“Life is a whole series of opportunity cost, you have to marry the best person who is convenient to find who will have you. Investment is very much the same sort of a process.” – Charlie Munger
The year is 1997, an investor approaches and ask an indirect question about opportunity cost. The response from both Munger and Buffett was a wonderful one and goes as following.
Investor Question on Opportunity Cost
“Mr. Buffett, my name is Pete Brown from Columbus Ohio Class B shareholder I had a couple questions if I could the first is I don’t have a very good idea in my mind how are typical Insurance operations work I mean in particular how many leaves the insurance pool in energy investment pool and how our operations are different than the typical run-of-the-mill Insurance operation in around the country why are we able to generate so much more float then you know the XYZ company you know somewhere else and a second question is it kind of goes back to an article you wrote for Fortune Magazine back in the late 70s about the effect of inflation on on Equity values and then that sort of thing in any you asserted that stalks were in businesses were really like Vons they just had their own par and the par being the average 12% return on Equity that companies have averaged you know what company does better than has a sensitive worth way more than a hundred cents in a dollar company does less you know will be less correspondingly my question is when you are projecting cash close up a company as a prospective investment why would you use the going interest rate you know of a risk-free treasury bills why wouldn’t you use the sort of opportunity cost to discount at the maybe Charlie was referring to maybe 12% return on Equity of average corporations maybe you know you’re 15% goal maybe Coca-Cola’s return Equity is a comparison I mean doing that would dramatically change the value of the company that year that you’re you know evaluating as I’m sure you know why would you use the risk-free rate is my question.”
“The risk-free weight is used merely to equate one item to another, in other word for looking for whatever is the most attractive but in terms of present valuing anything we’re going to use a number and then obviously we can always buy the Government Bond so that that becomes the yardstick rate, it doesn’t mean we want to buy government bonds that doesn’t mean we want to buy government bonds if the best thing we can find is only as a present value that works out and a half percent of year better than the government bond but it’s it’s the appropriate yardstick in our view you just simply use to compare across all kinds of investment opportunities oil wells, farms, whatever it may be now gets into degree of certainty too but it’s the yardstick rate it’s not it’s not because we want to buy government government bonds but it does it does serve to make that a constant throughout the valuation process.
In our insurance business will be to have a group of insurance businesses they have different characteristics the consistent characteristic actually is it they’re all very very good businesses that some of them a lot larger and have opportunities to get larger and some of them we’re not so large and and have limited opportunities in terms of growth but every Insurance operation we have is a distinct asset to Berkshire we’ve got smaller workers comp operation ,credit card operation, we’ve got a home state operation we have all these different business Kansas Banker Surety whatever they’re all good businesses some of them don’t develop a lot of float relative to premium volume of the nature Kansas Banker Surety is it won’t develop a lot of Float, just happened to be the kind of business they write the nature of comp is that it develops more float because comp claims pay more slowly.
You really should think of each one of those having different characteristics, Geico is entirely different the Supercat business but both good businesses, in terms of how we invest the money when it comes in we invest it when it comes in I mean we will get a large Supercat premium today it’s invested. Now if we have a claim tomorrow then we disinvest and you know and in a substantial way, if you take something like Geico the cash flow is always going to be positive probably on that we won’t have another Hurricane Andrew because we backed out of the homeowners business to quite an extent so month by month the money comes in at Geico an the faster it grows the more the money that comes in we have so much Capital that we can basically put that money into whatever makes the most sense for Berkshire so we have none of them either the mental or psychological constraints or the regulatory constraints that that the that many insurance companies operate under than many of them think they should have this portion of this in this, or this portion of that. Investments usually play second fiddle to the insurance business as most companies that are in the insurance business we look at them as being of equal importance and we run them as two distinct businesses we do whatever makes most sense on the investment side whatever makes the most sense on the insurance side we never do anything on the investment side that will impinge on our business on the insurance side but you really should look at each one of our business separately Geico has entirely different characteristics then Supercat business they both call themselves insurance and they both develop float but an economic terms and in terms of competitive strengths and that sort of thing or two with two very different businesses that are smaller businesses are different businesses some of those might grow well, we’ll keep working on it. Charlie?”
“Yeah you look at a corporate stock it’s obvious you can buy any maturity of Government Bond you want so one opportunity cost of buying the stock is to compare it with the bond what you may find that have two stocks in America you’re so careful about or know so little about or think so poorly of that you would rather have the Government Bond so opportunity cost basis they’re taking out of the filter now you start finding corporations where you like the stocks way better than then government bonds you got to compare them against the other and when you find one that you regard as the best opportunity that you can understand that’s the best opportunity now you’ve got one to buy so very simple idea, it uses nothing but the most elementary ideas from economics or game theory, child’s play is a mental process now it’s hard to make the business appraisals but the mental process is a cinch.”
“If Charlie and I were forced told we had a choice of buying stock A B C or D in all 2500 or 3000 whatever may be listed on their stock exchange or buying a 10-year Government Bond that we had to hold a stock for 10 years or the bond for 10 years probably at least 80% of the cases we would take the 10-year government many cases because we didn’t understand the business well enough elsewhere or we may understand and still prefer the 10% sure everything that way and I don’t know what you come up with 80% or where Charlie? Desert island 10 years? Get to fondle a stock certificate or fondle a government bond? I mean which one are you going to choose? Haha”
“Life is a whole series of opportunity cost, you have to marry the best person who is convenient to find who will have you. Investment is very much the same sort of a process.”
I knew we would get in trouble after lunch.
Dialogue Provided by: Berkshire’s Annual Shareholders Meeting 2006