Warren Buffett’s 2006 Letter to Shareholders was posted yesterday. As always, it’s simply and clearly written. It’s also full of smart observations and sensible advice. And of course it’s highly entertaining (if you like cornball humor). Read the whole thing closely. Here are a few selected excerpts to whet your appetite:

Size seems to make many organizations slow-thinking, resistant to change and smug. In Churchill’s words: “We shape our buildings, and afterwards our buildings shape us.” Here’s a telling fact: Of the ten non-oil companies having the largest market capitalization in 1965 – titans such as General Motors, Sears, DuPont and Eastman Kodak – only one made the 2006 list.

My only tasks are to cheer [my managers] on, sculpt and harden our corporate culture, and make major capital-allocation decisions.

At ISCAR, as throughout Israel, brains and energy are ubiquitous.

We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk. We are not willing, though, to take on even very small exposures at prices that don’t reflect our evaluation of loss probabilities.

Our behavior… in financial markets: Be fearful when others are greedy, and be greedy when others are fearful.

We sometimes encounter accounting footnotes about important transactions that leave us baffled, and we go away suspicious that the reporting company wished it that way. (For example, try comprehending transactions “described” in the old 10-Ks of Enron, even after you know how the movie ended.)

When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. (As a wise friend told me long ago, “If you want to get a reputation as a good businessman, be sure to get into a good business.”) And fundamentals are definitely eroding in the newspaper industry, a trend that has caused the profits of our Buffalo News to decline. The skid will almost certainly continue.

…the economic potential of a newspaper internet site – given the many alternative sources of information and entertainment that are free and only a click away – is at best a small fraction of that existing in the past for a print newspaper facing no competition.

Charlie and I love newspapers – we each read five a day – and believe that a free and energetic press is a key ingredient for maintaining a great democracy. We hope that some combination of print and online will ward off economic doomsday for newspapers…. But the days of lush profits from our newspaper are over.

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 Scarlett O’Hara scenario: “I’ll think about that tomorrow.” For many home owners, “tomorrow” has now arrived.

I fervently believe in real trade – the more the better for both us and the world.

… derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts – few in number but sometimes for large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are free of counterparty credit risk.

It’s not hard, of course, to find smart people, among them individuals who have impressive investment records. But there is far more to successful long-term investing than brains and performance that has recently been good. Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions. Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.

… board members [must] be owner-oriented, business-savvy, interested and truly independent. … Charlie and I believe our four criteria are essential if directors are to do their job – which, by law, is to faithfully represent owners. Yet these criteria are usually ignored. … I’ve been queried many times about potential directors and have yet to hear anyone ask, “Does he think like an intelligent owner?”

At Berkshire… I am a one-man compensation committee who determines the salaries and incentives for the CEOs of around 40 significant operating businesses. How much time does this aspect of my job take? Virtually none. How many CEOs have voluntarily left us for other jobs in our 42-year history? Precisely none. … When we use incentives – and these can be large – they are always tied to the operating results for which a given CEO has authority. We issue no lottery tickets that carry payoffs unrelated to business performance.

Compensation reform will only occur if the largest institutional shareholders – it would only take a few – demand a fresh look at the whole system.

In my will I’ve stipulated that the proceeds from all Berkshire shares I still own at death are to be used for philanthropic purposes within ten years after my estate is closed. … I’ve set this schedule because I want the money to be spent relatively promptly by people I know to be capable, vigorous and motivated. These managerial attributes sometimes wane as institutions – particularly those that are exempt from market forces – age.

When Walter and Edwin [Schloss] were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.

… a finance instructor who [has] the nerve to question EMT [efficient markets theory] [has] about as much chance of major promotion as Galileo had of being named Pope.

Fred Schwed’s classic, 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 lightly delivers many truly important messages on the subject.

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 more to 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 tapdance to work.

Related:

Warren Buffett’s 2005 Letter To Berkshire Shareholders
Warren Buffett’s 2004 Letter To Berkshire Shareholders
Warren Buffett’s 2003 Letter To Berkshire Shareholders (still can’t find my notes)
Warren Buffett’s 2002 Letter To Berkshire Shareholders
Warren Buffett’s 2001 Letter To Berkshire Shareholders