What Are the Odds?

“Take the probability times the amount of

possible loss from the probability of gain

times the amount of possible gain. that is

what we are trying to do. its imperfect, but

that's what it is all about.”- Buffett

The Primacy of the Expected Value Table

Wells Fargo

“Our purchases of Wells Fargo in 1990 were helped by a

chaotic market in bank stocks.

The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. “As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. “Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.”

Three Risks:

1. Earthquake2. Systemic

3. Real estate exposure

“Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them.

“A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run.

“Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. “Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.”

“None of these eventualities can be

ruled out. The probability of the

first two occurring, however, is low

and even a meaningful drop in real estate values is

unlikely to cause major problems for

well-managed institutions.

“Consider some mathematics: Wells Fargo currently earns well over

$1 billion pre-tax annually after expensing more than

$300 million for loan losses. If 10% of all $48

billion of the bank's loans - not just its real estate

loans - were hit by problems in 1991, and these produced losses (including foregone

interest) averaging 30% of principal, the company would roughly break

even.”

A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. “In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity.

Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990.

“Even though we had bought some

shares at the prices prevailing before

the fall, we welcomed the

decline because it allowed us to pick

up many more shares at the new,

panic prices.”

Fear is a Foe of the Faddist, but a Friend of the

Fundamentalist.

"The best thing that could happen from our standpoint is to have markets go down a tremendous amount. If you asked us next month whether we'd be better off if the stock market were down 50% or if it remained where it is now, we'd tell you that we'd be better off if it were down 50%. We're going to be buyers of things over time. If we're going to be buyers of groceries over time, we'd like grocery prices to go down. If we're going to be buying cars over time we'd like car prices to go down. We buy businesses. We buy parts of businesses called shares. And we're going to be much better off if we can buy those things at attractive prices than if we can't. We don't have anything to fear. What we fear is a long, sustained, irrational bull market."

“It's not that hard to learn. What is hard is to

get so you use it routinely almost everyday of your life. The Fermat/Pascal system is dramatically

consonant with the way that the world works. And it's fundamental

truth. So you simply have to have the technique.”

Fermat/pascal Letters:http://www.york.ac.uk/depts/maths/histstat/pascal.pdf

Numbers in our words

https://www.e-education.psu.edu/drupal6/files/sgam/Words_Estimative_Probability.pdf

http://en.wikipedia.org/wiki/Words_of_Estimative_Probability

Converting Confidence Level into a Money Bet

Buffett on Debt

Our consistently-conservative financial policies may appear to have been a mistake, but in my view were

not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced

considerably better returns on equity than the 23.8% we have actually

averaged. Even in 1965, perhaps we could have judged there to be a 99%

probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary

anguish and default.

We wouldn't have liked those 99:1 odds

- and never will. A small chance of

distress or disgrace cannot, in our view, be offset by a large

chance of extra returns.

If you hand me a gun metaphor

The Predictables

Severe change and exceptional returns usually don't mix. Most investors, of

course, behave as if just the opposite were

true. That is, they usually confer the

highest price-earnings ratios on exotic-

sounding businesses that hold out the

promise of feverish change.

That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.

“We make bricks in Texas which use the same process

as in Mesopotamia.” - Munger

Warren Buffett has made most of his money in businesses which you may consider as BORING - Carpets, furniture, insurance, candy, cola…

Experience, however, indicates that the

best business returns are usually achieved by companies that

are doing something quite similar today to

what they were doing five or ten

years ago.

That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.

The Fortune study I mentioned earlier

supports our view. Only 25 of the 1,000 companies

met two tests of economic excellence - an average return on equity

of over 20% in the ten years, 1977 through 1986, and no year worse than

15%. These business superstars were also

stock market superstars: During the decade, 24 of the 25 outperformed the

S&P 500.

The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don't need to borrow. Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non- sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.

“After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve

difficult business problems. What we have learned is to avoid them. To the extent

we have been successful, it is because we concentrated

on identifying one-foot hurdles that we could step

over rather than because we acquired any ability to clear

seven-footers.” - Buffett

The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult. - Buffett

Vs.

1998 Meeting:Munger: I’ve heard Warren say since very early in his life that the difference between a good business and a bad one is that a good business throws up one easy decision after another whereas a bad one gives you horrible choices – decisions that are extremely hard to make: “Can it work?” “Is it worth the money?”

One way to determine which is the good business and which is the bad one is to see which one is throwing management bloopers – pleasant, no-brainer decisions – time aftertime after time. For example, it’s not hard for us to decide whether or not we want to open a See’s store in a new shopping center in California. It’s going to succeed. That’s a blooper.

On then other hand, there are plenty of businesses where the decisions that come across your desk are awful. And those businesses, by and large, don’t work very well.

Buffett: I’ve been on the board of Coke for 10 years now. And during that time, we’ve had project after project come up to be reviewed by the board. And they always estimate the ROI – the return on investment. However, it doesn’t make much difference to me – because in the end, almost any decision you make that solidifies and extends Coke’s dominance around the world in a rapidly growing industry that enjoys great inherent profitability is going to be right. And you’ve got people there to execute ‘em well.

Munger: …You get blooper after blooper?

Buffett: Yeah.

Buffett: In contrast, Charlie and I sat on the board of USAir. And there, decisions would come along – and they’d be: “Do you buy the Eastern Shuttle?” And you’re running out of money. And yet, to play the game and keep traffic flows such that it will connect passengers, you just have to continually make these decisions where you spend $100 million more on some airport. You’re in agony – because you don’t have any real choice. And you also don’t have any great conviction that the expenditures are going to translate into real money later on.

So one game is just forcing you to push more money onto the table with no idea of what kind of hand you hold. And in the other you get a chance to push more money in knowing that you’ve got a winning hand all the way.

Investors should remember that

their scorecard is not computed

using Olympic-diving methods:

Degree-of-difficulty doesn't count.

If you are right about a business whose value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables.

On Valuation

The economic value of any asset is essentially the

present value of all future cash flows

going into and out of the business

discounted at the appropriate interest

rate.

There are all kinds of businesses where Charlie and I don’t have the faintest idea what that future steam will look like. And if we don’t have the faintest idea what those streams will look like, then we don’t have the faintest idea what it’s worth today. If you think you know what the price of a stock should be today, but you don’t think you have any idea what the stream of cash will be over the next 20 years, then you’ve got cognitive dissonance.

We’re looking for things where we feel a fairly high degree of probability that we can come within a range of those numbers over a period of time. And then we discount them back. And we’re more concerned with the certainty of those numbers than we are with getting the one that looks absolutely the cheapest, but is based on numbers that we don’t have great confidence in. That’s basically what economic value is all about.

It’s nonsense to get into situations – or to try and

evaluate situations – where we don’t have

any conviction to speak of as to what the future is going to look-like. I

don’t think that you can compensate for that by

having a higher discount rate and saying, “Well, it’s riskier. And I don’t

really know what’s going to happen.

Therefore, I’ll apply a higher discount rate.”

Buffett uses long term treasury bond yield as discount rate for DCF

Bonds inside stocks

Probability Chains

Last year MidAmerican

wrote off a major investment in a zinc recovery

project that was initiated in 1998

and became operational in 2002.

“Large quantities of zinc are present in the brine produced by our California geothermal operations, and we believed we could profitably extract the metal. For many months, it appeared that commercially-viable recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was solved, another popped up. In September, we threw in the towel.

Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%. In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono-linked chains.”

A Chain is weaker than it’s weakest link.

Milestones in Risk Arb

On financing

We prefer to finance in

anticipation of need rather than in

reaction to it. A business obtains the best financial

results possible by managing both

sides of its balance sheet well.

This means obtaining the highest-possible return on assets and the lowest-possible cost on liabilities. It would be convenient if opportunities for intelligent action on both fronts coincided. However, reason tells us that just the opposite is likely to be the case: Tight money conditions, which translate into high costs for liabilities, will create the best opportunities for acquisitions, and cheap money will cause assets to be bid to the sky. Our conclusion: Action on the liability side should sometimes be taken independent of any action on the asset side.

Alas, what is "tight" and "cheap" money is far from clear at

any particular time. We have no ability to forecast interest rates

and - maintaining our usual open-minded spirit -

believe that no one else can.

Therefore, we simply borrow when conditions seem non-oppressive and hope that we will later find intelligent expansion or acquisition opportunities, which - as we have said - are most likely to pop up when conditions in the debt market are clearly oppressive.

Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun.

Our fund-first, buy-or-expand-later policy almost always penalizes near-term earnings. For example, we are now earning about 6 1/2% on the $250 million we recently raised at 10%, a disparity that is currently costing us about $160,000 per week. This negative spread is unimportant to us and will not cause us to stretch for either acquisitions or higher-yielding short-term instruments. If we find the right sort of business elephant within the next five years or so, the wait will have been worthwhile.

On Diversification

Some investment

strategies - for instance, our

efforts in arbitrage over

the years - require wide

diversification.

If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually- independent commitments. Thus, you may consciously purchase a risky investment - one that indeed has a significant possibility of causing loss or injury - if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Most venture capitalists employ this strategy. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.

It is not given to human beings to have such talent that they can just know everything about everything

all the time. But it is given to human beings who work hard at it – who

look and sift the world for a mispriced bet – that they can

occasionally find one. And the wise ones bet heavily when the world

offers them that opportunity. They bet big when they have odds. And the rest of the time, they don’t. It’s

just that simple.

"Our experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical

thing, will often dramatically improve the financial results of that lifetime. A few

major opportunities, clearly recognizable as such, will usually come to one who

continuously searches and waits, with a curious mind, loving diagnosis involving

multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of

prudence and patience in the past."

Exploiting Loss Aversion

The bottom right cell is where insurance is bought. People are willing to pay much more for insurance than expected value—which is how insurance companies cover their costs and make their profits. Here again, people buy more than protection against an unlikely disaster; they eliminate a worry and purchase peace of mind.

This is Buffett’s speciality. He sells overpriced insurance to people in this cell.

On Technology

Betting on Interest Rates