The following list contains the 10 most important pieces of wisdom and information from Warren Buffett’s 2005 letter to the shareholders of Berkshire Hathaway, Inc.  I have also posted the most important “Buffett-isms” from his 2006 and 2007 letters.  I highly recommend that you read those posts. 
If you’ve never read one of these letters, you should make it a priority.  They are often short (this 2005 letter is just 23 pages long).  It takes about 30 minutes to read, but the information you gain is priceless.  Each of the letters, dating back to 1977, is available on the Berkshire Hathaway website in PDF form free of charge.

As I have done previously, the words within quotes are Buffett’s words; the words not in quotes that follow each item–if any–-are my humbled analyses.

1) On his decision to wait several years to sell a failing insurance company: “When a problem exists, whether in personnel or in business operations, the time to act is now.”

Hesitation can be a tragic non-decision.  Too often, as investors and in life, we wait and wait, hoping that a bad course of events will reverse itself.  But the best way to correct a problem is to tackle it right away.  Cut your losses while you can.   

2) “When our long-term competitive position improves as a result of [delighting customers, eliminating unnecessary costs, and improving our products and services], 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.”

A business that isn’t built for the long-term inevitably fails.  The problem with planning for the long-term is that it involves non-sexy things like “eliminating unnecessary costs” and “improving . . . services.”  These tasks build your brand and help establish an identity for your business, and those intangibles are what last longer than any product you sell. 

3) More on widening the moat: “If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.  Take a look at the dilemmas of managers in the auto and airline industries today as they struggle with the huge problems handed them by their predecessors.  Charlie is fond of 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.”

Quoting Benjamin Franklin makes it as clear as it can be.

4) “[E]xecutive compensation in the U.S. is ridiculously out of line with performance.  That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay.  The upshot is that a mediocre-or-worse CEO–aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo–all too often receives gobs of money from an ill-designed compensation arrangement.”

I love Buffett railing against the insane executive compensation we see today.  Most of it, as he points out, is so out of line with the performances of these companies.  It doesn’t make sense, and it seems to rob investors of their money and trust.

5) “Getting fired can produce a particularly bountiful payday for a CEO.  Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker earns in a lifetime of cleaning toilets.  Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all-too-prevalent rule is that nothing succeeds like failure.”

We have seen this phenomenon all too often in corporate America.

6) “The U.S. . . . is extraordinarily rich and will get richer.  As a result, the huge imbalances in its current account may continue for a long time without their having noticeable deleterious effects on the U.S. economy or on markets.  I doubt, however, that the situation will forever remain benign.  Either Americans address the problem soon in a way we select, or at some point the problem will likely address us in an unpleasant way of its own.”

Has this prophecy come to fruition already.  Buffett wrote these words in early 2006.  The state of our economy today and the “imbalances” of our trade deficit seem to be “address[ing] us in an unpleasant way” already. 

7) On shareholders minimizing the returns on their investments: “[T]he most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn.  True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B.  And, yes, all investors feel richer when stocks soar.  But an owner can exit only by having someone take his place.  If one investor sells high, another must buy high.  For owners as a whole, there is simply no magic–no shower of money from outer space–that will enable them to extract wealth from their companies beyond that created by the companies themselves.”

This paragraph is a great, concise explanation of markets and supply and demand.  Investing in stocks isn’t about buying low and selling high, as the large majority of individuals–who think they’re stock investors–try to do.  The “buy, hold, and pray” mentality is a recipe for disaster.  Investing in stocks is about investing in companies, and the return on your investment is directly tied to the wealth those companies create.  Thus, when you invest, it is crucial that you understand what kind of company or business you are investing in and how financially sound it is.

8) On the fact that a record portion of a company’s earnings that would normally go to owners now goes to an army of “Helpers,” or a bureaucratic system of brokers, managers, financial planners, and consultants: “[T]he 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.”

This is a fantastic comment on the price of bureaucracy. 

9) More on the problem with Helpers: “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 can 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.”

10) “[T]he 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.”

Can the Dow–and the wealth of American companies–increase at the same rate again?  Is this 2,000,000 mark achievable?

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