WARREN BUFFETT: You've heard us talk here about the importance of our managers. However, occasionally, Charlie and I get involved in management ourselves. And we would normally be too modest to claim any great accomplishments.

But we have had one rather incredible performance which, since Charlie participated in it as well I do — I think if we put up the slide on the company that Charlie and I have managed personally, you'll see that this entity — you can't — Charlie, here it is, right here.

It's one where we took over 30-odd years ago. And as you can see, the 46,000 became — what?

VOICE: That's the wrong slide.

WARREN BUFFETT: Oh. Excuse me. Are you sure? Oh.

VOICE: Oh, yeah.

WARREN BUFFETT: OK. Well, I guess we better put up the next slide.

We — (laughter) — they got that first one — they got it reversed. We were doing 120 million when we took over, and we're now doing $46,000 a year. But we may get a bounce one of these years. (Laughter)

That was a company that also had a lot of float — (laughs) that we were attracted to. And the interesting thing is, you know, this was Blue Chip Stamps.

Although Blue Chip was a copy, of a sort, of Sperry & Hutchinson, which really was the main inventor of trading stamps on any large scale in the country, and they go back to the 19th century.

But if you think about it, S&H Stamps — Green Stamps — or Blue Chip Stamps, had many similarities to frequent flyer miles. You know, the only difference being that, you know, you got them a lot at, like, grocery stores and all of that and then you had to lick them and put them in a book. Whereas now, it's all done electronically.

But the basic underlying business was very similar to frequent flyer miles, which have this incredible hold on the American public. But somehow, we were not able to make the transfer.

We haven't yet made the transformation, let's put it that way, from the lick-it stamp to something that the public will accept.

But we've still got $47,000 of revenue annually from the entire state of California, so we're building a base. (Laughter)

Charlie and I continue to spend most of our time working on this one.

WARREN BUFFETT: Let's go to area 7. I think we stopped in area 6 last time, and we'll go from there.

AUDIENCE MEMBER: Yes, my name is Mort November. I'm from Cleveland, Ohio. I'm here with my wife, Iris, who in 1986 founded the Statue of Liberty Collectors’ Club.

I wanted to tell you personally what Berkshire Hathaway has meant for me. By owning it, we have become philanthropists in Cleveland. And the way it happened is we sold all our other stock. It was never any fun owning it, and I could never understand that my stock went down and the CEO's bonuses went up.

So, I got rid of that, and we took all of that money and we're doing things for children in Cleveland. On May 16th, we're sending a group — (applause) — thank you.

On May 16th, for the tenth year in a row, we're sending a group of children from Cleveland Municipal Schools, who win the trip by doing good work in their class and good work in the community, to Dearborn, Michigan, Henry Ford Museum, Greenfield Village. It's a lot of fun for them and it's really a lot of fun for us.

We invested in a building in the Cuyahoga National Park for campers, and hopefully we'll be able to help put up an addition to a library in East Cleveland, Ohio, which really needs all the help it can get.

So, my wish for you gentlemen is that you have many, many more years of good health and that we have the opportunity to see you on this stage, or any stage, for as many years as you want. I salute you both.

WARREN BUFFETT: Thank you. (Applause)

It's terrific what a number — a large number — of Berkshire shareholders, particularly the ones, perhaps — well maybe not particularly — but in the Omaha area, because they go way back to the partnership, and a number of them are in their mid-seventies or thereabouts.

But there have been a lot of things that have come out of the stock. In fact, there's been a suggestion that somebody may do a book on some of the things that have flowed from various Berkshire shareholders.

And I'm sure many of you know about the case of Don and Mid Othmer. Don went to Central High, here in Omaha. Mid Othmer's mother, Mattie Topp, was a wonderful woman, who was a customer when I started selling securities when I was 20 or 21, and she ran a dress shop.

And they, you know, they left about $750 million to a group of mainly 4 or 5 charities, one of which was the University of Nebraska.

But there have been all kinds of things. And there may actually be something done on that at some point, but I'm glad to hear what you're doing in Cleveland.

WARREN BUFFETT: Let's hear from area 8, please.

AUDIENCE MEMBER: Hi, my name is Jennifer Pearlman from Toronto, Canada.

Mr. Buffett, in 1998, you were asked to comment on the pharmaceutical industry, and at that time your answer was that you considered it a mistake not to have taken a basket approach to the industry.

I was wondering if you could revisit the issue, now that valuations have contracted so dramatically.

And also, considering that health care spending is outpacing inflation, and that there are significant moats in the industry, I was wondering if you could share with us your thoughts on the health care industry at large.

WARREN BUFFETT: Charlie may be better equipped on that than I am, but it certainly — it's been, as an industry, a very, very good business over time. And if you take the aggregate capital in it and what it's earned over time, it's been a very good business.

And we did make a mistake, your memory's 100 percent accurate, in we’d — in what we said in earlier meetings, because we should have taken a package approach. We actually did buy a tiny, tiny bit, but that's worse than buying none almost. I mean, it's just aggravating — back there in '93.

It’s certainly the — they're certainly the kind of businesses that, as an industry, we can understand. We would not have great insights on specific companies. So, if we did something, we would be more inclined to do it on an industry-wide basis.

It's hard to evaluate the individual companies. As you know, Bristol-Myers has recently had a big stumble, and even Merck has fallen back. And so, it's hard to pick the winners.

But that's no reason not to have a basket approach to the industry. And at some valuation level, it would be something we would think very hard about. And it's something where we could put quite a bit of money if it happened, which is another plus to us.

Charlie?

CHARLIE MUNGER: Well, I mean, failed to get it right the last time. We'll probably fail to get it right the next time. (Laughter)

WARREN BUFFETT: I don't know what he had for lunch. (Laughter)

WARREN BUFFETT: OK, we'll go to number 1. Well, wait a second, is there anybody at number 9? Probably not, now.

AUDIENCE MEMBER: Yes, there is.

WARREN BUFFETT: OK, good enough. Nine.

AUDIENCE MEMBER: Phil McCaw (PH), from Greenwich, Connecticut.

Could you discuss if and how you take into account the individual balance sheets of the Coca-Cola bottlers to the Coca-Cola Company, and if you view various regulatory control issues as a potential problem for Coca-Cola?

WARREN BUFFETT: Yeah, well, certain Coca-Cola bottlers became quite leveraged, the ones that were, in general, acquiring companies. Coca-Cola Enterprises certainly became very leveraged over — it started out fairly leveraged, and it became more leveraged in recent times.

And they have a business that's a solid, steady business, but it's not one with abnormal profitability. So, it can take leverage, in the sense that it won't be subject to huge dips, but it also is a business where it's very tough to increase margins significantly.

So, if most of the money goes to debt service, you know, that is something that you have to take into account when you value the equity.

It's a fairly capital-intensive business, the bottling business. On average, you'll probably spend between 5 and 6 percent of revenues on capital expenditures just to stay in the same place.

And in a business that, before depreciation, makes — and interest and taxes — makes maybe 15 cents on the dollar, having 5 or 6 cents on the dollar go to capital expenditures is a pretty healthy percentage of that. That's true at the Pepsi-Cola bottling company, too.

It's just the nature of the bottling business. It's a reason why I like, basically, the syrup business better than the bottling business. It's less capital-intensive.

And I think that the bottling business is a perfectly decent business. It isn't a wonderful business because the — it's very competitive out there.

I mean, on any given weekend, the big supermarket in town, or the Walmart, or whatever, is going to be featuring one or the other of the colas, and they’re going to — it's going to be based on price. And you're going to read ads saying, you know, 12 for something or other, or 6 for something or other.

And it has become something where a lot of people will switch from one to another, based on price, on that weekend. And that makes it a tough business for bottlers. But it's a decent business.

But it doesn't, in terms of the Coca-Cola Company, itself, its bottlers are going to do perfectly OK over time. And they've got to earn enough money to be able to sustain that kind of capital expenditure and earn a cost of capital.

And if they get in trouble, it's because, if they pay too much for another bottler, it gets tough to make the math work.

Was there a second question about Coca-Cola then, too?

AUDIENCE MEMBER: Well, I was curious if you concern yourself, when you see FASB-type issues come out about control —

WARREN BUFFETT: No. Yeah, no, I understand. I’m talking —

AUDIENCE MEMBER: Combining all the balance sheets, type of thing.

WARREN BUFFETT: Yeah, that really doesn't make any difference to us. I mean, in the end, the Coca-Cola Company, there's no question about it in my mind, the Coca-Cola Company needs a successful bottling group in order to prosper as a syrup manufacturer.

But the profitability of bottling will allow that. And the capital requirements at the — at Big Coke, as it's called — are relatively minor, so most of the money they make can either be used as dividends or share repurchases.

But nobody's going to run out of money at Coca-Cola, nor are their bottlers, basically, going to run out of money. So, it is not a big balance sheet issue at all. And whether the figures are consolidated or otherwise, the economics are basically the same.

I mean, you have a, you know, there's not going to be a capital crunch of any kind. It would show different ratios if you consolidated and if you didn't, but it really wouldn't change the basic economics any.

Charlie?

AUDIENCE MEMBER: Thank you.

CHARLIE MUNGER: Yeah, I don't think it changes anything on a basic level. But ideally, in the world, you wouldn't have capitalization structures that are designed partly for appearance's sake.

AUDIENCE MEMBER: Thank you.

WARREN BUFFETT: We — thank you.

WARREN BUFFETT: We pay a lot of attention to what we regard as the reality of the balance sheets and economic conditions and cash situation, all of that of a business. And sometimes we think accounting reflects reality, and sometimes we don't.

It's a good starting point for us always, but I mean, there are companies in the United — there's at least one company, at least last year, that was using a 12 percent investment return assumption on its pension plan, and there are other companies that use, I think, even below six, certainly six.

And in the end, should we look at the figures the same of one company, particularly if the pension fund's a big element, that uses 12 and six? No, we look at what it says they're using.

But, in our minds, we don't think the company that's using a 12 percent assumption is likely to do any better with their pension fund than one of the one's that's using six. In fact, we might even think the one that's using six is likely to do better because we might think they're more realistic about the world.

So, we start with the figures of the companies we look at, but we've got our own model in mind as to what they will look like. It's true of the businesses we own a hundred percent of. Some of them have some debt in them, some of them don't, partly that situation's inherited.

In the end, we've got the same metrics that apply to them, whether they happen to have some debt on their own particular balance sheet or not, because in the end, we're not going to be willing to have very much debt at all at Berkshire.

And where it's placed doesn't really make any difference because we're going to pay everything we owe, no matter where it is. And it's almost an accident whether company A or company B has a little debt attached to it.

WARREN BUFFETT: Area 10, is there anybody there?

AUDIENCE MEMBER: Yes, sir. My name Adam Chud. I'm from Columbus, Ohio. I attend the Ohio State University.

My question is, your comments on the new standards for the accounting of goodwill?

WARREN BUFFETT: Yeah, the question about the new standards for goodwill.

Actually, if you read, I think, the annual report — maybe the 2000 annual report, and maybe even earlier.

But we prescribed — we said what we thought would be the preferable system for how goodwill was handled, namely, that it would not be amortized, and that combinations of companies be accounted for as purchases. And it pretty well is what ended up coming out of the accounting profession.

So, the goodwill rules now are in accord with what we believe they should be. And for a long time, they weren't.

You might argue that it was against our interests to have what we think proper accounting has put in, because some people were averse to buying businesses because of a goodwill charge they would incur, whereas it didn’t make — it made no difference to us whatsoever. We just looked at the underlying economics.

So we may have a little more competition, even, on buying businesses simply because now, competitive buyers are not faced with a goodwill charge which may have bothered them but didn't bother us. I regard the present goodwill rules as making sense.

Charlie?

CHARLIE MUNGER: Well, I agree.

WARREN BUFFETT: OK.

AUDIENCE MEMBER: Thank you.

WARREN BUFFETT: Area 1.

AUDIENCE MEMBER: My name is Martin Wiegand, from Bethesda, Maryland.

Thank you for hosting this wonderful and formative shareholder meeting. Thank you also for running Berkshire in a manner that is an example to corporate America and the world. You make us proud to be shareholders.

My question, you touched on just before the lunch break. Did the compensation plans at Berkshire and its competitors have anything to do with the mispriced insurance policies they issued?

And if so, has Berkshire or its competitors changed their compensation plans to correctly price those policies?

WARREN BUFFETT: Incidentally, I asked you this last year, I think, but are you my Martin's son or grandson?

AUDIENCE MEMBER: Son.

WARREN BUFFETT: Son, OK. Good enough. It — Martin's father and I went to high school together. Matter of fact, your Aunt Barbara and I went to high school together also.

And she went out on one date with me, and that was the end. (Laughter)

It was not because I didn't ask her out again. (Laughter)

I picked her up in a hearse. I think that kind of put the — (Laughter)

I think compensation plans lead to a lot of silly things, but I would say that, at Berkshire's insurance companies, I don't think our problems resulted from compensation plans at all.

I think we had an — and we're talking about General Re here basically, because that's where we had the problem.

I think General Re had an enormously successful operation, which went on for a long time. And I think that there was some drift away, perhaps because competitors were drifting away in a big way, too, from certain disciplines, and we paid a price for that.

But I don't think the comp plans entered in at — in any significant way, if at all, into the fact that we did drift away for a while.

I think it — I think you want to have rational comp plans. I think we've got a rational comp plan at General Re, but — and it's quite similar to what we had before. And I just don't think that was the problem.

It's very difficult, it's difficult in the investment world, when other people are doing things that look like they're working very well, you know, and they get sillier and sillier. It’s — it could be difficult for many people to not succumb and do the same things.

And that happens in investments, but it also happens in insurance. And it was, you know, it's a competitive world, and your people are out there every day, and they're competing against Swiss Re, and Munich Re, and Employers Re, and all of these people.

And you've worked hard to get clients, and the client says, "I want to stay with you, but the competitor says if I go with him, I don't have to do this or that, or I can get it a little cheaper," or whatever. You know, it's tough to walk away. And it may even be a mistake to walk away in certain cases.

So, I just think that there was a — what you might call a cultural drift. I don't think it was a shift, but it was a drift. And I think it was produced, in part, by the environment in which the company was operating. And it took a jolt to get it back. And I think that it is back.

I think it's probably stronger than ever in terms of what we have now, but I would not attribute it much to the compensation system.

But I have seen a great many compensation systems that are abominations and lead to all kinds of behavior that I would regard not as in the interest of shareholders. But I don't think we've had much of that at Berkshire.

Charlie?

CHARLIE MUNGER: Yeah, I think if you talk generally about stock option plans in America, you see a lot of terrible behavior caused. And, no doubt, they do a lot of good at other places. But whether they do more good than harm overall, I wouldn't know.

I think, in particular, if you have a corporation where a man has risen to be CEO, and he now has hundreds of millions of dollars in the stock of the company.

He's been loyal to the company and the company's been loyal to him for decades, and he has his directors vote him a great stock option annually to preserve his loyalty to the company, and his enthusiasm to the business when he's already old, I think it's demented.

WARREN BUFFETT: How about when they grant options as he leaves the company?

CHARLIE MUNGER: I — and I also think it's immoral. I think that there comes a time when — (Applause)

I don't think you would improve the behavior of the surgeons at the Mayo Clinic, or the partners of Cravath, Swaine & Moore, if you gave the top people stock options in their sixties.

I mean, by that time, you ought to have settled loyalties, and you ought to be thinking more about the right example for the company than whether you take another hundred million for yourself.

WARREN BUFFETT: Yeah, well, we had a case — (Applause)

We've inherited some option plans because the companies we merged with had them. And in some cases they got settled for cash at the time, in some cases they continued on, depending on the situation.

But more money has been made from options at Berkshire by accident, and that, you know, this is not — it just happened that way, but more money was made by people that had options on General Re stock during a period when General Re contributed to a decrease in value of Berkshire.

So we had all of the other managers essentially, in a great many cases, turning in fine results, and we had a bad result at General Re, and yet more money, by a significant margin, was made under options at General Re than had been made probably by all other entities combined.

But it was an accident, but that's the point, it leads — it can lead to extremely capricious compensation results that have no bearing on the performance of the people that, in some cases get great benefits, and in other cases people did great jobs and were — their efforts were negated by results elsewhere.

So, it’s — it would be very capricious at Berkshire — you can argue that at Berkshire, for those that succeed me and Charlie, that anybody that is in the very top position at Berkshire has got the job of allocating resources for the whole place.

There could be a logically constructed option plan for that person, and it would make some sense because they are responsible for what takes place overall.

But a logically constructed plan would have a cost of capital built into it for every year. We don't pay out any dividends, so why should we get money from you free?

We could put it in a savings account and it would grow in value without us doing anything. And a fixed-price option over 10 years would accrue dramatic value to whoever was running the place, if they had a large option, for putting the money in a savings account or in government bonds.

So, there has to be a cost of capital factor in to make options equitable, in my view, that there can be cases where they make sense. They should not be granted at below the intrinsic value of the company.

I mean, the market — a CEO who says, you know, my stock is ridiculously low when a merger — when somebody comes around and wants to buy the company, but then grants himself an option at a price that he's just gotten through saying is ridiculously low, that bothers me.

So if somebody says, you know, I wouldn't — we don't want to sell this company for less than $30 this year because it's going to be worth a lot more later on, you know, my notion is that the option should be at $30 even if the stock is 15.

You know, otherwise you have a — actually a premium built in of — for having a low stock price in relation to value. And I've never gotten too excited about that.

Charlie, you have any further thoughts on options?

CHARLIE MUNGER: Well, we've been — we're so different from the rest of corporate America on this subject that, you know, we can sound like a couple of Johnny One Notes, but I don't think we ever quite tire of the subject. (Laughter)

A lot is horribly wrong in corporate compensation in America. And the system of using stock options on the theory they really don't cost anything has contributed to a lot of gross excess. And that excess is not good for the country.

You know, Aristotle said that systems work better when people look at the different outcomes and basically appraise them as fair. And when large percentages of people look at corporate compensation practices and think of them as unfair, it's not good for the country. (Applause)

WARREN BUFFETT: It will be hard to change though, because basically, the corporate CEOs have their hands on the switch. I mean, they control the process.

You can have comp committees and all of that, but as a practical matter — I've been on 19 public boards, Charlie's been on a lot of them.

And in the end, the CEOs tend to get pretty much what they want. And what they want tends to go up every year because they see other people getting more every year. And there's a ratcheting effect, and the consultants fan the flames. And it's very difficult to get changed.

And right now, you've got corporate CEOs descending upon Washington, doing everything from trying to persuade to threaten your elected representatives to not have options expensed. And it’s — I think it's kind of shameful, actually.

Because it, you know, this group, who is getting fed very well under the system does not want to have those — what clearly is a compensation expense recorded because they know they won't get as much. I mean, it's that simple. And it's not based on anything much more complicated. (Applause)

WARREN BUFFETT: Area 2?

AUDIENCE MEMBER: Good afternoon. David Winters, Mountain Lakes, New Jersey.

Mr. Buffett and Mr. Munger, thank you for hosting "Woodstock for Capitalists." I know it's a lot of fun for everybody, and I think a lot of fun for you, too.

Assuming growth of low-cost float and the sins of the past do not impede progress, does the sheer size of the float create constraints that change the allocation of future investments to more high-quality fixed-income obligations rather than equity coupons or workouts that can grow over time?

It seems otherwise Berkshire is incredibly well positioned if valuations ever decline.

WARREN BUFFETT: Well, I think the answer is we probably are pretty well positioned if valuations decline.

And it's a good question. If you have 37 billion of float, are you going to be more constrained to conventional investments than if you were working with a half a billion or a billion, as we were not so long ago?

As long as you have a huge capital position, which we have and will continue to have, and as long as you have a lot of outside earning power, which we have and will continue to have, I don't think we're constrained very much.

I mean, that — we'll always want to have a significant level of liquidity, relative to any kind of payment pattern that we see for a good length of time.

But we will probably be operating with so much capital and with so much earning power, independent of the insurance business, and with so much liquidity, that we really will be able to make decisions as to where — as to how — the assets should be deployed, in terms of, simply, where we see the best returns and virtually no risk.

And sometimes we see virtually no risk in equities when they're extremely cheap. We don't see that situation now, but we could see it again. And I don't think we'll be much — I don't think we'll be very constrained when the time comes.

Charlie?

CHARLIE MUNGER: Yeah, our constraint doesn't come from structure, it comes from a lack of enthusiasm for stocks generally. The bonds are held as a default option.

WARREN BUFFETT: Area 3.

AUDIENCE MEMBER: Dear Mr. Buffett and Mr. Munger, my name is Adrian Chur (PH), and I'm a shareholder from Hong Kong.

Thank you for your leadership and inspiration, as always. It's wonderful, always, listening to you. If I may, I would like to ask of you both gentlemen, a question in two parts.

Perhaps I can ask the second part after you've answered the first part. The first part of the question relates to the Fortune article dated 10th of December you included in our shareholder materials.

In this article, you mentioned that one couldn't explain the remarkable divergence in markets by differences in the growth of GNP. However, one could explain the divergence by interest rates.

The first question I have is this: I wonder, sir, if you were to look at the price of gold during the two periods of times you mentioned, that is to say 1948-‘64 and '64-'81, if the explanation could be even more clear?

Thus, the logical reason would be why the Dow in '48 was 177 was because — and half the level of 1929, of 381 index points — is because of the 71 percent devaluation of the American dollar from 20.5 cents an ounce to 35 cents an ounce, which would put the fair value of the Dow at 166, after factoring in the record 50 percent per capita gain of the 1940s that you had mentioned.

WARREN BUFFETT: Yeah, I grew up in a household — and my sisters are here — where gold was talked about frequently. So I've been exposed to a lot of thinking on that over the years.

I don't really think gold has really — the price of gold, I should say — has anything, really, to do with the valuation of businesses.

It may reflect certain things that are going on in prices attached to those businesses at given times.

But I would not regard — I mean, the price of gold does not enter into my thinking in any way, shape, or form, in terms of how I value a business today, a year ago, 10 years ago, or tomorrow.

When we look at Larson-Juhl, the custom picture frame operation, you know, I'm not thinking against — I'm not thinking of that and relating it in any way to what gold has done.

So, I — it's just not a factor with us, any more than other commodities would be. I mean, you know, whether it's wheat, whether it's cocoa beans or whatever.

It has — you know, it has a certain hold on some people and they — but we don't look at it as an interesting investment and we don't look at it as a yardstick for valuing other investments.

Charlie?

CHARLIE MUNGER: Yeah, Warren is right when he says that interest rates are very important in determining the value of stocks, generally. And I think he's also right when he says gold is very unimportant.

WARREN BUFFETT: And the second part of the question?

AUDIENCE MEMBER: Thank you, sir. The second part of my question is this: given your assumptions on gold, if you were to factor a significant decline in the value of the dollar against gold, let's say 40 percent or more, and given the correlation of 1929-‘48 and '64-'81 eras positively to the decline of the dollar, and the negative correlation in the other two areas that you had studied, would you care to adjust the 7 percent total annual return you were quoted as expecting for common equity in the coming decade?

And in conjunction with that, would you care to comment on your expected rate or return on all other major asset classes, perhaps like bonds, real estates? And which would you believe offers the best value for investors? Thank you very much.

WARREN BUFFETT: Yeah. Well, except under unusual circumstances, my expected rate — my expectancy on something like bonds is what bonds are producing at a given time. I don't think I'm smarter than the bond market.

Now, you can say, when they — when those rates swing all over, does that mean I swing all over? The answer is pretty close to yes. I mean, that — I don't know what the right rate for bonds is. I think that if there's —

I'm very leery of economic correlations. I mean, I spent years fooling around with that sort of thing, and I mean, I correlated stock prices with everything in the world. And the — and you know, the problem was when I found a correlation.

I mean, it’s — (laughs) — you know, you've seen these things on whether the AFC or the NFL wins the Super Bowl and all of that sort of thing. You can find something that correlates with something else.

But in the end, a business or any economic asset is going to be worth what it produces in the way of cash over its lifetime.

And if you own a — if you own an oil field, if you own a farm, if you own an apartment house, you know, with the oil field, it's the life of the oil field and what you can get out of it. And maybe you get secondary recovery, maybe you get tertiary recovery.

But whatever it may be, it's worth the discounted value of the oil that's going to come out. And then you have to make an estimate as to volume and as to price.

With a farm, you might make an estimate as to crop yield, and cost, and crop prices.

And the apartment house, you make an estimate as to rentals, and operating expenses, and how long it'll last, and when people will build other new apartment houses that potential renters in the future will find preferable, and so on.

But all investment is, is laying out some money now to get more money back in the future. Now, there's two ways of looking at the getting the money back. One is from what the asset itself will produce. That's investment.

One is from what somebody else will pay you for it later on, irrespective of what the asset produces, and I call that speculation.

So, if you are looking to the asset itself, you don't care about the quote because the asset is going to produce the money for you. And that's how — that’s what society, as a whole, is going to get from investing in that asset.

Then there's the other way of looking at it, is what somebody will pay you tomorrow for it, even if it's valueless. And that's speculation. And of course, society gets nothing out of that eventually, but one group profits at the expense of another.

And of course, you had that operate in a huge way in the bubble of a few years ago. You had all kinds of things that were going to produce nothing, but where you had great amounts of wealth transfer in the short term.

As investments, you know, they were a disaster. As means of wealth transfer, they were terrific for certain people. And they were, for the other people that were on the other side of the wealth transfer, they were disasters.

We look solely — we don't care whether something's quoted because we're not — we don't buy it with the idea of selling it to somebody. We look at what the business itself will produce.

We bought See's Candy in 1972. The success of that has been because of the cash it's produced subsequently.

It's not based on the fact that I call up somebody at a brokerage house every day and say, "What's my See's Candy stock worth?" And that is our approach to anything.

On interest rates, I'm no good. I bought some REITs a couple of years ago because I thought they were undervalued. Why did I think they were undervalued?

Because I thought they could produce 11 or 12 percent, in terms of the assets that those companies had. And I thought an 11 or 12 percent return was attractive.

Now the REITs are selling at higher prices and, you know, they're not as attractive as they were then.

But you just look at — every asset class, every business, every farm, every REIT, whatever it may be, and say, "What is this thing likely to produce over time?" and that's what it's worth.

It may sell at vastly different prices from time to time, but that just means one person is profiting against another, and that's not our game.

Charlie?

CHARLIE MUNGER: Yeah, what makes common stock prices so hard to predict is that a general liquid market for common stocks creates, from time to time, either in sectors of the market or in the whole market, a Ponzi scheme.

In other words, you have an automatic process where people get sucked in and other people come in because it worked last month or last year. And it can build to perfectly ridiculous levels, and the levels can last for considerable periods.

Trying to predict that kind of thing, sort of a Ponzi scheme which is, if you will, accidentally thrown into the valuation of common stocks by just the forces of life, by definition that's going to be very, very hard to predict. But that's what makes it so dangerous to short stocks, even when they're grossly overvalued.

It's hard to know just how overvalued they can become in addition to the overvaluation that exists. And I don't think you're going to predict the Ponzi scheme effect in markets by looking at the price of gold or any other correlation.

WARREN BUFFETT: Charlie and I probably — I mean, I'm pulling a figure out of the air — we have probably agreed on at least a hundred companies, maybe more, that we felt were frauds, you know, bubble-type things.

And if we had acted on shorting those over the years, we might be broke now, but we were right on probably just about a hundred out of a hundred. It's very hard to predict how far what Charlie calls the Ponzi scheme will go.

It's not exactly a scheme in the sense that it isn't concocted, for most cases, by one person. It's sort of a natural phenomenon that seems to — nursed along by promoters and investment bankers and venture capitalists and so on. But they don't all sit in a room and work it out.

It just — it plays on human nature in certain ways and it creates its own momentum, and eventually it pops, you know. And nobody knows when it's going to pop, and that's why you can't short, at least we don't find it makes good sense to short those things.

But they are — it is recognizable. You know when you're dealing with those kind of crazy things, but you don't know when the — how high they'll go or when it'll end or anything else.

And people who think they do, you know, sometimes play in it. And other people know how to take advantage of it, I mean there's no question about that.

You do not have to have a 200 IQ to see a period like that and figure out how to have a big wealth transfer from somebody else to you, you know. And that was done on a huge scale, you know, in recent years. It’s not the, you know — it's not the most admirable aspect of capitalism.

WARREN BUFFETT: Area 4.

AUDIENCE MEMBER: Yes, good afternoon, Mr. Buffett and Mr. Munger. My name is Ho Nam (PH), and I'm from San Francisco, California.

I have a question related to an issue you touched on a few moments ago on the debate over whether or not stock options should be expensed and reflected on the income statement of companies.

With the current system, shareholders are incurring the burden of stock options since exercised options dilute earnings per share.

As a shareholder of companies that issue stock options, I think I'm OK with that, especially in entrepreneurial companies that may not have enough cash to attract talent from larger competitors, or in cases where you have younger employees or lower-level employees who do not have the cash to purchase stock without the use of options.

I have a two-part question. If companies are required to expense stock options and it hits — impacts the P&L, does it — would that lead to double-counting the impact of stock options?

And the second part is, if the use of stock options are largely eliminated, might that impact the competitiveness of entrepreneurial companies which help drive innovation and growth and create more of a dividing line between shareholders and employees?

WARREN BUFFETT: Yeah, the first question is that there really isn't the double-counting necessarily.

For example, let's just take a company with a million shares of stock outstanding, selling at a hundred dollars a share.

And let's say that options are granted for 9 million shares — we'll make it extreme — at a hundred dollars a share. At that moment, you've given 90 percent of the upside to the management. We're taking a very extreme example. That's been a huge cost to the shareholders.

Now, interestingly enough, if the stock was selling at $100 a share, the fully diluted earnings are exactly the same as the basic earnings in that year, because the dilution is not counted at all unless the stock is selling above, and then only by the difference in the market value and what it costs to repurchase the optioned shares. So, there is not double-counting.

And you can — you could issue — the very fact that you issued that million, the options on 9 million more shares at 100, would undoubtedly cause the price to actually fall well below 100 and there would be no dilution shown in terms of the way GAAP reports diluted earnings.

The second question, as to whether, if you expense the options, it would discourage the option use.

Well, the argument, you know, that is made when there — people issue options is that it's doing more for the company than giving people cash compensation. It may be more convenient than cash compensation, too, for young and upcoming companies.

But the fact that you are doing something in terms of paying people in a way that you say is even more effective than paying them in cash, to say that therefore you shouldn't have to record the payment, I've never really followed.

I don't have any objection to options under some conditions. I've never taken a blanket position that options are sinful or anything of the sort. I just say they are an expense.

And to be truthful with people about what you're earning, you should record the expense. And if a company can't afford to be truthful, you know, I have trouble with that.

And we will take, as we've said, you can pay your insurance premium to me in options. There'd be lots of companies I'd be happy to take options in and give them credit.

I'd take options above the market. Give me a 10-year option 50 percent above the market in many companies, and we will take that — appropriate number of shares — and take that in lieu of cash.

But that means we simply like, you know, the value of what we're getting better than the equivalent amount of cash and we think the company that gives it to us has incurred an expense.

We've received something of value, they've given something of value up, and that's income to us and expense to them.

And I think all of the opposition, at bottom, to the — to expensing of options comes from people who know they're not going to get as many options if they're expensed. And you know, they would like cash not to be expensed, but they can't get away with that, you know. I mean —

CHARLIE MUNGER: Yeah. (Laughter)

WARREN BUFFETT: If you had an accounting rule that said the CEO's salary should not be counted in cash, believe me, the CEOs would be in there fighting to have that rule maintained.

I mean, because no one would — they would feel that they were going to get more cash if it wasn't expensed, and options are the same way.

It’s another argument I get a kick out of, I was just reading it the other day, where they say, "Well, options are too tough to value."

Well, I've answered that in various forms, but I notice that — what is it, Dell Computer, you know, has a great number of put options out, and it's going to cost them a lot of money on the put options they have out.

And for a company to say, "We can't figure out the value of options, and therefore we can't expense them," and then at the same time be dealing in billions of dollars' worth of options, they are saying, "We are out buying or selling options in the billions of dollars, but we don't know how to value these things." That strikes me as a little bit specious — a little disconnected, cognitive dissonance, as they say.

Charlie?

CHARLIE MUNGER: Yeah, I'm not at all against stock options in venture capital, for instance. But the argument that prominent venture capitalists have made, that not expensing stock options is appropriate because if you expense them it would be counting the stock options double, that's an insane argument.

The stock option is both an expense and a dilution, and both factors should be taken into account in proper accounting.

John Doerr, the venture capitalist, as he argues to the contrary, is taking a public position that, "Were it offered to me as part of my employment, I would rather make my living playing a piano in a whorehouse." (Laughter)

WARREN BUFFETT: We always get to the good stuff in the afternoon. (Laughter)

I hope the children are in bed.

WARREN BUFFETT: Number 5.

AUDIENCE MEMBER: Good afternoon. My name is Bob Baden (PH), from Rochester, New York.

Mr. Munger, this morning, while discussing index funds, you used the example of Japan as a real example of poor performance of a major index over a long period.

Indeed, the S&P 500 index declined over 60 percent, in real terms, from the early '60s through the mid-'70s.

Could you discuss the mental models you use to consider the impact of inflation or deflation on your investment decisions and the likelihood of either occurring over the next decade?

CHARLIE MUNGER: Well, that's partly easy and partly tough.

If interest rates are going to go way up, you can obviously have a lot of deflation of stock prices. And a lot of that happened in the American period you're talking about.

What's interesting about Japan is that I don't think anybody thought that a major modern Keynesian democracy, pervaded by a good culture in terms of engineering, product quality, product innovation, and so forth, could have a period where you would have negative returns over 13 years without major depression either.

WARREN BUFFETT: (Inaudible)

CHARLIE MUNGER: I think — and that it would occur while interest rates were going down, not up. I think that was so novel that the models of the past totally failed to predict it.

But I think these anomalies are always very interesting, and I think it's crazy for Americans to assume that what's happening in Argentina, what has happened in Japan, are totally inconceivable forever in America. They are not totally inconceivable.

WARREN BUFFETT: You had a huge bubble in equity prices in Japan, and now you've had interest rates go to virtually nothing.

You've had the passage of time, the country hasn't disappeared. People are going to work every day, and you've had this — the Nikkei, you know, now at a third of what it sold for not that many years ago. It's an interesting phenomenon.

CHARLIE MUNGER: And huge fiscal stimulus in the whole period from the government.

WARREN BUFFETT: Post-bubble periods, I think, depending on how big the bubble is and how many were participating in it, but post-bubble periods, I think, can produce fallout that not everyone will be terribly good at predicting.

WARREN BUFFETT: Six?

AUDIENCE MEMBER: Hi, I'm Steve Rosenberg (PH). I'm 22, from Ann Arbor, Michigan. It's a privilege to be here.

First, I'd just like to thank you both for serving as a hero and positive role model for me and many others. Much more than your success, itself, I respect your unparalleled integrity.

I have three quick questions for you. The first is how a youngster like myself would develop and define their circle of competence.

The second involves the role of creative accounting in the stories of tremendous growth and success over many years. GE, Tyco, and IBM immediately come to mind for me, but I was hoping you could also discuss that issue in relation to Coke.

Some people have said that their decision to lay off much of the capital in the system onto the bottlers, who earn low returns on capital, is a form of creative accounting.

On the flip side, others counter that Coke's valuation, at first glance on, say, a price-to-book metric, is actually less richly valued than it seems because they earn basically all the economic rents in the entire system.

My final question is, if you could comment on the A.W. Jones model, the long/short equity model. I understand that it doesn't make sense for capital the size of Berkshire's to take that type of a strategy.

But it just seems to me that playing the short side in combination also seems incredibly compelling, even giving the inherent structural and mathematical disadvantages of shorting. And I was wondering if you could talk a little bit more about why you would have lost money on your basket of a hundred frauds.

WARREN BUFFETT: Yeah, it's an interesting question. And we'll start — we'll go in reverse order.

Many people think of A.W. Jones, who was a Fortune writer at one time, and who developed the best-known hedge fund, whenever it was, in the early '60s or thereabouts, maybe the late '50s even.

And for some of the audience, the idea originally with A.W. Jones is that they would go long and short more or less equal amounts and have a market-neutral fund so that it didn't make any difference which way the market went.

They didn't really stick with that over time. And I'm not even sure whether A.W. Jones said that they would. But they, you know, sometimes they'd be 140 percent long and 80 percent short, so they'd have a 60 percent net long, or whatever it might be.

They were not market-neutral throughout the period, but they did operate on the theory of being long stocks that seemed underpriced and short stocks that were overpriced.

Even the Federal Reserve, in a report they made on the Long-Term Capital Management situation a few years ago, credited A.W. Jones with being sort of the father of this theory of hedge funds.

As Mickey Newman, if he's still here, knows, I think it was in 1924 that Ben Graham set up the Benjamin Graham Fund, which was designed exactly along those lines, and which even used paired securities.

In other words, he would look at General Motors and Chrysler and decide which he thought was undervalued relative to the other, and go long one and short the other.

So, the idea — and he was paid a percentage of the profits. And it had all of the attributes of today's hedge funds, except it was started in 1924.

And I don't know that Ben was the first on that, but I know that he was 30 years ahead of the one that the Federal Reserve credited with being the first, and that many people still talk about as being the first, A.W. Jones.

Ben did not find that particularly successful. And he even wrote about it some in his — in terms of the problems he encountered with that approach.

And my memory is that a quite high percentage of the paired investments worked out well. He was right. The undervalued one went up and the overvalued — or the spread between the two narrowed.

But the one time out of four, or whatever it was, that he was wrong lost a lot more money than the average of the three that he was right on.

And you know, all I can say is that I've shorted stocks in my life, and had one particularly harrowing experience in 1954. And I have — I can't — I can hardly think of a situation where I was wrong, if viewed from 10 years later.

But I can think of some ones where I was certainly wrong from the view of 10 weeks later, which happened to be the relevant period, and during which my net worth was evaporating and my liquid assets were getting less liquid, and so on. So, it’s — all I can tell you is it's very difficult.

And the interesting thing about it, of course, is A.W. Jones was a darling of the late 1960's. And Carol Loomis is here, and she wrote an article called “The Jones Nobody Keeps Up With.” And it's a very interesting article, but nobody's writing articles — nobody was writing articles about A.W. Jones in 1979.

I mean, something went wrong, and there were spin-offs from his operation. Carl Jones spun off from his operation, Dick Radcliffe spun off from his operation. There were — you can go down the list.

And out of many, many, many that left, they — a very high percentage of them bit the dust, including suicides, cab drivers, subsequent employment — the whole thing. And these people were —

There was a book written in the late '60s, it had a lot of pictures in it. I don't remember the name of it, but it showed all these portraits of all these people that were highly successful in the hedge fund business, but they didn't bring out a second edition. So, it's just tough.

Logically, it should work well, but the math of only — you can't short a lot of something. You can buy till the cows come home if you've got the money. You can buy the whole company if need be, but you can't short the whole company.

A fellow named Robert Wilson, there's some interesting stories about him. He's a very, very smart guy, and he took a trip to Asia one time, being short, I think it was Resorts International or maybe it's Mary Carter Paint, it was still called in those days.

And he lost a lot of money before he got back to this country. He's a very smart guy, and he made a lot of money shorting stocks, but it just takes one to kill you.

And you need more and more money as the stock goes up. You don't need more and more money when a stock goes down, if you paid for it originally and didn't buy it on margin. You just sit and find out whether you were right or not.

But you can't necessarily sit and find out whether you're right on being short a stock.

I think I'll let Charlie comment on that before I go to your other two questions.

CHARLIE MUNGER: Well, he asked about creative accounting and he named certain companies. I wouldn't agree that all those companies were plainly sinful, although I'm sure there are significant sins in the group as a whole.

Creative accounting is an absolute curse to a civilization. You can argue that one of the great inventions of man was double-entry bookkeeping, where we could keep our economic affairs under better control.

And it was a north Italian development, spread by a monk. And anything that sort of undoes the monk's work by turning this great system into kind of a tool for fraud and folly, I think, does enormous damage to the country.

Now, I think a democracy is ordinarily set up so it takes a big scandal to cause much reform. And there may be some favorable fallout from Enron because that was certainly the most disgusting example of a business culture gone wrong that any of us has seen in a long, long time.

And what was particularly interesting was it took in, eventually, a lot of nice people that you wouldn't have expected to sink into the whirlpool.

And I think we'll always get Enron-type behavior, but it may be moderated some in the next few years.

WARREN BUFFETT: A question of accounting and the economic profits to be gathered in the bottling system versus the production of the syrup, Coke. I've just gotten through reading the annual reports of Coca-Cola FEMSA and Panamco, which are two big Latin American bottlers.

And I mean, they make pretty decent money, quite significant money. And there is more money in owning the trademark. It isn't the plants that make the syrup or anything to sell. The trademark is where a huge amount of value is.

The trademark is where a huge amount of value is in See's Candy. You know, those are big, big assets.

And I would say that you can make good money as a bottler. A lot of bottlers have become rich over the years. If I had a choice between owning the trademark and owning a bottling business, I'd rather own the trademark, but that doesn't mean the bottling business is a bad business at all.

And it's riding on the back of a trademark. I mean, that is why a bottling system is valuable, is because it has the right to sell a trademarked product, which hundreds of millions of people every day are going to go in and ask for by name. And the right to distribute that product is worth good money.

And it really — I don't see any accounting questions in that sort of thing. In other words, if the Coca-Cola Company did not own a share in any of its bottlers, and for many years it either owned a hundred percent of a bottler, or a large part, or — and very few of those — or none of it.

But if they owned no interest in their bottlers, I think the economics would be very, very similar to what they are now.

I mean, the bottlers would still be able to borrow a lot of money because they would have contracts with the Coca-Cola Company, and that were important, and that would allow them to make decent money distributing the product.

But they don't make the kind of money that you make if you own the trademark. That's just the way it works.

WARREN BUFFETT: What was the first question again that —

AUDIENCE MEMBER: It was how a youngster like myself would define and develop a circle of competence.

WARREN BUFFETT: Oh, yeah, that's a good question. And I'm — you know. I’d — I would say this, if you have doubts about something being into your circle of competence, it isn't.

You know, I mean, in other words, I would look down the list of businesses and I would bet you that you can — I mean, you can understand a Coke bottler. You can understand the Coca-Cola Company. You can understand McDonald's.

You can understand, you know, you can understand, in a general way, General Motors. You may not be able to value it.

But there are all kinds of businesses. You can certainly understand Walmart. That doesn't mean whether you decide whether the price — what the price should be — but you understand Walmart. You can understand Costco.

And if you get to something that your friend is buying, or that everybody says a lot of money's going to be made, and you don't — you're not sure whether you understand it or not, you don't.

You know, I mean, and it's better to be well within the circle than to be trying to tiptoe along the line.

And you'll find plenty of things within the circle. I mean, it's not terrible to have a small circle of competence. I'd say my circle of competence is pretty small, but it's big enough. You know, I can find a few things.

And when somebody calls me with a Larson-Juhl, that is within my circle of competence. I hadn't even thought about it before, but I know it's within it. I mean, I can evaluate a business like that.

And if I get called — I got called the other day on a very large finance company. I understand what they do, but I don't understand everything that's going on within it, and I don't understand that — whether I can continually fund it, you know, on a basis, independent from using Berkshire's credit, and so on.

So, even though I could understand every individual transaction they did, I don't regard the whole enterprise, or the operation of it, necessarily as being within my circle of competence.

Charlie?

CHARLIE MUNGER: Yeah, I think that if you have competence, you almost automatically have a feeling of where the edge of the competence is. Because after all, it wouldn't be much of a competence if you didn't know its boundary. And so, I think you've asked a question that almost answers itself.

And my guess is you do know what you're perfectly competent to do, you know, all kinds of areas. And you do have all kinds of other areas where you know you'd be over your depth.

I mean, you're not trying to play chess against Bobby Fischer or do stunts on the high trapeze if you've had no training for it.

And my guess is you know pretty well where the boundaries of your competence lies. And I think you also probably know pretty well where you want to stretch the boundary. And you've got to stretch the boundary by working at it, including practice.

WARREN BUFFETT: And one of the drawbacks to Berkshire, of course, is that Charlie and I, our circles largely overlap, so you don't get two big complete circles at all, but that's just the way it is. And it's probably why we get along so well, too.

WARREN BUFFETT: Number 7.

AUDIENCE MEMBER: Good afternoon, gentlemen. Wayne Peters is my name, and I'm from Sydney, Australia.

WARREN BUFFETT: I'd have never guessed.

AUDIENCE MEMBER: No. (Laughter)

I'll speak a little slower so my accent doesn't throw you.

WARREN BUFFETT: Good.

AUDIENCE MEMBER: My question goes further to the resolution on population control raised this morning. Firstly, can I just say I voted against it, and I guess that's just the beauty of the democratic society?

Of concern, however, was the gentleman's implication that the world's population has decreased, or is decreasing.

Having read the book Charlie recommended last year, by Garrett Hardin, called “Living Within Limits,” I've got a reasonable feel and understand the population grew by about 1.7 percent last year, which is approximately 67 million people.

In my terms, I'd relate that to approximately 4 times the population of Australia, clearly an alarming rate over the long term if you're talking, you know, 500 or a thousand years.

Reading between the lines, my guess is that the issue of population growth is likely to be a key focus of the Buffett Foundation.

My question to you this afternoon is, how do you currently see this critical issue being tackled?

WARREN BUFFETT: Yeah, well, population projections are just that, they're projections. And they've been notoriously inaccurate over the years. And the gentleman that made the motion referred to a recent New York Times story.

And there are some — there are projections that, based on fertility rates and what happens to them in different countries, under different economic conditions and all that, I mean, you can come up with all kinds of projections.

I don't know the answer on it. Nobody does at any given time. And the carrying capacity of the Earth has turned out to be a lot greater than people have thought in the past, but there is some amount that does relate to the carrying capacity. It may have been expandable, but it's not infinitely expandable.

And I would suggest that the errors of being on the low side, in terms of population relative to estimated carrying capacity, the danger from those errors is far, far less than the dangers from overshooting, in terms of population compared to carrying capacity.

And since we don't know what carrying capacity is or will be a hundred years from now, I think that, generally, that mankind has an interest in making sure it doesn't overshoot, in terms of population. And if it — there's no great penalties attached to undershooting at all that I see.

And it's very, you know, it's the old analogy. If you were going to go on a spaceship for a hundred years and you knew in the back of the spaceship there were provisions — there were a lot of provisions, but you didn't know exactly how much — in terms of filling the front of the spaceship with a given number of people, you would probably err on the low side.

I mean, you would — and if you thought maybe it could handle 300, in terms of the provisions, I don't think you'd put 300 people in there. I think you'd put about 150 or 200.

And you'd figure that you just didn't know, you know, for sure, the spaceship would get back in a hundred years. You wouldn't know how much was in the back. And you would be careful, in terms of not overshooting the carrying capacity of whatever the vehicle you were in.

And we are in a vehicle called Earth. We don't know its carrying capacity. We have learned that it's a lot larger than might have been thought by Malthus or somebody a few hundred years ago, but that doesn't mean it's infinite at all.

And I don't — the one thing I will assure you is that the projections that were run in the New York Times, you know, a few weeks ago, are not going to be the ones that are going to be run 50 years from now, or 30 years from now.

And it's not the sort of thing that is cured after the fact. I mean, you're not going to go around trying to intentionally reduce the population. It's much better to prevent population growth than to try and correct afterwards. And Garrett Hardin has got some interesting stuff on that.

Charlie?

CHARLIE MUNGER: Yeah, I will say that the whole controversy has been interesting in the way both sides don't understand the other side's model.

But by and large, on the population alarm side, the ecology side, they've always underestimated the capacity of modern civilization to increase carrying capacity.

And the more they underestimate, why the least — the less they seem to learn. That is not to the credit.

And the other side has equal folly. I think it's — I think you're just talking about the human condition.

It's a complicated, controversial subject and people feel strongly about it, and they learn slowly. And I just think that's the way it's going to be as far ahead as you can see.

WARREN BUFFETT: I think the chances of a world inhabited by 15 billion people having behavior, on average, better than if the world were inhabited by 5 billion people is low, but you know, that is — we'll never find a way to test that. But that's my instinct on it.

WARREN BUFFETT: Number 8.

AUDIENCE MEMBER: My name is Bert Flossbach. I'm from Cologne, in Germany. And first of all, I would like you gentlemen, for all the monitoring you have done and the pristine investment philosophy, which is more and more followed in Germany as well.

My question refers to the importance of realism. If the dim prospects of the — on the stock market Mr. Munger made earlier become true, and given that the size of Berkshire Hathaway diminishes the impact of small investments, what do you think would be the realistic return on the float over the next 10 years or 20 years?

WARREN BUFFETT: Well, I wish I knew. The only thing I can tell you is it'll be less than it's been in the last 20 years.

But I think it'll be satisfactory, compared to most alternatives. But I don't know whether the alternatives are going to produce 4 percent a year or 8 percent a year. I don't think they're going to produce 15 percent a year.

And I would think that if we obtain very low-cost float, which I think we should and I think we will, and we keep getting chances to buy businesses on reasonable terms, not sensational terms, and we get occasional market — which we've even had a few occasions of things we've done in the bond market the last few years. We haven't made huge amounts of money, but we've made a pretty good amount of money. And we'll see some things to do on equities.

I think overall, we can have a return that we won't be ashamed of, but we won't come close to a return that you might think, looking back, we could achieve, but —

We don't think the returns on equities are going to be terrible over the next 20 years. We just think that people whose expectations were built by 1982 to 1999 are going to be very disappointed.

But there's nothing wrong with earning 6 or 7 percent on your money. I mean, there — it’s — in a world of relatively low inflation, you know, how much more is capital entitled to than that? I mean, it has to come out of somebody.

And to keep doing it on increasing amounts of money, if you earned much higher returns than that, you would have a whole shift in the national income stream over time.

So, I think we'll get chances to do things that will leave us satisfied, but the question is whether they leave you satisfied.

Charlie?

CHARLIE MUNGER: Well, I certainly can't improve on that, but it won't stop me from trying to say something. (Laughter) The —

I think one of the smartest things that a person can do under present conditions is just dampen the expectations way down from the investment achievements of the past, including, of course, with reference to Berkshire stock. I think that's maturity and good sense.

All that said, I like our model and I like what we have in place, and I like what's been coming in recently.

And I think we've had a lot of fun in the past, and some achievement, and my guess is we'll continue to do that.

And I'm just up here, most of the time, to indicate to the rest of you that maybe you've got 10 more tolerable years coming out of Warren — (laughter) — and I'm doing the best I can at that. (Applause)

WARREN BUFFETT: Number 9, please.

AUDIENCE MEMBER: Good afternoon. I'd like to get back to the basics and talk about the insurance side, which is the core of Berkshire.

In '98, when we bought Gen Re, they had a Lloyd's syndicate, DP Mann, now known as Faraday. In addition, in 2000, we bought the Marlborough Agency.

I'd like to get your perspective on what you see is happening at Lloyd's and their future, as well as our commitment to the Lloyd's market.

WARREN BUFFETT: Yeah, well, we do have what is now known as the Faraday syndicate. And actually, our takedown of their capacity, which I think was maybe, I don't know, in the area of 30 percent a few years back, is now well into the mid-90s percent.

So, we, in effect, have a much larger commitment, through Faraday, to the London market. And I would think we would do pretty well with that commitment.

But in the end it really doesn't make any difference whether you're in London or whether you're in Washington, as GEICO is, or whether you're in — I mean, actually, for a while, Ajit lived here in Omaha, or whether, you know, you — it really depends —because you're — it's a worldwide market.

You're going to see things — assuming that you have a reputation for paying claims and for having the capital to do things, and being willing to act — you're going to see things every place in the world.

It's really like investing. I mean, you can invest, whether you're in London or Omaha or New York. It doesn't make any difference where you're located.

What counts is the ability to, and the discipline, to look at thousands of different things and select from them a group to do, because you can do anything in the world in insurance.

I mean, we could write tens of billions of premiums in, you know, in a month if we just opened the floodgates, but it's out there.

There's lots of business out there. There's lots of investment opportunities — or investment choices — out there. And the question is, is what you say yes to and what you say no to.

And that should be determined by what you are able to evaluate and, in the case of insurance, even if they're attractive, preventing an aggregation risk that could cause you major embarrassment at some time.

But we don't have any — we don't specifically think the London market is better than the U.S. — being domiciled in the U.S. — or vice versa. And as you know, we have an operation domiciled in Germany. And that isn't the key to it.

You know, the key is having people making decisions daily where they accept risks they understand and that are properly priced, and avoiding undue aggregation, and the occasional problem, in terms of dealing with people that are less than honest.

But the first two items are the important ones day in and day out. And that can be done at Lloyd's, it can be done at Omaha.

I mean, National Indemnity did not have any great geographical advantage in sitting at 30th and Harney, but it's done very well, just in its primary business, ever since Jack Ringwalt founded it in 1941, or whatever year it was.

I mean, it — and Jack Ringwalt — some of you here may have known him — Jack Ringwalt — a very good friend of mine — but Jack Ringwalt was not an insurance genius.

And he never, you know, my guess is he never looked at an actuarial book in his life or even thought about it. But he just was an intelligent fellow who had enough sense to do — to stick with what he understood in virtually all cases, and to make sure that he got paid appropriately for the risk he was taking.

And he beat the pants off, you know, people that had been around for a hundred years in Hartford, who you know, had vast agency organizations and huge amounts of capital and actuaries and all kinds, you know, all kinds of data and everything.

But they didn't have the discipline that he had. And that's what it's all about.

So, I don't really relate it to geography. I would like to be exposed to as much business in the world as possible and have that exposure be manifested through people that have the disciplines I talked about.

And if we can see everything that takes place in the world, and people want to come to us for one reason or another, often because of our capital position or our willingness to take on volatility —

If those people come to us, wherever they come to us, and the people that they — who represent us use the guidelines we've talked about, we'll do very well.

And you know, the more places they have to intersect with us, as far as I'm concerned, as long as that intersection takes place with people who have that discipline.

Charlie?

CHARLIE MUNGER: Yeah, the insurance business is a lot like the investment business at Berkshire.

If you combine a vast exposure with a vast decline rate, you have an opportunity to make quite a few good decisions.

WARREN BUFFETT: And I think we're making them now. You can check on me next year on that.

WARREN BUFFETT: Number 10.

AUDIENCE MEMBER: I'm Lowell Chrisman (PH), from Phoenix, Arizona. I am retired and teaching in — seniors in high school. I wish they could be here to hear you today.

I'm teaching these people an investment course part-time. And the first class I went to, they asked me to teach them how to prepare for retirement.

I would like to know what the two or three things are that you would suggest that I include in this course.

WARREN BUFFETT: Well —

CHARLIE MUNGER: What the hell does Warren know about retirement? (Laughter)

WARREN BUFFETT: Yeah. We haven't even thought about it.

Now, let me give you one suggestion for that group. I use this sometimes when I talk to high school — a bunch of high school seniors down in Nebraska Wesleyan, a few weeks ago.

Tell the youngsters in the class, they're probably around 16 or 17, and if they're like I was when I was 16, you know, I was only thinking of two things.

And Martin's Aunt Barbara wasn't going out with me, so I was down to cars. (Laughter)

I tried hearses, but that didn't work. The —

And let's assume, and I use this with — let's assume a genie appeared to you when you turned 16, and the genie said, "You get any car you want tomorrow morning, tied up in a big pink ribbon, anything you name. And it can be a Rolls Royce, it can be a Jaguar, it can be a Lexus, you name it, and that car will be there and you don't owe me a penny."

And having heard the genie stories before, you say to the genie, "What's the catch?" And of course, the genie says, "Well, there's just one. That car, which you're going to get tomorrow morning, the car of your dreams, is the only car you're ever going to get. So you can pick one, but that's it."

And you still name whatever the car of your dreams is, and the next morning you receive that car.

Now, what do you do, knowing that's the only car you're going to have for the rest of your life? Well, you read the owner's manual about 10 times before you put the key in the ignition, and you keep it garaged.

You know, you change the oil twice as often as they tell you to do. You keep the tires inflated properly. If you get a little nick, you fix it that day so it doesn't rust on you.

In other words, you make sure that this car of your dreams at age 16 is going to still be the car of your dreams at age 50 or 60, because you treat it as the only one you'll ever get in your lifetime.

And then I would suggest to your students in Phoenix that they are going to get exactly one mind and one body, and that's the mind and body they're going to have at age 40 and 50 and 60.

And it isn't so much a question of preparing for retirement, precisely, at those ages, it's a question of preparing for life at those ages.

And that they should treat the importance of taking care and maximizing that mind, and taking care of that body in a way, that when they get to be 50 or 60 or 70, they've got a real asset instead of something that's rusted and been ignored over the years.

And it will be too late to think about that when they're 60 or 70. You can't repair the car back into the shape it was. You can maintain it. And in the case of a mind, you can enhance it in a very big way over time.

But the most important asset your students have is themselves.

You know, I will take a person graduating from college, and assuming they're in normal shape and everything, I will be glad to pay them, you know, probably $50,000 for 10 percent of all their earnings for the rest of their lives.

Well, I'm willing to pay them 10 percent for — $50,000 for 10 percent — that means they're worth $500,000 if they haven't got a dime in their pocket, as long as they've got a good mind and a good body.

Now that asset is far, far more important than any other asset they've got, unless they've been very lucky in terms of inheritance or something, but overwhelmingly their main asset is themselves. And they ought to treat their main asset as they would any other asset that was divorced from themselves.

And if they do that, and they start thinking about it now, and they develop the habits that maintain and enhance the asset, you know, they will have a very good car, mind, and body when they get to be 60. And if they don't, they'll have a wreck.

Charlie? (Applause)

WARREN BUFFETT: Number 1?

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. I'm George Brumley, from Durham, North Carolina.

It's been reasonably argued that the most critical factor in evaluating a business is establishing the sustainability of a competitive advantage.

Let's assume that we have knowledge in hand about a few truly unique companies that possess sufficient strengths to out-duel the competition, and that we can therefore estimate future cash flows with relative certainty.

I admit that getting this far is far from easy, moreover it seems that the wild card of an unchecked tort system has grave potential to turn even such sound analysis on its head.

Predicted cash flows and reasonably estimated terminal values can be effectively driven to zero for business owners via a transfer to both litigants and litigators.

My question is, how should intelligent investors attempt to factor such uncertainty into their valuations of potential investment opportunities?

WARREN BUFFETT: Charlie's the lawyer, so I'll tell him how — I'll have him tell you how to protect yourself from his brethren.

AUDIENCE MEMBER: And I have quick follow-up.

CHARLIE MUNGER: I think it is entirely fair, as an investor, to just quitclaim certain areas of business as having too many problems.

I almost feel that way about workman's compensation insurance in California.

In other words, the system morphs into something that is so unfair and so crazy that I'm willing to pretty much, at least, leave it behind. And I think there are all kinds of areas like that.

Another fellow and I once controlled a company that invented a better policeman's helmet. And we told them not to make it. We told them to sell it to somebody else who was judgment-proof or — we wanted the policemen to have the helmet, but we didn't want to make it.

I think there are whole areas of activity where, for the already rich, the tort system makes participation foolish. And I think you can sort of figure out where those are and avoid them. I don't think the tort system is going to be fixed quickly.

WARREN BUFFETT: Yeah, George — actually, George Gillespie is, I think, here today. And he and I were directors of Pinkerton 20 years ago. And in fact, we owned a very significant percentage of Pinkertons, although it was controlled by the family foundation.

But one of the interesting problems then was a question of whether we would want to supply guards, for example, at airports.

And if you think about it, Berkshire, itself — well, forget about Pinkerton — would be absolutely crazy to go into the business of supplying guards to airports.

We might be more responsible, in terms of selecting the guards. But if we were to have a guard, say, at that Portland airport from which a plane took off — or where from what the original boarding was of the people that took off from Logan — or we are the guards at Logan or wherever — we might have been held liable for billions and billions of dollars.

You know that people would have gone after us because we would have had deep pockets and we would have had an employee of ours, and people would have said that if it hadn't for your employee, these people wouldn't have all died, and everything else wouldn't have happened.

And for us to be in a business, like Charlie and the helmet business, I mean, for us to be in a business like that would be madness when some other guy operating out of his basement can have guards and if, you know, if they blow up the whole airport it doesn't make any difference because he's judgment-proof.

So, it actually is a system that may discourage, perhaps, more responsible people from ever even dreaming of being in that kind of business.

And unfortunately, I would say that the range of businesses, since 1980, when we were thinking about that sort of thing at Pinkertons, the range of businesses to whom such reasoning might apply has probably enlarged to a significant degree.

There's just a lot of things that a rich corporation shouldn't do because they will pay a price if they are wrong, or if even somebody maybe suspects they were wrong, that would be incredibly disproportionate to what somebody in different economic circumstances would bear.

It's absolutely a selection by the tort system of people that are going to provide certain services and products. And I don't know any answer for that except to avoid it.

WARREN BUFFETT: Now, you had another question, George?

AUDIENCE MEMBER: Yes, just briefly, if you could give us an update on the economics of the Finova deal?

WARREN BUFFETT: Well, the Finova deal is about like — well, it is like when we wrote the annual report.

And actually, Finova's annual report deals with this, too. I think most of you know the terms of it.

We guaranteed what was originally going to be a $6 billion loan that enabled creditors to be paid a large percentage of their claim in the Finova bankruptcy. And we only took down 5.6 billion of the 6 billion because there had been payments made faster at Finova.

Finova was a failed finance company, a very big one, and we were in partnership with Leucadia in this operation. And they have management responsibility, and they're doing a fine job.

That loan of 5.6 billion, on which, in effect, we make roughly a 2 percent override on 90 percent of the loan. So, if it had been 6 billion, we would have had a carry of 108 million a year, although it was going to come down.

Now the loan is down to 3.2 billion, I believe. There was a bulk sale of some franchise receivables for about 500 million to GE Credit here not so long ago.

So the exposure's down to 3.2 billion, but of course the 2 percent override is down to 2 percent on 3.2 billion.

We feel — well, after September 11th, many of the assets at Finova were aircraft. And they were not the latest of aircraft, and they were not to the greatest of lessees in many cases.

So there was a big hit to the aircraft portfolio, and there was — there were other receivables relating to resort properties and that sort of thing, which were also hit by anything that impacted travel and that sort of thing.

So the portfolio was worth less — appreciably less — on September 12th than it was on September 10th. And that will not, in my view — our 3.2 billion, as far as I'm concerned, we've guaranteed it, but I think that is very close to 100 percent OK.

And then there's a group of bonds underneath it which are the residual bonds, you might say, of the ones that existed in the bankruptcy, because 70 percent got paid off and 30 percent didn't. And we own that means of that residual — we own 13 percent or so.

Those bonds are going to be worth a lot less than we thought they were going to be worth the summer of last year.

We bought our position at 67 cents on the dollar, and we’ve already — we got 70 cents on the dollar, plus these bonds, plus we get the override on the Berkadia loan.

So we got all our money back, and then some, on the bonds that we bought, and we get the override on the Berkadia, so we will, in all likelihood, almost certainly, I would say — although, who knows? I mean, I didn't know about September 11th — but we will almost — we’re very, very likely — to make a significant amount of money on the whole transaction, but not as much money as we thought we were going to make last summer.

And we feel very pleased with the way Leucadia's handling things, but there is not as much value in that portfolio today because of the events of September 11th.

Charlie?

CHARLIE MUNGER: Yeah, it's an interesting example of Ben Graham's margin of safety principle. A whole lot has gone wrong that we didn't predict, and yet we're coming out fine.

WARREN BUFFETT: Yeah, we should make some hundreds of millions in aggregate over time on it, but a lot went wrong. But we, as Charlie said, we had a margin of safety when we bought into it, and we felt we had a margin of safety, and it turns out we needed it.

AUDIENCE MEMBER: Thank you.

WARREN BUFFETT: Number 2.

AUDIENCE MEMBER: I'm Bob Kline (PH), from Los Angeles.

I wonder if you could give us a glimpse into your investment process, the way you approach looking at a particular industry. And I wonder if you could use real estate as an example.

I know real estate hasn't been a big, huge part of Berkshire's portfolio over the years. And I wonder if that's because you view real estate as a commodity business or if, maybe, the cash flows from real estate tend to be more predictable than, perhaps, from some other industries, and thus, it tends to be less likely to be mispriced, and therefore less likely to find terrific bargains in real estate. So —

WARREN BUFFETT: Yeah, you're — go ahead.

AUDIENCE MEMBER: So, just wondering if we could — if we were watching a discussion between you and Charlie hashing out the merits of real estate,[tell us] how it would go.

WARREN BUFFETT: Well, it would go like all our other conversations. He would say no for about 15 minutes — (laughter) — and I would gauge by the degree to which he — the emotion he put into his ‘no’s as to whether he really liked the deal or not. (Laughter) But the —

We've both had a fair amount of experience in real estate, and Charlie made his early money in real estate. The second point is the more important point.

Real estate is not a commodity, but I think it tends to be more accurately priced — particularly developed real estate — more accurately priced most of the time.

Now, during the RTC period, when you had huge amounts of transactions and you had an owner that didn't want to be an owner in a very big way, and they didn't know what the hell they owned, and all of that sort of thing, I mean, you had a lot of mispricing then. And I know a few people in this room that made a lot of money off of that.

But under most conditions, it's hard to find real estate that's really mispriced.

I mean, when I look at the transactions that REITs engage in currently — and you get a lot of information on that sort of thing — you know, they're very similar. But it's a competitive world and, you know, they all know about what a class A office building in, you know, in Chicago or wherever it may be, is going to produce.

So at least they have — they may all be wrong, as it turns out, because of some unusual events, but it's hard to argue with the current conventional wisdom, most of the time, in the real estate world.

But occasionally there have been some, you know, there could be big opportunities in the field. But if they exist, it will certainly be because there's a — there’ll probably be a lot of chaos in real estate financing for one reason or another.

We've done some real estate financing and you have to have the money shut off to quite a degree, probably, to get any big mispricing across the board.

Charlie?

CHARLIE MUNGER: Yeah, we don't have any competitive advantage over experienced real estate investors in the field, and we wouldn't have if were operating with our own money as a partnership.

And if you operate as a corporation such as ours, which is taxable under Chapter C of the Internal Revenue Code, you've got a whole layer of corporate taxes between the real estate income and the use of the income by the people who own the real estate.

So, by its nature, real estate tends to be a very lousy investment for people who are taxed under Subchapter C of the code relating to corporations.

So, the combination of having it generally allows the activity for people with our tax structure, and having no special competence in the field means that we spend almost no time thinking about anything in real estate.

And then such real estate as we've actually done, like holding surplus real estate and trying to sell it off, I'd say we have a poor record at.

WARREN BUFFETT: Yeah, C corps really, it doesn't make any sense. I mean, I know there are C corps around that are in real estate, but there are other structures that are more attractive.

There really aren't other structures — I mean, Lloyd's is an attempt at it, to some degree — but there aren't other structures that work well for big insurance companies, or —

I mean, you can't have a Walmart very well that does not exist in a C corp. So, they are not subject to S corp, or partnership competition, that determines the returns on capital in the discount store field.

But if you're competing with S — the equivalent of S corps — REITs or partnerships or individuals, you've just got an economic disadvantage as a C corp, which is, for those of you who don't love reading the Internal Revenue Code, is just the standard vanilla corporation that you think of — all of the Dow Jones companies, all of the S&P companies, and so on.

And as Charlie says, it's unlikely that the disadvantage of our structure, combined with the competitive nature of people with better structures buying those kinds of assets, will ever lead to anything really interesting.

Although, I would say that we missed the boat, to some extent, during the RTC days. I mean, it was a sufficiently inefficient market at that time, and there was a lack of financing that— we could have made a lot of money if we were — had been geared up for it at that time.

We actually had a few transactions that were pretty interesting, but not — but nothing that was significant in relation to our total capital.

CHARLIE MUNGER: We thought significantly about buying the Irvine Corporation —

WARREN BUFFETT: Yeah.

CHARLIE MUNGER: — when it became available. So, but that's the only big one I can remember that we seriously thought about.

WARREN BUFFETT: Yeah, and that was in 1977 or so, as I remember?

CHARLIE MUNGER: Way back.

WARREN BUFFETT: Yeah, Mobil Oil was interested, and you know, Don Bren ended up putting together a group for it.

And that kind of thing could conceivably happen, but it's unlikely.

WARREN BUFFETT: Number 3?

AUDIENCE MEMBER: Hello, my name is Joseph Lepre (PH). I'm a shareholder from Minneapolis, Minnesota, and I'd like to thank you for this opportunity to ask a question.

Mr. Buffett, you mentioned earlier today that you'd be willing to sell insurance in exchange for stock options. If possible, could you please describe a methodology for the valuation of stock options, particularly in cases where there is no market pricing data available for the option being valued?

WARREN BUFFETT: Yeah, I would — I could figure out what I would pay for an option on a private business. I could figure out what I could pay for an option on a public business. It might be a little easier. I could figure out what I'd pay for an option on an apartment house or a farm.

I had a friend, I mean, when I was 20 years old, we developed a big plan and we were going to go out and option out — option farms, you know, outside of what were then the city limits of Omaha.

And we figured that if we offered a farmer a modest amount, which would be annual income to him, to option his farm at double the price it was bringing then, that it would, you know, he would be happy to sell for double the price that year, and maybe we could do something. And it might have worked out OK.

Every option has value. You know, I've got a house worth X. If you offer me a few dollars to give you an option at 2X for 10 years, I'm not going to take it, because there are all kinds of possibilities in terms of inflation.

All options have value. And people that get options usually understand that better than people that give options. I'm not talking about stock options now, but in other arenas.

So we would be happy, you know. I mean, what I could get — let's say — we'll just pull one out of the air. Let's take an untraded company like Mars, Inc.

Would I be happy to have an option, a 10-year option on a piece of Mars, Inc. at some given price?

Sure, I would. And there's an amount I would take for that — I would take in lieu of getting cash if I was writing a big insurance policy with Mars, Inc. They're not going to do this with me, but that —

And I would be happy, you know, instead of if you buy homeowner's insurance from me, if you want to give me an option on your house for 10 years, I'll take that in lieu of the premium.

I'll make my own calculation as to value. It won't be Black-Scholes, although that might be the best arrangement under many circumstances, but I would probably crank into — in my own case.

We've bought and sold options some. And as a matter of fact, on June 3rd, Berkshire Hathaway will receive $60 million if the S&P 500 closes at 1150-something or below.

And two years ago, when the S&P was 14-something, we agreed for — on that June 3rd option, or whatever it was — $400 million nominal value, where, in effect the counter party would get the profit above 2,000 and something, 42 percent up from the current cash price. And we got the profit between 5 and 20 percent on the downside on a put.

People who were calculating the values of options at that time, under traditional methods, felt that that was a cashless transaction — that the value of the call that we gave was equal to the value of the put that we received. You know, I decided differently.

So, we don't accept, blindly, option values as determined by the calculations of people who win Nobel Prizes. Instead, you know, we actually put an aspect of judgment into some.

There would be businesses that would come out with identical Black-Scholes values on options for 10 years, and we would pay a different amount for one than the other, maybe a significantly different amount.

But we would pay something for just about any option. And you know, it is the nature of prices in this world to change, and economic conditions to change. And an option is a chance to participate in a change without giving up anything other than that original premium you pay.

Many people just don't seem to grasp that, but believe me, the people who are getting options on stock do grasp that.

And the people who are giving them, which are the shareholders, you know, represented by a group like this, who don't have any real voice in giving it, but they sometimes don't fully realize what's being given away.

Imagine, you know, going up a few miles away from here and having two farms for sale. And you say to the guy, "How much do you want for them?" and they both say a thousand dollars an acre, but the one guy says, "But every year, I want you to option, you know, I want you to give me 2 percent of the place back at a thousand. So, you know, at the end of 10 years, 20 percent of the upside belongs to me, but you've got all the downside." I mean, which farm are you going to buy? The one without the options or the one with the options? It's not very complicated.

And we will — we are dead serious when we say we will take options in lieu of cash. Incidentally, the company that gives us those options in lieu of cash for an insurance premium has to record the expense in terms of the fair value of the option they've given us.

The only item for which they don't have to record that as expense is compensation. But if they give it to us for their light bill, or if they give it to us for their insurance premium, or they give it to us for their rent, they have to call it a cost.

But only when it comes to the CEO's compensation, and other people like it, do they not have to record it as a cost, and that's because they've been able to get Congress to bow to their will and to their campaign contributions.

Charlie?

CHARLIE MUNGER: Yeah, the Black-Scholes crowd really did get a Nobel Prize for inventing this formula to value options, not executive stock options, but just options generally.

And if you don't know anything about the company, except the past price history of stock transactions —

WARREN BUFFETT: And dividends.

CHARLIE MUNGER: — and if it's — and the dividend being paid — and if the option is over a very short term, it's a very good way of approximating the value of the option.

But if it's a long-term option and you think you know something, it's an insane way to value the option.

And Wall Street is full of people with IQs of 150 that are using Black-Scholes to value options that shouldn't be tortured into the model.

And all of corporate — of America is using Black-Scholes to price stock options in the footnotes of the accounting statements, and they do that because it comes up with the lowest cost number.

WARREN BUFFETT: Well, they not only do that, but they assume the term is less than the actual term of the option. And I mean, they'll do everything they can, and I've been in on these discussions. They'll do everything they can to make the number look as low as possible. It's that simple.

CHARLIE MUNGER: And they're using a phony process to determine the number in the first place. So, it's a Mad Hatter's tea party, and the only thing that's consisting — consistent — in it is that the whole thing is disgusting. (Laughter and applause)

WARREN BUFFETT: Number 4, please.

AUDIENCE MEMBER: I'm John Golob, from Kansas City. I'm mostly retired, but also teach a course on financial markets at the University of Missouri in Kansas City.

I always tell my students that I learned much more about investing at Berkshire Hathaway meetings than I ever did from my professors at the Wharton School. (Applause)

I have a general question about investment banks. Now, given your connection with Salomon, I'm always surprised at sort of the attitude you represent to this industry. Somehow I get the idea that you view them as just their main social value is charging very high fees for unnecessary churning.

I'm wondering if you have any perspective on the general influence of investment banks in U.S. finance that is — rising or falling.

I hate to be a Pollyanna, but I might hope that Enron-like debacles would reduce, maybe, the influence of investment banks, that people wouldn't necessarily trust, you know, some of the advice they're giving.

WARREN BUFFETT: I think Enron is bound to have some favorable fallout in various areas. I mean, it — to the extent that it causes people to look more carefully at how various entities behave and that sort of thing. No, I think Enron was a plus for the American economy.

And the truth is our capital system, you know, despite all kinds of excesses and errors and everything else, you know, one way or another, we've come up in this country with 50-odd-percent of the world's market value for 4 1/2 percent of the world's population.

So, you know, I'm not negative on how the American capital system has developed. I do get negative about how certain people behave within that system, but you know, they would behave badly in any system. So, you know, it's the human condition.

But that is, you know, Charlie and I still think we should criticize things that we think are improper, but we don't criticize the whole system in any way, shape, or form. It's — you know, it's been a tremendous economic machine in this country.

But I would say that a market system, and I don't have anything better than — in fact, I think a market system is responsible in a material way for the prosperity of this country. So, I have no substitute in mind for the market system.

I do think it produces extraordinarily inequitable results, in terms of some overall view of humanity, and that that should be largely corrected by a tax system.

I don't think it should be any comparable worth system or anything like that. I just — the idea of the government trying to — (laughs) — assign all that just strikes me as wild.

But the market system lets a fellow like me, you know, make so much money because I know how to allocate capital, you know, compared to a great teacher, or nurses, cancer — whatever. I mean, it just showers rewards on somebody that has this particular skill at this particular time.

And that's great for me, but it should — there — in a really prosperous society, that should — there should be some corrective aspects to that.

Because it really strikes me as inappropriate that the spread of prosperity in a hugely prosperous economy should be decided totally by the quirks of skills that come into play and get rewarded so hugely from the market system.

So, I — but I, you know, I believe that — that's why I believe in a progressive tax system, and so on.

I would say, in terms of investment banking particularly — I mean — (laughs) — I was standing one time with an investment banker, and he was looking out the window, and he said, "Just look." He says, "As far as you can see, nobody's producing anything." And I said, "Yeah, that seems to be a mandate they take pretty seriously, too." (Laughter)

But it — you know, there is a huge amount of money in a system, you know, with 14 trillion, or whatever it may be, of market values, and where people are spending other people's money, and corporations, and where the more you spend for something, sometimes you get — gets equated with value as in fairness opinions, and all of that sort of thing.

It's quite disproportionate to what I really think the ultimate contribution to the country is of various people, but I don't have a better system — (laughter) — to substitute for it. I don't want anybody to think — come away thinking that I think we ought to tinker with that very much.

I think that the — I think your tax system should be the way that you distribute the prosperity in a somewhat better way.

When we ask people to go to war, you know, or that sort of thing, we don't take the person who's made the most money and say, "Well, they benefited the most from society, so we'll send them and put them in the front lines," or anything like that.

I mean, we — there's various aspects of being a citizen in this country that I think should make sure the people that don't get the great tickets for — that make them prosper in a market setting, they still should do pretty darn well, as far as I'm concerned.

And really, people like me shouldn't, you know —

It doesn't make any sense to compensate me the way this world has. And it wouldn't have happened if I'd been born in Bangladesh, or it wouldn't have happened if I had been born 200 years ago.

You know, somebody — another one of those genie stories. Imagine, you know, when I was — 24 hours before I was born and there had been some guy with exactly my DNA right next to me, who was also going to be born in 24 hours. And the genie had come to the two of us and said, "We're now going to have a bidding contest.

"And the one that bids the most of their future income gets to be born in the United States, and the one that loses in this is born in Bangladesh. And what percent of your future income will you give to be born in the United States?"

I'd have gone pretty high in the bidding. (Laughs)

You know, I mean, that would have been an interesting test of how important I thought my own abilities were compared to the soil in which I was going to be planted.

So, I, you know, I feel I'm lucky, and I am lucky, I mean, obviously. But I think we ought to figure out ways to take care of the people that are less lucky.

And I think that investment bankers should consider themselves in the lucky part of society.

And you know, there's nothing wrong with what they do. Raising capital for American business is a fine thing and all that. I just think that they are paid, in relation to the talent and that sort of thing they bring to the game, I think they are paid obscenely high, but I think that's true of me, too.

Charlie?

CHARLIE MUNGER: Yeah, the — but I would argue that the general culture of investment banking has deteriorated over the last 30 or 40 years. And it — remember, we issued a little bond issue, Warren, way back?

WARREN BUFFETT: Yeah, 6 million.

CHARLIE MUNGER: Diversified Retailing. And we had this very high-grade investment bankers from Omaha and Lincoln. And they cared terribly whether their customers, whom they knew, were going to get their money back.

WARREN BUFFETT: Yep.

CHARLIE MUNGER: And they fussed over every clause in the indenture, and they talked about whether we were really OK. And so, that was a very admirable process that we were put through.

WARREN BUFFETT: Yeah, we were screened in that.

CHARLIE MUNGER: We were screened, and intelligently screened. And it may not have been too intelligent to let us through, but it was an intelligent process.

And I'd say the culture on Wall Street lately has drifted more and more to anything that can be sold at a profit will be sold at a profit.

WARREN BUFFETT: Yeah. Can you sell it? That's the question.

CHARLIE MUNGER: Can you sell it is the moral test. That is not an adequate test for investment banking. And —

WARREN BUFFETT: And there used to be two classes of investment bankers, too, really. I mean, there were the ones that did the screening and all of that.

And then there was a really low-class element that essentially merchandised securities no matter what they were. And there were clean lines, but the lines have disappeared.

CHARLIE MUNGER: Yeah, so it hasn't been good to have this deterioration of standards in high finance.

And will it ever swing back? You would certainly hope so.

WARREN BUFFETT: You can see why were so popular at Salomon. (Laughter)

CHARLIE MUNGER: But in fairness, we had a very effective investment banking service from Salomon.

WARREN BUFFETT: That is true. That is true. And we — when we sold the B stock, for example, now we set the rules. And they wouldn't have done it that way necessarily, but they did a very good job of doing it the way we asked them to do it.

And so, we said we don't want people hyped into the stock. We want a very low commission and we're going to issue as much as the market takes so that nobody gets excited about the after-market behavior and buys because they think it's a hot issue.

I mean, we set a bunch of rules we thought were rational, and Salomon did a terrific job of following through on that and doing exactly what we asked them to. And it was successful by our standards.

So, no, I would say they did a terrific job in that case.

CHARLIE MUNGER: And they thoroughly enjoyed doing it, the people working on the job.

WARREN BUFFETT: That's true.

CHARLIE MUNGER: They'd never done one like it before.

WARREN BUFFETT: That's true. Yeah.

We've changed our whole opinion here in a matter of seconds. (Laughter)

CHARLIE MUNGER: Well, but there's a lesson in that.

Certain kinds of clients get higher quality service than other kinds of clients. In fact, there are many clients who should never be accepted at all at investment banking houses, yet they are.

WARREN BUFFETT: Are you thinking of the fellow at Normandy? (Laughter)

CHARLIE MUNGER: Yeah.

WARREN BUFFETT: I mean, can I you imagine that guy even getting in the door? I mean, it just — it blows your mind. I mean, he went to jail subsequently. He should have.

CHARLIE MUNGER: He was married to his high school teacher, who was at least two decades older than he was.

WARREN BUFFETT: Charlie has more opinions on this kind of thing than I do, but go ahead. (Laughter)

CHARLIE MUNGER: There were enough peculiarities in the situation. (Laughter)

I wouldn't have thought it so peculiar, except that he was a man and she was a woman.

WARREN BUFFETT: OK, number 5. (Laughter)

AUDIENCE MEMBER: Good afternoon. Mike Envine (PH) from Chelmsford, Massachusetts.

I noticed in the annual report that you took a charge-off for Dexter and put it under the management of H.H. Brown.

And I was thinking back, I believe in 1985 you wrote about the process you went through in closing the textile business. And I was wondering if you could elaborate how this situation is different.

I believe you indicated, in the textile business, that despite excellent management, it wasn't possible to earn an economic return on the assets.

WARREN BUFFETT: Yeah. Did you say that we took a charge-off on H.H. Brown?

AUDIENCE MEMBER: No, I meant to say we took a charge-off on Dexter.

WARREN BUFFETT: Oh, Dexter, yeah, absolutely. We lost a very significant amount of money on Dexter, thanks to a dumb decision that I made, and maybe several dumb decisions.

And I mean, that is a business that went offshore in a huge way. They're close to 1,200,000,000 pairs of shoes made in — or used in this country. I never can figure out how they get to that number. I mean, I use a pair — (laughs) — about every five years. But four for every man, woman, and child. I don't know, but that's the number.

And you know, I don't know whether it's 5 percent now, but it's something in that area, are made in this country, and hundreds of thousands of jobs have gone offshore with that.

The textile business, as you know, has gotten almost destroyed in this country. And when you have somebody like Burlington go into bankruptcy, you know, a wonderful company, spent lots of money on keeping their plants up to date and all of that sort of thing.

But in the end, you know, if you're paying 10 times as much per hour for labor as somebody else, it's awfully hard to be that good.

And that's going on in furniture manufacturing now, too. We have a number of furniture retailers and, you know, Bill Child, or Irv Blumkin will go over to the Orient fairly frequently now. We'll buy — we buy a lot — a lot of furniture comes from there. And that trend is moving in that direction in a very significant way.

And your question is — was your question why Fruit of the Loom would be different?

AUDIENCE MEMBER: No, I was just wondering if there's any hope for Dexter, or if it's going down the same path as with textiles?

WARREN BUFFETT: Oh, no, well, Dexter is now part of H.H. Brown, and it's selling product which, overwhelmingly, is produced abroad. And H.H. Brown sells a very significant amount of product that's produced outside the United States, although they still produce a lot of product in the United States.

But — no, the Dexter — we will have a significant shoe business. The shoe business — we had some contracts on the books from Dexter that were unprofitable, and they will run for another quarter. But we made a fair amount of money in the shoe business in the first quarter. Justin made money.

I think our shoe business will be OK. It won't be a bonanza over time, but I think our shoe business — we've got very good management in there. We've got good management at H.H. Brown, and we've got good management at Justin.

And I would expect that we would have a substantial and a reasonably profitable shoe business in the future, but we will not be able to do it with a hundred percent or 90 percent or 80 percent domestic-produced shoes.

And in that respect, I was very wrong in paying what I did, and paying it in the manner I did, which was stock in the case of Dexter, for a domestic shoe manufacturer.

Charlie?

CHARLIE MUNGER: Yeah, that shows, which is important to show, that no matter how hard you work at having systems for avoiding error and practices of trying to stay within your circle of competency, et cetera, et cetera, you still make mistakes. And I think I can confidently promise that it won't be our last mistake.

WARREN BUFFETT: OK, here's our Blue Chip Stamps. (Laughter)

But you know, you might think about this a bit, too. We had a lot of workers up in Dexter, Maine, and we've had a lot of workers at some of the H.H. Brown plants.

And you know, we take a little hit financially and we make it up by some trading strategy in government bonds or something like that, that requires, you know, no effort and not really too much brain power.

And when you think of the consequences to the people that have spent a lifetime learning one trade, you know, and who live in those areas, and through no fault of their own — none, I mean they've done a good job — they've done a great job — working.

They're productive, but in the end, you know, their cost was 10 times or more, and they weren't getting paid that well, but 10 times what it could get done for elsewhere in the world.

So, we haven't really paid the price for that change in economic conditions. I mean, it's the people who work there, the people who work at Burlington, or wherever, where the jobs disappear.

And that's no argument for huge tariffs or anything of the sort. But retraining doesn't do much good if you've worked in our textile mill, as many people did years ago, and you're 60 years old and you only speak Portuguese.

Or if you work in Dexter, Maine, and you're 58. I mean, retraining, it gets kind of meaningless. So, we're the lucky ones, you know, basically in these situations.

And it is tough when you know one trade, particularly if you live in a small town, not lots of other employment opportunities or anything. So, you know, we have a charge-off and they have a huge change in their lives, basically.

WARREN BUFFETT: Number 6.

AUDIENCE MEMBER: Jack Hurst (PH), Philadelphia. I have 3 questions, or 3 points.

The first is, I want to thank you for the pleasure it is to shop at Borsheims or Nebraska Furniture Mart, or even Benjamin Moore.

You have terrific people working there, and I've never been as satisfied with products as with what I've bought at those firms.

WARREN BUFFETT: Oh, well, thank you for that. And I thank you on behalf of the managements. They are terrific people that work at those companies.

AUDIENCE MEMBER: I agree with that.

You've dropped quite a bit from the annual report. There must be some God-given decree that it be limited to 72 pages.

But I wondered if you could put that in an internet message, such as that wonderful table about GEICO, its renewal policies and new policies, and the four pages at the end of the report about the business categories, where you separate the insurance from the finance from the manufacturing, and also that discussion that you had of look-through earnings. I think that it's invaluable for looking at the company.

WARREN BUFFETT: OK, well, I appreciate the suggestions. And I —

AUDIENCE MEMBER: I have a third point. Oh, go ahead.

WARREN BUFFETT: But we do go through a — I mean, I don't know whether 72 pages is the magic number, or when I get to about 11,000 words, but occasionally, you know, we do make an editorial decision.

The look-through earnings, for example, didn't seem that important, and they're fairly easy to roughly calculate, for anybody that's interested. But you know, they are something that if I wrote for 15,000 words, I would have included.

So, I appreciate the suggestion on it, and I don't think anybody's accused me of writing too short a report — (laughter) — yet. But I'll take —

It's certainly on the — it's possible on the internet to put up anything, and we'll put up any material we've given you here before the opening on Monday morning so that nobody has a jump on any information.

We try to make it — I mean, I really want to cover the things that would be important to me if I were hearing about them on the other end. And we try to keep it to some number of pages, but I'm glad you want more. (Laughs)

AUDIENCE MEMBER: OK, the third point is — the first of March, the Wall Street Journal analyzed — or compared — the auditing fees by the fees related to audit services and other audit services for the 30 stocks in the Dow Jones Industrial Average.

And there seems to be an inverse relation between the amount of non-audit fees with respect to market capitalization, an inverse correlation with that factor to the five-year compound growth of earnings, or the five-year total return for the companies.

And for the top — for the companies with the lowest ratio of non-audit fees to market capitalization, the increase in earnings was 10 percent annually. The total return was 18 percent annually.

For the other — for the total — it was 5.2 percent return annually on increase in earnings, and 11 percent increase in total return.

Is it because these non-audit fees are non-productive that it has this result? Or is it a chance — just a spurious fluctuation? Or is there something to the relation?

WARREN BUFFETT: I don't know the answer to that. And I hadn't seen what you are referring to. But it doesn't totally surprise me, because we like places that care about expenses.

And you know, I've never — I think Jack Welch had something in his book about no, you know, no company ever getting — going broke from cutting expenses too rapidly.

And when you see managements that are pretty lavish in what they toss around, you know, I think on balance that group doesn't do as well for shareholders as the other, but I have no statistical way of proving that.

And I don't know a way that — I don't know how you would set up a sample that would really be valid in terms of one kind versus the other kind.

But what you say doesn't shock me. We try to watch all expenses around Berkshire.

And I think that, at our subsidiaries, we — generally speaking — we have managers that are very, very good about that.

And I think that our audit costs, relative to the size of the enterprise and all of that, I think, are fairly low, although they're not as low as they were a few years back. But it's something that we care about, I can assure you of that.

I don't know how to — I wouldn't want to buy stocks, though, or sell stocks, based on any kind of statistical measure like that, even though that it looks good on what they call a backtest.

Charlie?

CHARLIE MUNGER: Well, one of the reasons our audit costs are so low is we have this passion for keeping everything simple. We don't want to be difficult to audit. And we prefer activities that are simple.

If you take the See's Candy company, the whole company goes to cash at the end of December every year, as if it were a farm where the crop came in and was sold in December.

I mean, an idiot could audit the See's Candy company without getting into trouble. (Laughter)

And there's a lot in Berkshire that's like the See's Candy company. It would be really hard to screw up.

WARREN BUFFETT: We don't like complicated accounting. I mean, it — we really do like things that produce cash.

And Enron is a good example. Enron's grotesque in what happened. But there's no question in my mind that auditors have been unduly compliant to client wishes over the last few decades, and more so as they went along, even to the point where they started suggesting what I would consider quite dubious accounting to people in mergers and so on, so as to make their figures look better later on. And I've seen it firsthand.

So, I just — I think that although the auditors are supposed to work for the shareholders, that they got too much so they were working for management.

But I think that Enron may push them back significantly, even in the other direction. So, I think Enron will have a distinct beneficial effect on auditing, and it was needed.

CHARLIE MUNGER: Well, it's going to have a distinct beneficial effect on one fewer auditors. (Laughter)

WARREN BUFFETT: Yeah, although — (applause) — you know, it's an interesting question, and Charlie and I may differ on this. I mean — I don't think that — I don't know how many people Andersen employed, but it was a huge number.

And I certainly — it's clear that the weaknesses and culpability at Andersen goes far beyond anything remotely we saw at Salomon.

But it would have been a shame for Salomon, with 8,000 people, to have, actually, the bad acts of one guy, and the lapse in terms of reporting and all of that — which was a big mistake, but by a few other people — cause 8,000 people to get dislocated in their lives and lose their jobs.

I don't know, how do you feel, Charlie, about, you know, the bottom 40,000 people at Andersen who really didn't have a damn thing to do with shredding or the Houston office or anything of the sort? I mean, their lives are really getting changed in many cases.

CHARLIE MUNGER: I regard it as very unfair and totally undeserved in all those cases. Yet even so, I think that capitalism without failure, as somebody once said, it's like religion without sin or —

WARREN BUFFETT: Religion without hell.

CHARLIE MUNGER: — religion without hell.

I think when it gets this bad, and the lack of adequate control mechanisms throughout the system, I mean, Andersen plainly didn't have a good total system of control.

And I think that it may be that capitalism should just accept this kind of unfairness in all these individual cases and let the firms go down.

WARREN BUFFETT: Well, let's say you and I did something really terrible, Charlie, at Berkshire. How do you feel about the 130,000 people then? I mean, should they —

CHARLIE MUNGER: You'd feel terrible about them, and there's no question about it.

And — but I'll tell you something, they wouldn't go down. The way we're organized, they wouldn't go down.

Warren, there's nothing you can do that is going to destroy the value of the subsidiaries — (applause) — and the careers within the subsidiaries.

You can blow your own reputation, you can blow the reputation at the holding company level, but you can't destroy their livelihood. I — that is a good —

WARREN BUFFETT: Well, we can mess up —

CHARLIE MUNGER: — way to be organized.

WARREN BUFFETT: We can mess up their lives though, I mean, if they lost their funding. Or yeah, I mean, I agree with you about their —

CHARLIE MUNGER: Not very much.

WARREN BUFFETT: — viability, but you know —

CHARLIE MUNGER: Not very — Andersen was particularly vulnerable, being a professional partnership.

But maybe you should be extraordinarily careful if you're a professional partnership, with what clients you take on and how far you go for them.

The law firms that I admire most have fairly strict cultures of risk control. I think it's crazy, in the kind of world we inhabit, to operate in any other way.

WARREN BUFFETT: OK, number 7. (Applause)

AUDIENCE MEMBER: My name is Rheon Martins (PH), from Cape Town, South Africa, and I became a big fan and avid reader of your ideas about 10 years ago.

In 1999, I did an MBA and was nicknamed Warren Buffett, because I quoted you in all the classroom discussions.

All I wanted to learn was how to value a stock and think about the stock prices, but sadly I was rather disappointed to find out that our MBA did not really teach that.

Mr. Buffett and Mr. Munger, my question is this: if you had to predict who would be the superior investors from a group of young, bright people, who share your investment philosophy and possess the realism and discipline you referred to earlier, which characteristics or work habits would you like to know about the individuals in the group?

And what weighting would you place on each factor to ensure the greatest probability of your prediction being correct?

WARREN BUFFETT: Well, that's too easy a question for me, so I'll let Charlie answer that. (Laughter)

CHARLIE MUNGER: I think the fair answer to that one is that I'm not capable of answering it.

WARREN BUFFETT: No, but I do — I think this: I think that's exactly right. I mean, if you ask me what should — how should you pick a wife, you know, 18 percent to humor, 12 percent to looks, you know, 17 percent, you know, to parents.

I can't give you the formula, but I think you'll make the right decision, you know — (laughter) — when you get —

And I think if Charlie and I were around a dozen very bright MBAs with good records and all of that, and we spent some time with them, I think we'd have a reasonable chance of picking somebody from that group that might not necessarily be number one, but they would be in the upper quartile, in terms of how they actually turned out.

And I — but I can't tell you how to, you know, I can't write out a software program or anything that will enable you to do that.

It — you know, I had that problem exactly at Salomon that went — on that Saturday morning, whatever it was, August 17th, and I had to pick a guy to run the place.

And there were a dozen or so people that all thought that they were the ones, or a number of them thought they were the ones to run it.

And they all had high IQs, and they all had lots of experience in investment banking and everything, and I — you know, in the end, I had to pick one.

And I did pick the right one, I will say that. And you know, was I — could I be a hundred percent sure at that time it was the right one? Well, probably not, but I felt pretty sure I had the right one.

And I can't tell you — I've had people say to me, "Well, what did you ask them? And how did you evaluate it?" and all, because I only had about three hours to do it.

And, I don't know. I mean, I can't write you out a set of questions that you should ask somebody.

And, you know, some of it may be body language and different things of that sort. There are a lot of variables in it.

But I think, in the end, you would have picked the same person I picked if you'd been in that spot.

You'd had to pick somebody in the three hours. And it — but quantifying it for you, I just — I can't do it.

Charlie, have you got —

CHARLIE MUNGER: Yeah, well, when multiple factors are causing success, you get these anomalies. You have two people who are going to be equally successful, and one is terribly good at A and terrible at Z, and the other is terribly good at Z — is very good at Z — and terrible at A.

They're equal. Which factor is most important? The answer, it doesn't matter in that case. When you've got multiple factors, great strength in one will compensate some for weakness in another.

And the factors can be quite different. I think the investment world is full of people who are succeeding based on quite different sorts of talent.

WARREN BUFFETT: We'll try to do better next year.

WARREN BUFFETT: Number 8.

AUDIENCE MEMBER: Good afternoon. My name is Catherine Dorr (PH), from Minneapolis, Minnesota. This is my first time here. Thank you for hosting this meeting today.

With the political and financial and corporate developments since September 11th, I am thankful every day that persons of your integrity and the managers that you have are still managing my inheritance money.

And I believe that the character and integrity is the most important criteria. I can sleep well at night.

I have two questions. The first one is for Mr. Munger.

When will there be a permanent store location, not a cart, of See's Candies at the Mall of America in Bloomington, Minnesota? (Laughter)

This is the largest indoor shopping mall, I believe, in the country, and hosts thousands of domestic and foreign visitors each year. A hint, you can sell See's Candies to other nationalities when they visit us.

Also, is it possible for Costco stores to sell See's Candies, since Mr. Munger has a shareholder interest in Costco? I would be interested in his answer. We could sell related products in our system. And I'll wait for his answer to ask the second question to Mr. Buffett.

CHARLIE MUNGER: The — the short answer to your questions is that, under our decentralized system, decisions of that kind go, rightly, to the person in charge of See's, who's here, Chuck Huggins.

And he may not be here through this afternoon session. He may have some limited interest, but Chuck can answer those questions. He knows a lot about candy.

WARREN BUFFETT: We had a Helzberg — we do have a Helzberg's at the Mall of America though, incidentally.

CHARLIE MUNGER: We have a what?

WARREN BUFFETT: We have a Helzberg's operation at Mall of America which does fine.

And I would add, we have not done as well moving away from the West as Charlie and I might have — well, certainly as well as we hoped for when we originally bought See's.

I mean, we've done way, way better in terms of the overall result, but it has been interesting to us.

Now, bear in mind, no one really makes any money with boxed chocolates through retail — through their own retail outlets in the United States, except for See's.

I mean, it — there's only one pound per capita of boxed chocolates, roughly, sold in the United States. I'm told I gave the wrong figure on — I said 64 ounces per year on people drinking. You really don't look like you only drink 64 ounces of liquid a year, it was a day.

But on this one, it is one pound per capita per year on boxed chocolates. So, it is not a big business. It's not a business — well, the truth is hundreds and hundreds of firms, including some that were a lot larger than See's, have failed. And there really is no one making any money elsewhere.

Russell Stover makes very good money selling through a distribution channel that is different, but nobody's found a way to do it in stores. We've found a way to do it in the West. We have not found a way to do it elsewhere.

And it's very irritating to me, and to Chuck, as far as that's concerned, that we can't figure out a way, because it's so successful when it works, as it does in the West.

But the answer is you can look at Archibald Candy, you know, the bonds are selling for 50. They own Fanny Farmer and Fannie May and Laura Secord up in Canada.

It is a very tough business in this country, because Americans just don't buy much boxed chocolate.

They're always happy to get it as a gift. Everybody in this room would love to get a gift of it, and they may buy it when they're here, but you don't normally walk down the street and — or walk in a mall and buy it for yourself. It's usually a gift or it's usually at holiday time.

So we don't do as well as you might think we would when we get to very successful malls that are located in other parts of the country.

We have opened holiday shops, kiosks really, at 50 stores at Christmastime, around the country, away from our natural territory. And we make some money out of that, but we wouldn't make money if we were there year-round.

And we've been thinking about it, I'll guarantee you, for 30 years because it's a terrific business where it works.

And it's a very good question you ask, because you would think, I mean and the Mall of America is an obvious example.

Simon would be tough to deal with, the landlord, but we could figure out a way to do that.

And the — but you would think we could make money at a Mall of America.

And we do fine with Helzberg's there, but I'm not positive a candy store would work. But we may try one, just because you asked the question. We'll — I'll talk to Chuck about it. (Laughter)

AUDIENCE MEMBER: OK —

WARREN BUFFETT: How about Costco?

AUDIENCE MEMBER: My second question —

CHARLIE MUNGER: Oh, Costco —

AUDIENCE MEBER: Oh, I’m sorry.

CHARLIE MUNGER: Costco makes its own decisions, and so does See's. And I wouldn't think of getting into that one.

AUDIENCE MEMBER: Oh.

WARREN BUFFETT: Well, I'll get into it. (Laughter)

We don't want people discounting our candy, it's very simple, any more than Rolex wants somebody discounting their watches.

And we will not — we're not going to go through any distribution channel at See's. We're already getting a bargain at our retail prices — (laughs) — and we're not going to go through any other distribution channel — any distribution channel at See's that's going to discount.

And Costco has no interest, and I don't blame them. I mean, they are based on giving people special prices. And that's fine, and God bless them, and, you know, we'll buy things from Costco, but we're not going to sell a product where the price is part of the integrity of the product — we're not going to sell it through a distribution system that — where discounting is basic to their whole approach.

Costco is a wonderful operation, and See's is a wonderful operation, and never the twain shall meet. (Laughter)

AUDIENCE MEMBER: Very logical.

AUDIENCE MEMBER: My second question is to Mr. Buffett.

Since I am a new shareholder, and because this is my first attendance here, I am not sure if this question has been asked before or not. And if it is addressed in your publications, I may have overlooked it, so please bear with me.

This is on the relationship between the A and the B shares. On page one of the booklet it states, quote, "Each share of Class A stock is entitled to one vote per share, and each class of — each share of Class B stock is entitled to 1/200th of one vote per share," close quote.

Calculating the voting weight per share would therefore be 200 Class B shares equaling one vote equally weighted of one Class A share. However, the Class B share price is 1/30th, traditionally, of a Class A share.

Given that the B share owners are purchasing into the same corporation and assets as the A share owners, and the cash is just as green no matter which share you buy, therefore it would be logical that the voting weight and price relationship of the shares be proportional all around, either 1/30th or 1/200th of pricing and voting weight, respectively.

The question, therefore, is why are the B shares not given voting weight of 1/30th instead of 1/200th? Or conversely why the B shares are not priced at 1/200th of an A share?

This may or may not be popular depending on with share you own. And I would appreciate your insight on that.

WARREN BUFFETT: Yeah, thank you. It's a good question. I — you may not be aware of the history of the issuance, but we issued the B shares — there were no — I mean, they're just a common share, so we renamed the old shares A shares. But we issued the B shares, whatever it was, what, seven or eight years ago, Charlie? Something like that.

And we did that in response to some people, particularly a fellow in Philadelphia, who we felt was going to induce people who really didn't understand Berkshire at all into a terribly expensive way of owning tiny pieces of Berkshire, probably sold on the basis of an historical record that we did not think was representative of what could be incurred in the future.

In other words, we were disturbed by somebody who saw a chance to make a lot of money off of people who were really uninformed, using our stock as the vehicle.

And we were going to reap the unhappiness of those people subsequently. They're going to run into tax problems and various administrative cost problems, and so on.

So, to ward that off, and only to ward that off, I mean, we issued the B stock, which effectively put that fellow out of business, because it was a better vehicle for doing what he was going to try and get people to do, at great profit for himself.

And when we issued it, it had not existed before, and we made — we put two differences in it from the A stock.

A, we wanted to create a lower value per share, so we did it on a 1/30th basis. At the time, it was around $1,100 or thereabouts because the A was selling for in the low 30,000.

But we put on the prospectus, which is a very unusual prospectus in other respects, we put on there we were going to differentiate the stock in only two ways, but we were going to differentiate it in those two ways.

And one was the voting power, because we didn't want to issue the stock and we didn't want to change the voting situation much.

And the second way was in terms of the designated charitable contributions, which we — the A was going to continue to enjoy and the B would not participate in.

And the reason the B wasn't going to participate in it is because the amounts would have gotten to the point where it would have been an administrative nightmare. I mean, this year, we designated $18 on the A shares. We've got a lot of one-share B holders, which would be 60 cents. And it just — it does not make any sense.

And we saw that, so we just said if you buy the B shares, you're buying into an instrument which economically is equal to 1/30th of an A. In voting, it is not equal to 1/30th of an A because we don't want to change the voting that much.

And it does not — it has a slight economic difference in terms of the fact it doesn't get to participate in the charitable contributions program, which is a very small item relative to the whole capitalization, but it's still — it's something.

But we do not — you'll notice our A and B, compared to other companies that have different voting arrangements — I was just looking at one the other day where the premium for the voting stock is 10 or 12 percent, or something like that, relative to the economic interests.

That's because people assume that if, you know, if the company's ever sold, or anything like that, the guy that owns the A will get treated better than the B. And Charlie and I have been in a situation where we got somewhat taken because of a situation — because of a relationship like that.

We will treat the B exactly as the A, except for those two things, which, at the time of issuance, we set out as being differences. We set — and those two items, everybody saw coming into the picture, and they're going to stay — they will stay as part of the picture.

Actually, you know, in terms of when the meeting will be held two years from now, you know, we aren't even going to vote by votes in a sense.

I mean, I'm going to get a sense of what people want to do, but I regard, in that respect, I think that it ought to be the most convenient for the most people, not for the most number of shares.

A will not vote any different than B or anything because, you know, you're all individual people and I want whatever works best for the most.

But in terms of those two other items, they were set out that way and they'll stay that way.

If — you know, if we'd set out a different — we would not change the relationship once the — of the two stocks once they were issued. We would not benefit one relative to the other, but those are the terms of the two.

Charlie?

CHARLIE MUNGER: Yeah, we had to issue the B stock to frustrate the ambitions of this jerk promoter. And — (laughter) — yet, we didn't want to split the A stock down into — all of it — down to tiny little fractions, which would have frustrated him, but forced us to have a stock split we didn't want.

So, we created a vehicle which was — had these two slight disadvantages, and that kept most of our capitalization in its traditional A-stock and also frustrated the promoter. It's an historical quirk. It's an accident of life.

WARREN BUFFETT: And the B is sold at a remarkably consistent relationship to the A. If the discount got as low as — or as high, I should say, as — I think it was over 4 percent for a small period of time — but it's, generally speaking, the B is sold at parity to slightly, very slightly, below parity.

And indeed, A shares get converted to B, and that would not happen unless the B were at parity. So, it — I think it's worked out pretty well. I mean, we didn't — we backed into it, but I don't think anybody's been disadvantaged by it.

WARREN BUFFETT: Number 9?

AUDIENCE MEMBER: I'm reading the question of Mark Rescigno (PH), from New York. "I've idolized you since I first heard of you 10 years ago. My only regret so far is that both of my children are girls, so I couldn't name them Warren."

WARREN BUFFETT: How about Warrenella? (Laughter)

AUDIENCE MEMBER: That might work.

Is there any merit to the argument that leasing of silver is suppressing the price of the metal, and thereby not allowing it to reflect the fundamentals?

WARREN BUFFETT: Oh, you hear that all the time. I don't think so. And in the end, the question of where it'll sell will be affected by how much there is around and how much there isn't.

And people get upset with shorts and they get upset with forward sales by producers, and they get upset with leasing, and all of that sort of thing. But in the end, if silver gets tight, it will go up in price. And if it isn't tight, it really doesn't make much difference whether it's leased or not.

It's like companies that get upset about the short position of their stock. I've even had a few people write me because there’d be some —

I don't care whether there's a thousand shares short of Berkshire or 300,000 shares short, it really doesn't make any difference, because someday, the people that are short have to buy and, you know, it's part of markets.

So the leasing of silver takes place because somebody's got some silver around, would rather get a small amount of income by leasing it to somebody that needs to use it for one reason or another.

But it's because the silver was sitting around in the first place that it's available for lease. And it really doesn't make much difference, I don't think, in terms of pricing over time.

Charlie?

CHARLIE MUNGER: I have nothing to say.

WARREN BUFFETT: Oh. (Laughter)

WARREN BUFFETT: OK. It’s — we've got time for one more question from number 10, and that will complete the cycle, also. So, shoot.

AUDIENCE MEMBER: My name is Jerry Miller (PH), Highland Park, Illinois, shareholder. I don't want to end this meeting on a down note, although I'm going to do it. (Laughter)

Before I say that, I would like to make a positive statement, one of many, but I'll hold it to one.

I have —since I've been retired, I've gone to quite a few shareholders meetings. And I only wish there was some way I could force most of the CEOs to attend.

They may not understand what's going on, but I would just like them to see how a shareholders meeting should be handled.

And now for the down — (applause) — a little bit.

I'm downstairs. I can hear some good results.

The — if you're going to sit behind the desk that says the $37 billion buck stops here, you're going to have to handle all questions. The one that I was really surprised I didn't hear, and I — today from anybody, including you — the two of you — would —

Although they've taken the ‘E’ word away from us, and the ‘AA’ word away from us, I don't want them to take the Berkshire Hathaway ‘K’ word away from us.

Do you understand that? If you do, just wave a finger. And if not, I'll explain it.

WARREN BUFFETT: Well, you're 0 for 2 at the head table. So, you better explain it. (Laughter)

AUDIENCE MEMBER: This morning, I had to chide some of the fellows down the stairs at the Kirby. A couple of weeks ago, there was a stain — or a tarnish — appeared on the Berkshire Hathaway name, and a little crack appeared in the charisma. Did you happen to see the program?

WARREN BUFFETT: Yeah, I saw the program. And it was interesting because it was focusing on the sales practices — or alleged sales practices — of some people that don't work for us, but work for distributors, just like salesmen work for Ford dealers or something of the sort.

And particularly, it was talking about them selling to older people. And interestingly enough, over 10 years ago, we put in a policy, which to my knowledge is the only one like it in the country, in that anybody, anybody over 65 who buys a Kirby vacuum and is unhappy for any reason, any time, up to a year, 11 months and 29 days later, can tell us so and they get their money back without question.

And I don't know of another consumer durable sold like that in the country. And one of the interesting things was that the fellow they interviewed, who talked about his mother having bought one and being terribly unhappy about it, had actually used the product for eight or nine months and gotten a full refund.

And that fact was not mentioned on the program, nor was the fact even that we had this policy. And I really regard that as rather extraordinary journalism.

AUDIENCE MEMBER: I trust you're not dusting off — (applause) — your Salomon notes then to read to the Kirby people.

WARREN BUFFETT: No, I can understand your reaction to the program, because it was pointed out to ABC News several times prior to the program, that this policy existed, that 300-and-some people in the previous year, and if they gave us a trade-in on the — on it and we — and they decided to call it off 11 months later, we gave them their money back, plus a machine equal to the — or better than the machine they gave us. And not a word was said about that in the program.

So, it — I do not regard it as a great moment in ABC journalism.

AUDIENCE MEMBER: Anyway, thanks for (Inaudible) —