Seeking Wisdom

by Peter Bevelin

  On how to get worldly wisdom

  I've long believed that a certain system - which almost any intelligent person can learn - works way better than the systems that most people use. As I said at the U.S.C. Business School, what you need is a latticework of mental models in your head. And you hang your actual experience and your vicarious experience (that you get from reading and so forth) on this latticework of powerful models. And, with that system, things gradually get to fit together in a way that enhances cognition.

  And you need the models - not just from one or two disciplines, but from all the important disciplines. You need the best 100 or so models from microeconomics, physiology, psychology particularly, elementary mathematics, hard science and engineering [and so on].

  You don't have to be a huge expert in any of those fields. All you've got to do is take the really big ideas and learn them early and well.

  You can't learn those 100 big ideas you really need the way many students do - where you learn 'em well enough to bang 'em back to the professor and get your grade and then you empty them out as though you were emptying a bathtub so you can take in more water next time. If that's the way you learn the 100 big models you're going to need, [you'll be] an "also ran" in the game of life. You have to learn the models so that they become part of your ever used repertoire. (Lecture by Charles T. Munger to the students of Professor William Lazier at Stanford Law School, Outstanding Investor Digest, December 29, 1997, p.24.)

  On what something really mean

  By its nature, the U.S. is running a substantial merchandise trade deficit. If you buy more

  272

  from the rest of the world than you're selling them - which is what happens by definition when you're running a trade deficit - you have to balance the books. They have to get something - some capital asset - in exchange: They may get a government bond. They may get a piece of a U.S. business. But they have to get something.‌

  The key thing in economics, whenever someone makes an assertion to you, is to always

  ask, "And then what?" Actually, it's not such a bad idea to ask it about everything. But you should always ask, "And then what?"

  So when you read that the merchandise trade deficit is $9 billion, what else does that mean? It means that somehow we must also have traded $9 billion of capital assets - (future) claims on our production - and given them to somebody else in the world. So they have to invest. They don't have any choice. And when somebody says, "Won't it be terrible if the Japanese sell all of their government bonds?" Well, they can't without getting another American asset in exchange. There's simply no other way to do it. They could sell it to the French, but then the French have the same problem.

  So trace through the transactions on the circle whenever you talk about any specific action in economics. (Warren Buffett, Berkshire Hathaway annual meeting, 1997, Outstanding Investor Digest, August 8, 1997, p.23.)

  On 3 timeless ideas for investing

  His [Benjamin Graham] three basic ideas - and none of them are complicated or require any mathematical talent or anything of that sort - are:

  that you should look at stocks as part ownership of a business,

  that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather participating in it, and finally,

  the three most important words in investing are "margin of safety" - ... always building a 15,000 pound bridge if you're going to be driving 10,000 pound truck across it ...

  So I think that it comes down to those ideas - although they sound so simple and commonplace that it kind of seems like a waste to go to school and get a Ph.D. in Economics and have it all come back to that. It's a little like spending eight years in divinity school and having somebody tell you that the ten commandments were all that counted. There is a certain natural tendency to overlook anything that simple and important. (Warren Buffett, speech at New York Society of Security Analysts, December 6, 1994, Outstanding Investor Digest, May 5, 1995, p.3.)

  On how to evaluate businesses

  Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out bya very smart man in about 600 B.C. (though he wasn't smart enough to know it was 600 B.C.).

  The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer

  273

  only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush - and the maximum number of the birds you now possess that should be offered for it. And, of course, don't literally think birds. Think dollars.

  Aesop's investment axiom, thus expanded and converted into dollars, is immutable. It

  applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota - nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe. (Warren Buffett, Berkshire Hathaway Inc., 2000 Annual Report, p.13.)

  On commodity businesses

  Businesses in industries with both substantial over-capacity and a "commodity" product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. These may be escaped, true, if prices or costs are administered in some manner and thereby insulated at least partially from normal market forces. This administration can be carried out (a) legally through government intervention (until recently, this category included pricing for truckers and deposit costs for financial institutions), (b) illegally through collusion, or (c) "extra legally" through OPEC-style foreign cartelization (with tag-along benefits for domestic non cartel operators).

  If, however, costs and prices are determined by full-bore competition, there is more than

  ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.

  Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a "two-ounce candy bar") but doesn't work with sugar (how often do you hear, "I'll have a cup of coffee with cream and C & H sugar, please").

  In many industries, differentiation simply can't be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent. For the great majority of companies selling "commodity" products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.

  Of course, over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.

  What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal. (It seems as if the most

  274

  recent supply-tight period in our textile business - it occurred some years back - lasted the better part of a
morning.)‌

  In some industries, however, capacity-tight conditions can last a long time. Sometimes actual growth in demand will outrun forecasted growth for an extended period. In other cases, adding capacity requires very long lead times because complicated manufacturing facilities must be planned and built. (Warren Buffett, Berkshire Hathaway Inc., Letters to Shareholders, 1982, pp.56-57.)

  On paying cash out or keeping it in the business

  When we have capital around, we have three questions... First, "Does it make more sense to pay it 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 it's 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 a 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.. .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 we 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. (Warren Buffett, Berkshire Hathaway annual meeting, 2001, Outstanding Investor Digest, Year End 2001 Edition, pp.38-39.)

  On how to avoid problems

  We handle negotiations way different than anybody. When we bought See's Candy, I spent an hour there. Every business we've bought on one call. On the Borsheim's deal, I dropped over to Ike Friedman's house for half an hour. He showed me some figures that weren't audited penciled on a piece of paper.

  lfl need a team oflawyers and accountants, it isn't going to be a good deal. We've never

  had an extended negotiation with anybody about anything. That's just not our style. If it's going to be that way, I don't want to deal with them - because it's going to ruin my life sooner or later. So we just walk away. (Warren Buffett, lecture at Stanford Law School, March 23, 1990, Outstanding Investor Digest, April 18, 1990, p.18.)

  275

  Buffett: Some businesses are a lot easier to understand than others. And Charlie and I don't like difficult problems. If something is difficult to figure... We'd rather multiply by 3 than by1t. Munger: That's such an obvious point. Yet so many people think that if they just hire somebody with the appropriate labels, they can do something very difficult. That is one of the most dangerous ideas a human being can have. All kinds of things can create problems by causing complexity. The other day I was dealing with a problem - it was a new building. And I said, "This problem has three things I've learned to fear- an architect, a contractor and a hill." If you go through life like that, I think you'll at least make fewer mistakes than people who think they can do anything, no matter how complex, by just hiring somebody with a credible‌

  label. You don't have to hire out your thinking if you keep it simple...

  Buffett: If you get into some complicated business, you can get a report that's 1,000 pages thick and you can have Ph.D.'s working on it. But it doesn't mean anything. What you'll have is a report. But you won't have any better understanding of that business and what it's going to look like in 10 or 15 years. The big thing to do is to avoid being wrong. (Berkshire Hathaway annual meeting, 1994, Outstanding Investor Digest, June 23, 1994, p.23.)

  On the real risk of investing

  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:

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

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

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

  The purchase price of the business:

  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. (Warren Buffett, Berkshire Hathaway Inc., Letters to Shareholders, 1993, p.135.)

  On the difficulty of developing a fair social system

  Let's just say, Sandy, that it was 24 hours before you were born, and a genie appeared, and said "Sandy, you look like a winner. I have enormous confidence in you, and what I'm going to do is let you set the rules of the society into which you will be born. You can set the economic rules, thesocial rules, and whatever rules you set will apply during your lifetime, and your children's lifetimes."

  And you'll say, "Well, that's nice, but what's the catch?"

  And the genie says, "Here's the catch. You don't know if you're going to be born rich or poor, white or black, male or female, able-bodied or infirm, intelligent or retarded. All you

  276

  know is that you're going to get one ball out of a barrel with, say, 5.8 billion balls in it." You're going to participate in what I call the Ovarian Lottery. And it's the most important thing that will happen to you in your life, but you have no control over it. It's going to determine far more than your grades at school or anything else that happens to you.

  Now, what rules do you want to have? I'm not going to tell you the rules, and nobody will tell you; you have to make them up for yourself. But they will affect how you think about what you do in your will and things of that sort. That's because you're going to want to have a system that turns out great quantities of goods and services, so that your kids can live better than you did, and so that your grandchildren can live better than your kids. You're going to want a system that keeps Bill Gates and Andy Grove and Jack Welch working long, long after they don't need to work. You're going to want the most able people working more than 12 hours a day. So you've got to have a system that incentives them, and that turns out goods.

  But you're also going to want a system that takes care of the bad balls, the ones that aren't lucky. If you have a system that is turning out enough goods and services, you can take care of them. You want a system where people are free of fear to some extent. You don't want people worrying about being sick in their old age, or fearful about going home at night. So you'll try to design something, assuming you have the goods and services to solve that sort of thing. You'll want equaliry of opportunity- a good public school system - to make you feel that every piece of talent out there will get the same shot at contributing. And your tax system will follow from your reasoning on that. And what you do with the money you make is another thing to think about it. As you work through that, everybody comes up with something a little different. I just suggest you play that little game. (Warren Buffett, "Buffett & Gates on Success", KCTS/Seattle, May 1998, transcript p.12.)

  For other issues re
garding investing, business economics and managing, read the annual reports of Berkshire Hathaway Inc. (www.berkshirehathaway.com) and subscribe to Outstanding Investor Digest. (www.oid.com)

  277

  - APPENDIX THREE -‌

  PROBABILITY

  Blaise Pascal and Pierre Fermat developed the fundamental principles of probability in a series ofletters exchanged starting in the year 1654.

  Definitions

  Experiment is the process of obtaining an observation. For example: Toss a coin twice and observe what happens.

  Outcome is the possible result of the experiment. All possible outcomes of the experiment are called the sample space. The experiment of tossing a coin twice results in one of four possible outcomes - Tail/Tail Head/Head, Head/Tail, or Tail/Head.

  Event is a set of outcomes of the experiment. One event would be: Observe at least one head. This event consists of the three outcomes HH, HT, TH A compound event is an event composed of two or more separate events.

  Independent events - two events A and Bare independent if no event can influence the probability of the other. Event A: observe one head when flipping a coin. Event B: observe one tail when flipping another coin. Each flip is independent of the other since whatever happens to the first coin cannot influence the flip of the second or tell us what outcome is likely to happen when we flip the second coin.