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ADAM SMITH'S MONEY GAME Missed the show? Get a phone call half way through? Fail to catch the name of a stock in "Personal Best"? In case you did, we are happy to provide you with a transcript. If you would like a transcript from a previous season, please visit 800-All-News at www.800-all-news.com or call them at (800) All-News. ANNOUNCER: [voice over] This program is made possible by a grant from MetLife, helping people become financially secure for 130 years. Funding has also been provided by the Roy R. and Marie S. Neuberger Foundation. ADAM SMITH: [voice over] In the Money Game this week, does investment legend Warren Buffett think stock prices are dangerously high? And why do smart people do dumb things? Find out next. ADAM SMITH: Hello, I'm Adam Smith and welcome to The Money Game. Warren Buffett is by now, of course, an American legend. It isn't merely the fortune he created for his investors. A single share bought for $40 in 1975 sells today for about $70,000. That alone would earn him the title of Wizard of Omaha. [voice over] Now the annual meeting of Berkshire Hathaway, once held in a single room, is held in a sports auditorium that has become the mecca of money, the Woodstock of capitalism. Leta Powell Drake of Nebraska Public Television was there for us. LETA POWELL DRAKE, Nebraska Public Television: Over 11,000 people from all over the world have come here. That's up from last year. Just like the stock, it's up. This is Ak-Sar-Ben. Ak-Sar-Ben spelled backwards means Nebraska -- Omaha, Nebraska. Warren Buffett calls Omaha the cradle of capitalism. 1ST SHAREHOLDER: She has some Westco and she also has some Berkshire. LETA POWELL DRAKE: Do you own the A or the B stock? 2ND SHAREHOLDER: Both. LETA POWELL DRAKE: Are you the Mad Hatter? 3RD SHAREHOLDER : No, I'm the-- we're the Yellow Berkers. We're on America-- AOL. I'm the Berkshire Hathaway bulletin board. LETA POWELL DRAKE: What do you think one share of Berkshire Hathaway A stock costs, Maggie? MAGGIE: Um, $20? LETA POWELL DRAKE: What do you think of Warren Buffett? 4TH SHAREHOLDER: I love Warren Buffett. 5TH SHAREHOLDER: He knows what he knows and he knows what he doesn't know. 2ND SHAREHOLDER: He's, like, it's an honor to shake your hand. He's a really nice person. LETA POWELL DRAKE: See's Candy. Warren Buffett puts his money where his mouth is. Dairy Queen. He just bought Dairy Queen. And wash it down with a Coca-Cola. Here's looking at you, kid. ADAM SMITH: The dean of security analysts, Ben Graham, introduced me to Warren in 1971 and we have had many lively exchanges over the years. Warren is famous not merely as an investor, but as an investor who thinks, who is consistent and who can turn out metaphors like Will Rogers. The annual report of Berkshire Hathaway has become necessary reading all over the world. There's always some priceless bit of Americana to quote. This year it was the president of Harvard in 1868 forbidding the use of the curve ball in baseball because Harvard did not approve of deception. Warren likes baseball metaphors. I talked to Warren Buffett in New York last week, face to face. Baseball metaphors -- how do you apply the metaphor to investing? Face to Face [Back to Top] WARREN BUFFETT, Chairman, Berkshire Hathaway, Inc.: I've applied Ted Williams' theory on hitting to investing because Ted Williams, in his book The Science of Hitting, carved the strike zone up into 77 cells. In fact, he's got a diagram in the book. And he says if he swings only at balls in a certain cell, right in the middle of the plate more or less, he'd bat .400, but if he swings at balls in the worst cell, which is the lower outside corner, he'd bat .230. So he says the most important thing in terms of being a good batter is to swing at good balls. And in investing, it's the same principle. ADAM SMITH: You were widely quoted as saying the current level of stock prices is justified. WARREN BUFFETT: What I said in the annual report and repeated elsewhere is that the stocks are not overvalued if, and I put the ``if'' in italics always, two conditions are met. And one is that interest rates stay at present levels or nearby or go down. And secondly, and the bigger ``if'' in my view, is that if corporate profits -- and by that I mean the return on equity of American business -- stays at something close to its present level. And the present level is, on a sustained basis, is unprecedented in American business history. So we're talking about something happening that hasn't happened before to justify these prices. But it could happen. I'm not saying it can't. ADAM SMITH: But can you really have corporate profits that continue to grow -- I'm talking about your return on equity -- at this rate with the GDP growing 3 or 4 percent? WARREN BUFFETT: You can't have American business earning 20 percent on equity and real GDP growing at 2 to 3 percent, nominal growing at 4-maybe percent if you retain equity, because obviously if you earn 20 percent on equity and retain it all you have to grow earnings 20 percent. And the one thing I can promise you is that corporate profits will not become more than 100 percent of GDP. ADAM SMITH: If they would? WARREN BUFFETT: They would under that kind of scenario. So you either have to distribute a very high percentage of the earnings by either dividends or repurchases, or you get into a mathematical absurdity. And the other possibility is that American business just won't earn anything like these returns in the future. We haven't seen it before, but it has been happening the last few years. ADAM SMITH: But something tells you it can't continue at this rate? WARREN BUFFETT: I don't want to bet on it continuing. I think that you are making a very strong affirmative bet on it continuing. But I'm saying if it does continue, then stocks are not overvalued, but it takes a rosy scenario to justify these prices. That may turn out to be true, but I haven't made money in the past by betting on rosy scenarios. ADAM SMITH: Well, you once said you pay a high price for a cheery consensus. WARREN BUFFETT: Correct. ADAM SMITH: You have never had such a cheery consensus about either Berkshire Hathaway or the stock market. What does that tell us? WARREN BUFFETT: It tells you there's not a lot of skepticism out there. And it's easier to-- a whole lot easier to make money when people are fearful than when they're feeling like they are presently. ADAM SMITH: Ben Graham used to tell us you need a margin of safety. WARREN BUFFETT: Right. ADAM SMITH: Is there a margin of safety? WARREN BUFFETT: I don't think there's much of a margin of safety in stock prices now. No, there's not a margin of safety. ADAM SMITH: That would lead one to some caution. WARREN BUFFETT: It leads to caution. But it doesn't predict a bear market. ADAM SMITH: I think all of America has gotten used to your idea of looking for great companies. People track them. People discuss them as a philosophy. But here you are buying oil contracts, silver, even zero coupon treasuries, which is a financial instrument. Walk me through the thinking in, for example, buying oil contracts. WARREN BUFFETT: Well, we bought the oil about three years ago. And at that time we were buying oil for delivery three or four years out and we just felt that it was on the cheap side. It was a small investment compared to equities. We have well over $35 billion in common equities. And at the peak in oil we had less than a billion. So it was 2 percent of the portfolio or thereabouts. We've owned things that are non-traditional in the past, when we felt the probabilities favored profit. But I never feel as good buying something like that as I do buying a business that I really understand that's cheap. ADAM SMITH: Well, we understand where you come from when you buy businesses that are cheap. But when you go to buy silver or oil, then you're a commodity speculator like anybody else because those are zero percentage games. WARREN BUFFETT: In terms of something like copper, which we were in many years ago, or oil or silver now, that's a question of evaluating supply and demand. And demand has been outstripping supply in silver for now, five or six years, depleting the silver bullion above ground in the world. There was a lot to start with, but there's quite a bit less now around and that's just a question-- again, that goes back to Economics 101, that unless something changes in the supply and demand equation, the price will change. ADAM SMITH: [voice over] In early May, one share of Berkshire Hathaway was worth about $70,000. The value of public companies Berkshire owns are about half the price -- that's Coca-Cola, Gillette, Disney and others. Wholly-owned companies -- See's Candies, The Buffalo News, Dairy Queen -- account for another part of the price. The rest is the Buffett premium -- the value investors place on Warren Buffett's investing talent. [on camera] Isn't there a little bit of halo in each share for the fact that you're buying it. WARREN BUFFETT: Well, I'll let you figure that one out. ADAM SMITH: We have an unusual situation today in that we have more people in the stock market than ever before in history and more than 90 percent of the money managers have never seen a bear market. What should we think about that? WARREN BUFFETT: Well, we should think they'll see one someday and the world won't come to an end. We've had a lot of bear markets in this country and American business will become worth more over time. And I think that a great many people do have an outlook where they are thinking where will these businesses be 10 or 20 or 30 years from now when I want this money? But for people who think that it's an easy way to make money, year after year, you're going to have some surprises. And if there are large numbers of those people, that accentuates the surprises. If you get a bear market rolling, you could shake up a significant percentage of the people because they haven't been through it. Now, how they'll behave, no one knows for sure. But if you look at human behavior in financial markets, people have exhibited fear and greed for centuries and they'll exhibit both in the future. And fear is a different thing to watch than greed. ADAM SMITH: [voice over] Buffett's annual reports are famous for their essay and teaching qualities. When I talked with him in 1990, investment bankers were a target. [on camera; earlier interview] You compare investment bankers to bartenders who give alcoholics one more drink for the road. What do you mean by that? WARREN BUFFETT: The proper job of an investment banker should probably be to shield the investing public from the excesses of promoters. And the promoter is going to take all the money you give him. He has all-- he shows all the resistance to fresh money that an alcoholic shows to whiskey. And bartenders have faced that problem in the past by shutting down people before they go out and damage the public by driving dangerously. And I just said that a standard bartender morality would not seem too high for the investment banking industry. But it has been rather difficult to attain. ADAM SMITH: Do you still feel that way about investment bankers? WARREN BUFFETT: Well, I may have been illustrating a point with that quote. I've also said don't ask the barber whether you need a haircut. So I think when a corporate CEO says to an investment banker, you know, ``Do I need an acquisition?'' I think that's a little like asking the barber whether you need a haircut. I think it's dangerous to get advice from people where their compensation -- and maybe very large compensation -- depends on a specific line of advice they give you. ADAM SMITH: Since you first said that, of course, investment bankers have waxed more profitable than ever. WARREN BUFFETT: Sure. It's a good business. ADAM SMITH: You and Charlie [Charles Munger, Vice Chairman, Berkshire Hathaway] do something in your shareholders' meeting that is absolutely unique. You have like a five-hour teach-in where people can ask you anything and you answer anything. WARREN BUFFETT: Six hours, actually. ADAM SMITH: Six hours. And you walk people through your process of thinking, which is fascinating to many people. I'd like you to do a little of that for me. WARREN BUFFETT: Fine. ADAM SMITH: For example, here's a statement -- why do smart people do dumb things? WARREN BUFFETT: That's the big question. Why do they do it in investing? Why do they do it in managing businesses? Because you have all these smart people out there. The money doesn't go to the people with the highest I.Q. There would be a very poor correlation between I.Q. and investing and results. And you say to yourself why does somebody with a 500-horsepower motor only get 100-horsepower out of it? And I would say that if you look at the intellect as being the horsepower that's available, but you look at the output as reflecting the efficiency of that motor, it is rationality that causes the capacity to be translated in output. Now what interferes with rationality? It's ego. It's greed. It's envy. It's fear. It's mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it's not because we're so smart, it is because we're rational and we very seldom let extraneous factors interfere with our thoughts. We don't let other people's opinion interfere with it. We don't get-- we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people's behavior. And those are the factors that cause smart people to get bad results. ADAM SMITH: But can you define them as smart people if they do all the things that you said? If they imitate other people. If they're moved by greed, fear and so on? WARREN BUFFETT: Well, they are people that would do very well on an I.Q. test. And they can play a great game of chess or whatever it may be. I mean, they have the intellectual capacity to do it. The wires are hooked up but something causes them to get off on different tracks and the wires just start flickering. And usually it's those emotional factors that-- You know, I've seen an awful lot of people on Wall Street that bring 150 I.Q. to the party and, you know, you have a chapter in your first book that said anything times zero is zero. So you have to make sure you don't have one of those decisions in there that has a big zero in it. ADAM SMITH: Can you think of an example of somebody really smart doing something really dumb? WARREN BUFFETT: Oh, I can think of lots of examples, both in business and investing. I'm not going to name names, but I-- ADAM SMITH: Don't name names, just tell me a story in investing. WARREN BUFFETT: Well, you know, you saw it in the late '60s and chronicled it in terms of smart people. And it's because they can't stand inaction sometimes. You see it in the corporate arena where people make very dumb acquisitions. I mean, you saw the oil companies in the '70s all rushing after each other into various things. And, actually, in the past, great companies like Coke and Gillette have gone into all kinds of different areas before they figured they had a pretty good business in razor blades or soft drinks. ADAM SMITH: There is a huge wave of mergers going on right now. Do you think some of that is the ego of the CEO? WARREN BUFFETT: You don't get to be a CEO by being a milquetoast. I mean, you have a certain amount of zest for action. In most cases that's how people get to the top. And it is no fun if you're CEO to look around and see your competitors and colleagues making deal after deal and being plastered all over the press and to sit there and say, you know, I don't think these deals make much sense. That's very difficult to do. And you've got other constituencies urging you on -- your own people. In an organization where other people are expanding enormously by acquisition, you will find it very difficult to resist the entreaties of the people below you who say why aren't we doing something? I mean, I've heard that a lot of times in various businesses. ADAM SMITH: So not being a lemming when all the other lemmings are running in a certain direction is a great advantage. WARREN BUFFETT: That's true. You want to do your own running off cliffs in the right place. And that can work in reverse. When people are depressed, that's the time often to be very aggressive. And you simply have to insulate yourself in some way from the emotions that are running around you. And that's easy to say but it's hard for people to do. ADAM SMITH: You and Charlie have talked a lot about thinking backwards. WARREN BUFFETT: Right. We believe in inverting. Einstein advised that. In fact, a lot of mathematicians have advised that. ADAM SMITH: Give me an investment example. I'd like to be like you and Charlie, tell me how to think backwards. WARREN BUFFETT: Well, we're doing it all the time. I mean, we are trying to think of where businesses will be 10 or 15 years from now. And what does that mean? Well, for one thing, it means getting into the kinds of businesses that we can understand as to the markets they're in and the lack of change. We can look at change usually as something to be fearful of in investments rather than-- the average person is saying what is going to change a lot? The Internet or whatever it may be, and they think they're going to get rich off of it. If I taught a course in investments, I would-- my final exam would be to value this Internet stock. And if they came up with an answer, they'd flunk. And if they came up with a blank sheet of paper, I'd probably give them a B. And if they say how the hell could you ask something so dumb? I'd give them an A. ADAM SMITH: [voice over] Buffett certainly isn't afraid to take public stands on issues that concern him. For instance, in 1982, he wrote to Congress warning about the dangers of financial derivatives. WARREN BUFFETT: [on camera; earlier interview]Any time you offer a big prize for a small amount of money, you encourage stupid behavior on behalf of those you're appealing to. And low margins, which you can get through the futures market, encourage that sort of activity. ADAM SMITH: Derivatives are bigger than ever. I mean, everything, the entire exchange has been sliced, diced. You can buy a synthetic and a derivative on anything. And they're all over the world. WARREN BUFFETT: Whatever can be sold, Wall Street will provide. ADAM SMITH: Does this give you any pause? WARREN BUFFETT: Well, it has the potential for trouble. I mean, take the simplest derivatives -- an S&P index. That's a margin account, basically. And it's a lot of margin, in most cases, for people that are buying. They don't put up 100 percent of the money. And we learned in the '20s that markets with participants playing heavily on margins could be more dangerous than markets where people are dealing in cash. And for that reason, the Federal Reserve started regulating margin requirements. And the margin requirement for outright stock ownership is far higher than what speculators could achieve through futures and derivatives. ADAM SMITH: Do you think derivatives ought to be more regulated? WARREN BUFFETT: I think it gets very tough to regulate them. I don't think there's an easy answer on that. No, they're here to stay. And I think regulation would be almost impossible. ADAM SMITH: What makes you sell a stock? WARREN BUFFETT: It doesn't happen too often, but if we think something like zeros last summer were more attractive than equities, we're still very reluctant to sell anything but we may sell-- trim a few holdings, maybe sell a few of the smaller holdings. We don't like to disturb holdings in great businesses. But when I started in this business I had way more ideas than money, so I had to sell things. Every time I'd get a new idea I'd get all excited and then I'd check my bank account and I didn't have any money. So I had to sell something. And the best reason to sell a stock is because you find something that you like much better. But it's not our natural style to sell. ADAM SMITH: I understand that, but when you do sell something, what are the characteristics of the sale? WARREN BUFFETT: Well, we'll pick the thing-- if I need money, we'll pick whatever we like the least at the present price. And that's not necessarily a negative comment about the business. Everything I've ever sold has gone up subsequently, and they should because they're good businesses. But I'll pick maybe the one I feel the least sure of where it's going to be 10 years from now, not necessarily the one that has the least potential. I like certainties, so if I feel 100 percent sure about one company being worth far more money 10 years from now and 95 percent sure about the second, I'll sell the second. ADAM SMITH: [voice over] Buffett's views on inheritance are well known. Almost all of his fortune will got to a foundation and not much to his three children. His daughter talked to me about that 10 years ago. [on camera; earlier interview] Your parents have over a billion dollars. Doesn't that sort of cramp when you think you have to get the kitchen fixed? SUSAN BUFFETT GREENBERG: Sometimes, yeah. I have to tell you the truth about that. It's like you said, it would be nice to have some once in a while, when you are fixing up the kitchen or doing something you think, you know, he has a billion dollars probably he could spare a little. But on the other hand, I think that basically what he has done makes a lot of sense as far as raising kids and trying to put good ideas in their heads and not totally screw them up, which does happen with some people who get lots of money. WARREN BUFFETT: I still say that you should, if you're very rich, as I am, you should leave your kids enough so they can do anything, but not enough so that they can do nothing. ADAM SMITH: Still, your own net worth has multiplied since that interview by a great deal. WARREN BUFFETT: I've noticed, yeah. ADAM SMITH: One percent would be $35 million. Would you leave them anything like that? WARREN BUFFETT: Well, I would leave them a significant sum, but I wouldn't want to create some dynasty of Buffetts that can go on for the next 10 generations and never do any work. ADAM SMITH: This is an age of money. There are money magazines everywhere. There is money television. It's a big difference over the last 25 years since we first met. How has that affected you? WARREN BUFFETT: Well, it probably made it a little more difficult in terms of finding things to buy. And we've gotten a lot larger in terms of funds involved, which makes my job more difficult. But it's the same game it was back when you wrote The Money Game. ADAM SMITH: You are still wonderfully optimistic. WARREN BUFFETT: I am optimistic. You've got a lot going for you. Peter Lynch always says buy a business that's so good that a dummy can run it because sooner or later one will. Well, this country is so good that a lot can go wrong and in the end we come through. We've come through in great fashion. And we've got all kinds of-- we had problems in the farm area 15 years ago and we had problems with the savings and loans. People are always talking about problems, but this country moves ahead. ADAM SMITH: Warren Buffett is the likable persona that comes across. There are not many people worth $30-odd billion who still live in the original house they bought for $40,000. Now Warren faces a real challenge. Berkshire has a market value of $70-odd billion; a group, even a mob, follows Buffett. Is he buying zero U.S. treasuries? Is he selling McDonald's? Mere rumors move the market. The reputation is now crowding the man and whatever he does. That doesn't stop his obvious enjoyment of life, but it is going to be more difficult for Warren Buffett to be the Wizard Warren Buffett. What question would you like answered to help you do your personal best in the money game? Get in touch with our e-mail address, letters@adamsmith.net. Or write to us the old-fashioned way at Adam Smith's Money Game, 885 Third Avenue, Suite 2800, New York, New York 10022. We look forward to hearing from you. And if we answer you letter on the air, I'll be sending you a personally-signed copy of my book, The Money Game. I'm Adam Smith. See you next week as the money game continues. ANNOUNCER: For more of the Money Game, visit us in cyberspace at www.adamsmith.net. ANNOUNCER: This program is made possible by a grant from MetLife with over $330 billion in assets under management. Funding has also been provided by the Roy R. and Marie S. Neuberger Foundation. CREDITS Produced by ADAM SMITH EDUCATIONAL PRODUCTION Special thanks to: 3-D Models Provided in Part by 3-D CAFE For a VHS cassette send $19.95 or $5.00 for a printed transcript to: Copyright _ 1998 Adam Smith Educational Productions Ltd.
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