WARREN BUFFETT: Let's settle down please and we'll —

We're going to go to — we skipped one last time so we're going to go first to zone 4.

AUDIENCE MEMBER: Hello. My name's Nelson Arata (PH), I'm from Southern California.

And I have a question. It's not really related to intrinsic value or any of that stock stuff, but more on — (laughter) — houses.

I'm still quite young, I don't have a house yet and I'm thinking about buying a house someday soon. And in order to do that I'm going to have to put a down payment, which means I might have to sell my shares.

And I was wondering if you can provide some insight on when is the best time to buy a house and how much down payment — (laughter) — you should be putting down, in relation to interest rates and also in relation to available cash and the stock market.

WARREN BUFFETT: Well, Charlie's going to give you an answer to that in a second. I'll just relay one story, which was when I got married we did have about $10,000 starting off, and I told Susie, I said, "Now, you know, there's two choices, it's up to you. We can either buy a house, which will use up all my capital and clean me out, and it'll be like a carpenter who's had his tools taken away for him. (Laughs)

"Or you can let me work on this and someday, who knows, maybe I'll even buy a little bit larger house than would otherwise be the case."

So she was very understanding on that point. And we waited until 1956. We got married in 1952.

And I decided to buy a house when it was about — when the down payment was about 10 percent or so of my net worth, because I really felt I wanted to use the capital for other purposes. But that was a way different environment in terms of what was available to buy.

In effect, if you have the house you want to buy, you know, I definitely believe in just going out and probably getting the job done. But in effect, you're probably making something in the area of a 7 or 8 percent investment, implicitly, when you do it. So you know, you'll have to figure out your own equation from that.

Charlie probably has better advice on that. He's a big homeowner — (laughter) — in both senses of the word.

CHARLIE MUNGER: I think the time to buy a house is when you need one. (Laughter)

WARREN BUFFETT: And when do you need one?

CHARLIE MUNGER: Well, I have very old-fashioned ideas on that, too. The single people, I don't care if they ever get a house. (Laughter)

WARREN BUFFETT: When do you need one if you're married, Charlie? I'll follow up for the — (Laughter)

You need one when your wife wants one.

CHARLIE MUNGER: Yeah, yes. (Laughter) I think you've got that exactly right. (Laughter)

VOICE: Mr. Buffett?

WARREN BUFFETT: Yeah.

VOICE: May I make an announcement?

WARREN BUFFETT: Sure.

VOICE: Gregory Crawford needs to go to the security office, please, for emergency message. Gregory Crawford to the security office for emergency message. Thank you.

WARREN BUFFETT: OK, hope it isn't a margin call. (Laughter)

WARREN BUFFETT: OK, we'll go to zone 1, please.

AUDIENCE MEMBER: I'm Ralph Bedford (PH) from Phoenix, Arizona.

The question I'm going to ask does not pertain to Berkshire Hathaway, but I would appreciate it if you gentlemen, if you can, explain the justification and rationalization for the exorbitant salaries, bonuses, perks, directors' fees, and other benefits that most public corporations are paying. (Applause)

WARREN BUFFETT: I would say this. In my own view, the most exorbitant are not necessarily the biggest numbers. What really bothers me is when companies pay a lot of money for mediocrity, and that happens all too often.

But we have no quarrel in our subsidiaries, for example, for paying a lot of money for outstanding performance. I mean, we get it back 10 or 20 or 50-for-1.

And similarly in public companies, we think that there have been managers — in our managers — who have taken companies to many, many, many billions of market value more than would've happened with virtually anyone else.

And they sometimes take a lot of money for that. Sometimes, as in the case of Tom Murphy at Cap Cities, you know, it just didn't make a difference to him.

I mean, he performed in a way that would justify — would have justified huge sums, but it wasn't — he would tell you that he had all the money he needed and he just didn't care to take what the market might bear.

But I am bothered by irrational pay systems. And I'm particularly bothered when average managers take really large sums.

I'm bothered when they design, or have designed for them, systems that are very costly to the company — maybe partly to make themselves look good because they want huge options themselves, so they feel if they give options widely throughout the company — so they design a system that is illogical company-wide because they want one that's illogical for them personally.

But large sums, per se, don't bother me. I'm not saying, you know, whether any individual should — might want to take them or not. But I do not mind paying a lot of money for performance.

It's done in athletics, it's done in entertainment, but in business the people who are the .200 hitters and the people who would not attract a crowd as an entertainer have worked it out so that — I mean, the system has evolved in such a way that — many of them take huge sums. And I think that's obscene, but I can tell you, there isn't much you can do about.

The system feeds on itself. And companies do look at other companies' proxy statements, every CEO does. And they say, "Well, if Joe Smith is worth X I have to be worth more." And they tell the directors that, "Certainly you wouldn't be hiring anybody that was below average, so how can you pay me below average?" And the consultants come in and ratchet up the rewards.

And it's not anything that's going to go away. It's like we were talking about campaign finance reform earlier. The people who have their hands on the switch are the beneficiaries of the system. And it's very hard to change the system when the guy whose hand is on the switch is benefitting enormously, and perhaps disproportionately, from that system.

Charlie?

CHARLIE MUNGER: Well yeah, I'd like to report that the original Vanderbilt behaved even better than the people at Berkshire Hathaway. He didn't take any salary at all. He thought it was beneath him as a significant shareholder to take a salary. That ideal, I'm afraid, died with him. (Laughter)

WARREN BUFFETT: Yeah, Charlie and I — our directors are paid $900 a year, but I tell them on an hourly basis they're making a fortune because we don't work them that hard. (Laughter)

But Charlie and I did not think through, when we established that $900 a year, is that they set our salaries, too, so — (Laughter)

We have not followed the standard procedure, which is to load it on the directors, and the directors shall load it on you.

CHARLIE MUNGER: I do think it will have pernicious effects for the country in its entirety as this thing keeps escalating, because I think you're getting a widespread perception that at the very top, corporate salaries in America are too high. And that is not a good thing for a civilization, when the leaders are regarded as not dealing fairly with the institutions that they head.

WARREN BUFFETT: Yeah. If — (Applause)

CHARLIE MUNGER: And as for the corporation consultants who advise on salaries, all I can say is that prostitution would be a step up for them. (Laughter)

WARREN BUFFETT: Put him down as undecided. (Laughter)

WARREN BUFFETT: Zone two, please.

AUDIENCE MEMBER: I'm Dan Blum (PH), from Seattle, Washington via Cambridge, Massachusetts.

I want to ask whether the issuance of Class B stock has achieved the objective which you announced for it, when it was created.

WARREN BUFFETT: Well, I would say this, that considering the alternatives we faced, which was the imminence of unit trusts that would've been promoted with heavy front-end commissions, with substantial annual fees, with bad tax consequences, and with, probably, a misrepresentation of the historical record in such a way that people who really didn't know much about securities would've been enticed in — with that as an alternative I think the B stock was the best thing we could've done, and I feel good about how it's worked out.

I think that, you know, we didn't set out to issue it. We don't like talking anybody into buying our stock. But I don't think in any way that the group we have here is diminished in the least by having a mix of B and A shareholders, as opposed to A only.

The B has worked out as well as possible. I hope that, you know, we haven't enticed anybody in with unreasonable expectations. That's the biggest thing that Charlie and I worry about. And it's hard not to have that happen with the historical record. I know it would've happened in a big way with the unit trust.

So, you know, it's like making the mistake originally of starting with Berkshire, I think. We enjoy things as they come along and we've gotten a good group with the B shareholders, and we're happy with the present situation.

Charlie?

CHARLIE MUNGER: Yeah, we wanted to step hard on what we regarded as a disreputable financial scheme, and that we did. And — (Laughter)

WARREN BUFFETT: And I think the way we sold the B was such as to not — as to attract the kind of people who really did look at it on a long-term basis. We did everything we could to discourage people who thought they were going to make a lot of money in a hurry.

So I think we attracted a whole new group of shareholders who are quite similar in perspective to the shareholder group that we already had, and that was our hope.

WARREN BUFFETT: Zone 3, please?

AUDIENCE MEMBER: My name is Alan Rank from Pittsburgh.

I first want to thank Susan Jacques for returning the cocktail yesterday, and I hope she was rewarded with good sales at Borsheims.

Question is regarding the fact that you don't report details of anything under $750 million, and with the change of the values of small-cap in relation to large-cap, would that be something that Berkshire or individuals might try to look as opportunity with the small-cap premium shrinking, as it has?

WARREN BUFFETT: We don't worry about whether a stock is small-cap or large-cap except to the extent that by now we've gotten to a point where anything below a certain level just is not of interest to us because it can't be material to our results, so —

We never think of opportunities as existing because something is small-cap, or sectors, or all that, you know, what generally gets merchandised.

So our cutoff point is set more or less at the point where we think it's material. That's not as defined by the SEC, we could have a higher limit.

But we think when you get down below 2 percent of assets or thereabouts that the reporting of positions would not affect anybody's calculation of intrinsic value or give them insights about the way we run the business, but it would be more for the people who were looking for things to piggyback on.

And so we will move the cutoff point up as we go along. Because of our size, we will never be in companies that have capitalizations that, you know, of a half a billion or a billion dollars, because we just can't put enough money in it. Occasionally we'll be in one just by accident.

But we're looking at things that we can put $500 million in ourselves, at least. At 500 million, a 5 percent position has a $10 billion market cap.

That limitation has hurt, will hurt, is hurting, our performance to some degree. You would — if Berkshire were exactly 1/100th of its present size in all respects, owning the operating businesses it did but all 1/100th the size, our prospects would be better than they are with the kind of money we have presently.

Charlie?

CHARLIE MUNGER: I've got nothing to add.

WARREN BUFFETT: OK. Zone four, please.

AUDIENCE MEMBER: OK. My name is Tom Conrad (PH), I'm from McLean, Virginia.

I just wanted to first thank you, Mr. Buffett and Mr. Munger, for each year answering our questions. I found myself at 5 a.m. standing outside the door here, and I don't do that for anyone. (Laughter)

And it's a real pleasure to hear your answers. I have two questions.

One is, with Travelers, the company Travelers, and their merger with Citibank, do you have confidence in the management of Sandy Weill?

My second question is, you said it in a few meetings ago that diversification is a protection against ignorance. And it only takes three great companies to be set for an investment lifetime. And I invested in those three companies: Coca-Cola, Gillette, and Disney.

And I went ahead and invested in a fourth company without asking you. I invested in Pfizer. And I just wonder what you think about the pharmaceutical industry, if you feel there's some great companies in that industry. Thank you very much.

WARREN BUFFETT: Yeah. Well, A) we think Sandy Weill is a very, very good manager. Sandy is — I mean, the record is clear. It is not easy to manage in Wall Street, and Sandy has done an excellent job there as well as in other allied, or somewhat allied, fields. So his record is proven.

And he has been (inaudible) ever since buying Commercial Credit from Control Data. He's built a terrific company.

And he built a terrific company in businesses that themselves aren't necessarily so terrific, so it's required real management skill.

WARREN BUFFETT: Pharmaceuticals, we missed. We would not have known how to pick out any single business, but we — single company — within the industry, but we certainly should've recognized — did recognize, didn't do anything about it — that the industry as a whole represented a group that would achieve good returns on equity, and where some sort of a group purchase might've made sense.

We did buy one a while back, but we didn't — it was peanuts. And it would of been — it was within our circle of competence to identify the industry as likely to enjoy very high profits over time. It would not have been within our circle of competence to try and pick a single company.

Charlie?

CHARLIE MUNGER: Yeah, we stupidly blew that one. (Laughter)

WARREN BUFFETT: We'll blow more, too. (Laughter)

WARREN BUFFETT: Zone five.

AUDIENCE MEMBER: Yes, sir. Good afternoon. My name is Matt Lovejoy from Lexington, Kentucky. And gladly, I'm not a consultant. (Laughter)

I have a question, sir, Mr. Buffett, about your operating management style. In my opinion, the mainstream media minimizes the significance of your nonpublic operating investments.

When you consider capital allocation in these companies, do you have the managers submit annual business plans? And if so, do you formally meet with those managers to see how well you can track progress against those plans?

WARREN BUFFETT: Yeah, that's a good question. And the answer is that we may meet with some of them annually, we may meet with others semiannually, but we have no formal system whatsoever, and we will never have a formal system. We don't demand any meetings of any of our managers. We have no operating plan submitted to headquarters.

Some of the companies use operating plans themselves, some of them don't. They are all run by people who have terrific records, and they have different batting styles. And we're not about to tinker with somebody that's batting with .375 just because somebody else holds the bat a little differently or uses a different weight bat, or something of the sort.

So we believe in letting them do, currently and in the future, what has been successful for them in the past.

And different people have very different styles. I've got my own style, you know?

But we have managers that like to talk things over, we have other managers that like to go their own way. And we have managers that have a by-the-book approach which works well, we have other managers who wouldn't dream of that. We have managers that — most managers probably have monthly statements of financials. We have other managers that don't.

And that really isn't a problem. What we want to have is good managers, and there's more than one way to get to, at least, business heaven, and we have a number that have found different ways to get there.

So we have never imposed — we have certain requirements because we're a public company, and SEC requirements, and International Revenue Service coordination.

But we've never imposed anything from the top on any of the operating managements.

We have MBAs running companies, we have people who never saw a business school. And talent is the scarce commodity, and when you find talent and they've got their own way of doing things, we let it — we're delighted to have them do it. More than letting them do it — we want them to do it their way. We don't want to change them.

Charlie?

CHARLIE MUNGER: Yeah, the truth of the matter is that we have decentralized power in the operating businesses to a point just short of total abdication. (Laughter)

And we don't think our system is right for everybody. It has suited us and the kind of people that have joined us. But we don't have criticism for other people, like Emerson Electric or something, who have operating plans, and compare performance quarterly against plan and all that sort of thing. It's just not our style.

WARREN BUFFETT: Yeah, we centralize money and — (laughs) — everything else we decentralize, pretty much, but —

I don't know whether you've met him here, but for example, Al Ueltschi is here. He started FlightSafety in 1951 and he's — I don't know what he'll spend on simulators this year, but it could easily be a hundred million dollars or thereabouts.

And he — if I spent hours with him, I couldn't add 1/100th of 1 percent to his knowledge of how to allocate that money. It would be ridiculous. It'd be a waste of his time and it would be an act of arrogance on my part. And I have no worries about how Al allocates the money. And that's an unusually capital intensive business compared to most of our businesses.

There's some that I get into the details more because I just worked with the person that's running things a long time and we kind of enjoy it.

Ajit and I talk virtually every night about the reinsurance business. You know, I am not improving the quality of his decisions at all, but it's an interesting game and I like hearing about it, and he doesn't mind talking about it, so we talk them over. But that's just a matter of personal chemistry.

And as we add managers, we will adapt to them. We adapt our accounting systems, to a degree, to them. Now, we do have certain requirements that result from the SEC and IRS. But we don't — our managers know their businesses and they know how to run them.

And if they don't — this hasn't been the case — but if they didn't, we would, you know, we'd do something about the manager, we wouldn't try and build a bunch of systems.

WARREN BUFFETT: Zone 6, please.

AUDIENCE MEMBER: Good afternoon, gentlemen. My name is George Donner from Fort Wayne, Indiana.

My question has to do with estimating the intrinsic value of a company, in particular the capital intensive companies like you were mentioning. I'm thinking of things like McDonald's and Walgreens, but there are lots of others where you have a very healthy and growing operating cash flow, but it's marginally or completely offset by heavy expenditures on putting up new stores or restaurants, or building a new plant.

And so my question is, what do you do for your estimate of future free cash flow? And with Treasurys around — long Treasurys around 6 percent — at what rate do you discount those cash flows?

WARREN BUFFETT: Well, we discount at the long rate just to have a standard of measurement across all businesses. But we would take the company that is spending the money as it comes in, and they don't get credit for gross cash flow, they get credit for whatever net cash is left every year.

But of course, if they're spending the money wisely, even though you have to discount it for more years, the growth in cash development should offset that or they weren't investing it wisely.

The best business is one that gives you more and more money every year without putting up anything to get it, or very little. And we've got some businesses like that.

The second-best business is a business that also gives you more and more money. It takes more money, but the rate at which you invest — reinvest — the money to get that growth is a very satisfactory rate.

The worst business of all is the one that grows a lot, and where you're forced — forced, in effect — forced to grow to stay in the game at all, and where you're reinvesting the capital at a very low rate of return. And sometimes people are in those businesses without knowing about it.

But in terms of discounting, in terms of calculating intrinsic value, you look at the cash that is expected to be generated and you discount back at — in our case, we use the long-term Treasury rate. That doesn't mean that you pay the amount that that present value calculation leads to, but it means that you use that as a common yardstick, that Treasury rate.

And that means that if somebody is reinvesting all their cash flow the next five years, they'd better have some very big figures coming in down the road. Because at some day, a financial asset has to give you back cash to justify you laying out cash for it now.

Investing is the art, essentially, of laying out cash now to get a whole lot more cash later on, and something at some point better deliver cash.

Ben Graham in his class, we used to talk about what he called the Frozen Corporation. And the Frozen Corporation was a company whose charter prohibited it from ever paying anything to its owners, or ever being liquidated, or ever being sold and —

CHARLIE MUNGER: Sort of like a Hollywood producer. (Laughter)

WARREN BUFFETT: Yeah. And the question was, what was such an enterprise worth? Well, that's sort of a theoretical question, but it forces you to think about the realities of what business is all about. And business is all about putting out money today to get back more money later on.

Charlie?

CHARLIE MUNGER: I do think there is an interesting problem that you raise, because I think there is a class of businesses where the eventual cash back part of the equation tends to be an illusion. I think there are businesses where you just keep pouring it in and pouring it in, and then all of a sudden it doesn't work, and no cash comes back.

And what makes our life interesting is trying to avoid those and get in the alternative kind that drowns you in cash. (Laughter)

WARREN BUFFETT: The one figure we regard as utter nonsense is the so-called EBITDA. I mean, the idea of looking at a figure before the cash requirements and merely staying in the same place — and there usually are — any business with significant fixed assets almost always has with it a concomitant requirement that major cash be reinvested in order simply to stay in the same place competitively and in terms of unit sales — to look at some figure that is before — that is stated before those cash requirements, is absolute folly and it's been misused by lots of people to sell lots of merchandise in recent years.

CHARLIE MUNGER: It's not to the credit of the investment banking fraternity that it has learned to speak in terms of EBITDA. I mean, the idea of using a measure that you know is nonsense, and then piling additional reasoning on that false assumption, it's not creditable intellectual performance. And then once everybody is talking in terms of nonsense, why, it gets to be standard. (Laughter)

WARREN BUFFETT: Zone 7, please.

AUDIENCE MEMBER: Hi. My name is Brennan Vecchio (PH) and I'm in the Academy of Finance at Northwest High School in Omaha.

Could you explain the criteria you look at when selecting your stocks?

WARREN BUFFETT: Well, we look at — I'm glad you came. I hope there's a large group. I got a note, I think from your teacher, on that. (Applause)

We look at it — the criteria for selecting a stock is really the criteria for looking at a business. We are looking for a business we can understand. That means they sell a product that we think we understand, or we understand the nature of the competition, what could go wrong with it over time.

And then when we find that business we try to figure out whether the economics of it means the earning power over the next five, or 10, or 15 years is likely to be good and getting better or poor and getting worse. But we try to evaluate that future stream.

And then we try to decide whether we're getting in with some people that we feel comfortable being in with.

And then we try to decide what's an appropriate price for what we've seen up to that point.

And as I said last year, what we do is simple but not necessarily easy.

The checklist that is going through our mind is not very complicated. Knowing what you don't know is important, and sometimes that's not easy. And knowing the future is definitely — it's impossible in many cases, in our view, and it's difficult in others. And sometimes it's relatively easy, and we're looking for the ones that are relatively easy.

And then when you get all through you have to find it at a price that's interesting to you, and that's very difficult for us now. Although there have been periods in the past where it's been a total cinch.

And that's what goes through our mind. If you were thinking of buying a service station, or a dry cleaning establishment, or a convenience store in Omaha to invest your life savings in and run as a business, you'd think about the same sort of things.

You'd think about the competitive position and what it would look like five or 10 years from now, and how you were going to run it, and who was going to run it for you, and how much you had to pay.

And that's exactly what we think of when we look at a stock, because the stock is nothing other than a piece of a business.

Charlie?

CHARLIE MUNGER: Yeah. If finance were — when finance is properly taught, it should be taught from cases where the investment decision is easy.

And the one I always cite is the early history of National Cash Register Company, and that was created by a fanatic who bought all the patents, and had the best salesforce, and the best production plants. He was a very intelligent man and passionately dedicated to the cash register business.

And of course, the cash register business was a godsend to retailing when cash registers were invented. So that was the pharmaceuticals of a former age.

If you read an early annual report prepared by Patterson, who was CEO of National Cash Register, an idiot could see that this was a talented fanatic. Very favorably located, and that, therefore, the investment decision was easy.

If I were teaching finance, I would collect a hundred cases like that. And that's the way I would teach the students.

WARREN BUFFETT: We have that annual report. What was that, 1904 or something, Charlie?

But it's really a classic report because Patterson not only tells you why his cash register is worth about 20 times what he's selling for to people, but he also — (laughs) — tells you that you're an idiot if you want to go in competition with him. It's a classic.

CHARLIE MUNGER: It is just a (inaudible). But no intelligent person can read this report and not realize — (laughs) — that this guy can't lose.

WARREN BUFFETT: Area 8, please.

AUDIENCE MEMBER: Good afternoon. My name is Robert Rowland (PH) from London, England.

I've been in Omaha all weekend with my wife on the first leg of my honeymoon, and I've noticed you're quite a buyer of nostalgic assets. Can I ask whether nostalgia is one of your filters? (Buffett laughs)

Are there any assets like that left in the U.S. to buy? And if not, can I suggest you come to the U.K. where all we do is sell them? (Laughter)

WARREN BUFFETT: Well, I don't want to interrupt your honeymoon. (Laughter)

But if you'd send me a list of those companies over there that are long on nostalgia, that might be to our liking. Because Charlie and I tend to operate from sort of a Norman Rockwell frame of mind. And it is true that the kind of companies we like sort of do have a homey, Norman Rockwell, Saturday Evening Post-type character to them there.

They have character. And they're the kind of companies, I think, frequently, that people, when they join them, expect to spend the rest of their lives there rather than look at it as something to stick on their resume.

And there are businesses like that. If you look at the businesses that we've bought in the last three or four years, there is real character to the businesses and to the people that build them.

And that's why the people that build them stay on and feel very strongly about running them correctly, even though they have no financial consequence to themselves whatsoever, so —

If you've got a list of those in England and you still have any strength left after your honeymoon, drop me a line. (Laughter)

WARREN BUFFETT: Zone 9, please.

AUDIENCE MEMBER: Good afternoon. Joshua Andrews (PH) from Omaha Northwest High School, Academy of Finance.

WARREN BUFFETT: Good.

AUDIENCE MEMBER: And on behalf of the Academy of Finance, we want to thank you for the tickets. There's 33 of us in attendance today.

WARREN BUFFETT: Terrific. (Applause)

AUDIENCE MEMBER: We had the opportunity to play a national game, the Investment Challenge. And on the list of the stocks there were BRK A and BRK B. Can you explain what the difference of the two stocks are?

WARREN BUFFETT: Yeah, the difference between the Berkshire A and B is simply that an A can be converted to a B at any time in the ratio of one A into 30 Bs. The B cannot be converted into the A, so it's a one-way street on conversion.

The economic value of the B is exactly 1/30th that of the A. So anytime the A ever gets any money of any kind from dividends, or liquidation, or a merger, or something of the sort, for every $30 that you get on the A you're going to get $1 on the B.

The two differences are that there is less voting power, proportionately, in the B. And the B does not participate in a designated-contributions program that Berkshire runs, simply because that would be very, very hard to administer. And when we issued the B we pointed out those two differences.

The B should never sell for more than 1/30th of the price of the A. When it sells just a tiny bit above that then arbitrage settles in as people buy the A and convert it to B, and sell the B. Occasionally the B may be at a slight discount to the A because it's not convertible the other way.

But I think as a practical matter you can treat the A and B as very equivalent investment choices. There's not enough difference to make it significant.

Charlie?

CHARLIE MUNGER: Nothing further.

WARREN BUFFETT: OK. Area 10, please.

AUDIENCE MEMBER: My name is Sheena Cho (PH) from the Academy of Finance.

What recommendations would you give us as teenagers to prepare for our future and become as successful as you? (Laughter)

WARREN BUFFETT: Well, if you're interested in business, I definitely think you ought to learn all the accounting you can by the time you're in your early 20s. Accounting is the language of business.

Now, that doesn't mean it's a perfect language, so you have to know the limitations of that language, as well as all aspects of it. So I would advise you to learn accounting. And I would advise you to be — in terms of part-time employment or anything else, work at a number of businesses.

There's nothing like seeing how business operates to build your judgment in the future about businesses. You know, when you understand what kind of things are very competitive, and what kind of things are less competitive, and why that works that way, all of that adds to your knowledge.

So I would do a lot of reading. If you're interested in investments, I would — A, I would take the accounting courses.

I'd do a lot of reading about investments and I would get as much business experience. I would talk business with people that are in business to find out what they think makes their operation tick, or where they have problems and why. I just think you just kind of sop it up every place that you can.

And if it turns you on, you'll do well in it. I mean, I think that, you know, certain activities grab different people. But if business is of interest to you, my guess is you'll do well.

And if you understand business you understand investments. Investments are simply business decisions in terms of capital allocation. I wish you well on it.

Charlie?

CHARLIE MUNGER: Yeah, there's also the little matter of underspending your income year after year after year.

WARREN BUFFETT: Which we have mastered. (Laughter)

CHARLIE MUNGER: Yes. That really works if you keep at it.

WARREN BUFFETT: Yeah, I mean, Charlie and I both — Charlie started having children at a rapid rate, so — and he was lawyer when there was not big money in then.

But, I was — any money you save before you get out and start having a family is probably — any dollar — is probably worth $10 later on simply because you can save it.

The time to save is young, and you'll never have a better time to save than really, free formation of a family. Because the expenditures come along then whether you like them or not. So I —

You know, work for yourself first and put the money aside. I was lucky that way, I didn't have to pay for my own college. Probably wouldn't have gone to college if I'd had to pay for it.

But I, you know, I was able to save everything I made in my teens and those dollars got magnified quite a bit.

Whereas the money I — when I started first selling securities, I mean, the money I made then was taken up by family needs to quite an extent. So start saving early. A lot of it's habit anyway, so it's a great habit to have.

WARREN BUFFETT: OK, zone 1, please.

TONI: I'm Toni Ausnit (PH) from New York City, following up on the questioner from London.

In light of the current dearth of investment opportunities, do you see yourselves investing in non-U.S. companies which are well-managed, understandable, and growing?

WARREN BUFFETT: Well, if we find such companies as you describe at a price that's half attractive we're perfectly willing to buy them. So the answer to that is yes.

But we would be looking, to an extent, worldwide irrespective of market conditions in the United States. Now, market valuations in this country tend to be fairly well-matched in most of the major countries. So we don't — there's been a bull market all over the world in a huge way in the bigger markets.

And so unfortunately — I mean, it would of been nice for us if the U.S. market had tripled and other markets had stayed the same, and then we would be very likely to be finding things abroad. We're not finding them abroad, but we're certainly looking for the kind of thing you're talking about.

We are not reluctant to invest abroad.

And our two — well, all three of our largest holdings — American Express, Gillette, and Coke — and we're talking about $25 billion of market value there that we have — all three of those have major businesses abroad. And in the case of Coke and Gillette, it's a majority of their earnings from abroad.

So we're interested and there's better growth opportunities in many areas abroad than here. But we're not finding bargains as we look around the world.

Charlie?

CHARLIE MUNGER: Nothing more.

WARREN BUFFETT: OK. Area two.

AUDIENCE MEMBER: My name is Henry Allen (PH), Mamaroneck, New York.

Question I have is a little delicate, relates to my family and heirs rather than myself, because I'm a couple of decades older than you gentlemen.

You've been very candid about the succession and the estate planning, but how will the recipients of huge grants — charitable grants — get the liquidity they need without — to use the money without unduly driving the stock down?

WARREN BUFFETT: Well, I don't think that supply and demand, in terms of specific — you know, let's just say that 3 percent of Berkshire were to be added to the supply, anyway. I don't think that makes much difference.

What really makes the difference is the prospects of the business.

If my charitable foundation were operative today, it would have to sell — it would have to give away 5 percent of the value of the foundation every year. And if Berkshire paid no dividend, that means it would have to sell 5 percent of the holdings per year.

I don't think that the price of Berkshire would be materially different if there were a seller of — that would be, in this case, 2 percent of Berkshire's capitalization — I don't think it would be materially different.

If it is, it probably should be different. I mean, there should be a reasonable amount of trading that can take place annually without affecting the price of the stock materially or the price of the stock is being propped for sort of unnatural reasons.

So I wouldn't really worry about that. We had one shareholder die about a year, year and a half ago, that had 3/4 of 1 percent of the company, for example. It was sold in, I don't know, six weeks or thereabouts, and they raised, at that time, $250 million or thereabouts from the sale.

I am not worried about that. I'm worried about — I mean, I don't worry — but the key factor is what are the prospects of the businesses? If the businesses are worth money — there are all kinds of companies on the New York Stock Exchange who are perfectly decent businesses where 30 or 40 percent of the stock turns over a year.

And Berkshire's price should not be way different if 10 percent trades a year as opposed to the present 3 percent.

Charlie?

CHARLIE MUNGER: I agree with that. I don't think there'd be any problem at all at the present time if the Buffett Foundation were selling 5 percent of its holdings every year.

WARREN BUFFETT: Could be 500 shares a week or something like that. But if there isn't demand for 500 shares a week of A on a company with our capitalization, then the price probably is artificially wrong at that time.

CHARLIE MUNGER: But I just had lunch with Susie and it doesn't look to me like she's in any imminent danger of mortality. (Laughter)

WARREN BUFFETT: No. Yeah, it will — it will come into play when the survivor of the two of us dies and when the estate gets cleaned up and everything else.

So I think — I certainly hope and I think it's quite a ways away.

CHARLIE MUNGER: You people have more important things to worry about. (Laughter and applause)

WARREN BUFFETT: Zone 3, please.

AUDIENCE MEMBER: My name is Jim Howard (PH). I'm from Syracuse, Indiana.

My question is, does the book "Buffettology" by Mary Buffett present fairly, in all material respects, the calculations you use in evaluating a business for purchase, or did the lady just write a book?

WARREN BUFFETT: Well, it was written by two authors. But I would say that — no, I would say that in a general way, it gets at the investment philosophy.

But I wouldn't say that — it's not the book I would've written, precisely, but I have no quarrel with it, either.

I actually think by reading Berkshire's reports, you should be able to get more — I would think you'd get more of our philosophy than in any other manner.

I think Larry Cunningham, the fellow who held the symposium at the Cardozo School at Yeshiva, did the best job, actually, of sort of reconstructing the various things that have been written at Berkshire into sort of the best-organized presentation of our philosophy. So and he —

CHARLIE MUNGER: And he's selling it right here. It's a very practical —

WARREN BUFFETT: Yeah, he had it at Borsheims — in the mall outside Borsheims yesterday.

And Larry did a very good job. You know, I had nothing to do with it, but I think that that — I really think he's done a first-class job of sort of organizing by topic, I mean, all these things that I've sort of written annually and Charlie's written over time. So that would be — that would probably be my — if I were picking one thing to read, that would probably be the one.

WARREN BUFFETT: OK, zone 4, please.

AUDIENCE MEMBER: My name is Leigh (inaudible). I'm from Los Angeles, California.

And I want to begin by thanking you for having Bob Hamman. It was a stroke of genius. I could shop at Borsheims and my husband was entertained while I did so. (Laughter)

WARREN BUFFETT: Well, Bob is not only the best bridge player around but he is an entertaining guy, too. We —

AUDIENCE MEMBER: He's great.

WARREN BUFFETT: Yeah, he is great. I agree with you.

AUDIENCE MEMBER: My question. You owned Disney once before and sold it. You also owned advertising companies in the '70s, I believe —

WARREN BUFFETT: Right.

AUDIENCE MEMBER: — and you sold them. Could we have some insight into your thinking as to why you sold them?

WARREN BUFFETT: I'm not sure I want to give you any insight into that thinking. (Laughs)

Well, we'll start off with the fact that when I was 11, I bought some Cities Service preferred at 38 and it went to 200, but I sold at 40, so — (laughter) — grabbing my $2 a share of profit.

So I — everything we've ever sold has gone up subsequently, but some of them have gone up more painfully, subsequently, than others.

And certainly the Disney sale in the '60s was a huge mistake. I should have been buying, forget about holding, and —

That's happened many times. I mean, we think that anything we sell should go up subsequently, because we own good businesses and we may sell them because we need money for something else, but we still think they're good businesses, and we think good businesses are going to be worth more over time.

So everything I sold in the past, virtually that I can think of, has gone on to sell at a lot more — for a lot more money. And I would expect that would continue to be the case.

That's not a source of distress. But I must say that selling the Disney was a mistake, and actually the ad agencies had done very well since we sold them, too. Now, maybe some of that money went into Coca-Cola or something else, so I don't worry about that.

I would worry, frankly, if I sold a bunch of things right at the top, because that would indicate that, in effect, I was practicing the bigger fool-type approach to investing, and I don't think that can be practiced successfully over time.

I think the most successful investors, if they sell at all, will be selling things that end up going a lot higher, because it means that they've been buying into good businesses as they've gone along.

Charlie?

CHARLIE MUNGER: Well, I'm glad that the questioner brought this touch of humility, because it is really useful to be reminded of your errors. (Laughter)

And I think we're pretty good at that. I mean, we kind of mentally rub our own noses in our own mistakes. And that is a very good mental habit.

Warren can tell you the exact number of cents per shares that he sold at and compare it with the current price. It actually hurts him. (Laughter)

WARREN BUFFETT: It actually doesn't hurt. (Laughs)

The truth is, you know, because, you know, you just keep on doing things.

But it is instructive to look at — to do postmortems on everything and say — as long as you don't get carried away with it.

But every acquisition decision, that kind of thing, you know, there should be postmortems. Now, most companies don't like to do postmortems on their capital expenditures.

I've been a director of a lot of companies over the years and they've usually not spent a lot of time on the postmortems. They spend a lot of time on telling you how wonderful the acquisitions are going to be, or the capital expenditures, but they don't like to look so hard, necessarily, at the results.

CHARLIE MUNGER: Think of how refreshing a board of directors meeting would be if they sat down, "And now we'll spend three hours examining all our stupid blunders and how much we've blown."

WARREN BUFFETT: And then after that the compensation committee will meet. Now — (laughter) — that's not going to happen. (Laughter)

CHARLIE MUNGER: Right.

WARREN BUFFETT: OK. Area 5, please.

AUDIENCE MEMBER: My name is Keller, Harpel Keller, from Portland, Oregon.

Two questions, one of a personal nature. Obviously there are many, many people here today. And I wonder if one of the true patriarchs of the investment business is here today, Phil Carret —

WARREN BUFFETT: Well, I'll answer —

AUDIENCE MEMBER: Many of his friends and admirers would wish him well.

WARREN BUFFETT: Phil, up till a week ago was going to be here today. Phil is 101, wrote a book on investments in 1924, and I've known Phil for about 46 or '7 years.

And Phil has made all the meetings for a number of years, would be here today, and he broke a hip about five or six days ago. But he sent a message that he will definitely be here next year. (Laughter) And he will be, too. (Applause)

WARREN BUFFETT: Phil is a hero of mine. Go ahead.

AUDIENCE MEMBER: Second question. Has to do with Ben Graham. And he changed his valuation standards as the decades progressed.

When he couldn't buy stocks below a net-net, he changed his standards because the environment changed.

Now, the world today seems to be a much different place than in 1989 when the U.S.S.R. collapsed. Even they are stumbling toward the free enterprise system. The Russian mafia is a perverse illustration of that.

Now there is only one superpower in the world, the U.S.A., and we must be extremely grateful for the men who put us on the track to the free enterprise system.

Now, the free enterprise system is out of the bottle, it's not going to get back in. It seems to be expanding and accelerating around the world. With the resulting expansion of world trade, may that lead to a reevaluation of historical measures for measuring investments?

WARREN BUFFETT: Well, my answer to that would be that I doubt it, but I, you know, I also don't know.

But I don't think that the end of the Cold War is something that I would factor into my evaluation of businesses. There are all kinds of events that happened, and their impact, in terms of being quantified, very difficult to figure over time, very difficult to isolate any single variable in a complex economic equation.

So in terms of how the world was going to work ten years from now, or the returns are going to be on equity in business, you know, I don't know what will be all the variables that impact on that.

And obviously, right now people are very bullish about the fact that those returns — or something like those returns — will continue.

But I don't — I would not rely in making such a projection on the fact that the Cold War has ended or really any political or economic development around the world.

I don't know how to predict future earnings of American business. And when I look at all of the great historic events of the past, nothing there gives me much in the way of a clue as to which ones would signal major changes in profitability of American business.

Charlie?

CHARLIE MUNGER: Well, I think you raise one very interesting question. If the rest of the world becomes very much more prosperous, as it will if it adopts the free enterprise system, which investments are likely to do best?

I would argue that the Cokes and Gillettes and so on are likely to be helped by a great increase in prosperity in what is now the Third World. And I'm not so sure that's true of a lot of other businesses.

WARREN BUFFETT: Yeah, we like the international businesses we have. And as I say, our three top holdings all have a major international aspect to them, and really, in aggregate, a dominant international aspect to them.

And there's no question in my mind that a Coke will grow faster outside of the United States than in the United States, and the same is true of Gillette, maybe the same is true of American Express. So that's built into what we — our evaluation of those businesses.

But I felt that way before 1989, too. I mean, it's very hard to evaluate how the ball is going to bounce, generally, around the world. But it is a plus to have products such as Gillette has or Coke has, that have demonstrated the fact that they travel extraordinarily well around the world, the people crave those products, and that they're going to — no one's going to find a way to do it better than those two companies in their respective fields. And they sell an inexpensive product, so all of that's going for us.

But in terms of how stocks generally sell or the profitability of American business generally is in the future, it doesn't help me much.

Charlie, any more on that?

CHARLIE MUNGER: No more.

WARREN BUFFETT: OK.

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: Hi. My name is Bartley Cohen (PH). I just want to thank you for a great weekend.

And my question is, after you bought Dairy Queen I heard they put Coca-Cola into all the stores, but yesterday when I went to the Nebraska Furniture Mart they said they don't take American Express. And my question is — (crowd noise) — my question is, do you encourage the subsidiaries and the companies that you have stock to use each other's products, or do you leave it up to the management of the subsidiary?

WARREN BUFFETT: Well, that's a good question. And it does tell you something about the Berkshire method of operation.

We tell each subsidiary to run their business in the way that they think is best for their operation. Borsheims takes American Express, See's takes American Express, the Furniture Mart doesn't, for example. But that'll be true in other areas, too.

If Harvey Golub at American Express — who has absolutely done a sensational job for us — if he wants to talk with — or have his representatives talk — with anybody at any of our operations, you know, we're all for that happening.

But we will never tell a subsidiary manager which vendor to patronize or anything of that sort.

Once we start making decisions for our managers in that respect then we become responsible for the operation, and they are no longer responsible for the operation.

They are responsible for their operations, and that means they get to call the decisions. And they should do what is best for their subsidiary, and it's up to any other company that wants to do business with them to prove why that is best for them. That's the Berkshire approach to things.

And I think on balance, our managers like it that way. So they're not getting second-guessed and somebody can't go over their head. I get letters all the time from people who are trying to jump over the heads of our managers, and they want us to say this advertising agency should be used or that, and that sort of thing.

It doesn't work at Berkshire. They deal with the managers of the businesses and they're not going to get around them.

Charlie? (Applause)

CHARLIE MUNGER: I love your answer. It gives Warren lots of time to read annual reports at headquarters. (Laughter)

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: Hello, my name is Steve Errico (PH). I'm from New York.

What do you think is likely to happen with respect to the tobacco settlement, and what do you think should happen?

And secondly, McDonald's and Dairy Queen are similar businesses. Was there a relationship between your acquisition of Dairy Queen and the disposal of McDonald's? Thank you.

WARREN BUFFETT: Yeah, there's no connection in the second case. They have certain similarities, but there's certainly a lot of differences, too.

You know, a Burger King and McDonald's would be much more similar, or a Wendy and McDonald's. But Dairy Queen is much more of a niche and away from that.

The tobacco settlement's interesting, just in terms of watching the dynamics of it. Because one of the things in labor negotiations that's always a problem is that when you — as a manager you have a labor negotiation, at the end of the negotiation you as management are committed, and basically the union isn't, because the union is going to have a vote on it.

And that's just the way it is. I mean, you can't get away from that. But it is not fun to be in a negotiating position where you're bound and the other side is not bound.

And although that wasn't totally contractually necessarily the situation of tobacco area, it smelled like trouble to me for the tobacco companies — whether you feel they should've had that trouble or not — but it smelled like trouble to me when they were bound and you had another side that was not bound in any way, and where there were lots of political considerations, and where there was a lot of time was going to expire.

I mean, that did not smell to me like a deal that would stick.

And I don't know any of the tobacco executives that were involved in that. I don't know how much they agonized over getting in a position where they were bound and the other party wasn't. But I can tell you from labor negotiations that that's not a pleasant place to be, and it's not a great strategic place to be.

Charlie, what do you think of it?

CHARLIE MUNGER: I don't feel I've got any great expertise in this situation.

WARREN BUFFETT: Well, neither did I, but I'm — (Laughter)

WARREN BUFFETT: OK, zone 8, please.

JAIME MCMAHON: Hello, I'm Jaime McMahon (PH) from Birmingham, Alabama.

And I was hoping that, Mr. Buffett and Mr. Munger, y'all would expand a little bit on your ideas of an inheritance, and the positive and negative influences that that can have on your heirs, and what you might be able to do as a businessperson, and an investor, and as a parent to sort of mitigate those negative influences.

WARREN BUFFETT: Yeah, well, I quoted — I think Kay Graham was quoting her father at the time but — some years back as saying, "If you're quite rich, probably the idea of leaving your children enough so they can do anything, but not enough so they can do nothing, is not a bad formula."

I think, if you're talking about people that aren't quite rich, I've seen — you know, socially, I wouldn't have a system that involved inheritances. But recognizing the situation that exists, I think probably at lower levels, that leaving to the children in this society is perfectly OK.

But I believe enough in a meritocracy that if I were devising the system with a consumption tax and everything, I would probably make inheritance a form of consumption that would be very heavily taxed, because I don't believe that because you happen to be the — come out of the right womb, essentially, that you are entitled to live an entirely different life than somebody who wasn't quite as lucky, in terms of womb selection. (Laughter)

But in my own case, you know, I follow the "enough so they can do anything, but not enough so they can do nothing." I think that society showered all these —

I was very lucky, I was wired the right way at the right time in history to do very well in this kind of a market economy. Whereas Bill Gates has told me if I was born some thousands of years ago, I'd been some animal's lunch. (Laughter)

You know, I don't run very fast. (Laughter)

And there are different assets that are useful at different times.

And I'll add, I'm not wired to play championship bridge, or championship chess, or not wired to be a basketball star or anything. It just so happens I'm in an area where it pays off like crazy to be good at capital allocation.

And that doesn't make me a more worthwhile human being than anybody else or anything. It just means I was lucky.

And should that luck, in effect, enable many generations of people that are good at womb selection to do nothing in this world? You know, I would have some reservations about that.

So that's my own feeling on inheritance. But Charlie has a bigger family and he can give you a better answer.

CHARLIE MUNGER: Well, I feel, in a capitalist system, that there should be an inheritance tax, and that once that's been imposed and paid, what each person wants to do in his own testamentary arrangements is up to that person.

I see very few people that I regard as ruined by money. Many of the people that I see ruined who have money would have been ruined without money. (Laughter)

And I think the percentage of the people that are going to be living the life of the French aristocracy before the revolution is always going to be very small.

And there are plenty of grasping people to take the money away from the incompetents who inherit it.

I don't think we have to worry about a whole class of incompetents ruling the world as their money cascades ever higher.

So I like a fair amount of charity, and certainly some testamentary charity is OK. But I feel it's an individual choice that people have to make.

WARREN BUFFETT: They get a choice there.

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: My name is Samuel Wong from Irvine, California. I have two questions.

Question number one, do you think the U.S.A. market is overvalued today?

And question number two, would you buy Berkshire Hathaway stock today, considering the fact that they've had a nice ride up already this year?

And if yes, presuming I have a kid, 20 years old, and he has $150,000 to invest in Berkshire Hathaway, and you won't need the money until five years later, gradually, would you recommend to buy A share or B share, or the combination? Thank you.

WARREN BUFFETT: If you decide to buy Berkshire, I don't think it really makes much difference whether you buy A or B.

But we don't make any recommendations about whether people buy or sell Berkshire. We never have and that's a game we don't want to get into.

In terms of — overvalue — the question whether the market's overvalued, generally, it's simply as we said last year here in the annual report.

It's not — the general market is not overvalued if two conditions are met, which is — in our view — which is that interest rates remain at or near present levels or go lower or — and that corporate profitability in the U.S. stay at the present — or close to the present — levels, which are virtually unprecedented.

Now, those are a couple of big ifs, as we pointed out. A lot of the stories that came out after the annual report would emphasize one aspect or another but it's simply — and they say, "What does he mean by that?" Well, it means exactly what I say. If the two conditions are met, I think it's not overvalued. And if either of the conditions is breached in an important way, I think it will turn out to be overvalued.

And I don't know the answer, which is why I put it in the form that I did.

It's very tough at any given time to look forward and know what level of valuation is justified. You do know when certain dangerous things appear, and certainly if you're predicating your answer that stocks are OK at these prices — if you come to that conclusion — you have to also come to the conclusion, in our view, that corporate earnings, at present levels, are likely to be maintained. And that's a conclusion you would have to come to. I don't think it's obvious that that's the case.

WARREN BUFFETT: Area 10, please.

AUDIENCE MEMBER: Good afternoon. My name's Stanley Harmon (PH) and I'm from Boston.

You say that companies should only spend a dollar on capital expenditures if it will create more than $1 of market value. I'm wondering, how do you determine this?

Is it based on A, historical returns on capital; B, a qualitative judgment of the company's competitive position; C) a quantitative projection of returns on capital; or D, something else?

WARREN BUFFETT: Yeah. Well, it's based on all of those factors you mention and more. But in the end we can say to date every dollar we've retained has been worthwhile, because on balance those dollars have produced more than a dollar of market value.

It's — actually, with a great many companies you can say that now, because things have turned out so well.

But it would be a case — the check on it is, if after three or four years, you've found that the dollars we've retained hasn't created more of that in value, then the presumption becomes very strong at that point that we should start paying out money.

But almost any management that wants to retain money is going to rationalize it by saying, "We're going to do wonderful things with the money we retain." And we think there should be checks on that, which is why in the report, in the ground rules, I suggest making checks on the validity of those projections.

Charlie and I, if you ask us today whether the single dollar we retain from the earnings today, we've got a use for today that will produce more than a dollar of value, the answer is no.

But we do think that based on history, that the prospects are better than 50 percent — well over 50 percent — that in the next few years, we would have an opportunity to do that. But there's no certainty to it.

Charlie?

CHARLIE MUNGER: Nothing more.

WARREN BUFFETT: OK. Area 1, please.

AUDIENCE MEMBER: Good afternoon. My name's Gary Bialis (PH), I'm from Southern California.

I want to thank you again for producing this Owner's Manual that you did a couple of years ago. I find it quite useful and use it quite often.

Two questions: can you tell me if the rule of thumb is still applicable regarding the statement in the Owner's Manual, that the percentage increase in the book value tracks pretty well with the percent increase in intrinsic value?

Or is the fact that you now have more owned businesses, especially ones like GEICO and FlightSafety, mean that the spread between those two has possibly narrowed?

WARREN BUFFETT: Well no, the two have tracked pretty well over the years. I mean, compared to the record of most businesses that are publicly owned, I would say that over the 33 or so year span, our market price has tracked intrinsic value more closely than, you know, 80 or 90 percent of the companies that we view, probably 90 percent.

But that doesn't mean it does it all the time. And there are times when the market price will outpace intrinsic value — the change in intrinsic value — and there are times when, obviously then, that it will lag behind. So it's far from perfect but it's better than most.

Ideally, we would like it to track it perfectly. If we ran this as a private company and we met once a year, and set a price on the stock to have it traded once a year, and Charlie and I were responsible for setting that price, we would try to set a price that was as close to intrinsic value as we could.

And that would be — to the extent that we could do it — it would be a perfect tracking. The market isn't like that, and the market responds to a lot of other things. So it's perfect. It's not getting more perfect, in our view. But we still think that Berkshire tracks it better than most companies.

Charlie, you have —

CHARLIE MUNGER: Nothing to add.

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: I'm Elizabeth Cruz (PH) from New York City. I have a question about Gillette.

Another significant Gillette investor, KKR, recently sold over a billion dollars in Gillette shares, shares that they had acquired through Gillette's acquisition of Duracell.

Knowing that KKR has also been a successful investor, do you see this as a negative signal about Gillette's future prospects, particularly on the eve of the launch of the Mach 3 razor? And what do you think their plans are for the remainder of their shares?

WARREN BUFFETT: Well, I think they may have even publicly stated — I'm pretty sure they have — the Duracell shares from which the Gillette shares came were held by a specific investment fund that was formed in, I don't know what year, but a given year, and which is scheduled to disband at a certain point.

So those shares, whether they were of Duracell or whether they're of Gillette, were scheduled for disposition at some point within a given term. And I think that KKR made the decision — and they've made it with other stocks, too — is to have maybe three or so offerings between now and that terminal date for their partnership.

And why they pick any one of — any given date, you know, is up to them and their advisors.

It means nothing to us. I mean, if they didn't have that kind of a fund and they decided to sell, it wouldn't make any difference to them [us]. And I presume if we made a decision to sell, it wouldn't make any difference in their case.

So we, you know, we form our ideas of valuation independent of anybody else's thinking on it. But in the case of KKR, specifically, they have a termination date on a partnership that owned those shares, and have to dispose of them one way or another between now and the termination date, and probably decided that with the quantity of stock they had, that they were going to have several sales.

The Mach 3 is terrific, incidentally. I've been using it since October. So Henry did not decide to sell that stock based on the Mach 3. (Laughter)

WARREN BUFFETT: Area 3, please.

AUDIENCE MEMBER: I am Gertrude Goodman (PH) from Palm Springs, California.

Mr. Buffett and Mr. Munger, there are many stocks that rise and eventually split. My question is, do you foresee in the near future a split for Berkshire Hathaway Class A?

WARREN BUFFETT: Well, that's an easy one. (Laughter)

No. The answer is no. We have no plans to split the A.

In effect, we let people who want to split the A split it themselves into a B. So that anybody who owns the A can have a 30-for-1 split any morning they wake up and want to have such a split. (Laughter)

Charlie, do you have any additional comment?

CHARLIE MUNGER: No, I think you said "no" perfectly. (Laughter and applause)

WARREN BUFFETT: We don't take that attitude because we're cavalier about how shareholders feel. We really think that in the long range interest of Berkshire that the policy we followed on not splitting has benefitted the company and shareholders.

Nothing dramatic about it, but I think that we have a better class of shareholders, in aggregate, in this room, than we would have if we were selling at $3 a share, or $30 a share, or maybe even $300 a share.

WARREN BUFFETT: Area 4, please.

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. My name is Jack Sutton (PH) from New York City. I have two questions.

The Japanese stock market has been likened to the U.S. market in 1974. With Japanese stocks selling at very low price-to-book values, as compared to U.S. stocks, would it not make sense to invest in a basket of Japanese stocks or an index fund of Japanese stocks?

Question number two: Berkshire Hathaway tends to invest in companies with high margins and high return on common equity. Berkshire's investment in the airline business seems to have digressed widely from those principles.

Could you elaborate on why Berkshire invested in the airline industry, and would Berkshire consider new investments in the industry in the future?

WARREN BUFFETT: I'm going to the first question. The reason that — and I don't know the exact figures — that Japanese stocks would sell at a lower price-book ratio than U.S. stocks is simply because Japanese companies are earning far less on book than American companies.

And earnings are what determine value, not book value. Book value is not a factor we consider. Future earnings are a factor we consider. And as we mentioned earlier this morning, earnings have been poor for a great many Japanese companies.

Now, if you think that the return on equity of Japanese business is going to increase dramatically, then you're going to make a lot of — I mean, and you're correct, you're going to make a lot of money in Japanese stocks.

But the return on equity for Japanese businesses has been quite low, and that makes a low price-to-book ratio very appropriate because earnings are measured against book. And if a company's earning 5 percent on book value, I don't want to buy it at book value if I think it's going to keep earning 5 percent on book value. So a low price-book ratio means nothing to us. It does not intrigue us.

In fact, if anything, we are less likely to look at something that sells at a low relationship to book than something that sells at a high relationship to book, because the chances are we're looking at a poor business in the first case and a good business in the second case.

WARREN BUFFETT: What was the other question on, Charlie?

CHARLIE MUNGER: Buying — airlines.

WARREN BUFFETT: Airlines. Yeah, I always repress everything on airlines. I don't want to — (Laughter)

No, we've never bought an airline common stock that I can remember. So what we did was we lent money to USAir for a 10-year period and we had a conversion privilege there.

It looked like it — it was a terrible mistake. I made the mistake. But we got bailed out. But we — we never made the determination — when we bought our stock, USAir was selling at $50 a share or thereabouts, the common. And we didn't have an interest in buying USAir at 50, or 40, or 30, or 20. And we got a chance to as things went along — (laughter) — all the way down to 4. (Laughter)

And we never bought it. And we've never bought American, or United, or Delta, or any other airline. It is not a business that intrigues us.

We did think it was intriguing to lend money to them with a conversion privilege and it's worked out now because we got lucky, and because Steve Wolf came along and really rescued the company from right at the brink of bankruptcy.

But we're unlikely to be in airlines, although again, we wouldn't mind lending money to a lot of businesses that we wouldn't buy common equity in. I mean, that could happen again in various industries, including the airline industry.

Charlie, do you have anything to say on either the airlines or the Japanese market?

CHARLIE MUNGER: Well, the airline experience was very unpleasant for us. The net worth just melted. It was (inaudible) a billion and a half, and it just went a hundred million, a hundred million, a hundred million, and finally the cash is running down. It is a very unpleasant experience. (Laughter)

We try and learn from those experiences but we're very slow learners. (Laughter)

WARREN BUFFETT: Japanese market (inaudible)?

CHARLIE MUNGER: Oh, the Japanese market.

I suppose anything — (Laughter as Buffett reaches for box of candy)

I suppose anything could happen. After all, we bought silver. (Laughter)

But we have never made a big sector play on a country. In fact, we've almost never made a big sector play.

WARREN BUFFETT: We would have to come to the conclusion that Japanese business, instead of earning whatever it's earning on equity now, is going to earn appreciably more on equity.

I've got no basis for it — I wouldn't argue if anybody else feels that way — I wouldn't argue with them. But I have no basis for coming to that conclusion.

And unless you come to that conclusion, you're not going to make good returns. I mean, unless that happens, you're not going to make good returns from Japanese stocks.

You can not — you can't earn a lot of money from businesses that are earning 5 percent on — or 6 percent — on equity. And I look at the reports but I don't see the earning power now.

Now, maybe it'll all change. I mean, there's talk of — there's already been a small temporary tax cut, but corporate tax rates are quite high, as you know, in Japan.

And they used to be 52 percent here in the United States, now they're 35. So you could have things happen that increase corporate profits, but I don't have any special insight into that that anyone that reads the press generally would not have.

CHARLIE MUNGER: There are also readings in corporate culture that have to be made. Owning stock in a corporation where you know that if shareholders or somebody else has to suffer, the choice is likely to be that somebody else will be chosen.

That is a different kind of a company to invest in than one that thinks that the principal purpose of life is to keep some steam boiler company going in a particular community or something, no matter how much the shareholders suffer.

I think it's hard to judge corporate culture in the foreign countries as well as we can judge it in our own.

WARREN BUFFETT: Area five?

AUDIENCE MEMBER: Yvonne Edmonds (PH) from Cedar Mountain, North Carolina.

I have a specific question but not a trivial one. You regularly compare Berkshire Hathaway's performance to the S&P 500, which is very helpful and very interesting.

But I haven't seen a correlation coefficient between the S&P 500 daily — from day-to-day — performance — to close, say — and Berkshire Hathaway's close.

Now, it so happens for me — and I'm sure some other people in the audience — that I don't always have access to newspapers — or the internet, for that matter — newspapers that publish Berkshire Hathaway performance on a daily basis, or even a weekly basis for that matter, or a monthly basis.

It would be very helpful to know the extent of a correlation coefficient between those two variables. If you have that, would you let us know what it is? And if you don't, would you please consider calculating it in the future?

WARREN BUFFETT: Well, it could be calculated but I don't think it would have much meaning. I mean, it would be an historical correlation coefficient which, you know, I would be very reluctant to have people place any weight in.

I try to indicate even the limitations of the yearly comparison of the relative performance, because what was doable by us in the past is not doable today. I mentioned in my annual report, the best decade I ever had on comparative performance by far was the 50s.

Now, I don't think it was because I was a lot smarter then — (laughs) — unwilling to accept that.

But you know, I had some edge of — well, it's probably 40-plus points per year. But I was working with it — that has no relevance to today whatsoever. It would be misleading to publish it or make calculations based on it.

So I think that you would find — I don't know what you'd find on a specific correlation between Berkshire and the S&P.

You'd find a lot of correlation — well, you might not find so much — you'd find it in intrinsic value between that and Coke, and a few stocks like that.

But I don't really think that's particularly useful information going forward. We have no objection, anybody wants to make the calculation. But it wouldn't be something that would be of any utility to us, and if we don't think it's utility to us, we don't want to put it out for shareholders as being of possible utility.

We do think that the S&P annual calculation has some meaning because it's an alternative for people to invest. They don't need us to buy the S&P. So unless, over time, we have some advantage over that, you know, what are we contributing? What value is added by our management?

So we think that that's — people should hold us accountable even though we would prefer not to be. Because it is a tough comparison for us as a tax-paying entity against a non — pre-tax calculation on the S&P.

But we don't pay any attention 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. And that's what we're focusing on all the time, and any kind of market movements or anything don't mean anything.

I don't know what Berkshire is selling for today and it really makes no difference. You know, it just doesn't make any difference.

What does count is where it is 10 years from now. And I can't tell you what it was selling for on May 4th, 1983, or May 4th, 1986, so I don't care what it sells for on May 4th, 1998.

I do care, you know, where it is, in general, 10 years from now, and that's where all the focus is.

Charlie?

CHARLIE MUNGER: Yeah, we're publishing data in the form where we would like it if we were the passive shareholder. And so you're getting the data and you're getting it on a time schedule based on what we would want if we were in your position. And we don't think — (laughter as Buffett holds up a Dairy Queen Dilly Bar that was just given to him) — and we don't think the correlation coefficients would help us.

WARREN BUFFETT: We don't think anything that relates either to volume, price action, relative strength, any of that sort of thing — and bear in mind, when I was in my teens I used to eat that stuff up. I mean, I was making calculations based on it all the time, and kept charts on it, even wrote an article or two on it.

But it just — it just has no place in the operation now.

CHARLIE MUNGER: One of the pleasant things about dealing with Warren all these years is he's never talked about a correlation coefficient. (Laughter)

If the correlation isn't so extreme you can see it with the naked eye, he doesn't compute it. (Laughter)

WARREN BUFFETT: OK, we're going to go to zone 6 and I'm going to have a Dilly Bar, and Charlie has got one here, too. (Laughter and applause)

These are terrific.

AUDIENCE MEMBER: My question has to do with what you mentioned earlier about how companies have to reinvest a certain amount of cash in their business every year just to stay in place.

And if one could say that the best businesses are the ones that not only throw off lots of cash, but can reinvest it in more capacity. But I suppose the paradox is that the better a company's opportunities for making expansionary capital expenditures, the worse they appear to be as consumers of cash rather than generators of cash.

What specific techniques have you used to figure out the maintenance capital expenditures that you need to do in order to figure out how much cash a company is throwing off? What techniques have you used on Gillette or other companies that you've studied?

WARREN BUFFETT: Well, if you look at a company such as Gillette or Coke, you won't find great differences between their depreciation — forget about amortization for the moment — but depreciation and sort of the required capital expenditures.

If we got into a hyperinflationary period or — I mean, you can find — you can set up cases where that wouldn't be true.

But by and large, the depreciation charge is not inappropriate in most companies to use as a proxy for required capital expenditures. Which is why we think that reported earnings plus amortization of intangibles usually gives a pretty good indication of earning power, and —

I don't — I've never given a thought to whether Gillette needs to spend a hundred million dollars more, a hundred million dollars less, than depreciation in order to maintain its competitive position. But I would guess the range is even considerably less than that versus its recorded depreciation.

Businesses you have to worry about — I mean, an airline business is a good case. In the airlines, you know, you just have to keep spending money like crazy. And you have to spend money like crazy if it's attractive to spend money, and you have to spend it the same way if it's unattractive. You just — it's part of the game.

Even in our textile business, to stay competitive we would've needed to spend substantial money without any necessary — any clear prospects of making any money when we got through spending it.

And those are real traps, those kind of businesses. And they make out one way or another, but they're dangerous. And in a See's Candy we would love to be able to spend 10 million, 100 million, $500 million and get anything like the returns we've gotten in the past.

But there aren't good ways to do it, unfortunately. We'll keep looking, but it's not a business where capital produces the profits.

At FlightSafety, capital produces the profits. You need more simulators as you go along, and more pilots are to be trained, and so capital is required to produce profits. But it's just not the case at See's.

And at Coca-Cola, particularly when new markets come along, you know, the Chinas of the world or East Germany or something of the sort, the Coca-Cola Company itself would frequently make the investments needed to build up the bottling infrastructure to rapidly capitalize on those markets, the old Soviet Union.

So those are — those are expenditures — you don't even make the calculation on them, you just know you've have to do it. You got a wonderful business, and you want to have it spread worldwide, and you want to capitalize on it to its fullest.

And you can make a return on investment calculation, but as far as I'm concerned it's a waste of time because you're going to do it anyway, and you know you want to dominate those markets over time. And eventually, you'll probably fold those investments into other bottling systems as the market gets developed. But you don't want to wait for conventional bottlers to do it, you want to be there.

One of the ironies, incidentally — and might get a kick out of it, some of the older members of the audience — that when the Berlin Wall went down and Coke was there that day with Coca-Cola for East Germany, that Coke came from the bottling plant at Dunkirk. So there was a certain poetic — (crowd noise) — irony there.

Charlie, do you have anything on this?

CHARLIE MUNGER: I've heard Warren say since very early in his life that the difference between a good business and a bad business is usually the good business just throws up one easy decision after another, whereas the bad business gives you a horrible choice where the decision is hard to make and, is this really going to work? And is it worth the money?

If you want a system for determining which is a good business and which is a bad business, just see which one is throwing the management bloopers time after time after time.

Easy decisions. It's not very hard for us to decide to open a new See's store in a new shopping center in California that's obviously going to succeed. It's a blooper.

On the other hand, there are plenty of businesses where the decisions that come across your desk are just awful. And those businesses, by and large, don't work very well.

WARREN BUFFETT: I've been on the board of Coke now for 10 years, and we've had project after project come up, and there's always an ROI. But it doesn't really make much difference to me, because in the end almost any decision you make that solidifies and extends the dominance of Coke around the world in an industry that's growing by a significant percentage, and which has great inherent underlying profitability, the decisions are going to be right and you've got people there that will execute them well.

CHARLIE MUNGER: You're saying you get blooper after blooper.

WARREN BUFFETT: Yeah. And then Charlie and I sat on USAir, and the decisions would come along, and it would be a question of, you know, do you buy the Eastern Shuttle, or whatever it may be?

And you're running out of money. And yet to play the game and to keep the traffic flow with connecting passengers, I mean, you just have to continually make these decisions — whether you spend a hundred million dollars more on some airport.

And they're agony because, again, you don't have any real choice, but you also don't have any real conviction that it's going to translate — those choices are going to — or lack of choices — are going to translate themselves into real money later on.

So one game is just forcing you to push more money in to the table with no idea of what kind of a hand you hold, and the other one you get a chance to push more money in, knowing that you've got a winning hand all the way.

Charlie? Why'd we buy USAir? (Laughter)

Could've bought more Coke.

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: My name is Bakul Patel (PH). I am from upstate New York.

And my question is, is Berkshire prepared for 1929 style of depression or, like, a prolonged bear market that exists in Japan? And would it be as successful in those situations?

WARREN BUFFETT: Well, we are probably — we don't expect what you're talking about, but we are probably about as well-prepared as any company can be for adversity, because Berkshire has been built to last.

Net, we would benefit over a 20-year period by having some periods of terrible markets periodically in that 20-year period. That doesn't mean we're wishing for them and it doesn't mean they're going to happen, but —

We make our money by allocating capital well, and the lower the general stock market would be, the better we can allocate capital. So we're well-prepared but we're not necessarily expecting.

Charlie?

CHARLIE MUNGER: Yeah, we are not going to ever sell everything and go to cash and wait for the crash so we can go back in.

On the other hand, we are structured so that I think, net, a lot of turmoil in the next 20 years will help us, not hurt us. I don't mean it'll be pleasant to go through the downcycle, but it's part of the game.

WARREN BUFFETT: Area 8.

AUDIENCE MEMBER: My name is Pete Banner (PH) from Boulder, Colorado. First of all, Mr. Buffett and Mr. Munger, thank you for your genuine generosity today.

Berkshire closed yesterday, the A share was about — or Friday — $69,000 and the B share was about $2,300. Do you feel that price is grossly overpriced, or grossly underpriced, or reasonably priced?

WARREN BUFFETT: Well, I'll let Charlie answer that one. (Laughter)

CHARLIE MUNGER: I'm not going to say. (Laughter)

WARREN BUFFETT: No, we're just never going to — we're never going to give out advice on Berkshire stock. There's no —

You know, that is up to people who want to buy and sell it, and anything we would say could easily get magnified, and people would be acting on it months later, and who knows all the problems that it could produce, so —

CHARLIE MUNGER: It would be quite eccentric if we were to every day put out an announcement, "Now's the time to buy, now's the time to sell," our own stock.

Eccentric we are, but that eccentric we aren't. (Laughter and applause)

WARREN BUFFETT: Area 9.

AUDIENCE MEMBER: Irene Finster, your longtime partner from Tulsa, Oklahoma —

WARREN BUFFETT: Hi, Irene. Yeah, Irene has a soda fountain. You ought to go visit her. (Laughter)

AUDIENCE MEMBER: First I want to thank you for giving your shareholders the opportunity to select their own charities.

And second, I'm very concerned about your health due to your diet — (Laughter) — of red meat —

WARREN BUFFETT: Irene. (Applause)

Irene, these are our products that I'm eating. (Laughter)

AUDIENCE MEMBER: Red meat, candy, ice cream — (laughter) — and —

WARREN BUFFETT: And that's just what I do — that's what I do in public —

AUDIENCE MEMBER: —and Coke. (Laughter)

And I want to know what your doctor says. (Laughter)

WARREN BUFFETT: My doctor says I must be heavily relying on my genes. (Laughter)

No, I will tell you, I — I mean, Charlie and I are both very healthful. If you were in the life insurance business, you would be happy to write us at standard rates, I could assure you of that. (Laughter)

CHARLIE MUNGER: You know, they asked George Burns when he was 95, "What does your doctor say about smoking these big, black cigars?" And he said, "My doctor's dead." (Laughter and applause)

WARREN BUFFETT: Charlie and I played bridge with George when he was about 97, I'd say, at the Hillcrest Country Club. And there was a big sign behind him that said, "No smoking by anyone under 95." (Laughter)

And actually, at his 95th birthday party, he had about five very good-looking young girls that were there to greet him with a big cake and everything. And he looked them over one after another and he said, "Oh girls," he said, "I'm 95. One of you is going to have to come back tomorrow." (Laughter and applause)

We're very big on George Burns in recent years. (Laughter)

WARREN BUFFETT: Area 10.

AUDIENCE MEMBER: My name is Hubert Vose (PH). I'm from Santa Barbara, California.

Earlier this morning, you made a comment that if the market fell you would be spending less time on the internet because you'd be very busy. And this is reinforced an impression I have had that the cash flows of Berkshire Hathaway are enormous, but that possibly in the last 12 months you've been investing less than you had previously.

And if so — if this is correct, what does that say about waiting for attractive values? How long are you willing to wait, and what does that say to the investment public in their own habits?

WARREN BUFFETT: Well, you're correct that we have not found anything to speak of in equities in a good many months, and —

The question of how long we wait, we wait indefinitely. We are not going to buy anything just to buy something. We will only buy something if we think we're getting something attractive.

And that — and incidentally, if things were 5 percent cheaper that — or 10 percent cheaper — that wouldn't change anything materially.

So we have no idea when that period ends. We have no idea whether — as I've said, it can turn out that these valuations are perfectly appropriate if returns on equity stay where they are. But even then, they aren't in the least mouthwatering, so we won't feel we've missed anything particularly if returns stay where they are.

Because if it turns out that these levels are OK, they still will not produce great returns from here, in our view. That doesn't mean you couldn't have a tremendous market in the short-term or something of the sort.

Markets can do anything. And you look at the history of markets and you just see everything under the sun.

But we will not — you know — we have no timeframe. If the money piles up, the money piles up. And when we see something that makes sense, we're willing to act very fast, very big. But we're not willing to act on anything that doesn't check out in our view.

There's no — you don't get paid for activity, you only get paid for being right.

Charlie?

CHARLIE MUNGER: Yeah. An occasional dull stretch for new buying, this is no great tragedy in an investment lifetime.

Other things may be possible in such an era, too. I mean, it isn't like we have a quiver with only one arrow.

WARREN BUFFETT: We sat through periods before. I mean, the most dramatic one being the early '70s — late '60s and early '70s.

For a long time it seemed — doesn't seem so long when you look back on it, seems long when you're going through it — but it — like having a tooth pulled or something, but it's, you know, what can you do about it?

The businesses aren't going to perform better in the future just because you got antsy and decided you had to buy something. We will wait till we find something we like.

We'll love it when we can swing in a big way, though. That's our style.

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: Larry Pekowski (PH), Millburn, New Jersey.

Berkshire seems never to have made any real, pure real estate investments, not counting facilities the operating companies might own, with the exception of Wesco's involvement in the residential project in California.

I was wondering if you've ever looked at a real estate transaction and tried to apply the same filters, meaning competitive advantages, returns on capital, that you do in operating companies.

And if not, is it a circle of competence issue, or is there something you find disinteresting about real estate?

CHARLIE MUNGER: (Inaudible)

WARREN BUFFETT: You want to take it? OK, Charlie wants to take this one.

CHARLIE MUNGER: Let me take this one, because here's an area where we have a perfect record that extends over many decades.

We have been demonstrably foolish in almost every operation that had to do with real estate we've ever touched.

Every time we had a surplus plant and didn't want to hit the bid and let some developer kind of take an unfair advantage of us, we would of been better off later if we'd hit the bid and invested the money in fields where we had the expertise.

That housing tract that I developed because I didn't want to let the zoning authorities rob me the way they wanted to. I wish I had let them. (Laughter)

We have a certified record of failure in this deal. (Laughter)

WARREN BUFFETT: And the funny thing is, we understand real estate. (Laughter)

CHARLIE MUNGER: And we're good at it. (Laughter and applause)

Right.

WARREN BUFFETT: Actually, (inaudible), we do understand real estate. And Charlie got his start in real estate.

CHARLIE MUNGER: Yeah, be we understand other things better. And so the chances that we're going to be big in real estate are low.

WARREN BUFFETT: Yeah. We've seen lots of things, and we've — the prices, you know, just don't intrigue us, in terms of what we get for our money.

I tried to buy a town when I was, what, 21 years old. The U.S. government had a town in Ohio for sale and it would of worked out very well. I'm always — there's nothing about the arena that turns us off, but we don't see great returns available.

And like Charlie says, the few things — (inaudible) old plant or something, that is not — we have not been great at working our way out of those.

Fortunately, they haven't been very important in relation to the net worth of Berkshire.

WARREN BUFFETT: Area 2.

AUDIENCE MEMBER: Good afternoon. My name is Fred Costano (PH) from Detroit, Michigan. My question concerns Nike.

Nike is a company experiencing some short-term problems, but it's a great company with an excellent track record. Phil Knight is similar to Bill Gates in the respect that he's a marketing genius and is a very hard worker. Making sneakers is a very simple business with high margins.

How do you view Nike and what do you think of the company?

WARREN BUFFETT: Well, I think Phil Knight is a terrific operator. I think — and he's a competitor. He's got a lot of money in Nike.

But as terms of what we think of the stock, you know, we keep all of those views to ourselves pretty much.

WARREN BUFFETT: Area 3? (Laughter)

AUDIENCE MEMBER: Hello, my name is Ed Clinton and I'm from Chicago, Illinois.

I'm wondering about the tobacco litigation. There's also — there have been some comments about fatty food.

Do you think there's going to be a new trend of fatty food litigation coming out of the tobacco problems?

WARREN BUFFETT: Well, I sign a waiver before I — (laughs) — do any of that myself.

No, I would doubt — I would — I do not see those two as being remotely similar.

But Charlie, do you have any different views on it?

CHARLIE MUNGER: Well, I think the traditional tort system is particularly ill-suited for solving what might be called the tobacco health problem. So I regard that whole thing as sort of a Mad Hatter's Tea-Party. And we sit out from afar.

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Yes, I'm Fred Bunch from near Tightwad, Missouri.

In light of the current —

WARREN BUFFETT: What was the name of that town? (Laughter)

AUDIENCE MEMBER: Tightwad, Missouri.

WARREN BUFFETT: Tightwad, Missouri, huh? (Laughter)

AUDIENCE MEMBER: There's a bank there.

WARREN BUFFETT: Did they name it after me or Charlie? (Laughter)

AUDIENCE MEMBER: Well, either one, really. (Buffett laughs)

You'd both fit in. (Buffett laughs)

In light of today's healthy growth and stability of the American economy at the present time and over the last five years or so, how much credit, if any, do you give the Clinton administration and why?

WARREN BUFFETT: Well, I give credit to — I give credit going back to Volcker, significant credit to Volcker.

I give credit to Reagan. I give credit to — certainly to Greenspan and to Rubin, and I give credit to Clinton on that — I think that first tax bill was very important. It carried by one vote. And I think he may listen to Rubin.

So I think there's a lot to give credit for and I think you can spread it around a fair amount.

Charlie may be less charitable here. Let's see. (Laughter)

CHARLIE MUNGER: No, I've got no great quarrel with the way the country — the economy's reformed. I think it's way better than any of us would've predicted.

WARREN BUFFETT: Area 5?

AUDIENCE MEMBER: My name is Travis Heath (PH). I'm from Dallas, Texas.

And my question regards what Phil Fisher referred to as "scuttlebutt." When you've identified a business that you consider to warrant further investigation — more intense investigation — how much time do you spend commonly, both in terms of total hours and in terms of the span in weeks or months that you perform that investigation over?

WARREN BUFFETT: Well, the answer to that question is that now I spend practically none because I've done it in the past. And the one advantage of allocating capital is that an awful lot of what you do is cumulative in nature, so that you do get continuing benefits out of things that you'd done earlier.

So by now, I'm probably fairly familiar with most of the businesses that might qualify for investment at Berkshire.

But when I started out, and for a long time I used to do a lot of what Phil Fisher described — I followed his scuttlebutt method. And I don't think you can do too much of it.

Now, the general premise of why you're interested in something should be 80 percent of it or thereabouts. I mean, you don't want to be chasing down every idea that way, so you should have a strong presumption.

You should be like a basketball coach who runs into a seven-footer on the street. I mean, you're interested to start with; now you have to find out if you can keep him in school, if he's coordinated, and all that sort of thing. That's the scuttlebutt aspect of it.

But I believe that as you're acquiring knowledge about industries in general, companies specifically, that there really isn't anything like first doing some reading about them, and then getting out and talking to competitors, and customers, and suppliers, and ex-employees, and current employees, and whatever it may be.

And you will learn a lot. But it should be the last 20 percent or 10 percent. I mean, you don't want to get too impressed by that, because you really want to start with a business where you think the economics are good, where they look like seven-footers, and then you want to go out with a scuttlebutt approach to possibly reject your original hypothesis.

Or maybe, if you confirm it, maybe do it even more strongly. I did that with American Express back in the '60s and essentially the scuttlebutt approach so reinforced my feeling about it that I kept buying more and more and more as I went along.

And if you talk to a bunch of people on an industry and you ask them what competitor they fear the most, and why they fear them, and all of that sort of thing. You know, who would they use the silver bullet of Andy Grove's on and so on, you're going to learn a lot about it.

You'll probably know more about the industry than most of the people in it when you get through, because you'll bring an independent perspective to it, and you'll be listening to everything everyone says rather than coming in with these preconceived notions and just sort of listening to your own truths after a while.

I advise it. I don't really do it much anymore. I do it a little bit, and I talked in the annual report about how when we made the decision on keeping the American Express when we exchanged our Percs for common stock in 1994, I was using the scuttlebutt approach when I talked to Frank Olson.

I couldn't have talked to a better guy than Frank Olson. Frank Olson, running Hertz Corporation, lots of experience at United Airlines, and a consumer marketing guy by nature. I mean, he understands business. And when I asked him how strong the American Express card was and what were the strengths and the weaknesses of it, and who was coming along after it, and so on, I mean, he could give me an answer in five minutes that would be better than I could accomplish in hours and hours and hours or weeks of roaming around and doing other things.

So you can learn from people. And Frank was a user of it. I mean, Frank was paying X percent to American Express for his Hertz cars. And Frank doesn't like to pay out money, so why was he paying that? And if he was paying more than he was paying on Master Charge or Visa, why was he paying more? And then what could he do about it?

I mean, you just keep asking questions. And I guess Davy [Lorimer Davidson] explained that in that video we had ahead of time. I'm very grateful to him for doing that, because that was a real effort for him.

But that was really what I was doing back in 1951 when I visited him down in Washington, because I was trying to figure out why people would insure with GEICO rather than with the companies that they were already insuring with, and how permanent that advantage was.

You know, what other things could you do with that advantage? And you know, there were just a lot of questions I wanted to ask him, and he was terrific in giving me the answer. It, you know, changed my life in a major way. So I have nobody to thank but Davy on that.

But that's the scuttlebutt method and I do advise it.

Charlie?

CHARLIE MUNGER: Nothing to add.

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: Hi, my name is Richard Lontok (PH) from Toronto, Canada. I have a question for both of you.

Mr. Buffett, Berkshire Hathaway's earnings in 1997 is less than that of 1996. What do you intend to do in 1998 to improve that earning. (Laughter)

And Mr. Munger, I've been watching you and Mr. Buffett eating the See's candies and drinking the Coca-Cola the whole day.

WARREN BUFFETT: Join in. (Laughter)

AUDIENCE MEMBER: Do you intend to do any commercials in the future like what Dave Thomas does with Wendy's? (Laughter and applause)

WARREN BUFFETT: Which of us do you think should do them? (Laughs)

Now you're talking.

CHARLIE MUNGER: We aren't old enough to be really good in a commercial. (Laughter)

What we would like to do is have somebody up here happily eating See's candy and answering these questions who's about 110 years old. Now, that would really be helpful.

WARREN BUFFETT: We — in terms of the earnings, the final bottom line GAAP reported earnings mean absolutely nothing at Berkshire to us.

Now, the look-through earnings which we publish do have some meaning, but even those have to be interpreted in terms of whether there was a super-cat occurrence, or whether GEICO had an unusually good year, and we try to mention those factors.

But we do hope that the look-through earnings do build at a reasonable clip over time.

But our final earnings include capital gains and we can report those in any number that we wanted to, and we pay no attention whatsoever to realized capital gains at Berkshire.

The IRS does, but — and that's why we may send them a billion or more dollars this year. But they mean nothing in terms of measuring our progress.

The look-through earnings say something about it. That table, the first couple of pages, it shows our change in book value versus the S&P says something about it, not perfect.

The real test is the gain in intrinsic value, for sure, over time. And there's no hard number for that, but so far Charlie and I judge it satisfactory, but we also judge it as non-repeatable.

Charlie, anything more —?

CHARLIE MUNGER: No.

WARREN BUFFETT: Area 7, please.

KEIKO MAHALICK: Good afternoon, Mr. Buffett and Mr. Munger. My name is Keiko Mahalick (PH) and I'm an M.B.A. student at Wharton, but please don't hold that against me.

WARREN BUFFETT: We won't. (Laughter)

I never made it that far. I was an undergraduate student. (Laughs)

AUDIENCE MEMBER: Could you please explain how you differentiate between types of businesses in your cash flow valuation process, given that you use the same discount rates across companies?

For example, in valuing Coke and GEICO, how do you account for the difference in the riskiness of their cash flows?

WARREN BUFFETT: We don't worry about risk in the traditional — the way you're taught, actually, at Wharton. We — (Laughter)

But it's a good question, believe me. But we are — if we could see the future of every business perfectly, it wouldn't make any difference whether the money came from running streetcars or from selling software, because all the cash that came out, which is all we're measuring between now and judgment day, would spend the same to us.

It really — the industry that it's earned in means nothing except to the extent that it may tell you something about the ability to develop the cash. But it has no meaning on the quality of the cash once it becomes distributable.

We look at riskiness, essentially, as being sort of a go/no-go valve in terms of looking at the future businesses. In other words, if we think we simply don't know what's going to happen in the future, that doesn't mean it's necessarily risky, it just means we don't know. It means it's risky for us. It might not be risky for someone else who understands the business.

In that case, we just give up. We don't try to predict those things.

And we don't say, "Well, we don't know what's going to happen, so therefore we'll discount it at 9 percent instead of 7 percent," some number that we don't even know. That is not our way to approach it.

We feel that once it passes a threshold test of being something about which we feel quite certain, that the same discount factor tends to apply to everything. And we try to do only things about which we are quite certain when we buy into the businesses.

So we think all the capital asset pricing model-type reasoning with different rates of risk-adjusted return and all that, we tend to think it is — well, we don't tend to — we think it is nonsense.

But we do 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. And we don't think you can compensate for that by having a higher discount rate and saying it's riskier, so then I don't really know what's going to happen and I'll have a higher discount rate. That just is not our way of approaching things.

Charlie?

CHARLIE MUNGER: Yeah. This great emphasis on volatility in corporate finance we just regard as nonsense.

If we have a statistical probability of putting out a million and having it turn into —

Put it this way: as long as the odds are in our favor and we're not risking the whole company on one throw or anything close to it, we don't mind volatility in results. What we want is the favorable odds. We figure the volatility, over time, will take care of itself at Berkshire.

WARREN BUFFETT: If we have a business about which we're extremely confident as to the business result, we would prefer that it have high volatility than low volatility. We will make more money out of a business where we know where the endgame is going to be if it bounces around a lot.

I mean, for example, if people reacted to the monthly earnings of See's, which might lose money eight months out of the year and makes a fortune, you know, in November and December — if people reacted to that and therefore made its stock as an independent company very volatile, that would be terrific for us because we would know it was all nonsense. And we would buy in July and sell in January.

Well, obviously, things don't behave that way. But when we see a business about which we're very certain, but the world thinks that its fortunes are going up and down, and therefore it behaves volatile — with great volatility — you know, we love it. That's way better than having a lower beta.

So we think that — we actually would prefer what other people would call risk.

When we bought The Washington Post — I've used that as — it went down 50 percent in a matter of a few months. Best thing that could've happened. I mean, doesn't get any better than that.

Business was fundamentally very nonvolatile in nature. I mean, TV stations and a strong, dominant newspaper, that's a nonvolatile business, but it was a volatile stock. And you know, that is a great combination from our standpoint.

WARREN BUFFETT: Area 8.

AUDIENCE MEMBER: Good afternoon, and thank you for staying around to answer our questions.

I have two. First of all, would you give us what logic went into your decision to both buy and sell McDonald's?

And my second question goes to a term that you've used. You talked about the caliber of the shareholders at Berkshire Hathaway. How do you define the caliber and what difference does it really make?

WARREN BUFFETT: Well, it makes a lot of difference. Our idea of a high-caliber group is one that is just like us. (Laughter)

And that's not entirely facetious in that we basically want shareholders who look at the business the same way we do. Because we're going to be around running something, and what could be worse than having a group out there had a whole different set of expectations than we did, and evaluated us in a different way, and all of this sort of thing?

I mean, if you are going to — you're going to have a given number of shares outstanding. Let's say we have an equivalent of a million, two-hundred and some thousand A shares. Somebody's going to own every single share.

Now, would you rather have them owned by people who understand your business, who understand your objectives, who measure you the same way you do, who have similar time horizons, or would you rather have the reverse? It makes a real difference over time to be in with people that are compatible with you.

So it's a significant plus to us, the operation of the business, and it leads to a more consistent relationship between price and intrinsic value when you have a group like that, because they understand themselves and the business, and they're not likely to do silly things in either direction.

So you get a much more consistent relationship than if we had a whole bunch of people who were thinking that the most important thing in evaluating this business was next quarter's earnings.

Question about McDonald's simply is, you know, it's an outstanding business and we don't talk about it when we buy it, we don't talk about it if we sell it.

Charlie?

CHARLIE MUNGER: Yeah. The question of what difference does it make to the management who the shareholders are, well, if you are into what I call trustee capitalism, where the shareholders aren't just a faceless bunch of nothings, you feel as a kind of a hair shirt, an obligation to do as well as you can by the shareholders. Well, wouldn't you rather feel an obligation to people you liked instead of people you didn't like? (Laughter)

WARREN BUFFETT: Yeah, let's say you were running a business and — (applause) — and you had a choice of three owners.

You could have a hundred percent of it owned by whatever your favorite philanthropy is, you could have a hundred percent of it owned by the U.S. government, and you could have a hundred percent of it owned by, you know, the worst person you can think of, you know, in your hometown.

I mean, I think it would make a difference in how you felt about going to work every day.

WARREN BUFFETT: Number 9.

AUDIENCE MEMBER: Yes, my name is Steve Jack (PH). I'm from Southern California. And my question has to deal with kind of quality versus price.

I've been to three annual meetings and I've heard great things about Coke every year. But as far as I'm aware, you have not bought any additional shares of Coke over the last three years even though the stock has done just fine.

If an investor has a relatively short timeframe, say three to five years, how much weight do you think one should give to quality versus price?

WARREN BUFFETT: Well, if your timeframe is three to five years, A) I wouldn't advise it being that way. Because I think if you think you're going to get out then, it gets more toward — leaning toward the bigger fool theory.

The best way to look at any investment is, how will I feel if I own it forever, you know, and put all my family's net worth in it?

But we basically believe in buying — if you talk about quality meaning the certainty that the business will perform as you expect it to perform over a period of time, so the range of possible performance is fairly narrow — you know, that's the kind of business we like to buy.

And all I can say is that we like to pay a comfortable price, and that depends to some extent on what interest rates are.

We haven't found comfortable prices for the kind of businesses we like in the last year. We don't find them uncomfortable, in the sense that we want to sell them. But they're not prices at which we — we added to Coke one time about, I don't know, five years ago or thereabouts, and it's conceivable we would add again. It's a lot more conceivable we would add than subtract.

But that's the way we feel about most of the businesses. We did make a decision last year that we thought bonds were relatively attractive, and we trimmed certain holdings and eliminated certain small holdings in order to make a bigger commitment in bonds.

Charlie?

CHARLIE MUNGER: Yeah. You talk about quality versus price. The investment game always involves considering both quality and price. And the trick is to get more quality than you're paying for in the price. It's just that simple.

WARREN BUFFETT: But not easy.

CHARLIE MUNGER: No, but not easy.

WARREN BUFFETT: Area 10.

AUDIENCE MEMBER: Gentlemen, good afternoon. Jeff Kirby from Green Village, New Jersey.

Would you comment please on tax-free spinoffs to shareholders in general, and particularly how you would feel about those were you to believe that a materially higher value would be ascribed to one of your operating companies in the public arena than as part of Berkshire Hathaway?

WARREN BUFFETT: Well, there's certainly been times in Berkshire's history when certain components of Berkshire might well have sold at higher multiples as individual companies than the amount they contributed to the whole of Berkshire, although I don't think that would be the case now.

But our reaction to spinoffs would be — even if we thought there was some immediate market advantage, it would have no interest, basically, to us.

We like the group of businesses we have as part of a single unit at Berkshire. We hope to add to that group of businesses. We will add to that group of businesses over time.

And the idea of creating a lot of little pieces because we could get a little more market value in the short term, it just doesn't mean anything to us.

Charlie?

CHARLIE MUNGER: Yeah, it would add a lot of frictional costs and overheads. We have the — I don't know anybody our size who has lower overhead than we do, and we like it that way.

WARREN BUFFETT: Yeah. (Applause)

Right now our after-tax cost of running the operation has gotten down to a half a basis point of capital value. And when you think that many mutual funds are at 125 basis points that means they have 250 times — (laughs) — the overhead ratio to capitalization that we have —

CHARLIE MUNGER: And all they've got is a bunch of marketable securities, and we got that plus businesses.

WARREN BUFFETT: Yeah. We don't need any more, incidentally —

CHARLIE MUNGER: We can get lower, Warren. (Buffett laughs)

We can get a lot lower —

WARREN BUFFETT: Yeah, I know. I know. (Laughter)

You think they'd [Berkshire's board of directors] work for $500 a year instead of $900, Charlie? (Laughter)

Groans from the front row.

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger.

I was kind of curious if you could tell me, do you know or can you tell us how much business Nebraska Furniture Mart and Borsheims did this weekend?

And secondly, do you have any interest in investing in the auto industry? And if not interested now, what would change your mind about this industry in the future?

WARREN BUFFETT: Well, the first question, I don't know what the Mart did but I do know they had a lot of shareholders there. Got a verbal report on that.

There would be less change in their normal — they do — you know, you're talking about a company that — at the Mart — that does $800,000 a day on average. It is a big operation.

So our shareholders have an impact, but not the relative impact that they would have at Borsheims.

Borsheims did over twice as much this year as last year, and they had a big day. (Laughter)

WARREN BUFFETT: And what was the other question, Charlie?

AUDIENCE MEMBER: — industry. The auto industry.

WARREN BUFFETT: Oh, the auto industry. Yeah, Charlie was big in General Motors in the mid-'60s, right Charlie? It was your biggest commitment?

CHARLIE MUNGER: I had a temporary delusion. (Laughter)

Luckily, it passed. (Laughter)

WARREN BUFFETT: Yeah.

No, he made money on it.

CHARLIE MUNGER: Yes, I did.

WARREN BUFFETT: We — it's the kind of industry that's — it's interesting for us to follow.

I mean, many years ago it was the dominant factor — or overwhelming factor — in the economy. It's diminished a fair amount but it's still a very important industry.

And it's the kind of industry that anyone can follow. I mean, you have experience with the product and competing products, and you — everyone in this room understands in a general way the economic nature of the industry.

But we've never felt that we understood it better than other people. So we've seen auto companies at very low multiples sometimes and with prices that in hindsight looked very attractive, but we never really felt that we knew who among the auto companies five years from now would have gained the most ground relative to where they are now, or that gained the most ground relative to what the market might expect. It just isn't given to us, that knowledge.

Charlie?

CHARLIE MUNGER: I agree.

WARREN BUFFETT: Area two.

SCOTT RUDD: Hi, my name is Scott Rudd from Evening Prairie, Minnesota.

And my question is this: ten years from now — and I'm referring to Borsheims as the retail part of it to the consumer, not so much the corporate division — ten years from now, what would be the three things that you would expect to change on a day-to-day operating basis, to change the most and affect your ability to be dominant in that area.

WARREN BUFFETT: Well, I think — are you talking about Borsheims specifically?

AUDIENCE MEMBER: Yes.

WARREN BUFFETT: Yeah, I think Borsheims — I won't have three things — but Borsheims may be one of a couple of our companies where the internet could be a huge — have a huge potential for us.

I don't know if that'll happen, but there's no question that we operate — and I've got a message on the internet — at considerably — very considerably — lower gross margins than does a Tiffany or publicly-held jewelry operations.

We are giving customers considerably more for their money. We've got way lower operating costs than the public companies.

And I say on the internet, our operating costs are 15 to 20 percentage points, and even more in some cases, less than publicly-owned competitors. So we've got a lot to offer.

Now, the big question people always have with jewelers is, "How do you know who to trust?" I mean, you know, it is an article that most people feel very uncomfortable buying.

And I think that the Berkshire Hathaway identification can help people feel comfortable on it. I think that the experience of customers around the country as they see it.

And I don't think that — I think it's a product — it's a high-ticket item, so saving money gets to be really important. Just like auto insurance, saving money gets to be really important.

So I think that the internet could be of significant assistance to Borsheims in terms of spreading and facilitating its nationwide reputation. So Borsheims could have a lot of growth and the internet could be a big part of it.

Our job is to get the message to people around the country that they can literally, you know, have us send a half a dozen items to them, that they can look at with no high-pressure salesmanship at all or anything of the sort, and look at the prices, decide what they want in their own homes, and they will do very well with us.

And we have a lot of people taking advantage of that now. But we could have 10, or 20, or 50 times that number as the years go by. And I think we should work very hard on that.

GEICO has possibilities through the internet, obviously, also.

Anything where you're offering a terrific deal to the consumer, but one of the problems has been how do you talk to that consumer, you know, the internet offers possibilities (inaudible). The thing is that everybody in the world is going to be there, and why should they click on you instead of somebody else?

Actually, the Berkshire Hathaway name may help a little bit on that, although GEICO's name is extremely well known. GEICO is — I said in the annual report we were going to spend a hundred million dollars in — basically in promotion this year. We'll spend more money than that.

The brand potential in GEICO is very, very big. And we intend to push and push and push on that.

Charlie?

CHARLIE MUNGER: Well all that said, if the internet helps some of our business, why certainly the CD-ROM and the personal computer combined to clobber World Book for us.

WARREN BUFFETT: Yeah, we paid our entry fee.

CHARLIE MUNGER: Yeah, we — (laughter) — it's not all plus.

WARREN BUFFETT: No.

WARREN BUFFETT: Area 3.

AUDIENCE MEMBER: My name is Jorge Gobbi (PH) from Zurich, Switzerland and my question refers to food businesses, mainly McDonald's and Dairy Queen.

Are there major differences in the investment territories fixed between McDonald's and Dairy Queen? And if yes, would you explain them?

WARREN BUFFETT: Yeah, there are major differences. McDonald's owns, perhaps, in the area of a third of all locations worldwide. I can't tell you the exact percentage, but if they've got 23,000 outlets, they own many, many thousands of them, and operate them. And then of the remainder, they own a very high percentage and lease them to their operators, their franchisees.

So they have a very large investment, on which they get very good returns, in physical facilities all over the world.

Dairy Queen has — counting Orange Julius— 6,000-plus operations, of which 30-odd are operated by the company. And even those, some are in joint ventures or partnerships.

So the investment in fixed assets is dramatically different between the two.

The fixed-assets investment by the franchisee, or the person — his landlord — obviously is significant at a Dairy Queen. But it's not significant to the company as the franchisor, so that the capital employed in Dairy Queen is relatively small compared to the capital employed in McDonald's.

But McDonald's also makes a lot of money out of owning those locations and receives —

Whereas Dairy Queen will, in most cases, receive 4 percent of the franchisee's sales, in terms of a royalty, at a McDonald's there's that — there's more than that percentage, plus rentals and so on.

So they're two different — very different — economic models. They both depend on the success of the franchisee in the end. I mean, you have to have a good business for the franchisee to, over time, have a good business for the parent company. Both companies have that situation to deal with.

Charlie?

CHARLIE MUNGER: I've got nothing to add. The 4 percent is not very much when you stop to think about providing a group of franchisees with a nationally recognized brand, and quality control, and all sorts of desirable business aids.

WARREN BUFFETT: No, 4 percent is at the low — if you look at the whole industry — 4 percent is in the lower part of the range. But it works fine —

CHARLIE MUNGER: Part of what attracted us was the fact that the charges to the franchisees are low at Dairy Queen.

WARREN BUFFETT: A successful franchisee can sell his operation for significantly more than he has invested in tangible assets. And we want it that way, obviously, because that means he's got a successful business, and it means that, over time, we will have a successful business.

You want — you want a franchise operation — you want the franchise operator to make money and you want him to create a capital asset that's worth more than he's put in it. That's the goal.

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Good afternoon, Mr. Munger and Mr. Buffett.

My name is Patrick Byrne, I'm a shareholder, and I'm here from Cincinnati, Ohio, back again this year to ask a question to see if I can get the two of you to disagree on a subject. I've picked education as an area where we might see some daylight between the two of you.

First though, on the subject of education, I'd like to offer some brief thanks.

I'm lucky in that my parents, in the late '70s, made the wise choice of buying some Berkshire stock and putting it in a college fund for my brothers and me, and that basically paid for our higher education.

I suspect there must be thousands of people like us who had our education paid for by wealth that the two of you created, and we owe you. Although we probably all have been a lot better to skip college and keep the stock. (Laughter and applause)

Well, on the subject of education, Milton Friedman has said, or has written, that if you really care about poverty in the U.S. and the disadvantage of women and minorities and so on, and you could cure one single thing in the U.S., it would be the public education system.

Mr. Buffett, of course you've been very publicly supportive and done many things, and I'm sure Mr. Munger has as well, for public education.

But I noticed last year, in this annual meeting, Mr. Munger — or both of you, of course, criticized some aspects of higher education, like business schools.

But Mr. Munger included — he was a tad critical, I would say, of the U.S. public education system.

And I wonder if you two agree with what Friedman says and what you think the importance of public education is, and what might be done to improve it.

WARREN BUFFETT: I'm going to let Charlie go in a second, but I just want to say, Patrick Byrne is the son of Jack Byrne, who made a fortune for us by resuscitating GEICO when it got into trouble in the mid-'70s.

In fact, I met Patrick's dad on a Wednesday night, about 8 o'clock at night, in Washington, when GEICO was — it was bankrupt and it was about — very close to being declared so.

And after talking with him about three hours that night, the next day I went out and bought 500 and some-thousand shares of GEICO, that Davy [Lorimer Davidson] referred to, at 2 1/8, so — which is forty cents on the stock that we paid $70 for later on.

So Patrick's dad — we may have made — (laughs) — we may have made the Byrne family more money; he made us a lot of money.

Patrick is now running Fechheimers in Cincinnati and doing a sensational job. His brother, Mark, on June 30, if we hit the target date, will be establishing a major operation in London and Bermuda that will — in which we will be a very large partner.

So he's only got one other brother left, and he's out playing golf in California. But if times get tough we're going to try and recruit him, too.

WARREN BUFFETT: Charlie, with all that time to prepare, what do you have to say about education? (Laughs)

CHARLIE MUNGER: Well, I certainly agree with Milton Friedman, that there's — it would be hard to name one factor, if we could fix it, that would be more worthy of fixing than education in the United States, particularly the lower grades in education where the failures are so horrible, in many big cities particularly.

So yes, I think it's a terrible problem and it needs fixing.

Of course, it's a huge debate as to what the best way is to fix it. And I am skeptical, myself, of big city school systems getting fixed under their own momentums. In other words, I'm quite sympathetic to the people who say we may have to go to an alternative, like vouchers.

That the incentive structure has — (applause) — gotten so bad in some places that you can't fix it with evolution; it takes revolution.

Warren, you're more optimistic about big city public schools —

WARREN BUFFETT: Well, I'm not necessarily more optimistic. I probably feel, though, that democracy without a good public school system available to the entire population is sort of a mockery.

Because there's so much — (applause) — inequality to start with. I mean, it isn't just inequality of money. But I mean, my kids, whether they inherit any money, or your kids, whether they inherit any money, compared to the kids of somebody where both parents are struggling to keep the place going, or maybe just one parent, and living in poverty — I mean, it is so unequal to start with that if you accentuate that inequality by giving those who are generally higher up on the ladder also a far better education than you give those who have chosen the wrong womb, I think that's just — I don't think that society should tolerate that — a rich society — should tolerate it.

That doesn't mean it's easy to solve. Because I've said a lot of times that, unfortunately, it seems like a good public school system is like virginity, that it can be preserved but not restored.

And it's very hard, when you get a system that's lousy, to do much about it, because under those circumstances the wealthy people are going to all opt out of the system, and they're going to be less interested in the bond issues, they're going to be less interested in the PTA, they're going to be less interested in the outcome of the other people's children, if they have all opted out for their own system.

And to have one educational system for the rich and another for the poor, with the poor being — getting the poorer system — strikes me as doing nothing but accentuating inequality and other problems that result from that in the future.

So I don't know the answers on improving the system. You know, I read some of the experiments that take place.

But I do believe to start with that if you have a good public school system, as we do in Omaha, that you do your damndest to maintain that so that there is no incentive for the rich grandparent or the rich parent to say, you know, "I love the idea of equality, but I love my grandchildren or my child more, so I'm going to yank him from the public school system," and then you get this sort of exodus which leaves behind only those who can't afford to make that choice.

And the problem I have with the voucher system, if there were a way — the idea of competition I like, you know, and I think a good parochial system does, for example, create a better public system — and I think we've had that situation in Omaha — but I think the voucher system, if it simply amounts to giving everyone an additional amount, simply means that the rich get X dollars of the public school system subsidized, but the poor still are — whatever that differential is — remains.

I mean, you could have a golf voucher system — because I play golf — I don't play very often — but if I play at the Omaha Country Club then you could have a voucher system so that everybody in Omaha would have more access to the country club by giving everybody a thousand dollars a year to play golf.

But it just means it would reduce my bill by a thousand bucks, but it still wouldn't do the job for the guy who's on the public course because he'd still be beyond his means to move to full-scale equality with me.

I — you know, I don't think there's anything more important — and I agree with Charlie totally — I think the first eight grades, you know, you can forget it after that. If you have the first eight grades right, good things are going to flow. And if you have those wrong, you're not going to correct it as you get beyond that point.

And I think that — you know, I commend Walter Annenberg on the $500 million. I think it is very tough to see results in that arena. And if you find something that is producing results, I think it should be replicated elsewhere.

I think that, obviously — a fellow in Chicago says that the unions have caused considerable problems in getting adjustments made, but he had the political clout behind him to overcome some of those problems.

It ought to be a top national priority. We have the money to educate everybody well in this country, and the question is, can we execute? And that's something I hope good minds like Patrick's work on.

Charlie, you have anything for that?

CHARLIE MUNGER: Yeah. I think when something is demonstrably failing at performing the function to which it's assigned by a civilization, just to keep pouring more and more money into a failing modality is not the Munger system.

So I'm all for taking the worst places where there's failure and trying a new modality. And it wouldn't bother me at all to have vouchers only for the poor.

But I think we have to do something in our most troubled schools to change our techniques. I think it's insane to keep going the way we are.

WARREN BUFFETT: So you'd go for means-tested vouchers, basically?

CHARLIE MUNGER: Oh, I —

WARREN BUFFETT: I mean, I don't disagree with that idea.

CHARLIE MUNGER: All I know is we're — it is a terrible place to fail.

And part of the trouble is ideological. If you have an absolute rule there can't be any tracking by ability, no matter how much better reading can measurably be taught by systems that involve tracking, well, people that brain-blocked shouldn't have the power. You know, we should — (applause) — do what works.

WARREN BUFFETT: You know, we got plenty — I mean, in Omaha, it works. The problem is that once it gets beyond a certain point on a downhill slope, essentially you have the citizens that are able to do something about it, essentially, opt out. And that — I don't know —

CHARLIE MUNGER: I am a product of the Omaha public schools, and in my day, the people who went to private schools were those who couldn't quite hack it in the public schools. That is still the situation in Germany today. I mean, private schools are for people who aren't up to the public schools.

I'd prefer a system like that. But once a big segment of that system measurably fails then I think you have to do something. You don't just keep repeating what isn't working.

WARREN BUFFETT: Well, I agree with that.

Patrick, have you gotten your answer? (Applause)

WARREN BUFFETT: Let's go to area 5.

AUDIENCE MEMBER: My name's Kevin Murphy, I'm from Camarillo, California.

And my question is, what do you look for when determining if a person is honest or not?

WARREN BUFFETT: Now, that's a good question, Kevin.

You — I think, generally, Charlie and I can do pretty well with the situations we see, but we have to have some evidence of behavior in front of us. And I would say even there's some occupations where we're going to expect to find a higher percentage of people who behave well than in others.

But if we work with someone over a period of a few months or more, I think we've got — we can come up with a pretty high batting average, in terms of how they behave.

At Salomon, I think I was able to separate out the people who I felt very good about and the people I was a little more nervous about fairly quickly, among the ones I worked with actively.

But how you spot that precisely, you know — leave your lunch money on their — (laughs) — on their desk sometime, Kevin. Maybe you'll find out in a hurry, but — (Laughter)

We like people — you know, I mean, the great example, you know, is somebody like a Tom Murphy, where they're just bending over backwards all the time to make sure that you get the better end of the deal.

That doesn't mean they aren't competitive. I mean, if you play him at a golf game for money or something like that, you know, he wants to win in the worst way. But he —

But there are people that just — they don't take credit for things that they didn't do. In fact, they give you credit for some of the things that maybe they did. You can get a feel for it over time.

Charlie, you have any good guidelines on that?

CHARLIE MUNGER: Yes. I think that people leave track records in life. And so, somebody at your age should figure that by the time he's 22 or '3, well, he will have left quite a track record and the world will be able to figure you out.

So I think that track records are very important. And if you start early, trying to have a perfect record in some simple thing like honesty, you're well on the way to success in this world. (Applause)

WARREN BUFFETT: [Italian industrialist] Gianni Agnelli one time told me, he said, "When you get older, you have the reputation you deserve." He said you can get away —

CHARLIE MUNGER: Yeah, yeah.

WARREN BUFFETT: — with it for a while early on. But by the time anybody gets to be 60 or so, they very probably have the reputation they deserve. And the truth is you can have the reputation that you want.

If you list all of the things that you admire in other people, you'll find out that almost everything you list — you may not be able to kick a football 60 yards or something of that sort — but almost everything you list in the people that you admire and like, they're qualities that you can have if you just set out to do that.

Didn't Ben Franklin do that, Charlie?

CHARLIE MUNGER: Oh, sure. I always say that the best way to get what you want is to deserve what you want.

WARREN BUFFETT: I'll have some more peanut brittle. (Laughter)

WARREN BUFFETT: Area 6.

AUDIENCE MEMBER: I'm Nancy Sill (PH) from Atlanta, Georgia.

You were asked earlier this morning a question about the year 2000 computer problem. Do you anticipate any negative financial impact to the economy or to our companies due to the millennium problem, and if so what financial strategies are you considering?

WARREN BUFFETT: Well, I don't think there'll be major problems for our companies. You know, there are going to be some problems — (laughs) — anytime you have something that big.

If people didn't see it coming in 1980 or 1985, they're not going to be perfect at solving it by 2000, you can count on that.

But I don't think it has any investment consequences for Berkshire Hathaway that we should be considering now. And I do think you'll see most of the problems in the governmental area.

You know, maybe they won't find your tax return for two or three years. (Laughter) Who knows?

Charlie?

WARREN BUFFETT: Area 7.

AUDIENCE MEMBER: In your description of McDonald's, you have a sense that there's a great business buried in McDonald's and two good businesses that are mixed in with it. And the problem is with the real estate and the operational business, that as the company is currently capitalized, they can't earn the same kind of returns they can earn in the franchising business.

You were, or still are, a significant shareholder of McDonald's. I guess my question is, the solution is obvious: why don't you push for a solution that creates the same opportunity to have at International Dairy Queen?

WARREN BUFFETT: Well, my guess is — I don't know the details on it — but my guess is that with 23,000 locations all over the world, I think it would be extraordinarily difficult to separate the real estate business out from the franchising business at this point.

I think they could've gone a different route. I'm not saying it would've been a better route at all. In fact, I think the odds are they followed the right route in owning and controlling so much real estate.

But I just think the problems would be horrendous. Certainly you wouldn't want to sell it and lease it back because you would not end up with more value, in my view, by doing that.

And spinning it off in a real estate trust or something, with operating in 100-plus countries, and with all of the franchise arrangements, I think it would be a huge, huge problem. I would not want to tackle it myself.

So I think that you should look at McDonald's — and I don't know anything about their plans on this — but I think you should look at McDonald's as being a very good business, but one that will continue in its present mode vis a vis the real estate. Although I think they've signaled that they're going to do less on new properties — somewhat less — in connection with ownership, than they've done to this point.

But there's 23,000 locations out there and every operator, his own arrangement is very important to him. And it just — it would be a mammoth job, and I'm not sure how much extra value would be created in the end anyway.

Charlie?

CHARLIE MUNGER: Yeah, the net returns on capital McDonald's has earned all these years are high, even though they have owned a lot of their real estate. I think it's hard to quarrel with the way they did it. They had the best record.

WARREN BUFFETT: And the multiple is not greatly different, in my view, than if the real estate were separate. You know, I mean, if you get all the real estate detached in some arrangement, you might get a little more out of it. But it doesn't strike me as a big deal.

WARREN BUFFETT: Area 8.

AUDIENCE MEMBER: Yeah, hi. I'm Rachel White (PH) from Missoula, Montana.

And during the lunch break, I heard some people talking about double taxation and how that impacts Berkshire's investment philosophy. So I was wondering if you could talk a little bit about it. I'm not sure I understood it. And if you could explain whether that impacts your investments.

WARREN BUFFETT: Well, we are structured very poorly. And if you were looking — if you’re going to start all over again and do most of the things we've done, you would probably not do it in corporate form, or precisely like we do it.

I mean, what that gentleman was talking about in connection with McDonald's applies much more to Berkshire Hathaway by far than McDonald's, in terms of de-taxing part of the income stream.

If we own Coca-Cola with a cost of a billion-two or a billion-three and a market value of 15 billion, we're not going to sell it.

But if we did sell it, we would incur a capital gains tax on the order, almost, of $5 billion.

That means that the 15 becomes 10 billion. Now, if that 10 billion is reflected in Berkshire's value and you bought your stock when we bought our Coke, then you pay a second tax, in turn, in reflection of the Coca-Cola appreciation that has taken place after tax. So it's a very disadvantageous way of owning securities, to have a corporation in between you and the securities themselves.

If we ran as a partnership that would not be the case. I ran Berkshire Hathaway — I mean, I ran Buffett Partnership for many years and we only had one tax at the individual level.

So our stockholders are — to the extent that we own marketable securities — and we own a lot of them — and to the extent that we have a lot of profits over time in those — own those securities in a disadvantageous way.

Now, we also have a float, which helps us own them, which is a big plus.

But corporate ownership of securities — if you have the option of owning them directly or through a partnership — corporate ownership is disadvantageous.

And we're stuck with it. We've had it for all these years. We've got no plans to do anything about it. We couldn't, probably, do anything about it if we wanted to.

So that is a drag on our performance, compared to what would be the situation if we operated as a partnership.

And Lloyd's syndicates, for example, didn't have that problem. Some insurance companies that operate in Bermuda may not have that problem to the same extent. Certainly partnerships don't have that problem, to the extent they own securities. But it's a fact of life with us and we're going to pay a lot of taxes.

Charlie?

CHARLIE MUNGER: Yeah, we have no cure for the corporate income tax, and it is a big disadvantage for the indirect owner of securities.

So far we've surmounted it well enough but we're carrying a load there.

WARREN BUFFETT: It's become a bigger disadvantage since the individual rate went to 20 percent with our corporate rate being 35 percent. If we make a dollar on a stock, it becomes 65 cents, and to the extent that you've owned Berkshire, that 65 cents, now 20 percent off that, becomes 52 cents. Whereas if you'd owned the stock directly, you'd have had 80 cents.

Now, when we owned GEICO and it wasn't consolidated with us, you carried that one more extreme. I mean, GEICO had capital gains and we had a capital gain proportionately in GEICO, and so on.

I mean, how you're structured does make a real difference. But usually once you get into a given structure, you're kind of stuck with it, as I indicated in the answer to the gentleman on McDonald's.

CHARLIE MUNGER: Now, to the extent we have very long holding periods at the corporate level, the real mathematical disadvantage shrinks.

WARREN BUFFETT: Yeah, and we might not have been able to get the float that we have, if we hadn't been operating it in a corporate structure, so that is a mitigating factor, too.

But we like to have the mitigating factors without anything to mitigate, if we get our choice. (Laughter)

WARREN BUFFETT: Area 9, please.

AUDIENCE MEMBER: Good afternoon. My name is Fred Strasheim (PH) and I'm from here in Omaha.

I have a question about your acquisition methodology. And I was intrigued to read in your annual report about your acquisition of Star Furniture.

And as I understand the process you followed, Mr. Buffett, you met with Mr. — or you — I'm sorry, you reviewed financials for a brief period, liked what you saw, then you met with Mr. Melvyn Wolff for two hours and struck a deal. And you wrote you had no need to check leases, work out employment contracts, et cetera.

WARREN BUFFETT: Right.

AUDIENCE MEMBER: I think that most companies, when they do acquisitions, would feel the need to do a significant amount of legal due diligence, to do things like check the leases, check into things like undisclosed environmental liability, or perhaps threatened litigation.

And I guess my question is, have you ever been burned by your approach?

WARREN BUFFETT: We've been burned by the — we've been burned only in the sense that we've made mistakes on judging the future economics of the business, which would've had nothing to do with due diligence.

We regard what people normally refer to "due diligence" as, as really sort of boilerplate in most cases.

It's a process that big companies go through. And they feel they have to go through it. And they're ignoring — oftentimes, in our view — they're ignoring what really counts, which is evaluating the people they're getting in with, and evaluating the economics of the business. That's 99 percent of the deal.

You know, you may run into an environmental liability problem, you know, one time in a hundred, or you may, you know, you may find a bad lease.

I asked Melvin about, you know, "Do you have any bad leases?" I mean, that's the easiest way to do it. And I could read them all and try and look for every clause or something, but it isn't going to — you know, that is not the problem.

We've made bad — lots of bad deals. We made a bad deal when we bought Hochschild Kohn, for example, the department store operation, back in 1966. But it had — fine people — but we were wrong on the economics of the business.

But the leases didn't make any difference. You know, that sort of thing just was not important. And I can't recall any time that what other people refer to as due diligence would've avoided a bad deal for us.

CHARLIE MUNGER: I can't either.

WARREN BUFFETT: No. That's 30-some years. And I —

The key thing — you just don't want to do — I go — I'm on various public company boards — I've been on 19 public company boards — and you know, their idea of the due diligence is to send the lawyers out and have a bunch of investment bankers come in and make presentations and all that.

And I regard that as terribly diversionary, because the board sits there, you know, entranced by all of that, and everybody reporting how wonderful this thing is and how they checked out patents and all that sort of thing. And nobody is focusing really on where the business is going to be in five or 10 years.

You know, business judgment about economics — and people to some extent — but the business economics — that is 99 percent of deal making. And the rest, people may do it for their protection. I think too often they do it as a crutch just to go through with the deal that they want to go through with anyway, and of course all the professionals know that. So believe me, they come back with the diligence, whether due or not. And — (Laughter)

We are not big fans of that. I don't know how many deals we've made over the years, but I cannot think of anything that traditional due diligence has had a thing to do with.

CHARLIE MUNGER: No, we've had surprises on the favorable side a couple of times —

WARREN BUFFETT: That is true. That is true.

The kind of people that we've generally dealt with have usually told us the bad things first and good things after we made the deal.

We made a deal with a fellow over in Rockford in 1969, Eugene Abegg, Illinois National Bank and Trust Company. I made that deal in a couple of hours and, I mean, there just wasn't any way that Gene was going to be hiding anything bad.

For the next ten years when I went over there, every time I'd go to lunch he'd point out some building in town that we owned that wasn't on the books, or some foundation we had that had money in it he hadn't told me about.

And he even gave me some bills, one of which I carry in my pocket, that he had still sitting around that were issued by the bank that were our own money which he never told me about. We could cut them out like paper dolls. I mean, Gene was not a guy to show all his cards. (Laughter)

And those are the kind of people we've generally dealt with, and I would certainly say that Melvyn and [his sister] Shirley [Toomin] fit that description in spades.