AUDIENCE MEMBER 00:08
Hi. My name is David Zelker (PH) and I currently live in Redmond, Washington where I work for one of your good friends. So if I get into trouble for having taken a busy Monday off work, maybe if I give you a call you could put in a word for me.
WARREN BUFFETT 00:20
If it’s without pay, we won’t complain. (Laughter)
AUDIENCE MEMBER 00:26
It’s vacation, yeah.
My question is about how you two assign value to certain intangibles that I know you look at when you value companies.
Anyone who’s read your writings knows that you look for great management and economic moats, as you call them, that enable companies to raise prices and margins.
I’d like you to drill down with us and tell us what, to you, are the signs of great management and economic moats.
And furthermore, do you try to put a dollar value on those management and moats and other intangibles when you value companies? And if so, can you guide us through your thinking there?
And lastly, I’m interested in how you pick your discount rate. I’m actually a — an alma mater of yours from business school and I learned a bunch of junk about beta, too.
I read that you just assign the Treasury rate. And I’m not sure if that’s right, but I’d love for you to talk about your discount rate. And I’d really appreciate as much detail about your thinking as you can give us, please.
WARREN BUFFETT 01:21
Yeah. We do — we think, in terms of the Treasury rate, but as I said earlier, that doesn’t mean we think once we’ve discounted something at the Treasury rate, that that’s the right price to pay. We use the Treasury rate just to get comparability across time and across companies.
But a dollar earned from a horseshoe company is the same as a dollar earned from an internet company, in terms of the dollar.
So it is not worth more, based on whether somebody — it comes from somebody named dot-com, you know, or somebody that — named, you know, the Old-Fashioned Horseshoe Company. The dollars are equal.
And our discount rates, they reflect different experience, different expectations about future streams of income, but they don’t reflect any difference in terms of whether it comes from something that the market is all enthused about or otherwise.
The moat and the management are part of the valuation process, in that they enter into our thinking as to the degree of certainty that we attribute to the stream of income — stream of cash, actually — that we expect in the future and the amount of it.
I mean it is, you know, it is — it’s an art, in terms of valuation of businesses. The formulas get simple at the end.
But if you and I were each looking at the chewing gum business — we own no Wrigley, so I use Wrigley fairly often in class — pick a figure that you would expect unit growth of chewing gum, you know, to grow in the next 10 or 20 years.
Give me your expectations on how much pricing flexibility you have, how much danger there is that Wrigley’s share of market is dramatically reduced. You can go through all of that. That’s what we go through.
That is — and in the — in that case, we are evaluating the moat. We are evaluating the price elasticity, which interacts with the moat in certain ways. We’re evaluating the likelihood of unit demand changing in the future. We’re evaluating the likelihood of the management being either very bright with the cash that they develop, or being very stupid with it.
And all of that gets into our evaluation of what that stream of money looks like over the years.
But the value of — how the investment will — works out depends on how that stream develops over the next 10 or 20 years.
We had a question earlier today that made certain suppositions about what could happen at Berkshire. And the formulation was exactly right. The question of what numbers to use is another question, but the formulation was proper. And that formulation — the moat enters into that. If you have a big enough moat, you don’t need as much management.
You know, it gets back to Peter Lynch’s remark that he likes to buy a business that’s so good that an idiot can run it, because sooner or later one will. Well — (Laughter)
That’s — I mean, he was saying the same thing. I mean, he was saying that what he really likes is a business with a terrific moat where nothing can happen to the moat. And there aren’t very many businesses like that. But then — so you get involved in evaluating all these shadings.
This [a can of Coca-Cola], not the cherry version, but the regular version — this one, has a terrific moat around it. There’s a moat even in this, you know, in the container.
You know, I — there was some study made as to what percentage of the people could identify blindfolded what product they were holding just by grabbing the container. And there aren’t many that could score like Coca-Cola in that respect.
So here you’ve got a case where that product has a share of mind. If there’s 6 billion people in the world — I don’t know what percentage of them have something in their mind that’s favorable about Coca-Cola, but it would be a huge number.
And the question is, 10 years from now is that number even larger, and is the impression just a slight bit more favorable, on average, for those billions of people that have it? And that’s what the business is all about.
If that develops in that manner, you’ve got a great business. I think it’s very likely to develop in that manner, but that’s my own judgment.
I think it is a huge moat at Coca-Cola. I think it varies by different parts of the world and all of that. And I think, on top of it, it has a terrific management.
But that — there’s no formula that gives you that precisely, you know, that says that the moat is 28 feet wide and 16 feet deep, you know, or anything of the sort. You have to understand the businesses.
And that’s what drives the academics crazy, because they know how to calculate standard deviations and all kinds of things, but that doesn’t tell them anything. And that what really tells you something is if you know how to figure out how wide the moat is and whether it’s likely to widen further or shrink on you.
CHARLIE MUNGER 06:20
Well, you aren’t sufficiently critical of the academic approach. (Laughter)
The academic approach to portfolio management, corporate finance, et cetera, et cetera, is very interesting. It’s a lot like Long-Term Capital Management. How can people so smart do such silly things? And yet, that’s the way it is.
WARREN BUFFETT 06:53
That’s the great book that needs to be written, really, is, you know, why do smart people do dumb things?
And it’s terribly important, because we’ve got a lot of smart people working with us and, you know, if we can just exorcise all the dumb things, you know, it’s just amazing what’ll happen.
And to some extent, the record of Berkshire, to the extent it’s been good, has been because we — not because we’ve done brilliant things, but we’ve probably done fewer dumb things than most people.
But why smart people do things that are against their self-interest is really puzzling. Charlie, tell me why. (Laughs)
CHARLIE MUNGER 07:34
Well the — you can argue that the very worst of the academic inanity is in the liberal arts departments of the great universities.
And there, if you ask the question, what one frame of mind is likely to do an individual the most damage to his happiness, to his contribution to others — what one frame of mind will be the worst?
And the answer would be some sort of paranoid self-pity. Couldn’t imagine a more destructive frame of mind. Now you have whole departments that want everyone to feel a victim. And you pay money to send your children to places where this is what they teach them.
It’s amazing how these pockets of irrationality creep into these eminent places.
One of the reasons I like the Berkshire meetings is I find fewer of those silly people. (Laughter and applause)
WARREN BUFFETT 08:43
He excluded the head table from (inaudible). (Laughs) Zone 2.
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"The moat and the management are part of the valuation process, in that they enter into our thinking as to the degree of certainty that we attribute to the stream of income — stream of cash, actually — that we expect in the future and the amount of it." ~Warren Buffett