Money and Finance

Berkshire Hathaway 2007 Annual Meeting - Valuation/IRR Question

Some thoughts from Mr. Buffett and Mr. Munger that I thought might be good to review:

QUESTION – AREA 8:

A follow up on the other valuation questions.

WB: Well, if government bonds earn 2%, we aren't going to buy something because it earns 3 or 4%. I don't ask Charlie every morning “what's our hurdle rate today?”

CM: The concept of hurdle rate makes nothing but sense, but a lot of terrible errors are made by people talking about hurdle rates.

WB: I've seen lots of presentations, on 19 corporate boards, all have calculated IRR. If they burned them all, the boards would have been better off. You just get nonsense figures.

CM: I have a young friend who sells private partnership interests to investments, and it's hard to get returns in that field. I asked him, “what returns do you tell them you can get?” He said 20%. I said, how did you come up with that number? He said, “if I told them any lower they wouldn't give me the money.”
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QUESTION – AREA 11: Australia

How do you judge the right margin of safety to use when investing? For example, in a long standing and stable business, would you demand a 10% margin of safety, and if so, how would you increase this in a weaker business?

WB: We favor the business where we think we know the answer. If a business gets to a point where we think anything is so chancy that we can't come up with a figure, we don't try to compensate. If we buy See's, or Coke, we don't think we need a huge margin of safety because we don't think we're going to be wrong about our assumptions. We'd love to find things selling at 40 cents on the dollar. If we get to something…when we see a great business, when you see someone walk in the door, you don't know if they weigh 300 pounds or 325 pounds, but you know he's fat. You don't need a huge margin of safety. There are times when we could buy businesses at a quarter of what they were worth, but you don't see those things very often. Should you sit around hoping that comes back for 10-15 years? That's not the way we do it.

CM: The margin of safety concept boils down to getting more value than you're paying -- and that value can exist in a lot of different forms. If you're paid 4 to 1 on something that's an even money proposition, that's a value proposition too.
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QUESTION – AREA 1: Chicago

Private equity is getting bigger than ever. Given the ocean of private equity firms out there chasing deals, are we in a bubble, and if so, what will cause it to burst?

WB: Well we're competing with those people so actually I started to cry as you were reading your question. What we are seeing is just the nature of the activity -- it isn't a bubble that bursts. If you buy businesses that aren't priced daily, even if you do a poor job, it takes many years for the score to come up on the board and for investors to get out of the firm. The investors can't leave, and a scorecard is lacking for a long time. What will slow down the activity is if yields on junk bonds became much higher than yields on high-grade bonds. Right now the spread is down to a very low level. History has shown that periodically, the spread widens dramatically. One other aspect, if you have a $20 billion fund and you're getting a two percent fee, you're getting $400 million a year. You also have a lot of money in that fund you need to invest, and you can't start another fund with a straight face until you've got that money invested. So there is a great compulsion to invest very quickly so you can get another fund. Charlie and I will be particularly affected in competing with them. The math has to make sense for us, and here we don't get paid based on activity. I think it will be quite some time before disillusionment sets in and the money quits floating to people who are promoting this.

CM: It can continue to go on quite a long time after you're in a state of total revulsion.

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Link: Whitney Tilson’s 2007 Berkshire Hathaway Annual Meeting Notes

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