BULLS & BEARS: Buffett’s skeptical eyes see plenty to fret about

Warren Buffett’s annual letter to Berkshire Hathaway shareholders was posted on the company’s Web site early this month. He has a way of distilling complex issues into simple messages using witty anecdotes.

Here is my Cliffs Notes version, but first a note of caution: One thing you don’t get from Buffett is the world viewed through rose-colored glasses.

Derivatives. Buffett resolved that when Berkshire acquired General Re, the large reinsurance company in 2001, he would unwind the company’s derivative contracts. Originally, General Re held 23,218 contracts and, as of year-end 2005, was down to 741 contracts. The cumulative loss incurred in the liquidation process has been $404 million.

He hopes this experience serves as a “canary in this business coal mine” as to the dangers that lurk in the multitrillion-dollar derivatives industry. In times of duress, the ability for multiple firms to liquidate derivatives in a chaotic market would pose serious problems for the financial system.

Here are his takes on a range of other topics:

Stocks. The stocks Berkshire holds “are not selling at anything like bargain prices. As a group, they may double in value in 10 years.” This confirms his earlier views that overall stock market returns may average in the mid-to-high single digits over the next several years.

The U.S. trade deficit. Here, Buffett repeats his views on the ominous long-term consequences for our widening trade deficit. “As foreigners increase their ownership of U.S. assets (or of claims against us) relative to U.S. investments abroad, these investors will begin earning more on their holdings than we do on ours.” (This brings to mind the national debate over the management of our ports by foreign entities and, closer to home, the Toll Road lease championed by Gov. Mitch Daniels). Uncorrected, he envisions a decline in the value of the U.S. dollar, higher inflation and rising interest rates.

Executive compensation. Too many boards lavish rich stock options on executives who simply compound earnings at unspectacular rates. Hefty severance payments, perks and outsized bonuses are all negotiated via compensation consultants who use this logic: “But, Mom, all the other kids have one.”

Investment “helpers.” Under the heading, “How to Minimize Investment Returns,” Buffett addresses the “frictional” costs “helpers” extract from investment returns for a family called the “Gotrocks.” He points out that investors, in aggregate, can earn only what their businesses in aggregate earn. After subtracting commissions and fees paid to advisers, consultants, hedge funds and private equity firms, he suspects equity investors earn only 80 percent of the returns they would have earned if they had just sat still. He muses that Isaac Newton, himself a poor investor, might well have discovered the Fourth Law of Motion: “For investors as a whole, returns decrease as motion increases.”

While some will criticize the scorn coming from a multibillionaire, one has only to look at the example he sets. Buffett collects a salary of $100,000 and holds 33 percent of Berkshire’s stock (99 percent of his net worth). He has never sold a share nor received company stock options. Berkshire’s gain in net worth has compounded at a 21.5-percent annual rate for 41 years-shareholders are getting the wisest capital allocator in history for a song.