Excerpts from Warren Buffet’s 2005 letter to shareholders

March 08th, 2006 - 6 Comments

There’s no one better to learn about long-term investing from than Warren Buffet. As usual, his 2005 letter to shareholders tells the straight-up truth. What a novel concept–being honest about where you made and lost money to your shareholders! WARREN WHERE DID YOU LEARN THAT?!

Excerpts from his 2005 letter to shareholders (PDF):

On moving quickly
“Forest River, our second acquisition, closed on August 31. A couple of months earlier, on 21, I received a two-page fax telling me – point by point – why Forest River met the acquisition criteria we set forth on page 25 of this report. I had not before heard of the company, recreational vehicle manufacturer with $1.6 billion of sales, nor of Pete Liegl, its owner manager. But the fax made sense, and I immediately asked for more figures. These came the morning, and that afternoon I made Pete an offer.

On honesty
“The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation.”

On telling jokes in a goddamn financial statement (I love Warren Buffet so much)
“When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

On pointing out how crooked many “experts” are
“It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in value that occurs when earnings are retained. But – surprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists.”

On fees and why they are stupid
“Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have. To understand how this toll has ballooned, imagine for a

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new “beatmy-brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch zombies?”

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with selfconfidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives. The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the 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.”

On philanthropy
“Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests.”

Read Warren Buffet’s full 2005 2005 letter to shareholders (PDF).

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6 Comments

 

Comments

  1. There’s no question in my mind about Buffet’s brilliance, but if these “Helpers” were not somehow creating value, how is it the likes of Goldman, Lehman, etc continue to exist in the long term?

  2. I really enjoyed the “On fees and why they are stupid” story. It’s not just fees that he’s railing against, however, it’s also the short-term mindset toward investing that is taken by so many Americans these days – not ‘short-term’ in the “I should buy bonds” sense, rather ‘short-term’ in the “I can make a lot of dough by day trading even though I know nothing about investing” sense.

  3. The financial services industry exists because society needs a way to allocate capital and risk.

    Warren’s analogy is quite correct in one sense, but flawed in another.

    Take the startup world. Most entrepreneurs are not wealthy enough to fund their own companies. They need access to someone else’s capital. However, there are very few individuals or organizations that would write $5 million checks to people with ideas. Thus the Venture Capital industry was born. VCs act as middlemen between the limited partners (LPs) with the dough, and the entrepreneurs who need it to start their companies.

    While I agree that intermediaries add little value, there is no better way to allocate money.

    On the other hand, Warren’s argument is spot on when it comes to hedge funds, who focus solely on the zero-sum game of trading public securities.

    By definition, for every hedged trade that delivers a profit to the LPs, someone else is losing the equivalent amount of money. In this case, Warren’s analogy is 100% correct. We would all be better off with passive index investing.

  4. All his money really is going to philantrophies

  5. Wasn’t Warren the general partner of an investment company in the 1960s where he charged his limited partners 25% of the earnings over 6%? How is that different from when he says, “Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky.”

    Does he not make a salary as CEO of Berkshire Hathaway in which he acts as a middleman between his shareholders and the companies that Berkshire Hathaway invests and/or buys?

  6. Hey Kevin – Yup, but:

    1. He agreed to make up any losses plus 6% compounded per year before earning that 25%. So if he lost 10% one year he’d have to gain back like 16.~% before making any money the next year.
    2. He had his own money on the line, invested with his partners, so if they lost money so did he.
    3. His salary from Berkshire is $100,000 per year or something very close to that (I forgot, read all the letters if you want to know) – that’s a pittance for a CEO of an almost $200 Billion public company.

    Thanks for trying, though.