BUFFETT’S LETTERS 2005

Even our insurance business in its entirety did well, though Hurricane Katrina inflicted record losses on both Berkshire and the industry.

I say “estimate” because calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base. (For an explanation of intrinsic value, see pages 77 —78.)

As they finished dinner on their 50th anniversary, however, the wife —stimulated by soft music, wine and candlelight —felt a long-absent tickle and demurely suggested to her husband that they go upstairs and make love. He agonized for a moment and then replied, “I can do one or the other, but not both.”

I particularly liked her penultimate paragraph: “We run a tight ship and keep unnecessary spending under wraps. No secretaries or management layers here. Yet we’ll invest big dollars to gain a technological advantage and move the business forward.”

Today 78, he has built a company that disseminates information in 150 countries for 25,000 clients.

Sid and Steve retain 19% of Applied. They started on a shoestring only 12 years ago, and it will be fun to see what they can accomplish with Berkshire’s backing.

Our advertising works because we have a great story to tell: … Last year, we achieved by far the highest conversion rate —the percentage of internet and phone quotes turned into sales —in our history. This is powerful evidence that our prices are more attractive relative to the competition than ever before.

Indeed, at age 21, I wrote an article about the company —it’s reproduced on page 24 —when its market value was $ 7 million. As you can see, I called GEICO “The Security I Like Best.” And that’s what I still call it. [in Supplements of the book]

Joe, Ajit and I don’t know the answer to these all-important questions. What we do know is that our ignorance means we must follow the course prescribed by Pascal in his famous wager about the existence of God. As you may recall, he concluded that since he didn’t know the answer, his personal gain/ loss ratio dictated an affirmative conclusion. So guided, we’ve concluded that we should now write mega-cat policies only at prices far higher than prevailed last year —and then only with an aggregate exposure that would not cause us distress if shifts in some important variable produce far more costly storms in the near future.

One thing, though, we have learned —the hard way —after many years in the business: Surprises in insurance are far from symmetrical. You are lucky if you get one that is pleasant for every ten that go the other way. Too often, however, insurers react to looming loss problems with optimism.

Our true economic interest, however, is the aforementioned 80.5%,

we will make major moves only when we are unanimous in thinking them wise.

the need of a compensation-conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

(Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

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.

Charlie is fond of quoting Ben Franklin’s “An ounce of prevention is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past.

It’s hard to overemphasize the importance of who is CEO of a company. Before Jim Kilts arrived at Gillette in 2001, the company was struggling, having particularly suffered from capital-allocation blunders.

Upon taking office at Gillette, Jim quickly instilled fiscal discipline, tightened operations and energized marketing, moves that dramatically increased the intrinsic value of the company.

Indeed, it’s difficult to overpay the truly extraordinary CEO of a giant enterprise. But this species is rare.

Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period.

In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we all used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.

Between December 31, 1899 and December 31, 1999, to give a really long-term example, the Dow rose from 66 to 11,497. [5.5%]…This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity.

This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

The befuddled family welcomes this assistance.

Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

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 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.

Here’s the answer to the question posed at the beginning of this section: To get very specific, the Dow increased from 65.73 to 11,497.12 in the 20th century, and that amounts to a gain of 5.3% compounded annually. (Investors would also have received dividends, of course.) To achieve an equal rate of gain in the 21st century, the Dow will have to rise by December 31, 2099 to —brace yourself —precisely 2,011,011.23. But I’m willing to settle for 2,000,000; six years into this century, the Dow has gained not at all.

From a risk standpoint, it is far safer to have earnings from ten diverse and uncorrelated utility operations that cover interest charges by, say, a 2: 1 ratio than it is to have far greater coverage provided by a single utility.

Humans age at greatly varying rates —but sooner or later their talents and vigor decline. Some managers remain effective well into their 80s —Charlie is a wonder at 82 —and others noticeably fade in their 60s. When their abilities ebb, so usually do their powers of self-assessment. Someone else often needs to blow the whistle.

Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests. It would be a tragedy if the philanthropic potential of my holdings was diminished because my associates shirked their responsibility to (tenderly, I hope) show me the door.