WARREN BUFFETT: (Applause) Thank you. We promise not to sing. (Laughter)

Good morning, and we're delighted to have you all here.

One of the things that makes it fun to run Berkshire is that we see real shareholders. We have — we probably have a larger proportion of our shares held by individuals and not by institutions than virtually any large company in America. And that's the way we like it.

We love it when you come, we get to see you, you buy our products. You know, there's still a few things left downstairs so — (laughter) — feel free to leave anytime during the meeting when Charlie's talking — (laughter) — to go down and make a few purchases.

WARREN BUFFETT: Now, we're going to do as we've always done.

First of all, I'd like to — I would like to give very special thanks to Andy Heyward. Andy, would you stand up if you will please? (Applause) Andy is the man that — there he is. (Applause)

Andy does those cartoons, he recruits Walter Cronkite and Bill Gates, and he does the script. He gets Charlie and me to do recordings. And it's just wonderful the production he's put on.

And for those of you — last year I mentioned a program that's on public broadcasting called "Liberty's Kids."

It's running in — consecutively. There's, I think, 40 episodes. It tells the story, really, of the founding of the country, and it's a marvelous way to learn history.

I've watched a number of the sessions myself, and it kind of comes back to me from my early days, grade school and high school.

And Andy's done, I think, the parents of America and the country, a real service in producing this. And I will predict that a hundred years from now, people will be watching "Liberty's Kids."

So I really salute Andy Heyward, and be sure to catch it on public broadcasting. And Andy, thanks for a wonderful production. (Applause)

WARREN BUFFETT: Now, we're going to follow our usual procedure of leisurely proceeding through the formal part of the business in three or four minutes. And — (laughter) — then we will —

I'll have a few comments, actually, on our business, and then — and a couple of acquisitions — and then we will spend the rest of the day, until 3:30 with a break for lunch, we will spend here to answer any questions you have.

We have microphones in various zones, and we will proceed around and try to get every — any subject that's on your mind, fire away and I'll answer the easy ones and Charlie will answer the tough ones. (Laughter)

WARREN BUFFETT: So now we will go through the formal part of the business, they've written a little script for me and I will go through this. The meeting will now come to order.

Oh, I should introduce Charlie over here, not that he needs an introduction. But Charlie — (Applause)

Charlie and I have been partners of one sort or another since 1959. We both grew up a good bit here in Omaha, but we didn't know each other at the time.

We both worked at the same grocery store. We had a similar experience, we found that neither one of us liked hard work. (Laughter)

And if you go down to the Western Heritage Museum, they just opened an exhibit of that grocery store. It's a permanent exhibit, and actually, I loved it. Charlie worked there a few years before I did in the past, but we didn't actually meet until I was 28 or 29, and Charlie was a few years older, as he still is.

And — (laughter) — we have worked together now for — in one way or another — for 44 years. We've never had an argument. And we disagree sometimes on things.

He — you have to learn to calibrate Charlie's answers. He — when I ask him whether he likes something, if he says, "No," that means we put all our money in it. I mean, that is a huge — (Laughter)

If he says, "That's the dumbest idea I've ever heard," that's a more moderate investment that we make. And then you have to calibrate his answers, but once you learn to do that you get a lot of wisdom.

WARREN BUFFETT: We have our directors with us, and I'll introduce them. We have, if you'll stand please as I call your name and then you can — it'll be hard to do — but you can withhold your applause till they're all standing.

Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Ronald L. Olson, and Walter Scott Jr., in addition to Charlie. Those are the directors of Berkshire Hathaway. (Applause)

As we mentioned in the annual report, we will be adding some directors who meet the four tests that I laid out in the report. We'll be adding some of those, probably within the next year. When we’re required — whenever we're required to do so, we will be doing it.

And we will have people who have a lot of their own money on the line, just like you do, in Berkshire. And they will prosper or suffer in relation to how Berkshire does, and not in relation to their directors’ fees or other things.

So they will be selected for business savvy, which they will have.

They will be selected for interest in the company, which is almost guaranteed by their holdings.

They will be selected by their shareholder orientation, which, again, I think that their holdings will produce. And we will have those people on board, probably by our next meeting.

WARREN BUFFETT: Also with us today are partners in the firm of Deloitte and Touche, our auditors. They're available to respond to appropriate questions you might have concerning their firm's audit of the accounts of Berkshire. And I might say that almost any question would be appropriate.

Mr. Forrest Krutter, secretary of Berkshire, he will make a written record of the proceedings. Miss Becki Amick has been appointed inspector of elections at this meeting, and she will certify to the count of votes cast in the election for directors.

The named proxy holders for this meeting are Walter Scott Jr. and Marc D. Hamburg. We will conduct the business of the meeting and then adjourn to the — adjourn the formal meeting. After that we will entertain questions that you might have.

WARREN BUFFETT: Does the secretary have a report of the number of Berkshire shares outstanding, entitled to vote, and represented at the meeting?

FORREST KRUTTER: Yes, I do. As indicated in the proxy statement that accompanied the notice of this meeting that was sent to all shareholders of record on March 5, 2003, being the record date for this meeting, there were 1,309,423 shares of Class A Berkshire Hathaway common stock outstanding, with each share entitled to one vote on motions considered at the meeting.

And 6,763,493 shares of Class B Berkshire Hathaway common stock outstanding, with each share entitled to 1/200th of one vote on motions considered at the meeting.

Of that number 1,071,967 Class A shares and 5,228,705 Class B shares are represented at this meeting by proxies returned through Thursday evening, May 1.

WARREN BUFFETT: Thank you. That number represents a quorum and we will therefore directly proceed with the meeting.

First order of business will be a reading of the minutes of the last meeting of shareholders. I recognize Mr. Walter Scott who will place a motion before the meeting.

WALTER SCOTT: I move that the reading of the minutes of the last meeting of the shareholders be dispensed with and the minutes approved.

WARREN BUFFETT: Do I hear a second? Motion has been moved and seconded. Are there any comments or questions? We will vote on this motion by voice vote. All those in favor say "aye."

VOICES: Aye.

WARREN BUFFETT: Opposed? You can signify by saying, "I'm leaving." (Laughter)

The motion is carried.

WARREN BUFFETT: The first item of business at the meeting is to elect directors. If a shareholder is present who wishes to withdraw a proxy previously sent in and vote in person on the election of directors, he or she may do so.

Also, if any shareholder that is present has not turned in a proxy and desires a ballot in order to vote in person, you may do so. If you wish to do this, please identify yourself to meeting officials in the aisles who will furnish a ballot to you.

Will those persons desiring ballots please identify themselves so we may distribute them?

I now recognize Mr. Walter Scott to place a motion before the meeting with respect to election of directors.

WALTER SCOTT: I move that Warren E. Buffett, Charles T. Munger, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Ronald L. Olson, and Walter Scott Jr., be elected as directors.

WARREN BUFFETT: Sounds good to me.

It has been moved and seconded that Warren E. Buffett, Charles T. Munger, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Ronald L. Olson, and Walter Scott Jr., be elected as directors.

Are there any other nominations? Is there any discussion?

The nominations are ready to be acted upon. If there are any shareholders voting in person, they should now mark their ballots on the election of directors and allow the ballots to be delivered to the inspector of elections.

Would the proxy holders please also submit to the inspector of elections a ballot on the election of directors voting and proxies in accordance with the instructions they have received?

Miss Amick, when you're ready you may give your report.

BECKI AMICK: My report is ready. The ballot of the proxy holders, in response to proxies that were received through last Thursday evening, cast not less than 1,058,098 votes for each nominee.

That number far exceeds a majority of the number of the total votes related to all Class A and Class B shares outstanding.

The certification required by Delaware law of the precise count of the votes, including the additional votes to be cast by the proxy holders in response to proxies delivered at this meeting, as well as any cast in person at this meeting, will be given to the secretary to be placed with the minutes of this meeting.

WARREN BUFFETT: Thank you, Miss. Amick. Warren E. Buffett, Susan T. Buffett, Howard G. Buffett, Malcolm G. Chace, Charles T. Munger, Ronald L. Olson, and Walter Scott Jr., have been elected as directors.

WARREN BUFFETT: The next item of business is a proposal put forth by Berkshire shareholder Christopher J. Fried, the owner of two Class B shares.

Mr. Fried's motion is set forth in the proxy statement, and provides that the shareholders request the company allows Class B shareholders who own at least seven registered shares of Class B stock to become eligible to participate in the shareholder-designated contributions program.

The directors recommended that the shareholders vote against this proposal.

We will now open the floor to recognize Mr. Fried, or his designee, to present his proposal.

CHRIS FRIED: Thank you, Mr. Buffett. Good morning, my fellow shareholders.

My name is Chris Fried, and I am here to present a shareholder proposal.

This proposal is designed to extend the shareholder-designated contribution program to include Class B shareholders.

Let me first start off by saying in our shareholder's "Owner Manual," there is a statement that I'd like to quote at this time.

“Although our forum is corporate, our attitude is partnership. Charles Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners.

“We do not view the company, itself, as the ultimate owner of our business assets, but instead view the company as a conduit through which our shareholders own the assets."

With that in mind, I present the following proposal for a vote.

This proposal would extend the shareholder contribution program to Class B shareholders who own at least seven registered shares of Class B stock. Under my proposal, each Class B stock would be allocated 1/30th the value to Class A donation rate.

Currently the Class A rate is $18 which translates to 60 cents per Class B share. The required minimum seven registered shares results in no less than $4.20 being donated by a Class B shareholder.

This figure is important, for when inflation is taken into account, the donation rate will be on par with the original 1981 donation level when the shareholder — proposal — designated program was initiated.

I do understand that there are certain perks involved with owning a Class A share. However, those perks should only be limited to voting rights and the ability to convert Class A shares to Class B shares.

Therefore, I believe that is an appropriate — to extend the shareholder-designated program to Class B shareholders.

If Berkshire Hathaway is to truly follow — truly follow what it preaches about this firm being a partnership among all of its shareholders, then Class B shareholders must have the right to at least have the option to take part in the shareholder-designated contribution program.

Thus, I ask my fellow Berkshire Hathaway shareholders to vote in affirmative on this matter. Thank you for your time.

WARREN BUFFETT: Thank you, Mr. Fried. And you're absolutely right that Charlie and I do regard our shareholders as partners, and we have ever since we really started.

In fact, Berkshire, in a sense, evolved out of a couple of partnerships. Charlie had a partnership, I had a partnership, we made an investment in certain things. And a lot of our original partners are still with us as shareholders.

The partnership — but partnerships have partnership agreements, and when we set forth — or when we issued the Class B shares some years ago, we set forth the relative terms of the partners. And the Class A and the Class B are quite similar in economic terms, but they're not identical.

And at the time we issued those shares to a new group of partners, Class B partners, we explained, quite clearly I believe, exactly what differences there were.

There was a difference in voting rights, there was a difference in that the Class A could be converted to B, but not the reverse. And there was a difference in the shareholder-designated contribution program.

Ever since we issued those shares, I don't know, maybe six or seven years ago, we, in effect, have had a compact with both the A and B shareholders that they — that we would treat the two classes in a way consistent with what was explained at the time of issuance.

So if we were to change the vote, the conversion ratio, or the shareholder-designated contribution program, we would, in effect, be changing a deal that was made, and that has been recognized as having been made, ever since the B shares were issued.

People have bought the A shares in preference to B because of certain reasons. People have bought the B shares for other reasons. But they have relied on the fact that we would abide by what we said we would do at the time we issued those shares.

We'll not take anything away from the B, we'll not take anything away from the A. We'll run things just as they are.

And in the future, you know, I happen to have shares — my holdings — concentrated in A shares.

But the A will never get any advantage over the B except for the ones we laid out at the time of issuance of the B.

It would actually be unfair to A shareholders, and particularly to A shareholders who have bought since the B was issued, to tell them that the economic relationship between the A and B was being changed, even though only in a slight way, to the benefit of the A — benefit of the B — and the detriment of the A.

We wouldn't do that in either direction, so that's why we recommended to vote against it.

Charlie, do you want to add anything?

CHARLIE MUNGER: Well, not only is all of that true, but the cost of getting down to all of B would — it would be a very inefficient process.

WARREN BUFFETT: Yeah, well of course — and that's the reason, back when we issued the B, I mean, we anticipated that.

So it seemed like something that would offer very little value to the B at a significant cost to the company, and therefore we spelled it out quite clearly, I believe, in the original prospectus, and it's been spelled out in every annual report subsequently.

So it's the deal, and the deal is that — is also that we never change things to benefit the A in any way over the B, except as originally explained in the original prospectus, and subsequently in all the annual reports.

Is there a second to Mr. Fried's motion?

What do we do if we don't get a second, Charlie?

CHARLIE MUNGER: It dies.

WARREN BUFFETT: OK. I guess it just died. (Laughter)

But, there's nothing inappropriate about bringing something like that up (inaudible).

I mean, I understand exactly, you know, what you're thinking about. But I think you have to think of fairness to both classes.

Moving right along — figuring out where we are.

WARREN BUFFETT: I guess we're moving along to adjournment of the meeting. And after that we will have the questions we talked about, and I'll also tell you a little bit about the business, since the annual report come out — came out.

Walter Scott, do you have a motion to put before the meeting?

WALTER SCOTT: I move we adjourn the meeting.

WARREN BUFFETT: Do we have a second?

VOICE: I second.

WARREN BUFFETT: Motion to adjourn has been made and seconded. We will vote by voice. Is there any discussion? If not, all in favor say, "aye."

VOICES: Aye.

WARREN BUFFETT: All opposed say, "No." The meeting's adjourned. (Laughter and applause)

WARREN BUFFETT: Now, I'd like to bring you up to date on a couple of things, and then we will proceed with questions.

We have eight microphones placed around the auditorium here, and we will proceed regularly around and just keep going around, and around.

And Marc, do we have anything in the — any microphones in the Music Hall or not? I'm not aware. Maybe if Marc could come up and inform me whether there's (inaudible) Music Hall or not, we can —

VOICE: There's two in there.

WARREN BUFFETT: There's two microphones in the Music —

VOICE: Yes, nine and 10.

WARREN BUFFETT: Nine and 10 are in the Music Hall. And are there quite a few people there?

VOICE: Yeah, it's full. It's full.

WARREN BUFFETT: It's full?

VOICE: Yeah.

WARREN BUFFETT: Oh OK.

We haven't put microphones out on the sidewalks yet, but we'll get to that someday. (Laughter)

WARREN BUFFETT: We've made — we’ve contracted to make — two acquisitions this year.

You just read about one, perhaps, in this morning's paper, but it went on the tape at 7:45 yesterday morning, Central Time, and that involved the contract to buy McLane's from the Walmart company.

McLane's is the very large wholesaler to all kinds of institutions, but convenience stores, quick-serve restaurants, the Walmart operation itself, theaters, restaurants.

And this year we'll probably do something like 22 billion of business. So it's a very substantial enterprise, with distribution centers around the country, with much in the way of transportation equipment.

Walmart had owned McLane's since about, I believe, 1990. It grew substantially while they owned it. It's been run by a terrific manager who's here with us today, Grady Rosier, and Grady took the business from 3 billion to 22 billion, or thereabouts.

Walmart, for very good reasons, wants to specialize in what they do extremely well, and through Goldman Sachs and Company, we were approached by them a little while back about the possibilities of buying the business.

It’s a — it really makes sense for both sides, because Walmart knows what to do with the capital very, very well in their own business, and has lots of opportunities. And this was something of a sideline to them.

On the other hand, their ownership of McLane's resulted in certain people that would be logical customers of McLane's not wanting to do business because they didn't want to do business with a competitor.

And we plan to see all those people very soon, and explain to them that that's no longer the case, and they can sleep well at night doing business with us and not worry about benefiting their competitor, Walmart.

So this deal — a representative of Walmart came up last Thursday to Omaha, a week ago this past Thursday, a CFO. And we made a deal in, maybe, an hour or two and shook hands. And when you shake hands with Walmart, you have a deal.

And so the time remaining until yesterday morning, a contract was put together and it must go through the Hart-Scott-Rodino process in — to be cleared. But there's obviously no conflict, so we fully expect that, in just a few weeks, that McLane's will become part of Berkshire.

It serves, presently, about 36,000 of the 125,000 or so, convenience stores. If you take the 50 largest convenience store chains in the country, it does 58 percent of the business with those companies. Sells each convenience store an average of, perhaps, 300,000 or a slight bit more of product a year, which those convenience stores then resell to the consumer.

It also serves about 18,000 quick-serve restaurants, primarily those operated by Yum! Brands: the Taco Bell, and Pizza Hut, and Kentucky Fried Chicken group.

And it will have opportunities to serve many more as we go along. So we're delighted.

If any of you get a chance to see Grady, or better yet, if any of you own a convenience store, step forward and we'll be glad to give you our card. (Laughter)

It's really — you know, Walmart knows that we will be a good owner, they know we'll be good for the people that work at McLane's.

They know our check will clear, that we won't, you know, make a proposition and then run into financing difficulties, or try to jiggle around the contract later on.

And it's just an ideal way to do business, and we're delighted to add McLane's to the Berkshire group of companies.

It's a very narrow-margin business, obviously. I mean, when you get up to 22 billion of sales and you've got Hershey, and Mars, and people like that on one side, and you've got buyers like 7-Eleven and Walmart on the other side, they're not going to leave a lot in between.

But you have to perform a valuable service for them in order to earn, you know, say, one cent on the dollar, pre-tax.

But McLane's knows how to do it. It's a very efficient operation, and it will continue to deliver value to both their vendors and their customers.

WARREN BUFFETT: The other acquisition that is in the works is Clayton Homes. Clayton is the class of the manufactured home industry, and the acquisition came about in kind of an interesting way.

Every year for the last five years, a group of about 40 finance students from the University of Tennessee in Knoxville would come up to Omaha, and they would have a lot of fun in Omaha. They'd go to the Furniture Mart.

And then in the afternoon they'd come to Kiewit Plaza and the 40 students or so, with their professor, Al Auxier, would have a session with me. We'd just have a classroom session for a couple of hours, and wonderful group of students.

And generally at the end of the session they would give me a football, or a basketball, they've got a great women's basketball team at the University of Tennessee, and so we'd have a good time together.

And, matter of fact, a year ago, when they came up, Bill Gates, by chance, was in town. So I presented him as a substitute teacher, which is a post he's always wanted. (Laughter) And students got quite a surprise.

This year when they came, 40 or so students, we had a good session together, a couple of hours at Kiewit Plaza. And when they got through, they gave me a book. And it was the autobiography of Jim Clayton, who started and ran Clayton Homes, and built it into a huge success.

And he'd written a nice inscription inside, and I mentioned to the students and the professor that the — that I was an admirer of Clayton. I'd followed the manufactured home industry in other ways, not always so successfully, and I'd seen what Clayton had done.

And so I said I look forward to reading the book, which I did. And then I called Kevin Clayton, Jim Clayton's son, and Kevin is the CEO of the company. And I told him how I'd enjoyed his dad's book.

And I said we still had a little money left in Omaha — (laughter) — and, if they ever decided to do anything, you know, we would be interested. And I suggested at what price we might be interested in.

A phone call or two later, a couple of phone calls, we made a deal.

And I had not been to Knoxville. You know, I checked out a few manufactured homes. Suggested that my family buy a repo. (Laughter)

But that deal came about in that manner. And that's the way things tend to happen at Berkshire.

It, you know, the phone rings or we pick up the phone, in this particular case. And the manufactured home industry got into significant trouble, very significant trouble, because credit terms — well, they went crazy on credit four or five years ago.

And when you go crazy on credit, you suffer in a very big way, and that's what happened to that industry.

Conseco, that some of you may have read about, ended up holding — or servicing I should say — $20 billion worth of manufactured home credit and they got in big trouble, for that and other reasons.

And Oakwood, where we own some junk bonds, went into bankruptcy. They're a big operation in the country, most of the — couple of the other biggest players in the industry are losing significant money.

Manufactured home companies have lost the ability to securitize the receivables they get when they sell these — when they sell homes. And so the industry's been in the tank.

This year, or this past year, there were maybe 160,000 new manufactured homes sold, but there were also about 90,000 repos came back and that depresses the market enormously. And like I say, financing sources have dried up. A lot of people that lent money have left the field.

So for the strong, as Clayton is, and particularly with the financial backer like Berkshire, it should be a good field. Twenty percent or so of all the new single-family homes are manufactured homes in this country.

I mean, you can — we can put you in one for about $30 a square foot, and if you compare that to a site-built home, it's quite a deal. I mean, I was amazed.

They have 2,500 square foot homes, two stories, I mean, it's changed a lot over the last 30 or 40 years.

And we've got an operation that is, even the competitors would admit, it's clearly the class of the field.

But even for Clayton, financing was getting more difficult. I mean, the lending community got burned very badly in manufactured homes, and people have sworn off them, from the lending standpoint.

And Clayton did securitize an issue in February this year, but they had to keep more of the bottom layers of the securitization themselves.

So it's a good marriage, and it's one where we will be useful to them. And we should do very well together in the future.

WARREN BUFFETT: The first quarter, I'll just — I don't have final figures yet, and we'll put this — what I say today — we'll put it on the website so that everyone has the information before the opening on Monday.

But the economy, as you know, has been quite sluggish. It's really been sluggish for a very long time.

It's interesting, I wrote in a letter that's also on the website, right after September 11th, I put something up there.

And I said that we were in — we had been in a recession, which was not something that was generally acknowledged at that time, and I thought would be longer and deeper than most people anticipated.

And what has happened is that, really since late 2000, housing and autos have done quite well, but the rest of the economy has just been plain sluggish. And it continues.

During that time we've dropped the federal funds rate dramatically down to 1 1/4 percent. Charlie and I weren’t — probably wouldn't have predicted that we might ever see that in our lifetime, and maybe it'll even go lower.

And we're running a huge budget deficit now, but business continues to be sluggish.

So our non-insurance businesses generally did not do great in the first quarter.

Our insurance businesses did extraordinarily well. And we will show — when the first quarter report is published — we will show an underwriting profit of about 290 million pre-tax, which is after about 140 million of charges for retroactive insurance, the acquisition costs on that — which I'm sure many of you that don't love accounting — all I can tell you is that it's a charge that many companies don't bear but that we willingly bear because it gives us benefits.

But our $290 million is after that charge.

Our float grew by, probably, at least 1.3 billion, so we're up to 42 1/2 billion or so of float. And people — that means people have — are letting us use that money.

And as I said in the first quarter, did it not only cost us nothing to use the money, but, in effect, people paid us to use the money, which we would like them to continue to do. (Laughter)

And I don't see our float growing much from this point. Charlie said last time that it was impossible for it to grow, but it probably would. I don't know whether he'll change his opinion on that, but I think — I really think our insurance businesses are in exceptionally good shape.

We have some of the best insurance businesses in the world.

GEICO's premium volume was up a little over 16 percent in the first quarter, and in April it was up just right at 17 percent. It had a 6 percent, roughly, underwriting profit in the first quarter.

Gen Re, thanks to an incredible job by Joe Brandon and Tad Montross, has turned the corner in a big, big way, and it showed an underwriting profit in the first quarter.

Ajit Jain made so much money I don't want to even tell you about it. (Applause)

Some of our primary operations — yeah, you should give him a hand. I mean, that — (Applause)

When you get Charlie to clap, you know he’s made us a lot of money. (Laughter)

And our primary businesses, particularly U.S. Liability and National Indemnity primary operations, and our Homestate Company, they’ve all done — they’re all doing remarkably well. And I —

You never know what's going to happen in insurance. I mean, there could be an 8.0 earthquake in California or Tokyo, or there could be one in New Madrid, Missouri, as there was a couple hundred years ago. And it could happen tomorrow, there could be huge hurricanes this summer, whatever.

But I can't imagine having a much better group of companies or managers than we have, and they're all working well now.

For a while, Gen Re was a drag, but that's not true now. And I think that we have an excellent chance of having very low cost, and perhaps even no-cost or negative cost float over the next five years or so, or really as far as the eye can see.

Now, that doesn't mean it won't fluctuate around. But if you average it out, I think we will have our float at a very cheap price. And it's — you know, as [TV personality] Martha [Stewart] would say, "Having 42 1/2 billion for nothing is a good thing." (Laughter)

Now, with that, I think we've covered — the first quarter was a good quarter. Overall, it's the best operating earnings we've ever had. Now, we've got more capital now than we've ever had, but nevertheless it will be a good quarter.

And I would estimate, I think it's fair to say, Marc [Hamburg], that from operating earnings we will have something like 1.7 — in the range of 1.7 billion. We had some securities gains too, but I don't count those because they can do anything from quarter to quarter. We don't pay any attention to the timing of those.

But we — from a straight operating standpoint, 1.7 billion or so after-tax. Am I safe with that number, Marc? Or — OK. What could he say? (Laughter)

We don't change numbers at Berkshire, I promise you that. There are — a lot of companies do, but fewer now than did a few years ago. (Laughter)

So, we're going to get the questions in. Charlie, do you have anything to add about acquisitions or operations, or anything else you'd care to say?

CHARLIE MUNGER: Well, I hate to be an optimist, but — (Laughter)

WARREN BUFFETT: Does he ever. (Laughs)

CHARLIE MUNGER: We really added a lot of wonderful businesses to Berkshire in the last few years. It's been some delightful business.

WARREN BUFFETT: That's all you're going to get out of him, folks. (Laughter and applause)

WARREN BUFFETT: OK we're going to start around and we — as we've added two microphones to the Music Hall — and let's start with zone 1, which is over on my right. And do we have the first question?

AUDIENCE MEMBER: Good morning. I'm George Brumley from Durham, North Carolina.

My first question is related to Executive Jet. It's been almost five years since the acquisition of Executive Jet, a purchase in a much different economic and geopolitical environment.

What business metrics do you use to measure success in an industry with as much flux as this one, and what has changed in those metrics since the time of acquisition?

What are the prospects for Europe, and have those prospects changed?

While none of the competitors approach Executive Jet in terms of scale and scope, what impact are they having on the competitive environment?

And lastly, would you please explain the long-term aspect of the business model, as many of the jets age out of the program?

WARREN BUFFETT: OK George, I got through college answering fewer questions than that. (Laughter)

But George's uncle [Fred Stanback] was best man in my wedding, so he gets all he wants.

The — NetJets, as you will see in the first quarter, had a significant loss. A large portion of that loss was caused by the write-down of planes because there — of —

I love it, they call it in the trade, they call them pre-owned planes. I call them used planes. But the — they did the same thing in manufactured homes, so they call them pre-owned homes instead of used homes.

But in any event, putting aside the euphemisms, there — the used plane market, well the entire business aircraft market, is very soft. The used plane market has far more planes for sale than, say, three or four or five years ago.

That's going to affect the production of new planes — already has. And it affects pricing in used planes, and we have bought back planes from people leaving the programs, which we do and will continue to do.

But we have bought during a declining market, some of those, and we have had write-downs in connection with those planes. And you will see in our first quarter report, I believe that that's probably the only operation we have that's losing money.

And we have — it's a popular product, it's a growing business, it's going to be a very big business in my opinion over the years. And we see it every day. I mean, we write a lot of business, and customers are joining us.

There are three main competitors. I think it's fair to say that they're losing significant money from operations, forgetting about any markdowns they might have on their own inventories.

Our market share, we get figures from the FAA as to registrations and as to people that are selling their planes.

And our share of market, which was always the largest, has gone up dramatically in the last couple of years. It's gone up to roughly 75 percent, in terms of value of planes. And we're talking 75 percent of the four-company market. It's gone up even higher than that, in terms of net planes. In other words, new planes sold, less planes coming back.

But the pricing we are receiving does not — in the U.S. it would be — absent this one write-down — it would be very, very modestly profitable.

In Europe, we have lost and we are losing significant amounts of money. Business jets in Europe, the total is about one — and I'm not talking about ours, I'm talking about all — are about roughly 1/10th the number as in the United States, even though the population is similar.

So we have grown from a small base quite rapidly over there. Nobody else will be taking us on. It's part of a service that will be part of a very big business worldwide, in my view, over the years. I don't think anybody else can come in after us.

So I think it's integral, and it is integral, to our operation. Half the — roughly half the miles flown in Europe arise from American owners. And that will just do nothing but get bigger over the years, because our number of — every month our number of owners goes up, goes up significantly.

We have people here from Marquis, who have essentially — they've become a customer of ours, and then they resell cards for 25 hours. And they have added 40 or 50 customers a month in recent months. So it's a popular service, it will be a much bigger business.

I think there will be a shakeout at some point, and maybe fairly soon. You can look at the Raytheon prospectus and — or the Raytheon 10K, and you will find some interesting information about their operation. And you can — it's not hard to figure out what's going on.

I don't know the answer as to when the shakeout will occur. But I can assure you that we will not be one of the shook. (Laughter)

Charlie, do you want to comment on it?

CHARLIE MUNGER: No. (Laughter)

WARREN BUFFETT: He'll comment on the profitable operations. He gives me the one —

The long-term business model is that, basically, we believe that, you know, perhaps 10 times the number of people that are now flying with us will be flying with us some years in the future.

That having the best service, the best record, and the best policies for safety and security, will leave us very dominant in the field, and that people will pay an appropriate price for the service.

And we see all kinds of evidence of that. But we do not see a profit this year, in my view, at NetJets.

WARREN BUFFETT: Let's go to number 2.

AUDIENCE MEMBER: Good morning. I'm Marc Rabinov from Melbourne, Australia.

I had two related questions for you gentlemen, basically both related to float.

Float, as you indicated, has become a very large part of our asset base. Assuming our policy holders continue to renew with us and we keep control of our combined ratio, can we count the float as pseudo equity when calculating the intrinsic value of Berkshire?

And the related question was, can we not expect the float to keep growing at, say, 10 percent per annum for the next five to 10 years given that we're still really a minority player in this segment? Thank you.

WARREN BUFFETT: Well, I wish it would grow at 10 percent or so, at least if it were profitable, which I do have a belief that it's likely to be.

Our float is 42 1/2 billion on March 31st, roughly.

I think the entire float of the American property-casualty industry, you know, could be something in the — roughly — in the area of 500 billion. So we may be some figure like, you know, 8 percent or a little bit more, maybe even 9 percent, somewhere in that range.

Of the total P-C float in the United States — now, it's true we have a little outside the country, too, but the big part of the world P-C market is in the United States.

When we started out in 1967, I think maybe we had 10 million of float. So to go from 10 million to 42 billion, frankly, surprises me. But it also — it's going to be much harder to grow at significant percentage rates in the future.

And our goal — we love the idea of growing — but what we really want is cost-free float. I mean, that is the goal, and growth is not a — not at the top of the list at all. I mean, I hold our managers responsible, not for delivering more float. I hold them responsible for delivering profitable float.

And that is key in our mind at all the time. If it comes along, we love it. But we will find out whether it comes along or not.

The first part of your question, if indeed 42 1/2 billion can be obtained at no cost, or even better yet at a profit, its utility to us is like equity.

Now, you couldn't realize it upon liquidation, necessarily. Oh you wouldn't realize it on liquidation. And you couldn't necessarily realize it on sale, that would depend. So I'm not telling you how to count it as in terms — whether you count it in terms of intrinsic value, you have to make that decision.

But it has the utility to us of 42 1/2 million — 42 1/2 billion — of funds derived from equity without issuing common shares. And that's one of the reasons we've always been so enthused about it now for, what, 35 or 36 years. It's a great business for us.

And every now and then we got off the track. You know, we got off the track in the early '80s, we had a problem or two in the mid '70s, and we had a problem with Gen Re for a few years.

So it — there's nothing automatic about it, and I will say this: I think, for most companies in the P-C business, that — the P-C business is not a great business. It's a commodity business to too big a degree.

So I do not think most companies in the P-C business will get float at an attractive cost. We have to be an exception.

But we have some exceptional companies and some exceptional managers, and I truly believe that we will obtain our float at considerably less cost than the industry. And that is the goal.

GEICO, if it would continue to grow at 16 percent, for example, this year, that adds a billion of premium volume. Well that doesn't generate as much float at GEICO as it generates at Gen Re, but it generates float. So GEICO's float will grow. I would, you know, I'd bet my life on that.

But certain of our other transactions are more opportunistic in nature, and that float could even shrink.

And if the float shrinks, you know, that is fine with me as long as we produce underwriting profits. We'll go wherever it goes.

Charlie?

CHARLIE MUNGER: Yeah, with interest rates as low as they are now, this float we have so laboriously built up isn't worth so much to us on a short-term basis. After all, what — if — what do we have, $16 billion of cash on hand earning a very low rate of return?

So the incremental dollar of float doesn't look all that advantageous now. But we have a more long-term view than that. We figure that eventually, we'll do a hell of a lot better than 2 percent.

WARREN BUFFETT: We're not getting 2 percent on that 16 billion, Charlie. (Laughs)

We have — we do have, incidentally on March 31st, we have roughly 16 billion in cash, not counting any cash in the finance operation, because that's a little bit phony in terms of its utility. I mean, it's offset by borrowed money.

But it — other than the finance operation, we have right at 16 billion in cash and cash equivalents, and we also have a lot of bonds and things of that sort.

On that 16 billion, you know, we are probably getting about 7/10ths of 1 percent, three-quarters of 1 percent, call it, after-tax on $16 billion, which does not make us salivate.

But — (laughter) — we would rather, you know, avoid salivation than to encounter problems. And we will use — Walmart put out the figure yesterday of roughly 1 1/2 billion for a combination of a small trucking company, plus what they sold us.

And we will, you know, we will use money, but money keeps coming in, too. If we earn a billion-seven in the first quarter, that billion-seven is pretty much all cash. And then on top of that we had the billion — billion-three or so float increase.

So float increase plus retained earnings, not counting securities gains, maybe $3 billion. Now we're not going to keep that up, but there's a lot of money coming in.

And — but we are getting some chances to deploy it. And if we deploy — if we get it at less than — at zero or less cost, it has —it’s very close to, in our — it has the utility of equity in a very big way.

WARREN BUFFETT: Let's go to number 3.

AUDIENCE MEMBER: Good morning, gentleman. My name is Hugh Stephenson (PH). I'm a shareholder from Atlanta.

You had indicated in the past that you did not think that the volatility base to Black-Scholes models for options pricing was correct.

Would you share with us how you would evaluate those options as you use them in the business or see them in the marketplace?

And also if you would update us on your thoughts on the asbestos tort situation, given the recent development of national settlement trusts, et cetera?

WARREN BUFFETT: Yeah, we — Charlie and I have thought about options all our life. I mean, my guess is Charlie was thinking about that in grade school.

And — (laughter) — you know, and I — you have to understand— you don't have to understand Black-Scholes at all — but you have to understand the utility and, in a general sense, the value of options. And you have to understand the cost of issuing options, which is very unpopular subject in certain quarters.

Any option has value. I mean, I bought a house in 1958 for $31,500. And let's assume the seller of that house had said to me, "I'd like an option on it, good in perpetuity, at $200,000." Well, that wouldn't have seemed like it'd cost me much if I'd give it to him, but an option has value.

Any option has value, and that's why some people who are, you know, kind of slick in business matters sometimes get options for very little or for nothing. I'm not talking about stock options. I'm just talking about an option to purchase anything.

They get options for far less than, really, a market value would be. Black-Scholes is an attempt to measure the market value of options, and it cranks in certain variables.

But the most important variable it cranks in that might be subject — well, might be a case where if you had differing views you could make some money — but it's based upon the past volatility of the asset involved. And past volatilities are not the best judge of value.

I mean, if you had looked at a five-year option at — on Berkshire stock — at various times Berkshire stock's had a fairly low beta, as they call it. Beta is a measure that — people in academia always like to give Greek names to things that are fairly simple, and so that they have sort of a priesthood. (Laughter)

You know, it’s — so it's like priests talking in Latin or something. I mean, it kind of cows the laity.

But they — beta is a measure of past volatility. Berkshire's had a low volatility, but that didn't mean that the option value of it, to anybody that really understood the business, was lower than a stock with a higher beta.

And I think Charlie — what Charlie said is that — last year, is that for over — that for longer-term options in particular, Black-Scholes can give some silly results.

I mean, it misprices things, but it's a mechanical system. And any mechanical system in securities markets is going to misprice things from time to time, and that's —

We made one — as I mentioned last year — we made one large commitment that basically was — had somebody on the other side of it using Black-Scholes and using market prices — took the other side of it and we made $120 million last year.

And we love the idea of other people using mechanistic formulas to price things, because they may be right 99 times out of 100 but we don't have to play those 99 times. We just play the one time when we have a differing view.

Charlie, do you want to comment on —?

CHARLIE MUNGER: Yeah, Black-Scholes is a — what I would call a know-nothing value system.

If you don't know anything at all about value compared with price — in other words, if price is teaching you all that can be known — then Black-Scholes, on a very short-term basis, is a pretty good guess, you know, for what a 90-day option may be worth in some stock or another.

The minute you get into longer-term options, or you don't have the know-nothing factor so extreme, it's crazy to use Black-Scholes. People use it just because they want some kind of a mechanical system.

But at Costco, for instance, within a fairly short period, we issued stock options at 30, and we also issued stock options at 60. And Black-Scholes valued the options we issued at 60 as the strike price way higher than the options we issued at 30. Well, this is insane.

WARREN BUFFETT: But we like a certain amount of insanity. (Laughter)

CHARLIE MUNGER: Yeah, well, it's good for Warren who picked up this extra $120 million. But —

WARREN BUFFETT: I mean —

CHARLIE MUNGER: — so he's fonder of this kind of insanity than I am. (Laughter)

WARREN BUFFETT: No, we will pay you real money if you will deliver to our offices at Kiewit Plaza somebody who wants to use the Black-Scholes model and is willing to price 100 options for three years, willing to — using the Black-Scholes model — and letting us pick and choose among those.

Because, as Charlie says, it's a know-nothing affair. And we are know-nothing guys, in respect to an awful lot of things, but every now and then we find something where we think we know something, and anybody that's using a mechanistic formula is going to get in trouble in that situation.

But options have value. I mean, we issued options, in a sense, last year when we when we sold those — the 400 million of bonds. And we know what we're giving up when we sell those bonds.

I mean, we may have gotten, what — a negative coupon of sorts, but that's because we gave up option value. And it, you know, it wasn't — it isn't truly a negative cost instrument at all, because options have value.

WARREN BUFFETT: Let's go to number 4.

AUDIENCE MEMBER: Hello, my name is Martin Wiegand from Bethesda, Maryland. And first I'd like to thank you, and all the folks working here at the microphones and staffing the booths, for hosting this wonderful shareholders' weekend. We enjoy your efforts. (Applause)

WARREN BUFFETT: Thanks, Martin.

AUDIENCE MEMBER: My question is about a company getting its employee compensation aligned with shareholder interest.

Charlie Munger, in one of his "Outstanding Investor Digest" interviews, cites the case of FedEx getting it right.

In the newspapers, we've all just read about American Airlines, Bethlehem Steel, and a lot of other companies getting it wrong. I find precious little written about compensation systems.

Would you share with us how you get it right at Berkshire companies?

Also, your old golf coach and racetrack friend, Bob Dwyer, asked me if you would like to share with us your pick in the Kentucky Derby. (Laughter)

WARREN BUFFETT: Is Bob back there with you, Martin?

AUDIENCE MEMBER: No, in the middle.

WARREN BUFFETT: Oh. Bob and I did spend a lot of time at the racetrack in high school. He was not only the basketball coach at Woodrow Wilson High, but he was also the golf coach.

And whenever I wanted to go the races he would write an excuse to my other teachers saying that we had to go out for the golf team. (Laughter)

And then we would head off to Charles Town, or Havre de Grace, or Pimlico or someplace.

And he cleaned up his act subsequently. (Laughter)

It's good to have Bob with us. He was known for his famous three-iron shots. He was known as "Trolley Wire" Dwyer in those days.

WARREN BUFFETT: Charlie, do you want to talk about comp a little?

CHARLIE MUNGER: Well, as the shareholders know, our system is different from that of most big corporations. We think it's less capricious.

The stock option system will give extraordinarily liberal awards sort of by accident to some people. And it'll deny other people any reward at all at some different time, in spite of great contributions made by the people who are getting nothing.

So except where we inherit it, we just don't use it. But we must be in a minority — far less than 1 percent, right?

WARREN BUFFETT: It's where we like to be, right.

It's interesting, we inherited some stock options at Berkshire, primarily in the General Re transaction. And, not through any failing of anybody or — there's no aspersions to be cast at all, but those options turned out to be quite valuable.

They would not have been valuable if General Re had been left alone as a standalone company. They were — they profited from the fact that other parts of Berkshire did well, and the money went to the people that had these options who delivered nothing to the performance of Berkshire for a while.

Now, that’s — that is not an indictment of anybody, in the least, at Gen Re. It's an indictment of an options system which represents a lottery ticket, and also a royalty on the passage of time.

Because as you know, an option holder has benefits from retained earnings and benefits not at all from dividends. And that puts his interest, maybe, quite contrary to that of the shareholders.

So we believe in paying for performance, but we believe in tying performance to what is actually under the reasonable control of the person that's being measured.

And we — to give a lottery ticket on the overall results of Berkshire Hathaway to someone who is running a business that's 1 percent of the whole is really crazy.

And I would say that you have seen probably more misdirected compensation throughout the corporate system — corporate America — in the last five years, you know, than in the hundred years before that. It's been extraordinary.

There was wealth creation in the '90s, just like in the '80s, in the '70s, in the '60s, in the '50s. But there was a wealth transfer like had never been experienced before.

And, you know, you can't blame people for wanting to cash in on it. You know, if anybody wants to walk up and hand me a half a dozen lottery tickets for the Nebraska lottery, you know, I'll accept them. But it will have nothing to do with how I do in terms of running Berkshire.

Actually, Charlie and I think a properly designed options system, which includes cost of capital and some other factors, and ties it to the performance of the people involved, we think that can make sense, when we've used various incentive programs that are similar to that.

But the idea of just passing them out and telling people that for 10 years they get a free ride and then repricing — you know, if your stock goes down, their stock doesn't go down, their option price goes down. You know, that is not our idea of a great compensation system.

CHARLIE MUNGER: Yeah, if we are right with our general approach, it has considerably important implications.

Because the natural implication is that more than 99 percent of corporate compensation systems are more than a little crazy in America.

And I want to emphasize that Berkshire is not illiberal. I mean, we've got various incentive systems out where people make tens of millions and may make hundreds of millions.

And so, we're not against rewards for people who make vast contributions.

But a system that's basically capricious, and which doesn't tailor the results per person and per activity very well, we just think it's crazy.

WARREN BUFFETT: We love to see people that are associated with Berkshire making money, as long as they're making money for you at the same time. It's very simple.

And — but we don't want them to get a free ride off your money. (Applause)

Compensation's an interesting subject and I'm going to write about it next year, some. But, you know, it's not a market system. You can read all you want. I mean, you know, the PR people will tell you, you know, that "Joe Smith's compensation was determined by a market system and he's just like a baseball player,” anything of the sort.

But he's not just like a baseball player. You know, the baseball player negotiates with somebody who's spending his money to hire the baseball player, and making a calculation whether he's better off laying out the money out of his own pocket — the owner of the team — to get that player.

But when you get a comp committee at a large American corporation, you have somebody with an enormous interest in the amount of comp on one side of the table.

And you've got somebody on the other side of the table, who was not picked because they were the Doberman of the board, believe me — and who is dealing with what — many times is what my friend, Tom Murphy, used to call "play money."

I mean, you know, it's almost meaningless to the person on one side of the table whether somebody gets 100,000 shares of restricted stock or a million shares of restricted stock, and it's not meaningless to the guy on the other side of the table.

Almost every other negotiation in American business, you have some parity of concern. But you do not have a parity of concern, you know, in terms of the — in terms of comp at the top levels.

You have a parity of concern when you get down to labor unions. I mean, the management wants to keep down the prices and the union wants to get more money. And that's a real negotiation.

And you have, you know, you have lots of other real negotiations in American business, but the compensation in many companies — not all, obviously — but in many, many companies has not been a real negotiation at all.

And the management has hired comp consultants to come in, and I have never seen a comp consultant come in and say, "We ought to reduce this guy's salary."

I've also never seen a comp consultant come in and say, "Why don't you get rid of this bozo?" You know, I mean — (laughter) — they can't all be wonderful.

But — you know, can you imagine a comp consultant doing that and ever getting another assignment? It wouldn't happen.

So it's a bad system, and it needs improvement. And it may be getting a little improvement. And as I wrote in the annual report this year, what happens with comp is the acid test of corporate reform.

Because frankly, the CEOs of America, they don't care whether their boards are diverse, or not diverse, or anything of the sort. They care about how much money they make, in a great many cases.

And you, the owners, and big owners in particular, you know, have to provide some countervailing force, or you'll have what you've had in the last 20 years, which is an enormous disparity in the rates of compensation of people at the top compared to people at the bottom.

And also a disconnect between the comp of people running businesses and the results of the owners who gave them the money. So arise, (inaudible) shareholder. (Applause)

WARREN BUFFETT: Let's go to number 5.

AUDIENCE MEMBER: Good morning. Good morning, my name is Matt Sauer and I'm from Durham, North Carolina.

In a 1977 Fortune magazine article titled "How Inflation Swindles the Equity Investor," you argued that corporate earnings in aggregate acted like a bond coupon, and thus, were negatively impacted by high inflation.

Due to high inflation at the time, you posited a world where a 12 percent return on corporate equity would —was reduced to 7 percent after taxes, and netted out to 0 percent in real terms.

You have been sounding downcast about the prospects for equities for several years, much of which we assume relates to extreme starting valuations.

If inflation was decidingly bad for investors in 1977, isn't the relative lack of it in today's economy at least one mark in the plus column for equity owners?

Is there also a future inflation expectation component in your warnings that investors are likely to be disappointed by equity results?

WARREN BUFFETT: Well, I would — there's no question that the lack of inflation is a plus for owners. I mean, the real return you will obtain, in my view, from owning American business — if purchased at similar prices — the real return will be higher if we have long periods of lower or close to no inflation, than if we had long periods of high inflation.

I don't think there's any question about that. Because that article went onto explain how you got taxed on nominal returns and fictitious returns in real terms.

So your question about which period is better for investors — a low inflation period over any long period is better for investors.

And the problem, as you pointed out also, was the starting point, in terms of predicting modest returns for equity investors.

The returns weren't necessarily so modest, I predicted. They were just modest compared to what people had begun to think returns would be during that long bull market from 1982 to 1999.

There were polls taken by Gallup working with, I think, PaineWebber at the time — now they've moved it over to UBS Warburg — that showed the expectancy of people in the stock market. And those returns that people expected got up to 14 or 15 percent, as I remember.

And they were thinking they were going to get 14 or 15 percent in a low-inflation environment.

Well that, you know, that was dreaming. And there's nothing wrong, in a low-inflation environment, at all, in earning, you know, 6 or 7 percent. That's probably as well —

Well, it is as good as will happen, because in a low inflation environment how much is GDP going to grow? Well, GDP, you know, if you have a 2 percent inflation and even 3 percent real growth, you're talking about 5 percent, in nominal terms, GDP growing.

If GDP grows at that rate, over time corporate profits will grow at — more or less, at that rate.

And if corporate profits grow at 5 percent a year, the value of those corporate profits, the capitalized value, will probably grow at something like that over any long term with sort of a normal starting point.

And add that to dividends and, you know, you will get 6 or 7 percent before frictional costs. Investors incur a lot of frictional cost. They don't have to, but they do. And that often is 1 1/2, 2 percent of their investment.

So the math isn't bad, it's just bad for those people that got used to, or expected, very high returns based on looking in the rearview mirror back in 1998 or 1999.

Charlie?

CHARLIE MUNGER: My general attitude is just slightly more negative than Warren's. (Laughter)

WARREN BUFFETT: You've heard it, folks. (Laughter)

That isn't the end of the world. I mean, in effect, if the people who own American business get 5 to 6 percent of the pie — $10 trillion economy now, someday a $20 trillion economy.

But if we get 5 or 6 percent of the pie, those of us who put our capital out to produce goods and services for American business — for American consumers, American population — is that a, you know, I don't know whether that's — you know, that's exactly what somebody who designed the universe would come up with.

But it doesn't strike me as crazy in either direction. You know, I think that — that's a lot of goods and services to go to people that put up the capital, but you — and you've got, you know, a hundred million-plus people in the working force that are working to turn that out for you, using your capital.

And it provides a — what I would regard as a pretty decent real return if you have low inflation.

If you get into high inflation, as I wrote about back in '77, you could easily have the real return, to investors, get to a very, very low number, and perhaps negative.

I mean, inflation can swindle the equity investor, as I wrote back then, and I used 7,000 words to explain why, and will be glad to send you a copy of that article if anyone's still interested.

But inflation is the one thing that, over a long period of time, can turn investors' results, in aggregate, into a negative figure. And it's the investors' enemy.

Charlie, does that bring forth any further thoughts?

CHARLIE MUNGER: I don't think you'll get perfect help on these subjects from the economics profession, either. They have certain standard formulas.

To an economist, when a manufacturing job goes to China, that's just so much productivity increase. And if you ask one, well suppose all of the manufacturing jobs in America went to China. Wouldn't that be a little too much efficiency increase?

And the answer would be no. And people actually get paid for thinking like this in major universities. (Laughter and applause)

WARREN BUFFETT: Yeah, if — what would get across the point, of course, is if all the teaching of economics got exported to China, in which — (laughter) — at that point a new insight would appear.

WARREN BUFFETT: Number 6.

AUDIENCE MEMBER: Jack Hurst (PH), Philadelphia. I have a question about the managers, and a comment and a question about the insurance operation.

These meetings are a lot more fun with more subsidiaries and more managers. I also think more educational, because you get to interact with them.

Is there any feed — do you get any feedback from the managers that they enjoy coming here and they get anything out of the meeting?

WARREN BUFFETT: Well, we have a number of our managers here and I — but we don't require anybody to come. I mean, we have managers that, very, very seldom have come to a meeting.

And I don't keep names, I can't even tell you which ones they are. But you know, if they enjoy it, they come.

Many of them, of course, have operations down below, selling you things, and some of them come to help out in that respect. But we've got a — you know, we have a sensational group of managers.

They run their own businesses, they're extraordinary at doing what they do and we don't get in their way. We don't demand that, virtually, that they do anything, except work for the owners.

But you will — I hope you meet some of them here today because they — you know, the ones that are here, obviously, enjoy interacting with the shareholders.

And it's fun to put faces to functions. I mean, it — I enjoy it, I think a lot of them enjoy coming here.

And the people that are working downstairs, you know, they volunteer to come. And they enjoy seeing the shareholders, and they enjoy bragging about their companies, and they've got a lot to brag about.

And I hope you thank them when you see them because, you know, it's a lot of effort for them.

I got here at six o'clock this morning, but there were people that were here a lot earlier than that, and they were working yesterday to get ready for this. And I want to thank them myself.

Charlie? (Applause)

CHARLIE MUNGER: I don't think our managers who come to this meeting are picking up new tricks. Most of our managers know all the tricks that are related to their businesses.

But this is a very interesting place, and it gets more interesting every year. And part of what makes it interesting is not discreditable, and I think people like being part of it.

WARREN BUFFETT: Yeah, our managers — in a few respects, we'll occasionally work together.

Sometimes a manager of subsidiary A will check with some of the others, not through Omaha, directly themselves. And they will say, you know, "What are you paying for software?” or “What are you paying for UPS?" or whatever it is, and "Can we make a better deal if we pool our efforts?"

There are times when we have saved money, sometimes pretty real money. But that has never been instituted by Omaha, it's never been overseen by Omaha.

It's because manager A decides to call manager B. And you know, they like each other and they can make their own operation better, sometimes by combining purchasing power, and occasionally by just having an idea here or there. But there's no organized way of going at that in Berkshire and nobody has to play.

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: I'm John Bailey (PH) from Boston.

I'd like to ask about our consumer businesses, which means that I have to ask about the consumer in general.

The situation, as I understand it, is that over the last 30 years or so the median consumer has seen his income rise only a little faster than inflation, and much slower than GDP, overall.

Income inequality is at a 400-year high. The present value of lifetime income for the median person has improved slowly. Yet the size of his lifetime liabilities, such as health care, housing, education, and retirement, has ballooned.

The economic net worth, then, of the consumer may be poorer than they think.

To cope, the median guy has put his wife to work, borrowed against the house, and also the credit cards.

So I think this may have some implications for the sustainability of consumer businesses. And seeing that we've been buying a number of them recently, how do we think about this problem? And are there any non-obvious risks that we should be considering?

WARREN BUFFETT: The American consumer, overall, is better, but not dramatically better off than 10 years ago. Even somewhat better off than 20 years ago. But you're quite right in that there's been considerable inequality, in terms of the progress of people financially during that period.

We don't have broad ideas about — I mean, we don't make decisions on what business we buy based on some sweeping future projections about things.

We think America will do pretty well over time. In fact, we’d — we're quite sure it will do pretty well over time and that our kids will live better than we live. My kids would say that wouldn't be so difficult. (Laughter)

But the — and the grandchildren will live better. You know, that has been the history of the American economy. The real income per capita grew sevenfold, I believe, in the 20th century. That is huge.

You know, it cost $18, as I remember, to make a three-minute station-to-station call from New York to San Francisco 40 years after the telephone was invented. And at the time the $18 was more than the average weekly wage in the United States.

You know, think if some little kid had picked up the phone on the other end and there went the whole weekly wage while you tried to get, you know, your daughter on the phone, or whatever.

So it — people will be better off in this country decade after decade. But we don't — we're not big on being futurologists or anything at Berkshire.

I will tell you this, in terms of our consumer businesses, right now, they're very soft.

Our furniture and jewelry businesses generally — candy business, businesses dealing with the consumer day by day — are soft, and the first quarter the earnings were down.

WARREN BUFFETT: One of the things you have to think about — and people don't — they don't focus on this very much. But you read about GDP, and this is one reason I think — I really think we've been in a recession now — not a huge one, but — or not a violent one — but for over two years.

When the government talks about GDP, A, they talk about GDP, we'll say, going up 2 percent. But of course, the population of the country, you know, goes up something over 1 percent per year. So it's per capita GDP that counts. And that has gone very close to no place.

But the more important factor, to some extent, is that GDP counts the people that, you know, have you take off your shoes when you go to get on an airplane. You know, it counts extra police. It counts all of these things that don't really translate into — they translate into goods and services that the country wants, but they are not goods and services — I mean, they're goods and services we wish we didn't want. And they — all of that counts the same way.

If there’s a — 20 guards at the airport instead of three guards, that goes into GDP. But does it make you feel any better about how you're spending your paycheck every month? Probably not.

And when you get into a war, for example, if you drop planes into the ocean, you know, that's part of GDP, the cost of manufacturing those planes. But it doesn't do anything for you at your house.

So in terms of what I would call "desirable GDP," I think my guess is that, on a per capita basis, that has gone no place in the last few years as we've diverted resources to other things that don't really translate to what goes into your house or onto your table.

And the quality of GDP is something that is not really talked about very much when you pick up the economic reports every day.

Charlie?

CHARLIE MUNGER: Yeah, and the type of figures you gave us about inequality tend to obscure a basic and important fact. If the same families were permanently at the top of the economic heap there would be huge resentments about current inequality.

But when the coupon clippers and the DuPont family go down, and somebody creates something like Pampered Chef and comes up, in a real sense, something wonderful is happening in terms of equality, even though at the end it looks like there's been no progress.

That much churn makes people think the whole system is fairer. (Applause)

WARREN BUFFETT: We prefer not to be part of the churn, though, actually, at this point, I think. (Laughter)

We were much more in favor of churn 30 or 40 years ago. (Laughter)

WARREN BUFFETT: Number 8, please.

AUDIENCE MEMBER: My name is Johann Freudenberg (PH). I come from Germany.

I would like to know the accounting book you like best. Thank you. (Laughter)

WARREN BUFFETT: Well, it's been a long time since I've read an accounting book. I read Finney back when I was in college, I remember that. And I always liked accounting. And for any of you in business, you know, you basically can't get enough accounting.

But I don't — you know, I am not really up to date on accounting books. Maybe Charlie's been reading some of those lately.

I would hope, actually, that if you read the Berkshire reports over time that you get certain, perhaps, lessons on accounting.

But I think you learn more accounting, probably, in terms of — well I mean, once you know the basics of it, by reading good business articles that deal with accounting issues, accounting scandals, that sort of thing.

I mean, what you really need to know is you need to know how the figures are put together, the underlying principles of it, and then you have to know what can be done with those.

And — you start with the accounting figures as the raw material of understanding a business, but you have to bring something additional to that.

And I can't think of any good books on that subject. I think I've read a lot of good magazine articles that contributed to my knowledge over the years.

And I've just, you know, I’ve read a lot of annual reports, and seen what people can do with accounting.

And as I've said before, if I don't understand it, I figure it's probably because the management doesn't want me to understand it.

And if the management doesn't want me to understand it, there's probably something wrong going on. I mean, people don't obfuscate with numbers, usually, without a purpose. And when you run into that the best thing to do is you stay away.

Charlie?

CHARLIE MUNGER: Yeah, asking Warren, you know, what good books he knows about accounting would be — it's like asking him what good books does he have about breathing. (Laughter)

The — and — (applause) — what the implication of that is, is that you start by learning the basic rules of bookkeeping, which are sort of like the basic rules of addition and subtraction. And then you have to spend a lot of time before that accounting gets related to the larger reality, and that's a lifelong process.

WARREN BUFFETT: OK, we're going to try to go to the Music Hall. Number 9. Is this working?

AUDIENCE MEMBER: I believe so.

WARREN BUFFETT: OK, good.

AUDIENCE MEMBER: Bill Ackman from New York City, and my question is as follows:

Insurance companies — could you comment on insurance companies taking on credit risk through the sale of credit derivatives, the adequacy of the accounting for these derivatives?

And finally, could you explain why the financial guarantee insurers, who are the primary sellers of these derivatives, have the same triple-A rating Berkshire has, despite their more than 140-to-one leverage, and the correlated nature of the risks that they take on?

WARREN BUFFETT: Well, I think you should go to work for Standard and Poor's or Moody’s.

The question about credit insurance or credit guarantees of one sort or another, you know, that's become very popular.

And it's become — actually, popular with, sort of, the standard insurance, property-casualty insurance, companies in recent years.

And I would say that, in many cases, the people participating in that business don't really know what they're doing.

It's so easy in the insurance business — it's the curse of the insurance business — it's also one of the benefits of it — is that people hand you a lot of money for writing out a little piece of paper.

And what you put on that piece of paper is enormously important. But the money that's coming in that seems so easy can tempt you into doing very, very foolish things.

We had a situation here in Omaha 15 or 20 years ago in the mid-'80s where Mutual of Omaha — largest health and accident association in the world, at least at one point — and they decided to go into the reinsurance — property-casualty reinsurance business.

And in a very, very, very short time they wrote not very many contracts, and it resulted in wiping out half of the net worth of everything that had built up over many, many decades.

If you are willing to do dumb things in insurance, the world will find you.

I mean, you do not — (Laughter)

You can be in a rowboat in the middle of the Atlantic and just whisper out, "I'm willing to write this," and then name a dumb price, and you will have brokers swimming to you, you know — (laughter) — with their fins showing, incidentally. (Laughter)

It is brutal. I mean, if you are willing to do dumb things, there are people out there, and it's understandable. But they will find you, and you will get the cash up front.

You will see a lot of cash and you won't see any losses, and you'll keep doing it because you won't see any losses for a little while. So you'll keep taking on more and more of this, you know, and then the roof will fall in.

And I mentioned in the annual report how GEICO had taken in, you know, 70-odd thousand dollars — $70,000 — of premiums in the early '80s for a few policies, and they thought they were just picking cherries at the time, and they reinsured a lot of it. And so far we've lost $93 million.

Now, the most we could make was 70-odd thousand, and I don't know what the most we can lose is. But I know that 93 million has gotten my attention. (Laughter)

When you're playing in a game like that, you can't afford to make a mistake. I mean, it's — the mistake — a single mistake or a few mistakes that are correlated, as you've mentioned — because these things do correlate — a few mistakes will overcome a lifetime of savings.

I mean, it is — you will make a few cents on the dollar when you're right, and you will lose incredible sums when you're wrong.

And in credit insurance, when you go around — a lot of people went around guaranteeing credits based on ratings.

And they said, well, we'll guarantee a whole bunch of single-A ratings, or we'll create these structured arrangements that involve A-rated credits.

And they would use a lot of studies that would show that X percent of A-rated credits defaulted per year, and you go back to the '30s, and all these back-tested arrangements.

But the problem with that is that what the questioner mentioned is correlation. And when things go bad, all kinds of things correlate that no one ever dreamed correlated.

And what you had, of course, in the debt field was you had a whole bunch of, say, telecoms or energy companies, that were all rated similarly. But they were correlated in a huge way and you weren't getting a diversification. You were getting a concentration that would — you didn't realize.

And there's nothing more deadly than unrecognized concentrations of risk, but it happens all the time.

So I would say we see a B-double-A credit enhanced to a triple-A credit by somebody guaranteeing it, and they may guarantee it for 10 or 15 basis points. And yet the spread in market yield might be 100 basis points.

That does not strike us as smart.

And I would say this about the triple-A rating. They have a triple-A rating for claims paying, but they don't carry, I don't think, general triple-A.

There's only, I think, eight or nine triple-As left in the United States. Berkshire Hathaway's one of them. But I believe there's only one other insurance company, which is AIG, and then there's a half a dozen other companies.

So those companies are not in the same class, credit-wise, as Berkshire, nor are they recognized as being in the same class.

But I would say you could get into a lot of trouble at 140-to-one — at some point — insuring credits.

Charlie?

CHARLIE MUNGER: Yeah, he also asked about the quality of accounting. And in my view, at least, the quality of accounting in America for derivative transactions is still terrible. And it's terrible in that it's too optimistic.

And one of the places where it's most terrible is when you talk about guaranteeing future credits way, way out — years ahead.

That sort of thing just lends itself to people getting very optimistic in their assumptions and in their audited figures.

And people pay attention to the audited figures, not the underlying reality. So therefore, if the accounting is lousy, the business decisions are lousy. And I think that's going on mightily as we sit here.

WARREN BUFFETT: Yeah, there are dozens of insurance organizations or trading organizations in the country that have written credit guarantee contracts in derivative form in the last few years, in fact, on a huge scale.

I will guarantee you, virtually, that every single one of those contracts that was written, in the first week, whoever wrote it, you know, recognized some sort of an income account or an income entry, and that somebody got paid a little bit of money for writing each one of them.

And you know that many of those are going to go bad, and maybe, as a category, that it's going to be a terrible category. But nobody ever wrote a contract and recorded a loss at the time they wrote it. I mean, they just don't do it.

And I will tell you that there are a lot of those contracts that if somebody wrote them for me, 10 seconds later I would've paid somebody to take them off my hands, so that I would've regarded them as having a built-in loss. Nobody ever records a built-in loss on a derivative contract.

In fact, I find it extraordinary that you have two derivative dealers, and dealer A and dealer B write a ticket, and dealer A records a profit and dealer B records a profit, you know, particularly if it's a 20-year contract, you know? I mean, that is the kind of world I'd love to live in, but I haven't found it yet.

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: Hey, good morning, Charlie, Warren. Jerry McLaughlin from San Mateo checking in from the Music Hall.

You should see yourselves over here. We're about 12 feet from wall-size images of both of you, which is interesting, but the See's Candy box is so big, I understand what Tantalus went through now.

WARREN BUFFETT: How many people do you have in the Music Hall?

AUDIENCE MEMBER: We probably want to get a cop to estimate, but I'd say it's a couple of thousand.

Anyway, moving right along — hoping I can get a twofer here.

One is, at Branders, small company we run, we're seeing — we’re spending a lot more on employee benefits anymore.

Health insurance in particular is going up and up again. And lots of times, in the press years ago and now again a little bit, you're hearing the drumbeat of a health care crisis and what it costs employers to provide health insurance.

I got to figure that's on the minds of a lot of Berkshire operating company managers. I'm wondering whether both of you feel — I mean, is crisis the right word, with respect to cost?

Looks like bigger percentages of our GDP are going to health care. Is that because we think we're getting better health care, or is it really just sort of inflationary?

Second thing is, at the risk of you thinking we're all a bunch of kooks over here, a couple of people over on this side of the hall have asked me to ask you, Warren, whether you're seriously considering being cryogenically frozen at some point — (laughter) — I think, hopefully, in the distant, distant future.

WARREN BUFFETT: What —?

CHARLIE MUNGER: Cryogenically frozen.

WARREN BUFFETT: Oh, we had that last year.

AUDIENCE MEMBER: Yeah, and the guy who asked the question last year has put me up to a follow-up for him.

Hey, and finally, unrelated to those two —

WARREN BUFFETT: Do I look like I'm closer to where I need it? (Laughter)

AUDIENCE MEMBER: Last thing is, when you guys look at companies and you're thinking about earnings into the future, just do you have any rule of thumb? How far in the future do you think you can look, typically, with a company you believe in, you think you understand the business?

Is it five years, 10 years? Do you really think you've got, you know, sort of the perpetual, into infinity income stream to calculate the value on? Thanks.

WARREN BUFFETT: Yeah, well we don't project as far out as we might have to if we thought we could be successfully frozen. (Laughter).

But we really — you know, we're going to own these businesses forever. So, we want a business that we think is going to have, if run well, some kind of competitive advantage — over many decades.

I mean, we're not going to resell them. And we better have something that is not only good now but that's going to stay good.

So we don't buy hula-hoop companies or pet rock companies, and we don't buy companies in industries that we think will have great explosions in demand, but where we don't know who the winners will be.

So we look a long — we try — we like to think we're looking a long way into the future.

WARREN BUFFETT: On health care costs — the only company-wide managers meeting — and we had far fewer managers then — but we had a meeting of most of the then-smaller number of managers 15 or 20 years ago where we did talk about what the various companies were doing on health costs, because they were then the fastest increasing part of our cost structure.

And today, workers' compensation costs would probably be — and some other insurance costs unrelated to health would be also — would, at least in the last couple of years, have moved up even more dramatically than health costs.

But health costs are huge for us. In many cases, you know, running 6- or $7,000 per employee, but moving up at a fast rate.

And you know, that is an inflationary part of the U.S. economy that we can't solve and our employees can't solve. And it becomes a big part of the kind of cost — it's a raw material cost — we had higher energy costs in the first quarter.

But health costs are the ones that are going to just keep coming and coming, in my view, and I don't have any great answers for it.

Charlie runs a hospital and knows a lot more about the health system than I do, so we'll see what he has to say.

CHARLIE MUNGER: Well, I would argue that the quality of the medical care delivered, including that from the pharmaceutical industry, has gone up enormously. And, of course, the cost has, too, but it's a much richer country.

And I don't think it's crazy if the United States wants to spend 15 percent of GDP on health care. If it went to 16 or 17, I wouldn't consider it the end of the world.

Eventually, of course, there would be a place where it wouldn't be smart to spend so much.

WARREN BUFFETT: Do you think, if we're spending 13 or 14 percent and other countries that seem to have fairly good systems are spending 7 or 8 percent, that we're getting our money's worth, relative to them?

CHARLIE MUNGER: Well, certainly they're getting more value per dollar out of their 7 percent than we're getting out of our 15. But does that mean that it's crazy for us to spend 15? I don't know.

I would guess not. But I don't see any sign from anything I see that it isn't continuing to go up.

WARREN BUFFETT: It's a — I don't know how much we — we never aggregate figures around Berkshire from the various companies because it wouldn't mean anything. But we spend a lot of money on health care.

And certain states, it's far higher than others. It makes a lot of difference where you're located.

WARREN BUFFETT: Number 1?

AUDIENCE MEMBER: Hello, Mr. Buffett and Mr. Munger. My name is Justin Fung (PH). I am 13 years old, from California. This is my third consecutive year in attendance.

First of all, I would like to wish you the best of health so we can continue to come to Omaha for many years to come. (Applause)

WARREN BUFFETT: Thank you.

AUDIENCE MEMBER: Thank you for answering my question on friendship last year. My question this year is, how do you define success and happiness? Are they related? And how would one achieve that? Thank you.

WARREN BUFFETT: Well, I tell college students that when you get to be my age, you will be successful if the people that you would hope to have love you, do love you.

I mean, you — if — Charlie and I know a few people that have got a lot of money, and they get testimonial dinners, and they get their names on buildings, and the truth is, nobody loves them.

And you know, not their family, not the people who name the buildings after them. You know, it's sad.

And it’s — unfortunately, you know, it's something you can't buy. I mean, Charlie and I have talked a lot of times, if we could just buy a million dollars’ worth of love, you know, I mean? It would be so much more satisfactory than to try and be lovable. (Laughter)

But it doesn't work that way, you know?

The only way to be loved is to be lovable. It's — and I hate to tell you that at 13, and — but the nice thing about it, of course, is that, you know, you always get back more than you give.

I don't know whether it was Oscar Hammerstein or who said, you know, "A bell's not a bell till you ring it, a song's not a song till you sing it. Love in the heart isn't put there to stay. Love isn't love till you give it away." And basically you'll always get back more than you give away.

And if you don't give any, you don't get any. It's very simple.

I don't know anybody my age that is loved by a lot of people — we had a dinner the other night, Don Keough was there — everybody loves Don Keough, you know, and for good reason.

And there is nobody I know that has — that commands the love of people around them, people they work with, their family, and their neighbors— that is other than a success or feels other than a success.

I don't know how the people feel that — where they know that nobody loves them, but I can't believe they feel very good.

So it's very simple. You can't get rid of love. If you try to give it out, you get it back more than you've given. And it's the best thing.

Charlie, what do you speak for? (Laughter)

CHARLIE MUNGER: Well, you don't want to be like the motion picture executive in California, and they said the funeral was so large because everybody wanted to make sure he was dead. (Laughter)

And there's a similar story about the minister saying at the funeral, "Won't anybody stand up and say a good word for the deceased?" And there was this long silence, and finally one guy stood up and he said, "Well," he said, "his brother was worse." (Laughter)

WARREN BUFFETT: Look, I would say this. Look around at, you know, people older than you are, look around at, you know, your older relatives or whatever, and you will not see a — an unhappy person who is loved by those around them.

I mean it — and it's — most people in this room are going to do very well financially. Most of the college students I talk to are going to do well financially.

And some of them are going to have very few friends — real friends — as they get older, and others, people won't be able to do enough for.

And I see it around me all the time. So that's our advice for the day on that.

WARREN BUFFETT: Number 2. (Applause)

AUDIENCE MEMBER: Hello, my name is Kevin Truitt (PH) and I'm a shareholder from Chicago, Illinois.

Mr. Buffett and Mr. Munger, thank you for putting on this marvelous event for your shareholders and partners. I thoroughly enjoy and love coming here.

I get so much education from this, in that the people here are just wonderful.

I have three, hopefully short, questions. The first two questions are for you and Mr. Munger, and the third question is for you.

My first question is, Mr. Munger, you are largely credited with moving Warren away from the cigar-butt approach to investing, as it was practiced by Ben Graham. It's been stated that it was the purchase of See’s Candy that taught you this important lesson of buying good businesses.

At what point did you realize that this concept of buying good businesses was a better long-term investment strategy? And what was it in your discussions with Warren that allowed you to persuade him to move in that direction?

Mr. Buffett, what was it in Mr. Munger's arguments for buying good businesses that persuaded you to abandon the cigar-butt approach and move in his direction?

My second question is, in both your experience have you or Mr. Munger ever known of a company that has regained or replaced its competitive advantage once it was lost?

My third question for you, Mr. Buffett, is, early in his career Richard Rainwater sought you out and asked you what it took to become a successful investor. Can you tell us what he asked you and what you told him? Thank you. (Applause)

WARREN BUFFETT: The last question, I don't remember at all. I mean, Rainwater called me a couple of times, but I don't really remember the conversation.

That was a lot of years ago and I probably said the same — I would have said the same thing to his as if I got a question asked in this meeting.

So I’ve really had no contact with Richard Rainwater over the years. Like I say, I think I met him once, I believe, and he called a couple of times, so —

WARREN BUFFETT: Charlie, do you want to answer the first question about how you —

CHARLIE MUNGER: Yeah, well, I think there's some mythology in this idea that I've been this great enlightener of Warren Buffett. (Laughter)

Warren hasn't needed much enlightenment, but we both kept learning all the time, so that the man we were five years earlier was less sensible than the man who ultimately was there.

And See’s Candy did teach us both a wonderful lesson. And it'll teach you a lesson if I tell you the full story.

If See’s Candy had asked $100,000 more, Warren and I would've walked. That's how dumb we were at that time.

WARREN BUFFETT: Ten-thousand more. (Laughter)

CHARLIE MUNGER: And one of the reasons we didn't walk is while we were making this wonderful decision we weren't going to pay a dime more, Ira Marshall said to us, "You guys are crazy. There are some things you should pay up for," quality of business — quality, and so forth. "You're underestimating quality."

Well, Warren and I instead of behaving the way they do in a lot of places, we listened to the criticism. We changed our mind.

And that is a very good lesson for anyone. The ability to take criticism constructively is — well, think of all the money we made from accepting that one criticism.

And if you count the indirect effects from what we learned from buying See’s, you can say that Berkshire's been built, partly, by learning from criticism. Now, we don't want any more today. (Laughter)

WARREN BUFFETT: We also like the peanut brittle, too. (Laughter)

WARREN BUFFETT: The — Charlie explained, I had learned investment, and got enormous benefit out of that learning, from a fellow who concentrated on the quantitative aspects, Ben Graham.

And who didn't dismiss the qualitative aspects, but he said you could make enough money focusing on quantitative aspects, which were a more sure way of going at things and would enable you to identify the cigar butts.

He would say that the qualitative is harder to teach, it's harder to write about, it may require more insight than the quantitative. And besides, the quantitative works fine, so why try harder?

And on a small scale, you know, there was a very good point to that.

But Charlie really did — it wasn't just Ira Marshall — but Charlie emphasized the qualitative much more than I did when I started.

He had a different background to some extent than did, and I was enormously impressed by a terrific teacher, and for good reason.

But it makes more sense, as we pointed out, to buy a wonderful business at a fair price, than a fair business at a wonderful price.

And we've changed our — or I've changed my focus anyway, and Charlie already had it — over the years in that direction. And then of course, we have learned by what we've seen.

I mean, we — it's not hard when you watch businesses for 50 years, you know, to learn a few things about them, as to where the big money can be made.

Now, you say when did it happen? It's very interesting on that. Because what happens, even when you're getting a new, important idea, is that the old ideas are still there. So there's this flickering in and out of things. I mean, there was not a strong, bright red line of demarcation where we went from cigar butts to wonderful companies.

And it — but we moved in that direction, occasionally moved back, because there is money made in cigar butts.

But overall, we've kept moving in the direction of better and better companies, and now we've got a collection of wonderful companies.

WARREN BUFFETT: In terms of competitive advantage and then regain — lost and then regained — there aren't many examples of that. In the property-casualty company, I’ve got a friend who always wants to buy lousy companies with the idea he's going to change them into wonderful companies.

And I just ask him, you know, "Where in the last hundred years have you seen it happen?"

I mean, GEICO got into trouble in the early '70s, but it had a wonderful business model. It did get off the tracks, but it wasn't because the model went astray, it's because they’d started reserving incorrectly and went crazy on growth, and a few things like that. But the basic model was still underlying it.

You might argue that one company that lost its competitive position and then came back in a different way, actually, was Pepsi-Cola. I mean, they were "Twice as much for a nickel, too."

They were selling on a quantitative basis, the fact that you got to guzzle more of the stuff for a nickel — twice as much, as the slogan went — and they lost that edge, post-World War II, when costs went up a lot.

And so they basically changed their marketing approach successfully, and that's very, very seldom done. But you have to give them credit for that.

To some extent, Gillette lost its competitive position somewhat in the '30s, lost market share against what they called penny blades and all that, and then regained it in a very big way in the next 10 or so years when their market share went up enormously.

But generally speaking, if you lose your competitive position — the Packard Motor Company had the premier car in the mid-'30s. The Cadillac was not the premier — it was the Packard.

And then they went downscale one year and they never came back. They jumped their sales that one year because everybody wanted to own a Packard, and now you could own one a little cheaper. But they never regained that upscale image again.

And certain department stores have done that, too. They've had a upscale image. And you can always juice up your sales, particularly if you've got a great upscale image, by having, you know, this sale or that sale, and going downmarket.

It's very hard to back upmarket again, and you've seen some great department stores that have had that — or specialty stores — that had that problem.

Charlie, you got any thoughts on that?

CHARLIE MUNGER: No more.

WARREN BUFFETT: OK.

WARREN BUFFETT: Number 3.

AUDIENCE MEMBER: Hi. I'm Bruce Gilbert (PH), a stockholder from New York City.

And about four or five years ago, I put most of my family's portfolio — actually all of it — into Berkshire Hathaway.

And over the past four or five years, the stock price has remained rather steady, and I've withstood the year 2000, when friends were making 50 percent and I was losing 50 percent on my investment.

But I have to admit, when I read your Fortune article last year and you referred to the stock price as expensive, I felt badly.

Now I spend my days sometimes having fun, figuring out the value of Berkshire Hathaway.

But at night after that comment I could also wake up in worry and fret. And I realize you talked, recently, a lot about the qualitative and quantitative aspects of things.

And I guess I would like you, with your self-reflective position, and knowing that I'm asking you to do something like maybe talking about your breathing, what went into that comment to call the stock price expensive, in terms of your weights and measures?

What price, what value? What do you think about the company and its stock price when you say it's expensive?

WARREN BUFFETT: I think if you — I don't remember the exact wording of that article, but I'm quite sure that I told the author of that article, and I'm almost positive it was in the article, that said I thought it was more attractive than owning the general market or the S&P.

So I was saying that I preferred it to the general market. I'm certainly happy having 99 and a large fraction percent of my net worth in it. I've never sold a share, I am not the least bit uncomfortable about holding it until the day I die, and quite a bit thereafter. (Laughter)

But I have not thought stocks were cheap at all for some time. And I've never wanted to encourage anybody, particularly in the last few years, to buy Berkshire or any other stock because — the market — I felt that the — you know, I felt we had a great bubble.

And you know, I think Berkshire's value has improved — I think Charlie does, too, fairly significantly — in recent years.

And I would — if I had a chance to swap, tax-free, my Berkshire for the S&P 500, or for any mutual fund or anything, you know, I wouldn't even give it a thought. But that does not mean I think, you know, either Berkshire or stocks are cheap.

Charlie?

CHARLIE MUNGER: I've got nothing to add to that.

WARREN BUFFETT: I don't think we've ever recommended the purchase or sale of Berkshire, that I can remember. We did say at one time we would repurchase shares, which has a certain underlying message to it.

And we said at other times we wouldn't buy shares. That doesn't mean we'd sell shares at all, but we wouldn't have bought them under the prevailing conditions.

But we have stayed away from recommending, actually not only the purchase or sale, not only of Berkshire, but just of any other specific shares.

We've only given our views, occasionally, on what we think about the level of the stock market, generally.

But I do think, if you go back and look at that article — I wish I had it here. But I think you'll find that I said I preferred it to equities, generally. It —

CHARLIE MUNGER: I do think that there's a lot to be said for developing a temperament that can own securities without fretting. I think that the fretful disposition is the — it's an enemy of long-term performance.

WARREN BUFFETT: Well, it’s almost — I think it's almost impossible if you're — to do well in equities over a period of time if you go to bed every night thinking about the price of them. I mean, Charlie and I, we think about the value of them.

But we would be happy, just as in that movie — if they closed the Stock Exchange tomorrow, you know, Dick Grasso wouldn't be happy and Jimmy Maguire, our specialist, wouldn't be happy.

It wouldn't bother me and Charlie, at all. We would keep selling bricks, selling Dilly Bars, selling candy, writing insurance. You know, a lot of people have private companies and they never get a quote on them.

You know, we bought See’s Candy in 1972. We haven't had a quote on it since. Does that make us wonder about how we're doing with See’s Candy? No, we looked at the company results.

So you — there's nothing wrong with focusing on company results. Focusing on the price of a stock is dynamite, because it really means that you think that the stock market knows more than you do.

Now if the stock market may know more than you do, but then you shouldn't be in stocks. I mean, you should have — the stock market is there to serve you and not to instruct you.

So you need to formulate your ideas on price and value, and if the price gets cheaper and you have funds, you know, logically, you should buy more, if — and we do that all the time.

Where we make our mistakes, frankly, is where we focus on price and value and we start buying, and the price goes up a little and we quit, you know, like Charlie referred to, we might have done on See’s Candy.

A mistake like that cost us $8 billion in the case of Walmart stock a few years ago, because it went up in price. And you know, we are not happy when things we're buying go up in price.

We want them to go down, and down, and down. And we'll keep buying more and — hopefully we won't run out of money. Of course, that's a different story.

Charlie?

CHARLIE: No.

WARREN BUFFETT: Number 4.

AUDIENCE MEMBER: Hi. David Anglin (PH) from St. Louis, Missouri. Thanks for the weekend, it's very nice. It's always entertaining here.

According to an article in The Economist, the triple-A rating is very important quality for reinsurance to have. Swiss Re, Munich Re have lost their triple-A ratings. Gerling is out of the ballpark.

Will the reinsurance business at Berkshire become unintentionally exposed to higher risk because it is now a major reinsurer still holding a triple-A rating, even though it practices a very severe underwriting discipline?

WARREN BUFFETT: No, the triple-A can't increase our risk, because it should not affect what we do.

It may affect what gets offered to us. I mean, logically we should get business offered to us first, and last. I mean, we are the reinsurer that's going to pay for sure, five years from now, 10 years from now.

So when — I mean, we have contracts, we have structured settlements with paraplegics that are counting on us to make a payment to them 50 years from now.

And those people are in wheelchairs, they may be on — you know, they may be on oxygen, all kinds of things. And they are depending on a little piece of paper that has our name on it, and it says we're going to pay them for the rest of their life. And it's very, very important to them whose name is on it.

But that shouldn't cause us to do — it shouldn’t cause us to do anything at all stupid. It just means that people that care about security of future promises should come to us.

But there's no reason at all, because Munich or Swiss Re loses their triple-A, that we should underwrite in any way differently than we do now. It just should mean that we have more to choose from.

And I can assure you that, as these companies lose their triple-A — and a number have in the last year or year and a half — we have been tightening our underwriting very materially at Gen Re.

Now, it needed tightening — but we are now, in my view — we have the right — we have a great underwriting culture at Gen Re, and historically it had it most of the years. It drifted away from that, but I think it's back in spades now. So I don't think you have to worry about that.

Charlie?

CHARLIE MUNGER: Well, I certainly hope we are better underwriters than Munich Re.

WARREN BUFFETT: Well, let's not name names. (Laughter)

No, no, Munich is a fine company. (Laughter)

The rule at Berkshire is we praise by name and we criticize by category. (Laughter)

And I do think Munich is a fine company, but they lost their triple-A, frankly, because they probably had — they were too exposed on the equity side — on the asset side — in equities, relative to net worth, and I think they probably agree with that.

But they have a very strong and important position in insurance. And we do a lot of business with Munich Re, and will continue to do so. But there are others we won't do business with, incidentally.

I mean, there are some very weak reinsurers in the world and if there were to be a major natural catastrophe, or if there were to be a major financial catastrophe, there are a number of reinsurers, in my view, that would not pay. And we conduct our affairs so we'll always be able to pay.

WARREN BUFFETT: Number 5?

AUDIENCE MEMBER: Good morning, gentlemen. My name is Olaf Heine (PH) from Germany. And not surprisingly, I have a question concerning the German reinsurance market, fitting nicely in the context of the questions before.

When you acquired General Re, I believe you inherited, also, a substantial stake in Cologne Re. Now in your last letter to your shareholders, you hinted that a major reinsurance company might be in trouble, widely believed to be Gerling Re, just mentioned.

You also mentioned, about an hour ago, that Germany was kind of a drag insurance-wise — (laughs) — if you are — if I understand you correctly.

WARREN BUFFETT: I don't — I mean, I don't believe I — I didn't mean to say that.

AUDIENCE MEMBER: OK, but it helps to formulate the question. (Laughter)

WARREN BUFFETT: OK, well, for the purpose of your question we'll assume I said it — (laughter) — yeah. But I didn't say it.

AUDIENCE MEMBER: So now Gen Re decided to exercise a call option on the remaining shares of Cologne Re, another German reinsurance company. And my question simply is, what motivated you to do so?

WARREN BUFFETT: Yeah, that's a good question. And it was mis — it was sort of somewhat misreported in the press, what happened on that.

What really happened is that Gen Re — I don't know whether it would be about six or seven years ago now — acquired a significant position in Cologne from the controlling shareholder, with a put and call arrangement for the remainder.

I don't even know the history, exactly, of why they went for this two-step transaction, but basically it was a two-step purchase.

So that all along we have accounted for Cologne as if we were going to exercise the option. Because, in effect, if we didn't exercise, they would exercise. And it was fait accompli that we would buy that stock right from the start.

So we made no affirmative — we made an affirmative decision six or seven years ago to buy a very significant percentage of Cologne. We now have — will have about 89 percent when the option's exercised.

But there's nothing new in the fact that we are now doing it. The put and call arrangement, as I remember, became effective, essentially, this year.

So this was the year that something had to be done, and was planned to be done all along. And it reflected no new judgment, no new decision about Cologne in the year 2003.

It reflects a decision that was made in 1996 or '97, whenever the original purchase was made.

And Cologne is an integral part of General Re. I mean, we knew all along that we would own 89 percent of it, pursuant to this contract. And it — that's always been in our thinking, from the moment we sat down with the Gen Re management to make a deal some years ago.

So the press has sort of implied that there's something new in this transaction that's occurring this year, and there really isn't.

WARREN BUFFETT: Number 6. Charlie, you don't have anything on that? No.

AUDIENCE MEMBER: Good morning — Mr. Buffett. This is Abhishek Dalmia coming from the land of Mr. Ajit Jain, (inaudible) India. The question is —

WARREN BUFFETT: If you have any more like Ajit over there, send them. We need them. (Laughter)

AUDIENCE MEMBER: Right. My question pertains to the allocation of a company's free cash. And the question is, under what circumstances would Berkshire consider parting with its money for a share buyback program, as opposed to retaining it for future acquisitions? Thank you.

WARREN BUFFETT: Yeah, that's a good question and we addressed that a bit back a couple of years ago. In fact, I think our annual report for 1999 came out on March 12th — I believe it was March 12th — on a Friday night or a Saturday morning.

That was the day the NASDAQ hit its high and Berkshire hit its low, on that exact day. And we said we would — the next morning, on the internet — on a Saturday morning — we said we would repurchase, but we wanted you to have the annual report first, but we might repurchase at those levels.

And the NASDAQ never saw its level of 5100 again, and Berkshire never saw its level of whatever it was, 41,000 or thereabouts.

Our preference — and we stated this 20 years ago, even to — is to buy businesses. We are — we want to add businesses of a quality with managers of a quality equal to those we already own, at prices that make sense. And that's our number one preference.

If we thought Berkshire was significantly undervalued and we thought the likelihood of using the money to buy businesses — the probability was low — we would be buying stock in — we probably wouldn't be able to buy a lot of stock in, but we would only buy stock in if we thought the stock was selling significantly below intrinsic value.

And there's no magic figure for intrinsic value. Intrinsic value is a range. Charlie would name a different number than I would name, but our ranges would be quite similar, if we were to write them down on a piece of paper now. But they wouldn't be identical.

So we leave a — we would leave a significant margin of safety and would want to buy at a — what would be a clear-cut, to us, discount from the lower levels of intrinsic value we might calculate.

It's not our number one preference. We would rather add — we love it when we add good businesses to Berkshire.

But we would have to — if the stock — if we could add intrinsic value per share by repurchasing, and we've given all the shareholders relevant information about the value so that we weren't putting anything over on them, that they had the same information we had, we would buy in stock.

I think it's unlikely that happens, that we don't find other opportunities to do things at a time like that. But it could happen, and it almost happened in March of 2000, and then things turned around very, very abruptly.

Charlie?

CHARLIE MUNGER: I’ve got nothing to add.

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: Good morning. My name is Ken Goldberg (PH) from Sharon, Massachusetts.

What is your long-term vision for MidAmerican Energy?

And specifically, assuming the repeal of the Public Utility Holding Company Act, what is the nature of the type of assets that you would be interested in acquiring, be they generation, transmission, distribution-type properties?

WARREN BUFFETT: Yeah, MidAmerican already is a big part of Berkshire. I would say it's likely to become much bigger. It will be easier to have it become much bigger if the Public Utility Holding Company Act, which was enacted in 1935 — if it were repealed.

Public Utility Holding Company Act, which is a melodiously named — called PUHCA — (laughter) — was enacted in 1935 in a reaction to what Sam Insull and people like that had done in the 1920s. It was very understandable.

But I really think it is quite outdated now. I mean, it is now 68 years later.

And I think we bring something to the utility field. In fact, I think we brought it in the last year.

There might well be a couple of companies that wouldn’t — would be in bankruptcy now if we hadn't been in a position to act very quickly on certain things.

So — but with or without the repeal — and I think there's a reasonable chance it'll be repealed. But with or without repeal, MidAmerican, which is big now, will become quite a bit bigger. And it could become a whole lot bigger.

Now, in terms of what kind of assets we'll buy, we don't have a —any clear-cut preference, for example, as to whether it would be a natural gas pipeline, or whether it would be a domestic utility, or conceivably, a utility, even, in some country that we felt good about.

We will look at things as they come along. We're always ready to act. I would say that it's certain we'll look at a few big deals this year. Whether we get one done or not depends on competition, depends on the sellers, and some things like that.

But something will happen with MidAmerican — over — you know, whether it's this year, or next year, or the year after, we'll get a shot at doing something significant.

And the nature of the energy field is you're talking big money, always. I mean, these are not lemonade stands. And you know, we're talking in the billions, frequently, on the kind of assets involved.

So it will be a — we’ve got a fabulous management — we’ve got two people running that in Dave Sokol and Greg Abel, who are — they're terrific businesspeople.

You know, they — and, incidentally — I should mention this publicly — they have done things that have made Berkshire significant money that had nothing to do with MidAmerican.

In other words, they have spent their time and energy, weekends, putting together a couple of things that MidAmerican itself could not do, but Berkshire could. And they didn't get paid a dime for that and MidAmerican did not get paid a dime for that.

So they have contributed to Berkshire's welfare beyond what they've contributed simply as managers of MidAmerican.

So it's a terrific asset. We love the idea of pouring money — (applause) — behind them, and you'll see something happen.

Charlie?

CHARLIE MUNGER: Well, I — the really interesting thing about it is the fact that the field is so big. I mean, you're talking about an enormous field.

One thing a modern civilization needs is energy, so we'll be very disappointed if there aren't more activities.

WARREN BUFFETT: Number 8.

When we get through with number 10 we're going to break for lunch, and then we'll come back and start all over again after 30 or 40 minutes. But I'd like to get through 8, 9, and 10.

Eight.

AUDIENCE MEMBER: I'm Norman Rentrop from Bonn, Germany.

Mr. Buffett and Mr. Munger, I have a thank you and a question for you. Thank you for allowing us shareholders to invest with you on equal terms, with almost no management fee and no performance fee. (Applause)

I came to fully appreciate it when I compared my 10 years of holding Berkshire Hathaway to a private equity fund, which over the same 10 years earned 19.8 percent before fees, and 11.2 percent after fees. — (Buffett laughs)

Now my question. Back in the 1950s and 1960s when you had a partnership, Mr. Buffett, you asked for and got a performance fee of 25 percent of what was earned above 6 percent a year.

WARREN BUFFETT: Correct.

AUDIENCE MEMBER: What caused you to switch from that performance fee to that no fees we are enjoying today? Was it the wisdom that to give is better than to receive? (Laughter)

WARREN BUFFETT: Try again. (Laughter)

AUDIENCE MEMBER: And do you feel that this switch from performance fee to no performance fee, that that is fully appreciated? And what did it mean to you personally?

WARREN BUFFETT: Well, I appreciate what you had to say, and I will — I would pay to have this job I have. I would pay a lot of money. And I hope I don't get tested on that, but you know, it's —

Why in the world — if I can work with people I like, and get the same result they have, and end up with all kinds of money, you know, why do I need to make some further override on them?

I was changing my position in life significantly when I started that partnership in 1956. A couple of the people that — well I guess, yeah, [Buffett's sister] Doris may be the only original partner here. But Doris, would you stand up? She joined on May 5th, 1956, wherever she is.

And the — you know, those people gave me their money but I wasn't — I needed some money then, too. And I did get an override, which I thought was fair.

I got no management fee at all, though. I never charged — today, most of the people who run hedge funds charge 1 percent a year, and then some percentage of the profits. I did not do that.

And I did have all my money in after 1962, so that the downside would be equal to the upside.

But I've always felt about the people as partners. And when we got into Berkshire — originally we got into Berkshire, Berkshire was owned by the partnership. So if I had taken a salary then I would've been double-dipping, in effect, by getting money out of Berkshire before, in turn, the partnership participated.

And frankly, by the time I got — where I was running Berkshire I had all the money I needed. And you know, I'd rather get the same result as my partners than have me get a different result. And it can't make any difference.

I mean, it'll make a difference in the size of my foundation someday, perhaps. You know, but so what? I like living the way I live.

Charlie?

CHARLIE MUNGER: Well, you raise a very interesting question, and it has parallels, if you go back.

[Andrew] Carnegie was always very proud that the bulk of his fortune had been earned where he took no salary at all from Carnegie Steel. John D. Rockefeller the First took practically nothing in salary.

Over the years — the original Vanderbilt prided himself on living on his dividends and taking no salary.

It was a common culture in a different era. And you realize that all those people had the psychology of being the founder, and maybe that's what influenced Warren.

WARREN BUFFETT: What influenced you, Charlie?

Charlie doesn't take anything either, so —

CHARLIE MUNGER: I was delighted to get rid of the psychological pressure brought by — brought on me by getting fees based on performance. I think Warren was, too.

If you're highly conscientious in your relations with other people, and you hate to disappoint, you're going to suffer more if you are liberally rewarded with performance fees.

So I think there was an enormous advantage to us, so I guess we should be thanking you.

WARREN BUFFETT: I should — (Applause)

Bill Gates has never taken an option at Microsoft, and takes a very small salary. And you'll find it interesting. The only reason he takes the small salary is if there — he feels that, if there's a bad year at some time in the future, he wants to be able to take a cut in salary at the same time he's asking other people to cut back.

And that is the reason. I mean, he takes peanuts as it is, but he just figures that — Bill is a very conservative guy, and he figures that some year there'll be a bad year. And he wants — if he's asking other people to take a 5 percent cut, he wants to be able to take a 90 percent cut, or something, himself.

But he's never taken an option, and I don't believe [Microsoft CEO] Steve Ballmer has either. They have gotten rich with their shareholders and not off their shareholders, and that's an attitude we admire.

WARREN BUFFETT: Number 9? (Applause)

AUDIENCE MEMBER: Good morning. I'm Whitney Tilson, a shareholder from New York City.

There was a lot of talk among the Berkshire faithful when you took what I believe was the unprecedented step of pre-releasing a portion of your annual letter, published in Fortune, which focused primarily on the dangers of derivatives — which you called "financial weapons of mass destruction."

I have two questions related to this — the first to you, Mr. Buffett.

Could you tell us the story of how the Fortune article came about? Were you trying to draw extra attention to something that you feel strongly is a great risk to our financial system?

And the second question to both of you, since you're warning about derivatives, there's been a huge rally in the credit markets, in general. Does this reflect investors' lack of concern for these systemic risks or is it caused by other factors?

WARREN BUFFETT: The first question, my friend [Fortune Magazine journalist] Carol Loomis is the editor of the Berkshire report. And we wouldn't get out the report without her. I mean, she is the world's greatest editor, in addition to being the world's greatest business writer.

So when I gave the report to her to edit — and it did not come back unmarked, I might add — she and I talked about — I mean, I was interested in having the section on derivatives because I thought it had a broader — I hoped it would have a broader audience than just the Berkshire annual report.

And I felt that publishing it, which had no relationship to the Berkshire business, basically, except the history of Gen Re's involvement, would not be, in any way, compromising fair disclosure, in terms of Berkshire's results itself.

So the primary reason for having it in Fortune was I hoped for a wider audience, basically, by having it in Fortune.

And you know, Charlie and I think there is a low, but not insignificant, probability — and low — that sometime, maybe in three years, maybe in five years, maybe in 20 years, and very possibly never, that derivatives could accentuate, in a major way, a systemic problem that might even arise from some other phenomenon.

And we think that's inadequately recognized. We think the problem grows as derivatives get more complex and as their usage increases.

So it was a call — what we hope was a mild wakeup call — to the financial world that these things could be very troublesome.

And of course, we saw it in the energy field in the last two years. It almost destroyed, or destroyed certain institutions that never should have been destroyed.

And the — we also saw, in 1998, the whole financial system almost become paralyzed, particularly in the credit markets, you know, by the action of a firm, which was not solely based on derivatives, but would not have gotten into as much trouble as it did without derivatives.

So it's a subject that no one quite knows what to do with. Charlie and I would not know how to regulate it, but we think we have had some experience in seeing both the firm's specific dangers in that field, and we think we have some insight into the systemic problems that could arise.

And you know, that people really — they don't want to think about it until it happens. But there are some things in the financial world that are better thought of before they happen, even if they're low probabilities.

And we're thinking about low probabilities all the time, in terms of Berkshire. I mean, we don't want anything to go wrong in a big way at Berkshire. And we therefore, I think, think about things that a good many people don't think about — simply because we worry about that.

And when we get our social hats on we think about it in terms of something like derivatives for financial systems of the world. And we have had some experience at both Salomon and at Gen Re.

And Charlie was on the audit committee at Salomon, and he saw some things in the audit committee in relationship to trading itself, and derivatives in particularly, that made him wonder why in the world people were doing these sort of things. I'll let Charlie expand on that.

CHARLIE MUNGER: Yeah, in engineering, people put big margins of safety into systems — atomic power plants being the extreme example. And in the financial world, in derivatives, it's as though nobody gave a damn about safety.

And they just let it balloon, and balloon, and balloon in usage, and number of trades, and size of trades.

And that ballooning is aided by this false accounting, where people are pretending to make money they're not really making.

I regard that as very dangerous, and I'm more negative than Warren in the sense that I'll be amazed, if I live another five or 10 years, if we don't have some significant blow-up.

WARREN BUFFETT: They've been advertised, and sometimes in a fairly prominent way — they've been advertised as shedding risk for participants in the system, and reducing risk for the system.

And I would say that I think they have long crossed the point where they decrease risk to the system, and now they enhance risk. Because you have — the truth is, the Coca-Cola Company couldn't bear the foreign exchange risk that they run, or the interest rate risk that they run, and all of that sort of thing.

But when the Coca-Cola Company starts laying those off, and every other company in the world — major company — does with just a relatively few players, you have now intensified the risk that exists in the system.

You have not shed risk at all, you have transferred it, and you have transferred it to very few players. And those players have huge interdependencies with each other, and to some extent, central banks and all of those similar institutions are vulnerable to the weaknesses of those institutions.

When Charlie and I were at Salomon, you know, they hated it if we brought up — and so therefore, we didn't do it — that we were too big to fail.

But the truth was that if Salomon failed at that time, the problems for the rest of the system could well have been significant. They might’ve been — who knows exactly what they would have been? But they could have been quite significant.

And when you start concentrating risks in institutions which are highly leveraged, and who intersect with a few other institutions like that — all bearing same risks, all having the same motivations in the trading departments — to take on more and more esoteric things because they can book more and more immediate profits, you are courting danger.

And that's why I wrote about it this time. And I — it's not a prediction, it's a warning.

WARREN BUFFETT: Number 10, and then we will break for lunch right after this.

AUDIENCE MEMBER: Good morning, my name is Ho Nam from San Francisco, California. I have a two-part question regarding how you evaluate your managers.

In your annual report, you wrote that Berkshire Hathaway owns "good to great" businesses and employs "great to great" managers, and we're thankful for that.

When you hire a manager, or are evaluating the management team of a business you're thinking about buying, what are the qualities you look for?

And some of your managers were entrepreneurs who started their businesses from scratch when their business models were unproven, and some of them took over businesses that were already performing well when they took charge.

What are the qualities of a great entrepreneur that might be different from those of a manager who can be great at running a company that's established, but may not be able to start a business from scratch and tinker around with a business model and figure out how to make it successful?

WARREN BUFFETT: Yeah, well we love managers that have a passion for their business. And when we're buying a business we have to ask ourselves, "Do they love the money or do they love the business?"

If they love the money, there's nothing wrong with that, but they probably wouldn't be running the business for us a year or two down the road.

I think one difference is that people that create their own businesses, the entrepreneurs, probably, on average would have a significantly greater degree of passion for those businesses than somebody that was just brought in a few years ago and sees themselves as making a profit in a few years on reselling the business and leaving.

I — you'll find exceptions in both camps. But we've had terrific luck with the entrepreneurs who basically love their businesses the way I love Berkshire. I mean, they are not going to let anything happen to their businesses.

They can — you know, they'll tell me to butt out if I'm going to screw up something in their operations, and they don't regard them — I mean, in a certain sense, I mean, they know they're part of Berkshire.

But they regard them in a certain jealousy, almost, as being their businesses, and we love it that way.

And you know, we can spot it when we see it. And we also can avoid it.

We have never — I just got one in the other day, something from an investment banker on somebody that wants to resell a business they bought a few years ago.

Well you know, the chances that they haven't doctored up the figures in some way or are trying to sell, I mean, you know, they're — it's a piece of meat to them. And if it's a piece of meat to them, you know, what am I going to do with it?

So we — if we make the proper judgment about the passion they have for their business, they’re going to keep running — they may have a lot of money in the bank — but they're going to keep running the businesses for us, because they love those businesses.

And they really are motivated the same way I am. You know, it wouldn't make any difference what I get paid, you know. I'm identified, in my own mind, with how Berkshire does.

I really don't care how the rest of the world thinks about how Berkshire's doing. I mean, in other words, when we looked like we were out of step a few years ago, that really doesn't make any difference to me, as long as I feel OK about how Berkshire is doing.

But I do — you know, that's how I measure what I'm doing every day — not by the price of the stock, but by what's going on in the business. And that's what — we have a group of managers like that, and there —

I don’t think there’s — well, there can't be a company in the country, in my view, that, if you could figure out some way to measure the passion involved, in terms of running their business, I don't think there's anybody that could come close to matching the quantity that we have managed to marshal together at Berkshire.

It's been accidental over time, but it's really almost unique. I think it is unique.

Charlie?

CHARLIE MUNGER: Well, it's very interesting to think about what matters most, the passion or the competence that was borne in?

Certainly Berkshire is full of people who have a peculiar amount of passion in their love for their own business. And I would argue that probably the passion is more important than the brainpower.

WARREN BUFFETT: Yeah, and by the time they get to us, if they were passionate but incompetent, they don't get to us.

I mean, they're not going to be there unless they're competent, but the question is whether they had a passion for money or a passion for their business, to some degree.

And they all like money, and the reason — and they like it, partly, because it enables them to build the business they love.

But they don't — we're not going to see an incompetent, but passionate, manager by the time we start laying out a lot of money for a business.

They got weeded out a long time ago. So I don't have to weed those out, but I do have to weed out the ones who want to cash a big paycheck and go off and do something else at some time. And like I say, we've had great luck at that.

But we have literally — I mean, we see lots and lots of businesses owned by — usually owned — by financial operator types, where it's absolutely clear that, you know, they have come in, they've leveraged it up, they've played games with the accounting.

They — that has about run out, you know, and they want to sell it. And interestingly enough, fairly often, those are built by — bought by — other financial operators who think they're going to play the game a second time.