Pharma? (How do you valuate the pipeline of drug companies)

WB: Unlike many businesses, when we invest in pharma We don’t know answer on pipeline and it’ll be different pipeline 5 years from now anyway. We don’t know whether Pfizer or Merck etc have better chance, which of those will come out with a blockbuster. But we do feel we have a group of companies bought at a fair price that overall will do well - should offer chances for decent profits. These companies are doing very important things. I could not tell you potential in the pipeline. A group approach makes sense. Not the way we would go at banks. If you buy pharma at reasonable multiple, you will probably do okay 5 – 10 yrs from now.

CM: You now have a monopoly on our joint knowledge of pharmacology.

What is outlined here is to me, a method for investing in industries or countries with uncertainties that are greater than you are used to. Concentration is somewhat sacrficied, but at the same time you are making bets across a wide number of cheap companies.
This is a good way to invest in an area where you want exposure but are unsure of who will be the best to profit from whatever you perceive to be coming. Some may lose, but you’re bound to come out on top if you bought the pool when they were cheap. Buffett has employed this method before in Korea and it worked particularly well. It is specifically noted that Buffett would not employ this with banks, a place where he has more expertise and can leverage that expertise for concentration. But maybe he would feel comfortable using 10% of his capital on a pool of 10 banks, or something similar.

I wasn’t satisfied with a few answers, but they dealt mostly with social issues. On some of these issues, I think it’s important to look at the contrary perspective of things, from the eyes of the people who may have had to endure hardships because of their situations. Contrarian thinking and overcoming bias is a good thing, so you should make an effort to practice it. I think in the end it will help you tremendously.