Friday, February 29, 2008

Warren Buffett's 2007 Shareholder Letter

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Excerpt:
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Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.
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Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.
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A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
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Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
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Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses
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But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.
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Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

It’s a matter of reading and asking questions

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Thursday, February 28, 2008

Eddie Lampert's Letter to Shareholders

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I mention this not because I am a Giants fan (I am actually a lifelong fan of the New York Jets) but rather because the Giants’ story reminds me of what we went through a few years ago with Kmart. When I first became involved with Kmart in 2002, during its bankruptcy, the company had been given up for dead by most industry analysts and media commentators. Kmart was like an undrafted free agent who nobody thought had a chance to play in the big leagues. Its more than 150,000 employees and its investors had an uncertain future. Despite intense criticism of and skepticism about the company and its prospects, we were able to rally Kmart’s various constituents and turn an unprofitable, failing company into a profitable company with hope for the future. Like Eli Manning, we know what it’s like to be underestimated and questioned, but we intend to keep working on our game to achieve our full potential.
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Looking forward, I continue to be excited about the prospects for Sears Holdings. In 2008, we need to reverse much of the profit erosion we experienced in 2007. It won’t be easy, especially if the economy stays soft. The environment surrounding U.S. retail has been very difficult; we were not alone in experiencing disappointing performance this past year. Many retail companies lost significant market value. As illustrated in the table below, while the recent correction has brought Sears Holdings’ stock price down from an increase of nearly 20 times since Kmart emerged from bankruptcy to around ten times, it remains one of the top-performing retail stocks over the past five years. In addition, it is not clear that heavy expenditures of capital guarantee either short or long term success. Like any investment of capital, the return on that capital over time will determine its wisdom.
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Pressing this point even further, some might ask, if you can’t justify investing in your stores, then how are you going to grow your business? To be clear, we are not saying that we can’t justify investing in our stores. The issue is more about the size and type of investment as well as the timing and sequencing of an investment. There are many things that a retailer can do to improve its business without the significant amounts of capital that a major remodel would require. Improving the assortment of products and services, mix of inventory, visual presentation, recruitment and training of employees, and marketing and communications to customers are all ways to generate improved performance. They all require significant investments, but we already invest a significant amount of capital and expense in all of these areas. The key is to improve the productivity of these investments. Our marketing and labor spend is in the billions of dollars each and we need to work diligently to get the most from these significant investments. Fundamentally, our capital allocation decisions are influenced by the alignment of management and owners with the goal of creating value for the shareholders of the business.

Tuesday, February 26, 2008

Mark Sellers: Take advantage when good companies come to market

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Free! Why $0.00 Is the Future of Business by Chris Anderson

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One day, while he was shaving with a straight razor that was so worn it could no longer be sharpened, the idea came to him. What if the blade could be made of a thin metal strip? Rather than spending time maintaining the blades, men could simply discard them when they became dull. A few years of metallurgy experimentation later, the disposable-blade safety razor was born. But it didn't take off immediately. In its first year, 1903, Gillette sold a total of 51 razors and 168 blades. Over the next two decades, he tried every marketing gimmick he could think of. He put his own face on the package, making him both legendary and, some people believed, fictional. He sold millions of razors to the Army at a steep discount, hoping the habits soldiers developed at war would carry over to peacetime. He sold razors in bulk to banks so they could give them away with new deposits ("shave and save" campaigns). Razors were bundled with everything from Wrigley's gum to packets of coffee, tea, spices, and marshmallows. The freebies helped to sell those products, but the tactic helped Gillette even more. By giving away the razors, which were useless by themselves, he was creating demand for disposable blades. A few billion blades later, this business model is now the foundation of entire industries: Give away the cell phone, sell the monthly plan; make the videogame console cheap and sell expensive games; install fancy coffeemakers in offices at no charge so you can sell managers expensive coffee sachets.
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· "Freemium"
What's free: Web software and services, some content. Free to whom: users of the basic version.
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· Advertising
What's free: content, services, software, and more. Free to whom: everyone.
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· Cross-subsidies
What's free: any product that entices you to pay for something else. Free to whom: everyone willing to pay eventually, one way or another.
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· Zero marginal cost
What's free: things that can be distributed without an appreciable cost to anyone. Free to whom: everyone.
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· Labor exchange
What's free: Web sites and services. Free to whom: all users, since the act of using these sites and services actually creates something of value.
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· Gift economy
What's free: the whole enchilada, be it open source software or user-generated content. Free to whom: everyone.
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Related 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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The Long Tail Web Site

Monday, February 25, 2008

Student Notes from Buffett Meeting Feb 15, 2008

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Friday, February 22, 2008

Beyond reason: The strange existence of market anomalies

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Wednesday, February 20, 2008

A Candidate for The Most Misused Quote of All Time

"In the long run we are all dead." - John Maynard Keynes
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The irony in Keynes' quote is not just that it is so often misinterpreted, but that it is generally misused in a way to defend a point that is the complete opposite of what Keynes was trying to say. The full quote (and description) goes as follows:
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"The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."
-- A Tract on Monetary Reform (1923) Ch. 3; many have thought this meant Keynes supported short terms gains against long term economic performance, but he was actually criticizing the belief that inflation would acceptably control itself without government intervention.
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-- A quote attributed to John Maynard Keynes, as a catch phrase in his rebuttal to laissez faire economics, as proposed by Adam Smith. The idea is that rather than "in the long run, everything will even out", that "in the long run, we're all dead", so we should aggressively push to rectify economic problems (within our lifetimes), rather than just letting everything work itself out.

Wednesday, February 13, 2008

Legg Mason Value Trust Investment Commentary: Fourth Quarter 2007

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Tuesday, February 12, 2008

Selected American Shares: Stocking up on Financials

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Berkshire Hathaway 2007 Annual Meeting - Valuation/IRR Question

Some thoughts from Mr. Buffett and Mr. Munger that I thought might be good to review:
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QUESTION – AREA 8:
A follow up on the other valuation questions.
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WB: Well, if government bonds earn 2%, we aren't going to buy something because it earns 3 or 4%. I don't ask Charlie every morning “what's our hurdle rate today?”
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CM: The concept of hurdle rate makes nothing but sense, but a lot of terrible errors are made by people talking about hurdle rates.
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WB: I've seen lots of presentations, on 19 corporate boards, all have calculated IRR. If they burned them all, the boards would have been better off. You just get nonsense figures.
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CM: I have a young friend who sells private partnership interests to investments, and it's hard to get returns in that field. I asked him, “what returns do you tell them you can get?” He said 20%. I said, how did you come up with that number? He said, “if I told them any lower they wouldn't give me the money.”
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QUESTION – AREA 11: Australia
How do you judge the right margin of safety to use when investing? For example, in a long standing and stable business, would you demand a 10% margin of safety, and if so, how would you increase this in a weaker business?
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WB: We favor the business where we think we know the answer. If a business gets to a point where we think anything is so chancy that we can't come up with a figure, we don't try to compensate. If we buy See's, or Coke, we don't think we need a huge margin of safety because we don't think we're going to be wrong about our assumptions. We'd love to find things selling at 40 cents on the dollar. If we get to something…when we see a great business, when you see someone walk in the door, you don't know if they weigh 300 pounds or 325 pounds, but you know he's fat. You don't need a huge margin of safety. There are times when we could buy businesses at a quarter of what they were worth, but you don't see those things very often. Should you sit around hoping that comes back for 10-15 years? That's not the way we do it.
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CM: The margin of safety concept boils down to getting more value than you're paying -- and that value can exist in a lot of different forms. If you're paid 4 to 1 on something that's an even money proposition, that's a value proposition too.
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QUESTION – AREA 1:
Chicago
Private equity is getting bigger than ever. Given the ocean of private equity firms out there chasing deals, are we in a bubble, and if so, what will cause it to burst?
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WB: Well we're competing with those people so actually I started to cry as you were reading your question. What we are seeing is just the nature of the activity -- it isn't a bubble that bursts. If you buy businesses that aren't priced daily, even if you do a poor job, it takes many years for the score to come up on the board and for investors to get out of the firm. The investors can't leave, and a scorecard is lacking for a long time. What will slow down the activity is if yields on junk bonds became much higher than yields on high-grade bonds. Right now the spread is down to a very low level. History has shown that periodically, the spread widens dramatically. One other aspect, if you have a $20 billion fund and you're getting a two percent fee, you're getting $400 million a year. You also have a lot of money in that fund you need to invest, and you can't start another fund with a straight face until you've got that money invested. So there is a great compulsion to invest very quickly so you can get another fund. Charlie and I will be particularly affected in competing with them. The math has to make sense for us, and here we don't get paid based on activity. I think it will be quite some time before disillusionment sets in and the money quits floating to people who are promoting this.
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CM: It can continue to go on quite a long time after you're in a state of total revulsion.
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Tuesday, February 5, 2008

Welcome to the Keynesian Nightmare - Annaly Capital Management

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Before World War II, the US had had many serious recessions or depressions, including 1807, 1837, 1873, 1882, 1893, 1907, 1920, 1933, and 1937. During the 1930s Depression, Keynes’ interpretation of the economic problem was that the US, indeed the world, was caught in what he described as a liquidity trap. A liquidity trap is defined as a time when institutions and consumers hoard money and refuse to spend, protecting their own financial assets for fear of losing them. He argued mightily for his solution to the problem, what we now call Keynesianism. To simplify, he wanted FDR to ‘prime the pump’ of the economy, to put so much money in people’s hands that the increased consumption would lead the way out of the liquidity trap, that the resulting improvement in consumer confidence and normalization of lending habits would reestablish the footing of the economy. The Roosevelt Administration and the economic community initially dismissed his ideas as too simplistic, but the New Deal came to look a lot like the Keynesian construct. Ultimately, the US was dragged out of the Depression by the deficit spending of World War II, but Keynesianism got the credit, thus setting the course of economic policy for much of the post-war Western world.
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So here we are sixty years past America’s emergence as the world’s dominant superpower, and the perversity of Keynesian theory has grown like a weed. I think it is fair to say that the world we are in today is not the world Keynes foresaw when he wrote his General Theory of Employment, Interest and Money in 1936. The most pronounced change, to me, is to the amount of debt capital issued in the US and its changing composition. The US grew during the Cold War economic boom thanks to the issuance of the US Treasury’s full faith and credit notes and bonds,, and since then the rest of the US economy has followed suit as society has gotten more and more comfortable with credit risk— first corporate debt, then consumer debt, then junk bonds, then mortgage debt, then structured debt. As a result, today the dominant part of the total debt structure in the US, the part that has played the largest role in driving GDP growth over the last decade, has occurred outside of the government’s purview.
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The Fairholme Fund - Annual Report and Letter to Shareholders

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Friday, February 1, 2008

Simplicity Still Pays - WCAM

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Four Goals of Tax Policy

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I [Mankiw] thought it might be useful to put the debate over fiscal stimulus in a broader perspective.
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When designing a tax system and evaluating tax proposals, policy analysts have at least four goals in mind:
  1. Efficiency: The tax system should distort incentives as little as possible (and, in the case of externalities and Pigovian taxes, correct incentives when necessary).
  2. Intergenerational equity: The tax system should raise enough revenue so current generations do not unduly burden future generations.
  3. Egalitarianism: The tax system should try to achieve a more equal distribution of after-tax incomes.
  4. Stabilization: The tax system should help maintain the economy at full employment.

The current debate over fiscal stimulus involves trading off these goals. The stimulus package being discussed is mainly aimed at achieving goal 4, but it does so at the cost of sacrificing goals 1 and 2 to some degree. Efficiency is sacrificed because the phase out raises effective marginal tax rates and because the higher future taxes that result from the extra government debt will likely be distortionary. Of course, the phase out is there in order to achieve goal 3: This is the classic tradeoff between efficiency and equality.

Differences of opinion arise when policy analysts weight these goals differently. Advocates of fiscal stimulus put a large weight on goal 4. Critics of fiscal stimulus come in two varieties. One type of critic discounts goal 4 entirely because they are skeptical of Keynesian theories that underlie this goal. A second type of critic admits that goal 4 is legitimate in principle but believes that in the current environment macroeconomic stabilization is best left to monetary policy so fiscal policy can focus on goals 1 and 2. I [Mankiw] am in this latter category.