Thursday, May 10, 2007

More from Berkshire 2007 annual meeting

Buffett said there’ll be something similar to the collapse of Long Term Capital Management in 1998. They don’t know when or what it will look like, but it could be bigger than before. He says derivatives make margin regulation a joke and will bring chaos.

According to Charlie Munger, most of the accounting profession doesn’t know how stupidly it is behaving, especially accounting for derivatives. By marking to market derivative positions, traders are being paid for profits that may or may not materialize, and increasing risk in the financial system as returns relative to risk are lop-sided for the trader. The aggregate balance sheet for all derivatives almost certainly doesn’t balance. In some cases, profits on different sides of the same trade are being accounted for differently, creating the illusion that profits are higher than they actually are. Traders will game the system to make its trade benefit itself as opposed to presenting an accurate reflection of profitability.

Charlie also noted the number of people who are seeing record profits thanks in part to derivatives. As we know, with record profits come record executive bonuses – and just as the monkey will do whatever it takes to get the banana, Charlie said those executives will also continue to do exactly what they’re doing to get their bonuses, tenable or not.


Buffett said corporate profits are today extraordinary and not sustainable. Over time, corporate profits have averaged 4% to 6% of GDP. Today it is 8%, and that will come down. Much of today’s profits are being derived from the financial sector.

People have a hard time thinking about what hasn’t happened in the past, Buffett said. Thus, they tend to incorrectly discount events in the future. On desired hurdle rates, it is amazing how gullible big investors, such as institutions, are. They’re willing to believe and invest with people who will tell them what they want to hear, even if those people cannot deliver the stated hurdle rate.

Someone asked if Buffett is the head of a $10 billion endowment, would his choice be stocks, bonds, cash, or a mixed, he said it would be 100% in stocks if his time frame is 20 years. However, he believes future returns will be moderate. They do not have high expectations for equities over the next 20 years but, equities will earn more than the 4.75% you will receive from bonds. There’ll be a severe dislocation at some time. He doesn’t believe in traditional asset allocation – 60% in equities, 30% in bonds and 10% in cash. You should invest entirely in stocks, bonds or cash. According to Charlie, opportunity cost is what you want to base your investing decisions on.

“I bought it too early, [and] I sold it too early,” Buffett quipped. “Other than that, it was a perfect trade. That shows you how much we know about silver. I’m flattered you asked because no one asks us our opinion on silver anymore. Commodity prices are determined by supply and demand, not conspiracy theories.”

If Buffett were working with a small fund, he would be investing totally differently. According to Charlie, the area where you should look for investment ideas when you are young is in inefficient markets.

Buffett said volatility is not a measure of risk. The people who teach risk in universities do not understand risk. Beta does not measure risk. Warren gave the example of a Nebraska farmland which he purchased in the early 1980s, for $600 an acre. Two years earlier, it was selling for $2000 an acre. However, when farmland was selling at $2000 an acre, its beta (risk) was lower. Thus, according to financial theory, farmland was less risky at $2000 an acre than it was $600 an acre. He went as far as to suggest “volatility as a measure of risk is nonsense.”

He believed volatility arises from not knowing what you are doing. Using volatility as a measure of risk is useful for people who wanted a career in teaching. According to Charlie, 50% of financial theory as taught in universities is “twaddle (nonsense).” Charlie went on to quip, “Very smart people do very dumb things,” and it is important to “know who those people are and avoid them.” People who talk about volatility being an accurate reflection of risk are crazy. You would have to believe in the tooth fairy to believe that Gaussian equations are a measure of risk in capital markets.

Buffett does not believe in meeting the management when buying marketable securities. They will instead read a lot, particularly annual reports. When they receive dishonest messages in the corporate literature, they avoid those companies. If consultants or the business write the message “why invest with someone who is responsible with your capital but won’t talk to you once a year,” then you should meet with the management before investing.

According to Charlie, “you’re not restricted to picking living people as your heroes. Some of the best people are dead.”


musicwhiz said...

Thanks for posting the notes from Berkshire's Annual Meeting, appreciate it. Please continue to post any info on value investing, Warren Buffett or Charlie Munger, thanks !

fishman said...

may I ask....then what is Risk? Isn't it a probability? that's why volatility is used to measure it.

So how did Buffett measure Risk?