Charlie Marger

7/31/2019 Charlie Marger

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Charlie Marger

This is a reconstruction of my notes and recollections of this mornings meeting with Charlie. Much of it

is heavily paraphrased with some interpretation on my part in various places when I missed exactly what

was said. I invite others who attended the meeting to correct and/or expand areas as necessary.

Wesco-Berkshire Merger

CM felt as though he were captain of a ship arriving at home port after a long voyage with a larger-than-

expected load on-board. Around half the WSC shares were redeemed for BRK shares and the other half

for cash. Due to BRKs recent low price, the merger was unfavorable to BRK. BRK has a reputation for

doing the right thing, particularly when it has more power than the other party, and BRK has benefited

from that reputation over the years.

Charlie the AcademicCM has benefited greatly from studying Lollapalooza effects, which are a confluence of factors operating

in one direction. He notes that these factors often arise out of separate academic disciplines. For

example, many economist hours spent trying to understand why candy costs so much at a movie theatre

and they cannot explain it using marginal utility concept. However, if one understands the psychology of

car buying, where a buyer readily adds a $400 gizmo that costs $20 to a $40,000 car because $400 is

small relative to the cost of the car, then one solves the mystery of candy prices in a movie theatre. For

a second example, Japan used every Keynesian trick to goose their economy only to experience stasis

for the last 20 years. Economists suggest those tricks have lost some of their power to influence an

economy since they were introduced in 1939. CM has an alternate explanation. Japans economy is

based on exports. Over last 20 years, competition from Korea and China has increased, and it is difficultto export as much as before. In short, CM recommends using a checklist approach and to consider

multiple approaches. Its a poor internist who sticks with his first conclusion and doesnt consider

alternate explanations.

Current Investment Scene

The Great Recession came about from a combination of megalomania (Dick Fuld cited here) + insanity +

evil. Greenspan overdosed on Ayn Rand. Cant have complete freedom where gambling is permitted.

Investment bankers had a great edge (better than casinos because no overhead required for

entertainers, restaurants, bars, etc.) and they didnt want to give it up. They essentially brought back the

bucket shop with unlimited credit (30-50x equity in assets). The entire process was helped by the

accounting profession who doesnt want any serious responsibility (i.e., for a system collapse). Jamie

Dimon is the only one to have expressed any contrition or shame. CM believes the US doesnt need this

kind of financial inventiveness; its ok to be boring. Activities should be regulated if government is

expected to extend credit.


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Bill Gross has it right. Expect a New Normal, which will be lousy compared with past. Good stock picks

will produce modest returns.

Country is too divisive at the moment. No tax increase at all is crazy. Just let the rich pay is crazy. Need

moderate taxes on broad base. Marshall Plan at end of WWII was good example where US was not

vindictive. Need to tap into those kind of values again.

Q&A Session

Q: What do you consider will be the three most important parts of your legacy?

A: CM does not feel he is a good example for others to emulate. They will be unpopular without the

same results. Irreverence will get you into trouble. One item CM did cite: relentless focus on self

improvement. Basic morality + self discipline + objectivity = something that really works.

Q: What does CM think about deterioration in WSJ editorial page and increase in mistakes since Rupert

Murdoch bought it?

A: Loves the WSJ, but never liked the editorial page anyway. The Economist is the best magazine.

Q: Should the California legislature be organized as a single chamber?

A: Unicameral system is not an obvious solution to anything. Agnostic on question.

Q: Opinion of ETFs versus mutual funds?

A: Doesnt invest using ETFs and cannot comment on any specific ETF. In general, likes recommending

low-cost index funds for the average investor.

Q: As a retired real estate developer myself, how did you ever put up with being in the real estate

development business?

A: CM feels he is partly crazy. Feels its his duty to not use his wealth to shield him from misery. Will limit

his masochistic ethos to a certain extent but not entirely.

Q: Two-column approach suggests BRK price is very low.

A: [CM said he didnt quite get question, so would answer the question he hoped had been asked

instead.+ Its hard to buy a business successfully. Can be very difficult to value a company. BRK failed to

recognize looming Chinese competition when it purchased Dexter Shoes. WEB and CM are better

investors due to the businesses BRK owns. Those who own BRK at current price will do all right.

Q: Advice on dealing with adversity?

A: Soldier on as best you can. Quitting or being frightened only brings contempt. People remember the

guy who kept his cool. Cited the example of Jackie Kennedy Onassis as Robert Kennedy was dying. She

urged that the plug be pulled while everyone else stood around blubbering.


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Q: What percentage of BYD would you recommend holding in a portfolio?

A: CM doesnt know much about early-stage venture capital but is learning. Admires BYDs culture and

will hold stock to end because he loves the people. However, CM cannot recommend what others

should do.

Q: US dollar has lost 95% of its value since 1955. How much longer before it loses the remaining 5%

through inflation?

A: Its obvious the US will experience significant inflation over a 50-100 yr span with Keynesian tricks in

its toolbox. Note that since 1955, the US has grown 2% per person over inflation, which is a success

beyond CMs expectations. It was a good period for the US. Looking ahead, one should be happy with 0%

return after inflation. Greece, and to some extent Italy as well, is contemptible. Should not have allowed

Greece into EU. (EU open but not for nut cases.) EU will have to draw the line somewhere. CM feels

Lehman Brothers was a good place for the US to draw the line. For future economic conditions, assume

it will be really tough. If you can bear that assumption, smile and get on with it.

Q: Do you feel your investing activities have added value to society?

A: Being a skilled investor has increased Munger family wealth but ashamed contributions to society

werent of a higher caliber. This is the reason CM takes on certain masochistic activities. CMs Q&A at

the annual meeting is his atonement.

Q: Advice on relationships with older children (e.g., financial support)?

A: CM has helped his children financially and doesnt agree with wealthy parents who create artificial

hardships for their children to develop motivation. 100% of the evidence shows those children grow up

hating their parents. Lose graciously.

Q: Are there any companies that have historical similarity to todays BRK?

A: Of the top companies in 1911, only GE and Standard Oil have survived to this day. Standard Oil had a

strong engineering culture and was in the right place/right time. Oil was seeping out of the ground and

cars were coming to the fore. Getty couldnt extract the oil from reserves quickly and prices rose, which

further fueled the companys success. CM cant confidently identify any company today that would be

like Standard Oil back in 1911. CM likes work ethic at BYD; they try harder when they fail. He has a love

for BYD based on his admiration of its employees.

Q: What is your view on value investors getting involved in corporate proxy fights?

A: Doesnt like the vulture investor approach or entrenched management. To paraphrase Oscar Wilde:

Pursuit of the uneatable by the unspeakable.

Q: Advice for segmenting life into phases and following a certain program within each phase?

A: Take joy in learning new things. For example, CM is learning astronomy now. Doesnt believe in

dividing life into phases or stepping through some life program. Definitely not in favor of starting out in

life as a greedy jerk and transforming into a nice guy later, as some might advocate.


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Q: Can we expect these meetings with you will continue in future years?

A: No, this is the last meeting. You folks need to find a new cult hero.

Q: If just out of college, what field to focus on for next 20 years to become an expert?

A: Find something you like and in which you are interested. Intersection of interests and talents.

Architect friend says he loves it so much, he never has to work.

Q: How do you view KOs prospects now versus 20 years ago?

A: Not as good today. KO is one of CMs favorite large companies, but its size precludes it from moving

fast. They are doing what makes sense: pouring new drinks down existing distribution lines. If everyone

needs 8 drinks per day, drinking a KO product is a cheap way to add pleasure to life for something you

have to do anyway.

Q: How do you prioritize your day?

A: Day structured around prior commitments. Reluctant to accept new commitments on his calendar,

however. CM and WEB have fairly open calendars to provide time to read, think, answer phone calls, etc.

Faces hard problems that arent well understood. Consequently, CM needs to structure his time

differently so that his day isnt fully booked like a dentists or urologists might be.

Q: WEB stated he expects BRK to exceed S&P by several percentage points. Will it?

A: CM predicts WEB will get his wish through current mix of operating businesses plus purchases from

owners who wouldnt sell to any company other than BRK.

Q: Advice for passing on values and habits to young children?

A: Teach by example every day. Dont preach something you cant live yourself.

Q: Has cult hero status opened doors for you or do you find it limiting?

A: Both. Dont want wider fan base than already exists. On balance, cult hero status is a plus.

Q: When will we see a BRK dividend?

A: When BRK can no longer increase market value over amount reinvested. CM hopes he dies before

that happens, but some in the room will live to see a dividend.

Q: What factors do you consider when evaluating a companys durable competitive advantage?

A: We consider all the factors we can in the time available. Need to focus on your own area of

competence and figure out what works for you.

Q: Do you see any parallels between the decline of the Roman empire and the US today?

A: Yes, there are parallels. No empire lasts forever in a geographic sense, but parts of old empires are

still with us in many ways. US may have a long period still ahead of it, but not forever. US has had a huge,

and very constructive, influence on Asia. Lee Kuan Yew deserves credit for changing China.


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Q: Given high unemployment rate, do you predict a depression in the near future?

A: Employment conditions are only bad when you contrast them to what is desired. Likes the word

gumption and recommends gumption to deal with the crisis.

Q: What is your prescription for lowering unemployment rate?

A: US should recognize that it now has huge competition in manufacturing and that affects all kinds of

things. Asians are so talented but, until recently, were caught in a Malthusian trap where they limped

along for decades. Great human talent and culture. Benefit to US has been low inflation but there are

side effects too. CM is philosophical about unemployment.

Q: CIO who likes concentrated portfolios wants CM advice on that approach.

A: On the right track. However, achieving better-than-average returns may still be disappointing to your

investors (or employer). Under the New Normal, 8% growth assumption is not realistic. Concentrated

approach is not typical. CIO has an important duty.

Q: What company and CEO do you most admire?

A: Costco. Jim Sinegal is one of the best retailers of all time. Costco will take a lot of future retailing

territory. It is run as a total meritocracy with a fanatical desire to serve the customer. Recommends

reading Costco annual reports to learn good retailing lessons. Everyone needs uplifting examples.

Q: What % cash do you recommend holding in a $10 million portfolio?

A: CMs portfolio is larger than $10 million and he is holding $10 million in cash. *Not sure I captured this

one correctly.]

Q: What books do you recommend and what books do you regret reading?

A: CM doesnt get through first chapter ofbooks he doesnt like. Read fiction when he was young (all the

great classics) but drifted out of it. Enjoyed Sherlock Holmes, so read other works by Arthur Conan Doyle

and discovered Doyle really wasnt that good he simply stumbled into a gold mine (i.e., the who-done-

it genre). Highlighted to CM the importance of finding a gold mine. Recommends that everyone should

rub their nose in their own mistakes with joy and notes that one will never lack for opportunities to do

so.

Q: Advice for how to select an investment manager without a track record?

A: Based on recent experience, this is really hard. Many upstanding candidates for BRK to chose from.

Could find good managers who focused on a particular niche but they can not scale, and BRK needs

someone who can scale. Does not like manager of managers concept leave that to Harvard.

Q: Given recent natural disasters, will insurance industry continue as before?

A: Insurance has always been a mediocre business. Life is worse than casualty.

Q: [Missed this one. Something about renewable energy and/or global warming.]

A: Growing corn for motor fuel is an asinine idea. In Iowa, 20% of power comes from wind. Appears now


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that we will be able to supply our energy needs directly from the sun. Lots of natural gas available, albeit

may have to dig deeper to get at it. US has problems with right-of-ways for power transmission (e.g.,

cannot cross state lines). China is installing huge power grids, and CM thinks they will work well. With

sufficient power, every technical problem can be resolved. Can turn seawater into potable water with

energy, for example. Ok for planet to be a little warmer. No one moving from SoCal to N. Dakota for the

weather after all. If need be, we can influence warming through geoengineering.

Q: Will new BRK CEO keep current position as well as assuming CEO duties?

A: Ajit doesnt want job. Duties for person moving into CEO position would change, of course.

Q: Public versus private schools?

A: Public education is good but nothing compared to the most selective private schools. CM feels his

public education was good enough and his life wouldnt have changed much if he had gone to a private

school.

I had to step out for a few minutes at this point and missed a couple questions. When I returned, CM

was wrapping up his answer to the last question of the morning. At that point the audience gave him a

sustained standing ovation, and CM seemed to beam with delight. For those who could not attend, the

meeting reminded me of a last lecture by a well-liked professor before many of his former students. I

have attended every Wesco shareholder meeting for the last 12 years and will miss the annual

pilgrimage to the Church of Rationality and Charlies sermons.

The following are the notes I took at the Morning With Charlie event this morning in Pasadena, CA.

Sorry for the short hand and paraphrasing used throughout, I am a little out of practice taking notes

during lectures. Overall, it was an excellent meeting full of wit and wisdom from one of the most wisemen on Earth. Enjoy!!

On the merger of Wesco with Berkshire:

This is the desirable outcome we have always wanted but just wasnt feasible.

- Mentions that half of the Wesco shareholders went with shares of Berkshire, the other half took cash.

On the power Berkshire holds but doesnt use:

How nice it is to have a tyrants strength, how wrong it is to use it like a tyrant.

On lollapalooza:

Almost always come from a confluence of factors going in the same direction from different academic

disciplines


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On Academic Economics:

Current economic doctrine is treated as definitely as physics doctrine, although it is no where close to

being as concrete

- Talks about pricing used by movie theater concession stands and car dealers. Explains that consumers

hardly notice the abuse of prices due to the high price of the car/entry.

- Charlie talks about Keynesian tactics and how the tricks do not work as well when everyone knows you

are playing them.

- Does not believe Americans would be as good at handing a situation like Japan economics.

- Stresses the need to use checklist techniques when approaching a problem.

On competition:

Competition in capitalism causes the most power and advantage to go to the most competent.

- Talks about the purchase of Blue Chip Stamps and its eventual extinction. Talked about recognizing the

need to use the float to purchase something as the company become extinct. Mentions only three

purchases were made in decades.

-Says most companies making acquisitions hurt shareholders. Mentions that Berkshire and Wesco did

not lose in this case.

-Emphasized patience being key. Also talked about purchasing individual securities rather than whole

companies being beneficial earlier on at Berkshire.

- Mentions the worst thing that happened in terms of acquisitions was Wesco.

-Envy is most stupid ; cant have much fun with it

-Talks about the purchase of Sees Candy. Says WEB and himself did not fully understand the power of

brands. Over the years of raising prices and seeing no resistance, huge shift in mentality.

- Berkshire was massively ignorant at the start; massive failure and loss.

On the Great Recession:

- The Great Recession is somewhat like Japan. Says the asinine bubble was caused by insanity and evil

on the part of mortgage bankers, investment bankers, etc.


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- Investment bankers had huge advantages and did not want to give them up. Makes correlation with

casino games.

- Situation was helped by the lack of responsibility and accountability of accounting individuals.

- Refers to Jamie Dimon as being the only outspoken individual on accounting.

- Talks about Bernie Maddoff and his lack of contrition. Maddoff says to fellow inmate, I kept that guy

flush for 25 years and in turn I am now doing 150.

- If you use government credit to borrow, there ought to be rules keeping you doing simple things that

are safe for the government.

- In Korea and Mexico, derivatives killed many companies. Says we do not need this type of inventionism

in the US. Also says we do need government regulation.

-Mentions he is a Republican who admires Elizabeth Warren.

On the Current Investment Scene:

- Bonds paying very low interest; lousy.

- Mentions Europe is finally having an adult experience.

- Common stocks carefully selected will return a modest amount

- Computer program investing is like letting rats loose in the grainery.

- Does not like the message of no tax increases period. Also does not like the response of solely taxing

the rich. Says we need a moderate tax system.

- Hard to be optimistic in the current political state, though is mildly hopeful it will change in the future.

- Combination of patience and opportunism is so beneficial. One needs to be ready when opportunities

come, and cannot be timid when big opportunities arise. Talks about how quickly Berkshire jumps on

opportunities.

Question and Answer Session:

-At your point in life, what are the three most important parts of your legacy?

Most people who try to follow my example will end up unpopular and unsuccessful. Follow life long


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learning. Dont emulate my attitude. Self discipline, basic morality, objectivity.

- Has the WSJ deteriorated since Murdoch took over?

Likes the WSJ, never liked the editorial page. Likes The Economist, thinks it is the best magazine for his

interests.

- Would it be a good thing for CA to become a single chamber state?

One cabinet legislature is not good. Agnostic on the subject.

- Can you recommend 3-5 authors regarding mental models?

Dont think I can answer that.

- What are your thoughts on ETFs inn comparison to mutual funds?

I never look at them. Approves of low cost ETF funds. Does not think about them because he doesnt

invest in them.

- Why do you stand by while others criticize you?

I am crazy.

- On the two column approach at Berkshire

It is hard to buy businesses and securities. Pays liberal prices when buying business. Does not necessarily

get businesses for cheap. Returns cannot reflect the past due to the size of Berkshire. I think those who

own Berkshire at current prices will do quite alright while sitting on their butts.

- What advice do you have for successfully developing a family?

Soldier through adversity. Quitting under adversity brings contempt. Coping with adversity is an

opportunity. Woe is me is not the route to take

- Asked about BYD valuation being an opportunity.

Early developing high technology company is difficult. Admires the culture. Will hold his BYD stock, even

if to the bitter end, because he likes the people. Cant constructively answer the question.

- On inflation.


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Obvious to have significant inflation over 50 year period. Says this is more of a success story than a

failure. Says a failure is significantly worse. Greece is contemptible raising all this h*ll about experiencing

adult life. If he was running the EU, he wouldnt have taken in Greece. Cannot allow major banks to fail.

Shareholders can be wiped out, but depositors need to be saved. Believes Paulson, Bush, and both

parties handled the situation well during the recession.

- Is there hope for engineering companies?

Subject I dont think about. Hard to see Google not having a strong position.

- Have you added social value in your financial activities?

Pick securities that will go up and sit on youre @ss. Only difference between others, I am ashamed of it.

- Have you helped your children financially?

Of course. Lose graciously. They may not be as motivated as a poor individual trying to make it, but can

be successful and contribute.

- Which economic entities in history are most similar to Berkshire?

General Electric and Standard Oil. Both in the right place at the right time. I do not know what the next

Standard Oil is.

- What are BYDs competitive advantages?

Likes their hard work on engineering problems. Likes that when they fail, they press on harder.

- Would you like to see more value investors buy large stakes and proxy to take boards over?

Doesnt like entrenched management, but doesnt like vultures raiding. Would rather endure current

evils than more raiding.

- Advice on how one should prioritize stages of life.

Continuous improvement. People shouldnt be a total greedy jerk all their life, then be nice at the end.

- Will you be doing this meeting next year?

No. We need to find a new cult hero.

- If you were college age and had 20 years to become an expert, what would it be in?


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Do what you are interested in. Passionate work. A man is a prisoner of his talents.

Take the best hour for yourself and use it for self improvement.

- Is Coca-Cola as good a business as it was 20 years ago?

No, but compared to others, it is a very good business. Its strategy to take its distribution lines and pour

new drinks down them is a very good strategy. Expensive items encourage competition to knock you out,

but low cost items like coke do not. If I were investing for pension funds, there wouldnt be a single

account without KO in it.

---One certain path to failure is to be unreliable. Does not like having his calendar full.

- On Berkshire Annual report statement of beating average by a few %

Doesnt think it is unrealistic. Might not happen with just large common stocks, but with people

approaching BRK with businesses to buy.

- Being famous, does it improve your ability to do what you want?

Only wants to impress people like those in the audience, which is a good thing because we are the only

ones he does impress.

- Prospects of Berkshire dividend

Some of us will live to see it. Hopes he doesnt because it means BRK isnt reinvesting at higher rates.

-How to evaluate competitive advantages

Evaluate all factors available in the time given. Stick to what you know.

- Are there parallels between the collapse of the Roman Empire and the current US situation?

Every great empire ends; failure rate of 100%. Everyone must pass the baton. The great things from

each empire endures in the next. If China becomes the next most powerful nation, some aspect of the

US will be there.

- On unemployment

I will be flabbergasted if it bounces back to previous levels. Will be a considerable problem for a


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considerable period. Favorite word: Gumption

- On improving unemployment

Chinese competition has affected employment opportunities. Investors must keep outside competition

in mind. A big problem we have is that Asians are so darn smart. We do benefit by cheaper goods, but

the side consequence is competition and less employment. Likes seeing the comeback of many Asian

countries.

- What company and CEO do you most admire?

Costco is the most admirable capitalistic organization in the world. Senegal is in the top 4 best retailers

of all time. Costco will take a lot of ground in the future. Unfortunately, Costco sells at 25 times earnings;

nosebleed prices. If you are comfortable with 25 times earnings with slow advances, its a good choice.

Thinks everyone should get Costcos annual reports.

- If you were managing a $10 million fund, how much would you have in cash?

I am managing one thats a little bigger, and it has less than $10 mill in cash. ( Do not know if this

actually means a much larger account, was kind of confused on this one)

- How would you select an investment manager without prior results?

BRK has had current experience with this, and it is very difficult. Must find a persons niche and put

them there. Knows only one young investment person who can scale. Does not like the managers

manager concept. Easy to know the ones to totally avoid.

- With all the recent natural disasters, will the insurance industry continue as usual?

It will continue to be a mediocre business. It will always attract more people who do stupid things with

premium float.

- On ethanol..

One of the most asinine ideas ever.

-On renewable energy

With wind and solar, we will have enough energy to make up for the depletion of oil and coal.

- Asked about Berkshire succession.


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I am a bold and crazy man, but I am not that crazy to comment on that.

- Is private school worth the tuition compared to public schools?

Two different educations. Concludes his public school education was good enough. If you have a

talented child, they must get that education.

- Advice for judging management

There are not many people who have the incentive to succeed like those at Iscar. It is easy when the

people are off the wall wonderful. If you are not frustrated by what you see, you dont understand it.

- Banks like Wells Fargo are better at managing risk than most

You have to make due with what is available. Feels more comfortable with bankers who can admit they

had their heads up their rears and are living with their mistakes.

- On Level 3...

I have never looked seriously at L3. It is in my too tough file.

- On Benjamin Franklin

When citizens of the Republic learn they can vote money, the end of the Republic is nigh. If Ben was

around now, he would have this large and in bold. If we had compulsory voting in America, it would ruin

us.

Again, these notes are pretty rough ad raw. I hope you are able to take something from them and put

them to good use.

Kyle

The Great Financial Scandal of 2003(An Account by Charles T. Munger)

The great financial scandal erupted in 2003 with the sudden, deserved disgrace of QuantTechnical Corporation, always called Quant Tech. By this time Quant Tech was the countryslargest pure engineering firm, having become so as a consequence of the contributions of itslegendary founder, engineer Albert Berzog Quant.

After 2003, people came to see the Quant Tech story as a sort of morality play, divided into twoacts. Act One, the era of the great founding engineer, was seen as a golden age of sound


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values. Act Two, the era of the founders immediate successors, was seen as the age of falsevalues with Quant Tech becoming, in the end, a sort of latter day Sodom or Gomorrah.

In fact, as this account will make clear, the change from good to evil did not occur all at oncewhen Quant Techs founder died in 1982. Much good continued after 1982, and serious evil had

existed for many years prior to 1982 in the financial culture in which Quant Tech had to operate.

The Quant Tech story is best understood as a classic sort of tragedy in which a single flaw isinexorably punished by remorseless Fate. The flaw was the countrys amazingly peculiaraccounting treatment for employee stock options. The victims were Quant Tech and itscountry. The history of the Great Financial Scandal, as it actually happened, could have beenwritten by Sophocles.

As his life ended in 1982, Albert Berzog Quant delivered to his successors and his Maker awonderfully prosperous and useful company. The sole business of Quant Tech was designing,for fees, all over the world, a novel type of super-clean and super-efficient small power plant that

improved electricity generation.

By 1982 Quant Tech had a dominant market share in its business and was earning $100 millionon revenues of $1 billion. Its costs were virtually all costs to compensate technical employeesengaged in design work. Direct employee compensation cost amounted to 70% of revenues. Ofthis 70%, 30% was base salaries and 40% was incentive bonuses being paid out under anelaborate system designed by the founder. All compensation was paid in cash. There were nostock options because the old man had considered the accounting treatment required for stockoptions to be weak, corrupt and contemptible, and he no more wanted bad accounting in hisbusiness than he wanted bad engineering. Moreover, the old man believed in tailoring his hugeincentive bonuses to precise performance standards established for individuals or small groups,

instead of allowing what he considered undesirable compensation outcomes, both high and low,such as he believed occurred under other companies stock option plans.

Yet, even under the old mans system, most of Quant Techs devoted longtime employees werebecoming rich, or sure to get rich. This was happening because the employees were buyingQuant Tech stock in the market, just like non-employee shareholders. The old man had alwaysfigured that people smart enough, and self-disciplined enough, to design power plants couldreasonably be expected to take care of their own financial affairs in this way. He wouldsometimes advise an employee to buy Quant Tech stock, but more paternalistic than that hewould not become.

By the time the founder died in 1982, Quant Tech was debt free and, except as a reputation-enhancer, really didnt need any shareholders equity to run its business, no matter how fastrevenues grew. However, the old man believed with Ben Franklin that it is hard for an emptysack to stand upright, and he wanted Quant Tech to stand upright. Moreover, he loved hisbusiness and his coworkers and always wanted to have on hand large amounts of cashequivalents so as to be able to maximize work-out or work-up chances if an unexpected adversityor opportunity came along. And so in 1982 Quant Tech had on hand $500 million in cashequivalents, amounting to 50% of revenues.


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Possessing a strong balance sheet and a productive culture and also holding a critical mass ofexpertise in a rapidly changing and rapidly growing business, Quant Tech, using the old mansmethods, by 1982 was destined for 20 years ahead to maintain profits at 10% of revenues whilerevenues increased at 20% per year. After this 20 years, commencing in 2003, Quant Techsprofit margin would hold for a very long time at 10% while revenue growth would slow down to

4% per year. But no one at Quant Tech knew precisely when its inevitable period of slowrevenue growth would begin.

The old mans dividend policy for Quant Tech was simplicity itself: He never paid adividend. Instead, all earnings simply piled up in cash equivalents.

Every truly sophisticated investor in common stocks could see that the stock of cash-rich QuantTech provided a splendid investment opportunity in 1982 when it sold at a mere 15 timesearnings and, despite its brilliant prospects, had a market capitalization of only $1.5 billion. Thislow market capitalization, despite brilliant prospects, existed in 1982 because other wonderfulcommon stocks were also then selling at 15 times earnings, or less, as a natural consequence of

high interest rates then prevailing plus disappointing investment returns that had occurred overmany previous years for holders of typical diversified portfolios of common stocks.

One result ofQuant Techs low market capitalization in 1982 was that it made Quant Techsdirectors uneasy and dissatisfied right after the old mans death. A wiser board would then havebought in Quant Techs stock very aggressively, using up all cash on hand and also borrowingfunds to use in the same way. However, such a decision was not in accord with conventionalcorporate wisdom in 1982. And so the directors made a conventional decision. They recruited anew CEO and CFO from outside Quant Tech, in particular from a company that then had aconventional stock option plan for employees and also possessed a market capitalization at 20times reported earnings, even though its balance sheet was weaker than Quant Techs and its

earnings were growing more slowly than earnings at Quant Tech. Incident to the recruitment ofthe new executives, it was made plain that Quant Techs directors wanted a higher marketcapitalization, as soon as feasible.

The newly installed Quant Tech officers quickly realized that the company could not wiselyeither drive its revenues up at an annual rate higher than the rate in place or increase Quant Techprofit margin. The founder had plainly achieved an optimum in each case. Nor did the newofficers dare tinker with an engineering culture that was working so well. Therefore, the newofficers were attracted to employing what they called modern financial engineering whichrequired prompt use of any and all arguably lawful methods for driving up reported earnings,with big, simple changes to be made first.

By a strange irony of fate, the accounting convention for stock options that had so displeasedQuant Techs founder now made the new officers job very easy and would ultimately ruinQuant Techs reputation. There was now an accounting convention in the United States that,provided employees were first given options, required that when easily marketable stock wasissued to employees at a below-market price, the bargain element for the employees, althoughroughly equivalent to cash, could not count as compensation expense in determining acompanys reported profits. This amazingly peculiar accounting convention had been selected


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by the accounting profession, over the objection of some of its wisest and most ethical members,because corporate managers, by and large, preferred that their gains from exercising optionscovering their employers stock not be counted as expense in determining their employersearnings. The accounting profession, in making its amazingly peculiar decision, had simplyfollowed the injunction so often followed by persons quite different from prosperous, entrenched

accountants. The injunction was that normally followed by insecure and powerless people: Hisbread I eat, his song I sing. Fortunately, the income tax authorities did not have the sameamazingly peculiar accounting idea as the accounting profession. Elementary common senseprevailed, and the bargain element in stock option exercises was treated as an obviouscompensation expense, deductible in determining income for tax purposes.

Quant Techs new officers, financially shrewd as they were, could see at a glance that , given theamazingly peculiar accounting convention and the sound income-tax rules in place, Quant Techhad a breathtakingly large opportunity to increase its reported profits by taking very simpleaction. The fact that so large a share of Quant Techs annual expense was incentive bonusexpense provided a modern financial engineering opportunity second to none.

For instance, it was mere childs play for the executives to realize that if in 1982 Quant Tech hadsubstituted employee stock option exercise profits for all its incentive bonus expense of $400million, while using bonus money saved, plus option prices paid, to buy back all shares issued inoption exercises and keeping all else the same, the result would have been to drive Quant Tech1982 reported earnings up by 400% to $500 million from $100 million while shares outstandingremained exactly the same! And so it seemed that the obviously correct ploy for the officers wasto start substituting employee stock option exercise profits for incentive bonuses. Why should agroup of numerate engineers care whether their bonuses were in cash of virtually perfectequivalents of cash? Arranging such substitutions, on any schedule desired, seemed like nodifficult chore.

However, it was also mere childs play for the new officers to realize that a certain amount ofcaution and restraint would be desirable in pushing their new ploy. Obviously, if they pushedtheir new ploy too hard in any single year there might be rebellion from Quant Techsaccountants or undesirable hostility from other sources. This, in turn, would risk killing a goosewith a vast ability to deliver golden eggs, at least to the officers. After all, it was quite clear thattheir ploy would be increasing reported earnings only by adding to real earnings an element ofphony earningsphony in the sense that Quant Tech would enjoy no true favorable economiceffect (except temporary fraud-type effect similar to that from overcounting closing inventory)from that part of reported earnings increases attributable to use of the ploy. The new CEOprivately called the desirable, cautious approach wisely restrained falsehood.

Plainly, the new officers saw, it would be prudent to shift bonus payments to employee stockoption exercise profits in only a moderate amount per year over many years ahead. Theyprivately called the prudent plan they adopted their dollop by dollop system which theybelieved had four obvious advantages:

First, a moderate dollop of phony earnings in any single year would be less likely to benoticed than a large dollop.


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Second, the large long-term effect from accumulating many moderate dollops of phonyearnings over the years would also tend to be obscured in the dollop by dollopsystem. As the CFO pithily and privately said: If we mix only a moderate minorityshare of turds with the raisins each year, probably no one will recognize what willultimately become a very large collection of turds.

Third, the outside accountants, once they had blessed a few financial statementscontaining earnings increases only a minority share of which were phony, wouldprobably find it unendurably embarrassing not to bless new financial statementscontaining only the same phony proportion of reported earnings increase.

Fourth, the dollop by dollop system would tend to prevent disgrace, or something moreseriously harmful, for Quant Techs officers. With virtually all corporations exceptQuant Tech having ever-more-liberal stock option plans, the officers could alwaysexplain that a moderate dollop of shift toward compensation in option-exercise form wasneeded to help attract or retain employees. Indeed, given corporate culture and stock

market enthusiasm likely to exist as a consequence of the strange accounting conventionfor stock options, this claim would often be true.

With these four advantages, the dollop by dollop system seemed so clearly desirable that itonly remained for Quant Techs officers to decide how big to make their annual dollops of phonyearnings. This decision, too, turned out to be easy. The officers first decided upon threereasonable conditions they wanted satisfied:

First, they wanted to be able to continue their dollop by dollop system without majordiscontinuities for 20 years.

Second, they wanted Quant Techs reported earnings to go up by roughly the samepercentage each year throughout the whole 20 years because they believed that financialanalysts, representing institutional investors, would value Quant Techs stock higher ifreported annual earnings growth never significantly varied.

Third, to protect credibility for reported earnings, they never wanted to strain credulity ofinvestors by reporting, even in their 20th year, that Quant Tech was earning more than 40%of revenues from designing power plants.

With these requirements, the math was easy, given the officers assumption that Quant Techsnon-phony earnings and revenues were both going to grow at 20% per year for 20 years. Theofficers quickly decided to use their dollop by dollop system to make Quant Techs reportedearnings increase by 28% per year instead of the 20% that would have been reported by thefounder.

And so the great scheme of modern financial engineering went forward toward tragedy atQuant Tech. And few disreputable schemes of man have ever worked better in achieving whatwas attempted. Quant Techs reported earnings, certified by its accountants, increased regularlyat 28% per year. No one criticized Quant Techs financial reporting except a few people widely


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regarded as impractical, overly theoretical, misanthropic cranks. It turned out that the founderspolicy of never paying dividends, which was continued, greatly helped in preserving credibilityfor Quant Techs reports that its earnings were rising steadily at 28% per year. With cashequivalents on hand so remarkably high, the Pavlovian mere-association effects that so oftenimpair reality recognition served well to prevent detection of the phony element in reported

earnings.

It was therefore natural, after the dollop by dollop system had been in place for a few years, forQuant Techs officers to yearn to have Quant Techs reported earnings per share keep going upat 28% per year while cash equivalents grew much faster than they were then growing. Thisturned out to be a snap. By this time, Quant Techs stock was selling at a huge multiple ofreported earnings, and the officers simply started causing some incremental stock-optionexercises that were not matched either by reductions in cash bonuses paid or by repurchases ofQuant Techs stock. This change, the officers easily recognized, was a very helpful revision oftheir original plan. Not only was detection of the phony element in reported earnings mademuch more difficult as cash accumulation greatly accelerated, but also a significant amount of

Ponzi-scheme or chain-letter effect was being introduced into Quant Tech, with real benefits forpresent shareholders, including the officers.

At this time the officers also fixed another flaw in their original plan. They saw that as QuantTechs reported earnings, containing an increasing phony element, kept rising at 28%, QuantTechs income taxes as a percentage of reported pre-tax earnings kept going lower andlower. This plainly increased chances for causing undesired questions and criticism. Thisproblem was soon eliminated. Many power plants in foreign nations were built and owned bygovernments, and it proved easy to get some foreign governments to raise Quant Techs designfees, provided that in each case slightly more than the fee increase was paid back in additionalincome taxes to the foreign government concerned.

Finally, for 2002, Quant Tech reported $16 billion in earnings on $47 billion of revenues thatnow included a lot more revenue from interest on cash equivalents than would have been presentwithout net issuances of new stock over the years. Cash equivalents on hand now amounted toan astounding $85 billion, and somehow it didnt seem impossible to most investors that acompany virtually drowning in so much cash could be earning the $16 billion it wasreporting. The market capitalization of Quant Tech at its peak early in 2003 became $1.4 trillion,about 90 times earnings reported for 2002.

However, all mans desired geometric progressions, if a high rate of growth is chosen, at lastcome to grief on a finite earth. And the social system for man on earth is fair enough, eventually,that almost all massive cheating ends in disgrace. And in 2003 Quant Tech failed in both ways.

By 2003, Quant Techs real earning power was growing at only 4% per year after sales growthhad slowed to 4%. There was now no way for Quant Tech to escape causing a bigdisappointment for its shareholders, now largely consisting of institutional investors. Thisdisappointment triggered a shocking decline in the price of Quant Tech stock which went downsuddenly by 50%. This price decline, in turn, triggered a careful examination of Quant Techsfinancial reporting practices which, at long last, convinced nearly everyone that a very large


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majority of Quant Techs reported earnings had long been phony earnings and that massive anddeliberate misreporting had gone on for a great many years. This triggered even more pricedecline for Quant Tech stock until in mid-2003 the market capitalization of Quant Tech was only$140 billion, down 90% from its peak only six months earlier.

A quick 90% decline in the price of the stock of such an important company, that was previouslyso widely owned and admired, caused immense human suffering, considering the $1.3 trillion inmarket value that had disappeared. And naturally, with Quant Techs deserved disgrace, thepublic and political reaction included intense hatred and revulsion directed at Quant Tech, eventhough its admirable engineers were still designing the nations best power plants.

Moreover, the hatred and revulsion did not stop with Quant Tech. It soon spread to othercorporations, some of which plainly had undesirable financial cultures different from QuantTechs only in degree. The public and political hatred, like the behavior that had caused it, soonwent to gross excess and fed upon itself. Financial misery spread far beyond investors into aserious recession like that of Japan in the 1990s following the long period of false Japanese

accounting.

There was huge public antipathy to professions following the Great Scandal. The accountingprofession, of course, got the most blame. The rule-making body for accountants had long bornethe acronym F.A.S.B. And now nearly everyone said this stood for Financial Accounts StillBogus.

Economics professors likewise drew much criticism for failing to blow the whistle on falseaccounting and for not sufficiently warning about eventual bad macroeconomic effects ofwidespread false accounting. So great was the disappointment with conventional economiststhat Harvards John Kenneth Galbraith received the Nobel Prize in economics. After all, he had

once predicted that massive, undetected corporate embezzlement would have a wonderfullystimulating effect on the economy. And people could now see that something very close to whatGalbraith had predicted had actually happened in the years preceding 2003 and had thereafterhelped create a big, reactive recession.

With Congress and the S.E.C. so heavily peopled by lawyers, and with lawyers having been soheavily involved in drafting financial disclosure documents now seen as bogus, there was a newlawyer joke every week. One such was: The butcher says the reputation of lawyers hasfallen dramatically, and the check-out clerk replies: How do you fall dramatically off apancake?

But the hostility to established professions did not stop with accountants, economists andlawyers. There were many adverse rub-off effects on reputations of professionals that hadalways performed well, like engineers who did not understand the financial fraud that theircountry had made not a permissible option but a legal requirement.

In the end, much that was good about the country, and needed for its future felicity, was widelyand unwisely hated.


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At this point, action came from a Higher Realm. God himself, who reviews all, changed Hisdecision schedule to bring to the fore the sad case of the Great Financial Scandal of 2003. Hecalled in his chief detective and said, Smith, bring in for harsh but fair judgment the mostdepraved of those responsible for this horrible outcome.

But when Smith brought in a group of security analysts who had long and uncritically touted thestock of Quant Tech, the Great Judge was displeased. Smith, he said, I cant come downhardest on low-level cognitive error, much of it subconsciously caused by the standard incentivesystems of the world.

Next, Smith brought in a group of S.E.C. Commissioners and powerful politicians. No, no,said the Great Judge, These people operate in a virtual maelstrom of regrettable forces and cantreasonably be expected to meet the behavioral standard you seek to impose.

Now the chief detective thought he had gotten the point. He next brought in the corporateofficers who had practiced their version of modern financial engineering at Quant Tech. You

are getting close, said the Great Judge, but I told you to bring in the most depraved. Theseofficers will, of course, get strong punishment for their massive fraud and disgusting stewardshipof the great engineers legacy. But I want you to bring in the miscreants who will soon be in thelowest circle in Hell, the ones who so easily could have prevented all this calamity.

At last the chief detective truly understood. He remembered that the lowest circle of Hell wasreserved for traitors. And so he now brought in from Purgatory a group of elderly persons who,in their days on earth, had been prominent partners in major accounting firms. Here are yourtraitors, said the chief detective. They adopted the false accounting convention for employeestock options. They occupied high positions in one of the noblest professions, which, like Yours,helps make society work right by laying down the right rules. They were very smart and

securely placed, and it is inexcusable that they deliberately caused all this lying and cheating thatwas so obviously predictable. They well knew what they were doing was disastrously wrong,yet they did it anyway. Owing to press of business in Your Judicial System, you made a mistakeat first in punishing them so lightly. But now you can send them into the lowest circle in Hell.

Startled by the vehemence and presumption, the Great Judge paused. Then He quietlysaid: Well done, my good and faithful servant.

----------------------------------------------------

This account is not an implied prediction about 2003. It is a work of fiction. Except in the caseof Professor Galbraith, any resemblances to real persons or companies is accidental. It waswritten in an attempt to focus possibly useful attention on certain modern behaviors and beliefsystems.

Many people on this board tend not to think much about Charlie Munger -- although the new Lowe

biography may change that somewhat. In general, I thought it a decent book about a fascinating subject.

Simply realizing the legal bent that he brings to an analysis made me reflect differently on some of the

BRK decisions that have been made in the past.


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I thought that I'd share one of the letters enclosed within the text. It was sent to the U.S. League shortly

before the Savings and Loan debacle came to a head. Mutual Savings (a Wesco subsiduary) was, at the

time, an S&L, and the U.S. League was a lobbying agency in Washington arguing against additional S&L

regulations. Since it was released to the media, fair use allows its reproduction here. It gives an

interesting insight into the author, IMO. Please forgive the inevitable typos.

May 30, 1989

Gentlemen:

This letter is the formal resignation of Mutual Savings and Loan Association from the United States

League of Saving Institutions.

Mutual Savings is a subsiduary of Wesco Financial Corporation, listed ASE, and Berkshire Hathaway Inc.,

listed NYSE, which are no longer willing to be associated with the league.

Mutual Savings does not lightly resign after belonging to the League for many years. But we believe that

the League's current lobbying operations are so flawed, indeed disgraceful, that we are not willing to

maintain membership.

Our savings and loan industry has now created the largest mess in the history of U.S. financial

institutions. While the mess has many causes, which we tried to summarize fairly in our last annual

report to stockholders, it was made much worse by (1) constant and successful inhibition over many

years, through League lobbying, of proper regulartory response to operations of a minoritry of insured

institutions dominated by crooks and fools, (2) Mickey Mouse accounting which made many insured

institutions look sounder than they really were, and (3) inadequate levels of real equity capital

underlying insured institutions' promises to holders of savings accounts.

It is not unfair to liken the situation now facing Congress to cancer and to liken the League to a

significant carcinogenic agent. And, like cancer, our present troubles will recur if Congress lacks the

wisdom and courage to excise elements which helped cause the troubles.

Moreover, despite the obvious need to a real legislative reform, involving painful readjustment, the

League's recent lobbying efforts regularly resist minimal reform. For instance, the League supports (1)

extension of accounting conventions allowing 'goodwill' (in the financial institutions' context translate

'air') to count as capital in relations with regulators and (2) minimization of the amount of real equity

capital required as a condition of maintenance of full scale operations relying on federal deposit

insurance.

In the face of a national disaster which League lobbying plainly helped cause, the League obdurately

persists in prescribing continuation of loose accounting principles, inadequate capital, and, in effect,


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inadequate management at many insured institutions. The League responds to the savings and lon mess

as Exxon would have responded to the oil spill from the Valdez if it had insisted thereafter on liberal use

of whiskey by tanker captains.

It would be much better if the League followed the wise example, in another era, of the manufacturer

which made a public apology to Congress. Because the League has clearly misled its government for a

long time, to the taxpayers' great detriment, a public apology is in order, not redoubled efforts to

mislead further.

We know that there is a school of thought that trade associations are to be held to no high standard,

that they are supposed to act as the league is acting. In this view, each industry creates a trade

association not to proffer truth or reason or normal human courtesy following egregious fault, but

merely to furnish self-serving nonsense and political contributions to counterbalance, in the legislative

meilieu, the self-serving nonsense and political contributions of other industries' trade associations. But

the evidence is now before us that the type of trade association conduct, when backed as in the

League's case by vocal and affluent constituents in every congressional district, has an immense capacity

to do harm to the country. Therefore, the League's public duty is to behave in an entirely different way,

much as major-league baseball reformed after the "Black Sox" scandal. Moreover, just as client savings

institutions are now worse off because of the increased mess caused by League short-sightedness in the

past, client institutions will later prove ill-served by the present short-sightedness of the League.

Believing this, Mr. Warren E. Buffett and I are not only causing Mutual Savings to resign from the U.S.

League of Savings Institutions; we are also, as one small measure of protest, releasing to the media, for

such attention as may ensue, copies of this letter of resignation.

Truly yours,

Charles T. Munger

--- --- ---

If you enjoyed that, you may find the stories as interesting as I did. I was especially glad to encounter a

sharp wit well beyond what's exhibited as WEB's 'straight man' at the BRK meeting. If you're interested,

it wouldn't hurt to buy the book:

While the book has its high and low patches, the direct quotes (most shorter than this) have inspired me

to make a real effort to go to the Wesco meeting next year. I'm very impressed by CTM's attitudes and

his ability to convey them (at least as represented by the book) and I'd love to listen to him myself.

-Richard

Charlie Marger

Documents

Transcript of Charlie Marger