Warren Buffett's Annual Letter: Here Are The Greatest Hits

As always, Warren Buffett has woven some gems into his folksy discussion of Berkshire’s past year and crazy half-century of success.

This year’s letter includes:

  • A body-slam of Wall Street CEOs who refuse to accept any responsibility for the huge risks that destroyed their firms
  • The requisite story of a boneheaded mistake Warren made this year (charming and hardly boneheaded, as always)
  • Advice for companies that actually want to get good advice from Wall Street
  • An explanation of why CEOs are eager to overpay for acquisitions
  • An explanation of how our government’s screwy housing policies are hammering some housing consumers and one of Berkshire’s companies
  • An explanation of why Warren focuses on book value instead of his share price as a measure of his success
  • Highlights of what you’ll be able to do at the Annual Meeting.

Let’s get right to it >

On CEOs who refuse to accept responsibility for risk control

Here's the huge boneheaded mistake I made this year

And now a painful confession: Last year your chairman closed the book on a very expensive business fiasco entirely of his own making.

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.

Source: Warren Buffett's Annual Letter

Here's the first reason CEOs always overpay for acquisitions: It's not their money

Here's the second reason CEOs always overpay for acquisitions: Wall Street gives them crappy advice

How to get good M&A advice from Wall Street

How the government's crazy housing subsidies are hosing low-income homeowners and screwing one of Berkshire's companies

The second reason that manufactured housing is troubled is specific to the industry: the punitive differential in mortgage rates between factory-built homes and site-built homes. Before you read further, let me underscore the obvious: Berkshire has a dog in this fight, and you should therefore assess the commentary that follows with special care. That warning made, however, let me explain why the rate differential causes problems for both large numbers of lower-income Americans and Clayton.

The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 5 1⁄ 4%.

In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.

In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton's homes offer terrific value. If the buyer needs mortgage financing, however -- and, of course, most buyers do -- the difference in financing costs too often negates the attractive price of a factory-built home.

Source: Warren Buffett's Annual Letter

From the start, Charlie and I have believed in having a rational and unbending standard for measuring what we have -- or have not -- accomplished. That keeps us from the temptation of seeing where the arrow of performance lands and then painting the bull's eye around it.

Selecting the S&P 500 as our bogey was an easy choice because our shareholders, at virtually no cost, can
match its performance by holding an index fund. Why should they pay us for merely duplicating that result?

A more difficult decision for us was how to measure the progress of Berkshire versus the S&P. There are
good arguments for simply using the change in our stock price. Over an extended period of time, in fact, that is the best test. But year-to-year market prices can be extraordinarily erratic. Even evaluations covering as long as a decade can be greatly distorted by foolishly high or low prices at the beginning or end of the measurement period. Steve Ballmer, of Microsoft, and Jeff Immelt, of GE, can tell you about that problem, suffering as they do from the nosebleed prices at which their stocks traded when they were handed the managerial baton.

The ideal standard for measuring our yearly progress would be the change in Berkshire's per-share intrinsic
value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93.

Additionally, book value at most companies understates intrinsic value, and that is certainly the case at
Berkshire. In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value -- understated though it is -- supplies the most useful tracking device for changes in intrinsic value. By this measurement, as the opening paragraph of this letter states, our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.

We should note that had we instead chosen market prices as our yardstick, Berkshire's results would
look better, showing a gain since the start of fiscal 1965 of 22% compounded annually. Surprisingly, this modest difference in annual compounding rate leads to an 801,516% market-value gain for the entire 45-year period compared to the book-value gain of 434,057% (shown on page 2). Our market gain is better because in 1965 Berkshire shares sold at an appropriate discount to the book value of its underearning textile assets, whereas today Berkshire shares regularly sell at a premium to the accounting values of its first-class businesses.

Summed up, the table on page 2 conveys three messages, two positive and one hugely negative. First,
we have never had any five-year period beginning with 1965-69 and ending with 2005-09 -- and there have been 41 of these -- during which our gain in book value did not exceed the S&P's gain. Second, though we have lagged the S&P in some years that were positive for the market, we have consistently done better than the S&P in the eleven years during which it delivered negative results. In other words, our defence has been better than our offence, and that's likely to continue.

The big minus is that our performance advantage has shrunk dramatically as our size has grown, an
unpleasant trend that is certain to continue. To be sure, Berkshire has many outstanding businesses and a cadre of truly great managers, operating within an unusual corporate culture that lets them maximise their talents. Charlie and I believe these factors will continue to produce better-than-average results over time. But huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge.

Source: Warren Buffett's Annual Letter

Some highlights of what you'll be able to do at this year's annual meeting

BONUS: Warren playing ping pong against the national junior champion at the 2007 annual meeting

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