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Taggart
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Post by Taggart »

Bylo Selhi wrote:
Taggart wrote:I'm surprised that the Spiegel reporters didn't question Buffett on his own use of derivatives, especially when he condemns a financial instrument and then turns around and uses them himself.
And I'm surprised that you (apparently) haven't read Buffett's letters to shareholders for the past several years where he annually explains what happened and repeats his mea culpa mantra ;)

BRK's purchase of GenRe several years ago included 10s of 1,000s of derivatives that GenRe had on its books. Buffett's intention was to unwind these ASAP, however, for various reasons, which he explains and for which he accepts full responsibility, this has taken longer than expected. Buffett didn't enter into those contracts, nor would he have.
Berkshire bought General Reinsurance about ten years ago. Buffett is supposed to be unwinding these derivatives over the years. However, Doug Kass is saying "There was even less coverage of Buffett's recent foray into derivatives. Berkshire's exposure to derivatives increased by $16 billion, to $40 billion, in the last year."
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Post by Bylo Selhi »

Buffet in his [url=http://www.berkshirehathaway.com/letters/2006ltr.pdf]2006 letter[/url] wrote:You will be happy to hear – and I’m even happier – that this will be my last discussion of the losses at Gen Re’s derivative operation. When we started to wind this business down early in 2002, we had 23,218 contracts outstanding. Now we have 197. Our cumulative pre-tax loss from this operation totals $409 million, but only $5 million occurred in 2006. Charlie says that if we had properly classified the $409 million on our 2001 balance sheet, it would have been labeled “Good Until Reached For.” In any event, a Shakespearean thought – slightly modified – seems appropriate for the tombstone of this derivative business: “All’s well that ends.”
Buffet in his [url=http://www.berkshirehathaway.com/letters/2007ltr.pdf]2007 letter[/url] wrote:Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.

First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013.

At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.
Considering how many $billions BRK's supercat and reinsurance business is on the hook for, this is small potatoes. Buffett, as usual, has been transparent about what BRK owns and what the potential risks are. Buffett and Munger don't seem to be concerned with this exposure. I own shares of BRK.b, in part because I trust Buffett and Munger. I certainly trust them more than I trust the manager of any other actively-managed fund. I'm not concerned about BRK's derivatives exposure. Should I be?

Or is the problem that Buffett has decried certain, very risky types of derivatives as WMD while BRK holds other, albeit far less risky, types of derivatives?

In your view are there any circumstances under which derivatives are a good thing and holding them is prudent?
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Post by Taggart »

Bylo Selhi wrote:
Buffet in his [url=http://www.berkshirehathaway.com/letters/2006ltr.pdf]2006 letter[/url] wrote:You will be happy to hear – and I’m even happier – that this will be my last discussion of the losses at Gen Re’s derivative operation. When we started to wind this business down early in 2002, we had 23,218 contracts outstanding. Now we have 197. Our cumulative pre-tax loss from this operation totals $409 million, but only $5 million occurred in 2006. Charlie says that if we had properly classified the $409 million on our 2001 balance sheet, it would have been labeled “Good Until Reached For.” In any event, a Shakespearean thought – slightly modified – seems appropriate for the tombstone of this derivative business: “All’s well that ends.”
Buffet in his [url=http://www.berkshirehathaway.com/letters/2007ltr.pdf]2007 letter[/url] wrote:Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.

First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013.

At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.
Considering how many $billions BRK's supercat and reinsurance business is on the hook for, this is small potatoes. Buffett, as usual, has been transparent about what BRK owns and what the potential risks are. Buffett and Munger don't seem to be concerned with this exposure. I own shares of BRK.b, in part because I trust Buffett and Munger. I certainly trust them more than I trust the manager of any other actively-managed fund. I'm not concerned about BRK's derivatives exposure. Should I be?

Or is the problem that Buffett has decried certain, very risky types of derivatives as WMD while BRK holds other, albeit far less risky, types of derivatives?

In your view are there any circumstances under which derivatives are a good thing and holding them is prudent?
I think you and I are getting a little of course here. I'm not saying in regards to derivatives that there aren't circumstances where they can't be a good thing or holding them can't be prudent (although in the wrong hands can prove to be a disaster). Nor am I saying anyone should sell their Berkshire shares because of it.

What I don't think is right though is when Buffett is interviewed and he goes on about the dangers of derivatives as if Berkshire doesn't use them, when indeed they do. You use the term "less risky", but these less risky derivatives came with a loss of 1 billion 600 million dollars. That's a lot of future compounding for Berkshire to lose.
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Post by Bylo Selhi »

Taggart wrote:What I don't think is right though is when Buffett is interviewed and he goes on about the dangers of derivatives as if Berkshire doesn't use them, when indeed they do.
But he doesn't. He qualifies himself. He told Spiegel [my bold], "I don't condemn the entire industry. When I mentioned weapons of mass destruction, I was merely referring to the out-of-control trading in derivatives. It doesn't make sense that hundreds of jobs are being eliminated, that entire branches of industry in the real economy are going under because of such financial gambles, even though they are in fact completely healthy. Besides, these types of constructs are so complicated that hardly anyone understands them anymore."

Since AFAIK (a) Buffett has never claimed that all derivatives are financial WMDs nor (b) does BRK own any of the types of derivatives that Buffett considers to be FWMDs, I don't understand what the problem is. (Just because someone cautions against the excessive consumption of alcohol doesn't make them a hypocrite for drinking a glass of wine with their dinner. (Nor should they be obliged to divulge that they do so.))

Finally -- and this is just pure speculation on my part -- interviews like this are usually heavily editted for space reasons. For all we know Buffett may even have addressed your concerns but they never made it into the published interview.
You use the term "less risky", but these less risky derivatives came with a loss of 1 billion 600 million dollars. That's a lot of future compounding for Berkshire to lose.
According to Buffett these are paper losses, not much different than if you buy a stock today and tomorrow it's down. If you bought the stock for the long run and/or its dividend stream then you're confident that regardless of current NAV you will make money on the transaction. Buffett explains this wrt to BRK's derivatives position [my bold] "Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings – even though they could easily amount to $1 billion or more in a quarter – and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well."
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Post by Shakespeare »

Derivatives can be used to decrease risk as well as to increase it.
Sic transit gloria mundi. Tuesday is usually worse. - Robert A. Heinlein, Starman Jones
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Post by carnet »

Shakespeare wrote:Derivatives can be used to decrease risk as well as to increase it.
That's true. But it looks like Warren and Charlie may not be using them that way. If the market value of their punts are down 1B then they are down 1B....it doesn't much matter what they think.
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Post by Taggart »

Bylo Selhi wrote:I don't understand what the problem is. (Just because someone cautions against the excessive consumption of alcohol doesn't make them a hypocrite for drinking a glass of wine with their dinner. (Nor should they be obliged to divulge that they do so.))

Finally -- and this is just pure speculation on my part -- interviews like this are usually heavily editted for space reasons. For all we know Buffett may even have addressed your concerns but they never made it into the published interview.
I don't disagree with anything you've said, except for the above. Buffett is in a position of authority, and if in an interview he's going to urge caution in the use of derivatives, then he should divulge in that interview that Berkshire does own derivatives. If he's not forthcoming, then the reporter should have done his homework beforehand, and at least say something along the lines of "but Berkshire owns derivatives?". Then we would have got some sort of response from Buffett. Then again, like you say, perhaps the interview was edited.
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Post by Taggart »

I look forward to someone writing a column on "Canadian moats". That would prove an interesting read.
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Post by Shakespeare »

Shakespeare wrote: Derivatives can be used to decrease risk as well as to increase it.
That's true. But it looks like Warren and Charlie may not be using them that way. If the market value of their punts are down 1B then they are down 1B....it doesn't much matter what they think
Although I have no idea how W&C are using derivatives, IMO your conclusion does not necessarily hold. Suppose, for example, a partial hedge was involved and they would have been down $2B if it had not been in place.
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Post by gyrfalcon »

Bylo Selhi wrote: ...
And I'm surprised that you (apparently) haven't read Buffett's letters to shareholders for the past several years where he annually explains what happened and repeats his mea culpa mantra ;)

BRK's purchase of GenRe several years ago included 10s of 1,000s of derivatives that GenRe had on its books. Buffett's intention was to unwind these ASAP, however, for various reasons, which he explains and for which he accepts full responsibility, this has taken longer than expected. *****Buffett didn't enter into those contracts, nor would he have.*****
My asterisks.
Bylo Selhi wrote: ...
Buffet in his [url=http://www.berkshirehathaway.com/letters/2007ltr.pdf]2007 letter[/url] wrote:Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories.

First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013.
Interesting. :roll:
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Post by Bylo Selhi »

gyrfalcon wrote:My asterisks.
My bold: "BRK's purchase of GenRe several years ago included 10s of 1,000s of derivatives that GenRe had on its books... Buffett didn't enter into those contracts..."
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Post by carnet »

Shakespeare wrote:
Although I have no idea how W&C are using derivatives, IMO your conclusion does not necessarily hold. Suppose, for example, a partial hedge was involved and they would have been down $2B if it had not been in place.
Well, that would fit too but is far less sensational. :wink: . Of course, then it's just looks a bit disingenuous/macho.
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Post by spencer »

Brix wrote:
You get a whole bunch of stocks right at the beginning of your life, and thus you are sort of on a welfare state of support from your rich parents from the beginning. What's the difference?
The difference is that your parents chose to have you and chose to name you in their wills. Libertarians live in dread of being forced to do something they haven't chosen to do. And worse, by and for people to whom they haven't even been introduced. And worse still, with money. :)
Well said! If I work hard all my life I want my kids to have the fruits of my labor, not some lazy, ignorant strangers.
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Post by Taggart »

Morningstar

Banking Lessons from Buffett

The Oracle's timeless advice points to today's true bargains in banking stocks.

By Jim Sinegal | 06-09-08
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Post by chiaroscuro »

Taggart wrote:Morningstar

Banking Lessons from Buffett

The Oracle's timeless advice points to today's true bargains in banking stocks.

By Jim Sinegal | 06-09-08
Buffett went on to explain an additional risk in the banking business: that of 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." Almost 20 years later, Buffett's words still ring true. Few financial institutions managed to resist the temptation to jump headlong into subprime mortgages, CDOs, and other questionable products. Banks that loaded up on home equity and construction loans during the housing boom are also now suffering the consequences. Again, Buffett's writings proved prescient: "In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate." Managers of some of the country's largest financial institutions indeed experienced this fate in the past year.

...and why is this so? Is it that bank executives are spineless suicidal creatures? Naw, I think they have a pack mentality that is highlycalculating, focused on a purely self centered greed. Like a pack of wolves...they know the worst that will happen is years of great paychecks and perks based on profits of fraud. Even when chastised, the worst punishment they get is exiting the job with a golden handshake of monumental proportions. Send them to jail I say with multi-million dollar fines, then this treadmill of group fraud will stop and the US and even world economy will be the better for it.
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Post by kcowan »

Big bank executives are more like bureaucrats than executives. They suffer through mind-numbing layers of BS and rise to the top like fat in water.

I once had the benefit of running an advanced marketing project for an aggressive marketing type in a bank in Boston. He delivered results that would blow your mind. Sales up fourfold, client sat up 10 points, employee sat up 8 points. He was fired. "We don't do those types of things here."

Such is the nature of the banking executive culture.
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Post by chiaroscuro »

kcowan wrote:Big bank executives are more like bureaucrats than executives. They suffer through mind-numbing layers of BS and rise to the top like fat in water.

I once had the benefit of running an advanced marketing project for an aggressive marketing type in a bank in Boston. He delivered results that would blow your mind. Sales up fourfold, client sat up 10 points, employee sat up 8 points. He was fired. "We don't do those types of things here."

Such is the nature of the banking executive culture.
Then why these US nation wide recurrent ponzi schemes that destroy billions of dollars of wealth? Clearly anyone with a 1/4 of a brain and who should be risk adverse by nature of the job, would stay away from things like ABCP with a ten foot pole...instead of actively marketing and profiting from it. You suggest that the employees within the bank are downright stupid, or that there is a mind numbing bureaucracy that would put Dilbert to shame.

The simpler explanation is that they know perfectly well what they are doing and expect to be rewarded handsomely for screwing society.
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Post by scomac »

chiaroscuro wrote: The simpler explanation is that they know perfectly well what they are doing and expect to be rewarded handsomely for screwing society.
ISTM that it is naive to expect anything different than the very behavior we are seeing when the rewards are so lucrative and the deterents so trivial.
"On what principle is it, that when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?"
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Post by kcowan »

scomac wrote:
chiaroscuro wrote: The simpler explanation is that they know perfectly well what they are doing and expect to be rewarded handsomely for screwing society.
ISTM that it is naive to expect anything different than the very behavior we are seeing when the rewards are so lucrative and the deterents so trivial.
Plus there is a herd mentality. You don't get fired if "everybody else is doing it".
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Buffet makes a $1 million bet

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Carol Loomis (one of my favorite financial writers) writes in this week's Fortune about a bet that Warren Buffett made with a hedge fund management company. You can read the fascinating story at http://money.cnn.com/2008/06/04/news/ne ... /index.htm.

Quoting:

"And to that there is a certain history, which began at Berkshire's May 2006 annual meeting. Expounding that weekend on the transaction and management costs borne by investors, Buffett offered to bet any taker $1 million that over 10 years and after fees, the performance of an S&P index fund would beat 10 hedge funds that any opponent might choose. Some time later he repeated the offer, adding that since he hadn't been taken up on the bet, he must be right in his thinking."

A New York firm, Protégé Partners, which manages $3.5 billion in a fund of hedge funds, decided to accept that bet. Basically, Buffet and Protégé each put $320,000 into 10-year zero-coupon Treasury bonds that will be worth $1 million in 10 years. The bet is straightforward. Protégé has chosen five funds of hedge funds, and these funds must return more than the S&P 500 over the 10 years beginning January of 2008. (The list of funds is a secret.) The winner gets the $1 million donated to their favorite charity.

Which way would you bet? If the online response at Fortune is any indication, 90% of you would bet with Warren. As one enthusiastic responder wrote, "How can you bet against Buffett? I'd bet my life savings on it ..." Well, Tom, you might want to hedge your bet. Even Warren said he thinks his odds are only 60%.

The basic premise to Buffett's position is that the high fees simply eat up any potential for extra profits, over those of a simple index fund. As Buffett writes:

"A number of smart people are involved in running hedge funds. But to a great extent their efforts are self-neutralizing, and their IQ will not overcome the costs they impose on investors. Investors, on average and over time, will do better with a low-cost index fund than with a group of funds of funds."

And he is right about the fees. Hedge funds, and especially funds of funds, must do much better than average to overcome their high fees. Loomis sums it up as follows:

"As for the fees that investors pay in the hedge fund world - and that, of course, is the crux of Buffett's argument - they are both complicated and costly. A fund of funds normally charges a 1% annual management fee. The hedge funds it puts that money into charge an annual management fee of their own, which for funds of funds is typically 1.5%. (The fees are paid quarterly by an investor and are figured on the value of his account at the time.)

"So that's 2.5% of an investor's capital that continually goes for these fees, regardless of the returns earned during a year. In contrast, Vanguard's S&P 500 index fund had an expense ratio last year of 15 basis points (0.15%) for ordinary shares and only seven basis points for Admiral shares, which are available to large investors. Admiral shares are the ones ‘bought' by Buffett in the bet.

"On top of the management fee, the hedge funds typically collect 20% of any gains they make. That leaves 80% for the investors. The fund of funds takes 5% (or more) of that 80% as its share of the gains. The upshot is that only 76% (at most) of the annual return made on an investor's money accrues to him, with the rest going to the ‘helpers' that Buffett has written about. Meanwhile, the investor is paying his inexorable management fee of 2.5% on capital.

"The summation is pretty obvious. For Protégé to win this bet, the five funds of funds it has picked must do much, much better than the S&P."
http://www.frontlinethoughts.com/gateway.asp
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Re: Buffet makes a $1 million bet

Post by George$ »

Some excellent historical reminders and charts in the above link ---- a bit here
Where are we today? The P/E ratio is 23.2. Earnings are dropping as we work our way through a very tough economy. As I have written elsewhere, I think the recovery, such as it is, will take at least two years before we can get back to 3% growth, because the twin bubbles of the housing market and the credit crisis will take at least two years to work themselves out. 1-2% growth in GDP for the next two years is not an environment for significant earnings growth. It is also not an environment in which stock markets are likely to thrive.

Roughly 20% of the S&P is financial stocks. Do you think they are likely as a group to start reporting robust earnings growth over the next two years? They are deleveraging, which will not help earnings growth. There are more write-offs to come. A significant portion of the S&P is tied to US consumers, who are pulling back. On the other hand, there are some very large multinational corporations that are benefitting from a weak dollar, as both their exports rise and their foreign subsidiaries profit.

But the climate is not favorable to robust earnings growth for the next few years. That will make it tougher for the stock market to keep up with the funds of hedge funds.
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Post by George$ »

Transcript of Buffett Lecture at the University of Florida School of Business October 15, 1998 - 24-page pdf file
- a bit ...
Question: Diversification?
Buffett: The question is about diversification. I have a dual answer to that. If you are not
a professional investor. If your goal is not to manage money to earn a significantly better
return than the world, then I believe in extreme diversification. I believe 98% - 99% who
invest should extensively diversify and not trade, so that leads them to an index fund type
of decision with very low costs. All they are going to do is own part of America. And
they have made a decision that owning a part of America is worthwhile. I don’t quarrel
with that at all. That is the way they should approach it unless they want to bring an
intensity to the game to make a decision and start evaluating businesses. Once you are in
the businesses of evaluating businesses and you decide that you are going to bring the
effort and intensity and time involved to get that job done, then I think diversification is a
terrible mistake to any degree. I got asked that question the other day at SunTrust. If you
really know businesses, you probably shouldn’t own more than six of them.
“The search for truth is more precious than its possession.” Albert Einstein
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Post by kcowan »

George$ wrote:Transcript of Buffett Lecture at the University of Florida School of Business October 15, 1998 - 24-page pdf file
- a bit ...
Question: Diversification?
Buffett: The question is about diversification. I have a dual answer to that. ...
If you really know businesses, you probably shouldn’t own more than six of them.
And make sure that they are not just insurance companies!
For the fun of it...Keith
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Post by Taggart »

Back in March of this year, some of the students and faculty from the Ben Graham Centre for Value Investing at the University of Western Ontario, paid Warren Buffett a visit in Omaha.

Major Takeaways from the visit with Mr. Warren Buffett

Questions and answers
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