1995: What are the fundamental rules of economics Buffett used to make money for Berkshire?

AUDIENCE MEMBER: Mike Assail (PH) from New York City.

In the mistake du jour section of the annual report, you mentioned a fundamental rule of economics that you missed. I’d like to know the two or three most important fundamental rules of economics you habitually get right.

In other words, what are the fundamental rules of economics you used to make money for Berkshire?

And I’m not talking about Ben Graham’s principles here, but rather, rules of economics which may be found in an economics textbook. Thank you.

WARREN BUFFETT: We — Yeah, we try to — I mean, we try to follow Ben’s principles, in terms of the attitude we bring toward both investing and in buying businesses.

But the most important thing you can — you know, what we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, surround — protecting a terrific economic castle with an honest lord in charge of the castle.

And in essence, that’s what business is all about. I mean, you want to be the lord of the castle, yourself. In which case, you don’t worry about that last factor.

But what you’re trying to — what we’re trying to find is a business that, for one reason or another — it can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it.

And then our — then what we have to decide is — all moats are subject to attack in a capitalistic system, so everybody is going to try and — if you’ve got a big castle in there, people are going to be trying to figure out how to get to it.

And what we have to decide — and most moats aren’t worth a damn in, you know, in capitalism. I mean, that’s the nature of it. And it’s a constructive thing that that’s the case.

But we are trying to figure out what is keeping — why is that castle still standing? And what’s going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?

And then if we feel good about the moat, then we try to figure out whether, you know, the lord is going to try to take it all for himself, whether he’s likely to do something stupid with the proceeds, et cetera. But that’s the way we look at businesses.

Charlie, you want to add anything?

CHARLIE MUNGER: Well, I think he wants it translated into the ordinary terms of economics. The honest lord is low agency cost. That’s the word in economics.

And the microeconomic business advantages are, by and large, advantages of scale — scale of market dominance, which can be a retailer that just has huge advantages in terms of buying cheaper and enjoying higher sales per square foot.

So you’re — by and large, you’re talking economies of scale. You can have scale of intelligence. In other words, you can have a lord with enough extra intelligence that he has a big advantage. So you’re — by and large, you’re talking scale advantages and low agency costs.

WARREN BUFFETT: Yeah, to some extent, Charlie and I try and distinguish between businesses where you have to have been smart once and businesses where you have to stay smart.

And, I mean, retailing is a good case of a business where you have to stay smart.

But you can — you are under attack all of the time. People are in your store. If you’re doing something successful, they’re in your store the next day trying to figure out what it is about your success that they can transplant and maybe add a little something on in their own situation. So, you cannot coast in retailing.

There are other businesses where you only have to be smart once, at least for a very long time. There was once a southern publisher who was doing very well with his newspaper. And someone asked him the secret of his success. And he said monopoly and nepotism. (Laughter)

And I mean, he wasn’t so dumb. I mean, he didn’t have any illusions about himself.

And if you had a big network of television affiliates station 30 years ago, there’s still a major difference between good management and bad management. I mean, a major difference.

But you could be a terrible manager and make a fortune, basically. Because the one decision to own the network TV affiliate overcame almost any deficiency that existed from that point forward.

And that would not be true if you were the first one to come up with some concept in retailing or something of the sort. I mean, you would have to be out there defending it every day.

Ideally, you know, is you want terrific management at a terrific business. And that’s what we look for.

But as we pointed out in the past, if you have to choose between the two, get a terrific business.

Charlie, any more?

CHARLIE MUNGER: No.