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Warren
Buffett on Investing
Brian
Trumbore
President/Editor, StocksandNews.com
Investors get a kick out of Warren
Buffett's annual letter to shareholders of Berkshire
Hathaway so I thought I'd put up some of his musings.
Financial advisers, mutual fund companies and hedge
funds can't be too happy with his conclusions on the
money management industry.
---
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?"
--
Getting
fired can produce a particularly bountiful payday
for a CEO. Indeed, he can "earn" more in that single
day, while cleaning out his desk, than an American
worker earns in a lifetime of cleaning toilets. Forget
the old maxim about nothing succeeding like success:
Today, in the executive suite, the all- too-prevalent
rule is that nothing succeeds like failure.
Huge
severance payments, lavish perks and outsized payments
for ho-hum performance often occur because comp committees
have become slaves to comparative data. The drill
is simple: Three or so directors - not chosen by chance
- are bombarded for a few hours before a board meeting
with pay statistics that perpetually ratchet upwards.
Additionally, the committee is told about new perks
that other managers are receiving. In this manner,
outlandish "goodies" are showered upon CEOs simply
because of a corporate version of the argument we
all used when children: "But, Mom, all the other kids
have one." When comp committees follow this "logic,"
yesterday's most egregious excess becomes today's
baseline.
Comp
committees should adopt the attitude of Hank Greenberg,
the Detroit slugger and a boyhood hero of mine. Hank's
son, Steve, at one time was a player's agent. Representing
an outfielder in negotiations with a major league
club, Steve sounded out his dad about the size of
the signing bonus he should ask for. Hank, a true
pay-for-performance guy, got straight to the point,
"What did he hit last year?" When Steve answered ".246,"
Hank's comeback was immediate: "Ask for a uniform."
--
My
views on America's long-term problem in respect to
trade imbalances, which I have laid out in previous
reports, remain unchanged. [ed. Buffett's bearish
take on the dollar, though, cost Berkshire $955 million
pre-tax in 2005.] ?
The
underlying factors affecting the U.S. current account
deficit continue to worsen, and no letup is in sight.
Not only did our trade deficit - the largest and most
familiar item in the current account - hit an all-time
high in 2005, but we also can expect a second item
- the balance of investment income - to soon turn
negative. As foreigners increase their ownership of
U.S. assets (or of claims against us) relative to
U.S. investments abroad, these investors will begin
earning more on their holdings than we do on ours.
Finally, the third component of the current account,
unilateral transfers, is always negative.
The
U.S., it should be emphasized, is extraordinarily
rich and will get richer. As a result, the huge imbalances
in its current account may continue for a long time
without their having noticeable deleterious effects
on the U.S. economy or on markets. I doubt, however,
that the situation will forever remain benign. Either
Americans address the problem soon in a way we select,
or at some point the problem will likely address us
in an unpleasant way of its own.
--
It's
been an easy matter for Berkshire and other owners
of American equities to prosper over the years. Between
December 31, 1899 and December 31, 1999, to give a
really long-term example, the Dow rose from 66 to
11,497. [Guess what annual growth rate is required
to produce this result; the surprising answer is at
the end of this section.] This huge rise came about
for a simple reason: Over the century American businesses
did extraordinarily well and investors rode the wave
of their prosperity. Businesses continue to do well.
But now shareholders, through a series of self-inflicted
wounds, are in a major way cutting the returns they
will realize from their investments.
The
explanation of how this is happening begins with a
fundamental truth: With unimportant exceptions, such
as bankruptcies in which some of a company's losses
are borne by creditors, the most that owners in aggregate
can earn between now and Judgment Day is what their
businesses in aggregate earn. True, by buying and
selling that is clever or lucky, investor A may take
more than his share of the pie at the expense of investor
B. And, yes, all investors feel richer when stocks
soar. But an owner can exit only by having someone
take his place. If one investor sells high, another
must buy high. For owners as a whole, there is simply
no magic - no shower of money from outer space - that
will enable them to extract wealth from their companies
beyond that created by the companies themselves.
Indeed,
owners must earn less than their businesses earn because
of "frictional" costs. And that's my point: These
costs are now being incurred in amounts that will
cause shareholders to earn far less than they historically
have.
To
understand how this toll has ballooned, imagine for
a moment that all American corporations are, and always
will be, owned by a single family. We'll call them
the Gotrocks. After paying taxes on dividends, this
family - generation after generation - becomes richer
by the aggregate amount earned by its companies. Today
that amount is about $700 billion annually. Naturally,
the family spends some of these dollars. But the portion
it saves steadily compounds for its benefit. In the
Gotrocks household everyone grows wealthier at the
same pace, and all is harmonious.
But
let's now assume that a few fast-talking Helpers approach
the family and persuade each of its members to try
to outsmart his relatives by buying certain of their
holdings and selling them to certain others. The Helpers
- for a fee, of course - obligingly agree to handle
these transactions. The Gotrocks still own all of
corporate America; the trades just rearrange who owns
what. So the family's annual gain in wealth diminishes,
equaling the earnings of American business minus commissions
paid. The more that family members trade, the smaller
their share of the pie and the larger the slice received
by the Helpers. This fact is not lost upon these broker-Helpers:
Activity is their friend and, in a wide variety of
ways, they urge it on.
After
a while, most of the family members realize that they
are not doing so well at this new "beat-my-brother"
game. Enter another set of Helpers. These newcomers
explain to each member of the Gotrocks clan that by
himself he'll outsmart the rest of the family. The
suggested cure: "Hire a manager - yes, us - and get
the job done professionally." These manager-Helpers
continue to use the broker-Helpers to execute trades;
the managers may even increase their activity so as
to permit the brokers to prosper still more. Overall,
a bigger slice of the pie now goes to the two classes
of Helpers.
The
family's disappointment grows. Each of its members
is now employing professionals. Yet overall, the group's
finances have taken a turn for the worse. The solution?
More help, of course.
It
arrives in the form of financial planners and institutional
consultants, who weigh in to advise the Gotrocks on
selecting manager-Helpers. The befuddled family welcomes
this assistance. By now its members know they can
pick neither the right stocks nor the right stock-pickers.
Why, one might ask, should they expect success in
picking the right consultant? But this question does
not occur to the Gotrocks, and the consultant- Helpers
certainly don't suggest it to them.
The
Gotrocks, now supporting three classes of expensive
Helpers, find that their results get worse, and they
sink into despair. But just as hope seems lost, a
fourth group - we'll call them the hyper-Helpers -
appears. These friendly folk explain to the Gotrocks
that their unsatisfactory results are occurring because
the existing Helpers - brokers, managers, consultants
- are not sufficiently motivated and are simply going
through the motions. "What," the new Helpers ask,
"can you expect from such a bunch of zombies?"
The
new arrivals offer a breathtakingly simple solution:
Pay more money. Brimming with self-confidence, the
hyper-Helpers assert that huge contingent payments
- in addition to stiff fixed fees - are what each
family member must fork over in order to really outmaneuver
his relatives.
The
more observant members of the family see that some
of the hyper-Helpers are really just manager-Helpers
wearing new uniforms, bearing sewn-on sexy names like
HEDGE FUND or PRIVATE EQUITY. The new Helpers, however,
assure the Gotrocks that this change of clothing is
all-important, bestowing on its wearers magical powers
similar to those acquired by mild- mannered Clark
Kent when he changed into his Superman costume. Calmed
by this explanation, the family decides to pay up.
And
that's where we are today: A record portion of the
earnings that would go in their entirety to owners
- if they all just stayed in their rocking chairs
- is now going to a swelling army of Helpers. Particularly
expensive is the recent pandemic of profit arrangements
under which Helpers receive large portions of the
winnings when they are smart or lucky, and leave family
members with all of the losses - and large fixed fees
to boot - when the Helpers are dumb or unlucky (or
occasionally crooked).
A
sufficient number of arrangements like this - heads,
the Helper takes much of the winnings; tails, the
Gotrocks lose and pay dearly for the privilege of
doing so - may make it more accurate to call the family
the Hadrocks. Today, in fact, the family's frictional
costs of all sorts may well amount to 20% of the earnings
of American business. In other words, the burden of
paying Helpers may cause American equity investors,
overall, to earn only 80% or so of what they would
earn if they just sat still and listened to no one.
Long
ago, Sir Isaac Newton gave us three laws of motion,
which were the work of genius. But Sir Isaac's talents
didn't extend to investing: He lost a bundle in the
South Sea Bubble, explaining later, "I can calculate
the movement of the stars, but not the madness of
men." If he had not been traumatized by this loss,
Sir Isaac might well have gone on to discover the
Fourth Law of Motion: For investors as a whole, returns
decrease as motion increases.
*Here's
the answer to the question posed at the beginning
of this section: To get very specific, the Dow increased
from 65.73 to 11,497.12 in the 20th century, and that
amounts to a gain of 5.3% compounded annually. [Investors
would also have received dividends, of course.] To
achieve an equal rate of gain in the 21st century,
the Dow will have to rise by December 31, 2099 to
- brace yourself - precisely 2,011,011.23. But I'm
willing to settle for 2,000,000; six years into this
century, the Dow has gained not at all.
---
Wall
Street History will return next week.
Brian
Trumbore
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