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-thanexpected 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 Academic CM 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 difficult to 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.

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.

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.

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.

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 of books 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-doneit 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

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 wise men 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

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.

- 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

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.

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?

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

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.

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 Quant Technical Corporation, always called Quant Tech. By this time Quant Tech was the countrys largest pure engineering firm, having become so as a consequence of the contributions of its legendary founder, engineer Albert Berzog Quant. After 2003, people came to see the Quant Tech story as a sort of morality play, divided into two acts. Act One, the era of the great founding engineer, was seen as a golden age of sound

values. Act Two, the era of the founders immediate successors, was seen as the age of false values 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 once when 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 is inexorably punished by remorseless Fate. The flaw was the countrys amazingly peculiar accounting treatment for employee stock options. The victims were Quant Tech and its country. The history of the Great Financial Scandal, as it actually happened, could have been written by Sophocles. As his life ended in 1982, Albert Berzog Quant delivered to his successors and his Maker a wonderfully 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 million on revenues of $1 billion. Its costs were virtually all costs to compensate technical employees engaged in design work. Direct employee compensation cost amounted to 70% of revenues. Of this 70%, 30% was base salaries and 40% was incentive bonuses being paid out under an elaborate system designed by the founder. All compensation was paid in cash. There were no stock options because the old man had considered the accounting treatment required for stock options to be weak, corrupt and contemptible, and he no more wanted bad accounting in his business than he wanted bad engineering. Moreover, the old man believed in tailoring his huge incentive 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 were becoming rich, or sure to get rich. This was happening because the employees were buying Quant Tech stock in the market, just like non-employee shareholders. The old man had always figured that people smart enough, and self-disciplined enough, to design power plants could reasonably be expected to take care of their own financial affairs in this way. He would sometimes advise an employee to buy Quant Tech stock, but more paternalistic than that he would not become. By the time the founder died in 1982, Quant Tech was debt free and, except as a reputationenhancer, really didnt need any shareholders equity to run its business, no matter how fast revenues grew. However, the old man believed with Ben Franklin that it is hard for an empty sack to stand upright, and he wanted Quant Tech to stand upright. Moreover, he loved his business and his coworkers and always wanted to have on hand large amounts of cash equivalents so as to be able to maximize work-out or work-up chances if an unexpected adversity or opportunity came along. And so in 1982 Quant Tech had on hand $500 million in cash equivalents, amounting to 50% of revenues.

Possessing a strong balance sheet and a productive culture and also holding a critical mass of expertise in a rapidly changing and rapidly growing business, Quant Tech, using the old mans methods, by 1982 was destined for 20 years ahead to maintain profits at 10% of revenues while revenues increased at 20% per year. After this 20 years, commencing in 2003, Quant Techs profit 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 slow revenue growth would begin. The old mans dividend policy for Quant Tech was simplicity itself: He never paid a dividend. Instead, all earnings simply piled up in cash equivalents. Every truly sophisticated investor in common stocks could see that the stock of cash-rich Quant Tech provided a splendid investment opportunity in 1982 when it sold at a mere 15 times earnings and, despite its brilliant prospects, had a market capitalization of only $1.5 billion. This low market capitalization, despite brilliant prospects, existed in 1982 because other wonderful common 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 over many previous years for holders of typical diversified portfolios of common stocks. One result of Quant Techs low market capitalization in 1982 was that it made Quant Techs directors uneasy and dissatisfied right after the old mans death. A wiser board would then have bought in Quant Techs stock very aggressively, using up all cash on hand and also borrowing funds to use in the same way. However, such a decision was not in accord with conventional corporate wisdom in 1982. And so the directors made a conventional decision. They recruited a new CEO and CFO from outside Quant Tech, in particular from a company that then had a conventional stock option plan for employees and also possessed a market capitalization at 20 times 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 of the new executives, it was made plain that Quant Techs directors wanted a higher market capitalization, as soon as feasible. The newly installed Quant Tech officers quickly realized that the company could not wisely either drive its revenues up at an annual rate higher than the rate in place or increase Quant Tech profit margin. The founder had plainly achieved an optimum in each case. Nor did the new officers dare tinker with an engineering culture that was working so well. Therefore, the new officers were attracted to employing what they called modern financial engineering which required 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 displeased Quant Techs founder now made the new officers job very easy and would ultimately ruin Quant 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 was issued to employees at a below-market price, the bargain element for the employees, although roughly equivalent to cash, could not count as compensation expense in determining a companys reported profits. This amazingly peculiar accounting convention had been selected

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 options covering their employers stock not be counted as expense in determining their employers earnings. The accounting profession, in making its amazingly peculiar decision, had simply followed the injunction so often followed by persons quite different from prosperous, entrenched accountants. The injunction was that normally followed by insecure and powerless people: His bread I eat, his song I sing. Fortunately, the income tax authorities did not have the same amazingly peculiar accounting idea as the accounting profession. Elementary common sense prevailed, and the bargain element in stock option exercises was treated as an obvious compensation expense, deductible in determining income for tax purposes. Quant Techs new officers, financially shrewd as they were, could see at a glance that , given the amazingly peculiar accounting convention and the sound income-tax rules in place, Quant Tech had a breathtakingly large opportunity to increase its reported profits by taking very simple action. The fact that so large a share of Quant Techs annual expense was incentive bonus expense 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 had substituted employee stock option exercise profits for all its incentive bonus expense of $400 million, while using bonus money saved, plus option prices paid, to buy back all shares issued in option exercises and keeping all else the same, the result would have been to drive Quant Tech 1982 reported earnings up by 400% to $500 million from $100 million while shares outstanding remained exactly the same! And so it seemed that the obviously correct ploy for the officers was to start substituting employee stock option exercise profits for incentive bonuses. Why should a group of numerate engineers care whether their bonuses were in cash of virtually perfect equivalents of cash? Arranging such substitutions, on any schedule desired, seemed like no difficult chore. However, it was also mere childs play for the new officers to realize that a certain amount of caution and restraint would be desirable in pushing their new ploy. Obviously, if they pushed their new ploy too hard in any single year there might be rebellion from Quant Techs accountants or undesirable hostility from other sources. This, in turn, would risk killing a goose with a vast ability to deliver golden eggs, at least to the officers. After all, it was quite clear that their ploy would be increasing reported earnings only by adding to real earnings an element of phony earnings phony in the sense that Quant Tech would enjoy no true favorable economic effect (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 CEO privately called the desirable, cautious approach wisely restrained falsehood. Plainly, the new officers saw, it would be prudent to shift bonus payments to employee stock option exercise profits in only a moderate amount per year over many years ahead. They privately called the prudent plan they adopted their dollop by dollop system which they believed had four obvious advantages: First, a moderate dollop of phony earnings in any single year would be less likely to be noticed than a large dollop.

Second, the large long-term effect from accumulating many moderate dollops of phony earnings over the years would also tend to be obscured in the dollop by dollop system. As the CFO pithily and privately said: If we mix only a moderate minority share of turds with the raisins each year, probably no one will recognize what will ultimately become a very large collection of turds. Third, the outside accountants, once they had blessed a few financial statements containing earnings increases only a minority share of which were phony, would probably find it unendurably embarrassing not to bless new financial statements containing only the same phony proportion of reported earnings increase. Fourth, the dollop by dollop system would tend to prevent disgrace, or something more seriously harmful, for Quant Techs officers. With virtually all corporations except Quant Tech having ever-more-liberal stock option plans, the officers could always explain that a moderate dollop of shift toward compensation in option-exercise form was needed to help attract or retain employees. Indeed, given corporate culture and stock market enthusiasm likely to exist as a consequence of the strange accounting convention for stock options, this claim would often be true. With these four advantages, the dollop by dollop system seemed so clearly desirable that it only remained for Quant Techs officers to decide how big to make their annual dollops of phony earnings. This decision, too, turned out to be easy. The officers first decided upon three reasonable conditions they wanted satisfied: First, they wanted to be able to continue their dollop by dollop system without major discontinuities for 20 years. Second, they wanted Quant Techs reported earnings to go up by roughly the same percentage each year throughout the whole 20 years because they believed that financial analysts, representing institutional investors, would value Quant Techs stock higher if reported annual earnings growth never significantly varied. Third, to protect credibility for reported earnings, they never wanted to strain credulity of investors 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 Techs non-phony earnings and revenues were both going to grow at 20% per year for 20 years. The officers quickly decided to use their dollop by dollop system to make Quant Techs reported earnings increase by 28% per year instead of the 20% that would have been reported by the founder. And so the great scheme of modern financial engineering went forward toward tragedy at Quant Tech. And few disreputable schemes of man have ever worked better in achieving what was attempted. Quant Techs reported earnings, certified by its accountants, increased regularly at 28% per year. No one criticized Quant Techs financial reporting except a few people widely

regarded as impractical, overly theoretical, misanthropic cranks. It turned out that the founders policy of never paying dividends, which was continued, greatly helped in preserving credibility for Quant Techs reports that its earnings were rising steadily at 28% per year. With cash equivalents on hand so remarkably high, the Pavlovian mere-association effects that so often impair 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, for Quant Techs officers to yearn to have Quant Techs reported earnings per share keep going up at 28% per year while cash equivalents grew much faster than they were then growing. This turned out to be a snap. By this time, Quant Techs stock was selling at a huge multiple of reported earnings, and the officers simply started causing some incremental stock-option exercises that were not matched either by reductions in cash bonuses paid or by repurchases of Quant Techs stock. This change, the officers easily recognized, was a very helpful revision of their original plan. Not only was detection of the phony element in reported earnings made much 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 for present shareholders, including the officers. At this time the officers also fixed another flaw in their original plan. They saw that as Quant Techs reported earnings, containing an increasing phony element, kept rising at 28%, Quant Techs income taxes as a percentage of reported pre-tax earnings kept going lower and lower. This plainly increased chances for causing undesired questions and criticism. This problem was soon eliminated. Many power plants in foreign nations were built and owned by governments, and it proved easy to get some foreign governments to raise Quant Techs design fees, provided that in each case slightly more than the fee increase was paid back in additional income taxes to the foreign government concerned. Finally, for 2002, Quant Tech reported $16 billion in earnings on $47 billion of revenues that now included a lot more revenue from interest on cash equivalents than would have been present without net issuances of new stock over the years. Cash equivalents on hand now amounted to an astounding $85 billion, and somehow it didnt seem impossible to most investors that a company virtually drowning in so much cash could be earning the $16 billion it was reporting. 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 last come 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 growth had slowed to 4%. There was now no way for Quant Tech to escape causing a big disappointment for its shareholders, now largely consisting of institutional investors. This disappointment triggered a shocking decline in the price of Quant Tech stock which went down suddenly by 50%. This price decline, in turn, triggered a careful examination of Quant Techs financial reporting practices which, at long last, convinced nearly everyone that a very large

majority of Quant Techs reported earnings had long been phony earnings and that massive and deliberate misreporting had gone on for a great many years. This triggered even more price decline 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 previously so widely owned and admired, caused immense human suffering, considering the $1.3 trillion in market value that had disappeared. And naturally, with Quant Techs deserved disgrace, the public and political reaction included intense hatred and revulsion directed at Quant Tech, even though 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 other corporations, some of which plainly had undesirable financial cultures different from Quant Techs only in degree. The public and political hatred, like the behavior that had caused it, soon went to gross excess and fed upon itself. Financial misery spread far beyond investors into a serious 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 accounting profession, of course, got the most blame. The rule-making body for accountants had long borne the acronym F.A.S.B. And now nearly everyone said this stood for Financial Accounts Still Bogus. Economics professors likewise drew much criticism for failing to blow the whistle on false accounting and for not sufficiently warning about eventual bad macroeconomic effects of widespread false accounting. So great was the disappointment with conventional economists that Harvards John Kenneth Galbraith received the Nobel Prize in economics. After all, he had once predicted that massive, undetected corporate embezzlement would have a wonderfully stimulating effect on the economy. And people could now see that something very close to what Galbraith had predicted had actually happened in the years preceding 2003 and had thereafter helped create a big, reactive recession. With Congress and the S.E.C. so heavily peopled by lawyers, and with lawyers having been so heavily involved in drafting financial disclosure documents now seen as bogus, there was a new lawyer joke every week. One such was: The butcher says the reputation of lawyers has fallen dramatically, and the check-out clerk replies: How do you fall dramatically off a pancake? But the hostility to established professions did not stop with accountants, economists and lawyers. There were many adverse rub-off effects on reputations of professionals that had always performed well, like engineers who did not understand the financial fraud that their country 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 widely and unwisely hated.

At this point, action came from a Higher Realm. God himself, who reviews all, changed His decision schedule to bring to the fore the sad case of the Great Financial Scandal of 2003. He called in his chief detective and said, Smith, bring in for harsh but fair judgment the most depraved of those responsible for this horrible outcome. But when Smith brought in a group of security analysts who had long and uncritically touted the stock of Quant Tech, the Great Judge was displeased. Smith, he said, I cant come down hardest on low-level cognitive error, much of it subconsciously caused by the standard incentive systems 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 cant reasonably 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 corporate officers 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. These officers will, of course, get strong punishment for their massive fraud and disgusting stewardship of the great engineers legacy. But I want you to bring in the miscreants who will soon be in the lowest 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 was reserved 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 your traitors, said the chief detective. They adopted the false accounting convention for employee stock 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 that was 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 mistake at 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 quietly said: 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 case of Professor Galbraith, any resemblances to real persons or companies is accidental. It was written in an attempt to focus possibly useful attention on certain modern behaviors and belief systems.
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.

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,

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