Buffett’s Letter

On Saturday, Warren Buffett published his annual letter to his shareholders.  It’s about 25 pages long and reviews Berkshire’s businesses.  While most of you don’t have interest in Berkshire’s individual businesses, there are loads of great takeaways in the letter, including his optimistic view of the future.  Here are some of them – most of these (but not all) are his exact words.

1.     The general business climate in 2011 will be somewhat better than 2010 but weaker than 2005 or 2006.


2.     In the past two years, when people were most scared, Berkshire invested $14 billion.  Most of this was invested in the US.


3.     There is an abundance of opportunity in America.


4.     Tomorrow is always uncertain.  Think of Dec. 6, 1941, Oct. 18, 1987 and September 10, 2001.


5.     The prophets of doom have overlooked the all-important factor that is certain: human potential is far from exhausted and the American system for unleashing that potential – a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War – remains alive and effective.


6.     America’s best days lie ahead.


7.     Management needs performance goals.  Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull’s-eye around wherever it lands.


8.     When calculating the intrinsic value of a company, you consider the assets in place and the efficacy with which retained earnings will be deployed in the future.  If a CEO does his job well, the reinvestment process adds value; if the CEO’s talents or motives are suspect, today’s value must be discounted.


9.     Berkshire is looking for acquisitions.  “Our elephant gun has been reloaded, and my trigger finger is itchy.”


10. Our trust is in people rather than process.


11. Many companies limit themselves to reinvesting funds within the industry in which they have been operating.  That often restricts them, however, to a universe for capital allocation that is both tiny and quite inferior.  Competition for a few opportunities is fierce.  (He analogized the situation to a party in which there are many boys and just one girl.)


12. You must evaluate the attractions of one business against a host of others.  In addition, you must compare it to marketable securities.


13. Buffett always talks about the beauty of the insurance business.  The goal is for the underwriting process to break even (where the premiums cover the future insurance losses).  If an insurance company can do that, they have the use of the money (called float) for free.  (Of course, if you can create an underwriting profit plus have the float, that’s even better.)  Berkshire has $66 billion of float – think of that as free money.  In addition, they have been running an underwriting profit.


14. A housing recovery will probably begin within a year or so.  In any event, it is certain to occur at some point.


15. One of Berkshire’s companies is Clayton Homes.  They own over 200,000 mortgages.  At the time these mortgages were originated, the average FICO score was 648 and 47% had a FICO score of 640 or lower.  Yet, their loss rates have been less than 2% in each year.  If you loan money to people who want to stay in their homes, the borrowers only borrow sensible amounts relative to their income, they make a significant downpayment and you are sensible in making loans (because you’re not going to sell the loans so that they can be securitized), problems shouldn’t occur.


16. Home ownership makes sense for most Americans, particularly at today’s lower prices and bargain interest rates.


17. But, a house can be a nightmare if the buyer’s eyes are bigger than his wallet and if a lender – often protected by a government guarantee – facilitates his fantasy.  Our country’s social goal should not be to put families into the house of their dreams, but rather to put them into a house that they can afford.


18. Buffett discussed the fact that the two best investments he ever made were wedding rings.  If Jenny ever found out about a second wedding ring, that first ring would turn out to be particularly expensive for me.  But, like Buffett, I’d also say that my wedding ring was my best investment.  Jenny, however, says that it evidences the fact that there’s a winner and a loser in every transaction.


19. Money-market yields are unlikely to increase significantly in the short-term.


20. The Fed has frozen dividend levels at major banks, whether strong or weak, during the last two years.  That made sense.  But, the Fed is likely to ease these restrictions in the near future.


21. Buffett looks for investment managers who understand risk.  He said that risk is not beta.  Understanding risk is the ability to anticipate the effects of economic scenarios not previously observed.


22. The hedge fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains.  Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses.  Investors who put money with such managers should be labeled patsies, not partners.


23. Buffett believes that the Black-Scholes option pricing model produces wildly inappropriate values when applied to long-dated options.


24. John Kenneth Galbraith once slyly observed that economists were most economical with ideas: they made the ones learned in graduate school last a lifetime.  University finance departments often behave similarly.  Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refuted it “anomalies.”  (Buffett continued, “I always love explanations of that kind: the Flat Earth Society probably views a ship’s circling of the globe as an annoying, but inconsequential anomaly.”)


25. Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination.  For that matter, so does the academic’s inclination to dwell on the valuation of options.  You can be highly successful as an investor without having the slightest ability to value an option.  What students should be learning is how to value a business.  That’s what investing is all about.


26. The assumption that a company can refinance debt is normally valid.  But, sometimes it isn’t valid – due to either company-specific problems or a worldwide shortage of credit.  When that happens, it can bring a company to its knees.


27. Quoting investment writer Ray DeVoe, “more money has been lost reaching for yield than at the point of a gun.”


28. We can afford to lose money – even a lot of money.  But we can’t afford to lose reputation – even a shred of reputation.


29. Sometimes, your associates will say, “everybody else is doing it.”  This rationale is almost always a bad one if it is the main justification for a business action.  It is totally unacceptable when evaluating a moral decision.  Whenever somebody offers that phrase as a rationale, in effect they are saying that they can’t come up with a good reason.  If anyone gives this explanation, tell them to try using it with a reporter or a judge and see how far it gets them.


30. Let me know promptly if there’s any significant bad news.  I can handle bad news but I don’t like to deal with it after it has festered for a while.


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