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Warren Buffet Finds Reason to Be Hopeful in Annual Letter

March 3, 2009

Berkshire Hathaway Chairman Warren Buffet found reason to be optimistic in his 2008 annual letter to shareholders (released at the end of February and available here).
 
He uses a slew of graphic metaphors - "By year-end, investors of all stripes were bloodied and confused, much as if they were small birds that had strayed into a badminton game." - but threw in some optimism, reminding his shareholders that the country has "faced far worse travails in the past." Among those: two great wars, a dozen or so panics and recessions; virulent inflation leading to a 21½% prime rate in 1980; and the Great Depression, when unemployment was between 15% and 25% for several years. To understate it a bit: "America has had no shortage of challenges," Buffett writes. And he points out that the country has overcome all of them.
 
He notes that the standard of living for Americans improved nearly seven-fold during the 1900s, with the Dow Jones Industrials rising from 66 to 11,497. Relative to other periods of human history, this is highly significant. "Though the path has not been smooth," he writes, "our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America's best days lie ahead."
 
Buffett isn't blinded by the bright side, however. In his honest way, he recognized the problems we are facing and the need to address them. "By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralyzing fear that engulfed the country," he writes. "A freefall in business activity ensued, accelerating at a pace that I have never before witnessed." Fear has fueled business contraction, leading to even more fear and contraction, he says.
 
At the end of his annual report introduction, he outlined the four goals of Berkshire Hathaway, "in good years and bad," points we can all learn from:



  • Maintain "Berkshire's Gibraltar-like financial position," featuring "huge amounts of excess liquidity, near-term obligations that are modest, and dozens of sources of earnings and cash."


  • Widen moats around operating businesses to give them durable competitive advantage


  • Acquire and develop new and diverse earnings streams


  • Nurture outstanding operating managers


Some gems from the annual report:
On derivatives, contributor to the financial meltdown -
"When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: 'I liked you better before I got to know you so well.'"
 
On the housing crisis -
"The stupefying losses in mortgage-related securities came in large part because of flawed, history-based models used by salesmen, rating agencies and investors. These parties looked at loss experience over periods when home prices rose only moderately and speculation in houses was negligible. They then made this experience a yardstick for evaluating future losses. They blissfully ignored the fact that house prices had recently skyrocketed, loan practices had deteriorated and many buyers had opted for houses they couldn't afford. In short, universe past" and universe "current" had very different characteristics. But lenders, government and media largely failed to recognize this all-important fact.
 
"Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas."
 
Find Berkshire Hathaway's annual report from 2008 (and from the past) at the Berkshire Hathaway Web site, www.berkshirehathaway.com. "

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