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1519 lines
83 KiB
1519 lines
83 KiB
2 years ago
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Chairman's Letter - 1984
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BERKSHIRE HATHAWAY INC.
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To the Shareholders of Berkshire Hathaway Inc.:
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Our gain in net worth during 1984 was $152.6 million, or
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$133 per share. This sounds pretty good but actually its
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mediocre. Economic gains must be evaluated by comparison with
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the capital that produces them. Our twenty-year compounded
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annual gain in book value has been 22.1% (from $19.46 in 1964 to
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$1108.77 in 1984), but our gain in 1984 was only 13.6%.
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As we discussed last year, the gain in per-share intrinsic
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business value is the economic measurement that really counts.
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But calculations of intrinsic business value are subjective. In
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our case, book value serves as a useful, although somewhat
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understated, proxy. In my judgment, intrinsic business value and
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book value increased during 1984 at about the same rate.
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Using my academic voice, I have told you in the past of the
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drag that a mushrooming capital base exerts upon rates of return.
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Unfortunately, my academic voice is now giving way to a
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reportorial voice. Our historical 22% rate is just that -
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history. To earn even 15% annually over the next decade
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(assuming we continue to follow our present dividend policy,
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about which more will be said later in this letter) we would need
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profits aggregating about $3.9 billion. Accomplishing this will
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require a few big ideas - small ones just wont do. Charlie
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Munger, my partner in general management, and I do not have any
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such ideas at present, but our experience has been that they pop
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up occasionally. (Hows that for a strategic plan?)
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Sources of Reported Earnings
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The table on the following page shows the sources of
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Berkshires reported earnings. Berkshires net ownership
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interest in many of the constituent businesses changed at midyear
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1983 when the Blue Chip merger took place. Because of these
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changes, the first two columns of the table provide the best
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measure of underlying business performance.
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All of the significant gains and losses attributable to
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unusual sales of assets by any of the business entities are
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aggregated with securities transactions on the line near the
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bottom of the table, and are not included in operating earnings.
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(We regard any annual figure for realized capital gains or losses
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as meaningless, but we regard the aggregate realized and
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unrealized capital gains over a period of years as very
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important.)
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Furthermore, amortization of Goodwill is not charged against
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the specific businesses but, for reasons outlined in the Appendix
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to my letter in the 1983 annual report, is set forth as a
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separate item.
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(000s omitted)
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----------------------------------------------------------
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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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1984 1983 1984 1983 1984 1983
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-------- -------- -------- -------- -------- --------
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Operating Earnings:
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Insurance Group:
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Underwriting ............ $(48,060) $(33,872) $(48,060) $(33,872) $(25,955) $(18,400)
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Net Investment Income ... 68,903 43,810 68,903 43,810 62,059 39,114
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Buffalo News .............. 27,328 19,352 27,328 16,547 13,317 8,832
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Nebraska Furniture Mart(1) 14,511 3,812 11,609 3,049 5,917 1,521
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Sees Candies ............. 26,644 27,411 26,644 24,526 13,380 12,212
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Associated Retail Stores .. (1,072) 697 (1,072) 697 (579) 355
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Blue Chip Stamps(2) (1,843) (1,422) (1,843) (1,876) (899) (353)
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Mutual Savings and Loan ... 1,456 (798) 1,166 (467) 3,151 1,917
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Precision Steel ........... 4,092 3,241 3,278 2,102 1,696 1,136
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Textiles .................. 418 (100) 418 (100) 226 (63)
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Wesco Financial ........... 9,777 7,493 7,831 4,844 4,828 3,448
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Amortization of Goodwill .. (1,434) (532) (1,434) (563) (1,434) (563)
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Interest on Debt .......... (14,734) (15,104) (14,097) (13,844) (7,452) (7,346)
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Shareholder-Designated
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Contributions .......... (3,179) (3,066) (3,179) (3,066) (1,716) (1,656)
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Other ..................... 4,932 10,121 4,529 9,623 3,476 8,490
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-------- -------- -------- -------- -------- --------
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Operating Earnings .......... 87,739 61,043 82,021 51,410 70,015 48,644
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Special GEICO Distribution .. -- 19,575 -- 19,575 -- 18,224
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Special Gen. Foods Distribution 8,111 -- 7,896 -- 7,294 --
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Sales of securities and
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unusual sales of assets .. 104,699 67,260 101,376 65,089 71,587 45,298
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-------- -------- -------- -------- -------- --------
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Total Earnings - all entities $200,549 $147,878 $191,293 $136,074 $148,896 $112,166
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======== ======== ======== ======== ======== ========
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(1) 1983 figures are those for October through December.
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(2) 1984 and 1983 are not comparable; major assets were
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transferred in the mid-year 1983 merger of Blue Chip Stamps.
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Sharp-eyed shareholders will notice that the amount of the
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special GEICO distribution and its location in the table have
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been changed from the presentation of last year. Though they
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reclassify and reduce accounting earnings, the changes are
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entirely of form, not of substance. The story behind the
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changes, however, is interesting.
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As reported last year: (1) in mid-1983 GEICO made a tender
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offer to buy its own shares; (2) at the same time, we agreed by
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written contract to sell GEICO an amount of its shares that would
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be proportionately related to the aggregate number of shares
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GEICO repurchased via the tender from all other shareholders; (3)
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at completion of the tender, we delivered 350,000 shares to
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GEICO, received $21 million cash, and were left owning exactly
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the same percentage of GEICO that we owned before the tender; (4)
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GEICOs transaction with us amounted to a proportionate
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redemption, an opinion rendered us, without qualification, by a
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leading law firm; (5) the Tax Code logically regards such
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proportionate redemptions as substantially equivalent to
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dividends and, therefore, the $21 million we received was taxed
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at only the 6.9% inter-corporate dividend rate; (6) importantly,
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that $21 million was far less than the previously-undistributed
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earnings that had inured to our ownership in GEICO and, thus,
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from the standpoint of economic substance, was in our view
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equivalent to a dividend.
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Because it was material and unusual, we highlighted the
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GEICO distribution last year to you, both in the applicable
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quarterly report and in this section of the annual report.
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Additionally, we emphasized the transaction to our auditors,
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Peat, Marwick, Mitchell & Co. Both the Omaha office of Peat
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Marwick and the reviewing Chicago partner, without objection,
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concurred with our dividend presentation.
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In 1984, we had a virtually identical transaction with
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General Foods. The only difference was that General Foods
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repurchased its stock over a period of time in the open market,
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whereas GEICO had made a one-shot tender offer. In the General
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Foods case we sold to the company, on each day that it
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repurchased shares, a quantity of shares that left our ownership
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percentage precisely unchanged. Again our transaction was
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pursuant to a written contract executed before repurchases began.
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And again the money we received was far less than the retained
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earnings that had inured to our ownership interest since our
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purchase. Overall we received $21,843,601 in cash from General
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Foods, and our ownership remained at exactly 8.75%.
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At this point the New York office of Peat Marwick came into
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the picture. Late in 1984 it indicated that it disagreed with
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the conclusions of the firms Omaha office and Chicago reviewing
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partner. The New York view was that the GEICO and General Foods
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transactions should be treated as sales of stock by Berkshire
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rather than as the receipt of dividends. Under this accounting
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approach, a portion of the cost of our investment in the stock of
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each company would be charged against the redemption payment and
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any gain would be shown as a capital gain, not as dividend
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income. This is an accounting approach only, having no bearing
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on taxes: Peat Marwick agrees that the transactions were
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dividends for IRS purposes.
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We disagree with the New York position from both the
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viewpoint of economic substance and proper accounting. But, to
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avoid a qualified auditors opinion, we have adopted herein Peat
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Marwicks 1984 view and restated 1983 accordingly. None of this,
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however, has any effect on intrinsic business value: our
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ownership interests in GEICO and General Foods, our cash, our
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taxes, and the market value and tax basis of our holdings all
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remain the same.
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This year we have again entered into a contract with General
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Foods whereby we will sell them shares concurrently with open
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market purchases that they make. The arrangement provides that
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our ownership interest will remain unchanged at all times. By
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keeping it so, we will insure ourselves dividend treatment for
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tax purposes. In our view also, the economic substance of this
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transaction again is the creation of dividend income. However,
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we will account for the redemptions as sales of stock rather than
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dividend income unless accounting rules are adopted that speak
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directly to this point. We will continue to prominently identify
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any such special transactions in our reports to you.
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While we enjoy a low tax charge on these proportionate
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redemptions, and have participated in several of them, we view
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such repurchases as at least equally favorable for shareholders
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who do not sell. When companies with outstanding businesses and
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comfortable financial positions find their shares selling far
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below intrinsic value in the marketplace, no alternative action
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can benefit shareholders as surely as repurchases.
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(Our endorsement of repurchases is limited to those dictated
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by price/value relationships and does not extend to the
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greenmail repurchase - a practice we find odious and repugnant.
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In these transactions, two parties achieve their personal ends by
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exploitation of an innocent and unconsulted third party. The
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players are: (1) the shareholder extortionist who, even before
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the ink on his stock certificate dries, delivers his your-
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money-or-your-life message to managers; (2) the corporate
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insiders who quickly seek peace at any price - as long as the
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price is paid by someone else; and (3) the shareholders whose
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money is used by (2) to make (1) go away. As the dust settles,
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the mugging, transient shareholder gives his speech on free
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enterprise, the muggee management gives its speech on the best
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interests of the company, and the innocent shareholder standing
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by mutely funds the payoff.)
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The companies in which we have our largest investments have
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all engaged in significant stock repurhases at times when wide
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discrepancies existed between price and value. As shareholders,
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we find this encouraging and rewarding for two important reasons
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- one that is obvious, and one that is subtle and not always
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understood. The obvious point involves basic arithmetic: major
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repurchases at prices well below per-share intrinsic business
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value immediately increase, in a highly significant way, that
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value. When companies purchase their own stock, they often find
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it easy to get $2 of present value for $1. Corporate acquisition
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programs almost never do as well and, in a discouragingly large
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number of cases, fail to get anything close to $1 of value for
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each $1 expended.
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The other benefit of repurchases is less subject to precise
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measurement but can be fully as important over time. By making
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repurchases when a companys market value is well below its
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business value, management clearly demonstrates that it is given
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to actions that enhance the wealth of shareholders, rather than
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to actions that expand managements domain but that do nothing
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for (or even harm) shareholders. Seeing this, shareholders and
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potential shareholders increase their estimates of future returns
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from the business. This upward revision, in turn, produces
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market prices more in line with intrinsic business value. These
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prices are entirely rational. Investors should pay more for a
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business that is lodged in the hands of a manager with
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demonstrated pro-shareholder leanings than for one in the hands
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of a self-interested manager marching to a different drummer. (To
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make the point extreme, how much would you pay to be a minority
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shareholder of a company controlled by Robert Wesco?)
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The key word is demonstrated. A manager who consistently
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turns his back on repurchases, when these clearly are in the
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interests of owners, reveals more than he knows of his
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motivations. No matter how often or how eloquently he mouths
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some public relations-inspired phrase such as maximizing
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shareholder wealth (this seasons favorite), the market
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correctly discounts assets lodged with him. His heart is not
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listening to his mouth - and, after a while, neither will the
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market.
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We have prospered in a very major way - as have other
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shareholders - by the large share repurchases of GEICO,
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Washington Post, and General Foods, our three largest holdings.
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(Exxon, in which we have our fourth largest holding, has also
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wisely and aggressively repurchased shares but, in this case, we
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have only recently established our position.) In each of these
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companies, shareholders have had their interests in outstanding
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businesses materially enhanced by repurchases made at bargain
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prices. We feel very comfortable owning interests in businesses
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such as these that offer excellent economics combined with
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shareholder-conscious managements.
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The following table shows our 1984 yearend net holdings in
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marketable equities. All numbers exclude the interests
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attributable to minority shareholders of Wesco and Nebraska
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Furniture Mart.
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No. of Shares Cost Market
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------------- ---------- ----------
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(000s omitted)
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690,975 Affiliated Publications, Inc. ....... $ 3,516 $ 32,908
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740,400 American Broadcasting Companies, Inc. 44,416 46,738
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3,895,710 Exxon Corporation ................... 173,401 175,307
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4,047,191 General Foods Corporation ........... 149,870 226,137
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6,850,000 GEICO Corporation ................... 45,713 397,300
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2,379,200 Handy & Harman ...................... 27,318 38,662
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818,872 Interpublic Group of Companies, Inc. 2,570 28,149
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555,949 Northwest Industries 26,581 27,242
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2,553,488 Time, Inc. .......................... 89,327 109,162
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1,868,600 The Washington Post Company ......... 10,628 149,955
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---------- ----------
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$573,340 $1,231,560
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All Other Common Stockholdings 11,634 37,326
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---------- ----------
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Total Common Stocks $584,974 $1,268,886
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========== ==========
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Its been over ten years since it has been as difficult as
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now to find equity investments that meet both our qualitative
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standards and our quantitative standards of value versus price.
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We try to avoid compromise of these standards, although we find
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doing nothing the most difficult task of all. (One English
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statesman attributed his countrys greatness in the nineteenth
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century to a policy of masterly inactivity. This is a strategy
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that is far easier for historians to commend than for
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participants to follow.)
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In addition to the figures supplied at the beginning of this
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section, information regarding the businesses we own appears in
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Managements Discussion on pages 42-47. An amplified discussion
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of Wescos businesses appears in Charlie Mungers report on pages
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50-59. You will find particularly interesting his comments about
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conditions in the thrift industry. Our other major controlled
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businesses are Nebraska Furniture Mart, Sees, Buffalo Evening
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News, and the Insurance Group, to which we will give some special
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attention here.
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Nebraska Furniture Mart
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Last year I introduced you to Mrs. B (Rose Blumkin) and her
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family. I told you they were terrific, and I understated the
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case. After another year of observing their remarkable talents
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and character, I can honestly say that I never have seen a
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managerial group that either functions or behaves better than the
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Blumkin family.
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Mrs. B, Chairman of the Board, is now 91, and recently was
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quoted in the local newspaper as saying, I come home to eat and
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sleep, and thats about it. I cant wait until it gets daylight
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so I can get back to the business. Mrs. B is at the store seven
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days a week, from opening to close, and probably makes more
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decisions in a day than most CEOs do in a year (better ones,
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too).
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In May Mrs. B was granted an Honorary Doctorate in
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Commercial Science by New York University. (Shes a fast track
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student: not one day in her life was spent in a school room prior
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|
|
to her receipt of the doctorate.) Previous recipients of honorary
|
||
|
|
degrees in business from NYU include Clifton Garvin, Jr., CEO of
|
||
|
|
Exxon Corp.; Walter Wriston, then CEO of Citicorp; Frank Cary,
|
||
|
|
then CEO of IBM; Tom Murphy, then CEO of General Motors; and,
|
||
|
|
most recently, Paul Volcker. (They are in good company.)
|
||
|
|
|
||
|
|
The Blumkin blood did not run thin. Louie, Mrs. Bs son,
|
||
|
|
and his three boys, Ron, Irv, and Steve, all contribute in full
|
||
|
|
measure to NFMs amazing success. The younger generation has
|
||
|
|
attended the best business school of them all - that conducted by
|
||
|
|
Mrs. B and Louie - and their training is evident in their
|
||
|
|
performance.
|
||
|
|
|
||
|
|
Last year NFMs net sales increased by $14.3 million,
|
||
|
|
bringing the total to $115 million, all from the one store in
|
||
|
|
Omaha. That is by far the largest volume produced by a single
|
||
|
|
home furnishings store in the United States. In fact, the gain
|
||
|
|
in sales last year was itself greater than the annual volume of
|
||
|
|
many good-sized successful stores. The business achieves this
|
||
|
|
success because it deserves this success. A few figures will
|
||
|
|
tell you why.
|
||
|
|
|
||
|
|
In its fiscal 1984 10-K, the largest independent specialty
|
||
|
|
retailer of home furnishings in the country, Levitz Furniture,
|
||
|
|
described its prices as generally lower than the prices charged
|
||
|
|
by conventional furniture stores in its trading area. Levitz,
|
||
|
|
in that year, operated at a gross margin of 44.4% (that is, on
|
||
|
|
average, customers paid it $100 for merchandise that had cost it
|
||
|
|
$55.60 to buy). The gross margin at NFM is not much more than
|
||
|
|
half of that. NFMs low mark-ups are possible because of its
|
||
|
|
exceptional efficiency: operating expenses (payroll, occupancy,
|
||
|
|
advertising, etc.) are about 16.5% of sales versus 35.6% at
|
||
|
|
Levitz.
|
||
|
|
|
||
|
|
None of this is in criticism of Levitz, which has a well-
|
||
|
|
managed operation. But the NFM operation is simply extraordinary
|
||
|
|
(and, remember, it all comes from a $500 investment by Mrs. B in
|
||
|
|
1937). By unparalleled efficiency and astute volume purchasing,
|
||
|
|
NFM is able to earn excellent returns on capital while saving its
|
||
|
|
customers at least $30 million annually from what, on average, it
|
||
|
|
would cost them to buy the same merchandise at stores maintaining
|
||
|
|
typical mark-ups. Such savings enable NFM to constantly widen
|
||
|
|
its geographical reach and thus to enjoy growth well beyond the
|
||
|
|
natural growth of the Omaha market.
|
||
|
|
|
||
|
|
I have been asked by a number of people just what secrets
|
||
|
|
the Blumkins bring to their business. These are not very
|
||
|
|
esoteric. All members of the family: (1) apply themselves with
|
||
|
|
an enthusiasm and energy that would make Ben Franklin and Horatio
|
||
|
|
Alger look like dropouts; (2) define with extraordinary realism
|
||
|
|
their area of special competence and act decisively on all
|
||
|
|
matters within it; (3) ignore even the most enticing propositions
|
||
|
|
failing outside of that area of special competence; and, (4)
|
||
|
|
unfailingly behave in a high-grade manner with everyone they deal
|
||
|
|
with. (Mrs. B boils it down to sell cheap and tell the truth.)
|
||
|
|
|
||
|
|
Our evaluation of the integrity of Mrs. B and her family was
|
||
|
|
demonstrated when we purchased 90% of the business: NFM had never
|
||
|
|
had an audit and we did not request one; we did not take an
|
||
|
|
inventory nor verify the receivables; we did not check property
|
||
|
|
titles. We gave Mrs. B a check for $55 million and she gave us
|
||
|
|
her word. That made for an even exchange.
|
||
|
|
|
||
|
|
You and I are fortunate to be in partnership with the
|
||
|
|
Blumkin family.
|
||
|
|
|
||
|
|
Sees Candy Shops, Inc.
|
||
|
|
|
||
|
|
Below is our usual recap of Sees performance since the time
|
||
|
|
of purchase by Blue Chip Stamps:
|
||
|
|
|
||
|
|
52-53 Week Year Operating Number of Number of
|
||
|
|
Ended About Sales Profits Pounds of Stores Open
|
||
|
|
December 31 Revenues After Taxes Candy Sold at Year End
|
||
|
|
------------------- ------------ ----------- ---------- -----------
|
||
|
|
1984 .............. $135,946,000 $13,380,000 24,759,000 214
|
||
|
|
1983 (53 weeks) ... 133,531,000 13,699,000 24,651,000 207
|
||
|
|
1982 .............. 123,662,000 11,875,000 24,216,000 202
|
||
|
|
1981 .............. 112,578,000 10,779,000 24,052,000 199
|
||
|
|
1980 .............. 97,715,000 7,547,000 24,065,000 191
|
||
|
|
1979 .............. 87,314,000 6,330,000 23,985,000 188
|
||
|
|
1978 .............. 73,653,000 6,178,000 22,407,000 182
|
||
|
|
1977 .............. 62,886,000 6,154,000 20,921,000 179
|
||
|
|
1976 (53 weeks) ... 56,333,000 5,569,000 20,553,000 173
|
||
|
|
1975 .............. 50,492,000 5,132,000 19,134,000 172
|
||
|
|
1974 .............. 41,248,000 3,021,000 17,883,000 170
|
||
|
|
1973 .............. 35,050,000 1,940,000 17,813,000 169
|
||
|
|
1972 .............. 31,337,000 2,083,000 16,954,000 167
|
||
|
|
|
||
|
|
This performance has not been produced by a generally rising
|
||
|
|
tide. To the contrary, many well-known participants in the
|
||
|
|
boxed-chocolate industry either have lost money in this same
|
||
|
|
period or have been marginally profitable. To our knowledge,
|
||
|
|
only one good-sized competitor has achieved high profitability.
|
||
|
|
The success of Sees reflects the combination of an exceptional
|
||
|
|
product and an exceptional manager, Chuck Huggins.
|
||
|
|
|
||
|
|
During 1984 we increased prices considerably less than has
|
||
|
|
been our practice in recent years: per-pound realization was
|
||
|
|
$5.49, up only 1.4% from 1983. Fortunately, we made good
|
||
|
|
progress on cost control, an area that has caused us problems in
|
||
|
|
recent years. Per-pound costs - other than those for raw
|
||
|
|
materials, a segment of expense largely outside of our control -
|
||
|
|
increased by only 2.2% last year.
|
||
|
|
|
||
|
|
Our cost-control problem has been exacerbated by the problem
|
||
|
|
of modestly declining volume (measured by pounds, not dollars) on
|
||
|
|
a same-store basis. Total pounds sold through shops in recent
|
||
|
|
years has been maintained at a roughly constant level only by the
|
||
|
|
net addition of a few shops annually. This more-shops-to-get-
|
||
|
|
the-same-volume situation naturally puts heavy pressure on per-
|
||
|
|
pound selling costs.
|
||
|
|
|
||
|
|
In 1984, same-store volume declined 1.1%. Total shop volume,
|
||
|
|
however, grew 0.6% because of an increase in stores. (Both
|
||
|
|
percentages are adjusted to compensate for a 53-week fiscal year
|
||
|
|
in 1983.)
|
||
|
|
|
||
|
|
Sees business tends to get a bit more seasonal each year.
|
||
|
|
In the four weeks prior to Christmas, we do 40% of the years
|
||
|
|
volume and earn about 75% of the years profits. We also earn
|
||
|
|
significant sums in the Easter and Valentines Day periods, but
|
||
|
|
pretty much tread water the rest of the year. In recent years,
|
||
|
|
shop volume at Christmas has grown in relative importance, and so
|
||
|
|
have quantity orders and mail orders. The increased
|
||
|
|
concentration of business in the Christmas period produces a
|
||
|
|
multitude of managerial problems, all of which have been handled
|
||
|
|
by Chuck and his associates with exceptional skill and grace.
|
||
|
|
|
||
|
|
Their solutions have in no way involved compromises in
|
||
|
|
either quality of service or quality of product. Most of our
|
||
|
|
larger competitors could not say the same. Though faced with
|
||
|
|
somewhat less extreme peaks and valleys in demand than we, they
|
||
|
|
add preservatives or freeze the finished product in order to
|
||
|
|
smooth the production cycle and thereby lower unit costs. We
|
||
|
|
reject such techniques, opting, in effect, for production
|
||
|
|
headaches rather than product modification.
|
||
|
|
|
||
|
|
Our mall stores face a host of new food and snack vendors
|
||
|
|
that provide particularly strong competition at non-holiday
|
||
|
|
periods. We need new products to fight back and during 1984 we
|
||
|
|
introduced six candy bars that, overall, met with a good
|
||
|
|
reception. Further product introductions are planned.
|
||
|
|
|
||
|
|
In 1985 we will intensify our efforts to keep per-pound cost
|
||
|
|
increases below the rate of inflation. Continued success in
|
||
|
|
these efforts, however, will require gains in same-store
|
||
|
|
poundage. Prices in 1985 should average 6% - 7% above those of
|
||
|
|
1984. Assuming no change in same-store volume, profits should
|
||
|
|
show a moderate gain.
|
||
|
|
|
||
|
|
Buffalo Evening News
|
||
|
|
|
||
|
|
Profits at the News in 1984 were considerably greater than
|
||
|
|
we expected. As at Sees, excellent progress was made in
|
||
|
|
controlling costs. Excluding hours worked in the newsroom, total
|
||
|
|
hours worked decreased by about 2.8%. With this productivity
|
||
|
|
improvement, overall costs increased only 4.9%. This performance
|
||
|
|
by Stan Lipsey and his management team was one of the best in the
|
||
|
|
industry.
|
||
|
|
|
||
|
|
However, we now face an acceleration in costs. In mid-1984
|
||
|
|
we entered into new multi-year union contracts that provided for
|
||
|
|
a large catch-up wage increase. This catch-up is entirely
|
||
|
|
appropriate: the cooperative spirit of our unions during the
|
||
|
|
unprofitable 1977-1982 period was an important factor in our
|
||
|
|
success in remaining cost competitive with The Courier-Express.
|
||
|
|
Had we not kept costs down, the outcome of that struggle might
|
||
|
|
well have been different.
|
||
|
|
|
||
|
|
Because our new union contracts took effect at varying
|
||
|
|
dates, little of the catch-up increase was reflected in our 1984
|
||
|
|
costs. But the increase will be almost totally effective in 1985
|
||
|
|
and, therefore, our unit labor costs will rise this year at a
|
||
|
|
rate considerably greater than that of the industry. We expect
|
||
|
|
to mitigate this increase by continued small gains in
|
||
|
|
productivity, but we cannot avoid significantly higher wage costs
|
||
|
|
this year. Newsprint price trends also are less favorable now
|
||
|
|
than they were in 1984. Primarily because of these two factors,
|
||
|
|
we expect at least a minor contraction in margins at the News.
|
||
|
|
|
||
|
|
Working in our favor at the News are two factors of major
|
||
|
|
economic importance:
|
||
|
|
|
||
|
|
(1) Our circulation is concentrated to an unusual degree
|
||
|
|
in the area of maximum utility to our advertisers.
|
||
|
|
Regional newspapers with wide-ranging circulation, on
|
||
|
|
the other hand, have a significant portion of their
|
||
|
|
circulation in areas that are of negligible utility to
|
||
|
|
most advertisers. A subscriber several hundred miles
|
||
|
|
away is not much of a prospect for the puppy you are
|
||
|
|
offering to sell via a classified ad - nor for the
|
||
|
|
grocer with stores only in the metropolitan area.
|
||
|
|
Wasted circulation - as the advertisers call it -
|
||
|
|
hurts profitability: expenses of a newspaper are
|
||
|
|
determined largely by gross circulation while
|
||
|
|
advertising revenues (usually 70% - 80% of total
|
||
|
|
revenues) are responsive only to useful circulation;
|
||
|
|
|
||
|
|
(2) Our penetration of the Buffalo retail market is
|
||
|
|
exceptional; advertisers can reach almost all of their
|
||
|
|
potential customers using only the News.
|
||
|
|
|
||
|
|
Last year I told you about this unusual reader acceptance:
|
||
|
|
among the 100 largest newspapers in the country, we were then
|
||
|
|
number one, daily, and number three, Sunday, in penetration. The
|
||
|
|
most recent figures show us number one in penetration on weekdays
|
||
|
|
and number two on Sunday. (Even so, the number of households in
|
||
|
|
Buffalo has declined, so our current weekday circulation is down
|
||
|
|
slightly; on Sundays it is unchanged.)
|
||
|
|
|
||
|
|
I told you also that one of the major reasons for this
|
||
|
|
unusual acceptance by readers was the unusual quantity of news
|
||
|
|
that we delivered to them: a greater percentage of our paper is
|
||
|
|
devoted to news than is the case at any other dominant paper in
|
||
|
|
our size range. In 1984 our news hole ratio was 50.9%, (versus
|
||
|
|
50.4% in 1983), a level far above the typical 35% - 40%. We will
|
||
|
|
continue to maintain this ratio in the 50% area. Also, though we
|
||
|
|
last year reduced total hours worked in other departments, we
|
||
|
|
maintained the level of employment in the newsroom and, again,
|
||
|
|
will continue to do so. Newsroom costs advanced 9.1% in 1984, a
|
||
|
|
rise far exceeding our overall cost increase of 4.9%.
|
||
|
|
|
||
|
|
Our news hole policy costs us significant extra money for
|
||
|
|
newsprint. As a result, our news costs (newsprint for the news
|
||
|
|
hole plus payroll and expenses of the newsroom) as a percentage
|
||
|
|
of revenue run higher than those of most dominant papers of our
|
||
|
|
size. There is adequate room, however, for our paper or any
|
||
|
|
other dominant paper to sustain these costs: the difference
|
||
|
|
between high and low news costs at papers of comparable size
|
||
|
|
runs perhaps three percentage points while pre-tax profit margins
|
||
|
|
are often ten times that amount.
|
||
|
|
|
||
|
|
The economics of a dominant newspaper are excellent, among
|
||
|
|
the very best in the business world. Owners, naturally, would
|
||
|
|
like to believe that their wonderful profitability is achieved
|
||
|
|
only because they unfailingly turn out a wonderful product. That
|
||
|
|
comfortable theory wilts before an uncomfortable fact. While
|
||
|
|
first-class newspapers make excellent profits, the profits of
|
||
|
|
third-rate papers are as good or better - as long as either class
|
||
|
|
of paper is dominant within its community. Of course, product
|
||
|
|
quality may have been crucial to the paper in achieving
|
||
|
|
dominance. We believe this was the case at the News, in very
|
||
|
|
large part because of people such as Alfred Kirchhofer who
|
||
|
|
preceded us.
|
||
|
|
|
||
|
|
Once dominant, the newspaper itself, not the marketplace,
|
||
|
|
determines just how good or how bad the paper will be. Good or
|
||
|
|
bad, it will prosper. That is not true of most businesses:
|
||
|
|
inferior quality generally produces inferior economics. But even
|
||
|
|
a poor newspaper is a bargain to most citizens simply because of
|
||
|
|
its bulletin board value. Other things being equal, a poor
|
||
|
|
product will not achieve quite the level of readership achieved
|
||
|
|
by a first-class product. A poor product, however, will still
|
||
|
|
remain essential to most citizens, and what commands their
|
||
|
|
attention will command the attention of advertisers.
|
||
|
|
|
||
|
|
Since high standards are not imposed by the marketplace,
|
||
|
|
management must impose its own. Our commitment to an above-
|
||
|
|
average expenditure for news represents an important quantitative
|
||
|
|
standard. We have confidence that Stan Lipsey and Murray Light
|
||
|
|
will continue to apply the far-more important qualitative
|
||
|
|
standards. Charlie and I believe that newspapers are very
|
||
|
|
special institutions in society. We are proud of the News, and
|
||
|
|
intend an even greater pride to be justified in the years ahead.
|
||
|
|
|
||
|
|
Insurance Operations
|
||
|
|
|
||
|
|
Shown below is an updated version of our usual table listing
|
||
|
|
two key figures for the insurance industry:
|
||
|
|
|
||
|
|
Yearly Change Combined Ratio
|
||
|
|
in Premiums after Policy-holder
|
||
|
|
Written (%) Dividends
|
||
|
|
------------- -------------------
|
||
|
|
1972 .............................. 10.2 96.2
|
||
|
|
1973 .............................. 8.0 99.2
|
||
|
|
1974 .............................. 6.2 105.4
|
||
|
|
1975 .............................. 11.0 107.9
|
||
|
|
1976 .............................. 21.9 102.4
|
||
|
|
1977 .............................. 19.8 97.2
|
||
|
|
1978 .............................. 12.8 97.5
|
||
|
|
1979 .............................. 10.3 100.6
|
||
|
|
1980 .............................. 6.0 103.1
|
||
|
|
1981 .............................. 3.9 106.0
|
||
|
|
1982 .............................. 4.4 109.7
|
||
|
|
1983 (Revised) .................... 4.5 111.9
|
||
|
|
1984 (Estimated) .................. 8.1 117.7
|
||
|
|
Source: Bests Aggregates and Averages
|
||
|
|
|
||
|
|
Bests data reflect the experience of practically the entire
|
||
|
|
industry, including stock, mutual, and reciprocal companies. The
|
||
|
|
combined ratio represents total insurance costs (losses incurred
|
||
|
|
plus expenses) compared to revenue from premiums; a ratio below
|
||
|
|
100 indicates an underwriting profit, and one above 100 indicates
|
||
|
|
a loss.
|
||
|
|
|
||
|
|
For a number of years, we have told you that an annual
|
||
|
|
increase by the industry of about 10% per year in premiums
|
||
|
|
written is necessary for the combined ratio to remain roughly
|
||
|
|
unchanged. We assumed in making that assertion that expenses as
|
||
|
|
a percentage of premium volume would stay relatively stable and
|
||
|
|
that losses would grow at about 10% annually because of the
|
||
|
|
combined influence of unit volume increases, inflation, and
|
||
|
|
judicial rulings that expand what is covered by the insurance
|
||
|
|
policy.
|
||
|
|
|
||
|
|
Our opinion is proving dismayingly accurate: a premium
|
||
|
|
increase of 10% per year since 1979 would have produced an
|
||
|
|
aggregate increase through 1984 of 61% and a combined ratio in
|
||
|
|
1984 almost identical to the 100.6 of 1979. Instead, the
|
||
|
|
industry had only a 30% increase in premiums and a 1984 combined
|
||
|
|
ratio of 117.7. Today, we continue to believe that the key index
|
||
|
|
to the trend of underwriting profitability is the year-to-year
|
||
|
|
percentage change in industry premium volume.
|
||
|
|
|
||
|
|
It now appears that premium volume in 1985 will grow well
|
||
|
|
over 10%. Therefore, assuming that catastrophes are at a
|
||
|
|
normal level, we would expect the combined ratio to begin
|
||
|
|
easing downward toward the end of the year. However, under our
|
||
|
|
industrywide loss assumptions (i.e., increases of 10% annually),
|
||
|
|
five years of 15%-per-year increases in premiums would be
|
||
|
|
required to get the combined ratio back to 100. This would mean
|
||
|
|
a doubling of industry volume by 1989, an outcome that seems
|
||
|
|
highly unlikely to us. Instead, we expect several years of
|
||
|
|
premium gains somewhat above the 10% level, followed by highly-
|
||
|
|
competitive pricing that generally will produce combined ratios
|
||
|
|
in the 108-113 range.
|
||
|
|
|
||
|
|
Our own combined ratio in 1984 was a humbling 134. (Here, as
|
||
|
|
throughout this report, we exclude structured settlements and the
|
||
|
|
assumption of loss reserves in reporting this ratio. Much
|
||
|
|
additional detail, including the effect of discontinued
|
||
|
|
operations on the ratio, appears on pages 42-43). This is the
|
||
|
|
third year in a row that our underwriting performance has been
|
||
|
|
far poorer than that of the industry. We expect an improvement
|
||
|
|
in the combined ratio in 1985, and also expect our improvement to
|
||
|
|
be substantially greater than that of the industry. Mike
|
||
|
|
Goldberg has corrected many of the mistakes I made before he took
|
||
|
|
over insurance operations. Moreover, our business is
|
||
|
|
concentrated in lines that have experienced poorer-than-average
|
||
|
|
results during the past several years, and that circumstance has
|
||
|
|
begun to subdue many of our competitors and even eliminate some.
|
||
|
|
With the competition shaken, we were able during the last half of
|
||
|
|
1984 to raise prices significantly in certain important lines
|
||
|
|
with little loss of business.
|
||
|
|
|
||
|
|
For some years I have told you that there could be a day
|
||
|
|
coming when our premier financial strength would make a real
|
||
|
|
difference in the competitive position of our insurance
|
||
|
|
operation. That day may have arrived. We are almost without
|
||
|
|
question the strongest property/casualty insurance operation in
|
||
|
|
the country, with a capital position far superior to that of
|
||
|
|
well-known companies of much greater size.
|
||
|
|
|
||
|
|
Equally important, our corporate policy is to retain that
|
||
|
|
superiority. The buyer of insurance receives only a promise in
|
||
|
|
exchange for his cash. The value of that promise should be
|
||
|
|
appraised against the possibility of adversity, not prosperity.
|
||
|
|
At a minimum, the promise should appear able to withstand a
|
||
|
|
prolonged combination of depressed financial markets and
|
||
|
|
exceptionally unfavorable underwriting results. Our insurance
|
||
|
|
subsidiaries are both willing and able to keep their promises in
|
||
|
|
any such environment - and not too many other companies clearly
|
||
|
|
are.
|
||
|
|
|
||
|
|
Our financial strength is a particular asset in the business
|
||
|
|
of structured settlements and loss reserve assumptions that we
|
||
|
|
reported on last year. The claimant in a structured settlement
|
||
|
|
and the insurance company that has reinsured loss reserves need
|
||
|
|
to be completely confident that payments will be forthcoming for
|
||
|
|
decades to come. Very few companies in the property/casualty
|
||
|
|
field can meet this test of unquestioned long-term strength. (In
|
||
|
|
fact, only a handful of companies exists with which we will
|
||
|
|
reinsure our own liabilities.)
|
||
|
|
|
||
|
|
We have grown in these new lines of business: funds that we
|
||
|
|
hold to offset assumed liabilities grew from $16.2 million to
|
||
|
|
$30.6 million during the year. We expect growth to continue and
|
||
|
|
perhaps to greatly accelerate. To support this projected growth
|
||
|
|
we have added substantially to the capital of Columbia Insurance
|
||
|
|
Company, our reinsurance unit specializing in structured
|
||
|
|
settlements and loss reserve assumptions. While these businesses
|
||
|
|
are very competitive, returns should be satisfactory.
|
||
|
|
|
||
|
|
At GEICO the news, as usual, is mostly good. That company
|
||
|
|
achieved excellent unit growth in its primary insurance business
|
||
|
|
during 1984, and the performance of its investment portfolio
|
||
|
|
continued to be extraordinary. Though underwriting results
|
||
|
|
deteriorated late in the year, they still remain far better than
|
||
|
|
those of the industry. Our ownership in GEICO at yearend
|
||
|
|
amounted to 36% and thus our interest in their direct
|
||
|
|
property/casualty volume of $885 million amounted to $320
|
||
|
|
million, or well over double our own premium volume.
|
||
|
|
|
||
|
|
I have reported to you in the past few years that the
|
||
|
|
performance of GEICOs stock has considerably exceeded that
|
||
|
|
companys business performance, brilliant as the latter has been.
|
||
|
|
In those years, the carrying value of our GEICO investment on our
|
||
|
|
balance sheet grew at a rate greater than the growth in GEICOs
|
||
|
|
intrinsic business value. I warned you that over performance by
|
||
|
|
the stock relative to the performance of the business obviously
|
||
|
|
could not occur every year, and that in some years the stock must
|
||
|
|
under perform the business. In 1984 that occurred and the
|
||
|
|
carrying value of our interest in GEICO changed hardly at all,
|
||
|
|
while the intrinsic business value of that interest increased
|
||
|
|
substantially. Since 27% of Berkshires net worth at the
|
||
|
|
beginning of 1984 was represented by GEICO, its static market
|
||
|
|
value had a significant impact upon our rate of gain for the
|
||
|
|
year. We are not at all unhappy with such a result: we would far
|
||
|
|
rather have the business value of GEICO increase by X during the
|
||
|
|
year, while market value decreases, than have the intrinsic value
|
||
|
|
increase by only 1/2 X with market value soaring. In GEICOs
|
||
|
|
case, as in all of our investments, we look to business
|
||
|
|
performance, not market performance. If we are correct in
|
||
|
|
expectations regarding the business, the market eventually will
|
||
|
|
follow along.
|
||
|
|
|
||
|
|
You, as shareholders of Berkshire, have benefited in
|
||
|
|
enormous measure from the talents of GEICOs Jack Byrne, Bill
|
||
|
|
Snyder, and Lou Simpson. In its core business - low-cost auto
|
||
|
|
and homeowners insurance - GEICO has a major, sustainable
|
||
|
|
competitive advantage. That is a rare asset in business
|
||
|
|
generally, and its almost non-existent in the field of financial
|
||
|
|
services. (GEICO, itself, illustrates this point: despite the
|
||
|
|
companys excellent management, superior profitability has eluded
|
||
|
|
GEICO in all endeavors other than its core business.) In a large
|
||
|
|
industry, a competitive advantage such as GEICOs provides the
|
||
|
|
potential for unusual economic rewards, and Jack and Bill
|
||
|
|
continue to exhibit great skill in realizing that potential.
|
||
|
|
|
||
|
|
Most of the funds generated by GEICOs core insurance
|
||
|
|
operation are made available to Lou for investment. Lou has the
|
||
|
|
rare combination of temperamental and intellectual
|
||
|
|
characteristics that produce outstanding long-term investment
|
||
|
|
performance. Operating with below-average risk, he has generated
|
||
|
|
returns that have been by far the best in the insurance industry.
|
||
|
|
I applaud and appreciate the efforts and talents of these three
|
||
|
|
outstanding managers.
|
||
|
|
|
||
|
|
Errors in Loss Reserving
|
||
|
|
|
||
|
|
Any shareholder in a company with important interests in the
|
||
|
|
property/casualty insurance business should have some
|
||
|
|
understanding of the weaknesses inherent in the reporting of
|
||
|
|
current earnings in that industry. Phil Graham, when publisher
|
||
|
|
of the Washington Post, described the daily newspaper as a first
|
||
|
|
rough draft of history. Unfortunately, the financial statements
|
||
|
|
of a property/casualty insurer provide, at best, only a first
|
||
|
|
rough draft of earnings and financial condition.
|
||
|
|
|
||
|
|
The determination of costs is the main problem. Most of an
|
||
|
|
insurers costs result from losses on claims, and many of the
|
||
|
|
losses that should be charged against the current years revenue
|
||
|
|
are exceptionally difficult to estimate. Sometimes the extent of
|
||
|
|
these losses, or even their existence, is not known for decades.
|
||
|
|
|
||
|
|
The loss expense charged in a property/casualty companys
|
||
|
|
current income statement represents: (1) losses that occurred and
|
||
|
|
were paid during the year; (2) estimates for losses that occurred
|
||
|
|
and were reported to the insurer during the year, but which have
|
||
|
|
yet to be settled; (3) estimates of ultimate dollar costs for
|
||
|
|
losses that occurred during the year but of which the insurer is
|
||
|
|
unaware (termed IBNR: incurred but not reported); and (4) the
|
||
|
|
net effect of revisions this year of similar estimates for (2)
|
||
|
|
and (3) made in past years.
|
||
|
|
|
||
|
|
Such revisions may be long delayed, but eventually any
|
||
|
|
estimate of losses that causes the income for year X to be
|
||
|
|
misstated must be corrected, whether it is in year X + 1, or
|
||
|
|
X + 10. This, perforce, means that earnings in the year of
|
||
|
|
correction also are misstated. For example, assume a claimant
|
||
|
|
was injured by one of our insureds in 1979 and we thought a
|
||
|
|
settlement was likely to be made for $10,000. That year we would
|
||
|
|
have charged $10,000 to our earnings statement for the estimated
|
||
|
|
cost of the loss and, correspondingly, set up a liability reserve
|
||
|
|
on the balance sheet for that amount. If we settled the claim in
|
||
|
|
1984 for $100,000, we would charge earnings with a loss cost of
|
||
|
|
$90,000 in 1984, although that cost was truly an expense of 1979.
|
||
|
|
And if that piece of business was our only activity in 1979, we
|
||
|
|
would have badly misled ourselves as to costs, and you as to
|
||
|
|
earnings.
|
||
|
|
|
||
|
|
The necessarily-extensive use of estimates in assembling the
|
||
|
|
figures that appear in such deceptively precise form in the
|
||
|
|
income statement of property/casualty companies means that some
|
||
|
|
error must seep in, no matter how proper the intentions of
|
||
|
|
management. In an attempt to minimize error, most insurers use
|
||
|
|
various statistical techniques to adjust the thousands of
|
||
|
|
individual loss evaluations (called case reserves) that comprise
|
||
|
|
the raw data for estimation of aggregate liabilities. The extra
|
||
|
|
reserves created by these adjustments are variously labeled
|
||
|
|
bulk, development, or supplemental reserves. The goal of
|
||
|
|
the adjustments should be a loss-reserve total that has a 50-50
|
||
|
|
chance of being proved either slightly too high or slightly too
|
||
|
|
low when all losses that occurred prior to the date of the
|
||
|
|
financial statement are ultimately paid.
|
||
|
|
|
||
|
|
At Berkshire, we have added what we thought were appropriate
|
||
|
|
supplemental reserves but in recent years they have not been
|
||
|
|
adequate. It is important that you understand the magnitude of
|
||
|
|
the errors that have been involved in our reserving. You can
|
||
|
|
thus see for yourselves just how imprecise the process is, and
|
||
|
|
also judge whether we may have some systemic bias that should
|
||
|
|
make you wary of our current and future figures.
|
||
|
|
|
||
|
|
The following table shows the results from insurance
|
||
|
|
underwriting as we have reported them to you in recent years, and
|
||
|
|
also gives you calculations a year later on an if-we-knew-then-
|
||
|
|
what-we think-we-know-now basis. I say what we think we know
|
||
|
|
now because the adjusted figures still include a great many
|
||
|
|
estimates for losses that occurred in the earlier years.
|
||
|
|
However, many claims from the earlier years have been settled so
|
||
|
|
that our one-year-later estimate contains less guess work than
|
||
|
|
our earlier estimate:
|
||
|
|
|
||
|
|
Underwriting Results Corrected Figures
|
||
|
|
as Reported After One Years
|
||
|
|
Year to You Experience
|
||
|
|
---- -------------------- -----------------
|
||
|
|
1980 $ 6,738,000 $ 14,887,000
|
||
|
|
1981 1,478,000 (1,118,000)
|
||
|
|
1982 (21,462,000) (25,066,000)
|
||
|
|
1983 (33,192,000) (50,974,000)
|
||
|
|
1984 (45,413,000) ?
|
||
|
|
|
||
|
|
Our structured settlement and loss-reserve assumption
|
||
|
|
businesses are not included in this table. Important
|
||
|
|
additional information on loss reserve experience appears
|
||
|
|
on pages 43-45.
|
||
|
|
|
||
|
|
To help you understand this table, here is an explanation of
|
||
|
|
the most recent figures: 1984s reported pre-tax underwriting
|
||
|
|
loss of $45.4 million consists of $27.6 million we estimate that
|
||
|
|
we lost on 1984s business, plus the increased loss of $17.8
|
||
|
|
million reflected in the corrected figure for 1983.
|
||
|
|
|
||
|
|
As you can see from reviewing the table, my errors in
|
||
|
|
reporting to you have been substantial and recently have always
|
||
|
|
presented a better underwriting picture than was truly the case.
|
||
|
|
This is a source of particular chagrin to me because: (1) I like
|
||
|
|
for you to be able to count on what I say; (2) our insurance
|
||
|
|
managers and I undoubtedly acted with less urgency than we would
|
||
|
|
have had we understood the full extent of our losses; and (3) we
|
||
|
|
paid income taxes calculated on overstated earnings and thereby
|
||
|
|
gave the government money that we didnt need to. (These
|
||
|
|
overpayments eventually correct themselves, but the delay is long
|
||
|
|
and we dont receive interest on the amounts we overpaid.)
|
||
|
|
|
||
|
|
Because our business is weighted toward casualty and
|
||
|
|
reinsurance lines, we have more problems in estimating loss costs
|
||
|
|
than companies that specialize in property insurance. (When a
|
||
|
|
building that you have insured burns down, you get a much faster
|
||
|
|
fix on your costs than you do when an employer you have insured
|
||
|
|
finds out that one of his retirees has contracted a disease
|
||
|
|
attributable to work he did decades earlier.) But I still find
|
||
|
|
our errors embarrassing. In our direct business, we have far
|
||
|
|
underestimated the mushrooming tendency of juries and courts to
|
||
|
|
make the deep pocket pay, regardless of the factual situation
|
||
|
|
and the past precedents for establishment of liability. We also
|
||
|
|
have underestimated the contagious effect that publicity
|
||
|
|
regarding giant awards has on juries. In the reinsurance area,
|
||
|
|
where we have had our worst experience in under reserving, our
|
||
|
|
customer insurance companies have made the same mistakes. Since
|
||
|
|
we set reserves based on information they supply us, their
|
||
|
|
mistakes have become our mistakes.
|
||
|
|
|
||
|
|
I heard a story recently that is applicable to our insurance
|
||
|
|
accounting problems: a man was traveling abroad when he received
|
||
|
|
a call from his sister informing him that their father had died
|
||
|
|
unexpectedly. It was physically impossible for the brother to
|
||
|
|
get back home for the funeral, but he told his sister to take
|
||
|
|
care of the funeral arrangements and to send the bill to him.
|
||
|
|
After returning home he received a bill for several thousand
|
||
|
|
dollars, which he promptly paid. The following month another
|
||
|
|
bill came along for $15, and he paid that too. Another month
|
||
|
|
followed, with a similar bill. When, in the next month, a third
|
||
|
|
bill for $15 was presented, he called his sister to ask what was
|
||
|
|
going on. Oh, she said. I forgot to tell you. We buried Dad
|
||
|
|
in a rented suit.
|
||
|
|
|
||
|
|
If youve been in the insurance business in recent years -
|
||
|
|
particularly the reinsurance business - this story hurts. We
|
||
|
|
have tried to include all of our rented suit liabilities in our
|
||
|
|
current financial statement, but our record of past error should
|
||
|
|
make us humble, and you suspicious. I will continue to report to
|
||
|
|
you the errors, plus or minus, that surface each year.
|
||
|
|
|
||
|
|
Not all reserving errors in the industry have been of the
|
||
|
|
innocent-but-dumb variety. With underwriting results as bad as
|
||
|
|
they have been in recent years - and with managements having as
|
||
|
|
much discretion as they do in the presentation of financial
|
||
|
|
statements - some unattractive aspects of human nature have
|
||
|
|
manifested themselves. Companies that would be out of business
|
||
|
|
if they realistically appraised their loss costs have, in some
|
||
|
|
cases, simply preferred to take an extraordinarily optimistic
|
||
|
|
view about these yet-to-be-paid sums. Others have engaged in
|
||
|
|
various transactions to hide true current loss costs.
|
||
|
|
|
||
|
|
Both of these approaches can work for a considerable time:
|
||
|
|
external auditors cannot effectively police the financial
|
||
|
|
statements of property/casualty insurers. If liabilities of an
|
||
|
|
insurer, correctly stated, would exceed assets, it falls to the
|
||
|
|
insurer to volunteer this morbid information. In other words,
|
||
|
|
the corpse is supposed to file the death certificate. Under this
|
||
|
|
honor system of mortality, the corpse sometimes gives itself
|
||
|
|
the benefit of the doubt.
|
||
|
|
|
||
|
|
In most businesses, of course, insolvent companies run out
|
||
|
|
of cash. Insurance is different: you can be broke but flush.
|
||
|
|
Since cash comes in at the inception of an insurance policy and
|
||
|
|
losses are paid much later, insolvent insurers dont run out of
|
||
|
|
cash until long after they have run out of net worth. In fact,
|
||
|
|
these walking dead often redouble their efforts to write
|
||
|
|
business, accepting almost any price or risk, simply to keep the
|
||
|
|
cash flowing in. With an attitude like that of an embezzler who
|
||
|
|
has gambled away his purloined funds, these companies hope that
|
||
|
|
somehow they can get lucky on the next batch of business and
|
||
|
|
thereby cover up earlier shortfalls. Even if they dont get
|
||
|
|
lucky, the penalty to managers is usually no greater for a $100
|
||
|
|
million shortfall than one of $10 million; in the meantime, while
|
||
|
|
the losses mount, the managers keep their jobs and perquisites.
|
||
|
|
|
||
|
|
The loss-reserving errors of other property/casualty
|
||
|
|
companies are of more than academic interest to Berkshire. Not
|
||
|
|
only does Berkshire suffer from sell-at-any-price competition by
|
||
|
|
the walking dead, but we also suffer when their insolvency is
|
||
|
|
finally acknowledged. Through various state guarantee funds that
|
||
|
|
levy assessments, Berkshire ends up paying a portion of the
|
||
|
|
insolvent insurers asset deficiencies, swollen as they usually
|
||
|
|
are by the delayed detection that results from wrong reporting.
|
||
|
|
There is even some potential for cascading trouble. The
|
||
|
|
insolvency of a few large insurers and the assessments by state
|
||
|
|
guarantee funds that would follow could imperil weak-but-
|
||
|
|
previously-solvent insurers. Such dangers can be mitigated if
|
||
|
|
state regulators become better at prompt identification and
|
||
|
|
termination of insolvent insurers, but progress on that front has
|
||
|
|
been slow.
|
||
|
|
|
||
|
|
Washington Public Power Supply System
|
||
|
|
|
||
|
|
From October, 1983 through June, 1984 Berkshires insurance
|
||
|
|
subsidiaries continuously purchased large quantities of bonds of
|
||
|
|
Projects 1, 2, and 3 of Washington Public Power Supply System
|
||
|
|
(WPPSS). This is the same entity that, on July 1, 1983,
|
||
|
|
defaulted on $2.2 billion of bonds issued to finance partial
|
||
|
|
construction of the now-abandoned Projects 4 and 5. While there
|
||
|
|
are material differences in the obligors, promises, and
|
||
|
|
properties underlying the two categories of bonds, the problems
|
||
|
|
of Projects 4 and 5 have cast a major cloud over Projects 1, 2,
|
||
|
|
and 3, and might possibly cause serious problems for the latter
|
||
|
|
issues. In addition, there have been a multitude of problems
|
||
|
|
related directly to Projects 1, 2, and 3 that could weaken or
|
||
|
|
destroy an otherwise strong credit position arising from
|
||
|
|
guarantees by Bonneville Power Administration.
|
||
|
|
|
||
|
|
Despite these important negatives, Charlie and I judged the
|
||
|
|
risks at the time we purchased the bonds and at the prices
|
||
|
|
Berkshire paid (much lower than present prices) to be
|
||
|
|
considerably more than compensated for by prospects of profit.
|
||
|
|
|
||
|
|
As you know, we buy marketable stocks for our insurance
|
||
|
|
companies based upon the criteria we would apply in the purchase
|
||
|
|
of an entire business. This business-valuation approach is not
|
||
|
|
widespread among professional money managers and is scorned by
|
||
|
|
many academics. Nevertheless, it has served its followers well
|
||
|
|
(to which the academics seem to say, Well, it may be all right
|
||
|
|
in practice, but it will never work in theory.) Simply put, we
|
||
|
|
feel that if we can buy small pieces of businesses with
|
||
|
|
satisfactory underlying economics at a fraction of the per-share
|
||
|
|
value of the entire business, something good is likely to happen
|
||
|
|
to us - particularly if we own a group of such securities.
|
||
|
|
|
||
|
|
We extend this business-valuation approach even to bond
|
||
|
|
purchases such as WPPSS. We compare the $139 million cost of our
|
||
|
|
yearend investment in WPPSS to a similar $139 million investment
|
||
|
|
in an operating business. In the case of WPPSS, the business
|
||
|
|
contractually earns $22.7 million after tax (via the interest
|
||
|
|
paid on the bonds), and those earnings are available to us
|
||
|
|
currently in cash. We are unable to buy operating businesses
|
||
|
|
with economics close to these. Only a relatively few businesses
|
||
|
|
earn the 16.3% after tax on unleveraged capital that our WPPSS
|
||
|
|
investment does and those businesses, when available for
|
||
|
|
purchase, sell at large premiums to that capital. In the average
|
||
|
|
negotiated business transaction, unleveraged corporate earnings
|
||
|
|
of $22.7 million after-tax (equivalent to about $45 million pre-
|
||
|
|
tax) might command a price of $250 - $300 million (or sometimes
|
||
|
|
far more). For a business we understand well and strongly like,
|
||
|
|
we will gladly pay that much. But it is double the price we paid
|
||
|
|
to realize the same earnings from WPPSS bonds.
|
||
|
|
|
||
|
|
However, in the case of WPPSS, there is what we view to be a
|
||
|
|
very slight risk that the business could be worth nothing
|
||
|
|
within a year or two. There also is the risk that interest
|
||
|
|
payments might be interrupted for a considerable period of time.
|
||
|
|
Furthermore, the most that the business could be worth is about
|
||
|
|
the $205 million face value of the bonds that we own, an amount
|
||
|
|
only 48% higher than the price we paid.
|
||
|
|
|
||
|
|
This ceiling on upside potential is an important minus. It
|
||
|
|
should be realized, however, that the great majority of operating
|
||
|
|
businesses have a limited upside potential also unless more
|
||
|
|
capital is continuously invested in them. That is so because
|
||
|
|
most businesses are unable to significantly improve their average
|
||
|
|
returns on equity - even under inflationary conditions, though
|
||
|
|
these were once thought to automatically raise returns.
|
||
|
|
|
||
|
|
(Lets push our bond-as-a-business example one notch
|
||
|
|
further: if you elect to retain the annual earnings of a 12%
|
||
|
|
bond by using the proceeds from coupons to buy more bonds,
|
||
|
|
earnings of that bond business will grow at a rate comparable
|
||
|
|
to that of most operating businesses that similarly reinvest all
|
||
|
|
earnings. In the first instance, a 30-year, zero-coupon, 12%
|
||
|
|
bond purchased today for $10 million will be worth $300 million
|
||
|
|
in 2015. In the second, a $10 million business that regularly
|
||
|
|
earns 12% on equity and retains all earnings to grow, will also
|
||
|
|
end up with $300 million of capital in 2015. Both the business
|
||
|
|
and the bond will earn over $32 million in the final year.)
|
||
|
|
|
||
|
|
Our approach to bond investment - treating it as an unusual
|
||
|
|
sort of business with special advantages and disadvantages -
|
||
|
|
may strike you as a bit quirky. However, we believe that many
|
||
|
|
staggering errors by investors could have been avoided if they
|
||
|
|
had viewed bond investment with a businessmans perspective. For
|
||
|
|
example, in 1946, 20-year AAA tax-exempt bonds traded at slightly
|
||
|
|
below a 1% yield. In effect, the buyer of those bonds at that
|
||
|
|
time bought a business that earned about 1% on book value
|
||
|
|
(and that, moreover, could never earn a dime more than 1% on
|
||
|
|
book), and paid 100 cents on the dollar for that abominable
|
||
|
|
business.
|
||
|
|
|
||
|
|
If an investor had been business-minded enough to think in
|
||
|
|
those terms - and that was the precise reality of the bargain
|
||
|
|
struck - he would have laughed at the proposition and walked
|
||
|
|
away. For, at the same time, businesses with excellent future
|
||
|
|
prospects could have been bought at, or close to, book value
|
||
|
|
while earning 10%, 12%, or 15% after tax on book. Probably no
|
||
|
|
business in America changed hands in 1946 at book value that the
|
||
|
|
buyer believed lacked the ability to earn more than 1% on book.
|
||
|
|
But investors with bond-buying habits eagerly made economic
|
||
|
|
commitments throughout the year on just that basis. Similar,
|
||
|
|
although less extreme, conditions prevailed for the next two
|
||
|
|
decades as bond investors happily signed up for twenty or thirty
|
||
|
|
years on terms outrageously inadequate by business standards.
|
||
|
|
(In what I think is by far the best book on investing ever
|
||
|
|
written - The Intelligent Investor, by Ben Graham - the last
|
||
|
|
section of the last chapter begins with, Investment is most
|
||
|
|
intelligent when it is most businesslike. This section is called
|
||
|
|
A Final Word, and it is appropriately titled.)
|
||
|
|
|
||
|
|
We will emphasize again that there is unquestionably some
|
||
|
|
risk in the WPPSS commitment. It is also the sort of risk that
|
||
|
|
is difficult to evaluate. Were Charlie and I to deal with 50
|
||
|
|
similar evaluations over a lifetime, we would expect our judgment
|
||
|
|
to prove reasonably satisfactory. But we do not get the chance
|
||
|
|
to make 50 or even 5 such decisions in a single year. Even
|
||
|
|
though our long-term results may turn out fine, in any given year
|
||
|
|
we run a risk that we will look extraordinarily foolish. (Thats
|
||
|
|
why all of these sentences say Charlie and I, or we.)
|
||
|
|
|
||
|
|
Most managers have very little incentive to make the
|
||
|
|
intelligent-but-with-some-chance-of-looking-like-an-idiot
|
||
|
|
decision. Their personal gain/loss ratio is all too obvious: if
|
||
|
|
an unconventional decision works out well, they get a pat on the
|
||
|
|
back and, if it works out poorly, they get a pink slip. (Failing
|
||
|
|
conventionally is the route to go; as a group, lemmings may have
|
||
|
|
a rotten image, but no individual lemming has ever received bad
|
||
|
|
press.)
|
||
|
|
|
||
|
|
Our equation is different. With 47% of Berkshires stock,
|
||
|
|
Charlie and I dont worry about being fired, and we receive our
|
||
|
|
rewards as owners, not managers. Thus we behave with Berkshires
|
||
|
|
money as we would with our own. That frequently leads us to
|
||
|
|
unconventional behavior both in investments and general business
|
||
|
|
management.
|
||
|
|
|
||
|
|
We remain unconventional in the degree to which we
|
||
|
|
concentrate the investments of our insurance companies, including
|
||
|
|
those in WPPSS bonds. This concentration makes sense only
|
||
|
|
because our insurance business is conducted from a position of
|
||
|
|
exceptional financial strength. For almost all other insurers, a
|
||
|
|
comparable degree of concentration (or anything close to it)
|
||
|
|
would be totally inappropriate. Their capital positions are not
|
||
|
|
strong enough to withstand a big error, no matter how attractive
|
||
|
|
an investment opportunity might appear when analyzed on the basis
|
||
|
|
of probabilities.
|
||
|
|
|
||
|
|
With our financial strength we can own large blocks of a few
|
||
|
|
securities that we have thought hard about and bought at
|
||
|
|
attractive prices. (Billy Rose described the problem of over-
|
||
|
|
diversification: If you have a harem of forty women, you never
|
||
|
|
get to know any of them very well.) Over time our policy of
|
||
|
|
concentration should produce superior results, though these will
|
||
|
|
be tempered by our large size. When this policy produces a
|
||
|
|
really bad year, as it must, at least you will know that our
|
||
|
|
money was committed on the same basis as yours.
|
||
|
|
|
||
|
|
We made the major part of our WPPSS investment at different
|
||
|
|
prices and under somewhat different factual circumstances than
|
||
|
|
exist at present. If we decide to change our position, we will
|
||
|
|
not inform shareholders until long after the change has been
|
||
|
|
completed. (We may be buying or selling as you read this.) The
|
||
|
|
buying and selling of securities is a competitive business, and
|
||
|
|
even a modest amount of added competition on either side can cost
|
||
|
|
us a great deal of money. Our WPPSS purchases illustrate this
|
||
|
|
principle. From October, 1983 through June, 1984, we attempted
|
||
|
|
to buy almost all the bonds that we could of Projects 1, 2, and
|
||
|
|
3. Yet we purchased less than 3% of the bonds outstanding. Had
|
||
|
|
we faced even a few additional well-heeled investors, stimulated
|
||
|
|
to buy because they knew we were, we could have ended up with a
|
||
|
|
materially smaller amount of bonds, purchased at a materially
|
||
|
|
higher price. (A couple of coat-tail riders easily could have
|
||
|
|
cost us $5 million.) For this reason, we will not comment about
|
||
|
|
our activities in securities - neither to the press, nor
|
||
|
|
shareholders, nor to anyone else - unless legally required to do
|
||
|
|
so.
|
||
|
|
|
||
|
|
One final observation regarding our WPPSS purchases: we
|
||
|
|
dislike the purchase of most long-term bonds under most
|
||
|
|
circumstances and have bought very few in recent years. Thats
|
||
|
|
because bonds are as sound as a dollar - and we view the long-
|
||
|
|
term outlook for dollars as dismal. We believe substantial
|
||
|
|
inflation lies ahead, although we have no idea what the average
|
||
|
|
rate will turn out to be. Furthermore, we think there is a
|
||
|
|
small, but not insignificant, chance of runaway inflation.
|
||
|
|
|
||
|
|
Such a possibility may seem absurd, considering the rate to
|
||
|
|
which inflation has dropped. But we believe that present fiscal
|
||
|
|
policy - featuring a huge deficit - is both extremely dangerous
|
||
|
|
and difficult to reverse. (So far, most politicians in both
|
||
|
|
parties have followed Charlie Browns advice: No problem is so
|
||
|
|
big that it cant be run away from.) Without a reversal, high
|
||
|
|
rates of inflation may be delayed (perhaps for a long time), but
|
||
|
|
will not be avoided. If high rates materialize, they bring with
|
||
|
|
them the potential for a runaway upward spiral.
|
||
|
|
|
||
|
|
While there is not much to choose between bonds and stocks
|
||
|
|
(as a class) when annual inflation is in the 5%-10% range,
|
||
|
|
runaway inflation is a different story. In that circumstance, a
|
||
|
|
diversified stock portfolio would almost surely suffer an
|
||
|
|
enormous loss in real value. But bonds already outstanding would
|
||
|
|
suffer far more. Thus, we think an all-bond portfolio carries a
|
||
|
|
small but unacceptable wipe out risk, and we require any
|
||
|
|
purchase of long-term bonds to clear a special hurdle. Only when
|
||
|
|
bond purchases appear decidedly superior to other business
|
||
|
|
opportunities will we engage in them. Those occasions are likely
|
||
|
|
to be few and far between.
|
||
|
|
|
||
|
|
Dividend Policy
|
||
|
|
|
||
|
|
Dividend policy is often reported to shareholders, but
|
||
|
|
seldom explained. A company will say something like, Our goal
|
||
|
|
is to pay out 40% to 50% of earnings and to increase dividends at
|
||
|
|
a rate at least equal to the rise in the CPI. And thats it -
|
||
|
|
no analysis will be supplied as to why that particular policy is
|
||
|
|
best for the owners of the business. Yet, allocation of capital
|
||
|
|
is crucial to business and investment management. Because it is,
|
||
|
|
we believe managers and owners should think hard about the
|
||
|
|
circumstances under which earnings should be retained and under
|
||
|
|
which they should be distributed.
|
||
|
|
|
||
|
|
The first point to understand is that all earnings are not
|
||
|
|
created equal. In many businesses particularly those that have
|
||
|
|
high asset/profit ratios - inflation causes some or all of the
|
||
|
|
reported earnings to become ersatz. The ersatz portion - lets
|
||
|
|
call these earnings restricted - cannot, if the business is to
|
||
|
|
retain its economic position, be distributed as dividends. Were
|
||
|
|
these earnings to be paid out, the business would lose ground in
|
||
|
|
one or more of the following areas: its ability to maintain its
|
||
|
|
unit volume of sales, its long-term competitive position, its
|
||
|
|
financial strength. No matter how conservative its payout ratio,
|
||
|
|
a company that consistently distributes restricted earnings is
|
||
|
|
destined for oblivion unless equity capital is otherwise infused.
|
||
|
|
|
||
|
|
Restricted earnings are seldom valueless to owners, but they
|
||
|
|
often must be discounted heavily. In effect, they are
|
||
|
|
conscripted by the business, no matter how poor its economic
|
||
|
|
potential. (This retention-no-matter-how-unattractive-the-return
|
||
|
|
situation was communicated unwittingly in a marvelously ironic
|
||
|
|
way by Consolidated Edison a decade ago. At the time, a punitive
|
||
|
|
regulatory policy was a major factor causing the companys stock
|
||
|
|
to sell as low as one-fourth of book value; i.e., every time a
|
||
|
|
dollar of earnings was retained for reinvestment in the business,
|
||
|
|
that dollar was transformed into only 25 cents of market value.
|
||
|
|
But, despite this gold-into-lead process, most earnings were
|
||
|
|
reinvested in the business rather than paid to owners.
|
||
|
|
Meanwhile, at construction and maintenance sites throughout New
|
||
|
|
York, signs proudly proclaimed the corporate slogan, Dig We
|
||
|
|
Must.)
|
||
|
|
|
||
|
|
Restricted earnings need not concern us further in this
|
||
|
|
dividend discussion. Lets turn to the much-more-valued
|
||
|
|
unrestricted variety. These earnings may, with equal
|
||
|
|
feasibility, be retained or distributed. In our opinion,
|
||
|
|
management should choose whichever course makes greater sense for
|
||
|
|
the owners of the business.
|
||
|
|
|
||
|
|
This principle is not universally accepted. For a number of
|
||
|
|
reasons managers like to withhold unrestricted, readily
|
||
|
|
distributable earnings from shareholders - to expand the
|
||
|
|
corporate empire over which the managers rule, to operate from a
|
||
|
|
position of exceptional financial comfort, etc. But we believe
|
||
|
|
there is only one valid reason for retention. Unrestricted
|
||
|
|
earnings should be retained only when there is a reasonable
|
||
|
|
prospect - backed preferably by historical evidence or, when
|
||
|
|
appropriate, by a thoughtful analysis of the future - that for
|
||
|
|
every dollar retained by the corporation, at least one dollar of
|
||
|
|
market value will be created for owners. This will happen only
|
||
|
|
if the capital retained produces incremental earnings equal to,
|
||
|
|
or above, those generally available to investors.
|
||
|
|
|
||
|
|
To illustrate, lets assume that an investor owns a risk-
|
||
|
|
free 10% perpetual bond with one very unusual feature. Each year
|
||
|
|
the investor can elect either to take his 10% coupon in cash, or
|
||
|
|
to reinvest the coupon in more 10% bonds with identical terms;
|
||
|
|
i.e., a perpetual life and coupons offering the same cash-or-
|
||
|
|
reinvest option. If, in any given year, the prevailing interest
|
||
|
|
rate on long-term, risk-free bonds is 5%, it would be foolish for
|
||
|
|
the investor to take his coupon in cash since the 10% bonds he
|
||
|
|
could instead choose would be worth considerably more than 100
|
||
|
|
cents on the dollar. Under these circumstances, the investor
|
||
|
|
wanting to get his hands on cash should take his coupon in
|
||
|
|
additional bonds and then immediately sell them. By doing that,
|
||
|
|
he would realize more cash than if he had taken his coupon
|
||
|
|
directly in cash. Assuming all bonds were held by rational
|
||
|
|
investors, no one would opt for cash in an era of 5% interest
|
||
|
|
rates, not even those bondholders needing cash for living
|
||
|
|
purposes.
|
||
|
|
|
||
|
|
If, however, interest rates were 15%, no rational investor
|
||
|
|
would want his money invested for him at 10%. Instead, the
|
||
|
|
investor would choose to take his coupon in cash, even if his
|
||
|
|
personal cash needs were nil. The opposite course - reinvestment
|
||
|
|
of the coupon - would give an investor additional bonds with
|
||
|
|
market value far less than the cash he could have elected. If he
|
||
|
|
should want 10% bonds, he can simply take the cash received
|
||
|
|
and buy them in the market, where they will be available at a
|
||
|
|
large discount.
|
||
|
|
|
||
|
|
An analysis similar to that made by our hypothetical
|
||
|
|
bondholder is appropriate for owners in thinking about whether a
|
||
|
|
companys unrestricted earnings should be retained or paid out.
|
||
|
|
Of course, the analysis is much more difficult and subject to
|
||
|
|
error because the rate earned on reinvested earnings is not a
|
||
|
|
contractual figure, as in our bond case, but rather a fluctuating
|
||
|
|
figure. Owners must guess as to what the rate will average over
|
||
|
|
the intermediate future. However, once an informed guess is
|
||
|
|
made, the rest of the analysis is simple: you should wish your
|
||
|
|
earnings to be reinvested if they can be expected to earn high
|
||
|
|
returns, and you should wish them paid to you if low returns are
|
||
|
|
the likely outcome of reinvestment.
|
||
|
|
|
||
|
|
Many corporate managers reason very much along these lines
|
||
|
|
in determining whether subsidiaries should distribute earnings to
|
||
|
|
their parent company. At that level,. the managers have no
|
||
|
|
trouble thinking like intelligent owners. But payout decisions
|
||
|
|
at the parent company level often are a different story. Here
|
||
|
|
managers frequently have trouble putting themselves in the shoes
|
||
|
|
of their shareholder-owners.
|
||
|
|
|
||
|
|
With this schizoid approach, the CEO of a multi-divisional
|
||
|
|
company will instruct Subsidiary A, whose earnings on incremental
|
||
|
|
capital may be expected to average 5%, to distribute all
|
||
|
|
available earnings in order that they may be invested in
|
||
|
|
Subsidiary B, whose earnings on incremental capital are expected
|
||
|
|
to be 15%. The CEOs business school oath will allow no lesser
|
||
|
|
behavior. But if his own long-term record with incremental
|
||
|
|
capital is 5% - and market rates are 10% - he is likely to impose
|
||
|
|
a dividend policy on shareholders of the parent company that
|
||
|
|
merely follows some historical or industry-wide payout pattern.
|
||
|
|
Furthermore, he will expect managers of subsidiaries to give him
|
||
|
|
a full account as to why it makes sense for earnings to be
|
||
|
|
retained in their operations rather than distributed to the
|
||
|
|
parent-owner. But seldom will he supply his owners with a
|
||
|
|
similar analysis pertaining to the whole company.
|
||
|
|
|
||
|
|
In judging whether managers should retain earnings,
|
||
|
|
shareholders should not simply compare total incremental earnings
|
||
|
|
in recent years to total incremental capital because that
|
||
|
|
relationship may be distorted by what is going on in a core
|
||
|
|
business. During an inflationary period, companies with a core
|
||
|
|
business characterized by extraordinary economics can use small
|
||
|
|
amounts of incremental capital in that business at very high
|
||
|
|
rates of return (as was discussed in last years section on
|
||
|
|
Goodwill). But, unless they are experiencing tremendous unit
|
||
|
|
growth, outstanding businesses by definition generate large
|
||
|
|
amounts of excess cash. If a company sinks most of this money in
|
||
|
|
other businesses that earn low returns, the companys overall
|
||
|
|
return on retained capital may nevertheless appear excellent
|
||
|
|
because of the extraordinary returns being earned by the portion
|
||
|
|
of earnings incrementally invested in the core business. The
|
||
|
|
situation is analogous to a Pro-Am golf event: even if all of the
|
||
|
|
amateurs are hopeless duffers, the teams best-ball score will be
|
||
|
|
respectable because of the dominating skills of the professional.
|
||
|
|
|
||
|
|
Many corporations that consistently show good returns both
|
||
|
|
on equity and on overall incremental capital have, indeed,
|
||
|
|
employed a large portion of their retained earnings on an
|
||
|
|
economically unattractive, even disastrous, basis. Their
|
||
|
|
marvelous core businesses, however, whose earnings grow year
|
||
|
|
after year, camouflage repeated failures in capital allocation
|
||
|
|
elsewhere (usually involving high-priced acquisitions of
|
||
|
|
businesses that have inherently mediocre economics). The
|
||
|
|
managers at fault periodically report on the lessons they have
|
||
|
|
learned from the latest disappointment. They then usually seek
|
||
|
|
out future lessons. (Failure seems to go to their heads.)
|
||
|
|
|
||
|
|
In such cases, shareholders would be far better off if
|
||
|
|
earnings were retained only to expand the high-return business,
|
||
|
|
with the balance paid in dividends or used to repurchase stock
|
||
|
|
(an action that increases the owners interest in the exceptional
|
||
|
|
business while sparing them participation in subpar businesses).
|
||
|
|
Managers of high-return businesses who consistently employ much
|
||
|
|
of the cash thrown off by those businesses in other ventures with
|
||
|
|
low returns should be held to account for those allocation
|
||
|
|
decisions, regardless of how profitable the overall enterprise
|
||
|
|
is.
|
||
|
|
|
||
|
|
Nothing in this discussion is intended to argue for
|
||
|
|
dividends that bounce around from quarter to quarter with each
|
||
|
|
wiggle in earnings or in investment opportunities. Shareholders
|
||
|
|
of public corporations understandably prefer that dividends be
|
||
|
|
consistent and predictable. Payments, therefore, should reflect
|
||
|
|
long-term expectations for both earnings and returns on
|
||
|
|
incremental capital. Since the long-term corporate outlook
|
||
|
|
changes only infrequently, dividend patterns should change no
|
||
|
|
more often. But over time distributable earnings that have been
|
||
|
|
withheld by managers should earn their keep. If earnings have
|
||
|
|
been unwisely retained, it is likely that managers, too, have
|
||
|
|
been unwisely retained.
|
||
|
|
|
||
|
|
Lets now turn to Berkshire Hathaway and examine how these
|
||
|
|
dividend principles apply to it. Historically, Berkshire has
|
||
|
|
earned well over market rates on retained earnings, thereby
|
||
|
|
creating over one dollar of market value for every dollar
|
||
|
|
retained. Under such circumstances, any distribution would have
|
||
|
|
been contrary to the financial interest of shareholders, large or
|
||
|
|
small.
|
||
|
|
|
||
|
|
In fact, significant distributions in the early years might
|
||
|
|
have been disastrous, as a review of our starting position will
|
||
|
|
show you. Charlie and I then controlled and managed three
|
||
|
|
companies, Berkshire Hathaway Inc., Diversified Retailing
|
||
|
|
Company, Inc., and Blue Chip Stamps (all now merged into our
|
||
|
|
present operation). Blue Chip paid only a small dividend,
|
||
|
|
Berkshire and DRC paid nothing. If, instead, the companies had
|
||
|
|
paid out their entire earnings, we almost certainly would have no
|
||
|
|
earnings at all now - and perhaps no capital as well. The three
|
||
|
|
companies each originally made their money from a single
|
||
|
|
business: (1) textiles at Berkshire; (2) department stores at
|
||
|
|
Diversified; and (3) trading stamps at Blue Chip. These
|
||
|
|
cornerstone businesses (carefully chosen, it should be noted, by
|
||
|
|
your Chairman and Vice Chairman) have, respectively, (1) survived
|
||
|
|
but earned almost nothing, (2) shriveled in size while incurring
|
||
|
|
large losses, and (3) shrunk in sales volume to about 5% its size
|
||
|
|
at the time of our entry. (Who says you cant lose em all?)
|
||
|
|
Only by committing available funds to much better businesses were
|
||
|
|
we able to overcome these origins. (Its been like overcoming a
|
||
|
|
misspent youth.) Clearly, diversification has served us well.
|
||
|
|
|
||
|
|
We expect to continue to diversify while also supporting the
|
||
|
|
growth of current operations though, as weve pointed out, our
|
||
|
|
returns from these efforts will surely be below our historical
|
||
|
|
returns. But as long as prospective returns are above the rate
|
||
|
|
required to produce a dollar of market value per dollar retained,
|
||
|
|
we will continue to retain all earnings. Should our estimate of
|
||
|
|
future returns fall below that point, we will distribute all
|
||
|
|
unrestricted earnings that we believe can not be effectively
|
||
|
|
used. In making that judgment, we will look at both our
|
||
|
|
historical record and our prospects. Because our year-to-year
|
||
|
|
results are inherently volatile, we believe a five-year rolling
|
||
|
|
average to be appropriate for judging the historical record.
|
||
|
|
|
||
|
|
Our present plan is to use our retained earnings to further
|
||
|
|
build the capital of our insurance companies. Most of our
|
||
|
|
competitors are in weakened financial condition and reluctant to
|
||
|
|
expand substantially. Yet large premium-volume gains for the
|
||
|
|
industry are imminent, amounting probably to well over $15
|
||
|
|
billion in 1985 versus less than $5 billion in 1983. These
|
||
|
|
circumstances could produce major amounts of profitable business
|
||
|
|
for us. Of course, this result is no sure thing, but prospects
|
||
|
|
for it are far better than they have been for many years.
|
||
|
|
|
||
|
|
Miscellaneous
|
||
|
|
|
||
|
|
This is the spot where each year I run my small business
|
||
|
|
wanted ad. In 1984 John Loomis, one of our particularly
|
||
|
|
knowledgeable and alert shareholders, came up with a company that
|
||
|
|
met all of our tests. We immediately pursued this idea, and only
|
||
|
|
a chance complication prevented a deal. Since our ad is pulling,
|
||
|
|
we will repeat it in precisely last years form:
|
||
|
|
|
||
|
|
We prefer:
|
||
|
|
(1) large purchases (at least $5 million of after-tax
|
||
|
|
earnings),
|
||
|
|
(2) demonstrated consistent earning power (future
|
||
|
|
projections are of little interest to us, nor are
|
||
|
|
turn-around situations),
|
||
|
|
(3) businesses earning good returns on equity while
|
||
|
|
employing little or no debt,
|
||
|
|
(4) management in place (we cant supply it),
|
||
|
|
(5) simple businesses (if theres lots of technology, we
|
||
|
|
wont understand it),
|
||
|
|
(6) an offering price (we dont want to waste our time or
|
||
|
|
that of the seller by talking, even preliminarily,
|
||
|
|
about a transaction when price is unknown).
|
||
|
|
|
||
|
|
We will not engage in unfriendly takeovers. We can promise
|
||
|
|
complete confidentiality and a very fast answer - customarily
|
||
|
|
within five minutes - as to whether were interested. We prefer
|
||
|
|
to buy for cash, but will consider issuance of stock when we
|
||
|
|
receive as much in intrinsic business value as we give. We
|
||
|
|
invite potential sellers to check us out by contacting people
|
||
|
|
with whom we have done business in the past. For the right
|
||
|
|
business - and the right people - we can provide a good home.
|
||
|
|
|
||
|
|
* * *
|
||
|
|
|
||
|
|
A record 97.2% of all eligible shares participated in
|
||
|
|
Berkshires 1984 shareholder-designated contributions program.
|
||
|
|
Total contributions made through this program were $3,179,000,
|
||
|
|
and 1,519 charities were recipients. Our proxy material for the
|
||
|
|
annual meeting will allow you to cast an advisory vote expressing
|
||
|
|
your views about this program - whether you think we should
|
||
|
|
continue it and, if so, at what per-share level. (You may be
|
||
|
|
interested to learn that we were unable to find a precedent for
|
||
|
|
an advisory vote in which management seeks the opinions of
|
||
|
|
shareholders about owner-related corporate policies. Managers
|
||
|
|
who put their trust in capitalism seem in no hurry to put their
|
||
|
|
trust in capitalists.)
|
||
|
|
|
||
|
|
We urge new shareholders to read the description of our
|
||
|
|
shareholder-designated contributions program that appears on
|
||
|
|
pages 60 and 61. If you wish to participate in future programs,
|
||
|
|
we strongly urge that you immediately make sure that your shares
|
||
|
|
are registered in the name of the actual owner, not in street
|
||
|
|
name or nominee name. Shares not so registered on September 30,
|
||
|
|
1985 will be ineligible for the 1985 program.
|
||
|
|
|
||
|
|
* * *
|
||
|
|
|
||
|
|
Our annual meeting will be on May 21, 1985 in Omaha, and I
|
||
|
|
hope that you attend. Many annual meetings are a waste of time,
|
||
|
|
both for shareholders and for management. Sometimes that is true
|
||
|
|
because management is reluctant to open up on matters of business
|
||
|
|
substance. More often a nonproductive session is the fault of
|
||
|
|
shareholder participants who are more concerned about their own
|
||
|
|
moment on stage than they are about the affairs of the
|
||
|
|
corporation. What should be a forum for business discussion
|
||
|
|
becomes a forum for theatrics, spleen-venting and advocacy of
|
||
|
|
issues. (The deal is irresistible: for the price of one share you
|
||
|
|
get to tell a captive audience your ideas as to how the world
|
||
|
|
should be run.) Under such circumstances, the quality of the
|
||
|
|
meeting often deteriorates from year to year as the antics of
|
||
|
|
those interested in themselves discourage attendance by those
|
||
|
|
interested in the business.
|
||
|
|
|
||
|
|
Berkshires meetings are a different story. The number of
|
||
|
|
shareholders attending grows a bit each year and we have yet to
|
||
|
|
experience a silly question or an ego-inspired commentary.
|
||
|
|
Instead, we get a wide variety of thoughtful questions about the
|
||
|
|
business. Because the annual meeting is the time and place for
|
||
|
|
these, Charlie and I are happy to answer them all, no matter how
|
||
|
|
long it takes. (We cannot, however, respond to written or phoned
|
||
|
|
questions at other times of the year; one-person-at-a time
|
||
|
|
reporting is a poor use of management time in a company with 3000
|
||
|
|
shareholders.) The only business matters that are off limits at
|
||
|
|
the annual meeting are those about which candor might cost our
|
||
|
|
company real money. Our activities in securities would be the
|
||
|
|
main example.
|
||
|
|
|
||
|
|
We always have bragged a bit on these pages about the
|
||
|
|
quality of our shareholder-partners. Come to the annual meeting
|
||
|
|
and you will see why. Out-of-towners should schedule a stop at
|
||
|
|
Nebraska Furniture Mart. If you make some purchases, youll save
|
||
|
|
far more than enough to pay for your trip, and youll enjoy the
|
||
|
|
experience.
|
||
|
|
|
||
|
|
Warren E. Buffett
|
||
|
|
February 25, 1985 Chairman of the Board
|
||
|
|
|
||
|
|
Subsequent Event: On March 18, a week after copy for this
|
||
|
|
report went to the typographer but shortly before production, we
|
||
|
|
agreed to purchase three million shares of Capital Cities
|
||
|
|
Communications, Inc. at $172.50 per share. Our purchase is
|
||
|
|
contingent upon the acquisition of American Broadcasting
|
||
|
|
Companies, Inc. by Capital Cities, and will close when that
|
||
|
|
transaction closes. At the earliest, that will be very late in
|
||
|
|
1985. Our admiration for the management of Capital Cities, led
|
||
|
|
by Tom Murphy and Dan Burke, has been expressed several times in
|
||
|
|
previous annual reports. Quite simply, they are tops in both
|
||
|
|
ability and integrity. We will have more to say about this
|
||
|
|
investment in next years report.
|