Leverage

WARREN BUFFETT: Question is about derivatives. We have in this room the author of the best thing you can read on that. There was an article in Fortune about a month ago or so by Carol Loomis on derivatives, and far and away it’s the best article that has been written. We also have some people in the room that do business in derivatives from Salomon. And it’s a very broad subject. It — as we said last year, I think someone asked what might be the big financial story of the ’90s and we said we obviously don’t know, but that if we had to pick a topic that it could well be derivatives because they lend themselves to the use of unusual amounts of leverage and they’re sometimes not completely understood by the people involved. And any time you combine ignorance and borrowed money — (laughter) — you can get some pretty interesting consequences. (Laughter) Particularly when the numbers get vague. And you’ve seen that, of course, recently with the recent Procter and Gamble announcement. AUDIENCE MEMBER: Mr. Buffett, my name is Bill Ackman. I’m from New York City. And my question relates to the appeal of Salomon Brothers as an investment. You talked earlier about leverage and the dangers of leverage. Salomon is a business which is levered 30-to-1, which has very narrow margins, and earns a relatively modest return on equity, in light of the amount of leverage that they use. What is the appeal of the business to you?

This group of companies sells products ranging from lollipops to jet airplanes. Some of the businesses enjoy terrific economics, measured by earnings on unleveraged net tangible assets that run from 25% after-tax to more than 100%. Others produce good returns in the area of 12-20%. Unfortunately, a few have very poor returns, a result of some serious mistakes I have made in my job of capital allocation. These errors came about because I misjudged either the competitive strength of the business I was purchasing or the future economics of the industry in which it operated. I try to look out ten or twenty years when making an acquisition, but sometimes my eyesight has been poor. Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.