Chairman Buffett’s 2005 Letter

Another great Letter to Shareholders from Warren Buffett — I especially enjoyed reading his straightforward take on executive compensation, the dangers of derivatives, and the importance of avoiding “frictional costs.” Every word is worth reading. Here are some selected excerpts:

When growth rates are under discussion, it will pay you to be suspicious as to why the beginning and terminal years have been selected.

You can’t expect to earn outsized profits in regulated utilities.

… low costs allow low prices that lead to steady gains in profitable business. That simple formula immediately impressed me 55 years ago when I first discovered GEICO.

Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

When a problem exists, whether in personnel or in business operations, the time to act is now.

Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner.

When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

If a management makes bad decisions in order to hit short-term earnings targets, and consequently gets behind the eight-ball in terms of costs, customer satisfaction or brand strength, no amount of subsequent brilliance will overcome the damage that has been inflicted.

It’s hard to overemphasize the importance of who is CEO of a company … Indeed, it’s difficult to overpay the truly extraordinary CEO of a giant enterprise. But this specie is rare. Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO – aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo – all too often receives gobs of money from an ill-designed compensation arrangement.

Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests.

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.

Previous posts:

Buffett’s Letter to Shareholders for 2004

(Can’t find 2003 yet… I know it’s around this site somewhere. ;-) )

Buffett’s Letter to Shareholders for 2002

Buffett’s Letter to Shareholders for 2001