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Collection: Warren Buffett - #109 Investing 'Risk and Circle of Competence'



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


We won’t. (Laughter) I never made it that far. I was an undergraduate student. (Laughs)


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

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


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

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

It really — the industry that it’s earned in means nothing except to the extent that it may tell you something about the ability to develop the cash. But it doesn't tell you — it has no meaning on the quality of the cash once it becomes distributable.

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

In that case, we just give up. We don’t try to predict those things. And we don’t say, “Well, we don’t know what’s going to happen, so therefore we’ll discount it at 9 percent instead of 7 percent,” some number that we don’t even know. That is not our way to approach it.

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

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

But we do think it’s also nonsense to get into situations, or to try and evaluate situations, where we don’t have any conviction to speak of as to what the future is going to look like. And we don’t think you can compensate for that by having a higher discount rate and saying it’s riskier, so then I don’t really know what’s going to happen and I’ll have a higher discount rate. That just is not our way of approaching things. Charlie?


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

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

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


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

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

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

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

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

Business was fundamentally very nonvolatile in nature. I mean, TV stations and a strong, dominant newspaper, that’s a nonvolatile business, but it was a volatile stock. And you know, that is a great combination from our standpoint. Area 8.


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