Letter reading time!

I had mentioned that I always look forward to reading Berkshire's letters to Shareholders . This is because that there is simply so much to learn from Buffett's wisdom and of course not forgetting his humor!

Here are some of my comments on what I thought was interesting in this year's letters:

When growth rates are under discussion, it will pay you to be suspicious as to why the beginning and terminal years have been selected. If either year was aberrational, any calculation of growth will be distorted. In particular, a base year in which earnings were poor can produce a breathtaking, but meaningless, growth rate. In the table above, however, the base year of 1965 was abnormally good; Berkshire earned more money in that year than it did in all but one of the previous ten.

==>> as shown in the posting ROI on Uchi, a company's compounded annual growth varies and each starting point of reference will yield a different interpretation!

Nevertheless, Charlie Munger, Berkshire’s Vice Chairman and my partner, and I want to increase the figures in both tables. In this ambition, we hope – metaphorically – to avoid the fate of the elderly couple who had been romantically challenged for some time. As they finished dinner on their 50 th anniversary, however, the wife – stimulated by soft music, wine and candlelight – felt a long-absent tickle and demurely suggested to her husband that they go upstairs and make love. He agonized for a moment and then replied, " I can do one or the other, but not both."

==>> OMIGOSH!!!! LOL!!!

In this quest, 2005 was encouraging. We agreed to five purchases: two that were completed last year, one that closed after yearend and two others that we expect to close soon. None of the deals involve the issuance of Berkshire shares. That’s a crucial, but often ignored, point: When a management proudly acquires another company for stock, the shareholders of the acquirer are concurrently selling part of their interest in everything they own. I’ve made this kind of deal a few times myself – and, on balance, my actions have cost you money.

==>> Remember this issiue, when a buyer of another company is made via the issuance of new shares, the shareholders of the buyer is concurrently selling part of their interest in everything they own. Think about it. And less we forget with the issuance of new shares, would most likely cause a dilution in earnings per share.. which will ultimately cost us, the minority shareholder money!

Unlike many business buyers, Berkshire has no "exit strategy." We buy to keep. We do, though, have an entrance strategy, looking for businesses in this country or abroad that meet our six criteria and are available at a price that will produce a reasonable return. If you have a business that fits, give me a call. Like a hopeful teenage girl, I’ll be waiting by the phone.

==>> LOL!!!

Long ago, Mark Twain said: "A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way." If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats. We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re’s derivative operation. Our aggregate losses since we began this endeavor total $ 404 million.
Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890.You might expect that our losses would have been stemmed by this point, but the blood has kept flowing.Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what "need" such a contract could fulfill except, perhaps, the need of a compensation-conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for "imagination" when traders are estimating their value.Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tendto be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

==>> Warren explains yet again the dangers in the derivative market.

I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. 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. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were particularly worrisome because their potential to explode could not be measured. More over, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

==>> See even the great Buffett makes mistakes! But he acknowledges his mistake and tries to correct it.. and for me... it is worth remembering (LOL!! and learn from Buffett's mistakes!) that when one makes a mistake, one should correct it immediately and not THUMB-SUCKING!!! The time to act is now!

How many times have we not seen or even experienced it ourselves that we realized we had made a mistake. However as per what Buffett did, we tried to exit the investment painlessly, ie we hope that the rising stock market would correct our mistake!!!

Tell me if this is not true!

The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, press ures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina.

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."

==>> LOL!!!!

When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as "widening the moat." An d 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. 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 quoting 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.

==>> The poor business economics in the auto and airline industries!

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? "

==>> OMIGOSH!!! LOL!!!! This is just too farnee!!!

Expect no miracles from our equity portfolio. Though we own major interests in a number of strong, highly-profitable businesses, they are not selling at anything like bargain prices.

==>> Ahem... stocks are not exactly cheap hor!

As a group, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth. (Their managers, of course, think my expectations are too modest – and I hope they’re right.)

==>> LOL!!!

to be continued...