Warren Buffett’s 2006 Letter to Shareholders

Warren Buffett’s 2006 Letter to Shareholders. Some interesting remarks:

On Risks

Don't think, however, that we have lost our taste for risk. We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk... Our behavior here parallels that which we employ in financial markets: Be fearful when others are greedy, and be greedy when others are fearful.

On Accounting

We sometimes encounter accounting footnotes about important transactions that leave us baffled, and we go away suspicious that the reporting company wished it that way. (For example, try comprehending transactions "described" in the old 10-Ks of Enron, evenafter you know how the movie ended.)

On Residential Real Estate & Mortgages

The "optional" contracts and "teaser" rates that have been popular have allowed borrowersto make payments in the early years of their mortgages that fall far short of covering normal interest costs. Naturally, there are few defaults when virtually nothing is required of a borrower. As a cynic has said, "A rolling loan gathers no loss." But payments not made add to principal, and borrowers who can't afford normal monthly payments early on are hit later with above-normal monthly obligations. This is the Scarlett O'Hara scenario: "I'll think about that tomorrow." For many home owners, "tomorrow" has now arrived.

On US Trade Deficit

As our U.S. trade problems worsen, the probability that the dollar will weaken over time continues to be high. ...Like a very wealthy but self-indulgent family, we peeled off a bit of what we owned in order to consume more than we produced. These transfers will have consequences, however. Already the prediction I made last year aboutone fall-out from our spending binge has come true: The "investment income" account of our country---positive in every previous year since 1915 --- turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we've used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience "reverse compounding" as we pay ever-increasing amounts of interest on interest.

On Derivatives

The answer is that derivatives, just like stocks and bonds, are sometimes wildly mispriced. For many years, accordingly, we have selectively written derivative contracts --- few in number but sometimesfor large dollar amounts. We currently have 62 contracts outstanding. I manage them personally, and they are free of counterparty credit risk.

On Efficient Market Theory

When I talked about Walter 23 yearsago, his record forcefully contradicted this dogma [EMT]. ... The faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope. Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was "right" (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses --- that is, stocks --- were useless. Walter meanwhile went on overperforming, his job made easierby the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it's helpful to have all of your potential competitors be taught that the earth is flat.