10 lessons from Warren Buffett’s annual letter to shareholders

It’s a big day for Warren Buffett’s countless disciples around the world. The release of the Berkshire Hathaway chairman’s annual letter to shareholders give Warren-watchers a chance to sift through the wit and wisdom of the Oracle of Omaha, looking for trends, investment recommendations and the usual corny gags.

Unlike last year, when Berkshire was being buffeted by the global financial crisis, Buffett had some good news for investors this year, with Berkshire posting a $US8.1 billion profit for calendar 2009 up from $US5 billion a year ago.

Here are 10 nuggets from Buffett’s annual missive.

If you want to know how the real value of your business (or investment), look into the future

“Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding.”

“Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable.”

The value of autonomy

“We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted.”

“We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy.”

Why older doesn’t always mean wiser

“For many years I had struggled to think of side products that we could offer our millions of loyal GEICO customers. Unfortunately, I finally succeeded, coming up with a brilliant insight that we should market our own credit card. I reasoned that GEICO policyholders were likely to be good credit risks and, assuming we offered an attractive card, would likely favour us with their business. We got business all right – but of the wrong type.”

“Our pre-tax losses from credit-card operations came to about $6.3 million before I finally woke up. We then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million.”

“GEICO’s managers, it should be emphasised, were never enthusiastic about my idea. They warned me that instead of getting the cream of GEICO’s customers we would get the… well, let’s call it the non-cream. I subtly indicated that I was older and wiser.”

“I was just older.”

How to solve America’s oversupply of houses

“There were three ways to cure this overhang: (1) blow up a lot of houses, a tactic similar to the destruction of autos that occurred with the “cash-for-clunkers” program; (2) speed up household formations by, say, encouraging teenagers to cohabitate, a program not likely to suffer from a lack of volunteers or; (3) reduce new housing starts to a number far below the rate of household formations.”

“Our country has wisely selected the third option, which means that within a year or so residential
housing problems should largely be behind us, the exceptions being only high-value houses and those in certain localities where overbuilding was particularly egregious.”

“Prices will remain far below “bubble” levels, of course, but for every seller (or lender) hurt by this there will be a buyer who benefits. Indeed, many families that couldn’t afford to buy an appropriate home a few years ago now find it well within their means because the bubble burst.”

Why you should always make the most of an opportunity

“We told you last year that very unusual conditions then existed in the corporate and municipal bond markets and that these securities were ridiculously cheap relative to US Treasuries. We backed this view with some purchases, but I should have done far more. Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.”

Why timing is everything is investing

“We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: a climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance.”

“In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.”

Why CEOs must take ultimate responsibility for risk management

“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the Government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.”

Why CEOs and directors need to be taught a lesson from the GFC

“The CEOs and directors of the failed companies, however, have largely gone unscathed. Their fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behaviour of these CEOs and directors that needs to be changed. If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance.”

“CEOs and, in many cases, directors have long benefitted from oversized financial carrots; some meaningful sticks now need to be part of their employment picture as well.”

Why the right type of shareholders are crucial

“Investors who buy and sell based upon media or analyst commentary are not for us. Instead we want partners who join us at Berkshire because they wish to make a long-term investment in a business they themselves understand and because it’s one that follows policies with which they concur. If Charlie and I were to go into a small venture with a few partners, we would seek individuals in sync with us, knowing that common goals and a shared destiny make for a happy business “marriage” between owners and managers. Scaling up to giant size doesn’t change that truth.”

Why mergers and acquisitions should be approached with caution

“I have been in dozens of board meetings in which acquisitions have been deliberated, often with the directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is worth far more than its market price. In more than 50 years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given.”

“Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through. Absent this drastic remedy, our recommendation in respect to the use of advisors remains: ‘Don’t ask the barber whether you need a haircut.'”