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Taking a leaf out of the Buffett book

Most people idolise great athletes or exceptional artists. We all can probably appreciate LeBron James' prowess on the basketball court or John Mayer's exceptional talent at writing and singing songs. My idol is neither of these sorts. It's actual an 80 year old guy from Omaha, Warren Buffett.

So you may be able to picture my excitement when I discovered that he had penned his 2010 annual report and it was available online. I quickly rushed to print out a copy, sat down by the fire and spent some time digesting the words of a true investing master. For those of you who have not had the privilege of reading this fine piece of literature I will highlight numerous parts from the letter. One can learn much from Mr. Buffett.

Warren is bullish on the US. He downplays the immense level of uncertainty out there. To quote: “Commentators today often talk of “great uncertainty.” But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain...Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born. The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential - a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War - remains alive and effective. We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America's best days lie ahead.”

Readers of this column already know that I agree. So much ink has been spilled bemoaning the demise of America. The fact is that the US is an innovative and resilient nation that has overcome some incredible obstacles. Buffett notes that “In 2011, we will set a new record for capital spending - $8 billion - and spend all of the $2 billion increase in the United States”.

For those in the insurance industry, Buffett gives some simple yet salient advice: “At bottom, a sound insurance operation requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can't be obtained.

Many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices. “The other guy is doing it so we must as well” spells trouble in any business, but none more so than insurance.”

I have always found it rather humorous that in a soft market EVERY insurer/reinsurer says they are extremely vigilant and will not write mispriced business. If everyone says this, however, then who is writing the bad business? Not everyone can be an “above average” driver?

Berkshire Hathaway owns a number of companies involved in the housing industry, including Clayton Homes, the country's leading producer and financer of manufactured homes. As a result Warren has a great insider take on housing in the US. He made the following comments:

“A housing recovery will probably begin within a year or so. In any event, it is certain to occur at some point.”

“Home ownership makes sense for most Americans, particularly at today's lower prices and bargain interest rates. All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.)”

Here is some advice for the bankers out there (underlined is my emphasis):

“Our borrowers get in trouble when they lose their jobs, have health problems, get divorced, etc. The recession has hit them hard. But they want to stay in their homes, and generally they borrowed sensible amounts in relation to their income. In addition, we were keeping the originated mortgages for our own account, which means we were not securitising or otherwise reselling them. If we were stupid in our lending, we were going to pay the price. That concentrates the mind.

If home buyers throughout the country had behaved like our buyers, America would not have had the crisis that it did. Our approach was simply to get a meaningful down-payment and gear fixed monthly payments to a sensible percentage of income.

But a house can be a nightmare if the buyer's eyes are bigger than his wallet and if a lender - often protected by a government guarantee - facilitates his fantasy. Our country's social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford.”

This discussion leads nicely into his thoughts on debt: “The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to business and guides our every action at Berkshire.

“Unquestionably, some people have become very rich through the use of borrowed money. However, that's also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbours get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade - and some relearned in 2008 - any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

“Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that's all that is noticed.”

From my calculations, Berkshires Hathaway looks like it will hold at minimum five percent of its current market cap in cash. Warren doesn't like this but appreciates the “comfort” and opportunity it offers in times of stress.

He notes that he does not expect to make a lot of money on this cash and an “increase in money-market yields is unlikely to come soon”.

The last segment of advice I'd like to pass on to you is some general comments Warren makes on investing.

First on hedge-funds: “The hedge-fund world has witnessed some terrible behavior by general partners who have received huge payouts on the upside and who then, when bad results occurred, have walked away rich, with their limited partners losing back their earlier gains.

Sometimes these same general partners thereafter quickly started another fund so that they could immediately participate in future profits without having to overcome their past losses. Investors who put money with such managers should be labeled patsies, not partners.”

And then on investment management in general: “It's easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager's understanding of - and sensitivity to - risk (which in no way should be measured by beta, the choice of too many academics).

In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed...(Fund consultants like to require style boxes such as “long-short”, “macro”, “international equities”. At Berkshire our only style box is “smart”).

If you haven't already, I suggest you get your hands on a copy of this letter. Much can be learned from this wise financial sage and your financial literacy will be greatly enhanced.

Here is the link:

http://www.berkshirehathaway.com/letters/letters.html

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Published March 07, 2011 at 1:00 am (Updated March 07, 2011 at 8:20 am)

Taking a leaf out of the Buffett book

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