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03/10/2006

Warren Buffett on Investing

Investors get a kick out of Warren Buffett’s annual letter to
shareholders of Berkshire Hathaway so I thought I’d put up some
of his musings. Financial advisers, mutual fund companies and
hedge funds can’t be too happy with his conclusions on the
money management industry.

---

The attitude of our managers vividly contrasts with that of the
young man who married a tycoon’s only child, a decidedly
homely and dull lass. Relieved, the father called in his new son-
in-law after the wedding and began to discuss the future:

“Son, you’re the boy I always wanted and never had. Here’s a
stock certificate for 50% of the company. You’re my equal
partner from now on.”

“Thanks, dad.”

“Now, what would you like to run? How about sales?”

“I’m afraid I couldn’t sell water to a man crawling in the
Sahara.”

“Well then, how about heading human relations?”

“I really don’t care for people.”

“No problem, we have lots of other spots in the business. What
would you like to do?”

“Actually, nothing appeals to me. Why don’t you just buy me
out?”

--

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.

Huge severance payments, lavish perks and outsized payments
for ho-hum performance often occur because comp committees
have become slaves to comparative data. The drill is simple:
Three or so directors – not chosen by chance – are bombarded
for a few hours before a board meeting with pay statistics that
perpetually ratchet upwards. Additionally, the committee is told
about new perks that other managers are receiving. In this
manner, outlandish “goodies” are showered upon CEOs simply
because of a corporate version of the argument we all used when
children: “But, Mom, all the other kids have one.” When comp
committees follow this “logic,” yesterday’s most egregious
excess becomes today’s baseline.

Comp committees should adopt the attitude of Hank Greenberg,
the Detroit slugger and a boyhood hero of mine. Hank’s son,
Steve, at one time was a player’s agent. Representing an
outfielder in negotiations with a major league club, Steve
sounded out his dad about the size of the signing bonus he should
ask for. Hank, a true pay-for-performance guy, got straight to
the point, “What did he hit last year?” When Steve answered
“.246,” Hank’s comeback was immediate: “Ask for a uniform.”

--

My views on America’s long-term problem in respect to trade
imbalances, which I have laid out in previous reports, remain
unchanged. [ed. Buffett’s bearish take on the dollar, though, cost
Berkshire $955 million pre-tax in 2005.]

The underlying factors affecting the U.S. current account deficit
continue to worsen, and no letup is in sight. Not only did our
trade deficit – the largest and most familiar item in the current
account – hit an all-time high in 2005, but we also can expect a
second item – the balance of investment income – to soon turn
negative. As foreigners increase their ownership of U.S. assets
(or of claims against us) relative to U.S. investments abroad,
these investors will begin earning more on their holdings than we
do on ours. Finally, the third component of the current account,
unilateral transfers, is always negative.

The U.S., it should be emphasized, 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.

--

It’s been an easy matter for Berkshire and other owners of
American equities to prosper over the years. Between December
31, 1899 and December 31, 1999, to give a really long-term
example, the Dow rose from 66 to 11,497. [Guess what annual
growth rate is required to produce this result; the surprising
answer is at the end of this section.] This huge rise came about
for a simple reason: Over the century American businesses did
extraordinarily well and investors rode the wave of their
prosperity. Businesses continue to do well. But now
shareholders, through a series of self-inflicted wounds, are in a
major way cutting the returns they will realize from their
investments.

The explanation of how this is happening begins with a
fundamental truth: With unimportant exceptions, such as
bankruptcies in which some of a company’s losses are borne by
creditors, the 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.

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 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 “beat-my-brother” game. Enter
another set of Helpers. These newcomers explain to each
member of the Gotrocks clan that by himself he’ll 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 family’s disappointment grows. Each of its members is now
employing professionals. Yet overall, the group’s finances have
taken a turn for the worse. The solution? More help, of course.

It arrives in the form of financial planners and institutional
consultants, who weigh in to advise the Gotrocks on selecting
manager-Helpers. The befuddled family welcomes this
assistance. By now its members know they can pick neither the
right stocks nor the right stock-pickers. Why, one might ask,
should they expect success in picking the right consultant? But
this question does not occur to the Gotrocks, and the consultant-
Helpers certainly don’t suggest it to them.

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 of zombies?”

The new arrivals offer a breathtakingly simple solution: Pay
more money. Brimming with self-confidence, 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 he 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.

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.

*Here’s the answer to the question posed at the beginning of this
section: To get very specific, the 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.

---

Wall Street History will return next week.

Brian Trumbore



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-03/10/2006-      
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Wall Street History

03/10/2006

Warren Buffett on Investing

Investors get a kick out of Warren Buffett’s annual letter to
shareholders of Berkshire Hathaway so I thought I’d put up some
of his musings. Financial advisers, mutual fund companies and
hedge funds can’t be too happy with his conclusions on the
money management industry.

---

The attitude of our managers vividly contrasts with that of the
young man who married a tycoon’s only child, a decidedly
homely and dull lass. Relieved, the father called in his new son-
in-law after the wedding and began to discuss the future:

“Son, you’re the boy I always wanted and never had. Here’s a
stock certificate for 50% of the company. You’re my equal
partner from now on.”

“Thanks, dad.”

“Now, what would you like to run? How about sales?”

“I’m afraid I couldn’t sell water to a man crawling in the
Sahara.”

“Well then, how about heading human relations?”

“I really don’t care for people.”

“No problem, we have lots of other spots in the business. What
would you like to do?”

“Actually, nothing appeals to me. Why don’t you just buy me
out?”

--

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.

Huge severance payments, lavish perks and outsized payments
for ho-hum performance often occur because comp committees
have become slaves to comparative data. The drill is simple:
Three or so directors – not chosen by chance – are bombarded
for a few hours before a board meeting with pay statistics that
perpetually ratchet upwards. Additionally, the committee is told
about new perks that other managers are receiving. In this
manner, outlandish “goodies” are showered upon CEOs simply
because of a corporate version of the argument we all used when
children: “But, Mom, all the other kids have one.” When comp
committees follow this “logic,” yesterday’s most egregious
excess becomes today’s baseline.

Comp committees should adopt the attitude of Hank Greenberg,
the Detroit slugger and a boyhood hero of mine. Hank’s son,
Steve, at one time was a player’s agent. Representing an
outfielder in negotiations with a major league club, Steve
sounded out his dad about the size of the signing bonus he should
ask for. Hank, a true pay-for-performance guy, got straight to
the point, “What did he hit last year?” When Steve answered
“.246,” Hank’s comeback was immediate: “Ask for a uniform.”

--

My views on America’s long-term problem in respect to trade
imbalances, which I have laid out in previous reports, remain
unchanged. [ed. Buffett’s bearish take on the dollar, though, cost
Berkshire $955 million pre-tax in 2005.]

The underlying factors affecting the U.S. current account deficit
continue to worsen, and no letup is in sight. Not only did our
trade deficit – the largest and most familiar item in the current
account – hit an all-time high in 2005, but we also can expect a
second item – the balance of investment income – to soon turn
negative. As foreigners increase their ownership of U.S. assets
(or of claims against us) relative to U.S. investments abroad,
these investors will begin earning more on their holdings than we
do on ours. Finally, the third component of the current account,
unilateral transfers, is always negative.

The U.S., it should be emphasized, 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.

--

It’s been an easy matter for Berkshire and other owners of
American equities to prosper over the years. Between December
31, 1899 and December 31, 1999, to give a really long-term
example, the Dow rose from 66 to 11,497. [Guess what annual
growth rate is required to produce this result; the surprising
answer is at the end of this section.] This huge rise came about
for a simple reason: Over the century American businesses did
extraordinarily well and investors rode the wave of their
prosperity. Businesses continue to do well. But now
shareholders, through a series of self-inflicted wounds, are in a
major way cutting the returns they will realize from their
investments.

The explanation of how this is happening begins with a
fundamental truth: With unimportant exceptions, such as
bankruptcies in which some of a company’s losses are borne by
creditors, the 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.

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 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 “beat-my-brother” game. Enter
another set of Helpers. These newcomers explain to each
member of the Gotrocks clan that by himself he’ll 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 family’s disappointment grows. Each of its members is now
employing professionals. Yet overall, the group’s finances have
taken a turn for the worse. The solution? More help, of course.

It arrives in the form of financial planners and institutional
consultants, who weigh in to advise the Gotrocks on selecting
manager-Helpers. The befuddled family welcomes this
assistance. By now its members know they can pick neither the
right stocks nor the right stock-pickers. Why, one might ask,
should they expect success in picking the right consultant? But
this question does not occur to the Gotrocks, and the consultant-
Helpers certainly don’t suggest it to them.

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 of zombies?”

The new arrivals offer a breathtakingly simple solution: Pay
more money. Brimming with self-confidence, 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 he 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.

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.

*Here’s the answer to the question posed at the beginning of this
section: To get very specific, the 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.

---

Wall Street History will return next week.

Brian Trumbore