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BERKSHIRE HATHAWAY INC.
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February 26, 1982
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To the Shareholders of Berkshire Hathaway Inc.:
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Operating earnings of $39.7 million in 1981 amounted to
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15.2% of beginning equity capital (valuing securities at cost)
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compared to 17.8% in 1980. Our new plan that allows stockholders
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to designate corporate charitable contributions (detailed later)
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reduced earnings by about $900,000 in 1981. This program, which
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we expect to continue subject to annual evaluation of our
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corporate tax position, had not been initiated in 1980.
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Non-Controlled Ownership Earnings
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In the 1980 annual report we discussed extensively the
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concept of non-controlled ownership earnings, i.e., Berkshire’s
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share of the undistributed earnings of companies we don’t control
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or significantly influence but in which we, nevertheless, have
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important investments. (We will be glad to make available to new
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or prospective shareholders copies of that discussion or others
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from earlier reports to which we refer in this report.) No
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portion of those undistributed earnings is included in the
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operating earnings of Berkshire.
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However, our belief is that, in aggregate, those
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undistributed and, therefore, unrecorded earnings will be
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translated into tangible value for Berkshire shareholders just as
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surely as if subsidiaries we control had earned, retained - and
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reported - similar earnings.
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We know that this translation of non-controlled ownership
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earnings into corresponding realized and unrealized capital gains
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for Berkshire will be extremely irregular as to time of
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occurrence. While market values track business values quite well
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over long periods, in any given year the relationship can gyrate
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capriciously. Market recognition of retained earnings also will
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be unevenly realized among companies. It will be disappointingly
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low or negative in cases where earnings are employed non-
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productively, and far greater than dollar-for-dollar of retained
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earnings in cases of companies that achieve high returns with
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their augmented capital. Overall, if a group of non-controlled
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companies is selected with reasonable skill, the group result
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should be quite satisfactory.
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In aggregate, our non-controlled business interests have
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more favorable underlying economic characteristics than our
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controlled businesses. That’s understandable; the area of choice
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has been far wider. Small portions of exceptionally good
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businesses are usually available in the securities markets at
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reasonable prices. But such businesses are available for
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purchase in their entirety only rarely, and then almost always at
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high prices.
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General Acquisition Behavior
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As our history indicates, we are comfortable both with total
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ownership of businesses and with marketable securities
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representing small portions of businesses. We continually look
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for ways to employ large sums in each area. (But we try to avoid
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small commitments - “If something’s not worth doing at all, it’s
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not worth doing well”.) Indeed, the liquidity requirements of our
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insurance and trading stamp businesses mandate major investments
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in marketable securities.
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Our acquisition decisions will be aimed at maximizing real
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economic benefits, not at maximizing either managerial domain or
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reported numbers for accounting purposes. (In the long run,
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managements stressing accounting appearance over economic
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substance usually achieve little of either.)
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Regardless of the impact upon immediately reportable
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earnings, we would rather buy 10% of Wonderful Business T at X
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per share than 100% of T at 2X per share. Most corporate
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managers prefer just the reverse, and have no shortage of stated
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rationales for their behavior.
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However, we suspect three motivations - usually unspoken -
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to be, singly or in combination, the important ones in most high-
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premium takeovers:
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(1) Leaders, business or otherwise, seldom are deficient in
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animal spirits and often relish increased activity and
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challenge. At Berkshire, the corporate pulse never
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beats faster than when an acquisition is in prospect.
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(2) Most organizations, business or otherwise, measure
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themselves, are measured by others, and compensate their
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managers far more by the yardstick of size than by any
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other yardstick. (Ask a Fortune 500 manager where his
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corporation stands on that famous list and, invariably,
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the number responded will be from the list ranked by
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size of sales; he may well not even know where his
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corporation places on the list Fortune just as
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faithfully compiles ranking the same 500 corporations by
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profitability.)
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(3) Many managements apparently were overexposed in
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impressionable childhood years to the story in which the
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imprisoned handsome prince is released from a toad’s
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body by a kiss from a beautiful princess. Consequently,
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they are certain their managerial kiss will do wonders
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for the profitability of Company T(arget).
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Such optimism is essential. Absent that rosy view,
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why else should the shareholders of Company A(cquisitor)
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want to own an interest in T at the 2X takeover cost
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rather than at the X market price they would pay if they
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made direct purchases on their own?
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In other words, investors can always buy toads at the
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going price for toads. If investors instead bankroll
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princesses who wish to pay double for the right to kiss
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the toad, those kisses had better pack some real
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dynamite. We’ve observed many kisses but very few
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miracles. Nevertheless, many managerial princesses
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remain serenely confident about the future potency of
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their kisses - even after their corporate backyards are
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knee-deep in unresponsive toads.
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In fairness, we should acknowledge that some acquisition
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records have been dazzling. Two major categories stand out.
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The first involves companies that, through design or
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accident, have purchased only businesses that are particularly
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well adapted to an inflationary environment. Such favored
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business must have two characteristics: (1) an ability to
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increase prices rather easily (even when product demand is flat
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and capacity is not fully utilized) without fear of significant
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loss of either market share or unit volume, and (2) an ability to
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accommodate large dollar volume increases in business (often
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produced more by inflation than by real growth) with only minor
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additional investment of capital. Managers of ordinary ability,
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focusing solely on acquisition possibilities meeting these tests,
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have achieved excellent results in recent decades. However, very
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few enterprises possess both characteristics, and competition to
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buy those that do has now become fierce to the point of being
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self-defeating.
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The second category involves the managerial superstars - men
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who can recognize that rare prince who is disguised as a toad,
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and who have managerial abilities that enable them to peel away
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the disguise. We salute such managers as Ben Heineman at
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Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at
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National Service Industries, and especially Tom Murphy at Capital
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Cities Communications (a real managerial “twofer”, whose
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acquisition efforts have been properly focused in Category 1 and
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whose operating talents also make him a leader of Category 2).
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From both direct and vicarious experience, we recognize the
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difficulty and rarity of these executives’ achievements. (So do
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they; these champs have made very few deals in recent years, and
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often have found repurchase of their own shares to be the most
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sensible employment of corporate capital.)
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Your Chairman, unfortunately, does not qualify for Category
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2. And, despite a reasonably good understanding of the economic
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factors compelling concentration in Category 1, our actual
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acquisition activity in that category has been sporadic and
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inadequate. Our preaching was better than our performance. (We
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neglected the Noah principle: predicting rain doesn’t count,
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building arks does.)
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We have tried occasionally to buy toads at bargain prices
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with results that have been chronicled in past reports. Clearly
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our kisses fell flat. We have done well with a couple of princes
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- but they were princes when purchased. At least our kisses
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didn’t turn them into toads. And, finally, we have occasionally
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been quite successful in purchasing fractional interests in
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easily-identifiable princes at toad-like prices.
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Berkshire Acquisition Objectives
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We will continue to seek the acquisition of businesses in
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their entirety at prices that will make sense, even should the
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future of the acquired enterprise develop much along the lines of
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its past. We may very well pay a fairly fancy price for a
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Category 1 business if we are reasonably confident of what we are
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getting. But we will not normally pay a lot in any purchase for
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what we are supposed to bring to the party - for we find that we
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ordinarily don’t bring a lot.
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During 1981 we came quite close to a major purchase
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involving both a business and a manager we liked very much.
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However, the price finally demanded, considering alternative uses
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for the funds involved, would have left our owners worse off than
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before the purchase. The empire would have been larger, but the
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citizenry would have been poorer.
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Although we had no success in 1981, from time to time in the
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future we will be able to purchase 100% of businesses meeting our
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standards. Additionally, we expect an occasional offering of a
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major “non-voting partnership” as discussed under the Pinkerton’s
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heading on page 47 of this report. We welcome suggestions
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regarding such companies where we, as a substantial junior
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partner, can achieve good economic results while furthering the
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long-term objectives of present owners and managers.
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Currently, we find values most easily obtained through the
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open-market purchase of fractional positions in companies with
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excellent business franchises and competent, honest managements.
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We never expect to run these companies, but we do expect to
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profit from them.
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We expect that undistributed earnings from such companies
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will produce full value (subject to tax when realized) for
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Berkshire and its shareholders. If they don’t, we have made
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mistakes as to either: (1) the management we have elected to
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join; (2) the future economics of the business; or (3) the price
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we have paid.
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We have made plenty of such mistakes - both in the purchase
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of non-controlling and controlling interests in businesses.
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Category (2) miscalculations are the most common. Of course, it
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is necessary to dig deep into our history to find illustrations
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of such mistakes - sometimes as deep as two or three months back.
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For example, last year your Chairman volunteered his expert
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opinion on the rosy future of the aluminum business. Several
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minor adjustments to that opinion - now aggregating approximately
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180 degrees - have since been required.
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For personal as well as more objective reasons, however, we
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generally have been able to correct such mistakes far more
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quickly in the case of non-controlled businesses (marketable
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securities) than in the case of controlled subsidiaries. Lack of
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control, in effect, often has turned out to be an economic plus.
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As we mentioned last year, the magnitude of our non-recorded
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“ownership” earnings has grown to the point where their total is
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greater than our reported operating earnings. We expect this
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situation will continue. In just four ownership positions in
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this category - GEICO Corporation, General Foods Corporation, R.
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J. Reynolds Industries, Inc. and The Washington Post Company -
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our share of undistributed and therefore unrecorded earnings
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probably will total well over $35 million in 1982. The
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accounting rules that entirely ignore these undistributed
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earnings diminish the utility of our annual return on equity
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calculation, or any other single year measure of economic
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performance.
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Long-Term Corporate Performance
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In measuring long-term economic performance, equities held
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by our insurance subsidiaries are valued at market subject to a
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charge reflecting the amount of taxes that would have to be paid
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if unrealized gains were actually realized. If we are correct in
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the premise stressed in the preceding section of this report, our
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unreported ownership earnings will find their way, irregularly
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but inevitably, into our net worth. To date, this has been the
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case.
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An even purer calculation of performance would involve a
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valuation of bonds and non-insurance held equities at market.
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However, GAAP accounting does not prescribe this procedure, and
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the added purity would change results only very slightly. Should
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any valuation difference widen to significant proportions, as it
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has at most major insurance companies, we will report its effect
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to you.
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On a GAAP basis, during the present management’s term of
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seventeen years, book value has increased from $19.46 per share
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to $526.02 per share, or 21.1% compounded annually. This rate of
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return number is highly likely to drift downward in future years.
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We hope, however, that it can be maintained significantly above
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the rate of return achieved by the average large American
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corporation.
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Over half of the large gain in Berkshire’s net worth during
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1981 - it totaled $124 million, or about 31% - resulted from the
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market performance of a single investment, GEICO Corporation. In
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aggregate, our market gain from securities during the year
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considerably outstripped the gain in underlying business values.
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Such market variations will not always be on the pleasant side.
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In past reports we have explained how inflation has caused
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our apparently satisfactory long-term corporate performance to be
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illusory as a measure of true investment results for our owners.
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We applaud the efforts of Federal Reserve Chairman Volcker and
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note the currently more moderate increases in various price
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indices. Nevertheless, our views regarding long-term
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inflationary trends are as negative as ever. Like virginity, a
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stable price level seems capable of maintenance, but not of
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restoration.
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Despite the overriding importance of inflation in the
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investment equation, we will not punish you further with another
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full recital of our views; inflation itself will be punishment
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enough. (Copies of previous discussions are available for
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masochists.) But, because of the unrelenting destruction of
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currency values, our corporate efforts will continue to do a much
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better job of filling your wallet than of filling your stomach.
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Equity Value-Added
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An additional factor should further subdue any residual
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enthusiasm you may retain regarding our long-term rate of return.
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The economic case justifying equity investment is that, in
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aggregate, additional earnings above passive investment returns -
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interest on fixed-income securities - will be derived through the
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employment of managerial and entrepreneurial skills in
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conjunction with that equity capital. Furthermore, the case says
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that since the equity capital position is associated with greater
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risk than passive forms of investment, it is “entitled” to higher
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returns. A “value-added” bonus from equity capital seems natural
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and certain.
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But is it? Several decades back, a return on equity of as
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little as 10% enabled a corporation to be classified as a “good”
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business - i.e., one in which a dollar reinvested in the business
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logically could be expected to be valued by the market at more
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than one hundred cents. For, with long-term taxable bonds
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yielding 5% and long-term tax-exempt bonds 3%, a business
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operation that could utilize equity capital at 10% clearly was
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worth some premium to investors over the equity capital employed.
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That was true even though a combination of taxes on dividends and
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on capital gains would reduce the 10% earned by the corporation
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to perhaps 6%-8% in the hands of the individual investor.
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Investment markets recognized this truth. During that
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earlier period, American business earned an average of 11% or so
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on equity capital employed and stocks, in aggregate, sold at
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valuations far above that equity capital (book value), averaging
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over 150 cents on the dollar. Most businesses were “good”
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businesses because they earned far more than their keep (the
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return on long-term passive money). The value-added produced by
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equity investment, in aggregate, was substantial.
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That day is gone. But the lessons learned during its
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existence are difficult to discard. While investors and managers
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must place their feet in the future, their memories and nervous
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systems often remain plugged into the past. It is much easier
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for investors to utilize historic p/e ratios or for managers to
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utilize historic business valuation yardsticks than it is for
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either group to rethink their premises daily. When change is
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slow, constant rethinking is actually undesirable; it achieves
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little and slows response time. But when change is great,
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yesterday’s assumptions can be retained only at great cost. And
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the pace of economic change has become breathtaking.
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During the past year, long-term taxable bond yields exceeded
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16% and long-term tax-exempts 14%. The total return achieved
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from such tax-exempts, of course, goes directly into the pocket
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of the individual owner. Meanwhile, American business is
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producing earnings of only about 14% on equity. And this 14%
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will be substantially reduced by taxation before it can be banked
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by the individual owner. The extent of such shrinkage depends
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upon the dividend policy of the corporation and the tax rates
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applicable to the investor.
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Thus, with interest rates on passive investments at late
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1981 levels, a typical American business is no longer worth one
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hundred cents on the dollar to owners who are individuals. (If
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the business is owned by pension funds or other tax-exempt
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investors, the arithmetic, although still unenticing, changes
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substantially for the better.) Assume an investor in a 50% tax
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bracket; if our typical company pays out all earnings, the income
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return to the investor will be equivalent to that from a 7% tax-
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exempt bond. And, if conditions persist - if all earnings are
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paid out and return on equity stays at 14% - the 7% tax-exempt
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equivalent to the higher-bracket individual investor is just as
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frozen as is the coupon on a tax-exempt bond. Such a perpetual
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7% tax-exempt bond might be worth fifty cents on the dollar as
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this is written.
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If, on the other hand, all earnings of our typical American
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business are retained and return on equity again remains
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constant, earnings will grow at 14% per year. If the p/e ratio
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remains constant, the price of our typical stock will also grow
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at 14% per year. But that 14% is not yet in the pocket of the
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shareholder. Putting it there will require the payment of a
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capital gains tax, presently assessed at a maximum rate of 20%.
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This net return, of course, works out to a poorer rate of return
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than the currently available passive after-tax rate.
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Unless passive rates fall, companies achieving 14% per year
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gains in earnings per share while paying no cash dividend are an
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economic failure for their individual shareholders. The returns
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from passive capital outstrip the returns from active capital.
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This is an unpleasant fact for both investors and corporate
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managers and, therefore, one they may wish to ignore. But facts
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do not cease to exist, either because they are unpleasant or
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because they are ignored.
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Most American businesses pay out a significant portion of
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their earnings and thus fall between the two examples. And most
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American businesses are currently “bad” businesses economically -
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producing less for their individual investors after-tax than the
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tax-exempt passive rate of return on money. Of course, some
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high-return businesses still remain attractive, even under
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present conditions. But American equity capital, in aggregate,
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produces no value-added for individual investors.
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It should be stressed that this depressing situation does
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not occur because corporations are jumping, economically, less
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high than previously. In fact, they are jumping somewhat higher:
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return on equity has improved a few points in the past decade.
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But the crossbar of passive return has been elevated much faster.
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Unhappily, most companies can do little but hope that the bar
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will be lowered significantly; there are few industries in which
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the prospects seem bright for substantial gains in return on
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equity.
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Inflationary experience and expectations will be major (but
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not the only) factors affecting the height of the crossbar in
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future years. If the causes of long-term inflation can be
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tempered, passive returns are likely to fall and the intrinsic
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position of American equity capital should significantly improve.
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Many businesses that now must be classified as economically “bad”
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would be restored to the “good” category under such
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circumstances.
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A further, particularly ironic, punishment is inflicted by
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an inflationary environment upon the owners of the “bad”
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business. To continue operating in its present mode, such a low-
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return business usually must retain much of its earnings - no
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matter what penalty such a policy produces for shareholders.
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Reason, of course, would prescribe just the opposite policy.
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An individual, stuck with a 5% bond with many years to run before
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maturity, does not take the coupons from that bond and pay one
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hundred cents on the dollar for more 5% bonds while similar bonds
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are available at, say, forty cents on the dollar. Instead, he
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takes those coupons from his low-return bond and - if inclined to
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reinvest - looks for the highest return with safety currently
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available. Good money is not thrown after bad.
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What makes sense for the bondholder makes sense for the
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shareholder. Logically, a company with historic and prospective
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high returns on equity should retain much or all of its earnings
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so that shareholders can earn premium returns on enhanced
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capital. Conversely, low returns on corporate equity would
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suggest a very high dividend payout so that owners could direct
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capital toward more attractive areas. (The Scriptures concur. In
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the parable of the talents, the two high-earning servants are
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rewarded with 100% retention of earnings and encouraged to expand
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their operations. However, the non-earning third servant is not
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only chastised - “wicked and slothful” - but also is required to
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redirect all of his capital to the top performer. Matthew 25:
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14-30)
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But inflation takes us through the looking glass into the
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upside-down world of Alice in Wonderland. When prices
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continuously rise, the “bad” business must retain every nickel
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that it can. Not because it is attractive as a repository for
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equity capital, but precisely because it is so unattractive, the
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low-return business must follow a high retention policy. If it
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wishes to continue operating in the future as it has in the past
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- and most entities, including businesses, do - it simply has no
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choice.
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For inflation acts as a gigantic corporate tapeworm. That
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tapeworm preemptively consumes its requisite daily diet of
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investment dollars regardless of the health of the host organism.
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Whatever the level of reported profits (even if nil), more
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dollars for receivables, inventory and fixed assets are
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continuously required by the business in order to merely match
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the unit volume of the previous year. The less prosperous the
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enterprise, the greater the proportion of available sustenance
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claimed by the tapeworm.
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Under present conditions, a business earning 8% or 10% on
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equity often has no leftovers for expansion, debt reduction or
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“real” dividends. The tapeworm of inflation simply cleans the
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plate. (The low-return company’s inability to pay dividends,
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understandably, is often disguised. Corporate America
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increasingly is turning to dividend reinvestment plans, sometimes
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even embodying a discount arrangement that all but forces
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shareholders to reinvest. Other companies sell newly issued
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shares to Peter in order to pay dividends to Paul. Beware of
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“dividends” that can be paid out only if someone promises to
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replace the capital distributed.)
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Berkshire continues to retain its earnings for offensive,
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not defensive or obligatory, reasons. But in no way are we
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immune from the pressures that escalating passive returns exert
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on equity capital. We continue to clear the crossbar of after-
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tax passive return - but barely. Our historic 21% return - not
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at all assured for the future - still provides, after the current
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capital gain tax rate (which we expect to rise considerably in
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future years), a modest margin over current after-tax rates on
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passive money. It would be a bit humiliating to have our
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corporate value-added turn negative. But it can happen here as
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it has elsewhere, either from events outside anyone’s control or
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from poor relative adaptation on our part.
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Sources of Reported Earnings
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The table below shows the sources of Berkshire’s reported
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|
earnings. Berkshire owns about 60% of Blue Chip Stamps which, in
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turn, owns 80% of Wesco Financial Corporation. The table
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displays aggregate operating earnings of the various business
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|
entities, as well as Berkshire’s share of those earnings. All of
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the significant gains and losses attributable to unusual sales of
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assets by any of the business entities are aggregated with
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securities transactions in the line near the bottom of the table
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and are not included in operating earnings.
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Net Earnings
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|
Earnings Before Income Taxes After Tax
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|
-------------------------------------- ------------------
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|
Total Berkshire Share Berkshire Share
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|
------------------ ------------------ ------------------
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|
1981 1980 1981 1980 1981 1980
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|
-------- -------- -------- -------- -------- --------
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|
(000s omitted)
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|
Operating Earnings:
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|
Insurance Group:
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|
Underwriting ............ $ 1,478 $ 6,738 $ 1,478 $ 6,737 $ 798 $ 3,637
|
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|
Net Investment Income ... 38,823 30,939 38,823 30,927 32,401 25,607
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|
Berkshire-Waumbec Textiles (2,669) (508) (2,669) (508) (1,493) 202
|
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|
Associated Retail Stores .. 1,763 2,440 1,763 2,440 759 1,169
|
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|
See’s Candies ............. 21,891 15,475 13,046 9,223 6,289 4,459
|
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|
Buffalo Evening News ...... (1,057) (2,777) (630) (1,655) (276) (800)
|
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|
Blue Chip Stamps - Parent 3,642 7,699 2,171 4,588 2,134 3,060
|
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|
Wesco Financial - Parent .. 4,495 2,916 2,145 1,392 1,590 1,044
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|
Mutual Savings and Loan ... 1,605 5,814 766 2,775 1,536 1,974
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|
Precision Steel ........... 3,453 2,833 1,648 1,352 841 656
|
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|
Interest on Debt .......... (14,656) (12,230) (12,649) (9,390) (6,671) (4,809)
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|
Other* .................... 1,895 1,698 1,344 1,308 1,513 992
|
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|
|
-------- -------- -------- -------- -------- --------
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|
Sub-total - Continuing
|
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|
|
Operations ............. $ 60,663 $ 61,037 $ 47,236 $ 49,189 $ 39,421 $ 37,191
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|
Illinois National Bank** .. -- 5,324 -- 5,200 -- 4,731
|
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|
|
-------- -------- -------- -------- -------- --------
|
|
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|
|
|
Operating Earnings .......... 60,663 66,361 47,236 54,389 39,421 41,922
|
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|
|
Sales of securities and
|
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|
|
unusual sales of assets .. 37,801 19,584 33,150 15,757 23,183 11,200
|
|
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|
|
-------- -------- -------- -------- -------- --------
|
|
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|
|
Total Earnings - all entities $ 98,464 $ 85,945 $ 80,386 $ 70,146 $ 62,604 $ 53,122
|
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|
======== ======== ======== ======== ======== ========
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*Amortization of intangibles arising in accounting for
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purchases of businesses (i.e. See’s, Mutual and Buffalo
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|
Evening News) is reflected in the category designated as
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“Other”.
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**Berkshire divested itself of its ownership of the Illinois
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|
National Bank on December 31, 1980.
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|
Blue Chip Stamps and Wesco are public companies with
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|
|
reporting requirements of their own. On pages 38-50 of this
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|
|
|
report we have reproduced the narrative reports of the principal
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|
|
|
executives of both companies, in which they describe 1981
|
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|
|
operations. A copy of the full annual report of either company
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|
will be mailed to any Berkshire shareholder upon request to Mr.
|
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|
|
Robert H. Bird for Blue Chip Stamps, 5801 South Eastern Avenue,
|
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|
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|
Los Angeles, California 90040, or to Mrs. Jeanne Leach for Wesco
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Financial Corporation, 315 East Colorado Boulevard, Pasadena,
|
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California 91109.
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As we indicated earlier, undistributed earnings in companies
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we do not control are now fully as important as the reported
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operating earnings detailed in the preceding table. The
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distributed portion of earnings, of course, finds its way into
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the table primarily through the net investment income segment of
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Insurance Group earnings.
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We show below Berkshire’s proportional holdings in those
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non-controlled businesses for which only distributed earnings
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|
|
(dividends) are included in our earnings.
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|
No. of Shares Cost Market
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|
------------- ---------- ----------
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|
(000s omitted)
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|
451,650 (a) Affiliated Publications, Inc. ........ $ 3,297 $ 14,114
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|
703,634 (a) Aluminum Company of America .......... 19,359 18,031
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|
420,441 (a) Arcata Corporation
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|
(including common equivalents) ..... 14,076 15,136
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|
475,217 (b) Cleveland-Cliffs Iron Company ........ 12,942 14,362
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|
441,522 (a) GATX Corporation ..................... 17,147 13,466
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|
2,101,244 (b) General Foods, Inc. .................. 66,277 66,714
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|
7,200,000 (a) GEICO Corporation .................... 47,138 199,800
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|
2,015,000 (a) Handy & Harman ....................... 21,825 36,270
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|
711,180 (a) Interpublic Group of Companies, Inc. 4,531 23,202
|
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|
|
282,500 (a) Media General ........................ 4,545 11,088
|
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|
|
391,400 (a) Ogilvy & Mather International Inc. ... 3,709 12,329
|
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|
|
370,088 (b) Pinkerton’s, Inc. .................... 12,144 19,675
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|
|
1,764,824 (b) R. J. Reynolds Industries, Inc. ...... 76,668 83,127
|
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|
785,225 (b) SAFECO Corporation ................... 21,329 31,016
|
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|
1,868,600 (a) The Washington Post Company .......... 10,628 58,160
|
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|
|
---------- ----------
|
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|
$335,615 $616,490
|
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|
|
|
|
All Other Common Stockholdings ...................... 16,131 22,739
|
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|
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|
|
---------- ----------
|
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|
|
Total Common Stocks ................................. $351,746 $639,229
|
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|
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|
========== ==========
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(a) All owned by Berkshire or its insurance subsidiaries.
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(b) Blue Chip and/or Wesco own shares of these companies. All
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|
numbers represent Berkshire’s net interest in the larger
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|
|
gross holdings of the group.
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Our controlled and non-controlled businesses operate over
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|
such a wide spectrum of activities that detailed commentary here
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|
would prove too lengthy. Much additional financial information
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|
is included in Management’s Discussion on pages 34-37 and in the
|
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|
narrative reports on pages 38-50. However, our largest area of
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both controlled and non-controlled activity has been, and almost
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|
certainly will continue to be, the property-casualty insurance
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|
area, and commentary on important developments in that industry
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|
is appropriate.
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Insurance Industry Conditions
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“Forecasts”, said Sam Goldwyn, “are dangerous, particularly
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|
|
those about the future.” (Berkshire shareholders may have reached
|
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|
|
|
a similar conclusion after rereading our past annual reports
|
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|
|
featuring your Chairman’s prescient analysis of textile
|
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|
|
|
prospects.)
|
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|
There is no danger, however, in forecasting that 1982 will
|
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|
|
be the worst year in recent history for insurance underwriting.
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|
That result already has been guaranteed by present pricing
|
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|
|
behavior, coupled with the term nature of the insurance contract.
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|
While many auto policies are priced and sold at six-month
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intervals - and many property policies are sold for a three-year
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|
|
term - a weighted average of the duration of all property-
|
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|
|
casualty insurance policies probably runs a little under twelve
|
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|
|
months. And prices for the insurance coverage, of course, are
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|
|
frozen for the life of the contract. Thus, this year’s sales
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|
|
contracts (“premium written” in the parlance of the industry)
|
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|
determine about one-half of next year’s level of revenue
|
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|
(“premiums earned”). The remaining half will be determined by
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sales contracts written next year that will be about 50% earned
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|
in that year. The profitability consequences are automatic: if
|
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you make a mistake in pricing, you have to live with it for an
|
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|
|
uncomfortable period of time.
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|
Note in the table below the year-over-year gain in industry-
|
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|
|
wide premiums written and the impact that it has on the current
|
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|
and following year’s level of underwriting profitability. The
|
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|
|
result is exactly as you would expect in an inflationary world.
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|
When the volume gain is well up in double digits, it bodes well
|
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|
|
for profitability trends in the current and following year. When
|
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|
|
the industry volume gain is small, underwriting experience very
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|
|
shortly will get worse, no matter how unsatisfactory the current
|
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|
level.
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The Best’s data in the table reflect the experience of
|
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|
|
practically the entire industry, including stock, mutual and
|
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|
|
reciprocal companies. The combined ratio indicates total
|
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|
|
operating and loss costs as compared to premiums; a ratio below
|
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|
|
100 indicates an underwriting profit, and one above 100 indicates
|
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|
|
a loss.
|
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|
Yearly Change Yearly Change Combined Ratio
|
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|
|
in Premium in Premium after Policy-
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|
|
Written (%) Earned (%) holder Dividends
|
|
|
|
|
|
------------- ------------- ----------------
|
|
|
|
|
|
1972 ............... 10.2 10.9 96.2
|
|
|
|
|
|
1973 ............... 8.0 8.8 99.2
|
|
|
|
|
|
1974 ............... 6.2 6.9 105.4
|
|
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|
|
1975 ............... 11.0 9.6 107.9
|
|
|
|
|
|
1976 ............... 21.9 19.4 102.4
|
|
|
|
|
|
1977 ............... 19.8 20.5 97.2
|
|
|
|
|
|
1978 ............... 12.8 14.3 97.5
|
|
|
|
|
|
1979 ............... 10.3 10.4 100.6
|
|
|
|
|
|
1980 ............... 6.0 7.8 103.1
|
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|
|
1981 ............... 3.6 4.1 105.7
|
|
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|
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|
|
Source: Best’s Aggregates and Averages.
|
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|
As Pogo would say, “The future isn’t what it used to be.”
|
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|
|
Current pricing practices promise devastating results,
|
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|
|
|
particularly if the respite from major natural disasters that the
|
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|
|
|
industry has enjoyed in recent years should end. For
|
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|
|
underwriting experience has been getting worse in spite of good
|
|
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|
|
|
luck, not because of bad luck. In recent years hurricanes have
|
|
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|
|
|
stayed at sea and motorists have reduced their driving. They
|
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|
|
won’t always be so obliging.
|
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|
And, of course the twin inflations, monetary and “social”
|
|
|
|
|
|
(the tendency of courts and juries to stretch the coverage of
|
|
|
|
|
|
policies beyond what insurers, relying upon contract terminology
|
|
|
|
|
|
and precedent, had expected), are unstoppable. Costs of
|
|
|
|
|
|
repairing both property and people - and the extent to which
|
|
|
|
|
|
these repairs are deemed to be the responsibility of the insurer
|
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|
|
|
|
- will advance relentlessly.
|
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|
|
Absent any bad luck (catastrophes, increased driving, etc.),
|
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|
|
an immediate industry volume gain of at least 10% per year
|
|
|
|
|
|
probably is necessary to stabilize the record level of
|
|
|
|
|
|
underwriting losses that will automatically prevail in mid-1982.
|
|
|
|
|
|
(Most underwriters expect incurred losses in aggregate to rise at
|
|
|
|
|
|
least 10% annually; each, of course, counts on getting less than
|
|
|
|
|
|
his share.) Every percentage point of annual premium growth below
|
|
|
|
|
|
the 10% equilibrium figure quickens the pace of deterioration.
|
|
|
|
|
|
Quarterly data in 1981 underscore the conclusion that a terrible
|
|
|
|
|
|
underwriting picture is worsening at an accelerating rate.
|
|
|
|
|
|
|
|
|
|
|
|
In the 1980 annual report we discussed the investment
|
|
|
|
|
|
policies that have destroyed the integrity of many insurers’
|
|
|
|
|
|
balance sheets, forcing them to abandon underwriting discipline
|
|
|
|
|
|
and write business at any price in order to avoid negative cash
|
|
|
|
|
|
flow. It was clear that insurers with large holdings of bonds
|
|
|
|
|
|
valued, for accounting purposes, at nonsensically high prices
|
|
|
|
|
|
would have little choice but to keep the money revolving by
|
|
|
|
|
|
selling large numbers of policies at nonsensically low prices.
|
|
|
|
|
|
Such insurers necessarily fear a major decrease in volume more
|
|
|
|
|
|
than they fear a major underwriting loss.
|
|
|
|
|
|
|
|
|
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|
|
But, unfortunately, all insurers are affected; it’s
|
|
|
|
|
|
difficult to price much differently than your most threatened
|
|
|
|
|
|
competitor. This pressure continues unabated and adds a new
|
|
|
|
|
|
motivation to the others that drive many insurance managers to
|
|
|
|
|
|
push for business; worship of size over profitability, and the
|
|
|
|
|
|
fear that market share surrendered never can be regained.
|
|
|
|
|
|
|
|
|
|
|
|
Whatever the reasons, we believe it is true that virtually
|
|
|
|
|
|
no major property-casualty insurer - despite protests by the
|
|
|
|
|
|
entire industry that rates are inadequate and great selectivity
|
|
|
|
|
|
should be exercised - has been willing to turn down business to
|
|
|
|
|
|
the point where cash flow has turned significantly negative.
|
|
|
|
|
|
Absent such a willingness, prices will remain under severe
|
|
|
|
|
|
pressure.
|
|
|
|
|
|
|
|
|
|
|
|
Commentators continue to talk of the underwriting cycle,
|
|
|
|
|
|
usually implying a regularity of rhythm and a relatively constant
|
|
|
|
|
|
midpoint of profitability Our own view is different. We believe
|
|
|
|
|
|
that very large, although obviously varying, underwriting losses
|
|
|
|
|
|
will be the norm for the industry, and that the best underwriting
|
|
|
|
|
|
years in the future decade may appear substandard against the
|
|
|
|
|
|
average year of the past decade.
|
|
|
|
|
|
|
|
|
|
|
|
We have no magic formula to insulate our controlled
|
|
|
|
|
|
insurance companies against this deteriorating future. Our
|
|
|
|
|
|
managers, particularly Phil Liesche, Bill Lyons, Roland Miller,
|
|
|
|
|
|
Floyd Taylor and Milt Thornton, have done a magnificent job of
|
|
|
|
|
|
swimming against the tide. We have sacrificed much volume, but
|
|
|
|
|
|
have maintained a substantial underwriting superiority in
|
|
|
|
|
|
relation to industry-wide results. The outlook at Berkshire is
|
|
|
|
|
|
for continued low volume. Our financial position offers us
|
|
|
|
|
|
maximum flexibility, a very rare condition in the property-
|
|
|
|
|
|
casualty insurance industry. And, at some point, should fear
|
|
|
|
|
|
ever prevail throughout the industry, our financial strength
|
|
|
|
|
|
could become an operational asset of immense value.
|
|
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|
|
We believe that GEICO Corporation, our major non-controlled
|
|
|
|
|
|
business operating in this field, is, by virtue of its extreme
|
|
|
|
|
|
and improving operating efficiency, in a considerably more
|
|
|
|
|
|
protected position than almost any other major insurer. GEICO is
|
|
|
|
|
|
a brilliantly run implementation of a very important business
|
|
|
|
|
|
idea.
|
|
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|
|
Shareholder Designated Contributions
|
|
|
|
|
|
|
|
|
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|
|
Our new program enabling shareholders to designate the
|
|
|
|
|
|
recipients of corporate charitable contributions was greeted with
|
|
|
|
|
|
extraordinary enthusiasm. A copy of the letter sent October 14,
|
|
|
|
|
|
1981 describing this program appears on pages 51-53. Of 932,206
|
|
|
|
|
|
shares eligible for participation (shares where the name of the
|
|
|
|
|
|
actual owner appeared on our stockholder record), 95.6%
|
|
|
|
|
|
responded. Even excluding Buffet-related shares, the response
|
|
|
|
|
|
topped 90%.
|
|
|
|
|
|
|
|
|
|
|
|
In addition, more than 3% of our shareholders voluntarily
|
|
|
|
|
|
wrote letters or notes, all but one approving of the program.
|
|
|
|
|
|
Both the level of participation and of commentary surpass any
|
|
|
|
|
|
shareholder response we have witnessed, even when such response
|
|
|
|
|
|
has been intensively solicited by corporate staff and highly paid
|
|
|
|
|
|
professional proxy organizations. In contrast, your
|
|
|
|
|
|
extraordinary level of response occurred without even the nudge
|
|
|
|
|
|
of a company-provided return envelope. This self-propelled
|
|
|
|
|
|
behavior speaks well for the program, and speaks well for our
|
|
|
|
|
|
shareholders.
|
|
|
|
|
|
|
|
|
|
|
|
Apparently the owners of our corporation like both
|
|
|
|
|
|
possessing and exercising the ability to determine where gifts of
|
|
|
|
|
|
their funds shall be made. The “father-knows-best” school of
|
|
|
|
|
|
corporate governance will be surprised to find that none of our
|
|
|
|
|
|
shareholders sent in a designation sheet with instructions that
|
|
|
|
|
|
the officers of Berkshire - in their superior wisdom, of course -
|
|
|
|
|
|
make the decision on charitable funds applicable to his shares.
|
|
|
|
|
|
Nor did anyone suggest that his share of our charitable funds be
|
|
|
|
|
|
used to match contributions made by our corporate directors to
|
|
|
|
|
|
charities of the directors’ choice (a popular, proliferating and
|
|
|
|
|
|
non-publicized policy at many large corporations).
|
|
|
|
|
|
|
|
|
|
|
|
All told, $1,783,655 of shareholder-designed contributions
|
|
|
|
|
|
were distributed to about 675 charities. In addition, Berkshire
|
|
|
|
|
|
and subsidiaries continue to make certain contributions pursuant
|
|
|
|
|
|
to local level decisions made by our operating managers.
|
|
|
|
|
|
|
|
|
|
|
|
There will be some years, perhaps two or three out of ten,
|
|
|
|
|
|
when contributions by Berkshire will produce substandard tax
|
|
|
|
|
|
deductions - or none at all. In those years we will not effect
|
|
|
|
|
|
our shareholder designated charitable program. In all other
|
|
|
|
|
|
years we expect to inform you about October 10th of the amount
|
|
|
|
|
|
per share that you may designate. A reply form will accompany
|
|
|
|
|
|
the notice, and you will be given about three weeks to respond
|
|
|
|
|
|
with your designation. To qualify, your shares must be
|
|
|
|
|
|
registered in your own name or the name of an owning trust,
|
|
|
|
|
|
corporation, partnership or estate, if applicable, on our
|
|
|
|
|
|
stockholder list of September 30th, or the Friday preceding if
|
|
|
|
|
|
such date falls on a Saturday or Sunday.
|
|
|
|
|
|
|
|
|
|
|
|
Our only disappointment with this program in 1981 was that
|
|
|
|
|
|
some of our shareholders, through no fault of their own, missed
|
|
|
|
|
|
the opportunity to participate. The Treasury Department ruling
|
|
|
|
|
|
allowing us to proceed without tax uncertainty was received early
|
|
|
|
|
|
in October. The ruling did not cover participation by
|
|
|
|
|
|
shareholders whose stock was registered in the name of nominees,
|
|
|
|
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such as brokers, and additionally required that the owners of all
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designating shares make certain assurances to Berkshire. These
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assurances could not be given us in effective form by nominee
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holders.
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Under these circumstances, we attempted to communicate with
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all of our owners promptly (via the October 14th letter) so that,
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if they wished, they could prepare themselves to participate by
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the November 13th record date. It was particularly important
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that this information be communicated promptly to stockholders
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whose holdings were in nominee name, since they would not be
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eligible unless they took action to re-register their shares
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before the record date.
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Unfortunately, communication to such non-record shareholders
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could take place only through the nominees. We therefore
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strongly urged those nominees, mostly brokerage houses, to
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promptly transmit our letter to the real owners. We explained
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that their failure to do so could deprive such owners of an
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important benefit.
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The results from our urgings would not strengthen the case
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for private ownership of the U.S. Postal Service. Many of our
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shareholders never heard from their brokers (as some shareholders
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told us after reading news accounts of the program). Others were
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forwarded our letter too late for action.
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One of the largest brokerage houses claiming to hold stock
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for sixty of its clients (about 4% of our shareholder
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population), apparently transmitted our letter about three weeks
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after receipt - too late for any of the sixty to participate.
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(Such lassitude did not pervade all departments of that firm; it
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billed Berkshire for mailing services within six days of that
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belated and ineffectual action.)
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We recite such horror stories for two reasons: (1) if you
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wish to participate in future designated contribution programs,
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be sure to have your stock registered in your name well before
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September 30th; and (2) even if you don’t care to participate and
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prefer to leave your stock in nominee form, it would be wise to
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have at least one share registered in your own name. By so
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doing, you can be sure that you will be notified of any important
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corporate news at the same time as all other shareholders.
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The designated-contributions idea, along with many other
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ideas that have turned out well for us, was conceived by Charlie
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Munger, Vice Chairman of Berkshire and Chairman of Blue Chip.
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Irrespective of titles, Charlie and I work as partners in
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managing all controlled companies. To almost a sinful degree, we
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enjoy our work as managing partners. And we enjoy having you as
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our financial partners.
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Warren E. Buffett
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Chairman of the Board
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