Warren Buffett says investors shouldn't get their hopes up.

Although prospects of an economic recovery may have rekindled notions of market euphoria, Buffett says lofty expectations will only disappoint stock market investors. As evidence, the chairman and CEO of Berkshire Hathaway (BRK.A:NYSE - news - commentary - research - analysis) pointed to Berkshire's equity portfolio.

"Our restrained enthusiasm for these securities is matched by decidedly lukewarm feelings about the prospects for stocks in general over the next decade or so," Buffett wrote in his annual letter to shareholders released Saturday morning.

He continued: Berkshire Vice Chairman "Charlie [Munger] and I believe that American business will do fine over time, but think that today's equity prices presage only moderate returns for investors. ... A market that no more than parallels business progress, however, is likely to leave many investors disappointed, particularly those relatively new to the game."

Buffett's disclosure of his top equity holdings exemplifies last year's stock market struggle. In the past, Berkshire would disclose individual equity positions that had a current market value of $1 billion; in a measure of today's tougher times, that disclosure level is now $500 million. Berkshire showed no changes in its large holdings from last year, still owning the same number of shares of American Express (AXP:NYSE - news - commentary - research - analysis), Coca-Cola (KO:NYSE - news - commentary - research - analysis), Gillette (G:NYSE - news - commentary - research - analysis), Wells Fargo (WFC:NYSE - news - commentary - research - analysis) and the Washington Post (WPO:NYSE - news - commentary - research - analysis).

However, Buffett added two large positions: nearly 16 million shares -- or about a 9% stake -- in H&R Block (HRB:NYSE - news - commentary - research - analysis), in stock worth $715 million at the end of last year and 24 million shares -- about 15% -- of Moody's (MCO:NYSE - news - commentary - research - analysis), the credit rating agency, shares valued at $957 million at the end of December.

The total Berkshire equity portfolio was valued at $28.7 billion as of Dec. 31, 2001, a decline of 23.7% from the $37.6 billion at the end of 2000. It isn't clear how much of the decline came from stock sales and how much came from the decline in value of shares in the portfolio.

A Difficult Year

Last year was challenging for Berkshire Hathaway. Profits sank nearly 76% and gains from investment activity dropped nearly 65%. Berkshire posted profits of $795 million, or $521 for each Class A share vs. $3.33 billion, or $2,185 a share, in 2000.

Buffett took the poor performance personally. "Though our corporate performance last year was satisfactory, my performance was anything but," he wrote to shareholders. "I manage most of Berkshire's equity portfolio, and my results were poor, just as they have been for several years. Of even more importance, I allowed General Re to take on business without a safeguard I knew was important, and on Sept.11, this error caught up with us."

General Re, Berkshire's major reinsurance unit, posted a $2.5 billion loss, largely because of the claims it will have to pay in the aftermath of the terrorist attacks in New York, Washington and Pennsylvania. Again, Buffett shouldered most of the blame. "I violated the Noah rule: Predicting rain doesn't count; building arks does," he wrote. "I consequently let Berkshire operate with a dangerous level of risk -- at General Re in particular."

Buffett said Berkshire will continue to write insurance to cover mega-catastrophes, including terrorism, but will have to be compensated for the risk. "At Berkshire, it should be noted, we have for some years been willing to assume more risk than any other insurer has knowingly taken on," he wrote. "That's still the case. We are perfectly willing to lose $2 billion to $2.5 billion in a single event if we have been paid properly for assuming the risk that caused the loss."

And in a chilling comment about world events, Buffett hints further losses are possible. "The probability of such mind-boggling disasters, though likely very low at present, is not zero," he wrote. "The probabilities are increasing, in an irregular and immeasurable manner, as knowledge and materials become available to those who wish us ill. Fear may recede with time, but the danger won't -- the war against terrorism can never be won. The best the nation can achieve is a long succession of stalemates. There can be no checkmate against hydra-headed foes."

While Buffett seemed generally pleased with other Berkshire businesses, he continues to manage expectations about the company's performance. "In the future we won't come close to replicating our past record," he warns. "To be sure, Charlie and I will strive for above-average performance and will not be satisfied with less."

Berkshire's size makes it difficult to find acquisitions large enough to have a meaningful effect on the company's results. "We need 'elephants' to make significant gains now," Buffett quipped. "And they are hard to find."

Accounting in the Rough

In his annual commentary on American business, Buffett was brief and direct. "Charlie and I are disgusted by the situation, so common in the last few years, in which shareholders have suffered billions in losses while the CEOs, promoters, and other higher-ups who fathered these disasters have walked away with extraordinary wealth," he wrote. "Indeed, many of these people were urging investors to buy shares while concurrently dumping their own, sometimes using methods that hid their actions. To their shame, these business leaders view shareholders as patsies, not partners."

Buffett says the problems are widespread. "Though Enron has become the symbol for shareholder abuse, there is no shortage of egregious conduct elsewhere in corporate America," Buffett wrote. "One story I've heard illustrates the all-too-common attitude of managers toward owners: A gorgeous woman slinks up to a CEO at a party and through moist lips purrs, 'I'll do anything -- anything -- you want. Just tell me what you would like.' With no hesitation, he replies, 'Reprice my options.' "

Also on Buffett's hit list is pro forma accounting, for which Buffett offered a "sub-par" illustration. "When companies or investment professionals use terms such as 'EBITDA' and 'pro forma,' they want you to unthinkingly accept concepts that are dangerously flawed," he notes. "In golf, my score is frequently below par on a pro forma basis: I have firm plans to 'restructure' my putting stroke and therefore only count the swings I take before reaching the green."

For corporate America, Buffett thinks there will be more companies forced to yell "Fore!"

This year's letter offers an in-depth discussion of the details and fundamentals of the insurance business. It is well worth the read and can be found here.

Buffett's letter will be followed by the annual pilgrimage to Omaha for Capitalist Woodstock, the Berkshire Hathaway annual meeting on May 4. We'll provide full coverage of the events leading up to the meeting as well as in-depth, on-site reporting from Omaha.

Plus, join me and Eric Gillin for TheStreet.com's Happy Hour this Thursday at 5 p.m. EST as we talk to two well-known Buffett followers and get their reaction to Buffett's missives as well as their thoughts on Berkshire Hathaway today and the upcoming annual meeting.

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