Monday, March 06, 2006

Warren's tidbits


Always fearful of derivatives, Warren's comments:

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the
needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s
difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation-conscious trader to have a long-dated contract on his books. 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.

So calculating options is an art, not a science, where two people trade paintings that are both more valuable than the other, as long as their worth is finally settled years into the future.

Warren almost apologizes to us shareholders in his letter for 2005.

I dwell on our experience in derivatives each year for two reasons. One is personal and
unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation.


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.”

Warren also admits failure with a few of his predictions:

Operating results at NetJets were a different story. I said last year that this business would earn
money in 2005 – and I was dead wrong.

He goes on happily about Europe making more money for NetJets, but comes back down to earth at the abysmal showing of the US market:

Despite a large increase in customers, however, our U.S. operation dipped far into the red. Its
efficiency fell, and costs soared.

On his major equity positions:

As a group, they may double in value in ten years.

Bill Cara disagress with Warren on this point, related to Gillette's CEO:

It’s hard to overemphasize the importance of who is CEO of a company.

On CEO compensation, coming from a man who pays himself just $100k per year (not like money really means anything to him anymore):

For his accomplishments, Jim was paid very well – but he earned every penny. (This is no academic evaluation: As a 9.7% owner of Gillette, Berkshire in effect paid that proportion of his compensation.) Indeed, it’s difficult to overpay the truly extraordinary CEO of a giant enterprise. But this species is rare.

This is an interesting note for all those companies repurchasing their stock:

Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of
Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company –
his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to
repurchase stock.

Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all.

Here is a good metric on whether a dividend is Buffett-approved.

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces
less extreme results but still can provide lush rewards for managers who achieve nothing.

He spins together another wording for his buy and hold mantra:

Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole,
returns decrease as motion increases.

And quite possibly the biggest reason why the Dow has been tanking lately...

Here’s the answer to the question posed at the beginning of this section: To get very specific, the
the Dow increased from 65.73 to 11,497.12 in the 20 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

Warren is a financial math genius. His most important point deals with risk:

Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero.

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