Insights from the 2006 Warren Buffett Letter to Shareholders

The Berkshire Hathaway Annual Report for 2006 was released yesterday, March 1, 2007, after the close of the market. As always, Warren Buffett shares his amazing wisdom with us in his letter to shareholders.  I’m going to attempt to capture some of the most interesting, revealing, and informative points that Mr. Buffett makes in this years letter.

Berkshire Hathaway Performance
First, per-share book value increased by an amazing 18.4% in 2006 for Berkshire Hathaway. Over the past 42 years, book value has grown at a rate of 21.4% compounded annually.  2006 was a great year for Berkshire Hathaway primarily because no major weather related events impacted the insurance business.  Mr. Buffett also had great things to say about Tony Nicely’s performance at managing GEICO.

Outstanding Managers
Warren Buffett admires the following managers of giant companies:

  • Ken Chenault of American Express
  • Jeff Immelt of G.E.
  • Dick Kovacevich of Wells Fargo

Berkshire Hathaway completed the acquisition of PacificCorp, Business Wire, Applied Underwritters, ISCAR, Justin Industries, and TTI. “Tuck-in” acquisitions included Russell Corp. and the intimate apparel business of VF Corp. at the Fruit of the Loom subsidiary. 

“In 2006, …everything went right in insurance – really right,” wrote Mr. Buffett.

I found it interesting that Warren Buffett mentions climate change and how it impacts Berkshire’s ability to see what lies ahead. Mr. Buffett writes, “We do know that it would be a huge mistake to bet that evolving atmospheric changes are benign in their implications for insurers.”

Mr. Buffett also reminds us, “Be fearful when others are greedy, and be greedy when others are fearful.”  I’m starting to become greedy this past week.

Warren Buffett provides a short history of Lloyd’s and how it created Equitas as result of the fallout from asbestos and other environmental and product claims that emerged in the 1980s.  Apparently, Mr. Buffett and Ajit have reviewed the pre-1993 liabilities associated with Equitas and has decided that it will survive the claims, so he offered a huge reinsurance policy to Equitas in 2006.  Mr. Buffett thinks the odds are in his favor if he receives $7.12 billion in cash and securities for paying all future claims up to $13.9 billion.  According to Scott Moser, the CEO of Equitas, “Names wanted to sleep easy at night, and we think we’ve just bought them the world’s best mattress.” It appears they were willing to pay a premium price for this top tier mattress.

“Now, however, almost 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.” Mr. Buffett then writes, “…the days of lush profits from our newspapers are over.” This is a clear sign to me that Mr. Buffett is going to stay clear of any “bargains” in the newspaper sector unless maybe a stock is trading for less than net asset value.

Real Estate
HomeService, the second largest real estate brokerage firm in the U.S., reported an overall volume decrease of 9% and profits fell by 50%.  “Nevertheless, we will be seeking to purchase additional brokerage operations,” wrote Mr. Buffett. I was also interested in real estate brokerage companies this past year.  I was hoping to still own one now, but my stake in Realogy (H) was sold when the company announced it was being bought out by private equity this year.

“Clayton Homes remains an anomaly in the manufactured-housing industry, which last year recorded its lowest unit sales since 1962.”  Ouch! Clayton’s financing business kept the company profitable, but that was primarily due to Berkshire’s financial strength.

Stock Investments
“We don’t itemize the two securities referred to, which have a market value of $1.9 billion, because we continue to buy them.  I could, of course, tell you their names. But then I would have to kill you,” warns Mr. Buffett. Yikes! Now I really want to know what Warren Buffett is up to in the stock market.  Anyone have any guesses?

Foreign Currency
Berkshire Hathaway is closing their direct foreign exchange position.  “When we first began making foreign exchange purchases, interest-rate differentials between the U.S. and most foreign countries favored a direct currency position. But that spread turned negative in 2005. We therefore looked for other ways to gain foreign-currency exposure, such as the ownership of foreign equities or of U.S. stocks with major earnings abroad.” Is this a clue to what those two securities he is still buying?

Regarding his foreign currency derivatives, Warren Buffett states, “…just like stocks and bonds, [derivatives] are sometimes wildly mispriced.” However, he makes a point that the derivates are managed by him personally and are free of counterparty credit risk.

Warren Buffett announced, “I intend to hire a younger man or woman with the potential to manage a very large portfolio, who we hope will succeed me as Berkshire’s chief investment officer when the need for someone to do that arises.” This sounds like a great opportunity for someone and it will be interesting to see who they pick for this important job.

Warren Buffett’s four criteria for selecting board members are as follows:

  • Owner-oriented
  • Business savvy
  • Interested
  • Truly independent

Berkshire Hathaway selected Susan Decker, CFO of Yahoo! to join the board this year.

Executive Compensation
Warren Buffett complains about the current state of executive compensation. Compensation consultants are driving CEO compensation inflation by creating reports showing all the perks and high salaries other companies are offering. Then “all the kids want one,” according to Buffett. I agree with Mr. Buffet that what we really need are very independent directors to stop this.

Hedge Fund Rates
2-and-20 compensation will lead to poorer investors that use these expensive managers. “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 the experience ends up with the money,” quips Buffett.

Walter Schloss
The key to Schloss’ success according to Edwin Schloss: “We try to buy stocks cheap.” Warren Buffett thinks it might have even been a benefit that Walter Schloss never went to college and learned about the efficient market theory (EMT).

“After all, if you are in the shipping business, it’s helpful to have all your potential competitors be taught that the earth is flat,” comments Buffett about the current state of college financial training.

The following three books were mentioned at the end of the letter:

These books will apparently be on sale at this years annual meeting on May 5, 2007.

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