057: Investing Intensive 2002-2006

Table of Contents

1. 2002 Letter
2. 2003 Letter
3. 2004 Letter
4. 2005 Letter
5. 2006 Letter

This issue does not and is not meant to fully summarize or recap the Berkshire Hathaway shareholder letters. Rather, it includes the tidbits I found interesting and wanted to highlight during my reading. Always do your own reading and come to your own conclusions about Mr. Buffett’s opinions.

How to find the quotations: It is difficult to cite specific sections of a given letter because there are no consistent page numbers and the sections are not numbered. The easiest way to find the quote is to open a PDF of the letter and use the search feature.

1. 2002 Berkshire Hathaway Letter, dated February 21, 2003

2002 Letter in PDF from Berkshire Hathaway website

Major Berkshire investments reported in the letter:

Standard of success mentioned at the beginning: net worth, and per-share book value.

Highlights:

  • This letter was about the mistakes of corporate governance, in their own companies and in general.
  • Bought Pampered Chef this year, which has a great origin story, but hasn’t gone that well for them. Another casualty of the internet.
  • He predicted the cause of the coming financial crisis. Soothsayer! “But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind.”
  • Hugely important section on “Corporate Governance.” Accountability and stewardship have been lost in the C-Suite, and boards should have stopped it.
    • I covered his comments about boards extensively in the 1993 Letter summary.
    • This answer isn’t punchy, and it isn’t easily changed with quotas or complex management systems; but it is the correct answer. “Why have intelligent and decent directors failed so miserably? The answer lies not in inadequate laws – it’s always been clear that directors are obligated to represent the interests of shareholders – but rather in what I’d call “boardroom atmosphere.” It’s almost impossible, for example, in a boardroom populated by well-mannered people, to raise the question of whether the CEO should be replaced….My own behavior, I must ruefully add, frequently fell short as well: Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders. In those cases, collegiality trumped independence.” (emphasis mine)
    • One checkpoint: meeting without CEO (and telling us about it). “These “social” difficulties argue for outside directors regularly meeting without the CEO – a reform that is being instituted and that I enthusiastically endorse.”
    • Limited CEO comp: “The acid test for reform will be CEO compensation. Managers will cheerfully agree to board “diversity,” attest to SEC filings and adopt meaningless proposals relating to process. What many will fight, however, is a hard look at their own pay and perks.”
    • Purchased ownership and little board compensation: “…we will add a test that we believe is important, but far from determinative, in fostering independence: We will select directors who have huge and true ownership interests (that is, stock that they or their family have purchased, not been given by Berkshire or received via options), expecting those interests to influence their actions to a degree that dwarfs other considerations such as prestige and board fees…At Berkshire, wanting our fees to be meaningless to our directors, we pay them only a pittance….Basically, we want the behavior of our directors to be driven by the effect their decisions will have on their family’s net worth, not by their compensation. That’s the equation for Charlie and me as managers, and we think it’s the right one for Berkshire directors as well.” (emphasis mine)
    • No D&O insurance (this is extremely weird, and I’m not sure I agree): “Additionally, not wanting to insulate our directors from any corporate disaster we might have, we don’t provide them with officers’ and directors’ liability insurance (an unorthodoxy that, not so incidentally, has saved our shareholders many millions of dollars over the years).”
    • Culture warrior: “Finally, we will continue to have members of the Buffett family on the board. They are not there to run the business after I die, nor will they then receive compensation of any kind. Their purpose is to ensure, for both our shareholders and managers, that Berkshire’s special culture will be nurtured when I’m succeeded by other CEOs.” I’m reminded of Adobe keeping its founder as a board member emeritus, essentially, for this same reason.

Checklist points:

  • Three-legged stool: “Berkshire acquired some important new businesses – with economic characteristics ranging from good to great, run by managers ranging from great to great. Those attributes are two legs of our “entrance” strategy, the third being a sensible purchase price. Unlike LBO operators and private equity firms, we have no “exit” strategy – we buy to keep.” (emphasis mine)
  • Such a great point: look out for the “except for” losses excuse, in any industry. “…in 2002 there was no megacatastrophe, which means that Berkshire (and other insurers as well) earned more from insurance than if losses had been normal. In years when the reverse is true – because of a blockbuster hurricane, earthquake or man-made disaster – many insurers like to report that they would have earned X “except for” the unusual event. The implication is that since such megacats are infrequent, they shouldn’t be counted when “true” earnings are calculated. That is deceptive nonsense. “Except for” losses will forever be part of the insurance business, and they will forever be paid with shareholders’ money.”
  • “…to be a winner, work with winners.”
  • I’ve included all of the following because it’s so valuable. He’s coming off a huge mistake with General Re, and the huge mistake of many others with Enron, and he has clearly reflected on what’s been going wrong in corporations generally. We should take heed. “Three suggestions for investors:
    • First, beware of companies displaying weak accounting. If a company still does not expense options, or if its pension assumptions are fanciful, watch out. When managements take the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom just one cockroach in the kitchen. Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Doing so implies that depreciation is not truly an expense, given that it is a “non-cash” charge. That’s nonsense. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will, that at the beginning of this year a company paid all of its employees for the next ten years of their service (in the way they would lay out cash for a fixed asset to be useful for ten years). In the following nine years, compensation would be a “non-cash” expense – a reduction of a prepaid compensation asset established this year. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?
    • Second, unintelligible footnotes usually indicate untrustworthy management. If you can’t understand a footnote or other managerial explanation, it’s usually because the CEO doesn’t want you to. Enron’s descriptions of certain transactions still baffle me.
    • Finally, be suspicious of companies that trumpet earnings projections and growth expectations. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers). Charlie and I not only don’t know today what our businesses will earn next year – we don’t even know what they will earn next quarter. We are suspicious of those CEOs who regularly claim they do know the future – and we become downright incredulous if they consistently reach their declared targets. Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.” (italics Buffett’s; bolded emphasis mine)

Particular points of candor:

  • Even in a great year, he praised others. “Our marketable securities outperformed most indices. For Lou Simpson, who manages equities at GEICO, this was old stuff. But, for me, it was a welcome change from the last few years, during which my investment record was dismal.”
  • “When I agreed in 1998 to merge Berkshire with Gen Re, I thought that company stuck to the three rules I’ve enumerated. I had studied the operation for decades and had observed underwriting discipline that was consistent and reserving that was conservative. At merger time, I detected no slippage in Gen Re’s standards. I was dead wrong. Gen Re’s culture and practices had substantially changed and unbeknownst to management – and to me – the company was grossly mispricing its current business. In addition, Gen Re had accumulated an aggregation of risks that would have been fatal had, say, terrorists detonated several large-scale nuclear bombs in an attack on the U.S. A disaster of that scope was highly improbable, of course, but it is up to insurers to limit their risks in a manner that leaves their finances rock-solid if the “impossible” happens. Indeed, had Gen Re remained independent, the World Trade Center attack alone would have threatened the company’s existence.” (emphasis mine)
    • What a statement. Management knew the culture had changed, probably, but did not know the lower-levels were mispricing its business. If Warren Buffett himself can be misled, after years of studying a company and then owning it for a few more, who are we to know what’s really going on? It’s a real cautionary tale. He pointed to “culture and practices” having changed, so paying even more attention to them is what I intend to take away from this.
    • It was also the wrong incentives. He said later, “Gen Re’s underwriting attitude has been dramatically altered: The entire organization now understands that we wish to write only properly-priced business, whatever the effect on volume. Joe and Tad judge themselves only by Gen Re’s underwriting profitability. Size simply doesn’t count.” (emphasis mine) Which means that before, they were judged (and probably compensated) on volume.
      • It’s just like another Berkshire investment, the Wells Fargo scandal, in which employees were incentivized to bring in any kind of business, no matter how unreliable. How are employees incentivized? How do they get a bonus? That’s my checklist takeaway.

I was also struck by:

  • This is just nuts. “In 38 years, we’ve never had a single CEO of a subsidiary elect to leave Berkshire to work elsewhere.” I doubt there is a single other public company in the world with that record.
  • These are excellent audit questions and I’m not sure they belong on my investing checklist because I have no way to get the answers, but I want to keep them around anyway.
    • “In my opinion, audit committees can accomplish this goal [of stress-testing the audit] by asking four questions of auditors, the answers to which should be recorded and reported to shareholders. These questions are:
    • 1. If the auditor were solely responsible for preparation of the company’s financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management’s argument and the auditor’s response should be disclosed. The audit committee should then evaluate the facts.
    • 2. If the auditor were an investor, would he have received – in plain English – the information essential to his understanding the company’s financial performance during the reporting period?
    • 3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?
    • 4. Is the auditor aware of any actions – either accounting or operational – that have had the purpose and effect of moving revenues or expenses from one reporting period to another?”

2. 2003 Berkshire Hathaway Letter, dated February 27, 2004

2003 Letter in PDF from Berkshire Hathaway website

Major Berkshire investments reported in the letter:

Standard of success mentioned at the beginning: net worth, and per-share book value.

Highlights:

  • This letter was about a lot of Berkshire housekeeping. Acquisitions, governance, and taxes.
  • After last year’s section on the miscreants running fund-management companies, he reports that it came out that many were indeed profiting at the expense of their investors. “I am on my soapbox now only because the blatant wrongdoing that has occurred has betrayed the trust of so many millions of shareholders. Hundreds of industry insiders had to know what was going on, yet none publicly said a word. It took Eliot Spitzer, and the whistleblowers who aided him, to initiate a housecleaning. We urge fund directors to continue the job. Like directors throughout Corporate America, these fiduciaries must now decide whether their job is to work for owners or for managers.”
  • He was getting pessimistic about the dollar’s prospects. Instructive for now, I think. “During 2002 we entered the foreign currency market for the first time in my life, and in 2003 we enlarged our position, as I became increasingly bearish on the dollar…[in 2002] the dollar’s value began to slide against major currencies. Even so, prevailing exchange rates will not lead to a material letup in our trade deficit. So whether foreign investors like it or not, they will continue to be flooded with dollars. The consequences of this are anybody’s guess. They could, however, be troublesome – and reach, in fact, well beyond currency markets….At yearend, our open foreign exchange contracts totaled about $12 billion at market values and were spread among five currencies. Also, when we were purchasing junk bonds in 2002, we tried when possible to buy issues denominated in Euros. Today, we own about $1 billion of these.”

Checklist points:

  • Can I really understand these financial statements? “If our derivatives experience – and the Freddie Mac shenanigans of mind-blowing size and audacity that were revealed last year – makes you suspicious of accounting in this arena, consider yourself wised up. No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, “Ignorance more frequently begets confidence than does knowledge.””
  • Love this stat, as a general goal – don’t be a broker’s favorite! “We bought some Wells Fargo shares last year. Otherwise, among our six largest holdings, we last changed our position in Coca-Cola in 1994, American Express in 1998, Gillette in 1989, Washington Post in 1973, and Moody’s in 2000. Brokers don’t love us.”

Particular points of candor:

  • Berkshire directors: he asked for shareholders to self-nominate themselves, but then he chose four friends of his instead. I’m sure they’re great choices, but it did strike me as odd that no stranger would be a useful addition to the Berkshire boardroom? It came off, to me, as a bit crony-ish.
    • Additionally, he makes a big point that one of the main roles of a director is to have “the willingness to challenge a forceful CEO when something is wrong or foolish.” Hence, it’s very important that they be independent from the control – financial, social, or otherwise – of the CEO. Then, he writes, “The primary job of our directors is to select my successor, either upon my death or disability, or when I begin to lose my marbles.” Another way to read that is that, while Mr. Buffett is alive and in possession of his faculties, the directors don’t do much. He then went on, “At our directors’ meetings we cover the usual run of housekeeping matters. But the real discussion – both with me in the room and absent – centers on the strengths and weaknesses of the four internal candidates to replace me.” I hope they’re doing more than housekeeping, as the the shareholders’ last line of defense against a potentially running-rampant CEO. He criticized a lot of other unnamed boards for not doing much, and then basically says his own board doesn’t do much.
    • This characterization of the Berkshire board feels like a blind spot, to me. I suspect that, in fact, the Berkshire board does indeed challenge decisions, and maybe that’s what he means by “housekeeping.” Furthermore, I imagine that at the time, there was criticism (as there is now) about not choosing a successor, and this was meant to address that criticism rather than characterize the Berkshire board as yes-men. But it could be read rather unflatteringly.
  • NetJets continued to lose money in Europe.

I was also struck by:

  • Ha! Political burn. ““Victory,” President Kennedy told us after the Bay of Pigs disaster, “has a thousand fathers, but defeat is an orphan.” At [Nebraska Furniture Mart], we knew we had a winner a month after the boffo opening in Kansas City, when our new store attracted an unexpected paternity claim. A speaker there, referring to the Blumkin family, asserted, “They had enough confidence and the policies of the Administration were working such that they were able to provide work for 1,000 of our fellow citizens.” The proud papa at the podium? President George W. Bush.”

3. 2004 Berkshire Hathaway Letter, dated February 28, 2005

2004 Letter in PDF from Berkshire Hathaway website

Major Berkshire investments reported in the letter:

Standard of success mentioned at the beginning: net worth, per-share book value percentage increase, and overall book value (change from per-share book value).

Highlights:

  • This letter was about market moves and more worries about the US dollar.
  • Averages can be misleading. “In one respect, 2004 was a remarkable year for the stock market, a fact buried in the maze of numbers on page 2. If you examine the 35 years since the 1960s ended, you will find that an investor’s return, including dividends, from owning the S&P has averaged 11.2% annually (well above what we expect future returns to be). But if you look for years with returns anywhere close to that 11.2% – say, between 8% and 14% – you will find only one before 2004. In other words, last year’s “normal” return is anything but.”
  • Don’t time the market! (I’m saying this to myself. I’ve unfortunately already learned this lesson and hope to avoid learning it a few more times.) “There have been three primary causes [of poor investment returns]: first, high costs, usually because investors traded excessively or spent far too much on investment management; second, portfolio decisions based on tips and fads rather than on thoughtful, quantified evaluation of businesses; and third, a start-and-stop approach to the market marked by untimely entries (after an advance has been long underway) and exits (after periods of stagnation or decline). Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.”
    • HOWEVER, in the very same letter, then he writes that he regrets not timing the market. Mr. Buffett, he’s just like us. “On a year-to-year basis, however, the business and market performances have often diverged, sometimes to an extraordinary degree. During The Great Bubble, market-value gains far outstripped the performance of the businesses. In the aftermath of the Bubble, the reverse was true. Clearly, Berkshire’s results would have been far better if I had caught this swing of the pendulum. That may seem easy to do when one looks through an always-clean, rear-view mirror. Unfortunately, however, it’s the windshield through which investors must peer, and that glass is invariably fogged. Our huge positions add to the difficulty of our nimbly dancing in and out of holdings as valuations swing. Nevertheless, I can properly be criticized for merely clucking about nose-bleed valuations during the Bubble rather than acting on my views. Though I said at the time that certain of the stocks we held were priced ahead of themselves, I underestimated just how severe the overvaluation was. I talked when I should have walked.”
  • Great way to look at investments. He hasn’t mentioned “look-through earnings” in a few years, but this is a similar way of thinking like an owner. “”Let’s look at how the businesses of our “Big Four” – American Express, Coca-Cola, Gillette and Wells Fargo – have fared since we bought into these companies. As the table shows, we invested $3.83 billion in the four, by way of multiple transactions between May 1988 and October 2003. On a composite basis, our dollar-weighted purchase date is July 1992. By yearend 2004, therefore, we had held these “business interests,” on a weighted basis, about 12½ years. In 2004, Berkshire’s share of the group’s earnings amounted to $1.2 billion.”
  • “…Americans end up owning a reduced portion of our country while non-Americans own a greater part. This force-feeding of American wealth to the rest of the world is now proceeding at the rate of $1.8 billion daily, an increase of 20% since I wrote you last year. Consequently, other countries and their citizens now own a net of about $3 trillion of the U.S. A decade ago their net ownership was negligible….This annual royalty paid the world – which would not disappear unless the U.S. massively underconsumed and began to run consistent and large trade surpluses – would undoubtedly produce significant political unrest in the U.S. Americans would still be living very well, indeed better than now because of the growth in our economy. But they would chafe at the idea of perpetually paying tribute to their creditors and owners abroad. A country that is now aspiring to an “Ownership Society” will not find happiness in – and I’ll use hyperbole here for emphasis – a “Sharecropper’s Society.” But that’s precisely where our trade policies, supported by Republicans and Democrats alike, are taking us.”
    • Overall, what a shift to major macroeconomic pronouncements. He never used to say stuff like this and instead would say it was foolish to give such predictions. It’s quite interesting to watch someone’s evolution from small investor to known investor to market-moving investor. With his platform, he chose to start speaking out.
    • Indeed, he acknowledged as much a few paragraphs later: “And, again, our usual caveat: macro-economics is a tough game in which few people, Charlie and I included, have demonstrated skill. We may well turn out to be wrong in our currency judgments. (Indeed, the fact that so many pundits now predict weakness for the dollar makes us uneasy.) If so, our mistake will be very public. The irony is that if we chose the opposite course, leaving all of Berkshire’s assets in dollars even as they declined significantly in value, no one would notice our mistake.”

Checklist points:

  • Why do most companies not make choices that decrease volume (but long-term increase revenue)? “Most American businesses harbor an “institutional imperative” that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop?…there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves that poorly-priced business must be tolerated in order to keep the organization intact and the distribution system happy. If this course isn’t followed, these employees will argue, the company will not participate in the recovery that they invariably feel is just around the corner….living day after day with dwindling volume – while competitors are boasting of growth and reaping Wall Street’s applause – is an experience few managers can tolerate.” True. Often because shareholders will insist they be dismissed. I wonder if there is another company out there other than Berkshire with a long-term shareholder base.
  • Tool to analyze high-capital businesses. “With this level of capital intensity, FlightSafety requires very high operating margins in order to obtain reasonable returns on capital, which means that utilization rates are all-important.” (emphasis mine)
  • Governance: “Two post-bubble governance reforms have been particularly useful at Berkshire, and I fault myself for not putting them in place many years ago. The first involves regular meetings of directors without the CEO present….The second reform concerns the “whistleblower line,” an arrangement through which employees can send information to me and the board’s audit committee without fear of reprisal.”
  • Questions to ask about the CEO: “First, does the company have the right CEO? Second, is he/she overreaching in terms of compensation? Third, are proposed acquisitions more likely to create or destroy per-share value?”
  • How he view reasonable options incentives. “…my successor at Berkshire may well receive much of his pay via options, albeit logically-structured ones in respect to 1) an appropriate strike price, 2) an escalation in price that reflects the retention of earnings, and 3) a ban on his quickly disposing of any shares purchased through options.”

Particular points of candor:

  • Ha! “I would like to tell you that these [furniture] stores were my idea. In truth, I thought they were mistakes. I knew, of course, how brilliantly Bill Child had run the R. C. Willey operation in Utah, where its market share had long been huge. But I felt our closed-on-Sunday policy would prove disastrous away from home. Even our first out-of-state store in Boise, which was highly successful, left me unconvinced. I kept asking whether Las Vegas residents, conditioned to seven-day-a-week retailers, would adjust to us. Our first Las Vegas store, opened in 2001, answered this question in a resounding manner, immediately becoming our number one unit. Bill and Scott Hymas, his successor as CEO, then proposed a second Las Vegas store, only about 20 minutes away. I felt this expansion would cannibalize the first unit, adding significant costs but only modest sales. The result? Each store is now doing about 26% more volume than any other store in the chain and is consistently showing large year-over-year gains. R. C. Willey will soon open in Reno. Before making this commitment, Bill and Scott again asked for my advice. Initially, I was pretty puffed up about the fact that they were consulting me. But then it dawned on me that the opinion of someone who is always wrong has its own special utility to decisionmakers.”

I was also struck by:

  • Hmmm. Standard corporate indemnity arrangement sounds like a BIG change from his proud statements before that Berkshire carried no D&O insurance for its board members. He snuck it in there. “…the Berkshire board is a model: (a) every director is a member of a family owning at least $4 million of stock; (b) none of these shares were acquired from Berkshire via options or grants; (c) no directors receive committee, consulting or board fees from the company that are more than a tiny portion of their annual income; and (d) although we have a standard corporate indemnity arrangement, we carry no liability insurance for directors.” I’m not entirely clear on what he means, since he has used different terms in this letter than in previous letters to refer to the insurance, but I think it’s safer for Berkshire as an entity to have some protection for its directors.
  • This is just a crazy, sketchy, corporate crap story. Bad faith. “Let’s look at an example [of director self-interest] based upon circumstantial evidence. I have first-hand knowledge of a recent acquisition proposal (not from Berkshire) that was favored by management, blessed by the company’s investment banker and slated to go forward at a price above the level at which the stock had sold for some years (or now sells for). In addition, a number of directors favored the transaction and wanted it proposed to shareholders. Several of their brethren, however, each of whom received board and committee fees totaling about $100,000 annually, scuttled the proposal, which meant that shareholders never learned of this multi-billion offer. Non-management directors owned little stock except for shares they had received from the company. Their open-market purchases in recent years had meanwhile been nominal, even though the stock had sold far below the acquisition price proposed. In other words, these directors didn’t want the shareholders to be offered X even though they had consistently declined the opportunity to buy stock for their own account at a fraction of X. I don’t know which directors opposed letting shareholders see the offer. But I do know that $100,000 is an important portion of the annual income of some of those deemed “independent,” clearly meeting the Matthew 6:21 [“For where your treasure is, there will your heart be also.”] definition of “treasure.” If the deal had gone through, these fees would have ended. Neither the shareholders nor I will ever know what motivated the dissenters. Indeed they themselves will not likely know, given that self-interest inevitably blurs introspection. We do know one thing, though: At the same meeting at which the deal was rejected, the board voted itself a significant increase in directors’ fees.“
  • Cute. “Charlie and I are lucky. We have jobs that we love and are helped every day in a myriad of ways by talented and cheerful associates. No wonder we tap-dance to work. But nothing is more fun for us than getting together with our shareholder-partners at Berkshire’s annual meeting. So join us on April 30 th at the Qwest for our annual Woodstock for Capitalists.”

4. 2005 Berkshire Hathaway Letter, dated February 28, 2006

2005 Letter in PDF from Berkshire Hathaway website

Major Berkshire investments reported in the letter:

Notable: the names on the above list have been steadily growing over the last few years.

Standard of success mentioned at the beginning: net worth, per-share book value, and overall book value.

Highlights:

  • This letter was about Berkshire’s acquisitions and the ups and downs of the stock market. He’s taken to educating a lot more in these letters, I think.
  • Section entitled, “How to Minimize Investment Returns”. Ha! Basically, sell and buy often, and pay commissions for doing so. He made this excellent point: “…a fundamental truth: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.” (emphasis Buffett’s)
    • “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.” (emphasis Buffett’s)

Checklist points:

  • To calculate intrinsic value more precisely: “…a wide variety of relatively-stable earnings streams, combined with great liquidity and minimum debt. These factors mean that Berkshire’s intrinsic value can be more precisely calculated than can the intrinsic value of most companies.”
  • When putting together growth rates for pricing/valuation: “When growth rates are under discussion, it will pay you to be suspicious as to why the beginning and terminal years have been selected. If either year was aberrational, any calculation of growth will be distorted. In particular, a base year in which earnings were poor can produce a breathtaking, but meaningless, growth rate.”
  • How many acquistitions have occurred for stock? “When a management proudly acquires another company for stock, the shareholders of the acquirer are concurrently selling part of their interest in everything they own. I’ve made this kind of deal a few times myself – and, on balance, my actions have cost you money.”
  • Widening the moat for the long-term – and the consequences of not doing so. “Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.” (emphasis mine)

Particular points of candor:

  • “Operating results at NetJets were a different story. I said last year that this business would earn money in 2005 – and I was dead wrong.”

I was also struck by:

  • To continue to hedge against US dollar weakening. “We reduced our direct position in currencies somewhat during 2005. We partially offset this change, however, by purchasing equities whose prices are denominated in a variety of foreign currencies and that earn a large part of their profits internationally. Charlie and I prefer this method of acquiring nondollar exposure.”
  • Ah – so succession HAS been a big question! I thought as much in the 2003 letter. Here, he has an entire section on it, without really providing any concrete response.
  • Very cute. Expands considerably on his blessings enumerated the previous year. “Charlie and I are extraordinarily lucky. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to other people who contribute as much or more to our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped every day in countless ways by talented and cheerful associates. No wonder we tapdance to work. But nothing is more fun for us than getting together with our shareholder-partners at Berkshire’s annual meeting. So join us on May 6 th at the Qwest for our annual Woodstock for Capitalists. We’ll see you there.”

5. 2006 Berkshire Hathaway Letter, dated February 28, 2007

2006 Letter in PDF from Berkshire Hathaway website

Major Berkshire investments reported in the letter:

Standard of success mentioned at the beginning: net worth, per-share book value, and overall book value.

Highlights:

  • This letter was about buying, buying, and more buying – and earnings. It was a big year for Berkshire in every way.
  • Soothsayer! “The slowdown in residential real estate activity stems in part from the weakened lending practices of recent years. The “optional” contracts and “teaser” rates that have been popular have allowed borrowers to make payments in the early years of their mortgages that fall far short of covering normal interest costs. Naturally, there are few defaults when virtually nothing is required of a borrower. As a cynic has said, “A rolling loan gathers no loss.” But payments not made add to principal, and borrowers who can’t afford normal monthly payments early on are hit later with above-normal monthly obligations. This is the Scarlett O’Hara scenario: “I’ll think about that tomorrow.” For many home owners, “tomorrow” has now arrived.”
  • Soothsayer, part two, though we haven’t gotten to the landing yet. “As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high….I want to emphasize that even though our course is unwise, Americans will live better ten or twenty years from now than they do today. Per-capita wealth will increase. But our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual “tribute” so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a “soft landing” seems like wishful thinking.”
    • He bought several non-US companies for the first time, to gain foreign-currency exposure.
  • Here it is – the source saying he did buy options, at least occasionally. “The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts – few in number but sometimes for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are free of counterparty credit risk. So far, these derivative contracts have worked out well for us, producing pre-tax profits in the hundreds of millions of dollars (above and beyond the gains I’ve itemized from forward foreign-exchange contracts). Though we will experience losses from time to time, we are likely to continue to earn – overall – significant profits from mispriced derivatives.”

Checklist points:

  • He connects management incentives to business performance. He doesn’t quite say it, but I conclude, he does not connect them to stock price. “When we use incentives – and these can be large – they are always tied to the operating results for which a given CEO has authority. We issue no lottery tickets that carry payoffs unrelated to business performance. If a CEO bats .300, he gets paid for being a .300 hitter, even if circumstances outside of his control cause Berkshire to perform poorly. And if he bats .150, he doesn’t get a payoff just because the successes of others have enabled Berkshire to prosper mightily.”

Particular points of candor:

  • He’s included Lou Simpson’s investing results at GEICO for a few years now, and starting really praising him. I went back to earlier letters and discovered Lou Simpson was first mentioned in 1982. 1982! And here we are in 2006. The first time Mr. Buffett listed Simpson’s annual returns was in the 2004 letter, and he did so under the beautifully restrained heading, “Portrait of a Disciplined Investor: Lou Simpson”.
    • In this 2006 letter, he for the first time slid in that “At one time, Charlie was my potential replacement for investing, and more recently Lou Simpson has filled that slot.”
    • I’m pointing this out because I think coming up, Simpson left GEICO to go on his own, and that departure made Mr. Buffett never again say the name of a potential successor. We shall read on!

I was also struck by:

  • On looking for an investment successor, with certain qualities. Useful for us to aim to emulate these qualities. “…there is far more to successful longterm investing than brains and performance that has recently been good. Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions. Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.” (emphasis mine)

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