BUFFETT’S LETTERS 2006

Size seems to make many organizations slow-thinking, resistant to change and smug. In Churchill’s words: “We shape our buildings, and afterwards our buildings shape us.” Here’s a telling fact: Of the ten non-oil companies having the largest market capitalization in 1965 —titans such as General Motors, Sears, DuPont and Eastman Kodak —only one made the 2006 list.

I know I wouldn’t enjoy many of the duties that come with their positions —meetings, speeches, foreign travel, the charity circuit and governmental relations. For me, Ronald Reagan had it right: “It’s probably true that hard work never killed anyone —but why take the chance?”

My only tasks are to cheer them on, sculpt and harden our corporate culture, and make major capital-allocation decisions. Our managers have returned this trust by working hard and effectively.

Charlie and I measure Berkshire’s progress and evaluate its intrinsic value in a number of ways. No single criterion is effective in doing these jobs, and even an avalanche of statistics will not capture some factors that are important. For example, it’s essential that we have managers much younger than I available to succeed me. Berkshire has never been in better shape in this regard —but I can’t prove it to you with numbers.

The result: ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success.

I am proud of our past and excited about our future.

Lumping their financial figures together impedes analysis.

Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses. Rates have recently fallen because a flood of capital has entered the super-cat field. We have therefore sharply reduced our wind exposures. Our behavior here parallels that which we employ in financial markets: Be fearful when others are greedy, and be greedy when others are fearful.

Lloyd’s, Equitas and Retroactive Reinsurance [great story ]

In 1688, Edward Lloyd opened a coffee shop where some capitalists became known as “underwriters at Lloyd’s.” … True, prospective names were always solemnly told that they would have unlimited and everlasting liability for the consequences of their syndicate’s underwriting —“down to the last cufflink,” as the quaint description went. But that warning came to be viewed as perfunctory. Three hundred years of retained cufflinks acted as a powerful sedative to the names poised to sign up. … then came asbestos in 1980s. … The specter of unending and unlimited losses terrified existing names and scared away prospects. Many names opted for bankruptcy; some even chose suicide. … From these shambles, there came a desperate effort to resuscitate Lloyd’s. Euitas formed. … But the new plan, by concentrating all of the liabilities in one place, had the advantage of eliminating much of the costly intramural squabbling that went on among syndicates.

if Equitas would give us $ 7.12 billion in cash and securities (this is the float I spoke about), we would pay all of its future claims and expenses up to $ 13.9 billion. That amount was $ 5.7 billion above what Equitas had recently guessed its ultimate liabilities to be. …Scott Moser, the CEO of Equitas, summarized the transaction neatly: “Names wanted to sleep easy at night, and we think we’ve just bought them the world’s best mattress.”

We sometimes encounter accounting footnotes about important transactions that leave us baffled, and we go away suspicious that the reporting company wished it that way. (For example, try comprehending transactions “described” in the old 10-Ks of Enron, even after you know how the movie ended.)

What’s important to remember is that retroactive insurance contracts always produce underwriting losses for us. Whether these losses are worth experiencing depends on whether the cash we have received produces investment income that exceeds the losses.

Manufacturing, Service and Retailing Operations; r/e:10%; debt 50%; pm: 3-5%;

This motley group, which sells products ranging from lollipops to motor homes, earned a pleasing 25% on average tangible net worth last year. …the earnings on our average carrying value to 10.8%.

MiTek, example of interest-motivated management. 55 employees bought 5%; Five years later, MiTek’s sales have tripled and the stock is valued more than septuple (7 times).

When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. (As a wise friend told me long ago, “If you want to get a reputation as a good businessman, be sure to get into a good business.”) And fundamentals are definitely eroding in the newspaper industry, a trend that has caused the profits of our Buffalo News to decline. The skid will almost certainly continue.

As one not-too-bright publisher famously said, “I owe my fortune to two great American institutions: monopoly and nepotism.” No paper in a one-paper city, however bad the product or however inept the management, could avoid gushing profits.

The industry’s staggering returns could be simply explained.

This circularity led to a law of the newspaper jungle: Survival of the Fattest. [赢家通吃]

(Interestingly, though papers regularly —and often in a disapproving way —reported on the profitability of, say, the auto or steel industries, they never enlightened readers about their own Midas-like situation. Hmmm . . .) [Midas Touch, golden touch]

Some publishers took umbrage at both this remark and other warnings from me that followed.

Unless we face an irreversible cash drain, we will stick with the News, just as we’ve said that we would. (Read economic principle 11, on page 76.)Charlie and I love newspapers —we each read five a day —and believe that a free and energetic press is a key ingredient for maintaining a great democracy. We hope that some combination of print and online will ward off economic doomsday for newspapers, and we will work hard in Buffalo to develop a sustainable business model. I think we will be successful.

Revenues from flight operations have increased 596% since our purchase in 1998. But profits had been erratic.

Somewhat incongruously, MidAmerican owns the second largest real estate brokerage firm in the U.S., HomeServices of America.

Clayton Homes remains an anomaly in the manufactured-housing industry,

Last year, we told you that our expectation was that these companies, in aggregate, would increase their earnings by 6% to 8% annually, a rate that would double their earnings every ten years or so. In 2006 American Express, Coca-Cola, Procter & Gamble and Wells Fargo, our largest holdings, increased per-share earnings by 18%, 9%, 8% and 11%. These are stellar results, and we thank their CEOs.

As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. I fervently believe in real trade —the more the better for both us and the world.

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.

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. Finally, we have a special problem to consider: our ability to keep the person we hire. Being able to list Berkshire on a resume would materially enhance the marketability of an investment manager. We will need, therefore, to be sure we can retain our choice, even though he or she could leave and make much more money elsewhere.

In selecting a new director, we were guided by our long-standing criteria, which are that board members be owner-oriented, business-savvy, interested and truly independent.

Charlie and I believe our four criteria are essential if directors are to do their job —which, by law, is to faithfully represent owners. Yet these criteria are usually ignored. Instead, consultants and CEOs seeking board candidates will often say, “We’re looking for a woman,” or “a Hispanic,” or “someone from abroad,” or what have you. It sometimes sounds as if the mission is to stock Noah’s ark. Over the years I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like an intelligent owner?

Susan Decker, CFO of Yahoo!, … She scores very high on our four criteria and additionally, at 44, is young —an attribute, as you may have noticed, that your Chairman has long lacked.

Corporate bigwigs often complain about government spending, criticizing bureaucrats who they say spend taxpayers’ money differently from how they would if it were their own. But sometimes the financial behavior of executives will also vary based on whose wallet is getting depleted.

Every now and then Charlie and I catch on early to a tide-like trend, one brimming over with commercial promise. For example, though American Airlines (with its “miles”) and American Express (with credit card points) are credited as being trailblazers in granting customers “rewards,” Charlie and I were far ahead of them in spotting the appeal of this powerful idea.

Our catalog of rewards was 116 pages thick and chock full of tantalizing items. When I was told that even certain brothels and mortuaries gave stamps to their patrons, I felt I had finally found a sure thing.

Well, not quite. From the day Charlie and I stepped into the Blue Chip picture, the business went straight downhill. By 1980, sales had fallen to $ 19.4 million. And, by 1990, sales were bumping along at $ 1.5 million. No quitter, I redoubled my managerial efforts. Sales then fell another 98%. Last year, in Berkshire’s $ 98 billion of revenues, all of $ 25,920 (no zeros omitted) came from Blue Chip. Ever hopeful, Charlie and I soldier on.

My ostracism has been peculiar, considering that I certainly haven’t lacked experience in setting CEO pay. At Berkshire, after all, I am a one-man compensation committee who determines the salaries and incentives for the CEOs of around 40 significant operating businesses. … How much time does this aspect of my job take? Virtually none. How many CEOs have voluntarily left us for other jobs in our 42-year history? Precisely none.

CEO perks at one company are quickly copied elsewhere. “All the other kids have one” may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees.

I’ve set this schedule because I want the money to be spent relatively promptly by people I know to be capable, vigorous and motivated. These managerial attributes sometimes wane as institutions —particularly those that are exempt from market forces —age.

In last year’s report I allegorically described the Gotrocks family —a clan that owned all of America’s businesses

It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing

The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these “hyper-helpers.” Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellow with experience ends up with the money.

When Walter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.

Walter meanwhile went on overperforming, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.