2014: What is Berkshire's cost of capital?

WARREN BUFFETT: OK. Gregg Warren of Morningstar. Gregg, welcome.

GREGG WARREN: Thank you. Warren and Charlie, on behalf of Morningstar, I want to thank you for having us on the panel this year.

I may not be an accredited bear, but hopefully, I ask probing questions that add value for shareholders.

My first question relates to the measurement of management performance.

For Morningstar, the ultimate measure of success is not just whether or not a firm can earn more than its cost of capital, but whether or not it can do so for an extended period of time.

Berkshire has historically done a good job of generating outsized returns. But as you’ve noted in the past, the sheer size of the firm’s operations, which continue to grow, will ultimately limit the returns that Berkshire could generate.

With that in mind, what do you believe Berkshire’s cost of capital is? How much do you think that this hurdle rate is increased as you’ve acquired more capital intensive, debt-heavy firms?

And how much confidence do you have that future capital allocators at Berkshire will be able to generate returns in excess of the firm’s cost of capital, acknowledging, of course, the fact that Berkshire’s days of outsized returns are most likely behind it?

WARREN BUFFETT: Yeah. Well, there’s no question that size is an anchor to performance. And we intend to prove that up to the point where it starts really biting.

But it — we cannot earn the returns on capital with well over 200 — well, with a market cap of 300-plus billion. It just isn’t doable.

Archimedes, he said he could move the world if he had a long enough lever, didn’t he, or something like that, Charlie?

CHARLIE MUNGER: Yes, he did.

WARREN BUFFETT: Well, I wish I had his lever because we don’t have that lever at Berkshire.

So we — well, we’ll answer two questions there.

In terms of cost of capital, Charlie and I always figure that our cost of capital is the — is what could be produced by our second best idea. And then our best idea has to exceed that.

We think — I have listened to so many nonsensical cost of capital discussions, that —

CHARLIE MUNGER: I’ve never heard an intelligent one.

WARREN BUFFETT: Yeah. Yeah. (Laughter)

It’s really true. I mean, and there’s — that’s another thing. I’ve been on boards and the CFO comes in and explains why we’re doing this and it always gets down to, you know, it exceeds our cost of capital.

And he doesn’t know what the hell his cost of capital is, and I don’t know. And — but I don’t embarrass him, you know?

So I just sit there and listen to this stuff and apply my own thing, and then still end up voting for it, probably, if I don’t like it, although there have been a few exceptions to that.

The real test, you know, over time, is whether the capital we retain produces more than a dollar of market value as we go along.

And if we keep putting billions in and those billions, in effect, are worth, in terms of present value terms, in terms of what they add to the value of the business, more than what we’re putting in, you know, we’ll keep doing it.

We bought a company day before yesterday, I guess it was. And we are spending close to $3 billion U.S. It’s a Canadian company.

And we think we will be better off financially because we did that and we thought it was the best thing that we could do with the $3 billion on that day. And those are the yardsticks that we have.

And what I do know is that I’ve never seen a CEO who wanted to do a deal where the CFO didn’t come in and say it exceeded the cost of capital.

It’s just — it’s a game, as far as we’re concerned.

And we think we can evaluate businesses. And we know the capital we have available. And we have things that we can sell to buy. Not businesses, but marketable securities that we can sell to buy businesses if we like.

And we are constantly measuring that opportunity cost that Charlie talked about in the movie. It’s an important subject. And one that I think has had more nonsense written about it than about anything.

But I’ll turn it over to Charlie to go over —

CHARLIE MUNGER: Well, a phrase like “cost of capital,” which means different things to different people, and often means silly things to people who teach in business schools, we just don’t use it.

Warren’s definition of behaving in a corporation, so that every dollar retained tends to create more than a dollar of market value for the shareholders, is probably the best way of describing cost of capital. That is not what they mean in business schools.

The answer’s perfectly simple. We’re right and they’re wrong. (Laughter)

WARREN BUFFETT: I look good compared to him, don’t I? (Laughter)