2002: How does litigation affect intrinsic value?

AUDIENCE MEMBER: Good afternoon, Mr. Buffett and Mr. Munger. I’m George Brumley, from Durham, North Carolina.

It’s been reasonably argued that the most critical factor in evaluating a business is establishing the sustainability of a competitive advantage.

Let’s assume that we have knowledge in hand about a few truly unique companies that possess sufficient strengths to out-duel the competition, and that we can therefore estimate future cash flows with relative certainty.

I admit that getting this far is far from easy, moreover it seems that the wild card of an unchecked tort system has grave potential to turn even such sound analysis on its head.

Predicted cash flows and reasonably estimated terminal values can be effectively driven to zero for business owners via a transfer to both litigants and litigators.

My question is, how should intelligent investors attempt to factor such uncertainty into their valuations of potential investment opportunities?

WARREN BUFFETT: Charlie’s the lawyer, so I’ll tell him how — I’ll have him tell you how to protect yourself from his brethren.

AUDIENCE MEMBER: And I have quick follow-up.

CHARLIE MUNGER: I think it is entirely fair, as an investor, to just quitclaim certain areas of business as having too many problems.

I almost feel that way about workman’s compensation insurance in California.

In other words, the system morphs into something that is so unfair and so crazy that I’m willing to pretty much, at least, leave it behind. And I think there are all kinds of areas like that.

Another fellow and I once controlled a company that invented a better policeman’s helmet. And we told them not to make it. We told them to sell it to somebody else who was judgment-proof or — we wanted the policemen to have the helmet, but we didn’t want to make it.

I think there are whole areas of activity where, for the already rich, the tort system makes participation foolish. And I think you can sort of figure out where those are and avoid them. I don’t think the tort system is going to be fixed quickly.

WARREN BUFFETT: Yeah, George — actually, George Gillespie is, I think, here today. And he and I were directors of Pinkerton 20 years ago. And in fact, we owned a very significant percentage of Pinkertons, although it was controlled by the family foundation.

But one of the interesting problems then was a question of whether we would want to supply guards, for example, at airports.

And if you think about it, Berkshire, itself — well, forget about Pinkerton — would be absolutely crazy to go into the business of supplying guards to airports.

We might be more responsible, in terms of selecting the guards. But if we were to have a guard, say, at that Portland airport from which a plane took off — or where from what the original boarding was of the people that took off from Logan — or we are the guards at Logan or wherever — we might have been held liable for billions and billions of dollars.

You know that people would have gone after us because we would have had deep pockets and we would have had an employee of ours, and people would have said that if it hadn’t for your employee, these people wouldn’t have all died, and everything else wouldn’t have happened.

And for us to be in a business, like Charlie and the helmet business, I mean, for us to be in a business like that would be madness when some other guy operating out of his basement can have guards and if, you know, if they blow up the whole airport it doesn’t make any difference because he’s judgment-proof.

So, it actually is a system that may discourage, perhaps, more responsible people from ever even dreaming of being in that kind of business.

And unfortunately, I would say that the range of businesses, since 1980, when we were thinking about that sort of thing at Pinkertons, the range of businesses to whom such reasoning might apply has probably enlarged to a significant degree.

There’s just a lot of things that a rich corporation shouldn’t do because they will pay a price if they are wrong, or if even somebody maybe suspects they were wrong, that would be incredibly disproportionate to what somebody in different economic circumstances would bear.

It’s absolutely a selection by the tort system of people that are going to provide certain services and products. And I don’t know any answer for that except to avoid it.