The Oracle Told You So

This is the continuation of our analysis of Warren Buffett's annual letter to shareholders. For Part 1, click here.

The Bubble Burst

Buffett appears to have at least a small sense of pride in his year-ago prediction that the market could not sustain its lofty valuations. He says all the signs of a bubble were present and it was bound to burst, creating significant pain.

"[A] pin lies in wait for every bubble," he wrote. "And when the two eventually meet, a new wave of investors learns some very old lessons. First, many in Wall Street -- a community where quality control is not prized -- will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest."

It was simply way too easy. "Far more irrational still were the huge valuations that market participants were then putting on businesses almost certain to end up being of modest or no value," Buffett wrote. "Yet, investors, mesmerized by soaring stock prices and ignoring all else piled into these enterprises. It's as if some virus, racing wildly among investment professionals as well as amateurs, induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the businesses that underlay them.""Nothing sedates rationality like large doses of effortless money."

What's next? Buffett isn't saying. Instead, he gives his grandchildren's update of Aesop: "A girl in a convertible is worth five in the phone book."

You can bet Buffett isn't cruising the "White Pages" in this market.

Buffett Briefs

Buffett's letter also always contains some gems. Here are a few from this year's missives:

On the aging Buffett and Berkshire Vice-Chairman Charlie Munger:

"Finally, there is a negative that occurs annually, Charlie Munger and I are a year older than when we last reported to you. Mitigating this adverse development is the indisputable fact that the age of your top managers is increasing at a considerably lower rate -- percentage-wise -- than is the case at almost all other major corporations. Better yet, this differential will widen in the future."

On one-time charges taken by corporations to "hide" mistakes:

"The financial consequences of these boners are regularly dumped into massive restructuring charges or write-offs that are casually waved off as 'nonrecurring.' Managements just love these. Indeed, in recent years, it has seemed that no earnings statement is complete without them. The origins of these charges, though, are never explored. When it comes to corporate blunders, CEOs invoke the concept of the Virgin Birth."

On recent speculation in the equity markets:

"The line separating investment and speculation, which is never bright and clear, becomes blurred further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands."

On former SEC Chairman Arthur Levitt, Jr. and his efforts to curb selective disclosure and CEOs who were selective:

"We applaud the work that Arthur Levitt, Jr., until recently the Chairman of the SEC, has done in cracking down on the corporate practice of 'selective disclosure' that has spread like cancer in recent years Thanks to Chairman Levitt, whose general efforts on behalf of investors were both tireless and effective, corporations are now required to treat all of their owners equally. The fact that reform came about because of coercion rather than conscience should be a matter of shame for CEOs and their investor relations departments."

On CEOs who provide flowery business forecasts to analysts and investors:

"Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic -- but others will turn out to be congenital optimists, or even charlatans. Unfortunately, it's not easy for investors to know in advance which species they are dealing with."

Buffett's annual letter is only the beginning of a period of anticipation for thousands of Berkshire shareholders, culminating in the annual pilgrimage to Omaha to hear the Oracle respond to shareholder questions at Berkshire's annual meeting. This year's meeting will be on April 28, along with the usual trappings -- jewels from Borshiem's, furniture from Nebraska Furniture Mart and even jet airplane time-shares from Executive Jet. Oh, and don't forget steak from Gorat's, ice cream from Dairy Queen and baseball with the Omaha Golden Spikes, complete with Buffett facing Mr. Cub, Ernie Banks.

Before then, join Robert Hagstrom -- author of The Warren Buffett Way and The Warren Buffett Portfolio -- and me for a chat about Buffett's letter and the annual report this Tuesday at 4 p.m. EST. You can join us by signing up from our chat page.

And, let us know what you think. Shoot me an email about Buffett's letter or join the discussion on our message boards.

To return to the beginning of this column, click here.