Thursday, March 1, 2007

Buffett's 2006 Annual Report

Warren Buffet's 2006 Annual Letter was unleashed today at 4pm. Having just read the bulk of the report, I decided to note some of points of interest from Buffett himself in this year's report. All emphasis is purely mine, but the words are directly from Buffett himself.

Buffett made the following statement on the nature of the insurance business, but I think it bodes well for all types of business operations and especially, investing.

"Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses"

Regarding the newspaper industry,

"When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. 'If you want a reputation of being a good businessman, get into a good business'”

Buffett, as he's done in recent, years, comments on the United States economic standing and its trade mechanisms. Pay note to what he says at the end here
"The investment income account of our country – positive in every year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than Americans on their investments abroad. Like a wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than what we produced."

"It won’t be pleasant to work every day to pay for the over consumption of your ancestors. I believe at some point in the future U.S. workers and voters will find this annual tribute so onerous that there will be a significant political backlash. How that will play out in the market is impossible to predict – but to expect a soft landing seems like wishful thinking."

The following remarks concern succession at Berkshire Hathaway. To my knowledge, this is the first time (someone kindly correct me if I am wrong) that Buffett's alludes to the hiring of someone to be the chief investment officer at Berkshire.

"I have told you that Berkshire has three outstanding candidates to replace me as CEO…

Frankly we are not as well prepared on the investment side of our business. Lou [Simpson] is a top notch investor with an outstanding long-term record of managing GEICO’s equity portfolio. But he is only six years younger than I…For the long-term, though, we need a different answer.

I intend to hire a young man or woman with the potential to manage a very large portfolio, who we hope will succeed me as Berkshire’s chief investment officer.

Picking the right person will not be an easy task. It’s not hard, of course, to find smart people, among them individuals who have impressive investment records. But there is far more to successful long-term 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.

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."

The qualifications that Buffett is looking for are specific and unique amongst the vast pool of money managers today. It is my guess that whomever assumes the privilege of filling Buffett's shoes will be someone whom the investment community is generally unaware.

Over the last year, I have had the great privilege of meeting, working with , and hearing some very talented money managers, who in their efforts to create value and preserve capital, exemplify the qualities that Buffett is seeking. Names that quickly come to mind: Mohnish Pabrai (Pabrai Investment Funds), Bahman Mossavar-Rahmani (UAS Asset Management), Bill Miller (Legg Mason), and Mason Hawkins (Longleaf). These individuals, along with others of course, all operate via different vehicles--funds, partnerships, individual accounts, etc.--but they all have demonstrated a knack for seeing the big picture that Buffett is talking about. And the thing is, you can't just sit down and say you want to learn how to see the big picture...that ability develops through the unique experience of these Buffett said "genetically wired."

Below, Buffett comments on executive pay and fees charged by hedge funds. Buffett has made clear his thoughts on this matter over the years...need I say more?

Compensation reform will only occur if the largest institutional shareholders – it would only take a few – demand a fresh look at the whole system. The consultants’ present drill of deftly selecting “peer” companies to compare with their clients will only perpetuate present excesses

Although Buffett is critical of the 2 and 20 fees, the fees may be justified by those talented individuals who are truly creating value for their investor. And they exist, you just have to find them.

"In 2006, promises and fees hit new highs. A flood of money went from institutional investors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you a bundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. For example, a manager who achieves a gross return of 10% in a year will keep 3.6 percentage points – two points off the top plus 20% of the residual 8 points – leaving only 6.4 percentage points for his investors. On a $3 billion fund, this 6.4% net “performance” will deliver the manager a cool $108 million. He will receive this bonanza even though an index fund might have returned 15% to investors in the same period and charged them only a token fee."

And finally...

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.

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