After reading Warren Buffett’s 2007 letter to the shareholders of Berkshire Hathaway, Inc. and posting the 11 most important pieces of wisdom from that letter, I decided to read every single one of his previous letters and do the same thing.  If you’ve never read one of these letters, I highly recommend it.  They are often short (the 2006 letter is just 24 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.

Like I did with Buffett’s 2007 letter, I picked out the most important things in his 2006 letter and listed them below.  As I did 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) The thoughts of Buffett and Charlie Munger (his partner and Berkshire’s vice chairman) on big businesses: “We both grew skeptical about the ability of big entities of any type to function well.  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.’”

Is there any way to stop this?  Is there any way to prevent our creations from dictating our actions?

2) On their insurance holdings: “Don’t think . . . that we have lost our taste for risk.  We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk.  We are not willing, though, to take on even very small exposures at prices that don’t reflect our evaluation of loss probabilities.  Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses. . . . Our behavior . . . parallels that which we employ in financial markets: Be fearful when others are greedy, and be greedy when others are fearful.”

That last line–”Be fearful when others are greedy, and be greedy when others are fearful”–can be applied in any context.  When everyone was buying real estate and jumping into this “flipping” epidemic, you could smell the greed that permeated those actions.  Any smart individual would have feared jumping into the same pool.  Now, however, when everyone is fearful of buying any real estate whatsoever, the smart investor is greedy . . . greedy for the opportunities that abound.

The same is true of the tech boom in the late 1990s.  When everyone was buying tech stocks, you could feel the greed in the air.  Tech stock prices were at all-time highs, and, yet, people kept buying.  The smart investor sat back, fearful of such speculation.  Then, when those stock prices plummeted, and investors became fearful of selling, and outsiders were fearful of jumping into the market, the smart investor became greedy . . . greedy for the bargains that were plentiful.

3) On the decline of 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.  (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 . . . .  The skid will almost certainly continue.”

4) More on the newspaper industry: “[A]lmost all newspaper owners realize that they are constantly losing ground in the battle for eyeballs.  Simply put, if cable and satellite broadcasting, as well as the internet, had come along first, newspapers as we know them probably would never have existed.”

5) On newspaper ownership: “We are likely . . . to see non-economic individual buyers of newspapers emerge, just as we have seen such buyers acquire major sports franchises.  Aspiring press lords should be careful, however: There’s no rule that says a newspaper’s revenues can’t fall below its expenses and that losses can’t mushroom. . . . As the importance of newspapers diminishes . . . the ‘psychic’ value of possessing one will wane, whereas owning a sports franchise will likely retain its cachet.”

Who would have ever thought that owning a sports franchise would be more profitable than owning a newspaper?

6) On the real estate bubble: “The slowdown in residential real estate activity stems in part from the weakened lending practices of recent years.  The ‘optional’ contracts and ‘teaser’ rates that have been popular have allowed borrowers to make payments in the early years of their mortgages that fall far short of covering normal interest costs.  Naturally, there are few defaults when virtually nothing is required of a borrower.  As a cynic has said, ‘A rolling loan gathers no loss.’  But payments not made add to principal, and borrowers who can’t afford normal monthly payments early on are hit later with above-normal monthly obligations.  This is the Scarlett O’Hara scenario: ‘I’ll think about that tomorrow.’  For many home owners, ‘tomorrow’ has arrived.”

When I read the Scarlett O’Hara quote, I tried desperately to remember when, in the movie Gone With The Wind, she said that.  I could not remember . . . probably because I never liked that movie at all.  But this concept is very important.  We can only put off so much until tomorrow.  We can only procrastinate so much.  Eventually, “tomorrow” will arrive, and our obligations will come to fruition.

7) On U.S. trade problems and the weakening dollar: “[T]he U.S. had $.76 trillion of pseudo-trade last year–imports for which we exchanged no goods or services.  (Ponder, for a moment, how commentators would describe the situation if our imports were $.76 trillion–a full 6% of GDP–and we had noexports.)  Making these purchases that weren’t reciprocated by sales, the U.S. necessarily transferred ownership of its assets or IOUs to the rest of the world.  Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced.”

8) More on U.S. spending problems: “Foreigners now earn more on their U.S. investments than we do on our investments abroad.  In effect, we’ve used up our bank account and turned to our credit card.  And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest.”

I can’t think of a better analogy to summarize America’s financial problems.  The U.S. has “turned to our credit card.”  Any understanding of how reliance on credits dooms an individual should inform us, generally, about where we are headed financially as a country.

9) Some bittersweet optimism about the future: “[E]ven though our course is unwise, Americans will live better ten or twenty years from now than they do today. . . . 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. . . . [A]t 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.”

This is an amazing prophecy . . . and one that will, indeed, occur.  It may not be for another 10 or 20 years, but these words will resonate for years to come. 

10) “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.”

11) “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.”

12) “[O]ur 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?’”

Knowing Warren Buffett’s political orientation, I was surprised–in this statement–to see him eschew political contrivances in favor of sound business principles.  Then again, why am I surprised?  Any businessman who elevates politics above sound financial principles would not be anywhere near as successful as Buffett. 

13) “In 2006 . . . . [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.”

Is this an endorsement of index funds?  I think so.  Read my post about the superiority of index funds to mutual funds.

14) “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.”

I can’t think of a better way to emphasize that each person should focus on his or her own financial education and not rely on the supposed wisdom or experience of others.

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