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BERKSHIRE HATHAWAY INC.
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To the Stockholders of Berkshire Hathaway Inc.:
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Operating earnings in 1977 of $21,904,000, or $22.54 per
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share, were moderately better than anticipated a year ago. Of
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these earnings, $1.43 per share resulted from substantial
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realized capital gains by Blue Chip Stamps which, to the extent
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of our proportional interest in that company, are included in our
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operating earnings figure. Capital gains or losses realized
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directly by Berkshire Hathaway Inc. or its insurance subsidiaries
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are not included in our calculation of operating earnings. While
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too much attention should not be paid to the figure for any
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single year, over the longer term the record regarding aggregate
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capital gains or losses obviously is of significance.
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Textile operations came in well below forecast, while the
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results of the Illinois National Bank as well as the operating
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earnings attributable to our equity interest in Blue Chip Stamps
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were about as anticipated. However, insurance operations, led
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again by the truly outstanding results of Phil Liesche’s
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managerial group at National Indemnity Company, were even better
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than our optimistic expectations.
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Most companies define “record” earnings as a new high in
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earnings per share. Since businesses customarily add from year
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to year to their equity base, we find nothing particularly
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noteworthy in a management performance combining, say, a 10%
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increase in equity capital and a 5% increase in earnings per
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share. After all, even a totally dormant savings account will
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produce steadily rising interest earnings each year because of
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compounding.
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Except for special cases (for example, companies with
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unusual debt-equity ratios or those with important assets carried
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at unrealistic balance sheet values), we believe a more
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appropriate measure of managerial economic performance to be
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return on equity capital. In 1977 our operating earnings on
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beginning equity capital amounted to 19%, slightly better than
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last year and above both our own long-term average and that of
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American industry in aggregate. But, while our operating
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earnings per share were up 37% from the year before, our
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beginning capital was up 24%, making the gain in earnings per
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share considerably less impressive than it might appear at first
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glance.
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We expect difficulty in matching our 1977 rate of return
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during the forthcoming year. Beginning equity capital is up 23%
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from a year ago, and we expect the trend of insurance
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underwriting profit margins to turn down well before the end of
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the year. Nevertheless, we expect a reasonably good year and our
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present estimate, subject to the usual caveats regarding the
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frailties of forecasts, is that operating earnings will improve
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somewhat on a per share basis during 1978.
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Textile Operations
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The textile business again had a very poor year in 1977. We
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have mistakenly predicted better results in each of the last two
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years. This may say something about our forecasting abilities,
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the nature of the textile industry, or both. Despite strenuous
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efforts, problems in marketing and manufacturing have persisted.
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Many difficulties experienced in the marketing area are due
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primarily to industry conditions, but some of the problems have
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been of our own making.
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A few shareholders have questioned the wisdom of remaining
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in the textile business which, over the longer term, is unlikely
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to produce returns on capital comparable to those available in
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many other businesses. Our reasons are several: (1) Our mills in
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both New Bedford and Manchester are among the largest employers
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in each town, utilizing a labor force of high average age
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possessing relatively non-transferable skills. Our workers and
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unions have exhibited unusual understanding and effort in
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cooperating with management to achieve a cost structure and
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product mix which might allow us to maintain a viable operation.
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(2) Management also has been energetic and straightforward in its
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approach to our textile problems. In particular, Ken Chace’s
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efforts after the change in corporate control took place in 1965
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generated capital from the textile division needed to finance the
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acquisition and expansion of our profitable insurance operation.
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(3) With hard work and some imagination regarding manufacturing
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and marketing configurations, it seems reasonable that at least
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modest profits in the textile division can be achieved in the
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future.
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Insurance Underwriting
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Our insurance operation continued to grow significantly in
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1977. It was early in 1967 that we made our entry into this
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industry through the purchase of National Indemnity Company and
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National Fire and Marine Insurance Company (sister companies) for
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approximately $8.6 million. In that year their premium volume
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amounted to $22 million. In 1977 our aggregate insurance premium
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volume was $151 million. No additional shares of Berkshire
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Hathaway stock have been issued to achieve any of this growth.
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Rather, this almost 600% increase has been achieved through
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large gains in National Indemnity’s traditional liability areas
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plus the starting of new companies (Cornhusker Casualty Company
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in 1970, Lakeland Fire and Casualty Company in 1971, Texas United
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Insurance Company in 1972, The Insurance Company of Iowa in 1973,
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and Kansas Fire and Casualty Company in late 1977), the purchase
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for cash of other insurance companies (Home and Automobile
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Insurance Company in 1971, Kerkling Reinsurance Corporation, now
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named Central Fire and Casualty Company, in 1976, and Cypress
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Insurance Company at yearend 1977), and finally through the
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marketing of additional products, most significantly reinsurance,
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within the National Indemnity Company corporate structure.
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In aggregate, the insurance business has worked out very
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well. But it hasn’t been a one-way street. Some major mistakes
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have been made during the decade, both in products and personnel.
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We experienced significant problems from (1) a surety operation
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initiated in 1969, (2) the 1973 expansion of Home and
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Automobile’s urban auto marketing into the Miami, Florida area,
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(3) a still unresolved aviation “fronting” arrangement, and (4)
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our Worker’s Compensation operation in California, which we
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believe retains an interesting potential upon completion of a
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reorganization now in progress. It is comforting to be in a
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business where some mistakes can be made and yet a quite
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satisfactory overall performance can be achieved. In a sense,
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this is the opposite case from our textile business where even
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very good management probably can average only modest results.
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One of the lessons your management has learned - and,
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unfortunately, sometimes re-learned - is the importance of being
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in businesses where tailwinds prevail rather than headwinds.
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In 1977 the winds in insurance underwriting were squarely
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behind us. Very large rate increases were effected throughout
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the industry in 1976 to offset the disastrous underwriting
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results of 1974 and 1975. But, because insurance policies
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typically are written for one-year periods, with pricing mistakes
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capable of correction only upon renewal, it was 1977 before the
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full impact was felt upon earnings of those earlier rate
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increases.
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The pendulum now is beginning to swing the other way. We
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estimate that costs involved in the insurance areas in which we
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operate rise at close to 1% per month. This is due to continuous
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monetary inflation affecting the cost of repairing humans and
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property, as well as “social inflation”, a broadening definition
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by society and juries of what is covered by insurance policies.
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Unless rates rise at a comparable 1% per month, underwriting
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profits must shrink. Recently the pace of rate increases has
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slowed dramatically, and it is our expectation that underwriting
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margins generally will be declining by the second half of the
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year.
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We must again give credit to Phil Liesche, greatly assisted
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by Roland Miller in Underwriting and Bill Lyons in Claims, for an
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extraordinary underwriting achievement in National Indemnity’s
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traditional auto and general liability business during 1977.
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Large volume gains have been accompanied by excellent
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underwriting margins following contraction or withdrawal by many
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competitors in the wake of the 1974-75 crisis period. These
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conditions will reverse before long. In the meantime, National
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Indemnity’s underwriting profitability has increased dramatically
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and, in addition, large sums have been made available for
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investment. As markets loosen and rates become inadequate, we
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again will face the challenge of philosophically accepting
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reduced volume. Unusual managerial discipline will be required,
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as it runs counter to normal institutional behavior to let the
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other fellow take away business - even at foolish prices.
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Our reinsurance department, managed by George Young,
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improved its underwriting performance during 1977. Although the
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combined ratio (see definition on page 12) of 107.1 was
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unsatisfactory, its trend was downward throughout the year. In
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addition, reinsurance generates unusually high funds for
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investment as a percentage of premium volume.
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At Home and Auto, John Seward continued to make progress on
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all fronts. John was a battlefield promotion several years ago
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when Home and Auto’s underwriting was awash in red ink and the
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company faced possible extinction. Under his management it
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currently is sound, profitable, and growing.
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John Ringwalt’s homestate operation now consists of five
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companies, with Kansas Fire and Casualty Company becoming
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operational late in 1977 under the direction of Floyd Taylor.
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The homestate companies had net premium volume of $23 million, up
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from $5.5 million just three years ago. All four companies that
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operated throughout the year achieved combined ratios below 100,
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with Cornhusker Casualty Company, at 93.8, the leader. In
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addition to actively supervising the other four homestate
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operations, John Ringwalt manages the operations of Cornhusker
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which has recorded combined ratios below 100 in six of its seven
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full years of existence and, from a standing start in 1970, has
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grown to be one of the leading insurance companies operating in
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Nebraska utilizing the conventional independent agency system.
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Lakeland Fire and Casualty Company, managed by Jim Stodolka, was
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the winner of the Chairman’s Cup in 1977 for achieving the lowest
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loss ratio among the homestate companies. All in all, the
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homestate operation continues to make excellent progress.
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The newest addition to our insurance group is Cypress
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Insurance Company of South Pasadena, California. This Worker’s
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Compensation insurer was purchased for cash in the final days of
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1977 and, therefore, its approximate $12.5 million of volume for
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that year was not included in our results. Cypress and National
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Indemnity’s present California Worker’s Compensation operation
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will not be combined, but will operate independently utilizing
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somewhat different marketing strategies. Milt Thornton,
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President of Cypress since 1968, runs a first-class operation for
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policyholders, agents, employees and owners alike. We look
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forward to working with him.
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Insurance companies offer standardized policies which can be
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copied by anyone. Their only products are promises. It is not
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difficult to be licensed, and rates are an open book. There are
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no important advantages from trademarks, patents, location,
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corporate longevity, raw material sources, etc., and very little
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consumer differentiation to produce insulation from competition.
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It is commonplace, in corporate annual reports, to stress the
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difference that people make. Sometimes this is true and
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sometimes it isn’t. But there is no question that the nature of
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the insurance business magnifies the effect which individual
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managers have on company performance. We are very fortunate to
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have the group of managers that are associated with us.
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Insurance Investments
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During the past two years insurance investments at cost
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(excluding the investment in our affiliate, Blue Chip Stamps)
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have grown from $134.6 million to $252.8 million. Growth in
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insurance reserves, produced by our large gain in premium volume,
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plus retained earnings, have accounted for this increase in
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marketable securities. In turn, net investment income of the
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Insurance Group has improved from $8.4 million pre-tax in 1975 to
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$12.3 million pre-tax in 1977.
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In addition to this income from dividends and interest, we
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realized capital gains of $6.9 million before tax, about one-
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quarter from bonds and the balance from stocks. Our unrealized
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gain in stocks at yearend 1977 was approximately $74 million but
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this figure, like any other figure of a single date (we had an
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unrealized loss of $17 million at the end of 1974), should not be
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taken too seriously. Most of our large stock positions are going
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to be held for many years and the scorecard on our investment
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decisions will be provided by business results over that period,
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and not by prices on any given day. Just as it would be foolish
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to focus unduly on short-term prospects when acquiring an entire
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company, we think it equally unsound to become mesmerized by
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prospective near term earnings or recent trends in earnings when
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purchasing small pieces of a company; i.e., marketable common
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stocks.
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A little digression illustrating this point may be
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interesting. Berkshire Fine Spinning Associates and Hathaway
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Manufacturing were merged in 1955 to form Berkshire Hathaway Inc.
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In 1948, on a pro forma combined basis, they had earnings after
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tax of almost $18 million and employed 10,000 people at a dozen
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large mills throughout New England. In the business world of
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that period they were an economic powerhouse. For example, in
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that same year earnings of IBM were $28 million (now $2.7
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billion), Safeway Stores, $10 million, Minnesota Mining, $13
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million, and Time, Inc., $9 million. But, in the decade
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following the 1955 merger aggregate sales of $595 million
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produced an aggregate loss for Berkshire Hathaway of $10 million.
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By 1964 the operation had been reduced to two mills and net worth
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had shrunk to $22 million, from $53 million at the time of the
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merger. So much for single year snapshots as adequate portrayals
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of a business.
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Equity holdings of our insurance companies with a market
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value of over $5 million on December 31, 1977 were as follows:
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(Thousands omitted)
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[TABLE]
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No. of Shares Company Cost Market
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220,000 Capital Cities Communications, Inc. ..... $ 10,909 $ 13,228
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1,986,953 Government Employees Insurance
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Company Convertible Preferred ........ 19,417 33,033
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1,294,308 Government Employees Insurance
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Company Common Stock ................. 4,116 10,516
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592,650 The Interpublic Group of Companies, Inc. 4,531 17,187
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324,580 Kaiser Aluminum& Chemical Corporation ... 11,218 9,981
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1,305,800 Kaiser Industries, Inc. ................. 778 6,039
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226,900 Knight-Ridder Newspapers, Inc. .......... 7,534 8,736
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170,800 Ogilvy & Mather International, Inc. ..... 2,762 6,960
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934,300 The Washington Post Company Class B ..... 10,628 33,401
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n/a Total ................................... $ 71,893 $139,081
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n/a All Other Holdings ...................... 34,996 41,992
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n/a Total Equities .......................... $106,889 $181,073
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[/TABLE]
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We select our marketable equity securities in much the same
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way we would evaluate a business for acquisition in its entirety.
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We want the business to be (1) one that we can understand, (2)
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with favorable long-term prospects, (3) operated by honest and
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competent people, and (4) available at a very attractive price.
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We ordinarily make no attempt to buy equities for anticipated
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favorable stock price behavior in the short term. In fact, if
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their business experience continues to satisfy us, we welcome
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lower market prices of stocks we own as an opportunity to acquire
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even more of a good thing at a better price.
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Our experience has been that pro-rata portions of truly
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outstanding businesses sometimes sell in the securities markets
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at very large discounts from the prices they would command in
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negotiated transactions involving entire companies.
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Consequently, bargains in business ownership, which simply are
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not available directly through corporate acquisition, can be
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obtained indirectly through stock ownership. When prices are
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appropriate, we are willing to take very large positions in
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selected companies, not with any intention of taking control and
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not foreseeing sell-out or merger, but with the expectation that
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excellent business results by corporations will translate over
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the long term into correspondingly excellent market value and
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dividend results for owners, minority as well as majority.
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Such investments initially may have negligible impact on our
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operating earnings. For example, we invested $10.9 million in
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Capital Cities Communications during 1977. Earnings attributable
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to the shares we purchased totaled about $1.3 million last year.
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But only the cash dividend, which currently provides $40,000
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annually, is reflected in our operating earnings figure.
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Capital Cities possesses both extraordinary properties and
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extraordinary management. And these management skills extend
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equally to operations and employment of corporate capital. To
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purchase, directly, properties such as Capital Cities owns would
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cost in the area of twice our cost of purchase via the stock
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market, and direct ownership would offer no important advantages
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to us. While control would give us the opportunity - and the
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responsibility - to manage operations and corporate resources, we
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would not be able to provide management in either of those
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respects equal to that now in place. In effect, we can obtain a
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better management result through non-control than control. This
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is an unorthodox view, but one we believe to be sound.
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Banking
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In 1977 the Illinois National Bank continued to achieve a
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rate of earnings on assets about three times that of most large
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banks. As usual, this record was achieved while the bank paid
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maximum rates to savers and maintained an asset position
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combining low risk and exceptional liquidity. Gene Abegg formed
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the bank in 1931 with $250,000. In its first full year of
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operation, earnings amounted to $8,782. Since that time, no new
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capital has been contributed to the bank; on the contrary, since
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our purchase in 1969, dividends of $20 million have been paid.
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Earnings in 1977 amounted to $3.6 million, more than achieved by
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many banks two or three times its size.
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Late last year Gene, now 80 and still running a banking
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operation without peer, asked that a successor be brought in.
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Accordingly, Peter Jeffrey, formerly President and Chief
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Executive Officer of American National Bank of Omaha, has joined
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the Illinois National Bank effective March 1st as President and
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Chief Executive Officer.
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Gene continues in good health as Chairman. We expect a
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continued successful operation at Rockford’s leading bank.
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Blue Chip Stamps
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We again increased our equity interest in Blue Chip Stamps,
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and owned approximately 36 1/2% at the end of 1977. Blue Chip
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had a fine year, earning approximately $12.9 million from
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operations and, in addition, had realized securities gains of
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$4.1 million.
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Both Wesco Financial Corp., an 80% owned subsidiary of Blue
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Chip Stamps, managed by Louis Vincenti, and See’s Candies, a 99%
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owned subsidiary, managed by Chuck Huggins, made good progress in
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1977. Since See’s was purchased by Blue Chip Stamps at the
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beginning of 1972, pre-tax operating earnings have grown from
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$4.2 million to $12.6 million with little additional capital
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investment. See’s achieved this record while operating in an
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industry experiencing practically no unit growth. Shareholders
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of Berkshire Hathaway Inc. may obtain the annual report of Blue
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Chip Stamps by requesting it from Mr. Robert H. Bird, Blue Chip
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Stamps, 5801 South Eastern Avenue, Los Angeles, California 90040.
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Warren E. Buffett, Chairman
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March 14,1978
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