BHLC: 2006 Notes and Reviews of Berkshire Hathaway Shareholder Letter

Notes on Berkshire Hathaway Shareholder Letter from 2006

Brief Summary of the Year:

Berkshire Hathaway claim the largest single year gain in net worth by an American organization in all time. It’s amazing. The piece is wary of the credit usage by American’s as a whole and the growth in “helpers” who take money out of the economy without producing much of value. It ends, as always on a happy note, inviting everyone to the big party.

Notes For the Year:

The pattern remains the same. I anticipate that Buffett will always start these letters with the same thing: Results. Of course, they are probably positive results.

21% means they are down from their previous results in 1994. Economic problems during 2001 must not have been great to Berkshire Hathaway but their results are still remarkable even when down. This will be exciting to read each new letter as we progress into the 2008 financial mess. Will Warren and Charlie be able to avoid the toxic debt? My guess is, yes because of their investment strategy.

Our gain in net worth during 2006 was $16.9 billion, which increased the per-sharebook value of both our Class A and Class B stock by 18.4%. Over the last 42 years (that is, since present management took over) book value has grown from $19 to $70,281, a rate of 21.4% compounded annually.*

We believe that $16.9 billion is a record for a one-year gain in net worth – more than has ever been booked by any American business, leaving aside boosts that haveoccurred because of mergers (e.g., AOL’s purchase of Time Warner). Of course, Exxon Mobil and other companies earn far more than Berkshire, but their earnings largely go to dividends and/or repurchases, rather than to building net worth. – Warren Buffett

Wow. 16.9 billion gain in net worth in a year. Perhaps the biggest gain in net value of any American business of all time. Amazing. I love to imagine being world class, imagine what it’d be like to be on the team that created the largest amount of wealth ever in a year. What a remarkable feeling.

Attributes the year’s success to the lack of super disasters which they insure against (hurricanes, floods, fires, etc.)

Last year, the red ink from this activity [super-cat insurance] turned black – very black. – Warren Buffett

This is a fun way to say, “we made a whole lot of money.”

Tony Nicely, GEICO’s CEO, went to work at the company 45 years ago, two months after turning 18. – Warren Buffett

As always, Warren places a high value on management. He goes on to describe how GEICO’s policies increased from 5.7 to 8.1 million at a time when employees fell 3.5 percent. Amazing results. Not so great for GEICO employees likely… that would be an interesting story to hear: “How working at GEICO changed during 2006.” Perhaps only interesting to business geeks that is.

Last year I told you that if you had a new son or grandson to be sure to name him Tony. But Don Keough, a Berkshire director, recently had a better idea. After reviewing GEICO’s performance in 2006, he wrote me, “Forget births. Tell the shareholders to immediately change the names of their present children to Tony or Antoinette.” Don signed his letter “Tony.” – Warren Buffett

This is hilarious. You can tell Warren loves the people he works with and the game of owning big companies.

“We shape our buildings, and afterwards our buildings shape us.” – Warren Buffett” – Winston Churchill

Buffett is great at selecting quality quotes.
He quotes Ronald Reagan again with this quote: “It’s probably true that hard work never killed anyone – but why take the chance?”

So I’ve taken the easy route, just sitting back and working through great managerswho run their own shows. My only tasks are to cheer them on, sculpt and harden ourcorporate culture, and make major capital-allocation decisions. – Warren Buffett

We’ve long wanted, nonetheless, to extend Berkshire’s appeal beyond U.S.borders. And last year, our globe-trotting finally got underway. – Warren Buffett

Berkshire went global in 2006. This is interesting.

Their first international purchase was ISCAR, who makes and sells small, consumable cutting tools and large machine tools.

The result: ISCAR makes money because it enables its customers to make more money.There is no better recipe for continued success. – Warren Buffett

How to succeed in business according to Warren Buffett. Of course, this statement is a standard for him. Common sense, clear as day statements that are so obvious that I guess they get overlooked.

[Owner of a company] loves running his business. – Warren Buffett

Another purchase in a year? Perhaps they are ramping it up because they are making so much more money.

This purchase for an electronic components company called TTI

It’s quite interesting to hear Warren talking about Love as an asset to a managerial team. This isn’t what I expected when reading through this. TTI’s CEO Paul Andrews, Jr. wanted to set up an owner for the company because he saw the disruptive nature of a dying founder. So reason for selling is clearly an important role when allocating capital.

Our exemplar is the older man who crashed his grocery cart into that of a much younger fellow while both were shopping. The elderly man explained apologetically that he had lost track of his wife and was preoccupied searching for her. His new acquaintance said that by coincidence his wife had also wandered off and suggestedthat it might be more efficient if they jointly looked for the two women. Agreeing, the older man asked his new companion what his wife looked like. “She’s a gorg- eous blonde,” the fellow answered, “with a body that would cause a bishop to go through a stained glass window, and she’s wearing tight white shorts. How about yours?” The senior citizen wasted no words: “Forget her, we’ll look for yours.”
 
What we are looking for is described on page 25. If you have an acquisition candidate that fits, call me – day or night. And then watch me shatter a stained glass window. – Warren Buffett

When we were due to close the purchase at Charlie’s office, Jack was late. Finallyarriving, he explained that he had been driving around looking for a parking meterwith some unexpired time. That was a magic moment for me. I knew then that Jack was going to be my kind of manager. – Warren Buffett

What Warren Buffett looks for in a quality management team? – FRUGALITY

The big unknown is super-cat insurance. Were the terrible hurricane seasons
of 2004-05 aberrations? Or were they our planet’s first warning that the climate of the 21st Century will differ materially from what we’ve seen in the past? If the answer to the second question is yes, 2006 will soon be perceived as a misleading period of calm preceding a series of devastating storms. These could
rock the insurance industry. It’s naïve to think of Katrina as anything close to aworst-case event.
 
Neither Ajit Jain, who manages our super-cat operation, nor I know what lies ahead. We do know that it would be a huge mistake to bet that evolving atmosphericchanges are benign in their implications for insurers. – Warren Buffett

Warren Buffett on climate change and super-cat insurance.

Be fearful when others are greedy, and be greedy when others are fearful. – WarrenBuffett

The super-cat industry is filling up with new entrants so they are making less from it. Warren alludes to the idea that they may soon not take on the exposure as the premiums are going down.

He goes on to give a history of the insurance agency. It’s well written and fun to read.

What’s important to remember is that retroactive insurance contracts always produce underwriting losses for us. – Warren Buffett

So reading this, I didn’t understand what Underwriting Losses were (wiki). Essentially underwriting gain or loss is the money left over from insurance activities after payouts and admin costs are covered. It doesn’t account for extra income created through investment of said activities.

In the above quote, Warren describes the accounting challenges when declaring big wins when playing the super-catastrophe insurance game. They diversify the costs to be $450 million a year while bringing in more than that to stay profitable. The size of this challenge is helpful to Berkshire Hathaway because they are a rare organization that can accept such large amounts.

Aren’t you glad that I promised you there would be no quiz? – Warren Buffett

Buffett is a great writer. This is the conclusion of a very dense accounting/super-cat insurance game details he wraps the whole thought up at the end with this. He promised at the beginning of the category that this was heavy stuff and there would be a quiz.

This motley group, which sells products ranging from lollipops to motor homes, earned a pleasing 25% on average tangible net worth last year. It’s noteworthy also that these operations used only minor financial leverage in achieving that return. Clearly we own some terrific businesses. – Warren Buffett

Companies that can grow in net worth without financial leverage is attractive to Buffett.

Companies and their products in Berkshire’s Manufacturing, Service and Retailing Operations:
Shaw Industries – Carpet Producer
MiTek – Manufacturer of Connectors for Roof Trusses

“If you want to get a reputation as a good businessman, be sure to get into a good business.” – A Wise Friend

Buffett goes into a story about how profitable the newspaper industry was when they were young, indeed even a poor newpaper couldn’t avoid, “gushing profits.”

According to Buffett the larger the paper, the more ad’s. People trusted the newspapers with more ad’s so the industry became a game of “Survival of the Fattest.”

Simply put, if cable and satellite broadcasting, as well as the internet, had comealong first, newspapers as we know them probably would never have existed. – Warren Buffett

In 2006 Buffett realized the newspaper game is a dying one.

Fixed costs are high in the newspaper business, and that’s bad news when unit volume heads south. – Warren Buffett

Again, on the decaying nature of the newspaper industry.
Surprisingly, Buffett decides to stay in the game despite his expectations that the gushing profits will stop. Still, they expect the businesses to stay profitable. Will be interesting to see going forward if they continue to stay afloat and if Berkshire Hathaway stays in the game.

Once you’ve flown NetJets, returning to commercial flights is like going back to holding hands. – Warren Buffett

Again with the value and management importance for their investments. NetJets is a company that does fractional ownership and rental of private business jets.

The slowdown in residential real estate activity stems in part from the weakened lending practices of recent years. The “optional” contracts and “teaser” rates that have been popular have allowed borrowers to make payments in the early years of their mortgages that fall far short of covering normal interest costs. Naturally, there are few defaults when virtually nothing is required of a borrower. As a cynic has said, “A rolling loan gathers no loss.” But payments not made add to principal, and borrowers who can’t afford normal monthly payments early on are hit later with above-normal monthly obligations. This is the ScarlettO’Hara scenario: “I’ll think about that tomorrow.” For many home owners, “tomorrow” has now arrived. Consequently there is a huge overhang of offerings in several of ‘HomeServices’ markets. Nevertheless, we will be seeking to purchase additional brokerage operations. A decade from now, HomeServices will almost certainly be much larger. – Warren Buffett

Here we’ve got Buffett seeing the growth in sub-prime mortgages. Despite that, he looks to the even longer term and he believes that purchasing housing brokerage companies going forward is still a good idea. I’m interested to see how this plays out in the upcoming letters.

I fervently believe in real trade – the more the better for both us and the world.We had about $1.44 trillion of this honest-to-God trade in 2006. But the U.S. alsohad $.76 trillion of pseudo-trade last year – imports for which we exchanged no goods or services. (Ponder, for a moment, how commentators would describe the situation if our imports were $.76 trillion – a full 6% of GDP – and we had no exports.) Making these purchases that weren’t reciprocated by sales, the U.S. necessarily transferred ownership of its assets or IOUs to the rest of the world. Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced. – Warren Buffett

Alluding to economic problems in the USA. We’re spending money we don’t have and giving nothing but IOUs in return. 2006 development of trade problems in the US.

He continues…

These transfers will have consequences, however. Already the prediction I made last year about one fall-out from our spending binge has come true: The “invest- ment income” account of our country – positive in every previous year since 1915 –turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience “reverse compounding” as we pay ever-increasing amounts of interest on interest. – Warren Buffett

The consequences of living on credit will be felt by the younger generations…
He continues…

I want to emphasize that even though our course is unwise, Americans will live better ten or twenty years from now than they do today. Per-capita wealth will increase. But our citizens will also be forced every year to ship a significant portion of their current production abroad merely to service the cost of our huge debtor position. It won’t be pleasant to work part of each day to pay for the over-consumption of your ancestors. I believe that at some point in the future U.S. workers and voters will find this annual “tribute” so onerous that there will be asevere political backlash. How that – Warren Buffett

Ominous stuff from Mr. Buffett. The nature of consumption in the USA turned from growth and production to gluttony and consumption in 2006. I’m very interested to see how this plays out going forward in the letters of 2007 and 2008 as it all comes crashing down.

Why, you may wonder, are we fooling around with such potentially toxic material? The answer is that derivatives, just like stocks and bonds, are sometimes wildly miss priced. – Warren Buffett

The derivatives markets play an important role in the coming financial crash. Of course, Buffett didn’t know this at the time. I’m very interested to see how this plays out going forward.

The good news: At 76, I feel terrific and, according to all measurable indicators,am in excellent health. It’s amazing what Cherry Coke and hamburgers will do for afellow. – Warren Buffett

As always, he discusses his health and the prospects of a new predecessor. Funny that they have a challenge for hiring someone because if they bring anyone on, they will immediately have a resume worth far more than their current position. If someone takes a job with Berkshire, they immediately could move on and make more money and manage more money at a different firm.

In 1929, the first Malcolm G. Chace played an important role in merging four New England textile operations into Berkshire Fine Spinning Associates. That company merged with Hathaway Manufacturing in 1955 to form Berkshire Hathaway, and MalcolmG. Chace, Jr. became its chairman. – Warren Buffett

How the name Berkshire Hathaway came to be.

And – surprise, surprise – director compensation has soared in recent years, pushed up by recommendations from corporate America’s favorite consultant, Ratchet, Ratchet and Bingo. – Warren Buffett

I didn’t understand what this means. Essentially Buffett is denouncing consulting firms (like Frederic W. Cook’s) who persuade large organizations to pay their managing directors wildly. In this New York Times article, you can learn all about it.
Funny, Buffett says he likes to live comfortably but Munger is all Sackcloth and Ashes.

Charlie and I believe our four criteria are essential if directors are to do theirjob – which, by law, is to faithfully represent owners. Yet these criteria are usually ignored. Instead, consultants and CEOs seeking board candidates will oftensay, “We’re looking for a woman,” or “a Hispanic,” or “someone from abroad,” or what have you. It sometimes sounds as if the mission is to stock Noah’s ark. Over the years I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like an intelligent owner?” The questions I instead get would sound ridiculous to someone seeking candidates for, say, a foot-ball team, or an arbitration panel or a military command. In those cases, the selectors would look for people who had the specific talents and attitudes that were required for a specialized job. At Berkshire, we are in the specialized activity of running a business well, and therefore we seek business judgment. – Warren Buffett

How to select a team to perform a specific job well. Also, this is really funny -> “… it sounds as if the mission is to stock Noah’s ark.” LoL

Berkshire will pay about $4.4 billion in federal income tax on its 2006 earnings. In its last fiscal year the U.S. Government spent $2.6 trillion, or about $7 billion per day. Thus, for more than half of one day, Berkshire picked up the tab for all federal expenditures, ranging from Social Security and Medicare payments to the cost of our armed services. Had there been only 600 taxpayers like Berkshire, no one else in America would have needed to pay any federal income or payroll taxes. – Warren Buffett

Wow! Berkshire and the federal government. The US government spends 7 billion a day. Holy Cow! Berkshire paid $4.4 billion in federal income tax for 2006… That’s tremendous…. but it only pays for 1/2 a day of federal expenditures. I’d guess that truckloads of money are being burnt in this world by the federal government. Wow.

Last year I arranged for the bulk of my Berkshire holdings to go to five charitable foundations, thus carrying out part of my lifelong plan to eventually use all of my shares for philanthropic purposes. – Warren Buffett

An honorable plan.

In last year’s report I allegorically described the Gotrocks family – a clan that owned all of America’s businesses and that counterproductively attempted to increase its investment returns by paying ever-greater commissions and fees to “helpers.” Sad to say, the “family” continued its self-destructive ways in 2006. – Warren Buffett

CNN Money has an excerpt of Warren’s 2005 letter which I thought was very valuable describing the allegoric Gotrocks Family and the helpers they bring on to suck their money away.
Note: Call this promise the adult version of Lake Woebegon. Another character trait of Buffett -> Old school American found of public radio’s, A Prairie Home Companion.

In 2006, promises and fees hit new highs. A flood of money went from institutionalinvestors to the 2-and-20 crowd. For those innocent of this arrangement, let me explain: It’s a lopsided system whereby 2% of your principal is paid each year to the manager even if he accomplishes nothing – or, for that matter, loses you abundle – and, additionally, 20% of your profit is paid to him if he succeeds, even if his success is due simply to a rising tide. – Warren Buffett

Two and Twenty is a pricing structure for financial planners and hedge fund managers. They’re the “helpers” in Buffett’s Gotrock Family allegory.

Buffett is clearly not a fan of all of these helpers that take money from productive businesses that create value and ingest it into “helping” organizations which create no real-value in the economy.

The inexorable math of this grotesque arrangement is certain to make the Gotrocks family poorer over time than it would have been had it never heard of these “hyper-helpers.” Even so, the 2-and-20 action spreads. Its effects bring to mind the old adage: When someone with experience proposes a deal to someone with money, too often the fellow with money ends up with the experience, and the fellowwith experience ends up with the money

There is simply no possibility that what Walter Schloss achieved over 47 years wasdue to chance. – Warren Buffett

Walter Schloss – Learn more about this guy. He, Warren Buffett and Benjamine Graham are the “value investors.”

…a new Berkshire movie will be shown at 8:30 – Warren Buffett

If you have ever seen a Berkshire movie could you please point it out. I’d love to link up a Berkshire movie in this post. Please comment below or send me a message (ian@ianrobinson.net) Thank you.

Books mentioned by Warren in this Letter:
Seeking Wisdom: From Darwin to Munger by Peter Bevelin

This book (Where are the Customers’ Yachts?) was first published in 1940 and is now in its 4th edition. The funniest book ever written about investing, it lightlydelivers many truly important messages on the subject – Warren Buffett

Where are the Customers’ Yachts? by Fred Schwed

Charlie and I are extraordinarily lucky. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to other people who contribute as much or moreto our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped every day in countless ways by talented and cheerful associates. No wonder we tap dance to work. But nothing is more fun for us than getting together with our shareholder-partners at Berkshire’s annual meeting. So join us on May 5th at the Qwest for our annual Woodstock for Capitalists. We’ll see you there. – Warren Buffett

As always, they seem to be enjoying life in a humble yet fitting way for a pair of guys who spent the year increasing their nominal net worth to a degree never before seen in American history.

Let’s see how they keep up in the coming years. 2007 will be another good one likely, but 2008? We’ll see…

– Thanks for Reading. I hope you found this helpful. Please feel free to leave a comment and contribute to the conversation.

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