Given his description of derivatives being “financial weapons of mass destruction” well before the Global Financial Crisis hit in 2008, Warren Buffett is often quizzed on whether the danger is now passed. This segment of the Berkshire Hathaway AGM transcript kicks off with his response to a question on derivatives and moves onto a similarly controversial subject – deploying high cash balances when interest rates are low or even negative. In more than a decade of attending and following these AGMs, I’ve never heard a question quite like one posed by shareholder Dan Chen who likened Berkshire to the Harry Potter school of Hogwarts – and was effusive in his praise for the Buffett-endorsed Secret Millionaires Club. Also in this segment is the first of numerous mentions at the AGM about US Presidential candidate Donald Trump – of whom Buffett is clearly no fan. Questions cover the full spectrum in Omaha. – Alec Hogg
WARREN BUFFETT: Some of these things get so complicated they are very hard to evaluate. That’s the kind that has the most profit in them usually, so they were quite enthusiastic about those when we were with Salomon Brothers (in the 1980s). Some derivatives can be extraordinarily hard to mark and, as I said, I don’t want that marked so much it would blow your mind. I don’t think the auditors are necessarily capable of holding that behaviour in check.
It’s very interesting because there’s really four big auditing firms. Obviously, they’re auditing companies where there’s a derivative position; auditing company A that’s on one side of the transaction and they’re auditing company B on the other side of the transaction. In some cases, it’s the same auditor and I will guarantee you there’s many times when the marks on what they’re attesting to are significantly different, which would be an interesting exercise to pursue, in terms of checking those numbers out.
Derivatives are still dangers in large quantities, and we would not do them on a collateralised basis because if there was a discontinuity I don’t know exactly where we’re going to end up. I’m never going to get us in a position where we could have money demanded of us, and not be able to fulfil it with ease – and with me sleeping well – so we won’t engage in it. We’ve got some in runoff but so far, we’ve made money and had the use of money for a decade or more. It’s been very attractive for us but that does not entice me at all into doing any derivative transactions that would involve collateral when collateral is not required.
It’s still a potential time bomb in the system. Anything where discontinuities can exist can be real poison.
The market in Kuwait some years ago went through a very delayed system on settlement of stock purchases. They didn’t have to settle up for six months or thereabouts. It caused all kinds of problems because if you’ve got an IOU from somebody for six months and if you’ve got zillions of those, a lot of trouble can ensue. I agree with general caution. But I’m not in the least troubled by our Bank of American investment. Nor Wells Fargo – we added to Wells Fargo. Our Bank of American position right now is a preferred stock but we’re very likely to exercise the warrants on.
On the other hand, there are a great number of banks in the world. If you take the 50 largest banks in the world, we wouldn’t even think about probably 45 of them.
Wouldn’t you say that Charlie?
CHARLIE MUNGER: Well, we’re in the awkward position where I think we’ll probably make about $20bn out of derivatives on just those few contracts that you and I did years ago. All that said we’re different from the banks. We would really prefer it if those derivatives had been illegal for us to buy. It would have been better for our country.
CAROL LOOMIS: This question relates to something that Warren briefly said earlier today. The question comes from Lyn Palmer, who is just finishing her freshman year in a Houston Texas high school. My question, she says, concerns the float generated by Berkshire’s insurance companies. In Mr Buffett’s 2015 annual letter, he said that the large amount of float that Berkshire possesses allows the company to significantly increase its investment income, but what happens when interest rates decline? If the U.S. were to implement negative interest rates, in the same way that the Eurozone and Japan have done, how would Berkshire be affected?
WARREN BUFFETT: Well, some of our float actually exists in Europe where we have the problem of negative interest rates on very high grade, short term, and even medium term bonds. Obviously, anything that reduces the value of having money is going to affect Berkshire because we’re always going to have a lot of cash. Because we have so much capital and so many sources of earning power, we have the ability to use our float in ways that most insurance companies can’t think about. We can find things to do. We’ve got $50bn odd of short-term government securities now and we’re going to get another $8.3-billion in all likelihood early in June, and so we’ll be back over $60bn again pretty soon.
We’ve got $60bn that’s out at say a quarter-of-one percent. Well the difference between a quarter-of-one percent and minus a quarter-of-one percent – it’s not that great. It’s almost as painful to have $60bn invested at a quarter-of-one percent as to have it out on a negative rate. The float is not worth as much to insurance companies now as it was ten or 15 years ago, and that’s true at Berkshire. I think it’s worth considerably more to us than it is to the typical insurance companies because I think we have a broader range of options to do with it.
But there’s no question that having a lot of money around now is not just a problem for insurance companies. It’s a problem for retirees. It’s a problem for anybody that’s stuck with fixed Dollar investments, and finds that their income now is a pittance – or in Europe, a negative rate was not something in their calculation at all 15 years ago. We love the idea however, of increasing our float. That money has been very useful to us over time. It’s useful to us today, even under present conditions and it’s likely to be very useful to us in the future. It’s shown as a liability but it’s actually a huge asset. Charlie?
CHARLIE MUNGER: I’ve got nothing to add.
WARREN BUFFETT: He’s now at full swing. Jonathan?
JONATHAN BROWN: The railroad industry seems right now to be suffering from exposure to some of the weakest parts of the economy, with volume declines of varying magnitudes in coal, oil, sand, and metals. Even intermodal, usually a steady source of growth, has been relatively weak of late. How much of the weakness is cyclical? How much is secular? In the last 15 months, the other Western Railroads’ market capitalisation is down by 35 percent, as projections of future growth have come down. Is your estimate of BNSF’s intrinsic value down by a material amount during the same period or is your view of the value of BNSFs irreplaceable network unaffected by these short-term wiggles?
WARREN BUFFETT: Well, certainly the decline in coal, which is a very important commodity, it’s about 20 percent of revenues – that’s secular. Now, there are other factors, which may cause the line of decline to jiggle around. We had a very mild winter and we went into the winter with utilities carrying unusual amounts of coal. Ironically, part of the reason for that was that our service the year before had been bad and they’d gotten low on coal, so they compensated by bringing in more than they needed, just to catch up and because the weather was mild electricity use was poor in the wintertime. So they continue, at this point, to have considerably more coal on hand, than they would like. They are not only trying to under-order what they will be using and that has a little affect, but the decline in coal, for sure, is secular and at 20 percent of revenues that’s a significant factor.
It’s true that the market, generally, got very enthused about railroad stocks a year or two ago. Now that people are seeing that coal holdings are down and earnings are down, in some places equity valuations have come down. We love the fact that we own BNSF. We think we bought it at an attractive price. We’d love to be able to buy a second thing exactly like it at that price, we’d do it in a second. We’d even pay a little bit more probably. But we don’t mark up and down our wholly owned businesses based on stock market valuations. Obviously, stock market valuations are some factor in our thinking, but we are not marking our wholly owned businesses to market because we’re going to hold them forever. We regard BNSF as a very good business to hold forever but it will lose coal volume, but it will gain another. It’s a terrific and valuable asset and it will earn a lot of money this year but it won’t earn as much money as it earned last year. Charlie?
CHARLIE MUNGER: I’ve got nothing to add.
WARREN BUFFETT: Okay, Station 4.
DAN CHEN: Hi, Warren and Charlie. It’s great to see you. This is Cora and Dan Chen from Talgarth Investments of Los Angeles, this annual meeting reminds me of the magical world of Hogwarts, of Harry Potter. This arena is our Hogwarts. Warren, you are headmaster and Professor Dumbledore.
WARREN BUFFETT: I haven’t read Harry Potter but I’ll take that as a compliment.
DAN CHEN: Charlie is our headmaster Snape, direct and full of integrity. The magic of long-term, concentrated value investing is real, yet similar to Harry Potter, the rest of the world doesn’t believe we exist. Your letter has changed my life. Your ‘Secret Millionaire’s Club’ has changed my children’s lives. They go to class chatting about investing. My question is for my children watching at home today and the children in the audience. How should they look at stocks when every day in the media, they see companies that have never been a time in their life go IPO, they are dilutive and they see a lot of very short-term span. The cycle is getting shorter and shorter. How should they view stocks and what is your message for them?
WARREN BUFFETT: The Secret Millionaires Club – we want to give great credit to Andy Hayward on that. I know it’s helped thousands and thousands of children and it was Andy’s idea and it grows in strength and having young children learn good lessons in terms of handling money and making friendships and just generally behaving as better citizens. It’s a great objective and Andy makes it easy for them to do so, on his behalf, I accept your comments.
You don’t have to really, worry about what’s going on in IPOs or people making money. People win lotteries every day but there’s no reason to have an effect on you. You shouldn’t be jealous about it. If they want to do mathematically unsound things and one of them occasionally gets lucky and they put the one person on television and the million that contributed to the winnings, with a big slice taken out for the State. Don’t get unnerved. It’s nothing to worry about just all you have to do is figure out what makes sense and when you buy a stock you get yourself in the mental frame of mind that you’re buying a business, and if you don’t look at a quote on it for five years that’s fine. You don’t get a quote on your farm every day, or every week, or every month. You don’t get it on your apartment house, if you own one. If you own a Mac Donald’s franchise, you don’t get a quote every day.
You want to look at your stocks as businesses and think about their performance as businesses.
Think about what you pay for them as you would think about buying a business, and let the rest of the world go its own way. You don’t want to get into a stupid game just because it’s available and I’m going to say a little bit more about that close to the break but with that, I’ll turn it over to Charlie.
CHARLIE MUNGER: Yes, I think that your children are right to look for people they can trust in dealing with stocks and bonds. Unfortunately, more than half the time they will fail, in a conventional answer. So they have a hard problem. If you just listen to your elders, they’ll lie to you and spread a lot of following.
WARREN BUFFETT: But they really have an easier problem in the sense that America’s business, as a whole, is going to do fine over time, so the only way that they can…
CHARLIE MUNGER: But not the average client of a stockbroker.
WARREN BUFFETT: Well, we’ll get to that later. The stockbroker will do fine.
CHARLIE MUNGER: Yes, that’s true.
WARREN BUFFETT: But they don’t have to do that and I’d rather address that just a little later but just, you don’t want to worry. You don’t want to be, a lot of problems as Charlie would say are caused by envy. You don’t want to get envious of somebody who’s won the lottery or bought an IPO that went up. You have to figure out what makes sense and follow your own course. Becky?
BECKY QUICK: This question comes from a shareholder named Lisa Kang-Lee in Singapore, and this has to do with NV Energy’s issue with solar energy in Nevada. Can the chairman help his environmentally conscious shareholders understand why NV Energy has lobbied for new rules in Nevada that make it prohibitive for households to use solar energy? Is there a good reason that we haven’t yet heard about and can the chairman or vice-chairman share their views on whether there’s a need to implement an environmental social and governance policy on Berkshire investments, going forward. I understand that Berkshire Hathaway typically lets the underlying operating companies and CEOs manage their own policies autonomously but should Berkshire’s board influence better environmental protection policies going forward?
WARREN BUFFETT: Well, the public utility and the pricing policy is everything – in Nevada as well as other places – but they’re determined by a Public Utility Commission so there are, I believe, three commissioners that decide what’s proper. The situation in Nevada is that in terms of rooftop power was that, for the last few years if you had a solar project on your roof, you could sell back excess power you generated to the grid at a price that was far, far above what we as the utility could buy it for elsewhere. You could sell it back, well say roughly at ten cents a kilowatt-hour. About 17 000 people had rooftop installations.
There were federal credits involved but they usually got sold to other people, in terms of tax credits, so they were being subsidised by the federal government. That encouraged solar generation as it encouraged us to do solar generation and wind generation as well. However, the people who had these 17 000 rooftop installations were selling back to the grid at 10cc, roughly, a kilowatt-hour energy that we could purchase or produce 3.5c. So 99 percent of our consumers were being asked to subsidise the one percent that had solar units by paying them triple the market price of what we could otherwise buy electricity for. It’s just a question of whether you wish to have the 99 percent subsidised or the one percent. The Public Utility Commission in Nevada had originally let this small amount of rooftop solar generation be allowed as an experiment, with this roughly 10c rebate. They decided they did not believe the 99 percent should be subsidising the one percent.
There’s no question, for solar to be competitive, just like wind it needs subsidisation. The costs are not yet at a level where it becomes competitive against natural gas, for example. Who pays the subsidy gets to be a real question if you want to encourage people to use renewables. In general, the federal government has done it through tax subsidies, which means taxpayers, generally, throughout the country subsidise it. The Public Utility Commission in Nevada decided that after seeing this experiment it was not right for well over a million customers to be buying electricity at a price that subsidised these 17 000 people, and therefore increase the price of electricity for the million.
That question of who subsidises renewable and how much is going to be a political question for a long time to come.
I personally think that if society is the one that’s benefiting from the lack of reduction of greenhouse gasses then society should pick up the tab. I don’t think that somebody sitting at a house in some place in Nevada should be picking up the subsidy for their neighbour. The Public Utility Commission agrees with that.
I think we have Greg Abel here who is CEO of Berkshire Hathaway Energy. Greg, was there anything you want to add?
GREG ABEL: As usual, Warren you summarised it extremely well. When we’re thinking Nevada, it’s exactly as you described. I will just add a few things. One – as you’ve touched on earlier, we absolutely support renewable, so we start with the fundamental concept that we are for solar but as you highlighted, we want to purchase renewable energy at the market rate and not at a heavily subsidised rate that one percent of the customers will benefit from and harm the other 99 percent. It goes back to being as fundamental as this. If you take, as you touched on, a working family in Nevada, who can’t afford the rooftop unit and you, ask them, “Do you want to subsidise your neighbour (that one percent)?” The answer is clearly ‘no’. At the same time, we’re absolutely committed to Nevada utilising renewable resources and absolutely proud of what our team is doing. By 2019, we’ll have eliminated or retired 76 percent of our coal units and we’re replacing it with solar energy, so we’re on a great path there. Thank you. We’re just going to encourage our team and with the work of the Commission and obviously, led by the State, we’ll head down a great path. Thank you.
WARREN BUFFETT: Yes, if the projectionist would put up slide seven it will give you a view of what the situation is and this counts for all of our Berkshire Hathaway Energy operations. You can see in the 20-year period, we’ll have a 57 percent reduction (in coal fired output). You wouldn’t want a 100 percent reduction tomorrow, believe me the lights would be all off all over the country but it’s moving at a fast pace but you want to be sure that you treat fairly the people involved in this because somebody pays the cost of electric generation. I do think that if you’re doing something that’s to benefit the planet, and it’s important that it be done, but that you have the cost be assessed for that. Not on a specific person, who is having trouble perhaps making ends meet, and their job. Obviously, if you’ve got over a million customers in Nevada, and a lot of them are struggling, but a lot of them are doing fine too. However, they are not the ones (in my view) to subsidise the person who could afford to put the solar unit in. Okay, Cliff.
CLIFF GALLANT: Over the past year, we’ve learnt, or perhaps I’ve learnt that Berkshire’s results were more influenced by oil markets than I previously appreciated. Revenues at the Railway Company and some of Berkshire’s manufacturing businesses were negatively impacted and arguably, low gas prices hurt GEICO’s loss ratio. Yet, during this year, Berkshire invested in Phillips 66, Kinder Morgan, and even PCP has revenues associated with the oil and gas industries. I know Berkshire wouldn’t make a bet on a commodity like oil but is Berkshire making a statement about the long-term outlook for oil?
WARREN BUFFETT: No, we haven’t the faintest idea what the long-term price of oil will be. You can buy oil, as you know, for delivery a year from now or two years from now, or three years from now. We actually did that once, Charlie, didn’t we some years back?
CHARLIE MUNGER: And we cashed it in too soon too.
WARREN BUFFETT: Yes, we made money but we could have made a lot more money but we don’t think we can predict commodity prices. We don’t hedge cocoa or sugar. We do some form of buying but basically, we are not two fellows who think we can predict the price of soya beans or corn or oil or anything else. Some of the securities you mentioned were bought by Todd (Combs) or Ted (Weschler) and one was bought by me. But neither they nor I bought those based on commodity price predictions. We don’t know how to do it and we’re thinking about other things when we make those decisions. Charlie?
CHARLIE MUNGER: I’m even more ignorant than you are and that will be hard to beat.
WARREN BUFFETT: Okay, I think that’s the first time I’ve heard him say that. It has a nice ring to it. Okay, Station Five.
KEN MARTIN: Hi Warren, hi Charlie. I’m an MBA student from the Tux School at Dartmouth. My question is about college tuition and the problem of rising student debt balances. In the past, prominent philanthropists have founded institutions that are now prominent research universities in our country. Why is this not a bigger part of today’s philanthropic debate – the founding of new colleges? Would not new supply in higher education be at least part of the solution to this problem?
WARREN BUFFETT: Charlie, do you want to tackle that one? You’re more of an expert than I am.
CHARLIE MUNGER: I think that you expect a lot of financial efficiency in American higher education you’re howling at the wind. I do a lot more than Warren does in this field and I’m frequently disappointed but the monopoly and bureaucracy have branches everywhere, and the universities aren’t exempted from it. Of course, they are the glory of civilisation and if people want to give more to it, I’m all for it.
WARREN BUFFETT: You’ve got the option of very good State schools and we spend a lot of money on education in this country. If you just take kindergarten through 12, it’s interesting. People talk about entitlements in this country. They say, “It’s terrible we have all these entitlements for Social Security and everything.”
We have entitlements for the young. We spend $600bn per year educating 50 million kids in the public schools between kindergarten and 12th grade.
Just think of what that is as an entitlement. Nobody ever seems to bring that up but it’s huge and I believe in it, obviously. However, the people in their working ages (generally speaking) and a rich society have an obligation – to both the young and the old, and based on the amount we spend. If we have problems with our school system, it’s not because we’re cheap. There are other problems that contribute to it. In terms of the money we put out, we’re right up there. I was the trustee of a college that saw the endowment go from $8m to over $1bn and I didn’t see the tuition come down and I didn’t see the number of students go up.
CHARLIE MUNGER: Nothing went up except the Professors’ salaries.
WARREN BUFFETT: From $8m to $1bn and very decent people running the place but when you read the figures on endowment of the big schools, and some of them have really gone up in the big numbers. The main objective of the people running the endowments is to have the endowment grow larger and that will be ever thus – that is the way humans operate. Do you have any more comments on that Charlie? You’ve seen a lot.
CHARLIE MUNGER: I’ve made all the enemies I can afford at the moment.
WARREN BUFFETT: Okay. That’s never slowed him down in the past. Andrew…?
ANDREW ROSS SORKIN: Thank you Warren. This from a shareholder who asked to remain anonymous, if Donald Trump becomes the President of the United States and recognising your public criticism of him and your public support for Hillary Clinton, what specific risks, regulatory, policy, or otherwise do you foresee for Berkshire Hathaway’s portfolio of businesses?
WARREN BUFFETT: That won’t be the main problem.
Well, Government is a very, big factor in our business and in all businesses. There’s the very broad policies that affect practically everybody and sometimes there can be some pretty, specific policies but I will predict that if either Donald Trump or Hillary Clinton becomes president, and one of them is very likely to be. I think Berkshire will continue to do fine. Charlie…?
CHARLIE MUNGER: I’m afraid to get into this area.
WARREN BUFFETT: We’ve operated under price controls. We’ve had 52% federal taxes applied to our earnings for many years. I mean they were higher at other times but we’ve had regulations come along and in the end business in this country has done extraordinarily well for a couple of hundred years, and it has adapted to the society and the society has adapted to business. This is a remarkably attractive place, in which to conduct a business. Imagine in a world of practically zero interest rates American business is earning terrific returns on tangible equity. Those are the assets that were actually employed in the business. The numbers are staggering and people have had their money in savings account or something.
They get destroyed but owners of business… If you look at returns on tangible equity just check them out some time and they have not suffered even as people who own fixed interest (fixed income), instruments have suffered enormously and farm prices are down. Now farmer income has fallen off a lot in the last couple of years but business has managed to take care of itself and for a good reason because it contributes to and has been the engine of our market economy that’s delivered output that is staggering, by the imagination of anyone that might have existed 100 years ago.
In my lifetime the GDP per capita, in real terms of the United States, has gone up 6:1. Can you imagine the society where, in one person’s lifetime overall people have six times the real output that they had at the beginning?
The system works very well, in terms of aggregate output. In terms of distribution of that output sometimes, it can fall very short, in my view, but it will keep working. You don’t have to worry about that. Twenty years from now there’ll be far more output per capita in the United States in real terms, than there is now. In 50 years, it will be far more and the quality will get better and no presidential candidate or president is going to end that. They can shape it in ways that are good or bad but they can’t end it. Now, Charlie give something pessimistic here to balance it.
CHARLIE MUNGER: No, I want to say something optimistic. I think that the GDP figures greatly understate the real advantage that our system has given our citizens. It under weights a lot of huge achievements because they don’t translate right into money, in a certain way that the economist can easily handle but the real achievements over the last Century say, are way higher than are indicated by the GDP figures and the GDP figures are good. I don’t think the future is necessarily going to be quite as good as the past but it doesn’t have to be.
WARREN BUFFETT: There’s no one you’ll run into, at least in my experience that says, with my same talents, “I wish I’d lived 50 years ago instead or born 50 years earlier.” The majority of the American public thinks that it’s a bad time to be born today, compared to when they were born. They’re wrong. It’s the pace of innovation. Just think how different you’re living compared to 20 years ago, in terms of what you do with your time now. A lot of people may condemn it or something to the sort but you’re making free choices that were not available to you 20 years ago, and you’re making them in a different direction. I’m still staying with the landline but you people are way ahead of me.
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