The document discusses Warren Buffett's investment strategy of maintaining financial flexibility through proactive financing, allowing Berkshire Hathaway to take advantage of opportunities when credit is tight and asset prices are low, though this strategy may penalize short-term earnings; it also emphasizes focusing investments on simple, predictable businesses rather than complex ventures with many variables.

1. What
Are the
Odds?

2. “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

3. Wells Fargo

4. “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.”

5. Three Risks:
1. Earthquake
2. 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.”

6. “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.

7. “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.

8. “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.”

9. 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."

10. “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

11. Numbers in our
words

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

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

15. Converting Confidence Level into a Money Bet

16. Buffett on Debt

17. 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.

18. 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

19. The Predictables

20. 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.

21. “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…

22. 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.

23. 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.

24. “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

25. 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.

26. 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.

27. On Valuation

28. 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.

29. 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

30. Probability Chains

31. 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

32. On financing

33. 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.

34. 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.

35. 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.

36. On Diversification

37. 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.

38. 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.

39. "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."

40. Exploiting Loss
Aversion

41. 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.

42. On Technology

43. Betting on Interest
Rates