| Source: Berkshire Hathaway 2004 annual report|
OMAHA (CNN/Money) -
It was below freezing here early Saturday morning, with frost silvering the golf courses and rolling lawns of the city where Warren Buffett's Berkshire Hathaway Inc. is headquartered.
But the atmosphere was warm inside the Qwest Center arena, where roughly 20,000 shareholders gathered from around the world to hear Buffett and his vice chairman, Charles Munger, answer questions for nearly six hours.
Not a single individual shareholder asked whether Berkshire might be implicated in the widening scandal about alleged earnings manipulations at American International Group – and even the money managers in the audience whose questions touched on the subject approached it gingerly. (Buffett announced at the outset that, at the request of the investigators who are exploring the AIG case, he could not discuss what he or other Berkshire executives might have revealed about AIG to the authorities.)
Buffett's shareholders are true believers; to them, the idea that he could have done (or known about) anything wrong is absurd.
In his answers to shareholders' questions, Buffett made it clear that he remains concerned about the trade deficit and the U.S. dollar, although he is bullish on the long-term strength of the U.S. economy. But he and Munger issued stern new warnings about the residential real estate "bubble," the destabilizing effect of hedge funds on the financial markets, and the possibility of another terrorist strike against the United States.
They also warned that they do not see a clear future for pharmaceutical stocks, that GM and Ford face severe trouble over pension and health costs, that hedge funds could wreak havoc in a market decline, and that the New York Stock Exchange is doing a disservice to investors by going public.
As always, Buffett spoke in elaborate paragraphs when replying to shareholders' questions, while Munger spoke in terse, tart sentences. The two often disagree about political and social policy, but for much of this meeting they sounded like identical twins. What follows is an edited and approximate transcript of their remarks.
Buffett and Munger on:
On real estate
Buffett: "A lot of the psychological well being of the American public comes from how well they've done with their house over the years. If indeed there's been a bubble, and it's pricked at some point, the net effect on Berkshire might well be positive [because the company's financial strength would allow it to buy real-estate-related businesses at bargain prices]....
"Certainly at the high end of the real estate market in some areas, you've seen extraordinary movement.... People go crazy in economics periodically, in all kinds of ways. Residential housing has different behavioral characteristics, simply because people live there. But when you get prices increasing faster than the underlying costs, sometimes there can be pretty serious consequences."
Munger: "You have a real asset-price bubble in places like parts of California and the suburbs of Washington, D.C."
Buffett: "I recently sold a house in Laguna for $3.5 million. It was on about 2,000 square feet of land, maybe a twentieth of an acre, and the house might cost about $500,000 if you wanted to replace it. So the land sold for something like $60 million an acre."
Munger: "I know someone who lives next door to what you would actually call a fairly modest house that just sold for $17 million. There are some very extreme housing price bubbles going on."
The trade deficit and the value of the dollar
Buffett: "That really is the $64,000 question. It seems to me that a $618 billion trade deficit, rich as we are, strong as this country is, well, something will have to happen that will change that. Most economists will still say some kind of soft landing is possible. I don't know what a soft landing is exactly, in how the numbers come down softly from levels like these....
"There are more people [like hedge-fund managers] that go to bed at night with a hair trigger than ever before, it's an electronic herd, they can give vent to decisions that move billions and billions of dollars with the click of a key. We will have some exogenous event, we will have that. There will be some kind of stampede by that herd....
"When you have far greater sums than ever before, in one asset class after another, that are held by people who operate on a hair-trigger mechanism, then they lend themselves to more explosive outcomes. People with very short time horizons with huge sums of money, they can all try to head for the exits at the same time. The only way you can leave your seat in burning financial markets is to find someone else to take your seat, and that is not always easy...."
Munger: "The present era has no comparable referent in the past history of capitalism. We have a higher percentage of the intelligentsia engaged in buying and selling pieces of paper and promoting trading activity than in any past era. A lot of what I see now reminds me of Sodom and Gomorrah. You get activity feeding on itself, envy and imitation. It has happened in the past that there came bad consequences."
Buffett: "I have no idea on timing. It's far easier to tell what will happen than when it will happen. I would say that what is going on in terms of trade policy is going to have very important consequences."
Munger: "A great civilization will bear a lot of abuse, but there are dangers in the current situation that threaten anyone who swings for the fences."
Buffett to Munger: "What do you think the end will be?"
Buffett: "We're like an incredibly rich family that owns so much land they can't travel to the ends of their domain. And they sit on the front porch and consume a little bit of everything that comes in, all the riches of the land, and they consume roughly 6 percent more than they produce. And they pay for it by selling off land at the edge of the landholdings that can't see. They trade away a little piece every day or take out a mortgage on a piece.
"That scenario couldn't end well. And we, also, keep consuming more than we produce. It can go on a long time. The world has demonstrated a diminishing enthusiasm for dollars in the last few years as they get flooded with them – every day there's $2 billion more going out than in. I have a hard time thinking of any outcome from this that involves an appreciating dollar.
[But, Buffett later added, he is not predicting an end to U.S. economic power.] "If you have a good business in this country that's earning dollars, you'll still do okay. Twenty years from now, a couple percentage points of GDP may go to servicing the deficit, but you'll do fine.... I don't think trade deficits will pull down the whole place; the country will survive those dislocations. I'm not pessimistic about the U.S. at all.... We have over 80 percent of our money tied to the dollar. It's not like we've left the country."
The threat of terrorism
Buffett: My job is to think absolutely in terms of the worst case and to know enough about what's going on in both [Berkshire's] investments and operations that I don't lose sleep. Everything that can happen will happen.... It's Berkshire job to be prepared absolutely for the very worst. A few years ago we did not have NBCs [nuclear, biological and chemical attacks] excluded from our exposure, but we do now....
"If you go to lastbestchance.org, you can obtain a tape, free, that the Nuclear Threat Initiative has sponsored, that has a dramatization that is fictional but is not fanciful. We would regard ourselves as vulnerable to extinction as a company if we did not have nuclear, biological and chemical risks excluded from our policies. There could be events happening that could make it impossible for our checks to clear the next day."
The overall climate for investors
Buffett: "If the [stock] market gets cheaper, we will have many more opportunities to do something intelligent with money. We are going to be buying things [like stocks and other financial assets] for as long as I live, just as I'm going to be buying groceries for the rest of my life. Would I rather have grocery prices go up or down?
"The stock market works the same way: If I'm a net buyer, obviously I would rather have prices go down than up. Charlie and I spend no time talking about what the stock market is going to do, because we don't know. We're not operating on basis of a market forecast. We don't make a list of the good things that are happening, or bad things.
"Overall, I'm an enormous bull on the country. This is the most remarkable success story in the history of the world. It does not make sense to bet against America. I do not get pessimistic about the country. The real worry is what can be done by terrorists or governments that may have access to nuclear or other weapons....
"If you had to make a choice between long-term bonds at around 4.5 percent and equities for the next 20 years, I would certainly prefer equities. But if people think they can earn more than 6-7 percent a year, they're making a big mistake. I don't think we're in bubble-type valuations in equities -- or anywhere close to bargain valuations.
"If you told me I had to go away for 20 years, I would rather take an index fund over long-term bonds. You'll get a chance to do something extremely intelligent with your money in the next few years. But right now there doesn't seem to be a clear enough direction to conclude anything dramatic."
The auto industry
Buffett: "[GM boss] Rick Wagoner and [Ford chairman] Bill Ford have both been handed, by past managers, extremely difficult hands to play. They're not the consequences of their own doing, but they have inherited a legacy cost structure, with contracts put in place decades ago, that make it very difficult for them to be competitive in today's world.
"Just imagine if they'd been made to sign contracts that made them pay several more tons per steel than their competitors have to, people would feel that's untenable. [GM and Ford] have to pay contracts that give them immense obligations for health-care and retirement annuities at high cost. Their competitors can buy steel and other commodities no cheaper, but the competitors don't have nearly the same level of costs for these [health-care and retirement expenses].
"Someone once asked Bill Buckley what he would do if he actually won his race for New York mayor back and the 1960s and he said, 'First thing I'd do is ask for a recount.' Well, that's what I'd do at GM. You've got a $90 billion pension fund, $20 billion set aside for health-care liabilities, and the whole equity value of the company is $14 billion. That's not sustainable.... Something will have to give."
Munger: "Warren gave a very optimistic prognosis. Some people seem to think there's no trouble just because it hasn't happened yet. If you jump out the window at the 42nd floor and you're still doing fine as you pass the 27th floor, that doesn't mean you don't have a serious problem. I would want to address the problem right now. They'd better face it."
The NYSE's merger with Archipelago
Buffett: "I personally think it would be better if the NYSE remained as a neutral, not-for-big-profit institution. The exchange has done a very good job over the centuries. It's one of the most important institutions in the world. The enemy of investment is activity.... I know the American investor will not be better off if volume doubles on the NYSE, and I know the NYSE will be trying to figure out how to do that if it is trying to maximize its own earnings per share. GM or IBM will not earn more money if their stock turns over more actively, but a for-profit NYSE will."
Munger: "I think we have lost our way when people like the [board of] governors and the CEO of the NYSE fail to realize they have a duty to the rest of us to act as exemplars. You do not want your first-grade school teacher to be fornicating on the floor or drinking alcohol in the closet and, similarly, you do not want your stock exchange to be setting the wrong moral example."
Whether pharmaceutical stocks have become bargains
Buffett: "That industry is in a state of flux right now. It's historically earned very good returns on invested capital, but it could well be that the world will unfold differently in the future than in the past. I'm not sure I can give you a good answer on that."
Munger: "We just throw some decisions into the 'too hard' file and go onto others."