One of the most commonly used terms in the world of investing is – Cost of Capital. According to the Harvard Business Review website: – “The cost of capital is simply the return expected by those who provide capital for the business”. Warren Buffett provides his own explanation for the cost of capital in his Berkshire Hathaway owners manual as:
“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.”
With this in mind, following is a great interaction between Charlie Munger and Professor William Bratton of the Rutgers-Newark School of Law. Munger is quizzing Bratton on his definition of cost of capital. This discussion highlights why you had better know what you’re talking about when discussing investing topics with one of the sharpest minds in investing – Charlie Munger. The interaction is taken from the book – Damn Right: Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger:
Charlie Munger often quotes the late Nobel laureate physicist Richard Feynman, who said the first rule is to not fool yourself, and you are the easiest person to fool. Munger can be merciless if he believes he has caught someone in an act of silly self-deception.
Pity the poor professor who gets caught up in a debate with Munger on the academic treatment of investment policy. Such was the case at The Benjamin Cardozo School of Law in New York City in 1996 when, due to the death of a close friend, the scheduled moderator was unable to attend. Charlie Munger was asked to step in.
Charlie told the audience: “The accidents of mortality have given you a Baptist bumpkin suddenly put in charge of a bunch of Catholic archbishops who are going to debate revisions of the Catholic mass, in Latin. But I figure I could moderate such a convention.”’
It was the panel’s assignment to discuss the research of Professor William Bratton of the Rutgers-Newark School of Law, which dealt with the corporate decision to pay dividends to shareholders rather than reinvest profits. Munger soon nailed Bratton with what he considered a flawed assumption in the research.
Munger: I take it that you believe that there is no one-size-fits-all dividend policy and that you’re with the professor (Jill E. Fisch of Fordham University School of Law) who said yesterday that there wasn’t any one-size-fits-all scheme for corporate governance?
Bratton: On that simple proposition I am entirely in concord with Professor Fisch.
Munger: But you say there is some vaguely established view in economics as to what is an optimal dividend policy or an optimal investment?
Bratton: I think we all know what an optimal investment is.
Munger: No, I do not. At least not as these people use the term.
Bratton: I don’t know it when I see it … but in theory, if I knew it when I saw it this conference would be about me and not about Warren Buffett. I Laughter from the audience]
Munger: What is the break point where a business becomes suboptimal in an ordinary corporation or when an investment becomes suboptimal?
Bratton: When the return on the investment is lower than the cost of capital.
Munger: And what is the cost of capital?
Bratton: Well, that’s a nice one ]Laughter] and I would …
Munger: Well, it’s only fair, if you’re going to use the cost of capital, to say what it is.
Bratton: I would be interested in knowing, we’re talking theoretically.
Munger: No, I want to know what the cost of capital is in the model.
Bratton: In the model? It will just be stated.
Munger: Where? Out of the forehead of job or something?
Bratton: That is correct. I Laughter]
Munger: Well, some of us don’t find this too satisfactory. [Laughter]
Bratton: I said, you’d be a fool to use it as a template for real world investment decision making. [Laughter] They’re only trying to use a particular perspective on human behavior to try to explain things
Munger: But if you explain things in terms of unexplainable subconcepts, what kind of an explanation is that? [Laughter]
Bratton: It’s a social science explanation. You take for what its worth.
Munger: Do you consider it understandable for some people to regard this as gibberish? [Laughter]
Bratton: Perfectly understandable, although I do my best to teach it. [Laughter)
Munger: Why? Why do you do this? [Laughter]
Bratton: It’s in my job description. [Laughter]
Munger: Because other people are teaching it, is what you’re telling me. [Laughter]
The audience laughter points are essential in this exchange, lest it sound like a food fight at a junior high school cafeteria. The bantering was done in a good-natured tone, but the point of the exchange was quite serious. Later, to make sure his comments were not misunderstood, Munger made amends:
I don’t want my remark about the cost of capital to be interpreted as meaning that I think the great bulk of Professor Bratton’s paper is wrong. I think it’s profoundly right. When he talks about agency costs in corporations and the discipline caused by levels of debt and the discipline caused by dividend conventions, I think he is profoundly right. And to the extent that those are the conventional academic explanations, I think it’s wisdom he’s giving. It’s just the cost of capital thing that always makes me go into orbit. [Laughter];
Although he did not say so then, Munger has his own idea of how the cost of investment capital should be measured. Buffett has explained that at Berkshire, the cost of capital is measured by the company’s ability to create more than $1 of value for every $1 of earnings retained. “If we’re keeping $1 bills that would be worth more in your hands than in ours, then we’ve failed to exceed our cost of capital,” Buffett said.
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