1997: Is it possible to overpay for an "inevitable" business, like Gillette or Coca-Cola?

AUDIENCE MEMBER: Mr. Buffett, my name is Pete Banner (PH) and I’m from Boulder, Colorado, and I’m a shareholder.

Recently [Federal Reserve Chairman] Mr. [Alan] Greenspan made his comments about exuberance. And it wasn’t long thereafter that you came out in the annual report and made your comments that you felt the market was fully valued or something of that nature.

Did you have, or have you had, any communication with Mr. Greenspan regarding the valuation of the stock market?

WARREN BUFFETT: No, the answer to that is no. The last time I — well, I can’t remember precisely when the last time I saw Alan Greenspan was. It was a long time ago.

We had one conversation the day of the Salomon crisis, and he was formerly on the board of Cap Cities before he took his job with the Fed — Cap Cities/ABC — so I knew him then, but —

You know, it’s very hard to understand what Alan says sometimes, so there’s not much sense talking to him, I mean — (Laughter)

He’s very careful about what he says.

But I should — I’m glad you brought up the subject of the annual report. Because what I was doing in the annual report is I had talked about Coke and Gillette as being “The Inevitables,” and what wonderful businesses they were.

And I thought it appropriate, particularly — the report goes to a lot of people — that they would not take that as an unqualified buy recommendation about the companies, because they’re absolutely wonderful companies run by outstanding managers.

But you can pay too much, at least in the short run, for businesses like that. So I thought it was only appropriate to point out that no matter how wonderful a business it is, that there always is a risk that you will pay a price where it will take a few years for the business to catch up with the stock. That the stock can get ahead of the business.

And I don’t know where that point is with those companies or any other companies, but I did say that I thought that the risks were fairly high that that situation existed with most securities in the market, including companies such as “The Inevitables.”

But it was designed to be sure that people did not take the remarks that I made about those companies, and just take that as an unqualified buy recommendation regardless of price.

We have no intention of selling those two stocks. We wouldn’t sell them if they were selling at prices considerably higher than they are now.

But I didn’t want — particularly — relatively unsophisticated people to see those names there and then think, “This guy is touting these as a wonderful buy.” Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10 percent too high or 5 percent too high or something of the sort.

And that’s a philosophy that I came slowly to. I originally was incredibly price conscious. We used to have prayer meetings before we would raise our bid an eighth, you know, around the office. (Laughter)

But that was a mistake. And in some cases, a huge mistake. I mean, we’ve missed things because of that.

And so what I said in the report was not a market prediction in any sense. We never try to predict the stock market.

We do try to price securities. We try to price businesses, is what we try to do. And we find it hard to find wonderful, good, average, substandard businesses that look to us like they’re cheap now. But, you know, you don’t always get a chance to buy things cheap.

Charlie?

CHARLIE MUNGER: Well, I certainly agree with that. (Laughter)

The one thing we can confidently guarantee is that real inflation-adjusted returns from investing in a standard collection of stocks will be lower in the long-term future than they’ve been in the last 15 years or so. This has been an unprecedented period, and there will be some regression toward the mean in average returns from investing in the stock market.

WARREN BUFFETT: American business has done extraordinarily well in the last decade-plus. And that’s a huge plus for securities, because they just represent pieces of those businesses.

Interest rates over the last 15 years have fallen. That’s a big plus for stocks. Anytime interest rates go down, the value of every financial asset goes up, in rational calculation.

Both of those factors have combined in recent years to produce conditions that enhance the true value of American business. But those are pretty widely recognized now, and after a while — Ben Graham always used to say you can get in more trouble in investment with a good premise than with a bad premise, because the bad premise will shout out to you immediately as being fallacious, whereas with a good premise it’ll work for awhile.

You know, businesses are worth more money if interest rates fall and stocks rise. But then eventually the market action of the securities themselves creates its own rationale for a whole — for a large crop of buyers, and people forget about the reasons and the mathematical limitations that were implied in what they — in what got them excited in the first place. And after a while, rising prices themselves alone will keep people excited and cause more people to enter the game.

And therefore the good premise, after a while, is forgotten except for the fact that it produced these rising prices. And the prices themselves take over.

He wrote about that and the connection with the 1920s when Edgar Lawrence Smith in 1924 wrote a fine book on why stocks were better than bonds. And that was sort of the Bible of the bull market of the ’20s, and it made sense, if you paid attention to a couple of the caveats which were in Edgar Lawrence Smith’s little book, which related to price.

But people tend to forget about the importance of the price they pay as the experience of a bull market just sort of dulls the senses generally.