Thursday, July 31, 2008

Video: A Conversation with Charlie Munger

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If you would like to download the video, see this post: RealPlayer - A Useful New Addition
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Poor Charlie's Almanack
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Fairholme: Semi-Annual Report

Over the eight and a half years since the Fund’s inception, we have lived by the belief that you should be fearful where others are greedy and to be greedy where others are fearful. We continue to ignore the crowd.

For instance, as energy stocks surged this year, we took profits in Canadian Natural
Resources, reducing our position to about 7% of net assets as of May 31, down from 15% on Nov. 30, 2007. Oil and gas prices have multiplied since our initial purchases and are now high enough to increase supply and slow demand. Alternative sources such as solar and wind are booming while sales of SUVs and other gas hogs have plunged.

We also halved our position in Berkshire Hathaway in the November-May period. While we have the greatest respect for Chairman Warren Buffett, we made this move because we cannot see how the company can replicate its past stellar performance given its current size and the age of its key personnel. Berkshire should still make good money for shareholders, but not enough to justify so large an investment at prices sold.

With the proceeds of sales, new inflows, and cash held for stressful times, we are buying healthcare stocks, ranging from manufacturers of ethical and generic drugs to health maintenance organizations, at what we consider reasonable or even dirtcheap valuations. Many of these stocks’ prices fell off the proverbial cliff prior to our purchases and have declined further since we took our initial positions. On May 31, global pharmaceutical giant Pfizer was about 10% of net assets, making it the Fund’s second largest holding. Also in the top ten is WellPoint, a provider of health maintenance organizations and other forms of medical insurance. These fundamentally sound businesses have become fallen angels, as slowing growth, rising costs, and election-year politics stoke investor fear. Still, these are companies with essential products and services and large free cash flows relative to purchase prices. We expect them to rise again.
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Wednesday, July 30, 2008

Bill Miller - Legg Mason Value Trust - Q2 Letter

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Monday, July 28, 2008

Oak Value Fund - Q2 Letter

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Also, Larry Coats (co-manager of the fund) recently made another appearance on BNN and discussed American Express and Tiffany, among other things.
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Thursday, July 24, 2008

Upfront and Unscripted with Jeff Bezos (Audio)

I think Jeff Bezos and Chris Anderson are two of the best people from which to learn. I don't know how I missed this podcast the first time, but it is really great (in my opinion). I also think the iPod-like comparison is a valid one for The Kindle. A quote I enjoyed from Bezos: "You have to have a willingness to be misunderstood if you're going to pioneer."
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Previous Bezos posts/links:
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Previous Anderson posts/links:
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Article: "The Long Tail" by Chris Anderson
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The Long Tail: Book and Audio Book
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Wednesday, July 23, 2008

The Capacity of Self-Control

A quick checklist that might be of use by one under the influence of temptation…...be it the temptation to invest outside of one’s circle of competence, the temptation to break a diet, give in to a bad habit one is trying to get rid of, act over an amorous occurrence (per the example of Epictetus below), or anything else.

1. Remind yourself to take care of your _______.

To illustrate, let’s use the example of one who is either on a diet or just trying (or needs) to eat healthy. When that fresh, 2-slice special of double cheese, pepperoni pizza crosses your path, it may be useful to remind yourself of the importance of taking care of your body/health (to fill in the blank above).

To use another example related to investing, when you see a stock with huge upside but it is either a little outside of your circle of competence or has too much debt, it may be a good idea to remind yourself to take care of your downside first, before thinking about the upside potential.

2. Just because something exists and you are able to do something (i.e. it is physically possible for you to do it, whether you should or not), that doesn’t mean it is an option for you to do (way for you to behave).

Just because the pizza exists (or the orange chicken, fried rice and egg roll combo), that doesn’t mean it is has to be an option for you to pursue if you are trying to eat healthy. Consider only what falls within your parameters.

Likewise, just because a stock looks like it is really undervalued by looking at a few numbers or by looking at who else is buying shares, it doesn’t mean it should actually be an option for you to buy if it is outside of your circle of competence, even if you are physically capable of executing the trade.

3. Ask yourself, what capacity do you have to deal with this situation?

This final determination comes from Epictetus in The Encheiridion (#10 – Nicholas P. White translation):

At each thing that happens to you, remember to turn to yourself and ask what capacity you have for dealing with it. If you see a beautiful boy or woman, you will find the capacity of self-control for that. If hardship comes to you, you will find endurance. If it is abuse [abusive words], you will find patience. And if you become used to this, you will not be carried away by appearances.
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For other translations of The Enchiridion (aka -The Encheiridion or The Handbook), click HERE.
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Monday, July 21, 2008

Mr. Buffett on the Stock Market - 1999 Article from FORTUNE

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Mandela: His 8 Lessons of Leadership - By Richard Stengel

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Wednesday, July 16, 2008

A Find in Fremont

This is an analysis by my friend and colleague, Matt Miller, on Fremont Michigan Insuracorp (FMMH.OB):
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A Find in Fremont

Fremont Michigan Insuracorp Inc. (FMMH.OB), headquartered in Fremont, MI, the “Baby Food Capital of the World,” underwrites multiple lines of personal and commercial insurance, including homeowners and automobile, exclusively in the state of Michigan. The company dates its founding back to 1876, though it only recently came public via a demutualization in 2004. The company struggled in the early to mid nineties with inadequate rates and was nearly forced out of business by state regulators. Fortunately, Dick Dunning, a former Gerber financial executive came in as CEO and turned the company around.

Discount to Book Value

The company currently trades at a significant discount to stated book value. The reported balance sheet book value per share is $21.64 (adjusted for recent stock dividend, as are all numbers that follow) and the company is currently trading at $18.34 [Note - it is actually at $16.50-$17.00 today, but $18.34 was the price when the numbers were pulled together for the analysis], which means its shares can be purchased for approximately 84.8% of book value.

Hidden Asset

Included in book value per share is the company’s owned headquarters building in the town of Fremont. It is large brick building which provides adequate room for growth, as within the last ten years it housed nearly 100 employees, but now currently hosts approximately 60. According to the company’s statutory financial statements filed with the state of Michigan, the book carrying value at December 31, 2006 was approximately $760,000 while the fair value of the property as appraised in 2005 was approximately $3,400,000. Given that the building has been further depreciated since that time and that there are approximately 1.83 mm shares outstanding, the book value of the company is being understated by at least $1.45 per share. Adjusting book value for this asset leads to an adjusted value of approximately $23.09 per share, which means shares in the company can be purchased in the open market at 79.4% of adjusted book value.

Insurance Operations and Underwriting

The company is a single state indirect writer in Michigan of both personal (70% of DPW) and commercial lines (30% of DPW), including its two largest lines of business, personal auto (33% of DPW) and homeowners (31% of DPW). Its other significant lines of business include business owners, commercial package, workers comp, farm and marine. For the most part, the company writes its business in rural and western Michigan, preferring to stay away from more litigious areas like Detroit. It focuses on insuring good risks, typically with higher insurance credit scores of 700 or higher. The company’s agent base consists of approximately 180 agents in its target markets, a number which has purposefully been trimmed over the last several years from about 220. The company has made a conscious effort to eliminate poor performing agents and create an atmosphere of “franchise-like” territories for its agents.

Despite the current soft market in insurance, the company has been prudently expanding its book of business by growing its auto coverage, a feat made possible by its investments in technology (detailed below). Most of the growth has been achieved by pairing auto policies with its traditionally larger book of homeowners policies. The company would like to be more aggressive with its expansion of its commercial lines, but given the current soft market and the greater price sensitivity in the commercial lines, it has been unwilling to sacrifice the quality of its commercial book for growth in its commercial book.

None of these numbers would mean very much if the company ran a poor insurance operation, but fortunately, the team at FMMH runs a fine book of business. The company’s reserves for claims tend to be conservative, and in fact the company has been redundant in six of the last ten years. Per the company’s most recent 10-k below is the cumulative net of reinsurance redundancies (deficiencies) over the last ten years.

Year..........Net Cumulative Redundancy
........................(Deficiency) (mm)

1997....................682
1998....................866
1999...................-407
2000...................-1,843
2001...................-256
2002...................-477
2003....................2,765
2004....................5,597
2005....................6,584
2006....................4,132

The company’s new CFO, Kevin Kaastra, joined the company in 2003. His stated desire or philosophy when it comes to reserving is to not have to go back to shareholders with deficiencies. There may be some additional upside to the company’s book value given the most recent reserving and this philosophy, but we do not build it into our valuation. At the very least this suggests that the company’s adjusted book value is not overstated because of reserving deficiencies. Stated book value and adjusted book value ought to be fairly representative of the company's true economic position.

Also provided below is a table, from the most recent 10-k of the company’s underwriting results over the last eight years. It highlights two important points. First the significant decline in loss experience, driven partly by the release of reserves and partly by some exceptional underwriting results in 2005 and 2006 (calm weather years). Second, it shows a more recent spike in the expense ratio, something the company is working on improving. All of the company’s investment in technology has taken place in the last three years and those cost of internal technology development are being amortized over three years, which is much shorter than the true useful life of the technology. It is admittedly an area the company needs to improve upon to remain competitive. The company’s target is a 34 expense ratio (as a note its target combined ratio is 94).


.......................................2000.....2001.....2002.....2003.....2004.....2005.....2006.....2007
Net loss and LAE ratio....65.60....86.70....64.80....62.80....62.70....53.40.....44.80.....57.10
Expense ratio....................35.50....33.10....39.40....38.10....35.40....32.30.....34.60.....37.20
GAAP combined ratio....101.10..119.80..104.20..100.90...98.10....85.70.....79.40.....94.30

The company runs a very conservative, perhaps too conservative, reinsurance program. Its maximum exposure on any one risk is $150,000 and on any one catastrophe event is $1,250,000. These low “deductibles” also play a part in the company’s higher expense ratio. As the company is now in a much stronger financial position, it has indicated its willingness to retain some additional risk. While such a decision may add additional risk to the balance sheet and result in a more volatile earnings stream, given the history of the company’s underwriting and the current cost of maintaining its reinsurance coverage, the long-term economics of the business should improve.

Balance Sheet

The company currently runs a conservative investment balance sheet. FMMH has no toxic investments, like those coming to light on a number of other insurers balance sheets. Below is the investment profile of the company’s balance sheet at December 31, 2007. The company’s mortgage-backed securities are all GSE securities.


.........................................................................................2007
...............................................................Fair Value........................Allocation
Fixed maturities:

U.S. Treasury securities and
Obligations of U.S. government
corporations and agencies..................................................3,198,181.............................5.40%
States and political subdivisions..................................... ...25,761,183...........................43.80%
Corporate securities..............................6,833,902...........................11.60%
Mortgage-backed securities..... ........................................14,735,608............................25.10%

Equity Securities:

Common Stocks.....................................8,305,133.............................14.10%
Preferred Stocks...................................................0...............................0.00%

Total investments.............................$ 58,834,007..........................100.00%


Investments in Technology

As the company has strengthened its capital position over the last several years, it has made significant investments in technology. An internally developed system known as Fremont Complete, positions them well in the agency community and for growth in the future. The company has spent approximately $2.5 mm over the last three years developing this automation platform.

Miscellaneous

- the company’s A.M. Best rating was reaffirmed in January of this year at B++ (company is targeting an A- to better position itself in commercial lines of business)
- 13.2% of the company is owned by management, the board and the company’s 401(k)
- the company recently announced a buy-back of 100,000 shares, representing approximately 5.6% of the outstanding shares
- company recently announced a 3% share dividend in conjunction with share repurchase (numbers in this write-up have been adjusted accordingly)
- very little to no institutional holdings

Risks

Local Catastrophes and Weather

The company is a single-state writer of homeowners insurance, which amplifies its risk on localized catastrophes. Though the risk is mitigated somewhat by the nature and frequencies of the risks in Michigan and its current reinsurance policies, expanding to additional states over time would broaden their geographic exposure and provide opportunities for significant growth. The major weather risks faced by the company are the impact of extreme cold weather in the winter (causing fires, frozen pipes, melting water, additional auto accidents, etc.) and thunderstorms in the summer (causing wind, rain damage, etc.). Though there are occasionally tornados in the state, their frequency is far below that of other states in the Midwest. The chart below, generated from NOAA Satellite and Information Services data, puts this storm type in perspective.


.................................................Number of Tornados (1998 through 2007)

State..................................Total Tornados..........F1 or Higher..........F2 or Higer
Michigan...................................178.............................77...........................14
Iowa...........................................643...........................237...........................77
Oklahoma..................................672...........................284...........................93
California...................................102.............................17.............................1
North Carolina..........................326...........................116...........................26

Michigan Economy

Also, as a single state writer in Michigan, the company faces a difficult local economy as industrial jobs have migrated elsewhere. Though something to keep an eye, the company’s focus on western, rural Michigan as opposed to the heavily industrialized areas of the eastern part of the state helps mitigate this risk to some degree.

Michigan Regulation

As a single state writer of insurance, which is heavily regulated by the state, the company will face the threat of adverse regulatory changes in Michigan. Michigan is currently a modified no-fault auto state (suits are permitted only when an injured person suffers death, serious disfigurement or serious impairment of a bodily function) and it requires unlimited medical coverage to auto accident victims. The state run MCCA fund provides mandatory reinsurance for claims over $325k. Currently the state allows the use of credit scoring in insurance underwriting, though this is now being challenged in the state courts. A change in any of these policies or other state regulations could have a significant impact on the company’s operations.

Dependence on Underwriting Results

One of the drawbacks to the current state of the company is the lack of investment leverage (see chart below). The significant growth in equity over the last several years has outpaced the growth in company’s investment portfolio. The result is that future growth in book value is almost completely dependent on sound underwriting results. It certainly necessitates discipline, something we believe the management to have, but it does need to be considered a risk and recognized as a diminishing factor in the company’s valuation profile.


..........................................2002.....2003.....2004.....2005.....2006.....2007
Investment Leverage......3.17.......4.22.......2.66.......2.05.......1.79.......1.60

Valuation

So considering the risks, nature of the business, and economics, what do we think the company is worth? Given the company specific risks, nature of its underwriting and reserving, its prospects for additional market share accumulation in the state of Michigan and possible expansion into other states we believe a multiple to book of 1.3 to 1.4 times is appropriate. The overall price to tangible book value of the property and casualty industry is 1.7 (FMMH book value is all tangible). Allowing for a discount of .4 to .3 times book value due to the single state nature of its business and the fact that it is a micro cap company, we derive a value, per share, of $30.02 to $32.33. That would result in a discount to intrinsic value of between approximately 39.5% and 43.3%, and since we are buying below an understated book value, we see very little downside to a long-term holder at these prices. Believing that the company has the infrastructure and management expertise to grow its intrinsic value in the range of 10-14% per year over the next several years, we find such a discount to be quite attractive. Given these parameters we expect a greater than 20% per year return over the next five years.

Potential Catalysts
- the company was demutualized in 2004 and as part of that process no individual entity could own more than 5% of the company’s outstanding shares for five years; this period ends next fall (there are a couple holders of more than 5% currently which had to go through exhaustive processes with the state of MI after inadvertently going over the 5% limit)
- share buy-back
- further leveraging of expense ratio
- continued growth in BV per share
- change in reinsurance program to add additional risk to balance sheet
- increase investor awareness of a small-cap bulletin board stock
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*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision. We own shares of the company, either directly or indirectly, and we may buy or sell shares at any time without updating this post.

Tuesday, July 15, 2008

Wesco Financial 1990 Letter

Great find by Dual_Bid on the MSN Berkshire Board.
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Also, if you own the latest edition of Peter Bevelin's Seeking Wisdom: From Darwin to Munger, check out page 268 where he gives Charlie's excerpt as a lesson on why bad lending happens so often. The current financial crisis provides further evidence of this and also shows the wisdom in Mark Twain's quote: "History doesn't repeat itself, but it rhymes." The present situation was very likely avoidable.
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Mr. Munger's insights on the lending business:
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Granting the presence of perverse incentives, what are the operating mechanics that cause widespread bad loans (where the higher interest rates do not adequately cover increased risk of loss) under our present system? After all, the bad lending, while it has a surface plausibility to bankers under cost pressure, is, by definition, not rational, at least for the lending banks and the wider civilization. How then does bad lending occur so often?

It occurs (partly) because there are predictable irrationalities among people as social animals. It is now pretty clear (in experimental social psychology) that people on the horns of a dilemma, which is where our system has placed our bankers, are extra likely to react unwisely to the example of other peoples' conduct, now widely called "social proof". So, once some banker has apparently (but not really) solved his cost-pressure problem by unwise lending, a considerable amount of imitative "crowd folly", relying on the "social proof", is the natural consequence. Additional massive irrational lending is caused by "reinforcement" of foolish behavior, caused by unwise accounting convention in a manner discussed later in this letter. It is hard to be wise when the messages which drive you are wrong messages provided by a mal-designed system.

In chemistry, if you mix items that explode in combination, you always get in trouble until you learn not to allow the mixture. So also, in the American banking system. To us, a lot of foolish, unproductive lending and many bank insolvencies are the natural consequences, given existing American banking culture, of the combination of the following two elements alone:

(1) virtually unlimited deposit insurance; and

(2) uncontrolled interest rates on insured deposits.

These two elements combine to create a Gresham's law effect, in which "bad lending tends to drive out good." Then, if factor (3) below is added to an already unsound combination, we think deposit-insurance troubles are sure to be further expanded -- and not by a small amount:

(3) relatively unregulated, non-insured, low-cost "non-bank" banks.

Moreover, when the government starts suffering big deposit-insurance losses, if it continuously responds (in a natural, unthinking reaction) by raising deposit-insurance prices, we think it creates a "runaway-feedback" mode and makes its problems worse. This happens because the government, by adding even more cost pressure on banks, increases the cause of the troubles it is trying to cure. The price-raising "cure" is the equivalent of trying to extinguish a fire with kerosene.

Many eminent "experts" would not agree with our notions about systemic irresponsibility from combining (1) "free-market" pricing of interest rates with (2) government guarantees of payment. If many eminent "experts" are wrong, how could this happen? Our explanation is that the "experts" are over-charmed with an admirable, powerful, predictive model, coming down from Adam Smith. Those discretionary interest rates on deposits have a "free-market" image, making it easy to conclude, automatically, that the discretionary rates, like other free- market processes, must be good. Indeed, they are appraised as remaining good even when combined with governmental deposit insurance, a radical non-free-market element.

Such illogical thinking, displays the standard folly bedeviling the "expert" role in any soft science: one tends to use only models from one's own segment of a discipline, ignoring or
underweighing others. Furthermore, the more powerful and useful is any model, the more error it tends to produce through overconfident misuse.
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This brings to mind Ben Graham's paradoxical observation that good ideas cause more investment mischief than bad ideas. He had it right. It is so easy for us all to push a really good idea to wretched excess, as in the case of the Florida land bubble or the "nifty fifty" corporate stocks. Then mix in a little "social proof" (from other experts), and brains (including ours) often turn to mush. It would be nice if great old models never tricked us, but, alas, "some dreams are not to be." Even Einstein got tricked in his later years.
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Markel Annual Meeting Notes 2008

These are a couple of months old, but with the stock price currently hanging just below $330 per share, I thought one line might be a worthwhile one to review:
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*This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

Monday, July 14, 2008

The endowment effect: It’s mine, I tell you

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Related books:
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Nudge: Improving Decisions About Health, Wealth, and Happiness
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Predictably Irrational: The Hidden Forces That Shape Our Decisions (Also available in an AUDIO BOOK)

Tectonic shifts - Apollo Asia Fund: the manager's report for 2Q2008

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IFRS, the new accounting standards, make the task of analysing individual companies much harder: for the amateur investor, or for strategists trying to evaluate the whole stock universe, they must be a nightmare. Spreadsheets are necessary to extract long lists of exceptional items from reported profits in order to discern the trends. Headline earnings are so volatile as to be meaningless; book values are now based on shifting sands rather than the rock of objectivity. The job of the institutional CIO is unenviable. A recent FT article revealed that Sir David Tweedie was reacting to abuses he saw in the 1980s: his cure seems likely to result in much greater abuse in the long run, with the immediate drawback of incomprehensibility - which seems especially unfortunate when business conditions are so volatile. The time-honoured Asian practice of keeping three sets of books - one for the bank, one for the taxman, and one for the management - is returning, but now we have one set for the management and another for the public (and doubtless the other sets too). Inefficient markets may favour the stockpicker, but are hardly in the public interest.
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Wednesday, July 9, 2008

The Gospel of Wealth by Andrew Carnegie

Description from Wikipedia:
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"Wealth", or what is more commonly known as "The Gospel of Wealth", is an essay written by Andrew Carnegie in 1889 that described the responsibility of philanthropy by the new upper class of self-made rich. The central thesis of Carnegie's essay was the peril of allowing large sums of money to be passed into the hands of persons or organizations ill-equipped mentally or emotionally to cope with them. As a result, the wealthy entrepreneur must assume the responsibility of distributing his fortune in a way that it will be put to good use, and not wasted on frivolous expenditure. The very existence of poverty in a capitalistic society could be negated by wealthy philanthropic businessmen and women.
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Andrew Carnegie effectively softened some of the harshness of the theory of social Darwinism. He preached that ostentatious living and amassing private treasures were wrong. Carnegie professed the virtues of a laissez-faire system in which the government did not interfere with an individual or organization's right to do as it pleased. His "gospel of wealth" earned much praise, but did not win many converts. Carnegie made it clear that the wealthy were responsible for the recirculation of their money back into society where it could be used to support the greater good. He claimed that, in bettering society and people here on earth, one would be rewarded at the gates of Paradise.
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Carnegie based his philosophy on the observation that the heirs of large fortunes frequently squandered them in riotous living rather than nurturing and growing them. Even bequeathing one's fortune to charity was no guarantee that it would be used wisely, since there was no guarantee that a charitable organization not under one's direction would use the money in accordance with one's wishes. Carnegie disapproved of charitable giving that merely maintained the poor in their impoverished state, and urged a movement toward the creation of a new mode of giving which would create opportunities for the beneficiaries of the gift to better themselves. As a result, the gift would not be merely consumed, but would be productive of even greater wealth throughout the society.
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Carnegie put his philosophy into practice through a program of gifts to endow public libraries in cities and towns throughout the United States, with the idea that he was thus providing people with the tools to better themselves. In order to ensure that his gifts would not be wasted, he stipulated that the municipality must pass an ordinance establishing a tax to support the library's ongoing operating costs after the initial grant provided the costs for building and equipping the library. After several communities squandered their grants on extravagant buildings, Carnegie established a system of architectural guidelines that mandated simplicity and functionality. When it became obvious that Carnegie could not give away his entire fortune within his lifetime, he established the Carnegie Foundation to continue his program of giving.
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