FREE KIC - NO. 6 MARCH 06

Brilliant Buffett

The financial commentary I look forward to reading most each year has to be the Berkshire Hathaway newsletter to shareholders. In this newsletter Warren Buffett writes in an entertaining way about his views on all sorts of financial issues. If there is one thing I could recommend to people who have an interest in stock markets, it is that they should read these newsletters. (www.berkshirehathaway.com). As a matter of fact maybe you should stop reading this right now and go straight to Buffett. If you have time come back to read the rest of this opinion piece and see if you agree with me on the most interesting parts of this year's newsletter.

You may be aware that most professional investors do not beat the stock market index. In fact academics have come up with "The Efficient Market Hypothesis" to describe their belief that it is impossible for any investor to consistently do this. What the academics that believe in this rarely mention is the track record of Warren Buffett. The first page of the newsletter gives his track record going back to 1965 (so he has a track record as long as my life) and what a track record it is. This is what any aspiring investor should hope to emulate and this is why I believe that this is such a useful read.

The first thing that I would like to highlight is his discussion on the use of financial derivatives. I hope that what he has said will strike a warning bell in the minds of any executives that use non-traded derivatives in their organisations. If I were in the shoes of any such executive I would want to make sure that I understood the assumptions that were used. I would also want an internal audit team to double and triple check. Just look at the scale of losses that Buffett talks about in what are benign markets. He raises the legitimate question of what would happen in a tougher environment. This highlights another aspect of what I love about Buffett and that is his willingness to point out his mistakes. He admits that he should have acted faster to close down the derivatives book but he dithered. Honest is refreshing.

The next thing I would like to highlight is his discussion on executive compensation. I love it when he highlights how ridiculous this has become. Some day shareholders (or their representatives) will finally put an end to this spiralling increase in pay. He highlights how easy it is to generate massive compensation from the use of options. Let this be a warning to all shareholders that they should vote against management option packages in companies that do not pay a decent dividend. I may return to this topic in another opinion piece but I do not think I could put it any better than Buffett.

The third thing I would highlight is his discussion of what returns we should expect from stock markets in the long run. He points out how difficult it is for stock markets to go up more than the growth in earnings. He believes that this is somewhere around six percent. So let this be a warning to anyone who expects significantly more than this. Too many people get carried away on dreams of get rich quick schemes in the stock market. The reality is that unless you are lucky enough to find another Buffett you arte unlikely to achieve anything more than high single digit returns. In talking about returns Buffett also highlights the danger of what he calls "Frictional Costs". In plain English what he is highlighting is that ordinary investors should be very careful about how much of their investments end up in the hands of salespeople, fund managers, consultants and stockbrokers. He even goes on to point out the skewed risks involved in giving money to hedge funds. When things go well the hedge funds take most of the upside but when things go bad they don't take the downside. So let this be a warning to na?ve investors, be careful when somebody recommends a hedge fund and personally I would be more inclined to warn people against funds of hedge funds. In my opinion these genuinely have enormous frictional costs.

Buffett is now 75 and so time is not on his side. In the newsletter he acknowledges this and talks about his successor. He believes that he has found somebody who can continue on where he leaves off. I trust his judgement so maybe it's still not too late to invest in Berkshire Hathaway.

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