The Associated Press February 26, 2011, 3:37PM ET

Excerpts from Warren Buffett's annual letter

Billionaire investor Warren Buffett released his annual letter to Berkshire Hathaway Inc. shareholders Saturday. Berkshire's chairman and CEO explained how the purchase of the Burlington Northern Santa Fe railroad contributed to a big jump in income at the Omaha-based company. Buffett also offered advice on several key business principles for investors.

Here's are excerpts of what Buffett had to say on a variety of topics:

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HOME BUYING

Buffett urged the policymakers who are getting ready to overhaul the nation's home loan policies to consider the example of Berkshire's manufactured home unit, Clayton Homes, which also finances purchases of manufactured homes.

Buffett said Clayton avoided any sort of housing crisis by requiring meaningful down payments and trying to match fixed payments to a sensible percentage of income. Clayton also retained ownership of its loans.

"Home ownership makes sense for most Americans, particularly at today's lower prices and bargain interest rates. All things considered, the third-best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.)

"For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come," Buffett said about his house in Omaha, which county officials currently value at $660,200.

"But a house can be a nightmare if the buyer's eyes are bigger than his wallet and if a lender -- often protected by a government guarantee -- facilitates his fantasy. Our country's social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford."

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AMERICA'S FUTURE

"Money will always flow toward opportunity, and there is an abundance of that in America," Buffett wrote. "Commentators today often talk of 'great uncertainty.' But think back, for example, to December 6, 1941, October 18, 1987 and September 10, 2001. No matter how serene today may be, tomorrow is always uncertain.

"Don't let that reality spook you. Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born.

"The prophets of doom have overlooked the all-important factor that is certain: Human potential is far from exhausted, and the American system for unleashing that potential -- a system that has worked wonders for over two centuries despite frequent interruptions for recessions and even a Civil War -- remains alive and effective.

"We are not natively smarter than we were when our country was founded nor do we work harder. But look around you and see a world beyond the dreams of any colonial citizen. Now, as in 1776, 1861, 1932 and 1941, America's best days lie ahead."

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GOOD MANAGEMENT

Buffett said investors should examine what Berkshire and other companies do with the earnings they retain instead of paying a dividend or repurchasing stock.

"Some companies will turn these retained dollars into fifty-cent pieces, others into two-dollar bills," he wrote.

Buffett said the results companies generate with retained earnings speak volumes about the quality of a company's CEO.

"The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck's or Montgomery Ward's CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton."

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LENDING LESSONS

Buffett says operating a business or a personal budget on borrowed money is dangerous and can make people very poor.

"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices," he said.

Borrowing can prove lethal for businesses at times when credit becomes unavailable either because of problems at the company or a worldwide shortage of credit.

"Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that's all that is noticed. Even a short absence of credit can bring a company to its knees," Buffett wrote. "In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees."

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A COSTLY OVERSIGHT

One of the strengths of Berkshire Hathaway is its ability to invest cash from its businesses in a variety of industries or in stock and bonds. Buffett admitted overlooking this advantage after acquiring the original Berkshire Hathaway textile business.

"When I took control of Berkshire in 1965, I didn't exploit this advantage," he wrote. "Berkshire was then only in textiles, where it had in the previous decade lost significant money.

"The dumbest thing I could have done was to pursue 'opportunities' to improve and expand the existing textile operation -- so for years that's exactly what I did. And then, in a final burst of brilliance, I went out and bought another textile company. Aaaaaaargh!

"Eventually I came to my senses, heading first into insurance and then into other industries."


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