Berkshire Hathaway 2003 Annual Meeting Audience Question # 54

Warren and Charlie doesn’t like to buy equities where the real expectancy is below 10 percent

Warren Buffett:

Number 3.

Audience Member:

Good afternoon. I’m Patrick Wolff from Arlington, Virginia.

Charlie, I can’t resist telling you that I’m actually the fellow who plays the chess games blindfolded.

Warren Buffett:


Audience Member:

So, I look forward to not seeing you there tomorrow.

Charlie Munger:


Audience Member:

I actually have a two-part question. I’d like to ask you to elaborate a bit how you think about opportunity costs. And I’m… I think I’m going to be elaborating very much on the very last question that was asked.

First of all, in the annual report you say explicitly that you look for a 10 percent pretax return on equity, in looking at common stocks. And I think you talked earlier about how you built up from that for 5 to 6 percent after-tax return, and then you layer on inflation, and then layer on taxes.

My first question would be, how do you adjust that required rate of return across periods of time? So, for example, when interest rates are higher. And do you look for a different equity premium return over different periods of time?

My second question would be, Warren, you just said that you actually would apply the same discount rate across the stocks.

And I’m sure you know that modern finance actually suggests that you should not do that… that you should be thinking about the timing of cash flows and, in particular, the covariance with the general market.

Now, you’ve made a point of emphasizing that when you think of risk, you think of risk primarily in terms of, will you get the cash flows that you predict you will get over time?

Sort of numerator risk, if you think in terms of discounted cash flow, which I think everyone here will have to acknowledge… your results speak for themselves… has probably been a very effective way of thinking about risk.

But there is a true economic cost to think about the timing of cash flows as well. And it may be a much smaller cost, but it is still a real cost.

I might, for example, suggest you think about somebody deciding between two jobs. The jobs are completely identical and the person expects to make the same amount of money from each job, but there’s one difference. And the difference is one job will pay him more when the economy’s in the tank, and the other job will pay him more when the economy’s going gangbusters.

Now, if he asked you which job was actually worth more, my guess is you would tell him that the one that would pay him more when the economy’s in the tank. And the reason is, if he wanted to make more money by moonlighting or doing something else, it’d be much easier when the economy’s doing better.

That’s the essential logic behind the idea that you look at the covariance of when cash flows come in with the overall market.
It’s a real cost, even though it is difficult to measure, and even if it is a smaller risk than numerator risk, the risk of getting the actual cash flows, since it’s a real cost, I imagine you must think about it.

And so, my second question to you would be how do you think about it? And if you decide not to, why?

Warren Buffett:

Now, first of all, I would like to say, Patrick, we appreciate you coming out, because Patrick… now, I don’t know how many years it’s been, but it’s been a number, has volunteered on Sunday to play.

Now, I think he’s playing six people or so, blindfolded, simultaneously, and after hearing that question you can understand how he does it.

But Patrick, as well as Bob Hamman, and then this year, Peter Morris and Bill Robertie, all come out. And on Sunday they… we’ve got these extraordinary talents out there. And for people who like the various games they play, they devote an afternoon for it and ask nothing in return.

So, I… we really appreciate it, Patrick, and I’ll look forward to seeing if you’re peeking out of your blindfold tomorrow.

The question on opportunity costs and the 10 percent we mention. You know, basically that’s the figure we quit on. And we quit on buying… we don’t want to buy equities where our real expectancy is below 10 percent.

Now, that’s true whether short rates are 6 percent or whether short rates are 1 percent. We just feel that it would get very sloppy to start dipping below that.

And we would add, we feel also, obviously, that we will get opportunities that are at least at that level, and perhaps substantially above.

So, there’s just a point at which we drop out of the game. And it’s arbitrary. There’s no… we have no scientific studies or anything.

But I will bet you that a lot of years in the future we, or you, will be able to find equities that you understand, or we understand, and that have the probability of returns at 10 percent or greater.

Now, once you find a group of equities in that range, and leaving aside the problem of huge sums of money, which we have, then we just buy the most attractive. That usually means the ones we feel the surest about, I mean, as a practical matter.

There’s just some businesses that possess economic characteristics that make their future prospects, far out, far more predictable than others. There’s all kinds of businesses that you just can’t remotely predict what they’ll earn, and you just have to forget about them.

But when we get… so, we have, over time, gotten very partial to the businesses where we think the predictability is high. But we still want a threshold return of 10 percent, which is not that great after-tax, anyway.

Charlie, do you want to comment on that portion of that question first?

Charlie Munger:

Yeah. The… I think in the last analysis, everything we do comes back to opportunity cost. But it, to some extent… in fact, to some considerable extent… we are guessing at our future opportunity cost.

Warren is basically saying that he’s guessing that he’ll have opportunities in due course to put out money at pretty attractive rates of return, and therefore, he’s not going to waste a lot of firepower now at lower returns. But that’s an opportunity cost calculation.

And if interest rates were to more or less permanently settle at 1 percent or something like that, and Warren were to reappraise his notions of future opportunity cost, he would change the numbers.

It’s like Keynes said, “What do you do when you change your view of the facts? Well, you change your conduct.” But so far at least, we have hurdles in our mind which are basically… well, they involve, implicitly, future opportunity cost.

Warren Buffett:

Right now, with our 16 billion that’s getting 1 1/4 percent pretax, that’s $200 million a year. We could very easily buy Governments due in 20 years and get roughly 5 percent. So, we could change that 200 million a year to 800 million a year of income.

And we’re making a decision, as Charlie says, that it’s better to take 200 million for a while, on the theory that we’ll find something that gives us 10 percent or better, than to commit to the 800 million a year and then find that, in a year or thereabouts, when the better opportunities came along, that what we had committed to had a big principal loss in it.

But that’s… you know that’s not… it’s not terribly scientific. But it… all I can tell you is, in practice, it seems to work pretty well. People…

Charlie Munger:

Years ago, when Warren ran a partnership, and to some extent the partnership that I ran was the… operated in the same way… we implicitly did what you’re suggesting, in that part of the partnership funds were in so-called event arbitrage investments.

And those tended to generate returns, occasionally, when the market, generally, was in the tank. And alternative investments would more mimic the general market. So, we were doing what this academic theory prescribes, you know, 40 years ago. And… but we didn’t use the modern lingo.

Warren Buffett:

Yeah, we’ve got some preferences for having a lot of money coming in all the time.

But we do go into insurance transactions with huge volatility, which could mean that a big chunk of money could go out at one time, or in a very short period of time.

And we won’t give up a lot in expectable return for smoothness, but if you give us a choice of having money come in every week and the same present value of money coming in in very lumpy ways that we wouldn’t know about, we would choose the smooth.

But if you give us a choice of a higher present value for the lumpiness, we will take the lumpiness. And that’s usually the choice that’s… I mean that’s usually… we get offered that choice. And other people value smoothness so highly that we do get a spread, in our view, for lumpy returns.

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