US billionaire investor Warren Buffett issued the latest of his renowned annual letters to shareholders on Friday to coincide with Berkshire Hathaway's 2007 earnings report.

"For the entire 42 years, our compounded annual gain in per-share investments was 27.1%. But the trend has been downward as we increasingly used our available funds to buy operating businesses," Buffett wrote. "Berkshire's past record can't be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future."

The Compounded Annual Gain – 1965-2007 - in share book value is 21.1%.

Berkshire Hathaway's share price closed at $140,250 - Warren Buffett likes to have long-term shareholders and does not like stock splits - on Friday, giving the group a market capitalisation of $216.6 billion.

In his letter, Buffett warned that the insurance business is likely to get tougher in 2008. "That party is over," he said.

Microsoft Chairman Bill Gates, Melinda Gates and Warren Buffett

Berkshire reported an 18% drop in fourth-quarter net income on lower investment gains and a drop in insurance-underwriting fees. "It's a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008," he wrote.

The investment holding company said the quarter's $597 million in investment gains compares with $715 million a year earlier.

Berkshire's operating earnings, which exclude investment gains, were $2.35 billion, compared with $2.87 billion a year earlier.

Insurance-underwriting earnings fell 46%, while insurance-investment earnings rose 12%. Earnings at the company's noninsurance businesses fell 8.5%.

Buffett wrote:"Overall, our 76 operating businesses did well last year. The few that had problems were primarily those linked to housing, among them our brick, carpet and real estate brokerage operations. Their setbacks are minor and temporary. Our competitive position in these businesses remains strong, and we have first class CEOs who run them right, in good times or bad.

Some major financial institutions have, however, experienced staggering problems because they engaged in the “weakened lending practices” I described in last year's letter. John Stumpf, CEO of Wells Fargo, aptly dissected the recent behavior of many lenders: “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.”

You may recall a 2003 Silicon Valley bumper sticker that implored,“Please, God, Just One More Bubble.” Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower's income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA – house price appreciation – would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief.

As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out – and what we are witnessing at some of our largest financial institutions is an ugly sight."

Buffett criticised companies that assume their pension funds will earn 8 a year from investments, a return he deems unlikely given the low level of interest rates, but one that lets them report higher profits now.

He compared money managers who promise double-digit returns to the queen in “Alice in Wonderland,” who proclaimed, “Why, sometimes I've believed as many as six impossible things before breakfast.” Buffett added,“Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.”

Buffett (b. 1930) explained what kind of businesses turn himself and longtime business partner Charlie Munger (b. 1924) on and what they avoid: "Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren't available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It's better to have a part interest in the Hope Diamond than to own all of a rhinestone.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area's premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership's moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can't name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There's no rule that you have to invest money where you've earned it. Indeed, it's often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can't for any extended period reinvest a large portion of their earnings internally at high rates of return."

Charlie Munger addresses the University of Southern California Law School Class of 2007

Buffett wrote that the US dollar weakened further in 2007 against major currencies, and it's no mystery why: Americans like buying products made elsewhere more than the rest of the world likes buying products made in the US Inevitably, that causes America to ship about $2 billion of IOUs and assets daily to the rest of the world. And over time, that puts pressure on the dollar.

"When the dollar falls, it both makes our products cheaper for foreigners to buy and their products more expensive for U.S. citizens. That's why a falling currency is supposed to cure a trade deficit. Indeed, the U.S. deficit has undoubtedly been tempered by the large drop in the dollar. But ponder this: In 2002 when the Euroaveraged 94.6¢, our trade deficit with Germany (the fifth largest of our trading partners) was $36 billion, whereas in 2007, with the Euro averaging $1.37, our deficit with Germany was up to $45 billion. Similarly, the Canadian dollar averaged 64¢ in 2002 and 93¢ in 2007. Yet our trade deficit with Canada rose as well, from $50 billion in 2002 to $64 billion in 2007. So far, at least, a plunging dollar has not done much to bring our trade activity into balance," he said.

"In developing a sensible trade policy, the U.S. should not single out countries to punish or industries to protect. Nor should we take actions likely to evoke retaliatory behavior that will reduce America's exports, true trade that benefits both our country and the rest of the world," Buffett wrote."Our legislators should recognize, however, that the current imbalances are unsustainable and should therefore adopt policies that will materially reduce them sooner rather than later. Otherwise our $2 billion daily of force-fed dollars to the rest of the world may produce global indigestion of an unpleasant sort."

Buffett said Berkshire's only direct foreign currency exposure last year was in the Brazilian real, an investment he conceded might seem odd.

“After all, during the past century, five versions of the Brazilian currency have, in effect, turned into confetti,” he said.

The real position earned $100 million in 2007, according to the report.

Annual Letter to Shareholders.