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Collection: Warren Buffett - #293 'Why Berkshire Wants At Least a 10% Return'



Good afternoon. I’m Patrick Wolff from Arlington, Virginia.

Charlie, I can’t resist telling you that I’m actually the fellow who plays the chess games blindfolded.




So, I look forward to not seeing you there tomorrow. (Laughter)


Right. (Laughter)


I actually have a two-part question. I’d like to ask you to elaborate a bit how you think about opportunity costs. And I’m — I think I’m going to be elaborating very much on the very last question that was asked.

First of all, in the annual report you say explicitly that you look for a 10 percent pretax return on equity, in looking at common stocks. And I think you talked earlier about how you built up from that for 5 to 6 percent after-tax return, and then you layer on inflation, and then layer on taxes.

My first question would be, how do you adjust that required rate of return across periods of time? So, for example, when interest rates are higher. And do you look for a different equity premium return over different periods of time?


The question on opportunity costs and the 10 percent we mention. You know, basically that’s the figure we quit on. And we quit on buying — we don’t want to buy equities where our real expectancy is below 10 percent.

Now, that’s true whether short rates are 6 percent or whether short rates are 1 percent. We just feel that it would get very sloppy to start dipping below that.

And we would add, we feel also, obviously, that we will get opportunities that are at least at that level, and perhaps substantially above.

So, there’s just a point at which we drop out of the game. And it’s arbitrary. There’s no — we have no scientific studies or anything.

But I will bet you that a lot of years in the future we, or you, will be able to find equities that you understand, or we understand, and that have the probability of returns at 10 percent or greater.

Now, once you find a group of equities in that range, and leaving aside the problem of huge sums of money, which we have, then we just buy the most attractive. That usually means the ones we feel the surest about, I mean, as a practical matter.

There’s just some businesses that possess economic characteristics that make their future prospects, far out, far more predictable than others. There’s all kinds of businesses that you just can’t remotely predict what they’ll earn, and you just have to forget about them.

But when we get — so, we have, over time, gotten very partial to the businesses where we think the predictability is high. But we still want a threshold return of 10 percent, which is not that great after-tax, anyway.

Charlie, do you want to comment on that portion of that question first?


Yeah. The — I think in the last analysis, everything we do comes back to opportunity cost. But it, to some extent — in fact, to some considerable extent — we are guessing at our future opportunity cost.

Warren is basically saying that he’s guessing that he’ll have opportunities in due course to put out money at pretty attractive rates of return, and therefore, he’s not going to waste a lot of firepower now at lower returns. But that’s an opportunity cost calculation.

And if interest rates were to more or less permanently settle at 1 percent or something like that, and Warren were to reappraise his notions of future opportunity cost, he would change the numbers.

It’s like [economist John Maynard] Keynes said, “What do you do when you change your view of the facts? Well, you change your conduct.” But so far at least, we have hurdles in our mind which are basically — well, they involve, implicitly, future opportunity cost.


Right now, with our 16 billion that’s getting 1 1/4 percent pretax, that’s $200 million a year. We could very easily buy Governments due in 20 years and get roughly 5 percent. So, we could change that 200 million a year to 800 million a year of income.

And we’re making a decision, as Charlie says, that it’s better to take 200 million for a while, on the theory that we’ll find something that gives us 10 percent or better, than to commit to the 800 million a year and then find that, in a year or thereabouts, when the better opportunities came along, that what we had committed to had a big principal loss in it.

But that’s — you know that’s not — it’s not terribly scientific. But it — all I can tell you is, in practice, it seems to work pretty well. People —


Years ago, when Warren ran a partnership, and to some extent the partnership that I ran was the — operated in the same way — we implicitly did what you’re suggesting, in that part of the partnership funds were in so-called event arbitrage investments.

And those tended to generate returns, occasionally, when the market, generally, was in the tank. And alternative investments would more mimic the general market. So, we were doing what this academic theory prescribes, you know, 40 years ago. And — but we didn’t use the modern lingo.


Yeah, we’ve got some preferences for having a lot of money coming in all the time.

But we do go into insurance transactions with huge volatility, which could mean that a big chunk of money could go out at one time, or in a very short period of time.

And we won’t give up a lot in expectable return for smoothness, but if you give us a choice of having money come in every week and the same present value of money coming in in very lumpy ways that we wouldn’t know about, we would choose the smooth.

But if you give us a choice of a higher present value for the lumpiness, we will take the lumpiness. And that’s usually the choice that’s — I mean that’s usually — we get offered that choice. And other people value smoothness so highly that we do get a spread, in our view, for lumpy returns.

We are writing — and then we’re going to close this up — but you will read a lot, or you may hear a lot, maybe you’ve heard it already, Pepsi-Cola’s having a contest. They’re going to have a drawing in September.

The contest goes through a lot of little phases, but in the end, there’s going to be one person who’s going to have one chance in a thousand of winning a billion dollars. That billion dollars will have a present value of maybe 250 million.

If whoever gets to that position hits the number, we will pay it. And we don’t mind paying out $250 million as long as we get paid appropriately for us. And that would create bad cash flow that particular week. We’re willing to — maybe even for two weeks. (Laughter)

We’re willing to assume that for a payment, and very, very few people in the world are. Even those that can afford it. We would even assume it for 2 1/2 billion, present value.

We’d want more proportionally to assume it for that, but Charlie and I, I think, would agree that we would take that on if we got paid well enough for it.

We wouldn’t do it for 25 billion, but we will do things, and therefore, you know, we get the calls on that sort of thing. And that is more profitable business, over time, than bread and butter business.

It also can, you know — it can lead you having an intense interest in watching the television show when the drawing takes place — (laughter) — making sure who draws the number, too.

Charlie, you have anything to add? Then we’ll —


Yeah, once you’re talking about opportunity cost that’s personal to yourself and your own situation and your own abilities, you’ve departed from modern finance, totally. And that’s what we’ve done.

We’re intelligently making these guesses, as best we can, based on our own circumstances and our own abilities. I think it’s crazy to do it based on somebody else’s circumstances and somebody else’s abilities.


Thanks for coming and I hope we'll see you all next year. (Applause)


~ Please visit the site above for full video of Berkshire Hathaway Annual Meeting.


[YAPSS Takeaway]

1. Set a minimum threshold in mind, turn down those that don't meet the requirement.

2. Make each decision with opportunity cost in mind.