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<HTML>
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<HEAD>
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<TITLE>Chairman's Letter - 1988</TITLE>
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</HEAD>
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<BODY>
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<P ALIGN=CENTER>
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<B>BERKSHIRE HATHAWAY INC.</B>
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</P>
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<PRE>
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<B>To the Shareholders of Berkshire Hathaway Inc.:</B>
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Our gain in net worth during 1988 was $569 million, or
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20.0%. Over the last 24 years (that is, since present management
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took over), our per-share book value has grown from $19.46 to
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$2,974.52, or at a rate of 23.0% compounded annually.
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We<57>ve emphasized in past reports that what counts, however,
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is intrinsic business value - the figure, necessarily an
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estimate, indicating what all of our constituent businesses are
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worth. By our calculations, Berkshire<72>s intrinsic business value
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significantly exceeds its book value. Over the 24 years,
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business value has grown somewhat faster than book value; in
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1988, however, book value grew the faster, by a bit.
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Berkshire<72>s past rates of gain in both book value and
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business value were achieved under circumstances far different
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from those that now exist. Anyone ignoring these differences
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makes the same mistake that a baseball manager would were he to
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judge the future prospects of a 42-year-old center fielder on the
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basis of his lifetime batting average.
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Important negatives affecting our prospects today are: (1) a
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less attractive stock market than generally existed over the past
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24 years; (2) higher corporate tax rates on most forms of
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investment income; (3) a far more richly-priced market for the
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acquisition of businesses; and (4) industry conditions for
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Capital Cities/ABC, Inc., GEICO Corporation, and The Washington
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Post Company - Berkshire<72>s three permanent investments,
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constituting about one-half of our net worth - that range from
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slightly to materially less favorable than those existing five to
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ten years ago. All of these companies have superb management and
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strong properties. But, at current prices, their upside
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potential looks considerably less exciting to us today than it
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did some years ago.
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The major problem we face, however, is a growing capital
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base. You<6F>ve heard that from us before, but this problem, like
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age, grows in significance each year. (And also, just as with
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age, it<69>s better to have this problem continue to grow rather
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than to have it <20>solved.<2E>)
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Four years ago I told you that we needed profits of $3.9
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billion to achieve a 15% annual return over the decade then
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ahead. Today, for the next decade, a 15% return demands profits
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of $10.3 billion. That seems like a very big number to me and to
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Charlie Munger, Berkshire<72>s Vice Chairman and my partner. (Should
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that number indeed prove too big, Charlie will find himself, in
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future reports, retrospectively identified as the senior
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partner.)
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As a partial offset to the drag that our growing capital
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base exerts upon returns, we have a very important advantage now
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that we lacked 24 years ago. Then, all our capital was tied up
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in a textile business with inescapably poor economic
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characteristics. Today part of our capital is invested in some
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really exceptional businesses.
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Last year we dubbed these operations the Sainted Seven:
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Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott
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Fetzer Manufacturing Group, See<65>s, and World Book. In 1988 the
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Saints came marching in. You can see just how extraordinary
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their returns on capital were by examining the historical-cost
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financial statements on page 45, which combine the figures of the
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Sainted Seven with those of several smaller units. With no
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benefit from financial leverage, this group earned about 67% on
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average equity capital.
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In most cases the remarkable performance of these units
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arises partially from an exceptional business franchise; in all
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cases an exceptional management is a vital factor. The
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contribution Charlie and I make is to leave these managers alone.
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In my judgment, these businesses, in aggregate, will
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continue to produce superb returns. We<57>ll need these: Without
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this help Berkshire would not have a chance of achieving our 15%
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goal. You can be sure that our operating managers will deliver;
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the question mark in our future is whether Charlie and I can
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effectively employ the funds that they generate.
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In that respect, we took a step in the right direction early
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in 1989 when we purchased an 80% interest in Borsheim<69>s, a
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jewelry business in Omaha. This purchase, described later in
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this letter, delivers exactly what we look for: an outstanding
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business run by people we like, admire, and trust. It<49>s a great
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way to start the year.
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<B>Accounting Changes</B>
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We have made a significant accounting change that was
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mandated for 1988, and likely will have another to make in 1990.
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When we move figures around from year to year, without any change
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in economic reality, one of our always-thrilling discussions of
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accounting is necessary.
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First, I<>ll offer my customary disclaimer: Despite the
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shortcomings of generally accepted accounting principles (GAAP),
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I would hate to have the job of devising a better set of rules.
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The limitations of the existing set, however, need not be
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inhibiting: CEOs are free to treat GAAP statements as a beginning
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rather than an end to their obligation to inform owners and
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creditors - and indeed they should. After all, any manager of a
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subsidiary company would find himself in hot water if he reported
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barebones GAAP numbers that omitted key information needed by his
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boss, the parent corporation<6F>s CEO. Why, then, should the CEO
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himself withhold information vitally useful to <I>his</I> bosses - the
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shareholder-owners of the corporation?
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What needs to be reported is data - whether GAAP, non-GAAP,
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or extra-GAAP - that helps financially-literate readers answer
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three key questions: (1) Approximately how much is this company
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worth? (2) What is the likelihood that it can meet its future
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obligations? and (3) How good a job are its managers doing, given
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the hand they have been dealt?
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In most cases, answers to one or more of these questions are
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somewhere between difficult and impossible to glean from the
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minimum GAAP presentation. The business world is simply too
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complex for a single set of rules to effectively describe
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economic reality for all enterprises, particularly those
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operating in a wide variety of businesses, such as Berkshire.
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Further complicating the problem is the fact that many
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managements view GAAP not as a standard to be met, but as an
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obstacle to overcome. Too often their accountants willingly
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assist them. (<28>How much,<2C> says the client, <20>is two plus two?<3F>
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Replies the cooperative accountant, <20>What number did you have in
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mind?<3F>) Even honest and well-intentioned managements sometimes
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stretch GAAP a bit in order to present figures they think will
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more appropriately describe their performance. Both the
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smoothing of earnings and the <20>big bath<74> quarter are <20>white lie<69>
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techniques employed by otherwise upright managements.
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Then there are managers who actively use GAAP to deceive and
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defraud. They know that many investors and creditors accept GAAP
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results as gospel. So these charlatans interpret the rules
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<EFBFBD>imaginatively<EFBFBD> and record business transactions in ways that
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technically comply with GAAP but actually display an economic
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illusion to the world.
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As long as investors - including supposedly sophisticated
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institutions - place fancy valuations on reported <20>earnings<67> that
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march steadily upward, you can be sure that some managers and
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promoters will exploit GAAP to produce such numbers, no matter
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what the truth may be. Over the years, Charlie and I have
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observed many accounting-based frauds of staggering size. Few of
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the perpetrators have been punished; many have not even been
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censured. It has been far safer to steal large sums with a pen
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than small sums with a gun.
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Under one major change mandated by GAAP for 1988, we have
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been required to fully consolidate all our subsidiaries in our
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balance sheet and earnings statement. In the past, Mutual
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Savings and Loan, and Scott Fetzer Financial (a credit company
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that primarily finances installment sales of World Book and Kirby
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products) were consolidated on a <20>one-line<6E> basis. That meant we
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(1) showed our equity in their combined net worths as a single-
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entry asset on Berkshire<72>s consolidated balance sheet and (2)
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included our equity in their combined annual earnings as a
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single-line income entry in our consolidated statement of
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earnings. Now the rules require that we consolidate each asset
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and liability of these companies in our balance sheet and each
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item of their income and expense in our earnings statement.
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This change underscores the need for companies also to
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report segmented data: The greater the number of economically
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diverse business operations lumped together in conventional
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financial statements, the less useful those presentations are and
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the less able investors are to answer the three questions posed
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earlier. Indeed, the only reason we ever prepare consolidated
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figures at Berkshire is to meet outside requirements. On the
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other hand, Charlie and I constantly study our segment data.
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Now that we are required to bundle more numbers in our GAAP
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statements, we have decided to publish additional supplementary
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information that we think will help you measure both business
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value and managerial performance. (Berkshire<72>s ability to
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discharge its obligations to creditors - the third question we
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listed - should be obvious, whatever statements you examine.) In
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these supplementary presentations, we will not necessarily follow
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GAAP procedures, or even corporate structure. Rather, we will
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attempt to lump major business activities in ways that aid
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analysis but do not swamp you with detail. Our goal is to give
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you important information in a form that we would wish to get it
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if our roles were reversed.
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On pages 41-47 we show separate combined balance sheets and
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earnings statements for: (1) our subsidiaries engaged in finance-
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type operations, which are Mutual Savings and Scott Fetzer
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Financial; (2) our insurance operations, with their major
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investment positions itemized; (3) our manufacturing, publishing
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and retailing businesses, leaving aside certain non-operating
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assets and purchase-price accounting adjustments; and (4) an all-
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other category that includes the non-operating assets (primarily
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marketable securities) held by the companies in (3) as well as
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various assets and debts of the Wesco and Berkshire parent
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companies.
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If you combine the earnings and the net worths of these four
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segments, you will derive totals matching those shown on our GAAP
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statements. However, we want to emphasize that our new
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presentation does not fall within the purview of our auditors,
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who in no way bless it. (In fact, they may be horrified; I don<6F>t
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want to ask.)
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I referred earlier to a major change in GAAP that is
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expected in 1990. This change relates to the calculation of
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deferred taxes, and is both complicated and controversial - so
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much so that its imposition, originally scheduled for 1989, was
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postponed for a year.
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When implemented, the new rule will affect us in various
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ways. Most important, we will be required to change the way we
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calculate our liability for deferred taxes on the unrealized
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appreciation of stocks held by our insurance companies.
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Right now, our liability is layered. For the unrealized
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appreciation that dates back to 1986 and earlier years, $1.2
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billion, we have booked a 28% tax liability. For the unrealized
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appreciation built up since, $600 million, the tax liability has
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been booked at 34%. The difference reflects the increase in tax
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rates that went into effect in 1987.
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It now appears, however, that the new accounting rule will
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require us to establish the entire liability at 34% in 1990,
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taking the charge against our earnings. Assuming no change in
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tax rates by 1990, this step will reduce our earnings in that
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year (and thereby our reported net worth) by $71 million. The
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proposed rule will also affect other items on our balance sheet,
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but these changes will have only a minor impact on earnings and
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net worth.
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We have no strong views about the desirability of this
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change in calculation of deferred taxes. We should point out,
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however, that neither a 28% nor a 34% tax liability precisely
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depicts economic reality at Berkshire since we have no plans to
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sell the stocks in which we have the great bulk of our gains.
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To those of you who are uninterested in accounting, I
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apologize for this dissertation. I realize that many of you do
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not pore over our figures, but instead hold Berkshire primarily
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because you know that: (1) Charlie and I have the bulk of our
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money in Berkshire; (2) we intend to run things so that your
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gains or losses are in direct proportion to ours; and (3) the
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record has so far been satisfactory. There is nothing
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necessarily wrong with this kind of <20>faith<74> approach to
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investing. Other shareholders, however, prefer an <20>analysis<69>
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approach and we want to supply the information they need. In our
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own investing, we search for situations in which both approaches
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give us the same answer.
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<B>Sources of Reported Earnings</B>
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In addition to supplying you with our new four-sector
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accounting material, we will continue to list the major sources
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of Berkshire<72>s reported earnings just as we have in the past.
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In the following table, amortization of Goodwill and other
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major purchase-price accounting adjustments are not charged
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against the specific businesses to which they apply but are
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instead aggregated and shown separately. This procedure lets you
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view the earnings of our businesses as they would have been
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reported had we not purchased them. I<>ve explained in past
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reports why this form of presentation seems to us to be more
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useful to investors and managers than the standard GAAP
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presentation, which makes purchase-price adjustments on a
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business-by-business basis. The total net earnings we show in
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the table are, of course, identical to the GAAP total in our
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audited financial statements.
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Further information about these businesses is given in the
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Business Segment section on pages 32-34, and in the Management<6E>s
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Discussion section on pages 36-40. In these sections you also
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will find our segment earnings reported on a GAAP basis. For
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information on Wesco<63>s businesses, I urge you to read Charlie
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Munger<EFBFBD>s letter, which starts on page 52. It contains the best
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description I have seen of the events that produced the present
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savings-and-loan crisis. Also, take special note of Dave
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Hillstrom<EFBFBD>s performance at Precision Steel Warehouse, a Wesco
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subsidiary. Precision operates in an extremely competitive
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industry, yet Dave consistently achieves good returns on invested
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capital. Though data is lacking to prove the point, I think it
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is likely that his performance, both in 1988 and years past,
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would rank him number one among his peers.
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<I>
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(000s omitted)
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------------------------------------------
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Berkshire's Share
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of Net Earnings
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(after taxes and
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Pre-Tax Earnings minority interests)
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------------------- -------------------
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1988 1987 1988 1987 </I>
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-------- -------- -------- --------
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Operating Earnings:
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Insurance Group:
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Underwriting ............... $(11,081) $(55,429) $ (1,045) $(20,696)
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Net Investment Income ...... 231,250 152,483 197,779 136,658
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Buffalo News ................. 42,429 39,410 25,462 21,304
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Fechheimer ................... 14,152 13,332 7,720 6,580
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Kirby ........................ 26,891 22,408 17,842 12,891
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Nebraska Furniture Mart ...... 18,439 16,837 9,099 7,554
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Scott Fetzer
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Manufacturing Group ....... 28,542 30,591 17,640 17,555
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See<65>s Candies ................ 32,473 31,693 19,671 17,363
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Wesco - other than Insurance 16,133 6,209 10,650 4,978
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World Book ................... 27,890 25,745 18,021 15,136
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Amortization of Goodwill ..... (2,806) (2,862) (2,806) (2,862)
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Other Purchase-Price
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Accounting Charges ........ (6,342) (5,546) (7,340) (6,544)
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Interest on Debt* ............ (35,613) (11,474) (23,212) (5,905)
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Shareholder-Designated
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Contributions ............. (4,966) (4,938) (3,217) (2,963)
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Other ........................ 41,059 23,217 27,177 13,697
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-------- -------- -------- --------
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Operating Earnings ............. 418,450 281,676 313,441 214,746
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Sales of Securities ............ 131,671 28,838 85,829 19,806
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-------- -------- -------- --------
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Total Earnings - All Entities .. $550,121 $310,514 $399,270 $234,552
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<I>*Excludes interest expense of Scott Fetzer Financial Group.</I>
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The earnings achieved by our operating businesses are
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superb, whether measured on an absolute basis or against those of
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their competitors. For that we thank our operating managers: You
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and I are fortunate to be associated with them.
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At Berkshire, associations like these last a long time. We
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do not remove superstars from our lineup merely because they have
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attained a specified age - whether the traditional 65, or the 95
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reached by Mrs. B on the eve of Hanukkah in 1988. Superb
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managers are too scarce a resource to be discarded simply because
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a cake gets crowded with candles. Moreover, our experience with
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newly-minted MBAs has not been that great. Their academic
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records always look terrific and the candidates always know just
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what to say; but too often they are short on personal commitment
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to the company and general business savvy. It<49>s difficult to
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teach a new dog old tricks.
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Here<72>s an update on our major non-insurance operations:
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<B>o</B> At Nebraska Furniture Mart, Mrs. B (Rose Blumkin) and her
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cart roll on and on. She<68>s been the boss for 51 years, having
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started the business at 44 with $500. (Think what she would have
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done with $1,000!) With Mrs. B, old age will always be ten years
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away.
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The Mart, long the largest home furnishings store in the
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country, continues to grow. In the fall, the store opened a
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detached 20,000 square foot Clearance Center, which expands our
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ability to offer bargains in all price ranges.
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Recently Dillard<72>s, one of the most successful department
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store operations in the country, entered the Omaha market. In
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many of its stores, Dillard<72>s runs a full furniture department,
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undoubtedly doing well in this line. Shortly before opening in
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Omaha, however, William Dillard, chairman of the company,
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announced that his new store would not sell furniture. Said he,
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referring to NFM: <20>We don<6F>t want to compete with them. We think
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they are about the best there is.<2E>
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At the Buffalo News we extol the value of advertising, and
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our policies at NFM prove that we practice what we preach. Over
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the past three years NFM has been the largest ROP advertiser in
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the Omaha World-Herald. (ROP advertising is the kind printed in
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the paper, as contrasted to the preprinted-insert kind.) In no
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other major market, to my knowledge, is a home furnishings
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operation the leading customer of the newspaper. At times, we
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also run large ads in papers as far away as Des Moines, Sioux
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City and Kansas City - always with good results. It truly does
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pay to advertise, as long as you have something worthwhile to
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offer.
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Mrs. B<>s son, Louie, and his boys, Ron and Irv, complete the
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winning Blumkin team. It<49>s a joy to work with this family. All
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its members have character that matches their extraordinary
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abilities.
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<B>o</B> Last year I stated unequivocally that pre-tax margins at
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The Buffalo News would fall in 1988. That forecast would have
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proved correct at almost any other newspaper our size or larger.
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But Stan Lipsey - bless him - has managed to make me look
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foolish.
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Though we increased our prices a bit less than the industry
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average last year, and though our newsprint costs and wage rates
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rose in line with industry norms, Stan actually improved margins
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a tad. No one in the newspaper business has a better managerial
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record. He has achieved it, furthermore, while running a paper
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that gives readers an extraordinary amount of news. We believe
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that our <20>newshole<6C> percentage - the portion of the paper devoted
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to news - is bigger than that of any other dominant paper of our
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size or larger. The percentage was 49.5% in 1988 versus 49.8% in
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1987. We are committed to keeping it around 50%, whatever the
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level or trend of profit margins.
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Charlie and I have loved the newspaper business since we
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were youngsters, and we have had great fun with the News in the
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12 years since we purchased it. We were fortunate to find Murray
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Light, a top-flight editor, on the scene when we arrived and he
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has made us proud of the paper ever since.
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<B>o</B> See<65>s Candies sold a record 25.1 million pounds in 1988.
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Prospects did not look good at the end of October, but excellent
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Christmas volume, considerably better than the record set in
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1987, turned the tide.
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As we<77>ve told you before, See<65>s business continues to become
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more Christmas-concentrated. In 1988, the Company earned a
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record 90% of its full-year profits in December: $29 million out
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of $32.5 million before tax. (It<49>s enough to make you believe in
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Santa Claus.) December<65>s deluge of business produces a modest
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seasonal bulge in Berkshire<72>s corporate earnings. Another small
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bulge occurs in the first quarter, when most World Book annuals
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are sold.
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Charlie and I put Chuck Huggins in charge of See<65>s about
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five minutes after we bought the company. Upon reviewing his
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record, you may wonder what took us so long.
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<B>o</B> At Fechheimer, the Heldmans - Bob, George, Gary, Roger and
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Fred - are the Cincinnati counterparts of the Blumkins. Neither
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furniture retailing nor uniform manufacturing has inherently
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attractive economics. In these businesses, only exceptional
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managements can deliver high returns on invested capital. And
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that<EFBFBD>s exactly what the five Heldmans do. (As Mets announcer
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Ralph Kiner once said when comparing pitcher Steve Trout to his
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father, Dizzy Trout, the famous Detroit Tigers pitcher: <20>There<72>s
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a lot of heredity in that family.<2E>)
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Fechheimer made a fairly good-sized acquisition in 1988.
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Charlie and I have such confidence in the business savvy of the
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Heldman family that we okayed the deal without even looking at
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it. There are very few managements anywhere - including those
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running the top tier companies of the <U>Fortune 500</U> - in which we
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would exhibit similar confidence.
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Because of both this acquisition and some internal growth,
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sales at Fechheimer should be up significantly in 1989.
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<B>o</B> All of the operations managed by Ralph Schey - World Book,
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Kirby, and The Scott Fetzer Manufacturing Group - performed
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splendidly in 1988. Returns on the capital entrusted to Ralph
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continue to be exceptional.
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Within the Scott Fetzer Manufacturing Group, particularly
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fine progress was recorded at its largest unit, Campbell
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Hausfeld. This company, the country<72>s leading producer of small
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and medium-sized air compressors, has more than doubled earnings
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since 1986.
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Unit sales at both Kirby and World Book were up
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significantly in 1988, with export business particularly strong.
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World Book became available in the Soviet Union in September,
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when that country<72>s largest American book store opened in Moscow.
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Ours is the only general encyclopedia offered at the store.
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Ralph<70>s personal productivity is amazing: In addition to
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running 19 businesses in superb fashion, he is active at The
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Cleveland Clinic, Ohio University, Case Western Reserve, and a
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venture capital operation that has spawned sixteen Ohio-based
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companies and resurrected many others. Both Ohio and Berkshire
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are fortunate to have Ralph on their side.
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<B>Borsheim<69>s</B>
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It was in 1983 that Berkshire purchased an 80% interest in
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The Nebraska Furniture Mart. Your Chairman blundered then by
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neglecting to ask Mrs. B a question any schoolboy would have
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thought of: <20>Are there any more at home like you?<3F> Last month I
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corrected the error: We are now 80% partners with another branch
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of the family.
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After Mrs. B came over from Russia in 1917, her parents and
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five siblings followed. (Her two other siblings had preceded
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her.) Among the sisters was Rebecca Friedman who, with her
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husband, Louis, escaped in 1922 to the west through Latvia in a
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journey as perilous as Mrs. B<>s earlier odyssey to the east
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through Manchuria. When the family members reunited in Omaha
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they had no tangible assets. However, they came equipped with an
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extraordinary combination of brains, integrity, and enthusiasm
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for work - and that<61>s all they needed. They have since proved
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themselves invincible.
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In 1948 Mr. Friedman purchased Borsheim<69>s, a small Omaha
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jewelry store. He was joined in the business by his son, Ike, in
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1950 and, as the years went by, Ike<6B>s son, Alan, and his sons-in-
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law, Marvin Cohn and Donald Yale, came in also.
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You won<6F>t be surprised to learn that this family brings to
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the jewelry business precisely the same approach that the
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Blumkins bring to the furniture business. The cornerstone for
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both enterprises is Mrs. B<>s creed: <20>Sell cheap and tell the
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truth.<2E> Other fundamentals at both businesses are: (1) single
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store operations featuring huge inventories that provide
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customers with an enormous selection across all price ranges, (2)
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daily attention to detail by top management, (3) rapid turnover,
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(4) shrewd buying, and (5) incredibly low expenses. The
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combination of the last three factors lets both stores offer
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everyday prices that no one in the country comes close to
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matching.
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Most people, no matter how sophisticated they are in other
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matters, feel like babes in the woods when purchasing jewelry.
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They can judge neither quality nor price. For them only one rule
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makes sense: If you don<6F>t know jewelry, know the jeweler.
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I can assure you that those who put their trust in Ike
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Friedman and his family will never be disappointed. The way in
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which we purchased our interest in their business is the ultimate
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testimonial. Borsheim<69>s had no audited financial statements;
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nevertheless, we didn<64>t take inventory, verify receivables or
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audit the operation in any way. Ike simply told us what was so -
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- and on that basis we drew up a one-page contract and wrote a
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large check.
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Business at Borsheim<69>s has mushroomed in recent years as the
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reputation of the Friedman family has spread. Customers now come
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to the store from all over the country. Among them have been
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some friends of mine from both coasts who thanked me later for
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getting them there.
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Borsheim<69>s new links to Berkshire will change nothing in the
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way this business is run. All members of the Friedman family
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will continue to operate just as they have before; Charlie and I
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will stay on the sidelines where we belong. And when we say <20>all
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members,<2C> the words have real meaning. Mr. and Mrs. Friedman, at
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88 and 87, respectively, are in the store daily. The wives of
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Ike, Alan, Marvin and Donald all pitch in at busy times, and a
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fourth generation is beginning to learn the ropes.
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It is great fun to be in business with people you have long
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admired. The Friedmans, like the Blumkins, have achieved success
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because they have deserved success. Both families focus on
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what<EFBFBD>s right for the customer and that, inevitably, works out
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well for them, also. We couldn<64>t have better partners.
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<B>Insurance Operations</B>
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Shown below is an updated version of our usual table
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presenting key figures for the insurance industry:
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<I>
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Statutory
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Yearly Change Combined Ratio Yearly Change Inflation Rate
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in Premiums After Policyholder in Incurred Measured by
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Written (%) Dividends Losses (%) GNP Deflator (%)</I>
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|
------------- ------------------ ------------- ----------------
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1981 ..... 3.8 106.0 6.5 9.6
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1982 ..... 3.7 109.6 8.4 6.4
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1983 ..... 5.0 112.0 6.8 3.8
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1984 ..... 8.5 118.0 16.9 3.7
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1985 ..... 22.1 116.3 16.1 3.2
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1986 ..... 22.2 108.0 13.5 2.7
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1987 ..... 9.4 104.6 7.8 3.3
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1988 (Est.) 3.9 105.4 4.2 3.6
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Source: A.M. Best Co.
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The combined ratio represents total insurance costs (losses
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incurred plus expenses) compared to revenue from premiums: A
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ratio below 100 indicates an underwriting profit, and one above
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100 indicates a loss. When the investment income that an insurer
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earns from holding on to policyholders<72> funds (<28>the float<61>) is
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taken into account, a combined ratio in the 107-111 range
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typically produces an overall break-even result, exclusive of
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earnings on the funds provided by shareholders.
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For the reasons laid out in previous reports, we expect the
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industry<EFBFBD>s incurred losses to grow by about 10% annually, even in
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years when general inflation runs considerably lower. If premium
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growth meanwhile materially lags that 10% rate, underwriting
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losses will mount, though the industry<72>s tendency to underreserve
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when business turns bad may obscure their size for a time. As
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the table shows, the industry<72>s underwriting loss grew in 1988.
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This trend is almost certain to continue - and probably will
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accelerate - for at least two more years.
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The property-casualty insurance industry is not only
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subnormally profitable, it is subnormally popular. (As Sam
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Goldwyn philosophized: <20>In life, one must learn to take the
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bitter with the sour.<2E>) One of the ironies of business is that
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many relatively-unprofitable industries that are plagued by
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inadequate prices habitually find themselves beat upon by irate
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customers even while other, hugely profitable industries are
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spared complaints, no matter how high their prices.
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Take the breakfast cereal industry, whose return on invested
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capital is more than double that of the auto insurance industry
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(which is why companies like Kellogg and General Mills sell at
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five times book value and most large insurers sell close to
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book). The cereal companies regularly impose price increases,
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few of them related to a significant jump in their costs. Yet
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not a peep is heard from consumers. But when auto insurers raise
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prices by amounts that do not even match cost increases,
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customers are outraged. If you want to be loved, it<69>s clearly
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better to sell high-priced corn flakes than low-priced auto
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insurance.
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The antagonism that the public feels toward the industry can
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have serious consequences: Proposition 103, a California
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initiative passed last fall, threatens to push auto insurance
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prices down sharply, even though costs have been soaring. The
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price cut has been suspended while the courts review the
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initiative, but the resentment that brought on the vote has not
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been suspended: Even if the initiative is overturned, insurers
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are likely to find it tough to operate profitably in California.
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(Thank heavens the citizenry isn<73>t mad at bonbons: If Proposition
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103 applied to candy as well as insurance, See<65>s would be forced
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to sell its product for $5.76 per pound. rather than the $7.60 we
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charge - and would be losing money by the bucketful.)
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The immediate direct effects on Berkshire from the
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initiative are minor, since we saw few opportunities for profit
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in the rate structure that existed in California prior to the
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vote. However, the forcing down of prices would seriously affect
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GEICO, our 44%-owned investee, which gets about 10% of its
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premium volume from California. Even more threatening to GEICO
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is the possibility that similar pricing actions will be taken in
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other states, through either initiatives or legislation.
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If voters insist that auto insurance be priced below cost,
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it eventually must be sold by government. Stockholders can
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subsidize policyholders for a short period, but only taxpayers
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can subsidize them over the long term. At most property-casualty
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companies, socialized auto insurance would be no disaster for
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shareholders. Because of the commodity characteristics of the
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industry, most insurers earn mediocre returns and therefore have
|
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little or no economic goodwill to lose if they are forced by
|
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government to leave the auto insurance business. But GEICO,
|
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|
because it is a low-cost producer able to earn high returns on
|
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equity, has a huge amount of economic goodwill at risk. In turn,
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so do we.
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At Berkshire, in 1988, our premium volume continued to fall,
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|
and in 1989 we will experience a large decrease for a special
|
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|
|
reason: The contract through which we receive 7% of the business
|
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|
|
of Fireman<61>s Fund expires on August 31. At that time, we will
|
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|
return to Fireman<61>s Fund the unearned premiums we hold that
|
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|
relate to the contract. This transfer of funds will show up in
|
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|
|
our <20>premiums written<65> account as a negative $85 million or so
|
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|
and will make our third-quarter figures look rather peculiar.
|
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|
However, the termination of this contract will not have a
|
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|
|
significant effect on profits.
|
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|
Berkshire<72>s underwriting results continued to be excellent
|
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|
|
in 1988. Our combined ratio (on a statutory basis and excluding
|
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|
|
|
structured settlements and financial reinsurance) was 104.
|
|
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|
|
Reserve development was favorable for the second year in a row,
|
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|
|
after a string of years in which it was very unsatisfactory.
|
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|
Details on both underwriting and reserve development appear on
|
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|
|
pages 36-38.
|
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|
|
Our insurance volume over the next few years is likely to
|
|
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|
|
run very low, since business with a reasonable potential for
|
|
|
|
|
|
profit will almost certainly be scarce. So be it. At Berkshire,
|
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|
|
we simply will not write policies at rates that carry the
|
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|
|
|
expectation of economic loss. We encounter enough troubles when
|
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|
|
we expect a gain.
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|
Despite - or perhaps because of - low volume, our profit
|
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|
|
picture during the next few years is apt to be considerably
|
|
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|
|
brighter than the industry<72>s. We are sure to have an exceptional
|
|
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|
|
|
amount of float compared to premium volume, and that augurs well
|
|
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|
|
|
for profits. In 1989 and 1990 we expect our float/premiums
|
|
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|
|
|
ratio to be at least three times that of the typical
|
|
|
|
|
|
property/casualty company. Mike Goldberg, with special help from
|
|
|
|
|
|
Ajit Jain, Dinos Iordanou, and the National Indemnity managerial
|
|
|
|
|
|
team, has positioned us well in that respect.
|
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|
At some point - we don<6F>t know when - we will be deluged with
|
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|
|
|
insurance business. The cause will probably be some major
|
|
|
|
|
|
physical or financial catastrophe. But we could also experience
|
|
|
|
|
|
an explosion in business, as we did in 1985, because large and
|
|
|
|
|
|
increasing underwriting losses at other companies coincide with
|
|
|
|
|
|
their recognition that they are far underreserved. in the
|
|
|
|
|
|
meantime, we will retain our talented professionals, protect our
|
|
|
|
|
|
capital, and try not to make major mistakes.
|
|
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|
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|
|
<B>Marketable Securities</B>
|
|
|
|
|
|
|
|
|
|
|
|
In selecting marketable securities for our insurance
|
|
|
|
|
|
companies, we can choose among five major categories: (1) long-
|
|
|
|
|
|
term common stock investments, (2) medium-term fixed-income
|
|
|
|
|
|
securities, (3) long-term fixed-income securities, (4) short-term
|
|
|
|
|
|
cash equivalents, and (5) short-term arbitrage commitments.
|
|
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|
|
We have no particular bias when it comes to choosing from
|
|
|
|
|
|
these categories. We just continuously search among them for the
|
|
|
|
|
|
highest after-tax returns as measured by <20>mathematical
|
|
|
|
|
|
expectation,<2C> limiting ourselves always to investment
|
|
|
|
|
|
alternatives we think we understand. Our criteria have nothing
|
|
|
|
|
|
to do with maximizing immediately reportable earnings; our goal,
|
|
|
|
|
|
rather, is to maximize eventual net worth.
|
|
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|
|
<B>o</B> Below we list our common stock holdings having a value over
|
|
|
|
|
|
$100 million, not including arbitrage commitments, which will be
|
|
|
|
|
|
discussed later. A small portion of these investments belongs to
|
|
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|
|
|
subsidiaries of which Berkshire owns less than 100%.
|
|
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|
|
<I>
|
|
|
|
|
|
Shares Company Cost Market
|
|
|
|
|
|
------ ------- ---------- ----------
|
|
|
|
|
|
(000s omitted) </I>
|
|
|
|
|
|
3,000,000 Capital Cities/ABC, Inc. .............. $517,500 $1,086,750
|
|
|
|
|
|
14,172,500 The Coca-Cola Company ................. 592,540 632,448
|
|
|
|
|
|
2,400,000 Federal Home Loan Mortgage
|
|
|
|
|
|
Corporation Preferred* ............. 71,729 121,200
|
|
|
|
|
|
6,850,000 GEICO Corporation ..................... 45,713 849,400
|
|
|
|
|
|
1,727,765 The Washington Post Company ........... 9,731 364,126
|
|
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|
<I>*Although nominally a preferred stock, this security is
|
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|
|
financially equivalent to a common stock.</I>
|
|
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|
|
Our permanent holdings - Capital Cities/ABC, Inc., GEICO
|
|
|
|
|
|
Corporation, and The Washington Post Company - remain unchanged.
|
|
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|
|
Also unchanged is our unqualified admiration of their
|
|
|
|
|
|
managements: Tom Murphy and Dan Burke at Cap Cities, Bill Snyder
|
|
|
|
|
|
and Lou Simpson at GEICO, and Kay Graham and Dick Simmons at The
|
|
|
|
|
|
Washington Post. Charlie and I appreciate enormously the talent
|
|
|
|
|
|
and integrity these managers bring to their businesses.
|
|
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|
|
Their performance, which we have observed at close range,
|
|
|
|
|
|
contrasts vividly with that of many CEOs, which we have
|
|
|
|
|
|
fortunately observed from a safe distance. Sometimes these CEOs
|
|
|
|
|
|
clearly do not belong in their jobs; their positions,
|
|
|
|
|
|
nevertheless, are usually secure. The supreme irony of business
|
|
|
|
|
|
management is that it is far easier for an inadequate CEO to keep
|
|
|
|
|
|
his job than it is for an inadequate subordinate.
|
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|
|
If a secretary, say, is hired for a job that requires typing
|
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|
|
|
ability of at least 80 words a minute and turns out to be capable
|
|
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|
|
of only 50 words a minute, she will lose her job in no time.
|
|
|
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|
|
There is a logical standard for this job; performance is easily
|
|
|
|
|
|
measured; and if you can<61>t make the grade, you<6F>re out.
|
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|
|
Similarly, if new sales people fail to generate sufficient
|
|
|
|
|
|
business quickly enough, they will be let go. Excuses will not
|
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|
|
|
|
be accepted as a substitute for orders.
|
|
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|
|
|
|
|
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|
|
However, a CEO who doesn<73>t perform is frequently carried
|
|
|
|
|
|
indefinitely. One reason is that performance standards for his
|
|
|
|
|
|
job seldom exist. When they do, they are often fuzzy or they may
|
|
|
|
|
|
be waived or explained away, even when the performance shortfalls
|
|
|
|
|
|
are major and repeated. At too many companies, the boss shoots
|
|
|
|
|
|
the arrow of managerial performance and then hastily paints the
|
|
|
|
|
|
bullseye around the spot where it lands.
|
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|
|
Another important, but seldom recognized, distinction
|
|
|
|
|
|
between the boss and the foot soldier is that the CEO has no
|
|
|
|
|
|
immediate superior whose performance is itself getting measured.
|
|
|
|
|
|
The sales manager who retains a bunch of lemons in his sales
|
|
|
|
|
|
force will soon be in hot water himself. It is in his immediate
|
|
|
|
|
|
self-interest to promptly weed out his hiring mistakes.
|
|
|
|
|
|
Otherwise, he himself may be weeded out. An office manager who
|
|
|
|
|
|
has hired inept secretaries faces the same imperative.
|
|
|
|
|
|
|
|
|
|
|
|
But the CEO<45>s boss is a Board of Directors that seldom
|
|
|
|
|
|
measures itself and is infrequently held to account for
|
|
|
|
|
|
substandard corporate performance. If the Board makes a mistake
|
|
|
|
|
|
in hiring, and perpetuates that mistake, so what? Even if the
|
|
|
|
|
|
company is taken over because of the mistake, the deal will
|
|
|
|
|
|
probably bestow substantial benefits on the outgoing Board
|
|
|
|
|
|
members. (The bigger they are, the softer they fall.)
|
|
|
|
|
|
|
|
|
|
|
|
Finally, relations between the Board and the CEO are
|
|
|
|
|
|
expected to be congenial. At board meetings, criticism of the
|
|
|
|
|
|
CEO<EFBFBD>s performance is often viewed as the social equivalent of
|
|
|
|
|
|
belching. No such inhibitions restrain the office manager from
|
|
|
|
|
|
critically evaluating the substandard typist.
|
|
|
|
|
|
|
|
|
|
|
|
These points should not be interpreted as a blanket
|
|
|
|
|
|
condemnation of CEOs or Boards of Directors: Most are able and
|
|
|
|
|
|
hard-working, and a number are truly outstanding. But the
|
|
|
|
|
|
management failings that Charlie and I have seen make us thankful
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that we are linked with the managers of our three permanent
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holdings. They love their businesses, they think like owners,
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and they exude integrity and ability.
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<B>o</B> In 1988 we made major purchases of Federal Home Loan
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Mortgage Pfd. (<28>Freddie Mac<61>) and Coca Cola. We expect to hold
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these securities for a long time. In fact, when we own portions
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of outstanding businesses with outstanding managements, our
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favorite holding period is forever. We are just the opposite of
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those who hurry to sell and book profits when companies perform
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well but who tenaciously hang on to businesses that disappoint.
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Peter Lynch aptly likens such behavior to cutting the flowers and
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watering the weeds. Our holdings of Freddie Mac are the maximum
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allowed by law, and are extensively described by Charlie in his
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letter. In our consolidated balance sheet these shares are
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carried at cost rather than market, since they are owned by
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Mutual Savings and Loan, a non-insurance subsidiary.
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We continue to concentrate our investments in a very few
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companies that we try to understand well. There are only a
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handful of businesses about which we have strong long-term
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convictions. Therefore, when we find such a business, we want to
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participate in a meaningful way. We agree with Mae West: <20>Too
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much of a good thing can be wonderful.<2E>
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<B>o</B> We reduced our holdings of medium-term tax-exempt bonds by
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about $100 million last year. All of the bonds sold were
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acquired after August 7, 1986. When such bonds are held by
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property-casualty insurance companies, 15% of the <20>tax-exempt<70>
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interest earned is subject to tax.
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The $800 million position we still hold consists almost
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entirely of bonds <20>grandfathered<65> under the Tax Reform Act of
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1986, which means they are entirely tax-exempt. Our sales
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produced a small profit and our remaining bonds, which have an
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average maturity of about six years, are worth modestly more than
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carrying value.
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Last year we described our holdings of short-term and
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intermediate-term bonds of Texaco, which was then in bankruptcy.
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During 1988, we sold practically all of these bonds at a pre-tax
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profit of about $22 million. This sale explains close to $100
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million of the reduction in fixed-income securities on our
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balance sheet.
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We also told you last year about our holdings of another
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security whose predominant characteristics are those of an
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intermediate fixed-income issue: our $700 million position in
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Salomon Inc 9% convertible preferred. This preferred has a
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sinking fund that will retire it in equal annual installments
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from 1995 to 1999. Berkshire carries this holding at cost. For
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reasons discussed by Charlie on page 69, the estimated market
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value of our holding has improved from moderately under cost at
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the end of last year to moderately over cost at 1988 year end.
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The close association we have had with John Gutfreund, CEO
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of Salomon, during the past year has reinforced our admiration
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for him. But we continue to have no great insights about the
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near, intermediate or long-term economics of the investment
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banking business: This is not an industry in which it is easy to
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forecast future levels of profitability. We continue to believe
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that our conversion privilege could well have important value
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over the life of our preferred. However, the overwhelming
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portion of the preferred<65>s value resides in its fixed-income
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characteristics, not its equity characteristics.
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<B>o</B> We have not lost our aversion to long-term bonds. We will
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become enthused about such securities only when we become
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enthused about prospects for long-term stability in the
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purchasing power of money. And that kind of stability isn<73>t in
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the cards: Both society and elected officials simply have too
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many higher-ranking priorities that conflict with purchasing-
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power stability. The only long-term bonds we hold are those of
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Washington Public Power Supply Systems (WPPSS). A few of our
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WPPSS bonds have short maturities and many others, because of
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their high coupons, are likely to be refunded and paid off in a
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few years. Overall, our WPPSS holdings are carried on our
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balance sheet at $247 million and have a market value of about
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$352 million.
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We explained the reasons for our WPPSS purchases in the 1983
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annual report, and are pleased to tell you that this commitment
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has worked out about as expected. At the time of purchase, most
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of our bonds were yielding around 17% after taxes and carried no
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ratings, which had been suspended. Recently, the bonds were
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rated AA- by Standard & Poor<6F>s. They now sell at levels only
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slightly below those enjoyed by top-grade credits.
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In the 1983 report, we compared the economics of our WPPSS
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purchase to those involved in buying a business. As it turned
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out, this purchase actually worked out better than did the
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general run of business acquisitions made in 1983, assuming both
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are measured on the basis of unleveraged, after tax returns
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achieved through 1988.
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Our WPPSS experience, though pleasant, does nothing to alter
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our negative opinion about long-term bonds. It only makes us
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hope that we run into some other large stigmatized issue, whose
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troubles have caused it to be significantly misappraised by the
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market.
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<B>Arbitrage</B>
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In past reports we have told you that our insurance
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subsidiaries sometimes engage in arbitrage as an alternative to
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holding short-term cash equivalents. We prefer, of course, to
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make major long-term commitments, but we often have more cash
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than good ideas. At such times, arbitrage sometimes promises
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much greater returns than Treasury Bills and, equally important,
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cools any temptation we may have to relax our standards for long-
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term investments. (Charlie<69>s sign off after we<77>ve talked about
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an arbitrage commitment is usually: <20>Okay, at least it will keep
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you out of bars.<2E>)
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During 1988 we made unusually large profits from arbitrage,
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measured both by absolute dollars and rate of return. Our pre-
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tax gain was about $78 million on average invested funds of about
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$147 million.
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This level of activity makes some detailed discussion of
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arbitrage and our approach to it appropriate. Once, the word
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applied only to the simultaneous purchase and sale of securities
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or foreign exchange in two different markets. The goal was to
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exploit tiny price differentials that might exist between, say,
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Royal Dutch stock trading in guilders in Amsterdam, pounds in
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London, and dollars in New York. Some people might call this
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scalping; it won<6F>t surprise you that practitioners opted for the
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French term, arbitrage.
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Since World War I the definition of arbitrage - or <20>risk
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arbitrage,<2C> as it is now sometimes called - has expanded to
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include the pursuit of profits from an announced corporate event
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such as sale of the company, merger, recapitalization,
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reorganization, liquidation, self-tender, etc. In most cases the
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arbitrageur expects to profit regardless of the behavior of the
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stock market. The major risk he usually faces instead is that
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the announced event won<6F>t happen.
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Some offbeat opportunities occasionally arise in the
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arbitrage field. I participated in one of these when I was 24
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and working in New York for Graham-Newman Corp. Rockwood & Co.,
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a Brooklyn based chocolate products company of limited
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profitability, had adopted LIFO inventory valuation in 1941
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when cocoa was selling for 5¢ per pound. In 1954 a
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temporary shortage of cocoa caused the price to soar to over
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60¢. Consequently Rockwood wished to unload its valuable
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inventory - quickly, before the price dropped. But if the cocoa
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had simply been sold off, the company would have owed close to
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a 50% tax on the proceeds.
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The 1954 Tax Code came to the rescue. It contained an
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arcane provision that eliminated the tax otherwise due on LIFO
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profits if inventory was distributed to shareholders as part of a
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plan reducing the scope of a corporation<6F>s business. Rockwood
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decided to terminate one of its businesses, the sale of cocoa
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butter, and said 13 million pounds of its cocoa bean inventory
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was attributable to that activity. Accordingly, the company
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offered to repurchase its stock in exchange for the cocoa beans
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it no longer needed, paying 80 pounds of beans for each share.
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For several weeks I busily bought shares, sold beans, and
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made periodic stops at Schroeder Trust to exchange stock
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certificates for warehouse receipts. The profits were good and
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my only expense was subway tokens.
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The architect of Rockwood<6F>s restructuring was an unknown,
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but brilliant Chicagoan, Jay Pritzker, then 32. If you<6F>re
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familiar with Jay<61>s subsequent record, you won<6F>t be surprised to
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hear the action worked out rather well for Rockwood<6F>s continuing
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shareholders also. From shortly before the tender until shortly
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after it, Rockwood stock appreciated from 15 to 100, even though
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the company was experiencing large operating losses. Sometimes
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there is more to stock valuation than price-earnings ratios.
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In recent years, most arbitrage operations have involved
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takeovers, friendly and unfriendly. With acquisition fever
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rampant, with anti-trust challenges almost non-existent, and with
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bids often ratcheting upward, arbitrageurs have prospered
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mightily. They have not needed special talents to do well; the
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trick, a la Peter Sellers in the movie, has simply been <20>Being
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There.<2E> In Wall Street the old proverb has been reworded: <20>Give a
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man a fish and you feed him for a day. Teach him how to
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arbitrage and you feed him forever.<2E> (If, however, he studied at
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the Ivan Boesky School of Arbitrage, it may be a state
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institution that supplies his meals.)
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To evaluate arbitrage situations you must answer four
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questions: (1) How likely is it that the promised event will
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indeed occur? (2) How long will your money be tied up? (3) What
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chance is there that something still better will transpire - a
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competing takeover bid, for example? and (4) What will happen if
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the event does not take place because of anti-trust action,
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financing glitches, etc.?
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Arcata Corp., one of our more serendipitous arbitrage
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experiences, illustrates the twists and turns of the business.
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On September 28, 1981 the directors of Arcata agreed in principle
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to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR),
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then and now a major leveraged-buy out firm. Arcata was in the
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printing and forest products businesses and had one other thing
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going for it: In 1978 the U.S. Government had taken title to
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10,700 acres of Arcata timber, primarily old-growth redwood, to
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expand Redwood National Park. The government had paid $97.9
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million, in several installments, for this acreage, a sum Arcata
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was contesting as grossly inadequate. The parties also disputed
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the interest rate that should apply to the period between the
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taking of the property and final payment for it. The enabling
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legislation stipulated 6% simple interest; Arcata argued for a
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much higher and compounded rate.
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Buying a company with a highly-speculative, large-sized
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claim in litigation creates a negotiating problem, whether the
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claim is on behalf of or against the company. To solve this
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problem, KKR offered $37.00 per Arcata share plus two-thirds of
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any additional amounts paid by the government for the redwood
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lands.
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Appraising this arbitrage opportunity, we had to ask
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ourselves whether KKR would consummate the transaction since,
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among other things, its offer was contingent upon its obtaining
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<EFBFBD>satisfactory financing.<2E> A clause of this kind is always
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dangerous for the seller: It offers an easy exit for a suitor
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whose ardor fades between proposal and marriage. However, we
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were not particularly worried about this possibility because
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KKR<EFBFBD>s past record for closing had been good.
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We also had to ask ourselves what would happen if the KKR
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deal did fall through, and here we also felt reasonably
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comfortable: Arcata<74>s management and directors had been shopping
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the company for some time and were clearly determined to sell.
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If KKR went away, Arcata would likely find another buyer, though
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of course, the price might be lower.
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Finally, we had to ask ourselves what the redwood claim
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might be worth. Your Chairman, who can<61>t tell an elm from an
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oak, had no trouble with that one: He coolly evaluated the claim
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at somewhere between zero and a whole lot.
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We started buying Arcata stock, then around $33.50, on
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September 30 and in eight weeks purchased about 400,000 shares,
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or 5% of the company. The initial announcement said that the
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$37.00 would be paid in January, 1982. Therefore, if everything
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had gone perfectly, we would have achieved an annual rate of
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return of about 40% - not counting the redwood claim, which would
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have been frosting.
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All did not go perfectly. In December it was announced that
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the closing would be delayed a bit. Nevertheless, a definitive
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agreement was signed on January 4. Encouraged, we raised our
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stake, buying at around $38.00 per share and increasing our
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holdings to 655,000 shares, or over 7% of the company. Our
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willingness to pay up - even though the closing had been
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postponed - reflected our leaning toward <20>a whole lot<6F> rather
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than <20>zero<72> for the redwoods.
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Then, on February 25 the lenders said they were taking a
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<EFBFBD>second look<6F> at financing terms <20> in view of the severely
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depressed housing industry and its impact on Arcata<74>s outlook.<2E>
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|
The stockholders<72> meeting was postponed again, to April. An
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Arcata spokesman said he <20>did not think the fate of the
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acquisition itself was imperiled.<2E> When arbitrageurs hear such
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reassurances, their minds flash to the old saying: <20>He lied like
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a finance minister on the eve of devaluation.<2E>
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On March 12 KKR said its earlier deal wouldn<64>t work, first
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cutting its offer to $33.50, then two days later raising it to
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$35.00. On March 15, however, the directors turned this bid down
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and accepted another group<75>s offer of $37.50 plus one-half of any
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redwood recovery. The shareholders okayed the deal, and the
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$37.50 was paid on June 4.
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We received $24.6 million versus our cost of $22.9 million;
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our average holding period was close to six months. Considering
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the trouble this transaction encountered, our 15% annual rate of
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return excluding any value for the redwood claim - was more than
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satisfactory.
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But the best was yet to come. The trial judge appointed two
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commissions, one to look at the timber<65>s value, the other to
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consider the interest rate questions. In January 1987, the first
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commission said the redwoods were worth $275.7 million and the
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second commission recommended a compounded, blended rate of
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return working out to about 14%.
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In August 1987 the judge upheld these conclusions, which
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meant a net amount of about $600 million would be due Arcata.
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The government then appealed. In 1988, though, before this
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appeal was heard, the claim was settled for $519 million.
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Consequently, we received an additional $29.48 per share, or
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about $19.3 million. We will get another $800,000 or so in 1989.
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Berkshire<72>s arbitrage activities differ from those of many
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arbitrageurs. First, we participate in only a few, and usually
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very large, transactions each year. Most practitioners buy into
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a great many deals perhaps 50 or more per year. With that many
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irons in the fire, they must spend most of their time monitoring
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both the progress of deals and the market movements of the
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related stocks. This is not how Charlie nor I wish to spend our
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lives. (What<61>s the sense in getting rich just to stare at a
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ticker tape all day?)
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Because we diversify so little, one particularly profitable
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or unprofitable transaction will affect our yearly result from
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arbitrage far more than it will the typical arbitrage operation.
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So far, Berkshire has not had a really bad experience. But we
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will - and when it happens we<77>ll report the gory details to you.
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The other way we differ from some arbitrage operations is
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that we participate only in transactions that have been publicly
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announced. We do not trade on rumors or try to guess takeover
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candidates. We just read the newspapers, think about a few of
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the big propositions, and go by our own sense of probabilities.
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At yearend, our only major arbitrage position was 3,342,000
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shares of RJR Nabisco with a cost of $281.8 million and a market
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value of $304.5 million. In January we increased our holdings to
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roughly four million shares and in February we eliminated our
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position. About three million shares were accepted when we
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tendered our holdings to KKR, which acquired RJR, and the
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returned shares were promptly sold in the market. Our pre-tax
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profit was a better-than-expected $64 million.
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Earlier, another familiar face turned up in the RJR bidding
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contest: Jay Pritzker, who was part of a First Boston group that
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made a tax-oriented offer. To quote Yogi Berra; <20>It was deja vu
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all over again.<2E>
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During most of the time when we normally would have been
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purchasers of RJR, our activities in the stock were restricted
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because of Salomon<6F>s participation in a bidding group.
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Customarily, Charlie and I, though we are directors of Salomon,
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are walled off from information about its merger and acquisition
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work. We have asked that it be that way: The information would
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do us no good and could, in fact, occasionally inhibit
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Berkshire<EFBFBD>s arbitrage operations.
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However, the unusually large commitment that Salomon
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proposed to make in the RJR deal required that all directors be
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fully informed and involved. Therefore, Berkshire<72>s purchases of
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RJR were made at only two times: first, in the few days
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immediately following management<6E>s announcement of buyout plans,
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before Salomon became involved; and considerably later, after the
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RJR board made its decision in favor of KKR. Because we could
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not buy at other times, our directorships cost Berkshire
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significant money.
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Considering Berkshire<72>s good results in 1988, you might
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expect us to pile into arbitrage during 1989. Instead, we expect
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to be on the sidelines.
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One pleasant reason is that our cash holdings are down -
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because our position in equities that we expect to hold for a
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very long time is substantially up. As regular readers of this
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report know, our new commitments are not based on a judgment
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about short-term prospects for the stock market. Rather, they
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reflect an opinion about long-term business prospects for
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specific companies. We do not have, never have had, and never
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will have an opinion about where the stock market, interest
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rates, or business activity will be a year from now.
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Even if we had a lot of cash we probably would do little in
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arbitrage in 1989. Some extraordinary excesses have developed in
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the takeover field. As Dorothy says: <20>Toto, I have a feeling
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we<EFBFBD>re not in Kansas any more.<2E>
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We have no idea how long the excesses will last, nor do we
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know what will change the attitudes of government, lender and
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buyer that fuel them. But we do know that the less the prudence
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with which others conduct their affairs, the greater the prudence
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with which we should conduct our own affairs. We have no desire
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to arbitrage transactions that reflect the unbridled - and, in
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our view, often unwarranted - optimism of both buyers and
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lenders. In our activities, we will heed the wisdom of Herb
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|
Stein: <20>If something can<61>t go on forever, it will end.<2E>
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|
<B>Efficient Market Theory</B>
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The preceding discussion about arbitrage makes a small
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discussion of <20>efficient market theory<72> (EMT) also seem relevant.
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|
This doctrine became highly fashionable - indeed, almost holy
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|
scripture in academic circles during the 1970s. Essentially, it
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|
said that analyzing stocks was useless because all public
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|
information about them was appropriately reflected in their
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prices. In other words, the market always knew everything. As a
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corollary, the professors who taught EMT said that someone
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|
throwing darts at the stock tables could select a stock portfolio
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|
having prospects just as good as one selected by the brightest,
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|
most hard-working security analyst. Amazingly, EMT was embraced
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|
not only by academics, but by many investment professionals and
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|
corporate managers as well. Observing correctly that the market
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was <I>frequently</I> efficient, they went on to conclude incorrectly
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that it was <I>always</I> efficient. The difference between these
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|
propositions is night and day.
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In my opinion, the continuous 63-year arbitrage experience
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|
|
of Graham-Newman Corp. Buffett Partnership, and Berkshire
|
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|
illustrates just how foolish EMT is. (There<72>s plenty of other
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|
|
evidence, also.) While at Graham-Newman, I made a study of its
|
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|
earnings from arbitrage during the entire 1926-1956 lifespan of
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|
the company. Unleveraged returns averaged 20% per year.
|
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|
Starting in 1956, I applied Ben Graham<61>s arbitrage principles,
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|
first at Buffett Partnership and then Berkshire. Though I<>ve not
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|
made an exact calculation, I have done enough work to know that
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|
the 1956-1988 returns averaged well over 20%. (Of course, I
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|
operated in an environment far more favorable than Ben<65>s; he had
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1929-1932 to contend with.)
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|
All of the conditions are present that are required for a
|
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|
|
fair test of portfolio performance: (1) the three organizations
|
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|
|
traded hundreds of different securities while building this 63-
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|
|
year record; (2) the results are not skewed by a few fortunate
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|
|
experiences; (3) we did not have to dig for obscure facts or
|
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|
develop keen insights about products or managements - we simply
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|
acted on highly-publicized events; and (4) our arbitrage
|
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|
positions were a clearly identified universe - they have not been
|
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|
selected by hindsight.
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|
Over the 63 years, the general market delivered just under a
|
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|
|
10% annual return, including dividends. That means $1,000 would
|
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|
have grown to $405,000 if all income had been reinvested. A 20%
|
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|
rate of return, however, would have produced $97 million. That
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|
strikes us as a statistically-significant differential that
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|
might, conceivably, arouse one<6E>s curiosity.
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|
Yet proponents of the theory have never seemed interested in
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|
|
discordant evidence of this type. True, they don<6F>t talk quite as
|
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|
much about their theory today as they used to. But no one, to my
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|
knowledge, has ever said he was wrong, no matter how many
|
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thousands of students he has sent forth misinstructed. EMT,
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|
moreover, continues to be an integral part of the investment
|
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|
curriculum at major business schools. Apparently, a reluctance
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|
to recant, and thereby to demystify the priesthood, is not
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limited to theologians.
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Naturally the disservice done students and gullible
|
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|
|
investment professionals who have swallowed EMT has been an
|
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|
extraordinary service to us and other followers of Graham. In
|
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|
|
any sort of a contest - financial, mental, or physical - it<69>s an
|
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|
|
enormous advantage to have opponents who have been taught that
|
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|
it<EFBFBD>s useless to even try. From a selfish point of view,
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|
Grahamites should probably endow chairs to ensure the perpetual
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teaching of EMT.
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|
All this said, a warning is appropriate. Arbitrage has
|
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|
|
|
looked easy recently. But this is not a form of investing that
|
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|
|
guarantees profits of 20% a year or, for that matter, profits of
|
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|
|
any kind. As noted, the market is reasonably efficient much of
|
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|
|
the time: For every arbitrage opportunity we seized in that 63-
|
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|
year period, many more were foregone because they seemed
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|
properly-priced.
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|
An investor cannot obtain superior profits from stocks by
|
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|
|
simply committing to a specific investment category or style. He
|
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|
can earn them only by carefully evaluating facts and continuously
|
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|
|
exercising discipline. Investing in arbitrage situations, per
|
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|
se, is no better a strategy than selecting a portfolio by
|
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|
throwing darts.
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|
<B>New York Stock Exchange Listing</B>
|
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|
Berkshire<72>s shares were listed on the New York Stock
|
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|
Exchange on November 29, 1988. On pages 50-51 we reproduce the
|
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|
letter we sent to shareholders concerning the listing.
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|
Let me clarify one point not dealt with in the letter:
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|
Though our round lot for trading on the NYSE is ten shares, any
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number of shares from one on up can be bought or sold.
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As the letter explains, our primary goal in listing was to
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reduce transaction costs, and we believe this goal is being
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|
achieved. Generally, the spread between the bid and asked price
|
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|
on the NYSE has been well below the spread that prevailed in the
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|
over-the-counter market.
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|
Henderson Brothers, Inc., the specialist in our shares, is
|
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|
|
the oldest continuing specialist firm on the Exchange; its
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|
progenitor, William Thomas Henderson, bought his seat for $500 on
|
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|
September 8, 1861. (Recently, seats were selling for about
|
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$625,000.) Among the 54 firms acting as specialists, HBI ranks
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|
second in number of stocks assigned, with 83. We were pleased
|
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|
when Berkshire was allocated to HBI, and have been delighted with
|
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|
|
the firm<72>s performance. Jim Maguire, Chairman of HBI, personally
|
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|
|
manages the trading in Berkshire, and we could not be in better
|
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hands.
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|
In two respects our goals probably differ somewhat from
|
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|
|
those of most listed companies. First, we do not want to
|
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|
maximize the price at which Berkshire shares trade. We wish
|
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|
instead for them to trade in a narrow range centered at intrinsic
|
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|
business value (which we hope increases at a reasonable - or,
|
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|
|
better yet, unreasonable - rate). Charlie and I are bothered as
|
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|
|
much by significant overvaluation as significant undervaluation.
|
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|
Both extremes will inevitably produce results for many
|
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|
|
shareholders that will differ sharply from Berkshire<72>s business
|
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|
results. If our stock price instead consistently mirrors
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|
business value, each of our shareholders will receive an
|
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|
|
investment result that roughly parallels the business results of
|
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|
Berkshire during his holding period.
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Second, we wish for very little trading activity. If we ran
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a private business with a few passive partners, we would be
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|
disappointed if those partners, and their replacements,
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|
frequently wanted to leave the partnership. Running a public
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|
company, we feel the same way.
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Our goal is to attract long-term owners who, at the time of
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|
purchase, have no timetable or price target for sale but plan
|
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|
instead to stay with us indefinitely. We don<6F>t understand the
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|
|
CEO who wants lots of stock activity, for that can be achieved
|
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|
only if many of his owners are constantly exiting. At what other
|
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|
|
organization - school, club, church, etc. - do leaders cheer when
|
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|
members leave? (However, if there were a broker whose livelihood
|
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|
|
depended upon the membership turnover in such organizations, you
|
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|
|
could be sure that there would be at least one proponent of
|
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|
|
activity, as in: <20>There hasn<73>t been much going on in Christianity
|
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|
|
for a while; maybe we should switch to Buddhism next week.<2E>)
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|
Of course, some Berkshire owners will need or want to sell
|
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|
from time to time, and we wish for good replacements who will pay
|
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|
|
them a fair price. Therefore we try, through our policies,
|
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|
|
performance, and communications, to attract new shareholders who
|
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|
understand our operations, share our time horizons, and measure
|
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|
us as we measure ourselves. If we can continue to attract this
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|
sort of shareholder - and, just as important, can continue to be
|
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uninteresting to those with short-term or unrealistic
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expectations - Berkshire shares should consistently sell at
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prices reasonably related to business value.
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<B>David L. Dodd</B>
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Dave Dodd, my friend and teacher for 38 years, died last
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year at age 93. Most of you don<6F>t know of him. Yet any long-
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time shareholder of Berkshire is appreciably wealthier because of
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the indirect influence he had upon our company.
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Dave spent a lifetime teaching at Columbia University, and
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he co-authored <I>Security Analysis</I> with Ben Graham. From the
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moment I arrived at Columbia, Dave personally encouraged and
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educated me; one influence was as important as the other.
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Everything he taught me, directly or through his book, made
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sense. Later, through dozens of letters, he continued my
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education right up until his death.
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I have known many professors of finance and investments but
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I have never seen any, except for Ben Graham, who was the match
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of Dave. The proof of his talent is the record of his students:
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No other teacher of investments has sent forth so many who have
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achieved unusual success.
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When students left Dave<76>s classroom, they were equipped to
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invest intelligently for a lifetime because the principles he
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taught were simple, sound, useful, and enduring. Though these
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may appear to be unremarkable virtues, the teaching of principles
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embodying them has been rare.
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It<49>s particularly impressive that Dave could practice as
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well as preach. just as Keynes became wealthy by applying his
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academic ideas to a very small purse, so, too, did Dave. Indeed,
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his financial performance far outshone that of Keynes, who began
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as a market-timer (leaning on business and credit-cycle theory)
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and converted, after much thought, to value investing. Dave was
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right from the start.
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In Berkshire<72>s investments, Charlie and I have employed the
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principles taught by Dave and Ben Graham. Our prosperity is the
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fruit of their intellectual tree.
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<B>Miscellaneous</B>
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We hope to buy more businesses that are similar to the ones
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we have, and we can use some help. If you have a business that
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fits the following criteria, call me or, preferably, write.
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Here<72>s what we<77>re looking for:
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(1) large purchases (at least $10 million of after-tax
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earnings),
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(2) demonstrated consistent earning power (future projections
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are of little interest to us, nor are <20>turnaround<6E>
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situations),
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(3) businesses earning good returns on equity while employing
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little or no debt,
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(4) management in place (we can<61>t supply it),
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(5) simple businesses (if there<72>s lots of technology, we won<6F>t
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understand it),
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(6) an offering price (we don<6F>t want to waste our time or that
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of the seller by talking, even preliminarily, about a
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transaction when price is unknown).
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We will not engage in unfriendly takeovers. We can promise
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complete confidentiality and a very fast answer - customarily
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within five minutes - as to whether we<77>re interested. We prefer
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to buy for cash, but will consider issuing stock when we receive
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as much in intrinsic business value as we give.
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Our favorite form of purchase is one fitting the Blumkin-
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Friedman-Heldman mold. In cases like these, the company<6E>s owner-
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managers wish to generate significant amounts of cash, sometimes
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for themselves, but often for their families or inactive
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shareholders. However, these managers also wish to remain
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significant owners who continue to run their companies just as
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they have in the past. We think we offer a particularly good fit
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for owners with these objectives and invite potential sellers to
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check us out by contacting people with whom we have done business
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in the past.
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Charlie and I frequently get approached about acquisitions
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that don<6F>t come close to meeting our tests: We<57>ve found that if
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you advertise an interest in buying collies, a lot of people will
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call hoping to sell you their cocker spaniels. Our interest in
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new ventures, turnarounds, or auction-like sales can best be
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expressed by another Goldwynism: <20>Please include me out.<2E>
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Besides being interested in the purchase of businesses as
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described above, we are also interested in the negotiated
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purchase of large, but not controlling, blocks of stock
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comparable to those we hold in Cap Cities and Salomon. We have a
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special interest in purchasing convertible preferreds as a long-
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term investment, as we did at Salomon.
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* * *
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We received some good news a few weeks ago: Standard &
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Poor<EFBFBD>s raised our credit rating to AAA, which is the highest
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rating it bestows. Only 15 other U.S. industrial or property-
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casualty companies are rated AAA, down from 28 in 1980.
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Corporate bondholders have taken their lumps in the past few
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years from <20>event risk.<2E> This term refers to the overnight
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degradation of credit that accompanies a heavily-leveraged
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purchase or recapitalization of a business whose financial
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policies, up to then, had been conservative. In a world of
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takeovers inhabited by few owner-managers, most corporations
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present such a risk. Berkshire does not. Charlie and I promise
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bondholders the same respect we afford shareholders.
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* * *
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About 97.4% of all eligible shares participated in
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Berkshire<EFBFBD>s 1988 shareholder-designated contributions program.
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Contributions made through the program were $5 million, and 2,319
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charities were recipients. If we achieve reasonable business
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results, we plan to increase the per-share contributions in 1989.
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We urge new shareholders to read the description of our
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shareholder-designated contributions program that appears on
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pages 48-49. If you wish to participate in future programs, we
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strongly urge that you immediately make sure your shares are
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registered in the name of the actual owner, not in the nominee
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name of a broker, bank or depository. Shares not so registered
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on September 30, 1989 will be ineligible for the 1989 program.
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* * *
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Berkshire<72>s annual meeting will be held in Omaha on Monday,
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April 24, 1989, and I hope you will come. The meeting provides
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the forum for you to ask any owner-related questions you may
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have, and we will keep answering until all (except those dealing
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with portfolio activities or other proprietary information) have
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been dealt with.
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After the meeting we will have several buses available to
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take you to visit Mrs. B at The Nebraska Furniture Mart and Ike
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Friedman at Borsheim<69>s. Be prepared for bargains.
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Out-of-towners may prefer to arrive early and visit Mrs. B
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during the Sunday store hours of noon to five. (These Sunday
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hours seem ridiculously short to Mrs. B, who feels they scarcely
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allow her time to warm up; she much prefers the days on which the
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store remains open from 10 a.m. to 9 p.m.) Borsheims, however, is
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not open on Sunday.
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Ask Mrs. B the secret of her astonishingly low carpet
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prices. She will confide to you - as she does to everyone - how
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she does it: <20>I can sell so cheap <20>cause I work for this dummy
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who doesn<73>t know anything about carpet.<2E>
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Warren E. Buffett
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February 28, 1989 Chairman of the Board
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</PRE>
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</BODY
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</HTML>
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