Lawrence A. Cunningham - The Essays Of Warren Buffett

If you are a speculator, gambler, or trader, then your short-term holding period is largely unaffected by the long-term behaviour of management. But if you are an investor, defined as one who buys and holds a business, then the actions of management are critical to the long-term net worth of the business and this the future price of the stock.

In fact, we would not care in the least if several years went by in which there was no trading, or quotation of prices, in the stocks of those companies. If we have good long-term expectations, short-term price changes are meaningless for us to the extent they offer us an opportunity to increase our ownership at an attractive price.

We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed rate basis. We will reject opportunities rather than over-leverage our balance sheet.

Deferred tax liabilities bear no interest.

We will favor long-term, fixed-rate loans.

It is true that investors should focus on fundamentals, be patient, and exercise good judgement based on common sense.

Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders' role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.

For Buffett, managers are stewards of shareholder capital. The best managers think like owners in making business decisions. They have shareholder interests at heart. But even first-rate managers will sometimes have interests that conflict with those of shareholders.

Special attention must be paid to selecting a chief executive officer (CEO) because of three major differences Buffett identifies between CEOs and other employees. First, standards of measuring a CEO's performance are inadequate or easy to manipulate , so a CEO's performance is harder to measure than of most workers. Second, no one is senior to the CEO, so no senior persons' performance can be measured either. Third, a board of directors cannot serve that senior role since relations between CEOs and boards are conventionally congenial.

The CEOs at Berkshire's various operating companies enjoy a unique position in corporate America. They are given a simple set of commands: to run their business as if (1) they are its sole owner, (2) it is the only asset they hold, and (3) they can never sell or merge it for a hundred years. This enables Berkshire CEOs to manage with a long-term horizon ahead to them, something alien to the CEOs of public companies whose short-term orientated shareholders obsess with meeting the latest quarterly earnings estimate. Short-term results matter, of course, but the Berkshire approach avoids any pressure to achieve them at the expense of strengthening long-term competitive advantages.

If only short-term results mattered, many managerial decisions would be much easier, particularly those relating to businesses whose economic characteristics have eroded.

Many corporations pay their managers stock options whose value increases simply by retention of earnings, rather than by superior deployment of capital. As Buffett explains, however, simply by retaining and reinvesting earnings, managers can report annual earnings on capital. Stock options thus often rob shareholders of wealth and allocate the booty to executives. Moreover, once granted, stock options are often irrevocable, unconditional, and benefit managers without regard to individual performance.

It is possible to use stock options to instill a managerial culture that encourages owner-like thinking, Buffett agrees. But the alignment will not be perfect. Shareholders are exposed to the downside risks of sub-optimal capital deployment in a way that an option holder is not. Buffett therefore cautions shareholders who are reading proxy statements about approving option plans to be aware of the asymmetry in this kind of alignment. Many shareholders rationally ignore proxy statements, but the abuse of stock options should be on the front-burner of shareholders, particularly institutional investors that periodically engage in promoting corporate governance improvements.

Modern finance theory

This is an elaborate set of ideas that boil down to one simple and misleading practical implication: it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense.

It says you can eliminate the peculiar risk of any security by holding a diversified portfolio. The risk that is left over is the only risk for which investors will be compensated.

This leftover risk can be measured by a simple mathematical term - called beta - that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule.

Reverence for these ideas was not limited to ivory tower academics in colleges, universities, business schools, and law schools, but became standard dogma throughout financial America in the past 35 years, from Wall Street to Main Street.

To live or be in an ivory tower is not to know about or to want to avoid the ordinary and unpleasant things that happen in people's lives: Academics sitting in ivory towers have no understanding of what is important for ordinary people.

Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion.

Buffett points out the absurdity of beta by observing that "a stock that has dropped very sharply compared to the market . . . becomes 'riskier' at the lower price than it was at the higher price" - that is how beta measures risk. Equally unhelpful, beta cannot distinguish the risk inherent in "a single-product toy company selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie." But ordinary investors can make those distinctions by thinking about consumer behaviour and the way consumer products companies compete, and can also figure out when a huge stock-price drop signals a buying opportunity.

Contrary to modern finance theory, Buffett's investment knitting does not prescribe diversification. It may even call for concentration.

Buffett reminds us that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy. On that view, risk rises when investments and investment thinking are spread too thin. A strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor's thinking about a business and the comfort level he must have with its fundamental characteristics before buying it.

Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognising that as a investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such "flitting from flower to flower" imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes.

Instead of "don't put all your eggs in one basket," we get Mark Twain's advice from Pudd'nhead Wilson: "Put all your eggs in one basket - and watch that basket."

The Intelligent Investor

It rejects a prevalent but mistaken mind-set that equates price with value. On the contrary, Graham held that price is what you pay and value is what you get. These two things are rarely identical, but most people rarely notice any difference.

Mr. Market. He is your hypothetical business partner who is daily willing to buy your interest in a business or to manic swings from joy to despair. Sometimes he offers prices way higher than value; sometimes he offers prices way lower than value. The more manic-depressive he is, the greater the spread between price and value, and therefore the greater the investment opportunities he offers.

Mr. Market would be unrecognisable to modern finance theorists.

Margin-of-safety principle. One should not make an investment in a security unless there is a sufficient basis for believing that the price being paid is substantially lower than the value being delivered. Buffett follows the principle devotedly, noting that Graham said that if forced to distill the secret of sound investment into three words, they would be: margin of safety.

Modern finance theory enthusiasts cite market efficiency to deny there is a difference between price (what you pay) and value (what you get), Buffett and Graham regard it as all the difference in the world.

That difference also shows that the term "value investing" is a redundancy. All true investing must be based on an assessment of the relationship between price and value.

Strategies that do not employ this comparison of price and value do not amount to investing at all, but to speculation - the hope that price will rise, rather than the conviction that the price being paid is lower than the value being obtained.

Speculations describes the use of cash to bet on lots of corporate events based on rumors of unannounced coming transactions.

The circle of competence principle. This commonsense rule instructs investors to consider investments only concerning businesses they are capable of understanding with a modicum of effort. It is this commitment to stick with what he knows that enables Buffett to avoid the mistakes others repeatedly make, particularly those who feast on the fantasies of fast riches promised by technological fads and new era rhetoric that have recurrently infested speculative markets over the centuries.

In all investment thinking, one must guard against what Buffett calls the "institutional imperative."

Warren Buffett defined the institutional imperative as “the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so.” 

"If we aren't happy owning a piece of that business with the Exchange closed, we're not happy owning with the Exchange open."

Buffett notes Phil Fisher's suggestion that a company is like a restaurant, offering a menu that attracts people with particular tastes.

Corporate dividend policy is a major capital allocation issue.

"Capital allocation is crucial to business and investment management." Since 1998, Berkshire's common stock has been priced in the market at above $50,000 per share and the company's book value, earnings, and intrinsic value have steadily increased well in excess of average annual rates. Yet the company has never effected a stock split, and has not paid a cash dividend in over three decades.

Share repurchase of underpriced stock can be a value-enhancing way to allocate capital, those these are not always what they seem.

Stock splits are another common action in corporate America that Buffett points out disserve owner interests. Stocks splits have three consequences: they increase transaction costs by promoting high share turnover; they attract shareholders with short-term, market-orientated views who unduly focus on stock market prices; and, as a result of both those effects, they lead to prices that depart materially from intrinsic business value.

Buffett emphasises that useful financial statements must enable a user to answer three basic questions about a business: approximately how much a company is worth, its likely ability to meet its future obligations, and how good a job its managers are doing in operating the business.

Accounting goodwill is essentially the fair value of the assets acquired (after deducting liabilities). It is recorded as an asset on the balance sheet and then amortised as an annual expense, usually over 40 years. So the accounting goodwill assigned to that business decreases over time by the aggregate amount of that expense.

Economics goodwill. It is the combination of intangible assets, like brand name recognition, that enable a business to produce earnings on tangible assets, like plant and equipment, in excess of average rates. The amount of economic goodwill is the capitalized value of that excess. Economic goodwill tends to increase over time, at least nominally in proportion to inflation for mediocre businesses, and more than that for businesses with solid economic or franchise characteristics. Indeed, businesses with more economic goodwill relative to tangible assets are hurt far less by inflation than businesses with less of that.

One advantage, rather was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

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

When investing. we view ourselves as business analysts - not as market analysts, not as macroeconomic analysts, and not even as security analysts.

He said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market who is your partner in a private business. Without fail Mr. Market appears daily and names a price at which he will either buy your interest or sell you his.

The poor fellow has incurable emotional problems. At times he feels euphoric and can see only the favorable factors affecting the business. When in that mood, he names a very high buy-sell price because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead of both the business and the world. On these occasions he will name a very low price, since he is terrified that you will unload your interest in him.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. If his quotation is unintersting to you today, he will be back with a new one tomorrow. Transactions are strictly at your option. Under these conditions, the more manic-depressive his behaviour, the better for you.

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

If he shows up some day in a particularly foolish mood. you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.

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

Following Ben's teachings, Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but eventually will confirm it.

As Ben said: "In the short run, the market is a voting machine but in the long run it is a weighing machine."

In fact, delayed recognition can be an advantage: It may give us the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be more valuable than the underlying facts would indicate it is. In such as case, we will sell our holdings. Sometimes, also, we will sell a security that is fairly valued or even undervalued because we require funds for a still more undervalued investment or one we believe we understand better.

If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock price rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy to seeing stocks rise. Prospective purchasers should much prefer sinking prices.

Efficient market theory (EMT). Analysing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.

EMT, moreover, continues to be an integral part of the investment curriculum at major business schools.

When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that dissapoint. Peter Lynch aptly likens such behaviour to cutting the flowers and watering the weeds.

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.

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

Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times. Indeed, we'll know settle for one good idea a year.

We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as "the possibility of loss or injury."

Academics, however, like to define investment "risk" differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks.

It is better to be approximately right than precisely wrong.

For example, under beta-based theory, a stock that has dropped very sharply compared to the market - as had Washington Post when we bought it in 1973 - becomes "riskier" at the lower price than it was at the higher price.

In fact, the true investor welcomes volatility.

The more manic-depressive this chap (Mr.Market) is, the greater opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.

In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two.

Moreover, both Coke and Gillette have actually increased their worldwide shares of market in recent years. The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: "Competition may prove hazardous to human wealth."

The competitive strengths of a Coke or Gillette are obvious to even the causal observer of business. Yet the beta of their stocks is similar to that of a great many run-of-the-mill companies who possess little or no competitive advantage.

Why, then, should Charlie and I now think we can predict the future of other rapidly evolving businesses? We'll stick instead with the easy ones. Why search for a needle buried in a haystack when one is sitting in plain sight?

Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. The investor should both own a large number of equities and space out his purchases.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. 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 that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: "Too much of a good thing can be wonderful."

Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.

We continually search for large businesses with understandable, enduring and mouth-watering economics that are run by able and shareholder-orientated managements. This focus doesn't guarantee results: We both have to buy at a sensible price and get business performance from our companies that validates our assessment. But this investment approach - searching for superstars - offers us our only chance for real success.

John Maynard Keynes, whose brilliance as a praticing investor matched his brilliance in thought, wrote a letter to a business associate, F.C. Scott, on August 15, 1934 that says it all: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one know something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence."

An extreme example of what their attitude leads to is "portfolio insurance," a money-management strategy that many leading investment advisors embraced in 1986-1987. This strategy - which is simply an exotically labeled version of the small speculator's stop-loss order - dictates that ever-increasing portions of a stock portfolio, or their index - future equivalents, be sold as prices decline. The strategy says nothing else matters: A downtick of a given magnitude automatically produces a huge sell order. According to the Brady Report, $60 billion to $90 billion of equities were poised on this hair trigger in mid-October of 1987.

The less these companies are being valued at, says this approach, the more vigorously they should be sold. As a "logical" corollary, the approach commands the institutions to repurchase these companies - I'm not making this up - once their prices have rebounded signficantly. Considering that huge sums are controlled by managers following such Alice-in-Wonderland practices, is it any surprise that markets sometimes behave in abberational fashion?

Many commentators, however, have drawn an incorrect conclusion upon observing recent events: They are fond of saying that the small investor has no chance in a market now dominated by the erratic behavior of the big boys. This conclusion is dead wrong: Such markets are ideal for any investor - small or large - so long he sticks to his investment knitting. Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell an untoward times.

In each case we try to buy into business with favorable long-term economics. our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.

We try to buy not only good businesses, but one by high-grade, talented and likeable managers.

In the end, plenty of unintelligent capital allocation takes place in corporate America. (That's why you hear so much about "restructuring.")

Our equity-investing strategy remains little changed from what it was when we said in the 1977 annual report: "We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; (d) available at a very attractive price."

Consciously paying more for a stock than its calculated value - in the hope that it can be sold for a still-higher price - should be labeled speculation.

The more the industry has grown, the worse the disaster for owners.

[A]n intelligent investor in common stocks will do better in the secondary market than he will do buying new issues. The reason has to do with the way prices are set in each instance. The secondary market, which is periodically ruled by mass folly, is constantly setting a "clearing" price. No matter how foolish that price may be, it's what counts for the holder of a stock or bond who needs or wishes to sell, of whom there are always going to be a few at any moment. In many instances, shares worth x in business have sold in the market for 1/2x or less.

The new-issue market, on the other hand, is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction: It's rare you'll find x for 1/2x here. Indeed, in the case of common-stock offerings, selling shareholders are often motivated to unload only when they feel the market is overpaying.

Inactivity strikes us as intelligent investor.

In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength 10 or 20 years from now. A fast-changing industry may offer the chance for huge wins, but it precludes the certainty we seek.

As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration: We applaud the endeavour but prefer to skip the ride.

Investors making purchases in an overheated market need to recognise that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged. Unfortunately that is precisely what transpired years ago at both Coke and Gillette. (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?)

Peter Lynch call this diworsification.

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

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught course - How to value a business, and how to think about market prices.

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher 5, 10, and 20 years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualified, you should buy a meaningful amount of stock. You must also resist the temptation to stray from your guidelines. If you aren't willing to own a stock for 10 years, don't even think about owning it for 10 minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.

Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful.

This explains, by the way, why we don't own stocks of tech companies, even though we share the general view that our society will be transformed by their products and services. Our problem - which we can't solve by studying up - is that we have no insights into which participants in the tech filed possess a truly durable competitive advantage.

For instance, we bring nothing to the table when it comes to evaluating patents, manufacturing processes or geological prospects. So we simply don't get into judgements in those fields.

If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are approaching the perimeter. Predicting the long-term economics of companies that operate in fast-changing industries is simply far beyond our perimeter. If others claim predictive skill in those industries - and seem to have their claims validated by the behaviour of the stock market - we neither envy or emulate them. Instead, we just stick with what we understand.

If you buy a stock at sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase
will that puff all profit.

In other instances, a great investment opportunity occurs when a marvellous business encounters a one-time huge, but solvable, problem.

Unquestionably. some people have become very rich through the use of borrowed money. However, that's also been a way to get very poor. When leverage works, it magnifies your gains.

Once having profited from its wonders, very few people retreat to more conservtive practices.

History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. 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.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. 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.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965. It takes no less than $7 today to buy what $1 did at that time.

Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as "income".

For tax-paying investors, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor's visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points.

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer's hope that someone else - who also knows that the assets will be forever unproductive.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce - it will remain lifeless forever - but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money. Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold had some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow.

Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard "cash is king" in late 2008, just when cash should have been deployed rather than held.

My own preference - and you knew this was coming - is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.

Whether the currency a century from now is based on gold, sea-shells, shark teeth, or a piece of paper (as today), people will be willing to exchange a couple of minutes of their daily labor for a Coca-Cola or some See's peanut brittle. In the future the U.S. population will move more goods, consume more food, and required more living space than it does now. People will forever exchange what they produce for what others produce.

I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we've examined. More important, it will be by far the safest.

Purchasing junk bonds, we are dealing with entreprises that are far more marginal. These businesses are usually overloaded with debt and often operate in industries characterized by low returns of capital. Additionally, the quality of management is sometimes questionable. Management may even have interests that are directly counter to those of debt-holders. Therefore, we expect that we will have occasional large losses in junk issues. So far, however, we have done reasonably well in this field.

The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rules rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price, our only interest is in buying into well-managed banks at fair prices.

Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.

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.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applied with unusual force in the financial world: "Most men would rather die than think. Many do."

Junk bonds remain a mine field, even at prices that today are often a small fraction of issue price. As we said last year, we have never bought a new issue of a junk bond.

Most bonds, of course, require regular payments of interest, usually semi-annually. A zero-coupon bond, conversely, requires no current interest payments; instead, the investor receives his yield by purchasing the security at a significant discount from maturity value. The effective interest rate is determined by the original issue price, the maturity value, and the amount of time between issuance and maturity.

Occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredicatable.

Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.

Gotrocks family Story.

For investors as a whole, returns decrease as motion increases.

The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value.

As shareholders, we find this encouraging and rewarding for two important reasons.

The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value.

The other benefit or repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company's market value is well below its business value, management clearly demonstrates that it is given to actions to enhance the wealth of shareholders, rather than to actions that expand management's domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are rational.

A manager who consistently turns his back on repurchases, when these clearly are in the interest of owners, reveals more than he knows of his motivations.

If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day's supply.

Then I read Chapter Eight of Ben Graham's The Intelligent Investor, the chapter dealing with how investors should view fluctuations in stock prices. Immediately the scales fell from my eyes, and low prices become my friend. Picking up that book was one of the luckiest moments in my life.

The goal of each investor should be to create a portfolio (in effect, a "company") that will deliver him or her the highest possible look-through earnings a decade or so from now.

An approach of this kind will force the investor to think about long-term business prospects rather than short-term stock market prospects, a perspective likely to improve results. It's true, of course, that, in the long run, the scoreboard for investment decisions is market price. But prices will be determined by future earnings.

For decades, much of the business world has waged war against accounting rule makers, trying to keep the costs of stock options from being reflected in the profits of the corporations that issue them.

Typically executives have argued that options are hard to value and that therefore their costs should be ignored. At other times managers have said that assigning a cost to options would injure small start-up businesses. Sometimes they have even solemnly declared that "out-of-the-money" options (those with an exercise price equal to or above the current market price) have no value when they are issued.

Oddly, the Council of Institutional Investors has chimed in with a variation on that theme, opining that options should not be viewed as a cost because they "aren't dollars out of a company's coffers." I see this line of reasoning as offering exciting possibilities to American corporations for instantly improving their reported profits. For example, they could eliminate the cost of insurance by paying it with options.

Shareholders should understand that companies incur costs when they deliver something of value to another party and not just when cash changes hands.

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 bank on his quickly disposing of any share purchased through options. We cheer arrangements that motivate managers, whether these be cash bonuses or options. And if a company is truly receiving value for the options it issues, we see no reason why recording their cost should cut down on their use.

We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessman.

Indeed, we have usually made our best purchases when apprehensions about some macro event were at a peak. Fear is the foe of the faddist, but the friend of the fundamentalist.

Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behaviour is vital to long-term investment success.