Quotes from The Annual Letters of Warren Buffett

Some of my notes while reading The Essays of Warren Buffett By Lawrence Cunningham.

I believe the annual letters of Buffett is an invaluable source of investment knowledge. I recently reread all of them, in addition to rereading Lawrence Cunningham’s The Essays Of Warren Buffett – Lessons For Investors And Managers. The book is excerpts from all the annual letters and is basically all you need.¬†

I have read the annual letters a few times, but I learn more from them the more investment experience I gain. My advice is to reread them now and then. There is always something new to learn.

Below you find some notes from Cunningham’s book:

On corporate governance:

The most common situation , however, is a corporation without a controlling shareholder. This is where management problems are most acute.

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What the wise do in the beginning, fools do in the end.

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Indeed, most acquisitions are value-decreasing.

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When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder….And we don’t want to read messages that a public relations department or consultant has turned out. Instead, we expect a company’s CEO to explain in his or her own words what’s happening.

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Charlie and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies…..be suspicious of companies that trumpet earnings projections and growth expectations.

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The requisites for board membership should be business savvy, interest in the job, and owner-orientation.

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Having the right money manager, of course, is far more important to a fund than reducing the manager’s fee.

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Many people who are smart, articulate and admired have no real understanding of business.

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If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But,if each of us hires people who are bigger than we are, we shall become a company of giants.

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We want our managers to think about what counts, not how it will be counted.

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If you want to get a reputation as a good businessman, be sure to get into a good business.

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In setting compensation, we like to hold out the promise of large carrots, but make sure their delivery is tied directly to results in the area that a manager controls.

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It has become fashionable at public companies to describe almost every compensation plan as aligning the interests of management with those of shareholders. In our book, alignment means being a partner in both directions, not just on the upside.

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Charlie and I believe that a CEO must not delegate risk control.

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We can afford to lose money – even a lot of money. But we can’t afford to lose reputation – even a shred of reputation.

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Culture, more than rule books, determines how an organization behaves.

On finance and investing:

We look at the economic prospects of the business, the people in charge of running it, and the price we must pay.

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Mr. Market is there to serve you, not to guide you.

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…investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace.

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An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style.

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An investor should ordinarily hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.

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Charlie and I decided long ago that in an investment lifetime it’s too hard to make hundreds of smart decisions.

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It’s better to be approximately right than precisely wrong.

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In fact, the true investor welcomes volatility (on Mr. Market).

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But by confining himself to a relatively few, easy to understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy.

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I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices – the businesses he understands best and present the least risk, along with the greatest profit potential.

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I would say that the controlled company offers two main advantages. First, when we control a company we get to allocate capital, whereas we are likely to have little or nothing to say about this process with marketable holdings. This point can be important because the heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration – or, sometimes, institutional politics.

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The lack of skill that many CEOs have at capital allocation is no small matter: after ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.

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In our opinion, the two approaches (value vs. growth) are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

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Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pay’s out most of its earnings in dividends or makes significant stock repurchases.

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What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know. An investor needs to do very few things right as long as he or she avoids big mistakes.

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Inactivity strikes us as intelligent behavior.

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Intelligent investing is not complex, though that is far from saying it is easy. What an investor needs is the ability to correctly evaluate selected businesses. You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

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Time is the friend of the wonderful business, the enemy of the mediocre.

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I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

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…both in business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult.

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A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns.

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Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds.

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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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Leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices……History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

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Moreover, during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival.

Investment alternatives:

We have no particular bias when it comes to choosing from these categories (different investment alternatives).

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Most of these currency-based investments are thought of as “safe”. In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

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Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control.

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“In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

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Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

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We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 19080s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

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And mistakes have been the rule rather than the exception at many major banks.

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The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.

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Junk bonds lived up to their name.

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Beware of past performance “proofs” in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.

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As usual, the Street’s enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce.

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It’s impossible to default on a promise to pay nothing.

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The change brings to mind a New Yorker cartoon in which the grateful borrower rises to shake the hand of the bank’s lending officer and gushes: ” I don’t know how I’ll ever repay you”.

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In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction.

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In a business selling commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.

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You don’t have to make it back the way that you lost it.

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Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them.

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But closing down a derivatives business is easier said than done. In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit.

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When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

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In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

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

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I should note that the cemetery for seers has a huge section set aside for macro forecasters.

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Our country’s dynamism and resiliency have repeatedly made fools of nay-sayers.

On Common Stocks:

Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community.

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…we do not want to maximize the price at which Berkshire shares trade. We wish instead for them to trade in a narrow range centered at intrinsic business value…..Charlie and I are bothered as much by significant overvaluation as significant undervaluation.

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Our goal is to attract long-term owners who, at the time of purchase, have no timetable or price target for sale but plan instead to stay with us indefinitely.

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Dividend policy is often reported back to shareholders, but seldom explained. A company will say something like, “Our goal is to pay out 40% to 50% of earnings, and to increase dividends at a rate at least equal to the rise in the CPI”. And that’s it – no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management.

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These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.

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…for every dollar retained by the corporation, at least one dollar of market value will be created for owners….you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.

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When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.

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We will not repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated….Continuing shareholders are hurt unless shares are purchased below intrinsic value.

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The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.

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What should a long-term shareholder, such as Berkshire, cheer for during that period?I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years.

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The key to a rational stock price is rational shareholders, both current and prospective.

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In large part, however, we feel that high quality ownership can be attracted and maintained if we consistently communicate our business and ownership philosophy – along with no other conflicting message – and then let self selection follow its course…..We want those who think of themselves as business owners and invest in companies with the intention of staying a long time.

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A hyperactive stock market is the pickpocket of enterprise.

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On merger and acquisitions:

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It pays to be active interested, and open-minded, but it does not pay to be in a hurry.

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Practice doesn’t make perfect; practice makes permanent. And thereafter I revised my strategy and tried to buy good businesses at fair prices rather than fair businesses at good prices.

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If something’s not worth doing at all, it’s not worth doing well.

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Our share issuances follow a simple basic rule: we will not issue shares unless we receive as much intrinsic business value s we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that.

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Instead, our problem has been that we own a truly marvellous collection of businesses, which means that trading away a portion of them for something new almost never makes sense.

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But often the CEO asks a strategic planning staff, consultants or investment bankers whether an acquisition or two might make sense. That’s like asking your interior decorator whether you need a $50,000 rug.

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The acquisition problem is often compounded by a biological bias: Many CEOs attain their positions in part because they possess an abundance of animal spirits and ego.

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It’s hard for an empty sack to stand upright.

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We believe most deals do damage to the shareholders of the acquiring company. “Things are seldom what they seem, skim milk masquerades as cream”.

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…why potential buyers even look at projections prepared by sellers baffles me.

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Even so, we do have a few advantages, perhaps the greatest being that we don’t have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners.

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At Berkshire, our carefully crafted acquisition strategy is simply to wait for the phone to ring.

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It’s a learning process, and mistakes made in one year often contribute to competence and success in succeeding years.

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We find it meaningful when an owner cares about whom he sells to…..When an owner auctions off his business, exhibiting a total lack of interest in what follows, you will frequently find that it has been dressed up for sale, particularly when the seller is a “financial owner”. And if owners behave with little regard for their business and its people, their conduct will often contaminate attitudes and practices throughout the company.

On valuation and accounting:

Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

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Nothing sedates rationality like large doses of effortless money.

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First, many in Wall Street – a community in which quality control is not prized – will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest.

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Over the long term there has been a more consistent relationship between Berkshire’s market value and business value than has existed for any other publicly traded equity with which I am familiar. This is a tribute to you. Because you have been rational, interested, and investment-oriented, the market price for Berkshire stock has almost always been sensible. This unusual result has been achieved by a shareholder group with unusual demographics: virtually all of our shareholders are individuals, not institutions. No other public company our size can claim the same.

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My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission…..Keynes identified my problem: “The difficulty lies not in the new ideas but in escaping from the old ones”.

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Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.

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In contrast, a disproportionate number of great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets.

On Accounting Shenanigans:

Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome.

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Few of the perpetrators have been punished; many have not even been censured. It has been far safer to steal large sums with a pen than small sums with a gun.

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Predictably, the major  auditing firms and an army of CEOs stormed Washington to pressure the Senate Рwhat better institution to decide accounting questions? Рinto castrating the FASB. The voices of the protesters were amplified by their large political contributions, usually made with corporate money belonging to the very owners about to be bamboozled. It was not a sight for a civics class.

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When we consider investing in an option-issuing company, we make an appropriate downward adjustment to reported earnings, simply subtracting an amount equal to what the company could have realized by publicly selling options of like quantity and structure.

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Indeed, my successor at Berkshire may well receive much of his pay via options, albeit logically structured ones in respect to 1) an appropriate strike price, 2) an escalation in price that reflects the retention of earnings, and 3) a ban on his quickly disposing of any shares purchased through options.

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Call this behavior Son of Gresham: Bad accounting drives out the good.

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In the acquisition arena, restructuring has been raised to an art form: Managements now frequently use mergers to dishonestly rearrange the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings.

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Though auditors should regard the investing public as their client, they tend to kow-tow instead to the managers who choose them and dole out their pay.

Some random quotes throughout the book:

What this little tale tells us is that tax-paying investors will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate. But I suspect many Berkshire shareholders figured that out long ago.

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In a finite world, high growth rates must self-destruct…A high growth rate eventually forges its own anchor.

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A fat wallet is the enemy of superior investment results.

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We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen…..Imagine the cost to us, then, if we had let a fear of unknowns cause us to defer or alter the deployment of capital….Fear is the foe of the faddist, but the friend of the fundamentalist.

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What we promise you – along with more modest gains – is that during your ownership of Berkshire, you will fare just as Charlie and I do. If you suffer, we will suffer; if we prosper, so will you. And we will not break this bond by introducing compensation arrangements that give us a greater participation in the upside than on the downside.

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But there is far more to successful long-term investing than brains and performance that has recently been good. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically¬† programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed by financial institutions. Temperament is also important. Independent thinking, emotional stability, a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.