+BERKSHIRE HATHAWAY INC. +
+ ++ + +To the Shareholders of Berkshire Hathaway Inc.: + + This past year our registered shareholders increased from +about 1900 to about 2900. Most of this growth resulted from our +merger with Blue Chip Stamps, but there also was an acceleration +in the pace of “natural” increase that has raised us from the +1000 level a few years ago. + + With so many new shareholders, it’s appropriate to summarize +the major business principles we follow that pertain to the +manager-owner relationship: + + o Although our form is corporate, our attitude is +partnership. Charlie Munger and I think of our shareholders as +owner-partners, and of ourselves as managing partners. (Because +of the size of our shareholdings we also are, for better or +worse, controlling partners.) We do not view the company itself +as the ultimate owner of our business assets but, instead, view +the company as a conduit through which our shareholders own the +assets. + + o In line with this owner-orientation, our directors are all +major shareholders of Berkshire Hathaway. In the case of at +least four of the five, over 50% of family net worth is +represented by holdings of Berkshire. We eat our own cooking. + + o Our long-term economic goal (subject to some qualifications +mentioned later) is to maximize the average annual rate of gain +in intrinsic business value on a per-share basis. We do not +measure the economic significance or performance of Berkshire by +its size; we measure by per-share progress. We are certain that +the rate of per-share progress will diminish in the future - a +greatly enlarged capital base will see to that. But we will be +disappointed if our rate does not exceed that of the average +large American corporation. + + o Our preference would be to reach this goal by directly +owning a diversified group of businesses that generate cash and +consistently earn above-average returns on capital. Our second +choice is to own parts of similar businesses, attained primarily +through purchases of marketable common stocks by our insurance +subsidiaries. The price and availability of businesses and the +need for insurance capital determine any given year’s capital +allocation. + + o Because of this two-pronged approach to business ownership +and because of the limitations of conventional accounting, +consolidated reported earnings may reveal relatively little about +our true economic performance. Charlie and I, both as owners and +managers, virtually ignore such consolidated numbers. However, +we will also report to you the earnings of each major business we +control, numbers we consider of great importance. These figures, +along with other information we will supply about the individual +businesses, should generally aid you in making judgments about +them. + + o Accounting consequences do not influence our operating or +capital-allocation decisions. When acquisition costs are +similar, we much prefer to purchase $2 of earnings that is not +reportable by us under standard accounting principles than to +purchase $1 of earnings that is reportable. This is precisely +the choice that often faces us since entire businesses (whose +earnings will be fully reportable) frequently sell for double the +pro-rata price of small portions (whose earnings will be largely +unreportable). In aggregate and over time, we expect the +unreported earnings to be fully reflected in our intrinsic +business value through capital gains. + + o We rarely use much debt and, when we do, we attempt to +structure it on a long-term fixed rate basis. We will reject +interesting opportunities rather than over-leverage our balance +sheet. This conservatism has penalized our results but it is the +only behavior that leaves us comfortable, considering our +fiduciary obligations to policyholders, depositors, lenders and +the many equity holders who have committed unusually large +portions of their net worth to our care. + + o A managerial “wish list” will not be filled at shareholder +expense. We will not diversify by purchasing entire businesses +at control prices that ignore long-term economic consequences to +our shareholders. We will only do with your money what we would +do with our own, weighing fully the values you can obtain by +diversifying your own portfolios through direct purchases in the +stock market. + + o We feel noble intentions should be checked periodically +against results. We test the wisdom of retaining earnings by +assessing whether retention, over time, delivers shareholders at +least $1 of market value for each $1 retained. To date, this +test has been met. We will continue to apply it on a five-year +rolling basis. As our net worth grows, it is more difficult to +use retained earnings wisely. + + o We will issue common stock only when we receive as much in +business value as we give. This rule applies to all forms of +issuance - not only mergers or public stock offerings, but stock +for-debt swaps, stock options, and convertible securities as +well. We will not sell small portions of your company - and that +is what the issuance of shares amounts to - on a basis +inconsistent with the value of the entire enterprise. + + o You should be fully aware of one attitude Charlie and I +share that hurts our financial performance: regardless of price, +we have no interest at all in selling any good businesses that +Berkshire owns, and are very reluctant to sell sub-par businesses +as long as we expect them to generate at least some cash and as +long as we feel good about their managers and labor relations. +We hope not to repeat the capital-allocation mistakes that led us +into such sub-par businesses. And we react with great caution to +suggestions that our poor businesses can be restored to +satisfactory profitability by major capital expenditures. (The +projections will be dazzling - the advocates will be sincere - +but, in the end, major additional investment in a terrible +industry usually is about as rewarding as struggling in +quicksand.) Nevertheless, gin rummy managerial behavior (discard +your least promising business at each turn) is not our style. We +would rather have our overall results penalized a bit than engage +in it. + + o We will be candid in our reporting to you, emphasizing the +pluses and minuses important in appraising business value. Our +guideline is to tell you the business facts that we would want to +know if our positions were reversed. We owe you no less. +Moreover, as a company with a major communications business, it +would be inexcusable for us to apply lesser standards of +accuracy, balance and incisiveness when reporting on ourselves +than we would expect our news people to apply when reporting on +others. We also believe candor benefits us as managers: the CEO +who misleads others in public may eventually mislead himself in +private. + + o Despite our policy of candor, we will discuss our +activities in marketable securities only to the extent legally +required. Good investment ideas are rare, valuable and subject +to competitive appropriation just as good product or business +acquisition ideas are. Therefore, we normally will not talk +about our investment ideas. This ban extends even to securities +we have sold (because we may purchase them again) and to stocks +we are incorrectly rumored to be buying. If we deny those +reports but say “no comment” on other occasions, the no-comments +become confirmation. + + That completes the catechism, and we can now move on to the +high point of 1983 - the acquisition of a majority interest in +Nebraska Furniture Mart and our association with Rose Blumkin and +her family. + +Nebraska Furniture Mart + + Last year, in discussing how managers with bright, but +adrenalin-soaked minds scramble after foolish acquisitions, I +quoted Pascal: “It has struck me that all the misfortunes of men +spring from the single cause that they are unable to stay quietly +in one room.” + + Even Pascal would have left the room for Mrs. Blumkin. + + About 67 years ago Mrs. Blumkin, then 23, talked her way +past a border guard to leave Russia for America. She had no +formal education, not even at the grammar school level, and knew +no English. After some years in this country, she learned the +language when her older daughter taught her, every evening, the +words she had learned in school during the day. + + In 1937, after many years of selling used clothing, Mrs. +Blumkin had saved $500 with which to realize her dream of opening +a furniture store. Upon seeing the American Furniture Mart in +Chicago - then the center of the nation’s wholesale furniture +activity - she decided to christen her dream Nebraska Furniture +Mart. + + She met every obstacle you would expect (and a few you +wouldn’t) when a business endowed with only $500 and no +locational or product advantage goes up against rich, long- +entrenched competition. At one early point, when her tiny +resources ran out, “Mrs. B” (a personal trademark now as well +recognized in Greater Omaha as Coca-Cola or Sanka) coped in a way +not taught at business schools: she simply sold the furniture and +appliances from her home in order to pay creditors precisely as +promised. + + Omaha retailers began to recognize that Mrs. B would offer +customers far better deals than they had been giving, and they +pressured furniture and carpet manufacturers not to sell to her. +But by various strategies she obtained merchandise and cut prices +sharply. Mrs. B was then hauled into court for violation of Fair +Trade laws. She not only won all the cases, but received +invaluable publicity. At the end of one case, after +demonstrating to the court that she could profitably sell carpet +at a huge discount from the prevailing price, she sold the judge +$1400 worth of carpet. + + Today Nebraska Furniture Mart generates over $100 million of +sales annually out of one 200,000 square-foot store. No other +home furnishings store in the country comes close to that volume. +That single store also sells more furniture, carpets, and +appliances than do all Omaha competitors combined. + + One question I always ask myself in appraising a business is +how I would like, assuming I had ample capital and skilled +personnel, to compete with it. I’d rather wrestle grizzlies than +compete with Mrs. B and her progeny. They buy brilliantly, they +operate at expense ratios competitors don’t even dream about, and +they then pass on to their customers much of the savings. It’s +the ideal business - one built upon exceptional value to the +customer that in turn translates into exceptional economics for +its owners. + + Mrs. B is wise as well as smart and, for far-sighted family +reasons, was willing to sell the business last year. I had +admired both the family and the business for decades, and a deal +was quickly made. But Mrs. B, now 90, is not one to go home and +risk, as she puts it, “losing her marbles”. She remains Chairman +and is on the sales floor seven days a week. Carpet sales are +her specialty. She personally sells quantities that would be a +good departmental total for other carpet retailers. + + We purchased 90% of the business - leaving 10% with members +of the family who are involved in management - and have optioned +10% to certain key young family managers. + + And what managers they are. Geneticists should do +handsprings over the Blumkin family. Louie Blumkin, Mrs. B’s +son, has been President of Nebraska Furniture Mart for many years +and is widely regarded as the shrewdest buyer of furniture and +appliances in the country. Louie says he had the best teacher, +and Mrs. B says she had the best student. They’re both right. +Louie and his three sons all have the Blumkin business ability, +work ethic, and, most important, character. On top of that, they +are really nice people. We are delighted to be in partnership +with them. + +Corporate Performance + + During 1983 our book value increased from $737.43 per share +to $975.83 per share, or by 32%. We never take the one-year +figure very seriously. After all, why should the time required +for a planet to circle the sun synchronize precisely with the +time required for business actions to pay off? Instead, we +recommend not less than a five-year test as a rough yardstick of +economic performance. Red lights should start flashing if the +five-year average annual gain falls much below the return on +equity earned over the period by American industry in aggregate. +(Watch out for our explanation if that occurs as Goethe observed, +“When ideas fail, words come in very handy.”) + + During the 19-year tenure of present management, book value +has grown from $19.46 per share to $975.83, or 22.6% compounded +annually. Considering our present size, nothing close to this +rate of return can be sustained. Those who believe otherwise +should pursue a career in sales, but avoid one in mathematics. + + We report our progress in terms of book value because in our +case (though not, by any means, in all cases) it is a +conservative but reasonably adequate proxy for growth in +intrinsic business value - the measurement that really counts. +Book value’s virtue as a score-keeping measure is that it is easy +to calculate and doesn’t involve the subjective (but important) +judgments employed in calculation of intrinsic business value. +It is important to understand, however, that the two terms - book +value and intrinsic business value - have very different +meanings. + + Book value is an accounting concept, recording the +accumulated financial input from both contributed capital and +retained earnings. Intrinsic business value is an economic +concept, estimating future cash output discounted to present +value. Book value tells you what has been put in; intrinsic +business value estimates what can be taken out. + + An analogy will suggest the difference. Assume you spend +identical amounts putting each of two children through college. +The book value (measured by financial input) of each child’s +education would be the same. But the present value of the future +payoff (the intrinsic business value) might vary enormously - +from zero to many times the cost of the education. So, also, do +businesses having equal financial input end up with wide +variations in value. + + At Berkshire, at the beginning of fiscal 1965 when the +present management took over, the $19.46 per share book value +considerably overstated intrinsic business value. All of that +book value consisted of textile assets that could not earn, on +average, anything close to an appropriate rate of return. In the +terms of our analogy, the investment in textile assets resembled +investment in a largely-wasted education. + + Now, however, our intrinsic business value considerably +exceeds book value. There are two major reasons: + + (1) Standard accounting principles require that common + stocks held by our insurance subsidiaries be stated on + our books at market value, but that other stocks we own + be carried at the lower of aggregate cost or market. + At the end of 1983, the market value of this latter + group exceeded carrying value by $70 million pre-tax, + or about $50 million after tax. This excess belongs in + our intrinsic business value, but is not included in + the calculation of book value; + + (2) More important, we own several businesses that possess + economic Goodwill (which is properly includable in + intrinsic business value) far larger than the + accounting Goodwill that is carried on our balance + sheet and reflected in book value. + + Goodwill, both economic and accounting, is an arcane subject +and requires more explanation than is appropriate here. The +appendix that follows this letter - “Goodwill and its +Amortization: The Rules and The Realities” - explains why +economic and accounting Goodwill can, and usually do, differ +enormously. + + You can live a full and rewarding life without ever thinking +about Goodwill and its amortization. But students of investment +and management should understand the nuances of the subject. My +own thinking has changed drastically from 35 years ago when I was +taught to favor tangible assets and to shun businesses whose +value depended largely upon economic Goodwill. This bias caused +me to make many important business mistakes of omission, although +relatively few of commission. + + Keynes identified my problem: “The difficulty lies not in +the new ideas but in escaping from the old ones.” My escape was +long delayed, in part because most of what I had been taught by +the same teacher had been (and continues to be) so +extraordinarily valuable. Ultimately, business experience, +direct and vicarious, produced my present strong preference for +businesses that possess large amounts of enduring Goodwill and +that utilize a minimum of tangible assets. + + I recommend the Appendix to those who are comfortable with +accounting terminology and who have an interest in understanding +the business aspects of Goodwill. Whether or not you wish to +tackle the Appendix, you should be aware that Charlie and I +believe that Berkshire possesses very significant economic +Goodwill value above that reflected in our book value. + +Sources of Reported Earnings + + The table below shows the sources of Berkshire’s reported +earnings. In 1982, Berkshire owned about 60% of Blue Chip Stamps +whereas, in 1983, our ownership was 60% throughout the first six +months and 100% thereafter. In turn, Berkshire’s net interest in +Wesco was 48% during 1982 and the first six months of 1983, and +80% for the balance of 1983. Because of these changed ownership +percentages, the first two columns of the table provide the best +measure of underlying business performance. + + All of the significant gains and losses attributable to +unusual sales of assets by any of the business entities are +aggregated with securities transactions on the line near the +bottom of the table, and are not included in operating earnings. +(We regard any annual figure for realized capital gains or losses +as meaningless, but we regard the aggregate realized and +unrealized capital gains over a period of years as very +important.) Furthermore, amortization of Goodwill is not charged +against the specific businesses but, for reasons outlined in the +Appendix, is set forth as a separate item. + + Net Earnings + Earnings Before Income Taxes After Tax + -------------------------------------- ------------------ + Total Berkshire Share Berkshire Share + ------------------ ------------------ ------------------ + 1983 1982 1983 1982 1983 1982 + -------- -------- -------- -------- -------- -------- + (000s omitted) +Operating Earnings: + Insurance Group: + Underwriting ............ $(33,872) $(21,558) $(33,872) $(21,558) $(18,400) $(11,345) + Net Investment Income ... 43,810 41,620 43,810 41,620 39,114 35,270 + Berkshire-Waumbec Textiles (100) (1,545) (100) (1,545) (63) (862) + Associated Retail Stores .. 697 914 697 914 355 446 + Nebraska Furniture Mart(1) 3,812 -- 3,049 -- 1,521 -- + See’s Candies ............. 27,411 23,884 24,526 14,235 12,212 6,914 + Buffalo Evening News ...... 19,352 (1,215) 16,547 (724) 8,832 (226) + Blue Chip Stamps(2) ....... (1,422) 4,182 (1,876) 2,492 (353) 2,472 + Wesco Financial - Parent .. 7,493 6,156 4,844 2,937 3,448 2,210 + Mutual Savings and Loan ... (798) (6) (467) (2) 1,917 1,524 + Precision Steel ........... 3,241 1,035 2,102 493 1,136 265 + Interest on Debt .......... (15,104) (14,996) (13,844) (12,977) (7,346) (6,951) + Special GEICO Distribution 21,000 -- 21,000 -- 19,551 -- + Shareholder-Designated + Contributions .......... (3,066) (891) (3,066) (891) (1,656) (481) + Amortization of Goodwill .. (532) 151 (563) 90 (563) 90 + Other ..................... 10,121 3,371 9,623 2,658 8,490 2,171 + -------- -------- -------- -------- -------- -------- +Operating Earnings .......... 82,043 41,102 72,410 27,742 68,195 31,497 +Sales of securities and + unusual sales of assets .. 67,260 36,651 65,089 21,875 45,298 14,877 + -------- -------- -------- -------- -------- -------- +Total Earnings .............. $149,303 $ 77,753 $137,499 $ 49,617 $113,493 $ 46,374 + ======== ======== ======== ======== ======== ======== + +(1) October through December +(2) 1982 and 1983 are not comparable; major assets were + transferred in the merger. + + For a discussion of the businesses owned by Wesco, please +read Charlie Munger’s report on pages 46-51. Charlie replaced +Louie Vincenti as Chairman of Wesco late in 1983 when health +forced Louie’s retirement at age 77. In some instances, “health” +is a euphemism, but in Louie’s case nothing but health would +cause us to consider his retirement. Louie is a marvelous man +and has been a marvelous manager. + + The special GEICO distribution reported in the table arose +when that company made a tender offer for a portion of its stock, +buying both from us and other shareholders. At GEICO’s request, +we tendered a quantity of shares that kept our ownership +percentage the same after the transaction as before. The +proportional nature of our sale permitted us to treat the +proceeds as a dividend. Unlike individuals, corporations net +considerably more when earnings are derived from dividends rather +than from capital gains, since the effective Federal income tax +rate on dividends is 6.9% versus 28% on capital gains. + + Even with this special item added in, our total dividends +from GEICO in 1983 were considerably less than our share of +GEICO’s earnings. Thus it is perfectly appropriate, from both an +accounting and economic standpoint, to include the redemption +proceeds in our reported earnings. It is because the item is +large and unusual that we call your attention to it. + + The table showing you our sources of earnings includes +dividends from those non-controlled companies whose marketable +equity securities we own. But the table does not include +earnings those companies have retained that are applicable to our +ownership. In aggregate and over time we expect those +undistributed earnings to be reflected in market prices and to +increase our intrinsic business value on a dollar-for-dollar +basis, just as if those earnings had been under our control and +reported as part of our profits. That does not mean we expect +all of our holdings to behave uniformly; some will disappoint us, +others will deliver pleasant surprises. To date our experience +has been better than we originally anticipated, In aggregate, we +have received far more than a dollar of market value gain for +every dollar of earnings retained. + + The following table shows our 1983 yearend net holdings in +marketable equities. All numbers represent 100% of Berkshire’s +holdings, and 80% of Wesco’s holdings. The portion attributable +to minority shareholders of Wesco has been excluded. + +No. of Shares Cost Market +------------- ---------- ---------- + (000s omitted) + 690,975 Affiliated Publications, Inc. .... $ 3,516 $ 26,603 + 4,451,544 General Foods Corporation(a) ..... 163,786 228,698 + 6,850,000 GEICO Corporation ................ 47,138 398,156 + 2,379,200 Handy & Harman ................... 27,318 42,231 + 636,310 Interpublic Group of Companies, Inc. 4,056 33,088 + 197,200 Media General .................... 3,191 11,191 + 250,400 Ogilvy & Mather International .... 2,580 12,833 + 5,618,661 R. J. Reynolds Industries, Inc.(a) 268,918 341,334 + 901,788 Time, Inc. ....................... 27,732 56,860 + 1,868,600 The Washington Post Company ...... 10,628 136,875 + ---------- ---------- + $558,863 $1,287,869 + All Other Common Stockholdings ... 7,485 18,044 + ---------- ---------- + Total Common Stocks .............. $566,348 $1,305,913 + ========== ========== + +(a) WESCO owns shares in these companies. + + Based upon present holdings and present dividend rates - +excluding any special items such as the GEICO proportional +redemption last year - we would expect reported dividends from +this group to be approximately $39 million in 1984. We can also +make a very rough guess about the earnings this group will retain +that will be attributable to our ownership: these may total about +$65 million for the year. These retained earnings could well +have no immediate effect on market prices of the securities. +Over time, however, we feel they will have real meaning. + + In addition to the figures already supplied, information +regarding the businesses we control appears in Management’s +Discussion on pages 40-44. The most significant of these are +Buffalo Evening News, See’s, and the Insurance Group, to which we +will give some special attention here. + +Buffalo Evening News + + First, a clarification: our corporate name is Buffalo +Evening News, Inc. but the name of the newspaper, since we began +a morning edition a little over a year ago, is Buffalo News. + + In 1983 the News somewhat exceeded its targeted profit +margin of 10% after tax. Two factors were responsible: (1) a +state income tax cost that was subnormal because of a large loss +carry-forward, now fully utilized, and (2) a large drop in the +per-ton cost of newsprint (an unanticipated fluke that will be +reversed in 1984). + + Although our profit margins in 1983 were about average for +newspapers such as the News, the paper’s performance, +nevertheless, was a significant achievement considering the +economic and retailing environment in Buffalo. + + Buffalo has a concentration of heavy industry, a segment of +the economy that was hit particularly hard by the recent +recession and that has lagged the recovery. As Buffalo consumers +have suffered, so also have the paper’s retailing customers. +Their numbers have shrunk over the past few years and many of +those surviving have cut their linage. + + Within this environment the News has one exceptional +strength: its acceptance by the public, a matter measured by the +paper’s “penetration ratio” - the percentage of households within +the community purchasing the paper each day. Our ratio is +superb: for the six months ended September 30, 1983 the News +stood number one in weekday penetration among the 100 largest +papers in the United States (the ranking is based on “city zone” +numbers compiled by the Audit Bureau of Circulations). + + In interpreting the standings, it is important to note that +many large cities have two papers, and that in such cases the +penetration of either paper is necessarily lower than if there +were a single paper, as in Buffalo. Nevertheless, the list of +the 100 largest papers includes many that have a city to +themselves. Among these, the News is at the top nationally, far +ahead of many of the country’s best-known dailies. + + Among Sunday editions of these same large dailies, the News +ranks number three in penetration - ten to twenty percentage +points ahead of many well-known papers. It was not always this +way in Buffalo. Below we show Sunday circulation in Buffalo in +the years prior to 1977 compared with the present period. In +that earlier period the Sunday paper was the Courier-Express (the +News was not then publishing a Sunday paper). Now, of course, it +is the News. + + Average Sunday Circulation + -------------------------- + Year Circulation + ---- ----------- + 1970 314,000 + 1971 306,000 + 1972 302,000 + 1973 290,000 + 1974 278,000 + 1975 269,000 + 1976 270,000 + + 1984 (Current) 376,000 + + We believe a paper’s penetration ratio to be the best +measure of the strength of its franchise. Papers with unusually +high penetration in the geographical area that is of prime +interest to major local retailers, and with relatively little +circulation elsewhere, are exceptionally efficient buys for those +retailers. Low-penetration papers have a far less compelling +message to present to advertisers. + + In our opinion, three factors largely account for the +unusual acceptance of the News in the community. Among these, +points 2 and 3 also may explain the popularity of the Sunday News +compared to that of the Sunday Courier-Express when it was the +sole Sunday paper: + + (1) The first point has nothing to do with merits of the + News. Both emigration and immigration are relatively + low in Buffalo. A stable population is more interested + and involved in the activities of its community than is + a shifting population - and, as a result, is more + interested in the content of the local daily paper. + Increase the movement in and out of a city and + penetration ratios will fall. + + (2) The News has a reputation for editorial quality and + integrity that was honed by our longtime editor, the + legendary Alfred Kirchhofer, and that has been preserved + and extended by Murray Light. This reputation was + enormously important to our success in establishing a + Sunday paper against entrenched competition. And without + a Sunday edition, the News would not have survived in the + long run. + + (3) The News lives up to its name - it delivers a very + unusual amount of news. During 1983, our “news hole” + (editorial material - not ads) amounted to 50% of the + newspaper’s content (excluding preprinted inserts). + Among papers that dominate their markets and that are of + comparable or larger size, we know of only one whose news + hole percentage exceeds that of the News. Comprehensive + figures are not available, but a sampling indicates an + average percentage in the high 30s. In other words, page + for page, our mix gives readers over 25% more news than + the typical paper. This news-rich mixture is by intent. + Some publishers, pushing for higher profit margins, have + cut their news holes during the past decade. We have + maintained ours and will continue to do so. Properly + written and edited, a full serving of news makes our + paper more valuable to the reader and contributes to our + unusual penetration ratio. + + Despite the strength of the News’ franchise, gains in ROP +linage (advertising printed within the newspaper pages as +contrasted to preprinted inserts) are going to be very difficult +to achieve. We had an enormous gain in preprints during 1983: +lines rose from 9.3 million to 16.4 million, revenues from $3.6 +million to $8.1 million. These gains are consistent with +national trends, but exaggerated in our case by business we +picked up when the Courier-Express closed. + + On balance, the shift from ROP to preprints has negative +economic implications for us. Profitability on preprints is less +and the business is more subject to competition from alternative +means of delivery. Furthermore, a reduction in ROP linage means +less absolute space devoted to news (since the news hole +percentage remains constant), thereby reducing the utility of the +paper to the reader. + + Stan Lipsey became Publisher of the Buffalo News at midyear +upon the retirement of Henry Urban. Henry never flinched during +the dark days of litigation and losses following our introduction +of the Sunday paper - an introduction whose wisdom was questioned +by many in the newspaper business, including some within our own +building. Henry is admired by the Buffalo business community, +he’s admired by all who worked for him, and he is admired by +Charlie and me. Stan worked with Henry for several years, and +has worked for Berkshire Hathaway since 1969. He has been +personally involved in all nuts-and-bolts aspects of the +newspaper business from editorial to circulation. We couldn’t do +better. + +See’s Candy Shops + + The financial results at See’s continue to be exceptional. +The business possesses a valuable and solid consumer franchise +and a manager equally valuable and solid. + + In recent years See’s has encountered two important +problems, at least one of which is well on its way toward +solution. That problem concerns costs, except those for raw +materials. We have enjoyed a break on raw material costs in +recent years though so, of course, have our competitors. One of +these days we will get a nasty surprise in the opposite +direction. In effect, raw material costs are largely beyond our +control since we will, as a matter of course, buy the finest +ingredients that we can, regardless of changes in their price +levels. We regard product quality as sacred. + + But other kinds of costs are more controllable, and it is in +this area that we have had problems. On a per-pound basis, our +costs (not including those for raw materials) have increased in +the last few years at a rate significantly greater than the +increase in the general price level. It is vital to our +competitive position and profit potential that we reverse this +trend. + + In recent months much better control over costs has been +attained and we feel certain that our rate of growth in these +costs in 1984 will be below the rate of inflation. This +confidence arises out of our long experience with the managerial +talents of Chuck Huggins. We put Chuck in charge the day we took +over, and his record has been simply extraordinary, as shown by +the following table: + + 52-53 Week Year Operating Number of Number of + Ended About Sales Profits Pounds of Stores Open + December 31 Revenues After Taxes Candy Sold at Year End +------------------- ------------ ----------- ---------- ----------- +1983 (53 weeks) ... $133,531,000 $13,699,000 24,651,000 207 +1982 .............. 123,662,000 11,875,000 24,216,000 202 +1981 .............. 112,578,000 10,779,000 24,052,000 199 +1980 .............. 97,715,000 7,547,000 24,065,000 191 +1979 .............. 87,314,000 6,330,000 23,985,000 188 +1978 .............. 73,653,000 6,178,000 22,407,000 182 +1977 .............. 62,886,000 6,154,000 20,921,000 179 +1976 (53 weeks) ... 56,333,000 5,569,000 20,553,000 173 +1975 .............. 50,492,000 5,132,000 19,134,000 172 +1974 .............. 41,248,000 3,021,000 17,883,000 170 +1973 .............. 35,050,000 1,940,000 17,813,000 169 +1972 .............. 31,337,000 2,083,000 16,954,000 167 + + The other problem we face, as the table suggests, is our +recent inability to achieve meaningful gains in pounds sold. The +industry has the same problem. But for many years we +outperformed the industry in this respect and now we are not. + + The poundage volume in our retail stores has been virtually +unchanged each year for the past four, despite small increases +every year in the number of shops (and in distribution expense as +well). Of course, dollar volume has increased because we have +raised prices significantly. But we regard the most important +measure of retail trends to be units sold per store rather than +dollar volume. On a same-store basis (counting only shops open +throughout both years) with all figures adjusted to a 52-week +year, poundage was down .8 of 1% during 1983. This small decline +was our best same-store performance since 1979; the cumulative +decline since then has been about 8%. Quantity-order volume, +about 25% of our total, has plateaued in recent years following +very large poundage gains throughout the 1970s. + + We are not sure to what extent this flat volume - both in +the retail shop area and the quantity order area - is due to our +pricing policies and to what extent it is due to static industry +volume, the recession, and the extraordinary share of market we +already enjoy in our primary marketing area. Our price increase +for 1984 is much more modest than has been the case in the past +few years, and we hope that next year we can report better volume +figures to you. But we have no basis to forecast these. + + Despite the volume problem, See’s strengths are many and +important. In our primary marketing area, the West, our candy is +preferred by an enormous margin to that of any competitor. In +fact, we believe most lovers of chocolate prefer it to candy +costing two or three times as much. (In candy, as in stocks, +price and value can differ; price is what you give, value is what +you get.) The quality of customer service in our shops - operated +throughout the country by us and not by franchisees is every bit +as good as the product. Cheerful, helpful personnel are as much +a trademark of See’s as is the logo on the box. That’s no small +achievement in a business that requires us to hire about 2000 +seasonal workers. We know of no comparably-sized organization +that betters the quality of customer service delivered by Chuck +Huggins and his associates. + + Because we have raised prices so modestly in 1984, we expect +See’s profits this year to be about the same as in 1983. + +Insurance - Controlled Operations + + We both operate insurance companies and have a large +economic interest in an insurance business we don’t operate, +GEICO. The results for all can be summed up easily: in +aggregate, the companies we operate and whose underwriting +results reflect the consequences of decisions that were my +responsibility a few years ago, had absolutely terrible results. +Fortunately, GEICO, whose policies I do not influence, simply +shot the lights out. The inference you draw from this summary is +the correct one. I made some serious mistakes a few years ago +that came home to roost. + + The industry had its worst underwriting year in a long time, +as indicated by the table below: + + Yearly Change Combined Ratio + in Premiums after Policy- + Written (%) holder Dividends + ------------- ---------------- +1972 .................... 10.2 96.2 +1973 .................... 8.0 99.2 +1974 .................... 6.2 105.4 +1975 .................... 11.0 107.9 +1976 .................... 21.9 102.4 +1977 .................... 19.8 97.2 +1978 .................... 12.8 97.5 +1979 .................... 10.3 100.6 +1980 .................... 6.0 103.1 +1981 .................... 3.9 106.0 +1982 (Revised) .......... 4.4 109.7 +1983 (Estimated) ........ 4.6 111.0 + +Source: Best’s Aggregates and Averages. + + Best’s data reflect the experience of practically the entire +industry, including stock, mutual, and reciprocal companies. The +combined ratio represents total insurance costs (losses incurred +plus expenses) compared to revenue from premiums; a ratio below +100 indicates an underwriting profit and one above 100 indicates +a loss. + + For the reasons outlined in last year’s report, we expect +the poor industry experience of 1983 to be more or less typical +for a good many years to come. (As Yogi Berra put it: “It will be +deja vu all over again.”) That doesn’t mean we think the figures +won’t bounce around a bit; they are certain to. But we believe +it highly unlikely that the combined ratio during the balance of +the decade will average significantly below the 1981-1983 level. +Based on our expectations regarding inflation - and we are as +pessimistic as ever on that front - industry premium volume must +grow about 10% annually merely to stabilize loss ratios at +present levels. + + Our own combined ratio in 1983 was 121. Since Mike Goldberg +recently took over most of the responsibility for the insurance +operation, it would be nice for me if our shortcomings could be +placed at his doorstep rather than mine. But unfortunately, as +we have often pointed out, the insurance business has a long +lead-time. Though business policies may be changed and personnel +improved, a significant period must pass before the effects are +seen. (This characteristic of the business enabled us to make a +great deal of money in GEICO; we could picture what was likely to +happen well before it actually occurred.) So the roots of the +1983 results are operating and personnel decisions made two or +more years back when I had direct managerial responsibility for +the insurance group. + + Despite our poor results overall, several of our managers +did truly outstanding jobs. Roland Miller guided the auto and +general liability business of National Indemnity Company and +National Fire and Marine Insurance Company to improved results, +while those of competitors deteriorated. In addition, Tom Rowley +at Continental Divide Insurance - our fledgling Colorado +homestate company - seems certain to be a winner. Mike found him +a little over a year ago, and he was an important acquisition. + + We have become active recently - and hope to become much +more active - in reinsurance transactions where the buyer’s +overriding concern should be the seller’s long-term +creditworthiness. In such transactions our premier financial +strength should make us the number one choice of both claimants +and insurers who must rely on the reinsurer’s promises for a +great many years to come. + + A major source of such business is structured settlements - +a procedure for settling losses under which claimants receive +periodic payments (almost always monthly, for life) rather than a +single lump sum settlement. This form of settlement has +important tax advantages for the claimant and also prevents his +squandering a large lump-sum payment. Frequently, some inflation +protection is built into the settlement. Usually the claimant +has been seriously injured, and thus the periodic payments must +be unquestionably secure for decades to come. We believe we +offer unparalleled security. No other insurer we know of - even +those with much larger gross assets - has our financial strength. + + We also think our financial strength should recommend us to +companies wishing to transfer loss reserves. In such +transactions, other insurance companies pay us lump sums to +assume all (or a specified portion of) future loss payments +applicable to large blocks of expired business. Here also, the +company transferring such claims needs to be certain of the +transferee’s financial strength for many years to come. Again, +most of our competitors soliciting such business appear to us to +have a financial condition that is materially inferior to ours. + + Potentially, structured settlements and the assumption of +loss reserves could become very significant to us. Because of +their potential size and because these operations generate large +amounts of investment income compared to premium volume, we will +show underwriting results from those businesses on a separate +line in our insurance segment data. We also will exclude their +effect in reporting our combined ratio to you. We “front end” no +profit on structured settlement or loss reserve transactions, and +all attributable overhead is expensed currently. Both businesses +are run by Don Wurster at National Indemnity Company. + +Insurance - GEICO + + Geico’s performance during 1983 was as good as our own +insurance performance was poor. Compared to the industry’s +combined ratio of 111, GEICO wrote at 96 after a large voluntary +accrual for policyholder dividends. A few years ago I would not +have thought GEICO could so greatly outperform the industry. Its +superiority reflects the combination of a truly exceptional +business idea and an exceptional management. + + Jack Byrne and Bill Snyder have maintained extraordinary +discipline in the underwriting area (including, crucially, +provision for full and proper loss reserves), and their efforts +are now being further rewarded by significant gains in new +business. Equally important, Lou Simpson is the class of the +field among insurance investment managers. The three of them are +some team. + + We have approximately a one-third interest in GEICO. That +gives us a $270 million share in the company’s premium volume, an +amount some 80% larger than our own volume. Thus, the major +portion of our total insurance business comes from the best +insurance book in the country. This fact does not moderate by an +iota the need for us to improve our own operation. + +Stock Splits and Stock Activity + + We often are asked why Berkshire does not split its stock. +The assumption behind this question usually appears to be that a +split would be a pro-shareholder action. We disagree. Let me +tell you why. + + One of our goals is to have Berkshire Hathaway stock sell at +a price rationally related to its intrinsic business value. (But +note “rationally related”, not “identical”: if well-regarded +companies are generally selling in the market at large discounts +from value, Berkshire might well be priced similarly.) The key to +a rational stock price is rational shareholders, both current and +prospective. + + If the holders of a company’s stock and/or the prospective +buyers attracted to it are prone to make irrational or emotion- +based decisions, some pretty silly stock prices are going to +appear periodically. Manic-depressive personalities produce +manic-depressive valuations. Such aberrations may help us in +buying and selling the stocks of other companies. But we think +it is in both your interest and ours to minimize their occurrence +in the market for Berkshire. + + To obtain only high quality shareholders is no cinch. Mrs. +Astor could select her 400, but anyone can buy any stock. +Entering members of a shareholder “club” cannot be screened for +intellectual capacity, emotional stability, moral sensitivity or +acceptable dress. Shareholder eugenics, therefore, might appear +to be a hopeless undertaking. + + In large part, however, we feel that high quality ownership +can be attracted and maintained if we consistently communicate +our business and ownership philosophy - along with no other +conflicting messages - and then let self selection follow its +course. For example, self selection will draw a far different +crowd to a musical event advertised as an opera than one +advertised as a rock concert even though anyone can buy a ticket +to either. + + Through our policies and communications - our +“advertisements” - we try to attract investors who will +understand our operations, attitudes and expectations. (And, +fully as important, we try to dissuade those who won’t.) We want +those who think of themselves as business owners and invest in +companies with the intention of staying a long time. And, we +want those who keep their eyes focused on business results, not +market prices. + + Investors possessing those characteristics are in a small +minority, but we have an exceptional collection of them. I +believe well over 90% - probably over 95% - of our shares are +held by those who were shareholders of Berkshire or Blue Chip +five years ago. And I would guess that over 95% of our shares +are held by investors for whom the holding is at least double the +size of their next largest. Among companies with at least +several thousand public shareholders and more than $1 billion of +market value, we are almost certainly the leader in the degree to +which our shareholders think and act like owners. Upgrading a +shareholder group that possesses these characteristics is not +easy. + + Were we to split the stock or take other actions focusing on +stock price rather than business value, we would attract an +entering class of buyers inferior to the exiting class of +sellers. At $1300, there are very few investors who can’t afford +a Berkshire share. Would a potential one-share purchaser be +better off if we split 100 for 1 so he could buy 100 shares? +Those who think so and who would buy the stock because of the +split or in anticipation of one would definitely downgrade the +quality of our present shareholder group. (Could we really +improve our shareholder group by trading some of our present +clear-thinking members for impressionable new ones who, +preferring paper to value, feel wealthier with nine $10 bills +than with one $100 bill?) People who buy for non-value reasons +are likely to sell for non-value reasons. Their presence in the +picture will accentuate erratic price swings unrelated to +underlying business developments. + + We will try to avoid policies that attract buyers with a +short-term focus on our stock price and try to follow policies +that attract informed long-term investors focusing on business +values. just as you purchased your Berkshire shares in a market +populated by rational informed investors, you deserve a chance to +sell - should you ever want to - in the same kind of market. We +will work to keep it in existence. + + One of the ironies of the stock market is the emphasis on +activity. Brokers, using terms such as “marketability” and +“liquidity”, sing the praises of companies with high share +turnover (those who cannot fill your pocket will confidently fill +your ear). But investors should understand that what is good for +the croupier is not good for the customer. A hyperactive stock +market is the pickpocket of enterprise. + + For example, consider a typical company earning, say, 12% on +equity. Assume a very high turnover rate in its shares of 100% +per year. If a purchase and sale of the stock each extract +commissions of 1% (the rate may be much higher on low-priced +stocks) and if the stock trades at book value, the owners of our +hypothetical company will pay, in aggregate, 2% of the company’s +net worth annually for the privilege of transferring ownership. +This activity does nothing for the earnings of the business, and +means that 1/6 of them are lost to the owners through the +“frictional” cost of transfer. (And this calculation does not +count option trading, which would increase frictional costs still +further.) + + All that makes for a rather expensive game of musical +chairs. Can you imagine the agonized cry that would arise if a +governmental unit were to impose a new 16 2/3% tax on earnings of +corporations or investors? By market activity, investors can +impose upon themselves the equivalent of such a tax. + + Days when the market trades 100 million shares (and that +kind of volume, when over-the-counter trading is included, is +today abnormally low) are a curse for owners, not a blessing - +for they mean that owners are paying twice as much to change +chairs as they are on a 50-million-share day. If 100 million- +share days persist for a year and the average cost on each +purchase and sale is 15 cents a share, the chair-changing tax for +investors in aggregate would total about $7.5 billion - an amount +roughly equal to the combined 1982 profits of Exxon, General +Motors, Mobil and Texaco, the four largest companies in the +Fortune 500. + + These companies had a combined net worth of $75 billion at +yearend 1982 and accounted for over 12% of both net worth and net +income of the entire Fortune 500 list. Under our assumption +investors, in aggregate, every year forfeit all earnings from +this staggering sum of capital merely to satisfy their penchant +for “financial flip-flopping”. In addition, investment +management fees of over $2 billion annually - sums paid for +chair-changing advice - require the forfeiture by investors of +all earnings of the five largest banking organizations (Citicorp, +Bank America, Chase Manhattan, Manufacturers Hanover and J. P. +Morgan). These expensive activities may decide who eats the pie, +but they don’t enlarge it. + + (We are aware of the pie-expanding argument that says that +such activities improve the rationality of the capital allocation +process. We think that this argument is specious and that, on +balance, hyperactive equity markets subvert rational capital +allocation and act as pie shrinkers. Adam Smith felt that all +noncollusive acts in a free market were guided by an invisible +hand that led an economy to maximum progress; our view is that +casino-type markets and hair-trigger investment management act as +an invisible foot that trips up and slows down a forward-moving +economy.) + + Contrast the hyperactive stock with Berkshire. The bid-and- +ask spread in our stock currently is about 30 points, or a little +over 2%. Depending on the size of the transaction, the +difference between proceeds received by the seller of Berkshire +and cost to the buyer may range downward from 4% (in trading +involving only a few shares) to perhaps 1 1/2% (in large trades +where negotiation can reduce both the market-maker’s spread and +the broker’s commission). Because most Berkshire shares are +traded in fairly large transactions, the spread on all trading +probably does not average more than 2%. + + Meanwhile, true turnover in Berkshire stock (excluding +inter-dealer transactions, gifts and bequests) probably runs 3% +per year. Thus our owners, in aggregate, are paying perhaps +6/100 of 1% of Berkshire’s market value annually for transfer +privileges. By this very rough estimate, that’s $900,000 - not a +small cost, but far less than average. Splitting the stock would +increase that cost, downgrade the quality of our shareholder +population, and encourage a market price less consistently +related to intrinsic business value. We see no offsetting +advantages. + +Miscellaneous + + Last year in this section I ran a small ad to encourage +acquisition candidates. In our communications businesses we tell +our advertisers that repetition is a key to results (which it +is), so we will again repeat our acquisition criteria. + + We prefer: + (1) large purchases (at least $5 million of after-tax + earnings), + (2) demonstrated consistent earning power (future + projections are of little interest to us, nor are + “turn-around” situations), + (3) businesses earning good returns on equity while + employing little or no debt, + (4) management in place (we can’t supply it), + (5) simple businesses (if there’s lots of technology, we + won’t understand it), + (6) an offering price (we don’t want to waste our time or + that of the seller by talking, even preliminarily, + about a transaction when price is unknown). + + We will not engage in unfriendly takeovers. We can promise +complete confidentiality and a very fast answer - customarily +within five minutes - as to whether we’re interested. We prefer +to buy for cash, but will consider issuance of stock when we +receive as much in intrinsic business value as we give. We +invite potential sellers to check us out by contacting people +with whom we have done business in the past. For the right +business - and the right people - we can provide a good home. + + * * * * * + + About 96.4% of all eligible shares participated in our 1983 +shareholder-designated contributions program. The total +contributions made pursuant to this program - disbursed in the +early days of 1984 but fully expensed in 1983 - were $3,066,501, +and 1353 charities were recipients. Although the response +measured by the percentage of shares participating was +extraordinarily good, the response measured by the percentage of +holders participating was not as good. The reason may well be +the large number of new shareholders acquired through the merger +and their lack of familiarity with the program. We urge new +shareholders to read the description of the program on pages 52- +53. + + If you wish to participate in future programs, we strongly +urge that you immediately make sure that your shares are +registered in the actual owner’s name, not in “street” or nominee +name. Shares not so registered on September 28, 1984 will not be +eligible for any 1984 program. + + * * * * * + + The Blue Chip/Berkshire merger went off without a hitch. +Less than one-tenth of 1% of the shares of each company voted +against the merger, and no requests for appraisal were made. In +1983, we gained some tax efficiency from the merger and we expect +to gain more in the future. + + One interesting sidelight to the merger: Berkshire now has +1,146,909 shares outstanding compared to 1,137,778 shares at the +beginning of fiscal 1965, the year present management assumed +responsibility. For every 1% of the company you owned at that +time, you now would own .99%. Thus, all of today’s assets - the +News, See’s, Nebraska Furniture Mart, the Insurance Group, $1.3 +billion in marketable stocks, etc. - have been added to the +original textile assets with virtually no net dilution to the +original owners. + + We are delighted to have the former Blue Chip shareholders +join us. To aid in your understanding of Berkshire Hathaway, we +will be glad to send you the Compendium of Letters from the +Annual Reports of 1977-1981, and/or the 1982 Annual report. +Direct your request to the Company at 1440 Kiewit Plaza, Omaha, +Nebraska 68131. + + + Warren E. Buffett +March 14, 1984 Chairman of the Board + ++ + + +
Appendix
+ +BERKSHIRE HATHAWAY INC.
+ ++
Goodwill and its Amortization: The Rules and The Realities
+ +This appendix deals only with economic and accounting Goodwill – not the goodwill of everyday usage. For example, a business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before the breakup, was generally well thought of, but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked by its customers but possess substantial, and growing, economic Goodwill. So, just for the moment, forget emotions and focus only on economics and accounting.
+ +When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired. Frequently the sum of the fair values put on the assets (after the deduction of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account entitled "excess of cost over equity in net assets acquired". To avoid constant repetition of this mouthful, we will substitute "Goodwill".
+ +Accounting Goodwill arising from businesses purchased before November 1970 has a special standing. Except under rare circumstances, it can remain an asset on the balance sheet as long as the business bought is retained. That means no amortization charges to gradually extinguish that asset need be made against earnings.
+ +The case is different, however, with purchases made from November 1970 on. When these create Goodwill, it must be amortized over not more than 40 years through charges – of equal amount in every year – to the earnings account. Since 40 years is the maximum period allowed, 40 years is what managements (including us) usually elect. This annual charge to earnings is not allowed as a tax deduction and, thus, has an effect on after-tax income that is roughly double that of most other expenses.
+ +That’s how accounting Goodwill works. To see how it differs from economic reality, let’s look at an example close at hand. We’ll round some figures, and greatly oversimplify, to make the example easier to follow. We’ll also mention some implications for investors and managers.
+ +Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars.
+ +Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.
+ +In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.
+ +Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.
+ +Let’s return to the accounting in the See’s example. Blue Chip’s purchase of See’s at $17 million over net tangible assets required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that $425,000 be charged to income annually for 40 years to amortize that asset. By 1983, after 11 years of such charges, the $17 million had been reduced to about $12.5 million. Berkshire, meanwhile, owned 60% of Blue Chip and, therefore, also 60% of See’s. This ownership meant that Berkshire’s balance sheet reflected 60% of See’s Goodwill, or about $7.5 million.
+ +In 1983 Berkshire acquired the rest of Blue Chip in a merger that required purchase accounting as contrasted to the "pooling" treatment allowed for some mergers. Under purchase accounting, the "fair value" of the shares we gave to (or "paid") Blue Chip holders had to be spread over the net assets acquired from Blue Chip. This "fair value" was measured, as it almost always is when public companies use their shares to make acquisitions, by the market value of the shares given up.
+ +The assets "purchased" consisted of 40% of everything owned by Blue Chip (as noted, Berkshire already owned the other 60%). What Berkshire "paid" was more than the net identifiable assets we received by $51.7 million, and was assigned to two pieces of Goodwill: $28.4 million to See’s and $23.3 million to Buffalo Evening News.
+ +After the merger, therefore, Berkshire was left with a Goodwill asset for See’s that had two components: the $7.5 million remaining from the 1971 purchase, and $28.4 million newly created by the 40% "purchased" in 1983. Our amortization charge now will be about $1.0 million for the next 28 years, and $.7 million for the following 12 years, 2002 through 2013.
+ +In other words, different purchase dates and prices have given us vastly different asset values and amortization charges for two pieces of the same asset. (We repeat our usual disclaimer: we have no better accounting system to suggest. The problems to be dealt with are mind boggling and require arbitrary rules.)
+ +But what are the economic realities? One reality is that the amortization charges that have been deducted as costs in the earnings statement each year since acquisition of See’s were not true economic costs. We know that because See’s last year earned $13 million after taxes on about $20 million of net tangible assets – a performance indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill. In other words, while accounting Goodwill regularly decreased from the moment of purchase, economic Goodwill increased in irregular but very substantial fashion.
+ +Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation.
+ +That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.
+ ++
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in "honest-to-God" assets. Could less really have been more, as our purchase price implied? The answer is "yes" – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.
+ +To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.
+ +But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.
+ +Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.
+ +After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)
+ +See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.
+ +Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.
+ +And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.
+ +In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.
+ ++
But that statement applies, naturally, only to true economic Goodwill. Spurious accounting Goodwill – and there is plenty of it around – is another matter. When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled "No-Will". Whatever the term, the 40-year ritual typically is observed and the adrenalin so capitalized remains on the books as an "asset" just as if the acquisition had been a sensible one.
+ +* * * * *
+If you cling to any belief that accounting treatment of Goodwill is the best measure of economic reality, I suggest one final item to ponder.
+ +Assume a company with $20 per share of net worth, all tangible assets. Further assume the company has internally developed some magnificent consumer franchise, or that it was fortunate enough to obtain some important television stations by original FCC grant. Therefore, it earns a great deal on tangible assets, say $5 per share, or 25%.
+ +With such economics, it might sell for $100 per share or more, and it might well also bring that price in a negotiated sale of the entire business.
+ +Assume an investor buys the stock at $100 per share, paying in effect $80 per share for Goodwill (just as would a corporate purchaser buying the whole company). Should the investor impute a $2 per share amortization charge annually ($80 divided by 40 years) to calculate "true" earnings per share? And, if so, should the new "true" earnings of $3 per share cause him to rethink his purchase price?
+ +* * * * *
+We believe managers and investors alike should view intangible assets from two perspectives:
+ +Operations that appear to be winners based upon perspective (1) may pale when viewed from perspective (2). A good business is not always a good purchase – although it’s a good place to look for one.
+ ++ +
+
We will try to acquire businesses that have excellent operating economics measured by (1) and that provide reasonable returns measured by (2). Accounting consequences will be totally ignored.
+ +At yearend 1983, net Goodwill on our accounting books totaled $62 million, consisting of the $79 million you see stated on the asset side of our balance sheet, and $17 million of negative Goodwill that is offset against the carrying value of our interest in Mutual Savings and Loan.
+ +We believe net economic Goodwill far exceeds the $62 million accounting number.
+ +_____________ + diff --git a/berkshire-hathaway/1984/1-in/berkshire-hathaway-1984-letter.txt b/berkshire-hathaway/1984/1-in/berkshire-hathaway-1984-letter.txt new file mode 100644 index 0000000..369428e --- /dev/null +++ b/berkshire-hathaway/1984/1-in/berkshire-hathaway-1984-letter.txt @@ -0,0 +1,1537 @@ + + + + + ++BERKSHIRE HATHAWAY INC. +
+ ++ + +To the Shareholders of Berkshire Hathaway Inc.: + + Our gain in net worth during 1984 was $152.6 million, or +$133 per share. This sounds pretty good but actually it’s +mediocre. Economic gains must be evaluated by comparison with +the capital that produces them. Our twenty-year compounded +annual gain in book value has been 22.1% (from $19.46 in 1964 to +$1108.77 in 1984), but our gain in 1984 was only 13.6%. + + As we discussed last year, the gain in per-share intrinsic +business value is the economic measurement that really counts. +But calculations of intrinsic business value are subjective. In +our case, book value serves as a useful, although somewhat +understated, proxy. In my judgment, intrinsic business value and +book value increased during 1984 at about the same rate. + + Using my academic voice, I have told you in the past of the +drag that a mushrooming capital base exerts upon rates of return. +Unfortunately, my academic voice is now giving way to a +reportorial voice. Our historical 22% rate is just that - +history. To earn even 15% annually over the next decade +(assuming we continue to follow our present dividend policy, +about which more will be said later in this letter) we would need +profits aggregating about $3.9 billion. Accomplishing this will +require a few big ideas - small ones just won’t do. Charlie +Munger, my partner in general management, and I do not have any +such ideas at present, but our experience has been that they pop +up occasionally. (How’s that for a strategic plan?) + +Sources of Reported Earnings + + The table on the following page shows the sources of +Berkshire’s reported earnings. Berkshire’s net ownership +interest in many of the constituent businesses changed at midyear +1983 when the Blue Chip merger took place. Because of these +changes, the first two columns of the table provide the best +measure of underlying business performance. + + All of the significant gains and losses attributable to +unusual sales of assets by any of the business entities are +aggregated with securities transactions on the line near the +bottom of the table, and are not included in operating earnings. +(We regard any annual figure for realized capital gains or losses +as meaningless, but we regard the aggregate realized and +unrealized capital gains over a period of years as very +important.) + + Furthermore, amortization of Goodwill is not charged against +the specific businesses but, for reasons outlined in the Appendix +to my letter in the 1983 annual report, is set forth as a +separate item. + + (000s omitted) + ---------------------------------------------------------- + Net Earnings + Earnings Before Income Taxes After Tax + -------------------------------------- ------------------ + Total Berkshire Share Berkshire Share + ------------------ ------------------ ------------------ + 1984 1983 1984 1983 1984 1983 + -------- -------- -------- -------- -------- -------- +Operating Earnings: + Insurance Group: + Underwriting ............ $(48,060) $(33,872) $(48,060) $(33,872) $(25,955) $(18,400) + Net Investment Income ... 68,903 43,810 68,903 43,810 62,059 39,114 + Buffalo News .............. 27,328 19,352 27,328 16,547 13,317 8,832 + Nebraska Furniture Mart(1) 14,511 3,812 11,609 3,049 5,917 1,521 + See’s Candies ............. 26,644 27,411 26,644 24,526 13,380 12,212 + Associated Retail Stores .. (1,072) 697 (1,072) 697 (579) 355 + Blue Chip Stamps(2) (1,843) (1,422) (1,843) (1,876) (899) (353) + Mutual Savings and Loan ... 1,456 (798) 1,166 (467) 3,151 1,917 + Precision Steel ........... 4,092 3,241 3,278 2,102 1,696 1,136 + Textiles .................. 418 (100) 418 (100) 226 (63) + Wesco Financial ........... 9,777 7,493 7,831 4,844 4,828 3,448 + Amortization of Goodwill .. (1,434) (532) (1,434) (563) (1,434) (563) + Interest on Debt .......... (14,734) (15,104) (14,097) (13,844) (7,452) (7,346) + Shareholder-Designated + Contributions .......... (3,179) (3,066) (3,179) (3,066) (1,716) (1,656) + Other ..................... 4,932 10,121 4,529 9,623 3,476 8,490 + -------- -------- -------- -------- -------- -------- +Operating Earnings .......... 87,739 61,043 82,021 51,410 70,015 48,644 +Special GEICO Distribution .. -- 19,575 -- 19,575 -- 18,224 +Special Gen. Foods Distribution 8,111 -- 7,896 -- 7,294 -- +Sales of securities and + unusual sales of assets .. 104,699 67,260 101,376 65,089 71,587 45,298 + -------- -------- -------- -------- -------- -------- +Total Earnings - all entities $200,549 $147,878 $191,293 $136,074 $148,896 $112,166 + ======== ======== ======== ======== ======== ======== + +(1) 1983 figures are those for October through December. +(2) 1984 and 1983 are not comparable; major assets were + transferred in the mid-year 1983 merger of Blue Chip Stamps. + + Sharp-eyed shareholders will notice that the amount of the +special GEICO distribution and its location in the table have +been changed from the presentation of last year. Though they +reclassify and reduce “accounting” earnings, the changes are +entirely of form, not of substance. The story behind the +changes, however, is interesting. + + As reported last year: (1) in mid-1983 GEICO made a tender +offer to buy its own shares; (2) at the same time, we agreed by +written contract to sell GEICO an amount of its shares that would +be proportionately related to the aggregate number of shares +GEICO repurchased via the tender from all other shareholders; (3) +at completion of the tender, we delivered 350,000 shares to +GEICO, received $21 million cash, and were left owning exactly +the same percentage of GEICO that we owned before the tender; (4) +GEICO’s transaction with us amounted to a proportionate +redemption, an opinion rendered us, without qualification, by a +leading law firm; (5) the Tax Code logically regards such +proportionate redemptions as substantially equivalent to +dividends and, therefore, the $21 million we received was taxed +at only the 6.9% inter-corporate dividend rate; (6) importantly, +that $21 million was far less than the previously-undistributed +earnings that had inured to our ownership in GEICO and, thus, +from the standpoint of economic substance, was in our view +equivalent to a dividend. + + Because it was material and unusual, we highlighted the +GEICO distribution last year to you, both in the applicable +quarterly report and in this section of the annual report. +Additionally, we emphasized the transaction to our auditors, +Peat, Marwick, Mitchell & Co. Both the Omaha office of Peat +Marwick and the reviewing Chicago partner, without objection, +concurred with our dividend presentation. + + In 1984, we had a virtually identical transaction with +General Foods. The only difference was that General Foods +repurchased its stock over a period of time in the open market, +whereas GEICO had made a “one-shot” tender offer. In the General +Foods case we sold to the company, on each day that it +repurchased shares, a quantity of shares that left our ownership +percentage precisely unchanged. Again our transaction was +pursuant to a written contract executed before repurchases began. +And again the money we received was far less than the retained +earnings that had inured to our ownership interest since our +purchase. Overall we received $21,843,601 in cash from General +Foods, and our ownership remained at exactly 8.75%. + + At this point the New York office of Peat Marwick came into +the picture. Late in 1984 it indicated that it disagreed with +the conclusions of the firm’s Omaha office and Chicago reviewing +partner. The New York view was that the GEICO and General Foods +transactions should be treated as sales of stock by Berkshire +rather than as the receipt of dividends. Under this accounting +approach, a portion of the cost of our investment in the stock of +each company would be charged against the redemption payment and +any gain would be shown as a capital gain, not as dividend +income. This is an accounting approach only, having no bearing +on taxes: Peat Marwick agrees that the transactions were +dividends for IRS purposes. + + We disagree with the New York position from both the +viewpoint of economic substance and proper accounting. But, to +avoid a qualified auditor’s opinion, we have adopted herein Peat +Marwick’s 1984 view and restated 1983 accordingly. None of this, +however, has any effect on intrinsic business value: our +ownership interests in GEICO and General Foods, our cash, our +taxes, and the market value and tax basis of our holdings all +remain the same. + + This year we have again entered into a contract with General +Foods whereby we will sell them shares concurrently with open +market purchases that they make. The arrangement provides that +our ownership interest will remain unchanged at all times. By +keeping it so, we will insure ourselves dividend treatment for +tax purposes. In our view also, the economic substance of this +transaction again is the creation of dividend income. However, +we will account for the redemptions as sales of stock rather than +dividend income unless accounting rules are adopted that speak +directly to this point. We will continue to prominently identify +any such special transactions in our reports to you. + + While we enjoy a low tax charge on these proportionate +redemptions, and have participated in several of them, we view +such repurchases as at least equally favorable for shareholders +who do not sell. When companies with outstanding businesses and +comfortable financial positions find their shares selling far +below intrinsic value in the marketplace, no alternative action +can benefit shareholders as surely as repurchases. + + (Our endorsement of repurchases is limited to those dictated +by price/value relationships and does not extend to the +“greenmail” repurchase - a practice we find odious and repugnant. +In these transactions, two parties achieve their personal ends by +exploitation of an innocent and unconsulted third party. The +players are: (1) the “shareholder” extortionist who, even before +the ink on his stock certificate dries, delivers his “your- +money-or-your-life” message to managers; (2) the corporate +insiders who quickly seek peace at any price - as long as the +price is paid by someone else; and (3) the shareholders whose +money is used by (2) to make (1) go away. As the dust settles, +the mugging, transient shareholder gives his speech on “free +enterprise”, the muggee management gives its speech on “the best +interests of the company”, and the innocent shareholder standing +by mutely funds the payoff.) + + The companies in which we have our largest investments have +all engaged in significant stock repurhases at times when wide +discrepancies existed between price and value. As shareholders, +we find this encouraging and rewarding for two important reasons +- one that is obvious, and one that is subtle and not always +understood. The obvious point involves basic arithmetic: major +repurchases at prices well below per-share intrinsic business +value immediately increase, in a highly significant way, that +value. When companies purchase their own stock, they often find +it easy to get $2 of present value for $1. Corporate acquisition +programs almost never do as well and, in a discouragingly large +number of cases, fail to get anything close to $1 of value for +each $1 expended. + + The other benefit of repurchases is less subject to precise +measurement but can be fully as important over time. By making +repurchases when a company’s market value is well below its +business value, management clearly demonstrates that it is given +to actions that enhance the wealth of shareholders, rather than +to actions that expand management’s domain but that do nothing +for (or even harm) shareholders. Seeing this, shareholders and +potential shareholders increase their estimates of future returns +from the business. This upward revision, in turn, produces +market prices more in line with intrinsic business value. These +prices are entirely rational. Investors should pay more for a +business that is lodged in the hands of a manager with +demonstrated pro-shareholder leanings than for one in the hands +of a self-interested manager marching to a different drummer. (To +make the point extreme, how much would you pay to be a minority +shareholder of a company controlled by Robert Wesco?) + + The key word is “demonstrated”. A manager who consistently +turns his back on repurchases, when these clearly are in the +interests of owners, reveals more than he knows of his +motivations. No matter how often or how eloquently he mouths +some public relations-inspired phrase such as “maximizing +shareholder wealth” (this season’s favorite), the market +correctly discounts assets lodged with him. His heart is not +listening to his mouth - and, after a while, neither will the +market. + + We have prospered in a very major way - as have other +shareholders - by the large share repurchases of GEICO, +Washington Post, and General Foods, our three largest holdings. +(Exxon, in which we have our fourth largest holding, has also +wisely and aggressively repurchased shares but, in this case, we +have only recently established our position.) In each of these +companies, shareholders have had their interests in outstanding +businesses materially enhanced by repurchases made at bargain +prices. We feel very comfortable owning interests in businesses +such as these that offer excellent economics combined with +shareholder-conscious managements. + + The following table shows our 1984 yearend net holdings in +marketable equities. All numbers exclude the interests +attributable to minority shareholders of Wesco and Nebraska +Furniture Mart. + + +No. of Shares Cost Market +------------- ---------- ---------- + (000s omitted) + 690,975 Affiliated Publications, Inc. ....... $ 3,516 $ 32,908 + 740,400 American Broadcasting Companies, Inc. 44,416 46,738 + 3,895,710 Exxon Corporation ................... 173,401 175,307 + 4,047,191 General Foods Corporation ........... 149,870 226,137 + 6,850,000 GEICO Corporation ................... 45,713 397,300 + 2,379,200 Handy & Harman ...................... 27,318 38,662 + 818,872 Interpublic Group of Companies, Inc. 2,570 28,149 + 555,949 Northwest Industries 26,581 27,242 + 2,553,488 Time, Inc. .......................... 89,327 109,162 + 1,868,600 The Washington Post Company ......... 10,628 149,955 + ---------- ---------- + $573,340 $1,231,560 + All Other Common Stockholdings 11,634 37,326 + ---------- ---------- + Total Common Stocks $584,974 $1,268,886 + ========== ========== + + It’s been over ten years since it has been as difficult as +now to find equity investments that meet both our qualitative +standards and our quantitative standards of value versus price. +We try to avoid compromise of these standards, although we find +doing nothing the most difficult task of all. (One English +statesman attributed his country’s greatness in the nineteenth +century to a policy of “masterly inactivity”. This is a strategy +that is far easier for historians to commend than for +participants to follow.) + + In addition to the figures supplied at the beginning of this +section, information regarding the businesses we own appears in +Management’s Discussion on pages 42-47. An amplified discussion +of Wesco’s businesses appears in Charlie Munger’s report on pages +50-59. You will find particularly interesting his comments about +conditions in the thrift industry. Our other major controlled +businesses are Nebraska Furniture Mart, See’s, Buffalo Evening +News, and the Insurance Group, to which we will give some special +attention here. + +Nebraska Furniture Mart + + Last year I introduced you to Mrs. B (Rose Blumkin) and her +family. I told you they were terrific, and I understated the +case. After another year of observing their remarkable talents +and character, I can honestly say that I never have seen a +managerial group that either functions or behaves better than the +Blumkin family. + + Mrs. B, Chairman of the Board, is now 91, and recently was +quoted in the local newspaper as saying, “I come home to eat and +sleep, and that’s about it. I can’t wait until it gets daylight +so I can get back to the business”. Mrs. B is at the store seven +days a week, from opening to close, and probably makes more +decisions in a day than most CEOs do in a year (better ones, +too). + + In May Mrs. B was granted an Honorary Doctorate in +Commercial Science by New York University. (She’s a “fast track” +student: not one day in her life was spent in a school room prior +to her receipt of the doctorate.) Previous recipients of honorary +degrees in business from NYU include Clifton Garvin, Jr., CEO of +Exxon Corp.; Walter Wriston, then CEO of Citicorp; Frank Cary, +then CEO of IBM; Tom Murphy, then CEO of General Motors; and, +most recently, Paul Volcker. (They are in good company.) + + The Blumkin blood did not run thin. Louie, Mrs. B’s son, +and his three boys, Ron, Irv, and Steve, all contribute in full +measure to NFM’s amazing success. The younger generation has +attended the best business school of them all - that conducted by +Mrs. B and Louie - and their training is evident in their +performance. + + Last year NFM’s net sales increased by $14.3 million, +bringing the total to $115 million, all from the one store in +Omaha. That is by far the largest volume produced by a single +home furnishings store in the United States. In fact, the gain +in sales last year was itself greater than the annual volume of +many good-sized successful stores. The business achieves this +success because it deserves this success. A few figures will +tell you why. + + In its fiscal 1984 10-K, the largest independent specialty +retailer of home furnishings in the country, Levitz Furniture, +described its prices as “generally lower than the prices charged +by conventional furniture stores in its trading area”. Levitz, +in that year, operated at a gross margin of 44.4% (that is, on +average, customers paid it $100 for merchandise that had cost it +$55.60 to buy). The gross margin at NFM is not much more than +half of that. NFM’s low mark-ups are possible because of its +exceptional efficiency: operating expenses (payroll, occupancy, +advertising, etc.) are about 16.5% of sales versus 35.6% at +Levitz. + + None of this is in criticism of Levitz, which has a well- +managed operation. But the NFM operation is simply extraordinary +(and, remember, it all comes from a $500 investment by Mrs. B in +1937). By unparalleled efficiency and astute volume purchasing, +NFM is able to earn excellent returns on capital while saving its +customers at least $30 million annually from what, on average, it +would cost them to buy the same merchandise at stores maintaining +typical mark-ups. Such savings enable NFM to constantly widen +its geographical reach and thus to enjoy growth well beyond the +natural growth of the Omaha market. + + I have been asked by a number of people just what secrets +the Blumkins bring to their business. These are not very +esoteric. All members of the family: (1) apply themselves with +an enthusiasm and energy that would make Ben Franklin and Horatio +Alger look like dropouts; (2) define with extraordinary realism +their area of special competence and act decisively on all +matters within it; (3) ignore even the most enticing propositions +failing outside of that area of special competence; and, (4) +unfailingly behave in a high-grade manner with everyone they deal +with. (Mrs. B boils it down to “sell cheap and tell the truth”.) + + Our evaluation of the integrity of Mrs. B and her family was +demonstrated when we purchased 90% of the business: NFM had never +had an audit and we did not request one; we did not take an +inventory nor verify the receivables; we did not check property +titles. We gave Mrs. B a check for $55 million and she gave us +her word. That made for an even exchange. + + You and I are fortunate to be in partnership with the +Blumkin family. + +See’s Candy Shops, Inc. + + Below is our usual recap of See’s performance since the time +of purchase by Blue Chip Stamps: + + 52-53 Week Year Operating Number of Number of + Ended About Sales Profits Pounds of Stores Open + December 31 Revenues After Taxes Candy Sold at Year End +------------------- ------------ ----------- ---------- ----------- +1984 .............. $135,946,000 $13,380,000 24,759,000 214 +1983 (53 weeks) ... 133,531,000 13,699,000 24,651,000 207 +1982 .............. 123,662,000 11,875,000 24,216,000 202 +1981 .............. 112,578,000 10,779,000 24,052,000 199 +1980 .............. 97,715,000 7,547,000 24,065,000 191 +1979 .............. 87,314,000 6,330,000 23,985,000 188 +1978 .............. 73,653,000 6,178,000 22,407,000 182 +1977 .............. 62,886,000 6,154,000 20,921,000 179 +1976 (53 weeks) ... 56,333,000 5,569,000 20,553,000 173 +1975 .............. 50,492,000 5,132,000 19,134,000 172 +1974 .............. 41,248,000 3,021,000 17,883,000 170 +1973 .............. 35,050,000 1,940,000 17,813,000 169 +1972 .............. 31,337,000 2,083,000 16,954,000 167 + + This performance has not been produced by a generally rising +tide. To the contrary, many well-known participants in the +boxed-chocolate industry either have lost money in this same +period or have been marginally profitable. To our knowledge, +only one good-sized competitor has achieved high profitability. +The success of See’s reflects the combination of an exceptional +product and an exceptional manager, Chuck Huggins. + + During 1984 we increased prices considerably less than has +been our practice in recent years: per-pound realization was +$5.49, up only 1.4% from 1983. Fortunately, we made good +progress on cost control, an area that has caused us problems in +recent years. Per-pound costs - other than those for raw +materials, a segment of expense largely outside of our control - +increased by only 2.2% last year. + + Our cost-control problem has been exacerbated by the problem +of modestly declining volume (measured by pounds, not dollars) on +a same-store basis. Total pounds sold through shops in recent +years has been maintained at a roughly constant level only by the +net addition of a few shops annually. This more-shops-to-get- +the-same-volume situation naturally puts heavy pressure on per- +pound selling costs. + + In 1984, same-store volume declined 1.1%. Total shop volume, +however, grew 0.6% because of an increase in stores. (Both +percentages are adjusted to compensate for a 53-week fiscal year +in 1983.) + + See’s business tends to get a bit more seasonal each year. +In the four weeks prior to Christmas, we do 40% of the year’s +volume and earn about 75% of the year’s profits. We also earn +significant sums in the Easter and Valentine’s Day periods, but +pretty much tread water the rest of the year. In recent years, +shop volume at Christmas has grown in relative importance, and so +have quantity orders and mail orders. The increased +concentration of business in the Christmas period produces a +multitude of managerial problems, all of which have been handled +by Chuck and his associates with exceptional skill and grace. + + Their solutions have in no way involved compromises in +either quality of service or quality of product. Most of our +larger competitors could not say the same. Though faced with +somewhat less extreme peaks and valleys in demand than we, they +add preservatives or freeze the finished product in order to +smooth the production cycle and thereby lower unit costs. We +reject such techniques, opting, in effect, for production +headaches rather than product modification. + + Our mall stores face a host of new food and snack vendors +that provide particularly strong competition at non-holiday +periods. We need new products to fight back and during 1984 we +introduced six candy bars that, overall, met with a good +reception. Further product introductions are planned. + + In 1985 we will intensify our efforts to keep per-pound cost +increases below the rate of inflation. Continued success in +these efforts, however, will require gains in same-store +poundage. Prices in 1985 should average 6% - 7% above those of +1984. Assuming no change in same-store volume, profits should +show a moderate gain. + +Buffalo Evening News + + Profits at the News in 1984 were considerably greater than +we expected. As at See’s, excellent progress was made in +controlling costs. Excluding hours worked in the newsroom, total +hours worked decreased by about 2.8%. With this productivity +improvement, overall costs increased only 4.9%. This performance +by Stan Lipsey and his management team was one of the best in the +industry. + + However, we now face an acceleration in costs. In mid-1984 +we entered into new multi-year union contracts that provided for +a large “catch-up” wage increase. This catch-up is entirely +appropriate: the cooperative spirit of our unions during the +unprofitable 1977-1982 period was an important factor in our +success in remaining cost competitive with The Courier-Express. +Had we not kept costs down, the outcome of that struggle might +well have been different. + + Because our new union contracts took effect at varying +dates, little of the catch-up increase was reflected in our 1984 +costs. But the increase will be almost totally effective in 1985 +and, therefore, our unit labor costs will rise this year at a +rate considerably greater than that of the industry. We expect +to mitigate this increase by continued small gains in +productivity, but we cannot avoid significantly higher wage costs +this year. Newsprint price trends also are less favorable now +than they were in 1984. Primarily because of these two factors, +we expect at least a minor contraction in margins at the News. + + Working in our favor at the News are two factors of major +economic importance: + + (1) Our circulation is concentrated to an unusual degree + in the area of maximum utility to our advertisers. + “Regional” newspapers with wide-ranging circulation, on + the other hand, have a significant portion of their + circulation in areas that are of negligible utility to + most advertisers. A subscriber several hundred miles + away is not much of a prospect for the puppy you are + offering to sell via a classified ad - nor for the + grocer with stores only in the metropolitan area. + “Wasted” circulation - as the advertisers call it - + hurts profitability: expenses of a newspaper are + determined largely by gross circulation while + advertising revenues (usually 70% - 80% of total + revenues) are responsive only to useful circulation; + + (2) Our penetration of the Buffalo retail market is + exceptional; advertisers can reach almost all of their + potential customers using only the News. + + Last year I told you about this unusual reader acceptance: +among the 100 largest newspapers in the country, we were then +number one, daily, and number three, Sunday, in penetration. The +most recent figures show us number one in penetration on weekdays +and number two on Sunday. (Even so, the number of households in +Buffalo has declined, so our current weekday circulation is down +slightly; on Sundays it is unchanged.) + + I told you also that one of the major reasons for this +unusual acceptance by readers was the unusual quantity of news +that we delivered to them: a greater percentage of our paper is +devoted to news than is the case at any other dominant paper in +our size range. In 1984 our “news hole” ratio was 50.9%, (versus +50.4% in 1983), a level far above the typical 35% - 40%. We will +continue to maintain this ratio in the 50% area. Also, though we +last year reduced total hours worked in other departments, we +maintained the level of employment in the newsroom and, again, +will continue to do so. Newsroom costs advanced 9.1% in 1984, a +rise far exceeding our overall cost increase of 4.9%. + + Our news hole policy costs us significant extra money for +newsprint. As a result, our news costs (newsprint for the news +hole plus payroll and expenses of the newsroom) as a percentage +of revenue run higher than those of most dominant papers of our +size. There is adequate room, however, for our paper or any +other dominant paper to sustain these costs: the difference +between “high” and “low” news costs at papers of comparable size +runs perhaps three percentage points while pre-tax profit margins +are often ten times that amount. + + The economics of a dominant newspaper are excellent, among +the very best in the business world. Owners, naturally, would +like to believe that their wonderful profitability is achieved +only because they unfailingly turn out a wonderful product. That +comfortable theory wilts before an uncomfortable fact. While +first-class newspapers make excellent profits, the profits of +third-rate papers are as good or better - as long as either class +of paper is dominant within its community. Of course, product +quality may have been crucial to the paper in achieving +dominance. We believe this was the case at the News, in very +large part because of people such as Alfred Kirchhofer who +preceded us. + + Once dominant, the newspaper itself, not the marketplace, +determines just how good or how bad the paper will be. Good or +bad, it will prosper. That is not true of most businesses: +inferior quality generally produces inferior economics. But even +a poor newspaper is a bargain to most citizens simply because of +its “bulletin board” value. Other things being equal, a poor +product will not achieve quite the level of readership achieved +by a first-class product. A poor product, however, will still +remain essential to most citizens, and what commands their +attention will command the attention of advertisers. + + Since high standards are not imposed by the marketplace, +management must impose its own. Our commitment to an above- +average expenditure for news represents an important quantitative +standard. We have confidence that Stan Lipsey and Murray Light +will continue to apply the far-more important qualitative +standards. Charlie and I believe that newspapers are very +special institutions in society. We are proud of the News, and +intend an even greater pride to be justified in the years ahead. + +Insurance Operations + + Shown below is an updated version of our usual table listing +two key figures for the insurance industry: + + Yearly Change Combined Ratio + in Premiums after Policy-holder + Written (%) Dividends + ------------- ------------------- +1972 .............................. 10.2 96.2 +1973 .............................. 8.0 99.2 +1974 .............................. 6.2 105.4 +1975 .............................. 11.0 107.9 +1976 .............................. 21.9 102.4 +1977 .............................. 19.8 97.2 +1978 .............................. 12.8 97.5 +1979 .............................. 10.3 100.6 +1980 .............................. 6.0 103.1 +1981 .............................. 3.9 106.0 +1982 .............................. 4.4 109.7 +1983 (Revised) .................... 4.5 111.9 +1984 (Estimated) .................. 8.1 117.7 +Source: Best’s Aggregates and Averages + + Best’s data reflect the experience of practically the entire +industry, including stock, mutual, and reciprocal companies. The +combined ratio represents total insurance costs (losses incurred +plus expenses) compared to revenue from premiums; a ratio below +100 indicates an underwriting profit, and one above 100 indicates +a loss. + + For a number of years, we have told you that an annual +increase by the industry of about 10% per year in premiums +written is necessary for the combined ratio to remain roughly +unchanged. We assumed in making that assertion that expenses as +a percentage of premium volume would stay relatively stable and +that losses would grow at about 10% annually because of the +combined influence of unit volume increases, inflation, and +judicial rulings that expand what is covered by the insurance +policy. + + Our opinion is proving dismayingly accurate: a premium +increase of 10% per year since 1979 would have produced an +aggregate increase through 1984 of 61% and a combined ratio in +1984 almost identical to the 100.6 of 1979. Instead, the +industry had only a 30% increase in premiums and a 1984 combined +ratio of 117.7. Today, we continue to believe that the key index +to the trend of underwriting profitability is the year-to-year +percentage change in industry premium volume. + + It now appears that premium volume in 1985 will grow well +over 10%. Therefore, assuming that catastrophes are at a +“normal” level, we would expect the combined ratio to begin +easing downward toward the end of the year. However, under our +industrywide loss assumptions (i.e., increases of 10% annually), +five years of 15%-per-year increases in premiums would be +required to get the combined ratio back to 100. This would mean +a doubling of industry volume by 1989, an outcome that seems +highly unlikely to us. Instead, we expect several years of +premium gains somewhat above the 10% level, followed by highly- +competitive pricing that generally will produce combined ratios +in the 108-113 range. + + Our own combined ratio in 1984 was a humbling 134. (Here, as +throughout this report, we exclude structured settlements and the +assumption of loss reserves in reporting this ratio. Much +additional detail, including the effect of discontinued +operations on the ratio, appears on pages 42-43). This is the +third year in a row that our underwriting performance has been +far poorer than that of the industry. We expect an improvement +in the combined ratio in 1985, and also expect our improvement to +be substantially greater than that of the industry. Mike +Goldberg has corrected many of the mistakes I made before he took +over insurance operations. Moreover, our business is +concentrated in lines that have experienced poorer-than-average +results during the past several years, and that circumstance has +begun to subdue many of our competitors and even eliminate some. +With the competition shaken, we were able during the last half of +1984 to raise prices significantly in certain important lines +with little loss of business. + + For some years I have told you that there could be a day +coming when our premier financial strength would make a real +difference in the competitive position of our insurance +operation. That day may have arrived. We are almost without +question the strongest property/casualty insurance operation in +the country, with a capital position far superior to that of +well-known companies of much greater size. + + Equally important, our corporate policy is to retain that +superiority. The buyer of insurance receives only a promise in +exchange for his cash. The value of that promise should be +appraised against the possibility of adversity, not prosperity. +At a minimum, the promise should appear able to withstand a +prolonged combination of depressed financial markets and +exceptionally unfavorable underwriting results. Our insurance +subsidiaries are both willing and able to keep their promises in +any such environment - and not too many other companies clearly +are. + + Our financial strength is a particular asset in the business +of structured settlements and loss reserve assumptions that we +reported on last year. The claimant in a structured settlement +and the insurance company that has reinsured loss reserves need +to be completely confident that payments will be forthcoming for +decades to come. Very few companies in the property/casualty +field can meet this test of unquestioned long-term strength. (In +fact, only a handful of companies exists with which we will +reinsure our own liabilities.) + + We have grown in these new lines of business: funds that we +hold to offset assumed liabilities grew from $16.2 million to +$30.6 million during the year. We expect growth to continue and +perhaps to greatly accelerate. To support this projected growth +we have added substantially to the capital of Columbia Insurance +Company, our reinsurance unit specializing in structured +settlements and loss reserve assumptions. While these businesses +are very competitive, returns should be satisfactory. + + At GEICO the news, as usual, is mostly good. That company +achieved excellent unit growth in its primary insurance business +during 1984, and the performance of its investment portfolio +continued to be extraordinary. Though underwriting results +deteriorated late in the year, they still remain far better than +those of the industry. Our ownership in GEICO at yearend +amounted to 36% and thus our interest in their direct +property/casualty volume of $885 million amounted to $320 +million, or well over double our own premium volume. + + I have reported to you in the past few years that the +performance of GEICO’s stock has considerably exceeded that +company’s business performance, brilliant as the latter has been. +In those years, the carrying value of our GEICO investment on our +balance sheet grew at a rate greater than the growth in GEICO’s +intrinsic business value. I warned you that over performance by +the stock relative to the performance of the business obviously +could not occur every year, and that in some years the stock must +under perform the business. In 1984 that occurred and the +carrying value of our interest in GEICO changed hardly at all, +while the intrinsic business value of that interest increased +substantially. Since 27% of Berkshire’s net worth at the +beginning of 1984 was represented by GEICO, its static market +value had a significant impact upon our rate of gain for the +year. We are not at all unhappy with such a result: we would far +rather have the business value of GEICO increase by X during the +year, while market value decreases, than have the intrinsic value +increase by only 1/2 X with market value soaring. In GEICO’s +case, as in all of our investments, we look to business +performance, not market performance. If we are correct in +expectations regarding the business, the market eventually will +follow along. + + You, as shareholders of Berkshire, have benefited in +enormous measure from the talents of GEICO’s Jack Byrne, Bill +Snyder, and Lou Simpson. In its core business - low-cost auto +and homeowners insurance - GEICO has a major, sustainable +competitive advantage. That is a rare asset in business +generally, and it’s almost non-existent in the field of financial +services. (GEICO, itself, illustrates this point: despite the +company’s excellent management, superior profitability has eluded +GEICO in all endeavors other than its core business.) In a large +industry, a competitive advantage such as GEICO’s provides the +potential for unusual economic rewards, and Jack and Bill +continue to exhibit great skill in realizing that potential. + + Most of the funds generated by GEICO’s core insurance +operation are made available to Lou for investment. Lou has the +rare combination of temperamental and intellectual +characteristics that produce outstanding long-term investment +performance. Operating with below-average risk, he has generated +returns that have been by far the best in the insurance industry. +I applaud and appreciate the efforts and talents of these three +outstanding managers. + +Errors in Loss Reserving + + Any shareholder in a company with important interests in the +property/casualty insurance business should have some +understanding of the weaknesses inherent in the reporting of +current earnings in that industry. Phil Graham, when publisher +of the Washington Post, described the daily newspaper as “a first +rough draft of history”. Unfortunately, the financial statements +of a property/casualty insurer provide, at best, only a first +rough draft of earnings and financial condition. + + The determination of costs is the main problem. Most of an +insurer’s costs result from losses on claims, and many of the +losses that should be charged against the current year’s revenue +are exceptionally difficult to estimate. Sometimes the extent of +these losses, or even their existence, is not known for decades. + + The loss expense charged in a property/casualty company’s +current income statement represents: (1) losses that occurred and +were paid during the year; (2) estimates for losses that occurred +and were reported to the insurer during the year, but which have +yet to be settled; (3) estimates of ultimate dollar costs for +losses that occurred during the year but of which the insurer is +unaware (termed “IBNR”: incurred but not reported); and (4) the +net effect of revisions this year of similar estimates for (2) +and (3) made in past years. + + Such revisions may be long delayed, but eventually any +estimate of losses that causes the income for year X to be +misstated must be corrected, whether it is in year X + 1, or +X + 10. This, perforce, means that earnings in the year of +correction also are misstated. For example, assume a claimant +was injured by one of our insureds in 1979 and we thought a +settlement was likely to be made for $10,000. That year we would +have charged $10,000 to our earnings statement for the estimated +cost of the loss and, correspondingly, set up a liability reserve +on the balance sheet for that amount. If we settled the claim in +1984 for $100,000, we would charge earnings with a loss cost of +$90,000 in 1984, although that cost was truly an expense of 1979. +And if that piece of business was our only activity in 1979, we +would have badly misled ourselves as to costs, and you as to +earnings. + + The necessarily-extensive use of estimates in assembling the +figures that appear in such deceptively precise form in the +income statement of property/casualty companies means that some +error must seep in, no matter how proper the intentions of +management. In an attempt to minimize error, most insurers use +various statistical techniques to adjust the thousands of +individual loss evaluations (called case reserves) that comprise +the raw data for estimation of aggregate liabilities. The extra +reserves created by these adjustments are variously labeled +“bulk”, “development”, or “supplemental” reserves. The goal of +the adjustments should be a loss-reserve total that has a 50-50 +chance of being proved either slightly too high or slightly too +low when all losses that occurred prior to the date of the +financial statement are ultimately paid. + + At Berkshire, we have added what we thought were appropriate +supplemental reserves but in recent years they have not been +adequate. It is important that you understand the magnitude of +the errors that have been involved in our reserving. You can +thus see for yourselves just how imprecise the process is, and +also judge whether we may have some systemic bias that should +make you wary of our current and future figures. + + The following table shows the results from insurance +underwriting as we have reported them to you in recent years, and +also gives you calculations a year later on an “if-we-knew-then- +what-we think-we-know-now” basis. I say “what we think we know +now” because the adjusted figures still include a great many +estimates for losses that occurred in the earlier years. +However, many claims from the earlier years have been settled so +that our one-year-later estimate contains less guess work than +our earlier estimate: + + Underwriting Results Corrected Figures + as Reported After One Year’s + Year to You Experience + ---- -------------------- ----------------- + 1980 $ 6,738,000 $ 14,887,000 + 1981 1,478,000 (1,118,000) + 1982 (21,462,000) (25,066,000) + 1983 (33,192,000) (50,974,000) + 1984 (45,413,000) ? + + Our structured settlement and loss-reserve assumption + businesses are not included in this table. Important + additional information on loss reserve experience appears + on pages 43-45. + + To help you understand this table, here is an explanation of +the most recent figures: 1984’s reported pre-tax underwriting +loss of $45.4 million consists of $27.6 million we estimate that +we lost on 1984’s business, plus the increased loss of $17.8 +million reflected in the corrected figure for 1983. + + As you can see from reviewing the table, my errors in +reporting to you have been substantial and recently have always +presented a better underwriting picture than was truly the case. +This is a source of particular chagrin to me because: (1) I like +for you to be able to count on what I say; (2) our insurance +managers and I undoubtedly acted with less urgency than we would +have had we understood the full extent of our losses; and (3) we +paid income taxes calculated on overstated earnings and thereby +gave the government money that we didn’t need to. (These +overpayments eventually correct themselves, but the delay is long +and we don’t receive interest on the amounts we overpaid.) + + Because our business is weighted toward casualty and +reinsurance lines, we have more problems in estimating loss costs +than companies that specialize in property insurance. (When a +building that you have insured burns down, you get a much faster +fix on your costs than you do when an employer you have insured +finds out that one of his retirees has contracted a disease +attributable to work he did decades earlier.) But I still find +our errors embarrassing. In our direct business, we have far +underestimated the mushrooming tendency of juries and courts to +make the “deep pocket” pay, regardless of the factual situation +and the past precedents for establishment of liability. We also +have underestimated the contagious effect that publicity +regarding giant awards has on juries. In the reinsurance area, +where we have had our worst experience in under reserving, our +customer insurance companies have made the same mistakes. Since +we set reserves based on information they supply us, their +mistakes have become our mistakes. + + I heard a story recently that is applicable to our insurance +accounting problems: a man was traveling abroad when he received +a call from his sister informing him that their father had died +unexpectedly. It was physically impossible for the brother to +get back home for the funeral, but he told his sister to take +care of the funeral arrangements and to send the bill to him. +After returning home he received a bill for several thousand +dollars, which he promptly paid. The following month another +bill came along for $15, and he paid that too. Another month +followed, with a similar bill. When, in the next month, a third +bill for $15 was presented, he called his sister to ask what was +going on. “Oh”, she said. “I forgot to tell you. We buried Dad +in a rented suit.” + + If you’ve been in the insurance business in recent years - +particularly the reinsurance business - this story hurts. We +have tried to include all of our “rented suit” liabilities in our +current financial statement, but our record of past error should +make us humble, and you suspicious. I will continue to report to +you the errors, plus or minus, that surface each year. + + Not all reserving errors in the industry have been of the +innocent-but-dumb variety. With underwriting results as bad as +they have been in recent years - and with managements having as +much discretion as they do in the presentation of financial +statements - some unattractive aspects of human nature have +manifested themselves. Companies that would be out of business +if they realistically appraised their loss costs have, in some +cases, simply preferred to take an extraordinarily optimistic +view about these yet-to-be-paid sums. Others have engaged in +various transactions to hide true current loss costs. + + Both of these approaches can “work” for a considerable time: +external auditors cannot effectively police the financial +statements of property/casualty insurers. If liabilities of an +insurer, correctly stated, would exceed assets, it falls to the +insurer to volunteer this morbid information. In other words, +the corpse is supposed to file the death certificate. Under this +“honor system” of mortality, the corpse sometimes gives itself +the benefit of the doubt. + + In most businesses, of course, insolvent companies run out +of cash. Insurance is different: you can be broke but flush. +Since cash comes in at the inception of an insurance policy and +losses are paid much later, insolvent insurers don’t run out of +cash until long after they have run out of net worth. In fact, +these “walking dead” often redouble their efforts to write +business, accepting almost any price or risk, simply to keep the +cash flowing in. With an attitude like that of an embezzler who +has gambled away his purloined funds, these companies hope that +somehow they can get lucky on the next batch of business and +thereby cover up earlier shortfalls. Even if they don’t get +lucky, the penalty to managers is usually no greater for a $100 +million shortfall than one of $10 million; in the meantime, while +the losses mount, the managers keep their jobs and perquisites. + + The loss-reserving errors of other property/casualty +companies are of more than academic interest to Berkshire. Not +only does Berkshire suffer from sell-at-any-price competition by +the “walking dead”, but we also suffer when their insolvency is +finally acknowledged. Through various state guarantee funds that +levy assessments, Berkshire ends up paying a portion of the +insolvent insurers’ asset deficiencies, swollen as they usually +are by the delayed detection that results from wrong reporting. +There is even some potential for cascading trouble. The +insolvency of a few large insurers and the assessments by state +guarantee funds that would follow could imperil weak-but- +previously-solvent insurers. Such dangers can be mitigated if +state regulators become better at prompt identification and +termination of insolvent insurers, but progress on that front has +been slow. + +Washington Public Power Supply System + + From October, 1983 through June, 1984 Berkshire’s insurance +subsidiaries continuously purchased large quantities of bonds of +Projects 1, 2, and 3 of Washington Public Power Supply System +(“WPPSS”). This is the same entity that, on July 1, 1983, +defaulted on $2.2 billion of bonds issued to finance partial +construction of the now-abandoned Projects 4 and 5. While there +are material differences in the obligors, promises, and +properties underlying the two categories of bonds, the problems +of Projects 4 and 5 have cast a major cloud over Projects 1, 2, +and 3, and might possibly cause serious problems for the latter +issues. In addition, there have been a multitude of problems +related directly to Projects 1, 2, and 3 that could weaken or +destroy an otherwise strong credit position arising from +guarantees by Bonneville Power Administration. + + Despite these important negatives, Charlie and I judged the +risks at the time we purchased the bonds and at the prices +Berkshire paid (much lower than present prices) to be +considerably more than compensated for by prospects of profit. + + As you know, we buy marketable stocks for our insurance +companies based upon the criteria we would apply in the purchase +of an entire business. This business-valuation approach is not +widespread among professional money managers and is scorned by +many academics. Nevertheless, it has served its followers well +(to which the academics seem to say, “Well, it may be all right +in practice, but it will never work in theory.”) Simply put, we +feel that if we can buy small pieces of businesses with +satisfactory underlying economics at a fraction of the per-share +value of the entire business, something good is likely to happen +to us - particularly if we own a group of such securities. + + We extend this business-valuation approach even to bond +purchases such as WPPSS. We compare the $139 million cost of our +yearend investment in WPPSS to a similar $139 million investment +in an operating business. In the case of WPPSS, the “business” +contractually earns $22.7 million after tax (via the interest +paid on the bonds), and those earnings are available to us +currently in cash. We are unable to buy operating businesses +with economics close to these. Only a relatively few businesses +earn the 16.3% after tax on unleveraged capital that our WPPSS +investment does and those businesses, when available for +purchase, sell at large premiums to that capital. In the average +negotiated business transaction, unleveraged corporate earnings +of $22.7 million after-tax (equivalent to about $45 million pre- +tax) might command a price of $250 - $300 million (or sometimes +far more). For a business we understand well and strongly like, +we will gladly pay that much. But it is double the price we paid +to realize the same earnings from WPPSS bonds. + + However, in the case of WPPSS, there is what we view to be a +very slight risk that the “business” could be worth nothing +within a year or two. There also is the risk that interest +payments might be interrupted for a considerable period of time. +Furthermore, the most that the “business” could be worth is about +the $205 million face value of the bonds that we own, an amount +only 48% higher than the price we paid. + + This ceiling on upside potential is an important minus. It +should be realized, however, that the great majority of operating +businesses have a limited upside potential also unless more +capital is continuously invested in them. That is so because +most businesses are unable to significantly improve their average +returns on equity - even under inflationary conditions, though +these were once thought to automatically raise returns. + + (Let’s push our bond-as-a-business example one notch +further: if you elect to “retain” the annual earnings of a 12% +bond by using the proceeds from coupons to buy more bonds, +earnings of that bond “business” will grow at a rate comparable +to that of most operating businesses that similarly reinvest all +earnings. In the first instance, a 30-year, zero-coupon, 12% +bond purchased today for $10 million will be worth $300 million +in 2015. In the second, a $10 million business that regularly +earns 12% on equity and retains all earnings to grow, will also +end up with $300 million of capital in 2015. Both the business +and the bond will earn over $32 million in the final year.) + + Our approach to bond investment - treating it as an unusual +sort of “business” with special advantages and disadvantages - +may strike you as a bit quirky. However, we believe that many +staggering errors by investors could have been avoided if they +had viewed bond investment with a businessman’s perspective. For +example, in 1946, 20-year AAA tax-exempt bonds traded at slightly +below a 1% yield. In effect, the buyer of those bonds at that +time bought a “business” that earned about 1% on “book value” +(and that, moreover, could never earn a dime more than 1% on +book), and paid 100 cents on the dollar for that abominable +business. + + If an investor had been business-minded enough to think in +those terms - and that was the precise reality of the bargain +struck - he would have laughed at the proposition and walked +away. For, at the same time, businesses with excellent future +prospects could have been bought at, or close to, book value +while earning 10%, 12%, or 15% after tax on book. Probably no +business in America changed hands in 1946 at book value that the +buyer believed lacked the ability to earn more than 1% on book. +But investors with bond-buying habits eagerly made economic +commitments throughout the year on just that basis. Similar, +although less extreme, conditions prevailed for the next two +decades as bond investors happily signed up for twenty or thirty +years on terms outrageously inadequate by business standards. +(In what I think is by far the best book on investing ever +written - “The Intelligent Investor”, by Ben Graham - the last +section of the last chapter begins with, “Investment is most +intelligent when it is most businesslike.” This section is called +“A Final Word”, and it is appropriately titled.) + + We will emphasize again that there is unquestionably some +risk in the WPPSS commitment. It is also the sort of risk that +is difficult to evaluate. Were Charlie and I to deal with 50 +similar evaluations over a lifetime, we would expect our judgment +to prove reasonably satisfactory. But we do not get the chance +to make 50 or even 5 such decisions in a single year. Even +though our long-term results may turn out fine, in any given year +we run a risk that we will look extraordinarily foolish. (That’s +why all of these sentences say “Charlie and I”, or “we”.) + + Most managers have very little incentive to make the +intelligent-but-with-some-chance-of-looking-like-an-idiot +decision. Their personal gain/loss ratio is all too obvious: if +an unconventional decision works out well, they get a pat on the +back and, if it works out poorly, they get a pink slip. (Failing +conventionally is the route to go; as a group, lemmings may have +a rotten image, but no individual lemming has ever received bad +press.) + + Our equation is different. With 47% of Berkshire’s stock, +Charlie and I don’t worry about being fired, and we receive our +rewards as owners, not managers. Thus we behave with Berkshire’s +money as we would with our own. That frequently leads us to +unconventional behavior both in investments and general business +management. + + We remain unconventional in the degree to which we +concentrate the investments of our insurance companies, including +those in WPPSS bonds. This concentration makes sense only +because our insurance business is conducted from a position of +exceptional financial strength. For almost all other insurers, a +comparable degree of concentration (or anything close to it) +would be totally inappropriate. Their capital positions are not +strong enough to withstand a big error, no matter how attractive +an investment opportunity might appear when analyzed on the basis +of probabilities. + + With our financial strength we can own large blocks of a few +securities that we have thought hard about and bought at +attractive prices. (Billy Rose described the problem of over- +diversification: “If you have a harem of forty women, you never +get to know any of them very well.”) Over time our policy of +concentration should produce superior results, though these will +be tempered by our large size. When this policy produces a +really bad year, as it must, at least you will know that our +money was committed on the same basis as yours. + + We made the major part of our WPPSS investment at different +prices and under somewhat different factual circumstances than +exist at present. If we decide to change our position, we will +not inform shareholders until long after the change has been +completed. (We may be buying or selling as you read this.) The +buying and selling of securities is a competitive business, and +even a modest amount of added competition on either side can cost +us a great deal of money. Our WPPSS purchases illustrate this +principle. From October, 1983 through June, 1984, we attempted +to buy almost all the bonds that we could of Projects 1, 2, and +3. Yet we purchased less than 3% of the bonds outstanding. Had +we faced even a few additional well-heeled investors, stimulated +to buy because they knew we were, we could have ended up with a +materially smaller amount of bonds, purchased at a materially +higher price. (A couple of coat-tail riders easily could have +cost us $5 million.) For this reason, we will not comment about +our activities in securities - neither to the press, nor +shareholders, nor to anyone else - unless legally required to do +so. + + One final observation regarding our WPPSS purchases: we +dislike the purchase of most long-term bonds under most +circumstances and have bought very few in recent years. That’s +because bonds are as sound as a dollar - and we view the long- +term outlook for dollars as dismal. We believe substantial +inflation lies ahead, although we have no idea what the average +rate will turn out to be. Furthermore, we think there is a +small, but not insignificant, chance of runaway inflation. + + Such a possibility may seem absurd, considering the rate to +which inflation has dropped. But we believe that present fiscal +policy - featuring a huge deficit - is both extremely dangerous +and difficult to reverse. (So far, most politicians in both +parties have followed Charlie Brown’s advice: “No problem is so +big that it can’t be run away from.”) Without a reversal, high +rates of inflation may be delayed (perhaps for a long time), but +will not be avoided. If high rates materialize, they bring with +them the potential for a runaway upward spiral. + + While there is not much to choose between bonds and stocks +(as a class) when annual inflation is in the 5%-10% range, +runaway inflation is a different story. In that circumstance, a +diversified stock portfolio would almost surely suffer an +enormous loss in real value. But bonds already outstanding would +suffer far more. Thus, we think an all-bond portfolio carries a +small but unacceptable “wipe out” risk, and we require any +purchase of long-term bonds to clear a special hurdle. Only when +bond purchases appear decidedly superior to other business +opportunities will we engage in them. Those occasions are likely +to be few and far between. + +Dividend Policy + + Dividend policy is often reported to shareholders, but +seldom explained. A company will say something like, “Our goal +is to pay out 40% to 50% of earnings and to increase dividends at +a rate at least equal to the rise in the CPI”. And that’s it - +no analysis will be supplied as to why that particular policy is +best for the owners of the business. Yet, allocation of capital +is crucial to business and investment management. Because it is, +we believe managers and owners should think hard about the +circumstances under which earnings should be retained and under +which they should be distributed. + + The first point to understand is that all earnings are not +created equal. In many businesses particularly those that have +high asset/profit ratios - inflation causes some or all of the +reported earnings to become ersatz. The ersatz portion - let’s +call these earnings “restricted” - cannot, if the business is to +retain its economic position, be distributed as dividends. Were +these earnings to be paid out, the business would lose ground in +one or more of the following areas: its ability to maintain its +unit volume of sales, its long-term competitive position, its +financial strength. No matter how conservative its payout ratio, +a company that consistently distributes restricted earnings is +destined for oblivion unless equity capital is otherwise infused. + + Restricted earnings are seldom valueless to owners, but they +often must be discounted heavily. In effect, they are +conscripted by the business, no matter how poor its economic +potential. (This retention-no-matter-how-unattractive-the-return +situation was communicated unwittingly in a marvelously ironic +way by Consolidated Edison a decade ago. At the time, a punitive +regulatory policy was a major factor causing the company’s stock +to sell as low as one-fourth of book value; i.e., every time a +dollar of earnings was retained for reinvestment in the business, +that dollar was transformed into only 25 cents of market value. +But, despite this gold-into-lead process, most earnings were +reinvested in the business rather than paid to owners. +Meanwhile, at construction and maintenance sites throughout New +York, signs proudly proclaimed the corporate slogan, “Dig We +Must”.) + + Restricted earnings need not concern us further in this +dividend discussion. Let’s turn to the much-more-valued +unrestricted variety. These earnings may, with equal +feasibility, be retained or distributed. In our opinion, +management should choose whichever course makes greater sense for +the owners of the business. + + This principle is not universally accepted. For a number of +reasons managers like to withhold unrestricted, readily +distributable earnings from shareholders - to expand the +corporate empire over which the managers rule, to operate from a +position of exceptional financial comfort, etc. But we believe +there is only one valid reason for retention. Unrestricted +earnings should be retained only when there is a reasonable +prospect - backed preferably by historical evidence or, when +appropriate, by a thoughtful analysis of the future - that for +every dollar retained by the corporation, at least one dollar of +market value will be created for owners. This will happen only +if the capital retained produces incremental earnings equal to, +or above, those generally available to investors. + + To illustrate, let’s assume that an investor owns a risk- +free 10% perpetual bond with one very unusual feature. Each year +the investor can elect either to take his 10% coupon in cash, or +to reinvest the coupon in more 10% bonds with identical terms; +i.e., a perpetual life and coupons offering the same cash-or- +reinvest option. If, in any given year, the prevailing interest +rate on long-term, risk-free bonds is 5%, it would be foolish for +the investor to take his coupon in cash since the 10% bonds he +could instead choose would be worth considerably more than 100 +cents on the dollar. Under these circumstances, the investor +wanting to get his hands on cash should take his coupon in +additional bonds and then immediately sell them. By doing that, +he would realize more cash than if he had taken his coupon +directly in cash. Assuming all bonds were held by rational +investors, no one would opt for cash in an era of 5% interest +rates, not even those bondholders needing cash for living +purposes. + + If, however, interest rates were 15%, no rational investor +would want his money invested for him at 10%. Instead, the +investor would choose to take his coupon in cash, even if his +personal cash needs were nil. The opposite course - reinvestment +of the coupon - would give an investor additional bonds with +market value far less than the cash he could have elected. If he +should want 10% bonds, he can simply take the cash received +and buy them in the market, where they will be available at a +large discount. + + An analysis similar to that made by our hypothetical +bondholder is appropriate for owners in thinking about whether a +company’s unrestricted earnings should be retained or paid out. +Of course, the analysis is much more difficult and subject to +error because the rate earned on reinvested earnings is not a +contractual figure, as in our bond case, but rather a fluctuating +figure. Owners must guess as to what the rate will average over +the intermediate future. However, once an informed guess is +made, the rest of the analysis is simple: you should wish your +earnings to be reinvested if they can be expected to earn high +returns, and you should wish them paid to you if low returns are +the likely outcome of reinvestment. + + Many corporate managers reason very much along these lines +in determining whether subsidiaries should distribute earnings to +their parent company. At that level,. the managers have no +trouble thinking like intelligent owners. But payout decisions +at the parent company level often are a different story. Here +managers frequently have trouble putting themselves in the shoes +of their shareholder-owners. + + With this schizoid approach, the CEO of a multi-divisional +company will instruct Subsidiary A, whose earnings on incremental +capital may be expected to average 5%, to distribute all +available earnings in order that they may be invested in +Subsidiary B, whose earnings on incremental capital are expected +to be 15%. The CEO’s business school oath will allow no lesser +behavior. But if his own long-term record with incremental +capital is 5% - and market rates are 10% - he is likely to impose +a dividend policy on shareholders of the parent company that +merely follows some historical or industry-wide payout pattern. +Furthermore, he will expect managers of subsidiaries to give him +a full account as to why it makes sense for earnings to be +retained in their operations rather than distributed to the +parent-owner. But seldom will he supply his owners with a +similar analysis pertaining to the whole company. + + In judging whether managers should retain earnings, +shareholders should not simply compare total incremental earnings +in recent years to total incremental capital because that +relationship may be distorted by what is going on in a core +business. During an inflationary period, companies with a core +business characterized by extraordinary economics can use small +amounts of incremental capital in that business at very high +rates of return (as was discussed in last year’s section on +Goodwill). But, unless they are experiencing tremendous unit +growth, outstanding businesses by definition generate large +amounts of excess cash. If a company sinks most of this money in +other businesses that earn low returns, the company’s overall +return on retained capital may nevertheless appear excellent +because of the extraordinary returns being earned by the portion +of earnings incrementally invested in the core business. The +situation is analogous to a Pro-Am golf event: even if all of the +amateurs are hopeless duffers, the team’s best-ball score will be +respectable because of the dominating skills of the professional. + + Many corporations that consistently show good returns both +on equity and on overall incremental capital have, indeed, +employed a large portion of their retained earnings on an +economically unattractive, even disastrous, basis. Their +marvelous core businesses, however, whose earnings grow year +after year, camouflage repeated failures in capital allocation +elsewhere (usually involving high-priced acquisitions of +businesses that have inherently mediocre economics). The +managers at fault periodically report on the lessons they have +learned from the latest disappointment. They then usually seek +out future lessons. (Failure seems to go to their heads.) + + In such cases, shareholders would be far better off if +earnings were retained only to expand the high-return business, +with the balance paid in dividends or used to repurchase stock +(an action that increases the owners’ interest in the exceptional +business while sparing them participation in subpar businesses). +Managers of high-return businesses who consistently employ much +of the cash thrown off by those businesses in other ventures with +low returns should be held to account for those allocation +decisions, regardless of how profitable the overall enterprise +is. + + Nothing in this discussion is intended to argue for +dividends that bounce around from quarter to quarter with each +wiggle in earnings or in investment opportunities. Shareholders +of public corporations understandably prefer that dividends be +consistent and predictable. Payments, therefore, should reflect +long-term expectations for both earnings and returns on +incremental capital. Since the long-term corporate outlook +changes only infrequently, dividend patterns should change no +more often. But over time distributable earnings that have been +withheld by managers should earn their keep. If earnings have +been unwisely retained, it is likely that managers, too, have +been unwisely retained. + + Let’s now turn to Berkshire Hathaway and examine how these +dividend principles apply to it. Historically, Berkshire has +earned well over market rates on retained earnings, thereby +creating over one dollar of market value for every dollar +retained. Under such circumstances, any distribution would have +been contrary to the financial interest of shareholders, large or +small. + + In fact, significant distributions in the early years might +have been disastrous, as a review of our starting position will +show you. Charlie and I then controlled and managed three +companies, Berkshire Hathaway Inc., Diversified Retailing +Company, Inc., and Blue Chip Stamps (all now merged into our +present operation). Blue Chip paid only a small dividend, +Berkshire and DRC paid nothing. If, instead, the companies had +paid out their entire earnings, we almost certainly would have no +earnings at all now - and perhaps no capital as well. The three +companies each originally made their money from a single +business: (1) textiles at Berkshire; (2) department stores at +Diversified; and (3) trading stamps at Blue Chip. These +cornerstone businesses (carefully chosen, it should be noted, by +your Chairman and Vice Chairman) have, respectively, (1) survived +but earned almost nothing, (2) shriveled in size while incurring +large losses, and (3) shrunk in sales volume to about 5% its size +at the time of our entry. (Who says “you can’t lose ‘em all”?) +Only by committing available funds to much better businesses were +we able to overcome these origins. (It’s been like overcoming a +misspent youth.) Clearly, diversification has served us well. + + We expect to continue to diversify while also supporting the +growth of current operations though, as we’ve pointed out, our +returns from these efforts will surely be below our historical +returns. But as long as prospective returns are above the rate +required to produce a dollar of market value per dollar retained, +we will continue to retain all earnings. Should our estimate of +future returns fall below that point, we will distribute all +unrestricted earnings that we believe can not be effectively +used. In making that judgment, we will look at both our +historical record and our prospects. Because our year-to-year +results are inherently volatile, we believe a five-year rolling +average to be appropriate for judging the historical record. + + Our present plan is to use our retained earnings to further +build the capital of our insurance companies. Most of our +competitors are in weakened financial condition and reluctant to +expand substantially. Yet large premium-volume gains for the +industry are imminent, amounting probably to well over $15 +billion in 1985 versus less than $5 billion in 1983. These +circumstances could produce major amounts of profitable business +for us. Of course, this result is no sure thing, but prospects +for it are far better than they have been for many years. + +Miscellaneous + + This is the spot where each year I run my small “business +wanted” ad. In 1984 John Loomis, one of our particularly +knowledgeable and alert shareholders, came up with a company that +met all of our tests. We immediately pursued this idea, and only +a chance complication prevented a deal. Since our ad is pulling, +we will repeat it in precisely last year’s form: + + We prefer: + (1) large purchases (at least $5 million of after-tax + earnings), + (2) demonstrated consistent earning power (future + projections are of little interest to us, nor are + “turn-around” situations), + (3) businesses earning good returns on equity while + employing little or no debt, + (4) management in place (we can’t supply it), + (5) simple businesses (if there’s lots of technology, we + won’t understand it), + (6) an offering price (we don’t want to waste our time or + that of the seller by talking, even preliminarily, + about a transaction when price is unknown). + + We will not engage in unfriendly takeovers. We can promise +complete confidentiality and a very fast answer - customarily +within five minutes - as to whether we’re interested. We prefer +to buy for cash, but will consider issuance of stock when we +receive as much in intrinsic business value as we give. We +invite potential sellers to check us out by contacting people +with whom we have done business in the past. For the right +business - and the right people - we can provide a good home. + + * * * + + A record 97.2% of all eligible shares participated in +Berkshire’s 1984 shareholder-designated contributions program. +Total contributions made through this program were $3,179,000, +and 1,519 charities were recipients. Our proxy material for the +annual meeting will allow you to cast an advisory vote expressing +your views about this program - whether you think we should +continue it and, if so, at what per-share level. (You may be +interested to learn that we were unable to find a precedent for +an advisory vote in which management seeks the opinions of +shareholders about owner-related corporate policies. Managers +who put their trust in capitalism seem in no hurry to put their +trust in capitalists.) + + We urge new shareholders to read the description of our +shareholder-designated contributions program that appears on +pages 60 and 61. If you wish to participate in future programs, +we strongly urge that you immediately make sure that your shares +are registered in the name of the actual owner, not in “street” +name or nominee name. Shares not so registered on September 30, +1985 will be ineligible for the 1985 program. + + * * * + + Our annual meeting will be on May 21, 1985 in Omaha, and I +hope that you attend. Many annual meetings are a waste of time, +both for shareholders and for management. Sometimes that is true +because management is reluctant to open up on matters of business +substance. More often a nonproductive session is the fault of +shareholder participants who are more concerned about their own +moment on stage than they are about the affairs of the +corporation. What should be a forum for business discussion +becomes a forum for theatrics, spleen-venting and advocacy of +issues. (The deal is irresistible: for the price of one share you +get to tell a captive audience your ideas as to how the world +should be run.) Under such circumstances, the quality of the +meeting often deteriorates from year to year as the antics of +those interested in themselves discourage attendance by those +interested in the business. + + Berkshire’s meetings are a different story. The number of +shareholders attending grows a bit each year and we have yet to +experience a silly question or an ego-inspired commentary. +Instead, we get a wide variety of thoughtful questions about the +business. Because the annual meeting is the time and place for +these, Charlie and I are happy to answer them all, no matter how +long it takes. (We cannot, however, respond to written or phoned +questions at other times of the year; one-person-at-a time +reporting is a poor use of management time in a company with 3000 +shareholders.) The only business matters that are off limits at +the annual meeting are those about which candor might cost our +company real money. Our activities in securities would be the +main example. + + We always have bragged a bit on these pages about the +quality of our shareholder-partners. Come to the annual meeting +and you will see why. Out-of-towners should schedule a stop at +Nebraska Furniture Mart. If you make some purchases, you’ll save +far more than enough to pay for your trip, and you’ll enjoy the +experience. + + Warren E. Buffett +February 25, 1985 Chairman of the Board + + Subsequent Event: On March 18, a week after copy for this +report went to the typographer but shortly before production, we +agreed to purchase three million shares of Capital Cities +Communications, Inc. at $172.50 per share. Our purchase is +contingent upon the acquisition of American Broadcasting +Companies, Inc. by Capital Cities, and will close when that +transaction closes. At the earliest, that will be very late in +1985. Our admiration for the management of Capital Cities, led +by Tom Murphy and Dan Burke, has been expressed several times in +previous annual reports. Quite simply, they are tops in both +ability and integrity. We will have more to say about this +investment in next year’s report. + ++ + + diff --git a/berkshire-hathaway/1985/1-in/berkshire-hathaway-1985-letter.txt b/berkshire-hathaway/1985/1-in/berkshire-hathaway-1985-letter.txt new file mode 100644 index 0000000..e27a830 --- /dev/null +++ b/berkshire-hathaway/1985/1-in/berkshire-hathaway-1985-letter.txt @@ -0,0 +1,1654 @@ + + + + + +
+BERKSHIRE HATHAWAY INC. +
+ ++ + +To the Shareholders of Berkshire Hathaway Inc.: + + You may remember the wildly upbeat message of last year’s +report: nothing much was in the works but our experience had been +that something big popped up occasionally. This carefully- +crafted corporate strategy paid off in 1985. Later sections of +this report discuss (a) our purchase of a major position in +Capital Cities/ABC, (b) our acquisition of Scott & Fetzer, (c) +our entry into a large, extended term participation in the +insurance business of Fireman’s Fund, and (d) our sale of our +stock in General Foods. + + Our gain in net worth during the year was $613.6 million, or +48.2%. It is fitting that the visit of Halley’s Comet coincided +with this percentage gain: neither will be seen again in my +lifetime. Our gain in per-share book value over the last twenty- +one years (that is, since present management took over) has been +from $19.46 to $1643.71, or 23.2% compounded annually, another +percentage that will not be repeated. + + Two factors make anything approaching this rate of gain +unachievable in the future. One factor probably transitory - is +a stock market that offers very little opportunity compared to +the markets that prevailed throughout much of the 1964-1984 +period. Today we cannot find significantly-undervalued equities +to purchase for our insurance company portfolios. The current +situation is 180 degrees removed from that existing about a +decade ago, when the only question was which bargain to choose. + + This change in the market also has negative implications for +our present portfolio. In our 1974 annual report I could say: +“We consider several of our major holdings to have great +potential for significantly increased values in future years.” I +can’t say that now. It’s true that our insurance companies +currently hold major positions in companies with exceptional +underlying economics and outstanding managements, just as they +did in 1974. But current market prices generously appraise these +attributes, whereas they were ignored in 1974. Today’s +valuations mean that our insurance companies have no chance for +future portfolio gains on the scale of those achieved in the +past. + + The second negative factor, far more telling, is our size. +Our equity capital is more than twenty times what it was only ten +years ago. And an iron law of business is that growth eventually +dampens exceptional economics. just look at the records of high- +return companies once they have amassed even $1 billion of equity +capital. None that I know of has managed subsequently, over a +ten-year period, to keep on earning 20% or more on equity while +reinvesting all or substantially all of its earnings. Instead, +to sustain their high returns, such companies have needed to shed +a lot of capital by way of either dividends or repurchases of +stock. Their shareholders would have been far better off if all +earnings could have been reinvested at the fat returns earned by +these exceptional businesses. But the companies simply couldn’t +turn up enough high-return opportunities to make that possible. + + Their problem is our problem. Last year I told you that we +needed profits of $3.9 billion over the ten years then coming up +to earn 15% annually. The comparable figure for the ten years +now ahead is $5.7 billion, a 48% increase that corresponds - as +it must mathematically - to the growth in our capital base during +1985. (Here’s a little perspective: leaving aside oil companies, +only about 15 U.S. businesses have managed to earn over $5.7 +billion during the past ten years.) + + Charlie Munger, my partner in managing Berkshire, and I are +reasonably optimistic about Berkshire’s ability to earn returns +superior to those earned by corporate America generally, and you +will benefit from the company’s retention of all earnings as long +as those returns are forthcoming. We have several things going +for us: (1) we don’t have to worry about quarterly or annual +figures but, instead, can focus on whatever actions will maximize +long-term value; (2) we can expand the business into any areas +that make sense - our scope is not circumscribed by history, +structure, or concept; and (3) we love our work. All of these +help. Even so, we will also need a full measure of good fortune +to average our hoped-for 15% - far more good fortune than was +required for our past 23.2%. + + We need to mention one further item in the investment +equation that could affect recent purchasers of our stock. +Historically, Berkshire shares have sold modestly below intrinsic +business value. With the price there, purchasers could be +certain (as long as they did not experience a widening of this +discount) that their personal investment experience would at +least equal the financial experience of the business. But +recently the discount has disappeared, and occasionally a modest +premium has prevailed. + + The elimination of the discount means that Berkshire’s +market value increased even faster than business value (which, +itself, grew at a pleasing pace). That was good news for any +owner holding while that move took place, but it is bad news for +the new or prospective owner. If the financial experience of new +owners of Berkshire is merely to match the future financial +experience of the company, any premium of market value over +intrinsic business value that they pay must be maintained. + + Management cannot determine market prices, although it can, +by its disclosures and policies, encourage rational behavior by +market participants. My own preference, as perhaps you’d guess, +is for a market price that consistently approximates business +value. Given that relationship, all owners prosper precisely as +the business prospers during their period of ownership. Wild +swings in market prices far above and below business value do not +change the final gains for owners in aggregate; in the end, +investor gains must equal business gains. But long periods of +substantial undervaluation and/or overvaluation will cause the +gains of the business to be inequitably distributed among various +owners, with the investment result of any given owner largely +depending upon how lucky, shrewd, or foolish he happens to be. + + Over the long term there has been a more consistent +relationship between Berkshire’s market value and business value +than has existed for any other publicly-traded equity with which +I am familiar. This is a tribute to you. Because you have been +rational, interested, and investment-oriented, the market price +for Berkshire stock has almost always been sensible. This +unusual result has been achieved by a shareholder group with +unusual demographics: virtually all of our shareholders are +individuals, not institutions. No other public company our size +can claim the same. + + You might think that institutions, with their large staffs +of highly-paid and experienced investment professionals, would be +a force for stability and reason in financial markets. They are +not: stocks heavily owned and constantly monitored by +institutions have often been among the most inappropriately +valued. + + Ben Graham told a story 40 years ago that illustrates why +investment professionals behave as they do: An oil prospector, +moving to his heavenly reward, was met by St. Peter with bad +news. “You’re qualified for residence”, said St. Peter, “but, as +you can see, the compound reserved for oil men is packed. +There’s no way to squeeze you in.” After thinking a moment, the +prospector asked if he might say just four words to the present +occupants. That seemed harmless to St. Peter, so the prospector +cupped his hands and yelled, “Oil discovered in hell.” +Immediately the gate to the compound opened and all of the oil +men marched out to head for the nether regions. Impressed, St. +Peter invited the prospector to move in and make himself +comfortable. The prospector paused. “No,” he said, “I think +I’ll go along with the rest of the boys. There might be some +truth to that rumor after all.” + +Sources of Reported Earnings + + The table on the next page shows the major sources of +Berkshire’s reported earnings. These numbers, along with far +more detailed sub-segment numbers, are the ones that Charlie and +I focus upon. We do not find consolidated figures an aid in +either managing or evaluating Berkshire and, in fact, never +prepare them for internal use. + + Segment information is equally essential for investors +wanting to know what is going on in a multi-line business. +Corporate managers always have insisted upon such information +before making acquisition decisions but, until a few years ago, +seldom made it available to investors faced with acquisition and +disposition decisions of their own. Instead, when owners wishing +to understand the economic realities of their business asked for +data, managers usually gave them a we-can’t-tell-you-what-is- +going-on-because-it-would-hurt-the-company answer. Ultimately +the SEC ordered disclosure of segment data and management began +supplying real answers. The change in their behavior recalls an +insight of Al Capone: “You can get much further with a kind word +and a gun than you can with a kind word alone.” + +In the table, amortization of Goodwill is not charged against the +specific businesses but, for reasons outlined in the Appendix to +my letter in the 1983 annual report, is aggregated as a separate +item. (A compendium of the 1977-1984 letters is available upon +request.) In the Business Segment Data and Management’s +Discussion sections on pages 39-41 and 49-55, much additional +information regarding our businesses is provided, including +Goodwill and Goodwill Amortization figures for each of the +segments. I urge you to read those sections as well as Charlie +Munger’s letter to Wesco shareholders, which starts on page 56. + + (000s omitted) + ----------------------------------------- + Berkshire's Share + of Net Earnings + (after taxes and + Pre-Tax Earnings minority interests) + ------------------- ------------------- + 1985 1984 1985 1984 + -------- -------- -------- -------- +Operating Earnings: + Insurance Group: + Underwriting ................ $(44,230) $(48,060) $(23,569) $(25,955) + Net Investment Income ....... 95,217 68,903 79,716 62,059 + Associated Retail Stores ...... 270 (1,072) 134 (579) + Blue Chip Stamps .............. 5,763 (1,843) 2,813 (899) + Buffalo News .................. 29,921 27,328 14,580 13,317 + Mutual Savings and Loan ....... 2,622 1,456 4,016 3,151 + Nebraska Furniture Mart ....... 12,686 14,511 5,181 5,917 + Precision Steel ............... 3,896 4,092 1,477 1,696 + See’s Candies ................. 28,989 26,644 14,558 13,380 + Textiles ...................... (2,395) 418 (1,324) 226 + Wesco Financial ............... 9,500 9,777 4,191 4,828 + Amortization of Goodwill ...... (1,475) (1,434) (1,475) (1,434) + Interest on Debt .............. (14,415) (14,734) (7,288) (7,452) + Shareholder-Designated + Contributions .............. (4,006) (3,179) (2,164) (1,716) + Other ......................... 3,106 4,932 2,102 3,475 + -------- -------- -------- -------- +Operating Earnings .............. 125,449 87,739 92,948 70,014 +Special General Foods Distribution 4,127 8,111 3,779 7,294 +Special Washington Post + Distribution ................. 14,877 --- 13,851 --- +Sales of Securities ............. 468,903 104,699 325,237 71,587 + -------- -------- -------- -------- +Total Earnings - all entities ... $613,356 $200,549 $435,815 $148,895 + ======== ======== ======== ======== + + Our 1985 results include unusually large earnings from the +sale of securities. This fact, in itself, does not mean that we +had a particularly good year (though, of course, we did). +Security profits in a given year bear similarities to a college +graduation ceremony in which the knowledge gained over four years +is recognized on a day when nothing further is learned. We may +hold a stock for a decade or more, and during that period it may +grow quite consistently in both business and market value. In +the year in which we finally sell it there may be no increase in +value, or there may even be a decrease. But all growth in value +since purchase will be reflected in the accounting earnings of +the year of sale. (If the stock owned is in our insurance +subsidiaries, however, any gain or loss in market value will be +reflected in net worth annually.) Thus, reported capital gains or +losses in any given year are meaningless as a measure of how well +we have done in the current year. + + A large portion of the realized gain in 1985 ($338 million +pre-tax out of a total of $488 million) came about through the +sale of our General Foods shares. We held most of these shares +since 1980, when we had purchased them at a price far below what +we felt was their per/share business value. Year by year, the +managerial efforts of Jim Ferguson and Phil Smith substantially +increased General Foods’ business value and, last fall, Philip +Morris made an offer for the company that reflected the increase. +We thus benefited from four factors: a bargain purchase price, a +business with fine underlying economics, an able management +concentrating on the interests of shareholders, and a buyer +willing to pay full business value. While that last factor is +the only one that produces reported earnings, we consider +identification of the first three to be the key to building value +for Berkshire shareholders. In selecting common stocks, we +devote our attention to attractive purchases, not to the +possibility of attractive sales. + + We have again reported substantial income from special +distributions, this year from Washington Post and General Foods. +(The General Foods transactions obviously took place well before +the Philip Morris offer.) Distributions of this kind occur when +we sell a portion of our shares in a company back to it +simultaneously with its purchase of shares from other +shareholders. The number of shares we sell is contractually set +so as to leave our percentage ownership in the company precisely +the same after the sale as before. Such a transaction is quite +properly regarded by the IRS as substantially equivalent to a +dividend since we, as a shareholder, receive cash while +maintaining an unchanged ownership interest. This tax treatment +benefits us because corporate taxpayers, unlike individual +taxpayers, incur much lower taxes on dividend income than on +income from long-term capital gains. (This difference will be +widened further if the House-passed tax bill becomes law: under +its provisions, capital gains realized by corporations will be +taxed at the same rate as ordinary income.) However, accounting +rules are unclear as to proper treatment for shareholder +reporting. To conform with last year’s treatment, we have shown +these transactions as capital gains. + + Though we have not sought out such transactions, we have +agreed to them on several occasions when managements initiated +the idea. In each case we have felt that non-selling +shareholders (all of whom had an opportunity to sell at the same +price we received) benefited because the companies made their +repurchases at prices below intrinsic business value. The tax +advantages we receive and our wish to cooperate with managements +that are increasing values for all shareholders have sometimes +led us to sell - but only to the extent that our proportional +share of the business was undiminished. + + At this point we usually turn to a discussion of some of our +major business units. Before doing so, however, we should first +look at a failure at one of our smaller businesses. Our Vice +Chairman, Charlie Munger, has always emphasized the study of +mistakes rather than successes, both in business and other +aspects of life. He does so in the spirit of the man who said: +“All I want to know is where I’m going to die so I’ll never go +there.” You’ll immediately see why we make a good team: Charlie +likes to study errors and I have generated ample material for +him, particularly in our textile and insurance businesses. + +Shutdown of Textile Business + + In July we decided to close our textile operation, and by +yearend this unpleasant job was largely completed. The history +of this business is instructive. + + When Buffett Partnership, Ltd., an investment partnership of +which I was general partner, bought control of Berkshire Hathaway +21 years ago, it had an accounting net worth of $22 million, all +devoted to the textile business. The company’s intrinsic +business value, however, was considerably less because the +textile assets were unable to earn returns commensurate with +their accounting value. Indeed, during the previous nine years +(the period in which Berkshire and Hathaway operated as a merged +company) aggregate sales of $530 million had produced an +aggregate loss of $10 million. Profits had been reported from +time to time but the net effect was always one step forward, two +steps back. + + At the time we made our purchase, southern textile plants - +largely non-union - were believed to have an important +competitive advantage. Most northern textile operations had +closed and many people thought we would liquidate our business as +well. + + We felt, however, that the business would be run much better +by a long-time employee whom. we immediately selected to be +president, Ken Chace. In this respect we were 100% correct: Ken +and his recent successor, Garry Morrison, have been excellent +managers, every bit the equal of managers at our more profitable +businesses. + + In early 1967 cash generated by the textile operation was +used to fund our entry into insurance via the purchase of +National Indemnity Company. Some of the money came from earnings +and some from reduced investment in textile inventories, +receivables, and fixed assets. This pullback proved wise: +although much improved by Ken’s management, the textile business +never became a good earner, not even in cyclical upturns. + + Further diversification for Berkshire followed, and +gradually the textile operation’s depressing effect on our +overall return diminished as the business became a progressively +smaller portion of the corporation. We remained in the business +for reasons that I stated in the 1978 annual report (and +summarized at other times also): “(1) our textile businesses are +very important employers in their communities, (2) management has +been straightforward in reporting on problems and energetic in +attacking them, (3) labor has been cooperative and understanding +in facing our common problems, and (4) the business should +average modest cash returns relative to investment.” I further +said, “As long as these conditions prevail - and we expect that +they will - we intend to continue to support our textile business +despite more attractive alternative uses for capital.” + + It turned out that I was very wrong about (4). Though 1979 +was moderately profitable, the business thereafter consumed major +amounts of cash. By mid-1985 it became clear, even to me, that +this condition was almost sure to continue. Could we have found +a buyer who would continue operations, I would have certainly +preferred to sell the business rather than liquidate it, even if +that meant somewhat lower proceeds for us. But the economics +that were finally obvious to me were also obvious to others, and +interest was nil. + + I won’t close down businesses of sub-normal profitability +merely to add a fraction of a point to our corporate rate of +return. However, I also feel it inappropriate for even an +exceptionally profitable company to fund an operation once it +appears to have unending losses in prospect. Adam Smith would +disagree with my first proposition, and Karl Marx would disagree +with my second; the middle ground is the only position that +leaves me comfortable. + + I should reemphasize that Ken and Garry have been +resourceful, energetic and imaginative in attempting to make our +textile operation a success. Trying to achieve sustainable +profitability, they reworked product lines, machinery +configurations and distribution arrangements. We also made a +major acquisition, Waumbec Mills, with the expectation of +important synergy (a term widely used in business to explain an +acquisition that otherwise makes no sense). But in the end +nothing worked and I should be faulted for not quitting sooner. +A recent Business Week article stated that 250 textile mills have +closed since 1980. Their owners were not privy to any +information that was unknown to me; they simply processed it more +objectively. I ignored Comte’s advice - “the intellect should be +the servant of the heart, but not its slave” - and believed what +I preferred to believe. + + The domestic textile industry operates in a commodity +business, competing in a world market in which substantial excess +capacity exists. Much of the trouble we experienced was +attributable, both directly and indirectly, to competition from +foreign countries whose workers are paid a small fraction of the +U.S. minimum wage. But that in no way means that our labor force +deserves any blame for our closing. In fact, in comparison with +employees of American industry generally, our workers were poorly +paid, as has been the case throughout the textile business. In +contract negotiations, union leaders and members were sensitive +to our disadvantageous cost position and did not push for +unrealistic wage increases or unproductive work practices. To +the contrary, they tried just as hard as we did to keep us +competitive. Even during our liquidation period they performed +superbly. (Ironically, we would have been better off financially +if our union had behaved unreasonably some years ago; we then +would have recognized the impossible future that we faced, +promptly closed down, and avoided significant future losses.) + + Over the years, we had the option of making large capital +expenditures in the textile operation that would have allowed us +to somewhat reduce variable costs. Each proposal to do so looked +like an immediate winner. Measured by standard return-on- +investment tests, in fact, these proposals usually promised +greater economic benefits than would have resulted from +comparable expenditures in our highly-profitable candy and +newspaper businesses. + + But the promised benefits from these textile investments +were illusory. Many of our competitors, both domestic and +foreign, were stepping up to the same kind of expenditures and, +once enough companies did so, their reduced costs became the +baseline for reduced prices industrywide. Viewed individually, +each company’s capital investment decision appeared cost- +effective and rational; viewed collectively, the decisions +neutralized each other and were irrational (just as happens when +each person watching a parade decides he can see a little better +if he stands on tiptoes). After each round of investment, all +the players had more money in the game and returns remained +anemic. + + Thus, we faced a miserable choice: huge capital investment +would have helped to keep our textile business alive, but would +have left us with terrible returns on ever-growing amounts of +capital. After the investment, moreover, the foreign competition +would still have retained a major, continuing advantage in labor +costs. A refusal to invest, however, would make us increasingly +non-competitive, even measured against domestic textile +manufacturers. I always thought myself in the position described +by Woody Allen in one of his movies: “More than any other time in +history, mankind faces a crossroads. One path leads to despair +and utter hopelessness, the other to total extinction. Let us +pray we have the wisdom to choose correctly.” + + For an understanding of how the to-invest-or-not-to-invest +dilemma plays out in a commodity business, it is instructive to +look at Burlington Industries, by far the largest U.S. textile +company both 21 years ago and now. In 1964 Burlington had sales +of $1.2 billion against our $50 million. It had strengths in +both distribution and production that we could never hope to +match and also, of course, had an earnings record far superior to +ours. Its stock sold at 60 at the end of 1964; ours was 13. + + Burlington made a decision to stick to the textile business, +and in 1985 had sales of about $2.8 billion. During the 1964-85 +period, the company made capital expenditures of about $3 +billion, far more than any other U.S. textile company and more +than $200-per-share on that $60 stock. A very large part of the +expenditures, I am sure, was devoted to cost improvement and +expansion. Given Burlington’s basic commitment to stay in +textiles, I would also surmise that the company’s capital +decisions were quite rational. + + Nevertheless, Burlington has lost sales volume in real +dollars and has far lower returns on sales and equity now than 20 +years ago. Split 2-for-1 in 1965, the stock now sells at 34 -- +on an adjusted basis, just a little over its $60 price in 1964. +Meanwhile, the CPI has more than tripled. Therefore, each share +commands about one-third the purchasing power it did at the end +of 1964. Regular dividends have been paid but they, too, have +shrunk significantly in purchasing power. + + This devastating outcome for the shareholders indicates what +can happen when much brain power and energy are applied to a +faulty premise. The situation is suggestive of Samuel Johnson’s +horse: “A horse that can count to ten is a remarkable horse - not +a remarkable mathematician.” Likewise, a textile company that +allocates capital brilliantly within its industry is a remarkable +textile company - but not a remarkable business. + + My conclusion from my own experiences and from much +observation of other businesses is that a good managerial record +(measured by economic returns) is far more a function of what +business boat you get into than it is of how effectively you row +(though intelligence and effort help considerably, of course, in +any business, good or bad). Some years ago I wrote: “When a +management with a reputation for brilliance tackles a business +with a reputation for poor fundamental economics, it is the +reputation of the business that remains intact.” Nothing has +since changed my point of view on that matter. Should you find +yourself in a chronically-leaking boat, energy devoted to +changing vessels is likely to be more productive than energy +devoted to patching leaks. + + * * * + + There is an investment postscript in our textile saga. Some +investors weight book value heavily in their stock-buying +decisions (as I, in my early years, did myself). And some +economists and academicians believe replacement values are of +considerable importance in calculating an appropriate price level +for the stock market as a whole. Those of both persuasions would +have received an education at the auction we held in early 1986 +to dispose of our textile machinery. + + The equipment sold (including some disposed of in the few +months prior to the auction) took up about 750,000 square feet of +factory space in New Bedford and was eminently usable. It +originally cost us about $13 million, including $2 million spent +in 1980-84, and had a current book value of $866,000 (after +accelerated depreciation). Though no sane management would have +made the investment, the equipment could have been replaced new +for perhaps $30-$50 million. + + Gross proceeds from our sale of this equipment came to +$163,122. Allowing for necessary pre- and post-sale costs, our +net was less than zero. Relatively modern looms that we bought +for $5,000 apiece in 1981 found no takers at $50. We finally +sold them for scrap at $26 each, a sum less than removal costs. + + Ponder this: the economic goodwill attributable to two paper +routes in Buffalo - or a single See’s candy store - considerably +exceeds the proceeds we received from this massive collection of +tangible assets that not too many years ago, under different +competitive conditions, was able to employ over 1,000 people. + +Three Very Good Businesses (and a Few Thoughts About Incentive +Compensation) + + When I was 12, I lived with my grandfather for about four +months. A grocer by trade, he was also working on a book and +each night he dictated a few pages to me. The title - brace +yourself - was “How to Run a Grocery Store and a Few Things I +Have Learned About Fishing”. My grandfather was sure that +interest in these two subjects was universal and that the world +awaited his views. You may conclude from this section’s title +and contents that I was overexposed to Grandpa’s literary style +(and personality). + + I am merging the discussion of Nebraska Furniture Mart, +See’s Candy Shops, and Buffalo Evening News here because the +economic strengths, weaknesses, and prospects of these businesses +have changed little since I reported to you a year ago. The +shortness of this discussion, however, is in no way meant to +minimize the importance of these businesses to us: in 1985 they +earned an aggregate of $72 million pre-tax. Fifteen years ago, +before we had acquired any of them, their aggregate earnings were +about $8 million pre-tax. + + While an increase in earnings from $8 million to $72 million +sounds terrific - and usually is - you should not automatically +assume that to be the case. You must first make sure that +earnings were not severely depressed in the base year. If they +were instead substantial in relation to capital employed, an even +more important point must be examined: how much additional +capital was required to produce the additional earnings? + + In both respects, our group of three scores well. First, +earnings 15 years ago were excellent compared to capital then +employed in the businesses. Second, although annual earnings are +now $64 million greater, the businesses require only about $40 +million more in invested capital to operate than was the case +then. + + The dramatic growth in earning power of these three +businesses, accompanied by their need for only minor amounts of +capital, illustrates very well the power of economic goodwill +during an inflationary period (a phenomenon explained in detail +in the 1983 annual report). The financial characteristics of +these businesses have allowed us to use a very large portion of +the earnings they generate elsewhere. Corporate America, +however, has had a different experience: in order to increase +earnings significantly, most companies have needed to increase +capital significantly also. The average American business has +required about $5 of additional capital to generate an additional +$1 of annual pre-tax earnings. That business, therefore, would +have required over $300 million in additional capital from its +owners in order to achieve an earnings performance equal to our +group of three. + + When returns on capital are ordinary, an earn-more-by- +putting-up-more record is no great managerial achievement. You +can get the same result personally while operating from your +rocking chair. just quadruple the capital you commit to a savings +account and you will quadruple your earnings. You would hardly +expect hosannas for that particular accomplishment. Yet, +retirement announcements regularly sing the praises of CEOs who +have, say, quadrupled earnings of their widget company during +their reign - with no one examining whether this gain was +attributable simply to many years of retained earnings and the +workings of compound interest. + + If the widget company consistently earned a superior return +on capital throughout the period, or if capital employed only +doubled during the CEO’s reign, the praise for him may be well +deserved. But if return on capital was lackluster and capital +employed increased in pace with earnings, applause should be +withheld. A savings account in which interest was reinvested +would achieve the same year-by-year increase in earnings - and, +at only 8% interest, would quadruple its annual earnings in 18 +years. + + The power of this simple math is often ignored by companies +to the detriment of their shareholders. Many corporate +compensation plans reward managers handsomely for earnings +increases produced solely, or in large part, by retained earnings +- i.e., earnings withheld from owners. For example, ten-year, +fixed-price stock options are granted routinely, often by +companies whose dividends are only a small percentage of +earnings. + + An example will illustrate the inequities possible under +such circumstances. Let’s suppose that you had a $100,000 +savings account earning 8% interest and “managed” by a trustee +who could decide each year what portion of the interest you were +to be paid in cash. Interest not paid out would be “retained +earnings” added to the savings account to compound. And let’s +suppose that your trustee, in his superior wisdom, set the “pay- +out ratio” at one-quarter of the annual earnings. + + Under these assumptions, your account would be worth +$179,084 at the end of ten years. Additionally, your annual +earnings would have increased about 70% from $8,000 to $13,515 +under this inspired management. And, finally, your “dividends” +would have increased commensurately, rising regularly from $2,000 +in the first year to $3,378 in the tenth year. Each year, when +your manager’s public relations firm prepared his annual report +to you, all of the charts would have had lines marching skyward. + + Now, just for fun, let’s push our scenario one notch further +and give your trustee-manager a ten-year fixed-price option on +part of your “business” (i.e., your savings account) based on its +fair value in the first year. With such an option, your manager +would reap a substantial profit at your expense - just from +having held on to most of your earnings. If he were both +Machiavellian and a bit of a mathematician, your manager might +also have cut the pay-out ratio once he was firmly entrenched. + + This scenario is not as farfetched as you might think. Many +stock options in the corporate world have worked in exactly that +fashion: they have gained in value simply because management +retained earnings, not because it did well with the capital in +its hands. + + Managers actually apply a double standard to options. +Leaving aside warrants (which deliver the issuing corporation +immediate and substantial compensation), I believe it is fair to +say that nowhere in the business world are ten-year fixed-price +options on all or a portion of a business granted to outsiders. +Ten months, in fact, would be regarded as extreme. It would be +particularly unthinkable for managers to grant a long-term option +on a business that was regularly adding to its capital. Any +outsider wanting to secure such an option would be required to +pay fully for capital added during the option period. + + The unwillingness of managers to do-unto-outsiders, however, +is not matched by an unwillingness to do-unto-themselves. +(Negotiating with one’s self seldom produces a barroom brawl.) +Managers regularly engineer ten-year, fixed-price options for +themselves and associates that, first, totally ignore the fact +that retained earnings automatically build value and, second, +ignore the carrying cost of capital. As a result, these managers +end up profiting much as they would have had they had an option +on that savings account that was automatically building up in +value. + + Of course, stock options often go to talented, value-adding +managers and sometimes deliver them rewards that are perfectly +appropriate. (Indeed, managers who are really exceptional almost +always get far less than they should.) But when the result is +equitable, it is accidental. Once granted, the option is blind +to individual performance. Because it is irrevocable and +unconditional (so long as a manager stays in the company), the +sluggard receives rewards from his options precisely as does the +star. A managerial Rip Van Winkle, ready to doze for ten years, +could not wish for a better “incentive” system. + + (I can’t resist commenting on one long-term option given an +“outsider”: that granted the U.S. Government on Chrysler shares +as partial consideration for the government’s guarantee of some +lifesaving loans. When these options worked out well for the +government, Chrysler sought to modify the payoff, arguing that +the rewards to the government were both far greater than intended +and outsize in relation to its contribution to Chrysler’s +recovery. The company’s anguish over what it saw as an imbalance +between payoff and performance made national news. That anguish +may well be unique: to my knowledge, no managers - anywhere - +have been similarly offended by unwarranted payoffs arising from +options granted to themselves or their colleagues.) + + Ironically, the rhetoric about options frequently describes +them as desirable because they put managers and owners in the +same financial boat. In reality, the boats are far different. +No owner has ever escaped the burden of capital costs, whereas a +holder of a fixed-price option bears no capital costs at all. An +owner must weigh upside potential against downside risk; an +option holder has no downside. In fact, the business project in +which you would wish to have an option frequently is a project in +which you would reject ownership. (I’ll be happy to accept a +lottery ticket as a gift - but I’ll never buy one.) + + In dividend policy also, the option holders’ interests are +best served by a policy that may ill serve the owner. Think back +to the savings account example. The trustee, holding his option, +would benefit from a no-dividend policy. Conversely, the owner +of the account should lean to a total payout so that he can +prevent the option-holding manager from sharing in the account’s +retained earnings. + + Despite their shortcomings, options can be appropriate under +some circumstances. My criticism relates to their indiscriminate +use and, in that connection, I would like to emphasize three +points: + + First, stock options are inevitably tied to the overall +performance of a corporation. Logically, therefore, they should +be awarded only to those managers with overall responsibility. +Managers with limited areas of responsibility should have +incentives that pay off in relation to results under their +control. The .350 hitter expects, and also deserves, a big +payoff for his performance - even if he plays for a cellar- +dwelling team. And the .150 hitter should get no reward - even +if he plays for a pennant winner. Only those with overall +responsibility for the team should have their rewards tied to its +results. + + Second, options should be structured carefully. Absent +special factors, they should have built into them a retained- +earnings or carrying-cost factor. Equally important, they should +be priced realistically. When managers are faced with offers for +their companies, they unfailingly point out how unrealistic +market prices can be as an index of real value. But why, then, +should these same depressed prices be the valuations at which +managers sell portions of their businesses to themselves? (They +may go further: officers and directors sometimes consult the Tax +Code to determine the lowest prices at which they can, in effect, +sell part of the business to insiders. While they’re at it, they +often elect plans that produce the worst tax result for the +company.) Except in highly unusual cases, owners are not well +served by the sale of part of their business at a bargain price - +whether the sale is to outsiders or to insiders. The obvious +conclusion: options should be priced at true business value. + + Third, I want to emphasize that some managers whom I admire +enormously - and whose operating records are far better than mine +- disagree with me regarding fixed-price options. They have +built corporate cultures that work, and fixed-price options have +been a tool that helped them. By their leadership and example, +and by the use of options as incentives, these managers have +taught their colleagues to think like owners. Such a Culture is +rare and when it exists should perhaps be left intact - despite +inefficiencies and inequities that may infest the option program. +“If it ain’t broke, don’t fix it” is preferable to “purity at any +price”. + + At Berkshire, however, we use an incentive@compensation +system that rewards key managers for meeting targets in their own +bailiwicks. If See’s does well, that does not produce incentive +compensation at the News - nor vice versa. Neither do we look at +the price of Berkshire stock when we write bonus checks. We +believe good unit performance should be rewarded whether +Berkshire stock rises, falls, or stays even. Similarly, we think +average performance should earn no special rewards even if our +stock should soar. “Performance”, furthermore, is defined in +different ways depending upon the underlying economics of the +business: in some our managers enjoy tailwinds not of their own +making, in others they fight unavoidable headwinds. + + The rewards that go with this system can be large. At our +various business units, top managers sometimes receive incentive +bonuses of five times their base salary, or more, and it would +appear possible that one manager’s bonus could top $2 million in +1986. (I hope so.) We do not put a cap on bonuses, and the +potential for rewards is not hierarchical. The manager of a +relatively small unit can earn far more than the manager of a +larger unit if results indicate he should. We believe, further, +that such factors as seniority and age should not affect +incentive compensation (though they sometimes influence basic +compensation). A 20-year-old who can hit .300 is as valuable to +us as a 40-year-old performing as well. + + Obviously, all Berkshire managers can use their bonus money +(or other funds, including borrowed money) to buy our stock in +the market. Many have done just that - and some now have large +holdings. By accepting both the risks and the carrying costs +that go with outright purchases, these managers truly walk in the +shoes of owners. + + Now let’s get back - at long last - to our three businesses: + + At Nebraska Furniture Mart our basic strength is an +exceptionally low-cost operation that allows the business to +regularly offer customers the best values available in home +furnishings. NFM is the largest store of its kind in the +country. Although the already-depressed farm economy worsened +considerably in 1985, the store easily set a new sales record. I +also am happy to report that NFM’s Chairman, Rose Blumkin (the +legendary “Mrs. B”), continues at age 92 to set a pace at the +store that none of us can keep up with. She’s there wheeling and +dealing seven days a week, and I hope that any of you who visit +Omaha will go out to the Mart and see her in action. It will +inspire you, as it does me. + + At See’s we continue to get store volumes that are far +beyond those achieved by any competitor we know of. Despite the +unmatched consumer acceptance we enjoy, industry trends are not +good, and we continue to experience slippage in poundage sales on +a same-store basis. This puts pressure on per-pound costs. We +now are willing to increase prices only modestly and, unless we +can stabilize per-shop poundage, profit margins will narrow. + + At the News volume gains are also difficult to achieve. +Though linage increased during 1985, the gain was more than +accounted for by preprints. ROP linage (advertising printed on +our own pages) declined. Preprints are far less profitable than +ROP ads, and also more vulnerable to competition. In 1985, the +News again controlled costs well and our household penetration +continues to be exceptional. + + One problem these three operations do not have is +management. At See’s we have Chuck Huggins, the man we put in +charge the day we bought the business. Selecting him remains one +of our best business decisions. At the News we have Stan Lipsey, +a manager of equal caliber. Stan has been with us 17 years, and +his unusual business talents have become more evident with every +additional level of responsibility he has tackled. And, at the +Mart, we have the amazing Blumkins - Mrs. B, Louie, Ron, Irv, and +Steve - a three-generation miracle of management. + + I consider myself extraordinarily lucky to be able to work +with managers such as these. I like them personally as much as I +admire them professionally. + +Insurance Operations + + Shown below is an updated version of our usual table, +listing two key figures for the insurance industry: + + Yearly Change Combined Ratio + in Premiums after Policyholder + Written (%) Dividends + ------------- ------------------ + 1972 ............... 10.2 96.2 + 1973 ............... 8.0 99.2 + 1974 ............... 6.2 105.4 + 1975 ............... 11.0 107.9 + 1976 ............... 21.9 102.4 + 1977 ............... 19.8 97.2 + 1978 ............... 12.8 97.5 + 1979 ............... 10.3 100.6 + 1980 ............... 6.0 103.1 + 1981 ............... 3.9 106.0 + 1982 ............... 4.4 109.7 + 1983 ............... 4.5 111.9 + 1984 (Revised) ..... 9.2 117.9 + 1985 (Estimated) ... 20.9 118.0 + +Source: Best’s Aggregates and Averages + + The combined ratio represents total insurance costs (losses +incurred plus expenses) compared to revenue from premiums: a +ratio below 100 indicates an underwriting profit, and one above +100 indicates a loss. + + The industry’s 1985 results were highly unusual. The +revenue gain was exceptional, and had insured losses grown at +their normal rate of most recent years - that is, a few points +above the inflation rate - a significant drop in the combined +ratio would have occurred. But losses in 1985 didn’t cooperate, +as they did not in 1984. Though inflation slowed considerably in +these years, insured losses perversely accelerated, growing by +16% in 1984 and by an even more startling 17% in 1985. The +year’s growth in losses therefore exceeds the inflation rate by +over 13 percentage points, a modern record. + + Catastrophes were not the culprit in this explosion of loss +cost. True, there were an unusual number of hurricanes in 1985, +but the aggregate damage caused by all catastrophes in 1984 and +1985 was about 2% of premium volume, a not unusual proportion. +Nor was there any burst in the number of insured autos, houses, +employers, or other kinds of “exposure units”. + + A partial explanation for the surge in the loss figures is +all the additions to reserves that the industry made in 1985. As +results for the year were reported, the scene resembled a revival +meeting: shouting “I’ve sinned, I’ve sinned”, insurance managers +rushed forward to confess they had under reserved in earlier +years. Their corrections significantly affected 1985 loss +numbers. + + A more disturbing ingredient in the loss surge is the +acceleration in “social” or “judicial” inflation. The insurer’s +ability to pay has assumed overwhelming importance with juries +and judges in the assessment of both liability and damages. More +and more, “the deep pocket” is being sought and found, no matter +what the policy wording, the facts, or the precedents. + + This judicial inflation represents a wild card in the +industry’s future, and makes forecasting difficult. +Nevertheless, the short-term outlook is good. Premium growth +improved as 1985 went along (quarterly gains were an estimated +15%, 19%, 24%, and 22%) and, barring a supercatastrophe, the +industry’s combined ratio should fall sharply in 1986. + + The profit improvement, however, is likely to be of short +duration. Two economic principles will see to that. First, +commodity businesses achieve good levels of profitability only +when prices are fixed in some manner or when capacity is short. +Second, managers quickly add to capacity when prospects start to +improve and capital is available. + + In my 1982 report to you, I discussed the commodity nature +of the insurance industry extensively. The typical policyholder +does not differentiate between products but concentrates instead +on price. For many decades a cartel-like procedure kept prices +up, but this arrangement has disappeared for good. The insurance +product now is priced as any other commodity for which a free +market exists: when capacity is tight, prices will be set +remuneratively; otherwise, they will not be. + + Capacity currently is tight in many lines of insurance - +though in this industry, unlike most, capacity is an attitudinal +concept, not a physical fact. Insurance managers can write +whatever amount of business they feel comfortable writing, +subject only to pressures applied by regulators and Best’s, the +industry’s authoritative rating service. The comfort level of +both managers and regulators is tied to capital. More capital +means more comfort, which in turn means more capacity. In the +typical commodity business, furthermore, such as aluminum or +steel, a long gestation precedes the birth of additional +capacity. In the insurance industry, capital can be secured +instantly. Thus, any capacity shortage can be eliminated in +short order. + + That’s exactly what’s going on right now. In 1985, about 15 +insurers raised well over $3 billion, piling up capital so that +they can write all the business possible at the better prices now +available. The capital-raising trend has accelerated +dramatically so far in 1986. + + If capacity additions continue at this rate, it won’t be +long before serious price-cutting appears and next a fall in +profitability. When the fall comes, it will be the fault of the +capital-raisers of 1985 and 1986, not the price-cutters of 198X. +(Critics should be understanding, however: as was the case in our +textile example, the dynamics of capitalism cause each insurer to +make decisions that for itself appear sensible, but that +collectively slash profitability.) + + In past reports, I have told you that Berkshire’s strong +capital position - the best in the industry - should one day +allow us to claim a distinct competitive advantage in the +insurance market. With the tightening of the market, that day +arrived. Our premium volume more than tripled last year, +following a long period of stagnation. Berkshire’s financial +strength (and our record of maintaining unusual strength through +thick and thin) is now a major asset for us in securing good +business. + + We correctly foresaw a flight to quality by many large +buyers of insurance and reinsurance who belatedly recognized that +a policy is only an IOU - and who, in 1985, could not collect on +many of their IOUs. These buyers today are attracted to +Berkshire because of its strong capital position. But, in a +development we did not foresee, we also are finding buyers drawn +to us because our ability to insure substantial risks sets us +apart from the crowd. + + To understand this point, you need a few background facts +about large risks. Traditionally, many insurers have wanted to +write this kind of business. However, their willingness to do so +has been almost always based upon reinsurance arrangements that +allow the insurer to keep just a small portion of the risk itself +while passing on (“laying off”) most of the risk to its +reinsurers. Imagine, for example, a directors and officers +(“D & O”) liability policy providing $25 million of coverage. +By various “excess-of-loss” reinsurance contracts, the company +issuing that policy might keep the liability for only the first +$1 million of any loss that occurs. The liability for any loss +above that amount up to $24 million would be borne by the +reinsurers of the issuing insurer. In trade parlance, a company +that issues large policies but retains relatively little of the +risk for its own account writes a large gross line but a small +net line. + + In any reinsurance arrangement, a key question is how the +premiums paid for the policy should be divided among the various +“layers” of risk. In our D & O policy, for example. what part of +the premium received should be kept by the issuing company to +compensate it fairly for taking the first $1 million of risk and +how much should be passed on to the reinsurers to compensate them +fairly for taking the risk between $1 million and $25 million? + + One way to solve this problem might be deemed the Patrick +Henry approach: “I have but one lamp by which my feet are guided, +and that is the lamp of experience.” In other words, how much of +the total premium would reinsurers have needed in the past to +compensate them fairly for the losses they actually had to bear? + + Unfortunately, the lamp of experience has always provided +imperfect illumination for reinsurers because so much of their +business is “long-tail”, meaning it takes many years before they +know what their losses are. Lately, however, the light has not +only been dim but also grossly misleading in the images it has +revealed. That is, the courts’ tendency to grant awards that are +both huge and lacking in precedent makes reinsurers’ usual +extrapolations or inferences from past data a formula for +disaster. Out with Patrick Henry and in with Pogo: “The future +ain’t what it used to be.” + + The burgeoning uncertainties of the business, coupled with +the entry into reinsurance of many unsophisticated participants, +worked in recent years in favor of issuing companies writing a +small net line: they were able to keep a far greater percentage +of the premiums than the risk. By doing so, the issuing +companies sometimes made money on business that was distinctly +unprofitable for the issuing and reinsuring companies combined. +(This result was not necessarily by intent: issuing companies +generally knew no more than reinsurers did about the ultimate +costs that would be experienced at higher layers of risk.) +Inequities of this sort have been particularly pronounced in +lines of insurance in which much change was occurring and losses +were soaring; e.g., professional malpractice, D & 0, products +liability, etc. Given these circumstances, it is not surprising +that issuing companies remained enthusiastic about writing +business long after premiums became woefully inadequate on a +gross basis. + + An example of just how disparate results have been for +issuing companies versus their reinsurers is provided by the 1984 +financials of one of the leaders in large and unusual risks. In +that year the company wrote about $6 billion of business and kept +around $2 1/2 billion of the premiums, or about 40%. It gave the +remaining $3 1/2 billion to reinsurers. On the part of the +business kept, the company’s underwriting loss was less than $200 +million - an excellent result in that year. Meanwhile, the part +laid off produced a loss of over $1.5 billion for the reinsurers. +Thus, the issuing company wrote at a combined ratio of well under +110 while its reinsurers, participating in precisely the same +policies, came in considerably over 140. This result was not +attributable to natural catastrophes; it came from run-of-the- +mill insurance losses (occurring, however, in surprising +frequency and size). The issuing company’s 1985 report is not +yet available, but I would predict it will show that dramatically +unbalanced results continued. + + A few years such as this, and even slow-witted reinsurers +can lose interest, particularly in explosive lines where the +proper split in premium between issuer and reinsurer remains +impossible to even roughly estimate. The behavior of reinsurers +finally becomes like that of Mark Twain’s cat: having once sat on +a hot stove, it never did so again - but it never again sat on a +cold stove, either. Reinsurers have had so many unpleasant +surprises in long-tail casualty lines that many have decided +(probably correctly) to give up the game entirely, regardless of +price inducements. Consequently, there has been a dramatic pull- +back of reinsurance capacity in certain important lines. + + This development has left many issuing companies under +pressure. They can no longer commit their reinsurers, time after +time, for tens of millions per policy as they so easily could do +only a year or two ago, and they do not have the capital and/or +appetite to take on large risks for their own account. For many +issuing companies, gross capacity has shrunk much closer to net +capacity - and that is often small, indeed. + + At Berkshire we have never played the lay-it-off-at-a-profit +game and, until recently, that put us at a severe disadvantage in +certain lines. Now the tables are turned: we have the +underwriting capability whereas others do not. If we believe the +price to be right, we are willing to write a net line larger than +that of any but the largest insurers. For instance, we are +perfectly willing to risk losing $10 million of our own money on +a single event, as long as we believe that the price is right and +that the risk of loss is not significantly correlated with other +risks we are insuring. Very few insurers are willing to risk +half that much on single events - although, just a short while +ago, many were willing to lose five or ten times that amount as +long as virtually all of the loss was for the account of their +reinsurers. + + In mid-1985 our largest insurance company, National +Indemnity Company, broadcast its willingness to underwrite large +risks by running an ad in three issues of an insurance weekly. +The ad solicited policies of only large size: those with a +minimum premium of $1 million. This ad drew a remarkable 600 +replies and ultimately produced premiums totaling about $50 +million. (Hold the applause: it’s all long-tail business and it +will be at least five years before we know whether this marketing +success was also an underwriting success.) Today, our insurance +subsidiaries continue to be sought out by brokers searching for +large net capacity. + + As I have said, this period of tightness will pass; insurers +and reinsurers will return to underpricing. But for a year or +two we should do well in several segments of our insurance +business. Mike Goldberg has made many important improvements in +the operation (prior mismanagement by your Chairman having +provided him ample opportunity to do so). He has been +particularly successful recently in hiring young managers with +excellent potential. They will have a chance to show their stuff +in 1986. + + Our combined ratio has improved - from 134 in 1984 to 111 in +1985 - but continues to reflect past misdeeds. Last year I told +you of the major mistakes I had made in loss-reserving, and +promised I would update you annually on loss-development figures. +Naturally, I made this promise thinking my future record would be +much improved. So far this has not been the case. Details on +last year’s loss development are on pages 50-52. They reveal +significant underreserving at the end of 1984, as they did in the +several years preceding. + + The only bright spot in this picture is that virtually all +of the underreserving revealed in 1984 occurred in the +reinsurance area - and there, in very large part, in a few +contracts that were discontinued several years ago. This +explanation, however, recalls all too well a story told me many +years ago by the then Chairman of General Reinsurance Company. +He said that every year his managers told him that “except for +the Florida hurricane” or “except for Midwestern tornadoes”, they +would have had a terrific year. Finally he called the group +together and suggested that they form a new operation - the +Except-For Insurance Company - in which they would henceforth +place all of the business that they later wouldn’t want to count. + + In any business, insurance or otherwise, “except for” should +be excised from the lexicon. If you are going to play the game, +you must count the runs scored against you in all nine innings. +Any manager who consistently says “except for” and then reports +on the lessons he has learned from his mistakes may be missing +the only important lesson - namely, that the real mistake is not +the act, but the actor. + + Inevitably, of course, business errors will occur and the +wise manager will try to find the proper lessons in them. But +the trick is to learn most lessons from the experiences of +others. Managers who have learned much from personal experience +in the past usually are destined to learn much from personal +experience in the future. + + GEICO, 38%-owned by Berkshire, reported an excellent year in +1985 in premium growth and investment results, but a poor year - +by its lofty standards - in underwriting. Private passenger auto +and homeowners insurance were the only important lines in the +industry whose results deteriorated significantly during the +year. GEICO did not escape the trend, although its record was +far better than that of virtually all its major competitors. + + Jack Byrne left GEICO at mid-year to head Fireman’s Fund, +leaving behind Bill Snyder as Chairman and Lou Simpson as Vice +Chairman. Jack’s performance in reviving GEICO from near- +bankruptcy was truly extraordinary, and his work resulted in +enormous gains for Berkshire. We owe him a great deal for that. + + We are equally indebted to Jack for an achievement that +eludes most outstanding leaders: he found managers to succeed him +who have talents as valuable as his own. By his skill in +identifying, attracting and developing Bill and Lou, Jack +extended the benefits of his managerial stewardship well beyond +his tenure. + +Fireman’s Fund Quota-Share Contract + + Never one to let go of a meal ticket, we have followed Jack +Byrne to Fireman’s Fund (“FFIC”) where he is Chairman and CEO of +the holding company. + + On September 1, 1985 we became a 7% participant in all of +the business in force of the FFIC group, with the exception of +reinsurance they write for unaffiliated companies. Our contract +runs for four years, and provides that our losses and costs will +be proportionate to theirs throughout the contract period. If +there is no extension, we will thereafter have no participation +in any ongoing business. However, for a great many years in the +future, we will be reimbursing FFIC for our 7% of the losses that +occurred in the September 1, 1985 - August 31, 1989 period. + + Under the contract FFIC remits premiums to us promptly and +we reimburse FFIC promptly for expenses and losses it has paid. +Thus, funds generated by our share of the business are held by us +for investment. As part of the deal, I’m available to FFIC for +consultation about general investment strategy. I’m not +involved, however, in specific investment decisions of FFIC, nor +is Berkshire involved in any aspect of the company’s underwriting +activities. + + Currently FFIC is doing about $3 billion of business, and it +will probably do more as rates rise. The company’s September 1, +1985 unearned premium reserve was $1.324 billion, and it +therefore transferred 7% of this, or $92.7 million, to us at +initiation of the contract. We concurrently paid them $29.4 +million representing the underwriting expenses that they had +incurred on the transferred premium. All of the FFIC business is +written by National Indemnity Company, but two-sevenths of it is +passed along to Wesco-Financial Insurance Company (“Wes-FIC”), a +new company organized by our 80%-owned subsidiary, Wesco +Financial Corporation. Charlie Munger has some interesting +comments about Wes-FIC and the reinsurance business on pages 60- +62. + + To the Insurance Segment tables on page 41, we have added a +new line, labeled Major Quota Share Contracts. The 1985 results +of the FFIC contract are reported there, though the newness of +the arrangement makes these results only very rough +approximations. + +After the end of the year, we secured another quota-share +contract, whose 1986 volume should be over $50 million. We hope +to develop more of this business, and industry conditions suggest +that we could: a significant number of companies are generating +more business than they themselves can prudently handle. Our +financial strength makes us an attractive partner for such +companies. + +Marketable Securities + +We show below our 1985 yearend net holdings in marketable +equities. All positions with a market value over $25 million are +listed, and the interests attributable to minority shareholders +of Wesco and Nebraska Furniture Mart are excluded. + +No. of Shares Cost Market +------------- ---------- ---------- + (000s omitted) + 1,036,461 Affiliated Publications, Inc. ....... $ 3,516 $ 55,710 + 900,800 American Broadcasting Companies, Inc. 54,435 108,997 + 2,350,922 Beatrice Companies, Inc. ............ 106,811 108,142 + 6,850,000 GEICO Corporation ................... 45,713 595,950 + 2,379,200 Handy & Harman ...................... 27,318 43,718 + 847,788 Time, Inc. .......................... 20,385 52,669 + 1,727,765 The Washington Post Company ......... 9,731 205,172 + ---------- ---------- + 267,909 1,170,358 + All Other Common Stockholdings ...... 7,201 27,963 + ---------- ---------- + Total Common Stocks $275,110 $1,198,321 + ========== ========== + + We mentioned earlier that in the past decade the investment +environment has changed from one in which great businesses were +totally unappreciated to one in which they are appropriately +recognized. The Washington Post Company (“WPC”) provides an +excellent example. + + We bought all of our WPC holdings in mid-1973 at a price of +not more than one-fourth of the then per-share business value of +the enterprise. Calculating the price/value ratio required no +unusual insights. Most security analysts, media brokers, and +media executives would have estimated WPC’s intrinsic business +value at $400 to $500 million just as we did. And its $100 +million stock market valuation was published daily for all to +see. Our advantage, rather, was attitude: we had learned from +Ben Graham that the key to successful investing was the purchase +of shares in good businesses when market prices were at a large +discount from underlying business values. + + Most institutional investors in the early 1970s, on the +other hand, regarded business value as of only minor relevance +when they were deciding the prices at which they would buy or +sell. This now seems hard to believe. However, these +institutions were then under the spell of academics at +prestigious business schools who were preaching a newly-fashioned +theory: the stock market was totally efficient, and therefore +calculations of business value - and even thought, itself - were +of no importance in investment activities. (We are enormously +indebted to those academics: what could be more advantageous in +an intellectual contest - whether it be bridge, chess, or stock +selection than to have opponents who have been taught that +thinking is a waste of energy?) + + Through 1973 and 1974, WPC continued to do fine as a +business, and intrinsic value grew. Nevertheless, by yearend +1974 our WPC holding showed a loss of about 25%, with market +value at $8 million against our cost of $10.6 million. What we +had thought ridiculously cheap a year earlier had become a good +bit cheaper as the market, in its infinite wisdom, marked WPC +stock down to well below 20 cents on the dollar of intrinsic +value. + + You know the happy outcome. Kay Graham, CEO of WPC, had the +brains and courage to repurchase large quantities of stock for +the company at those bargain prices, as well as the managerial +skills necessary to dramatically increase business values. +Meanwhile, investors began to recognize the exceptional economics +of the business and the stock price moved closer to underlying +value. Thus, we experienced a triple dip: the company’s business +value soared upward, per-share business value increased +considerably faster because of stock repurchases and, with a +narrowing of the discount, the stock price outpaced the gain in +per-share business value. + + We hold all of the WPC shares we bought in 1973, except for +those sold back to the company in 1985’s proportionate +redemption. Proceeds from the redemption plus yearend market +value of our holdings total $221 million. + + If we had invested our $10.6 million in any of a half-dozen +media companies that were investment favorites in mid-1973, the +value of our holdings at yearend would have been in the area of +$40 - $60 million. Our gain would have far exceeded the gain in +the general market, an outcome reflecting the exceptional +economics of the media business. The extra $160 million or so we +gained through ownership of WPC came, in very large part, from +the superior nature of the managerial decisions made by Kay as +compared to those made by managers of most media companies. Her +stunning business success has in large part gone unreported but +among Berkshire shareholders it should not go unappreciated. + + Our Capital Cities purchase, described in the next section, +required me to leave the WPC Board early in 1986. But we intend +to hold indefinitely whatever WPC stock FCC rules allow us to. +We expect WPC’s business values to grow at a reasonable rate, and +we know that management is both able and shareholder-oriented. +However, the market now values the company at over $1.8 billion, +and there is no way that the value can progress from that level +at a rate anywhere close to the rate possible when the company’s +valuation was only $100 million. Because market prices have also +been bid up for our other holdings, we face the same vastly- +reduced potential throughout our portfolio. + + You will notice that we had a significant holding in +Beatrice Companies at yearend. This is a short-term arbitrage +holding - in effect, a parking place for money (though not a +totally safe one, since deals sometimes fall through and create +substantial losses). We sometimes enter the arbitrage field when +we have more money than ideas, but only to participate in +announced mergers and sales. We would be a lot happier if the +funds currently employed on this short-term basis found a long- +term home. At the moment, however, prospects are bleak. + + At yearend our insurance subsidiaries had about $400 million +in tax-exempt bonds, of which $194 million at amortized cost were +issues of Washington Public Power Supply System (“WPPSS”) +Projects 1, 2, and 3. 1 discussed this position fully last year, +and explained why we would not disclose further purchases or +sales until well after the fact (adhering to the policy we follow +on stocks). Our unrealized gain on the WPPSS bonds at yearend +was $62 million, perhaps one-third arising from the upward +movement of bonds generally, and the remainder from a more +positive investor view toward WPPSS 1, 2, and 3s. Annual tax- +exempt income from our WPPSS issues is about $30 million. + +Capital Cities/ABC, Inc. + + Right after yearend, Berkshire purchased 3 million shares of +Capital Cities/ABC, Inc. (“Cap Cities”) at $172.50 per share, the +market price of such shares at the time the commitment was made +early in March, 1985. I’ve been on record for many years about +the management of Cap Cities: I think it is the best of any +publicly-owned company in the country. And Tom Murphy and Dan +Burke are not only great managers, they are precisely the sort of +fellows that you would want your daughter to marry. It is a +privilege to be associated with them - and also a lot of fun, as +any of you who know them will understand. + + Our purchase of stock helped Cap Cities finance the $3.5 +billion acquisition of American Broadcasting Companies. For Cap +Cities, ABC is a major undertaking whose economics are likely to +be unexciting over the next few years. This bothers us not an +iota; we can be very patient. (No matter how great the talent or +effort, some things just take time: you can’t produce a baby in +one month by getting nine women pregnant.) + + As evidence of our confidence, we have executed an unusual +agreement: for an extended period Tom, as CEO (or Dan, should he +be CEO) votes our stock. This arrangement was initiated by +Charlie and me, not by Tom. We also have restricted ourselves in +various ways regarding sale of our shares. The object of these +restrictions is to make sure that our block does not get sold to +anyone who is a large holder (or intends to become a large +holder) without the approval of management, an arrangement +similar to ones we initiated some years ago at GEICO and +Washington Post. + + Since large blocks frequently command premium prices, some +might think we have injured Berkshire financially by creating +such restrictions. Our view is just the opposite. We feel the +long-term economic prospects for these businesses - and, thus, +for ourselves as owners - are enhanced by the arrangements. With +them in place, the first-class managers with whom we have aligned +ourselves can focus their efforts entirely upon running the +businesses and maximizing long-term values for owners. Certainly +this is much better than having those managers distracted by +“revolving-door capitalists” hoping to put the company “in play”. +(Of course, some managers place their own interests above those +of the company and its owners and deserve to be shaken up - but, +in making investments, we try to steer clear of this type.) + + Today, corporate instability is an inevitable consequence of +widely-diffused ownership of voting stock. At any time a major +holder can surface, usually mouthing reassuring rhetoric but +frequently harboring uncivil intentions. By circumscribing our +blocks of stock as we often do, we intend to promote stability +where it otherwise might be lacking. That kind of certainty, +combined with a good manager and a good business, provides +excellent soil for a rich financial harvest. That’s the economic +case for our arrangements. + + The human side is just as important. We don’t want managers +we like and admire - and who have welcomed a major financial +commitment by us - to ever lose any sleep wondering whether +surprises might occur because of our large ownership. I have +told them there will be no surprises, and these agreements put +Berkshire’s signature where my mouth is. That signature also +means the managers have a corporate commitment and therefore need +not worry if my personal participation in Berkshire’s affairs +ends prematurely (a term I define as any age short of three +digits). + + Our Cap Cities purchase was made at a full price, reflecting +the very considerable enthusiasm for both media stocks and media +properties that has developed in recent years (and that, in the +case of some property purchases, has approached a mania). it’s no +field for bargains. However, our Cap Cities investment allies us +with an exceptional combination of properties and people - and we +like the opportunity to participate in size. + + Of course, some of you probably wonder why we are now buying +Cap Cities at $172.50 per share given that your Chairman, in a +characteristic burst of brilliance, sold Berkshire’s holdings in +the same company at $43 per share in 1978-80. Anticipating your +question, I spent much of 1985 working on a snappy answer that +would reconcile these acts. + + A little more time, please. + +Acquisition of Scott & Fetzer + + Right after yearend we acquired The Scott & Fetzer Company +(“Scott Fetzer”) of Cleveland for about $320 million. (In +addition, about $90 million of pre-existing Scott Fetzer debt +remains in place.) In the next section of this report I describe +the sort of businesses that we wish to buy for Berkshire. Scott +Fetzer is a prototype - understandable, large, well-managed, a +good earner. + + The company has sales of about $700 million derived from 17 +businesses, many leaders in their fields. Return on invested +capital is good to excellent for most of these businesses. Some +well-known products are Kirby home-care systems, Campbell +Hausfeld air compressors, and Wayne burners and water pumps. + + World Book, Inc. - accounting for about 40% of Scott +Fetzer’s sales and a bit more of its income - is by far the +company’s largest operation. It also is by far the leader in its +industry, selling more than twice as many encyclopedia sets +annually as its nearest competitor. In fact, it sells more sets +in the U.S. than its four biggest competitors combined. + + Charlie and I have a particular interest in the World Book +operation because we regard its encyclopedia as something +special. I’ve been a fan (and user) for 25 years, and now have +grandchildren consulting the sets just as my children did. World +Book is regularly rated the most useful encyclopedia by teachers, +librarians and consumer buying guides. Yet it sells for less +than any of its major competitors. Childcraft, another World +Book, Inc. product, offers similar value. This combination of +exceptional products and modest prices at World Book, Inc. helped +make us willing to pay the price demanded for Scott Fetzer, +despite declining results for many companies in the direct- +selling industry. + + An equal attraction at Scott Fetzer is Ralph Schey, its CEO +for nine years. When Ralph took charge, the company had 31 +businesses, the result of an acquisition spree in the 1960s. He +disposed of many that did not fit or had limited profit +potential, but his focus on rationalizing the original potpourri +was not so intense that he passed by World Book when it became +available for purchase in 1978. Ralph’s operating and capital- +allocation record is superb, and we are delighted to be +associated with him. + + The history of the Scott Fetzer acquisition is interesting, +marked by some zigs and zags before we became involved. The +company had been an announced candidate for purchase since early +1984. A major investment banking firm spent many months +canvassing scores of prospects, evoking interest from several. +Finally, in mid-1985 a plan of sale, featuring heavy +participation by an ESOP (Employee Stock Ownership Plan), was +approved by shareholders. However, as difficulty in closing +followed, the plan was scuttled. + + I had followed this corporate odyssey through the +newspapers. On October 10, well after the ESOP deal had fallen +through, I wrote a short letter to Ralph, whom I did not know. I +said we admired the company’s record and asked if he might like +to talk. Charlie and I met Ralph for dinner in Chicago on +October 22 and signed an acquisition contract the following week. + + The Scott Fetzer acquisition, plus major growth in our +insurance business, should push revenues above $2 billion in +1986, more than double those of 1985. + +Miscellaneous + + The Scott Fetzer purchase illustrates our somewhat haphazard +approach to acquisitions. We have no master strategy, no +corporate planners delivering us insights about socioeconomic +trends, and no staff to investigate a multitude of ideas +presented by promoters and intermediaries. Instead, we simply +hope that something sensible comes along - and, when it does, we +act. + + To give fate a helping hand, we again repeat our regular +“business wanted” ad. The only change from last year’s copy is +in (1): because we continue to want any acquisition we make to +have a measurable impact on Berkshire’s financial results, we +have raised our minimum profit requirement. + + Here’s what we’re looking for: + (1) large purchases (at least $10 million of after-tax + earnings), + (2) demonstrated consistent earning power (future + projections are of little interest to us, nor are + “turn-around” situations), + (3) businesses earning good returns on equity while + employing little or no debt, + (4) management in place (we can’t supply it), + (5) simple businesses (if there’s lots of technology, we + won’t understand it), + (6) an offering price (we don’t want to waste our time + or that of the seller by talking, even preliminarily, + about a transaction when price is unknown). + + We will not engage in unfriendly takeovers. We can promise +complete confidentiality and a very fast answer - customarily +within five minutes - as to whether we’re interested. We prefer +to buy for cash, but will consider issuance of stock when we +receive as much in intrinsic business value as we give. Indeed, +following recent advances in the price of Berkshire stock, +transactions involving stock issuance may be quite feasible. We +invite potential sellers to check us out by contacting people +with whom we have done business in the past. For the right +business - and the right people - we can provide a good home. + + On the other hand, we frequently get approached about +acquisitions that don’t come close to meeting our tests: new +ventures, turnarounds, auction-like sales, and the ever-popular +(among brokers) “I’m-sure-something-will-work-out-if-you-people- +get-to-know-each-other”. None of these attracts us in the least. + + * * * + + Besides being interested in the purchases of entire +businesses as described above, we are also interested in the +negotiated purchase of large, but not controlling, blocks of +stock, as in our Cap Cities purchase. Such purchases appeal to +us only when we are very comfortable with both the economics of +the business and the ability and integrity of the people running +the operation. We prefer large transactions: in the unusual case +we might do something as small as $50 million (or even smaller), +but our preference is for commitments many times that size. + + * * * + + About 96.8% of all eligible shares participated in +Berkshire’s 1985 shareholder-designated contributions program. +Total contributions made through the program were $4 million, and +1,724 charities were recipients. We conducted a plebiscite last +year in order to get your views about this program, as well as +about our dividend policy. (Recognizing that it’s possible to +influence the answers to a question by the framing of it, we +attempted to make the wording of ours as neutral as possible.) We +present the ballot and the results in the Appendix on page 69. I +think it’s fair to summarize your response as highly supportive +of present policies and your group preference - allowing for the +tendency of people to vote for the status quo - to be for +increasing the annual charitable commitment as our asset values +build. + + We urge new shareholders to read the description of our +shareholder-designated contributions program that appears on +pages 66 and 67. If you wish to participate in future programs, +we strongly urge that you immediately make sure that your shares +are registered in the name of the actual owner, not in “street” +name or nominee name. Shares not so registered on September 30, +1986 will be ineligible for the 1986 program. + + * * * + + Five years ago we were required by the Bank Holding Company +Act of 1969 to dispose of our holdings in The Illinois National +Bank and Trust Company of Rockford, Illinois. Our method of +doing so was unusual: we announced an exchange ratio between +stock of Rockford Bancorp Inc. (the Illinois National’s holding +company) and stock of Berkshire, and then let each of our +shareholders - except me - make the decision as to whether to +exchange all, part, or none of his Berkshire shares for Rockford +shares. I took the Rockford stock that was left over and thus my +own holding in Rockford was determined by your decisions. At the +time I said, “This technique embodies the world’s oldest and most +elementary system of fairly dividing an object. Just as when you +were a child and one person cut the cake and the other got first +choice, I have tried to cut the company fairly, but you get first +choice as to which piece you want.” + + Last fall Illinois National was sold. When Rockford’s +liquidation is completed, its shareholders will have received +per-share proceeds about equal to Berkshire’s per-share intrinsic +value at the time of the bank’s sale. I’m pleased that this +five-year result indicates that the division of the cake was +reasonably equitable. + + Last year I put in a plug for our annual meeting, and you +took me up on the invitation. Over 250 of our more than 3,000 +registered shareholders showed up. Those attending behaved just +as those present in previous years, asking the sort of questions +you would expect from intelligent and interested owners. You can +attend a great many annual meetings without running into a crowd +like ours. (Lester Maddox, when Governor of Georgia, was +criticized regarding the state’s abysmal prison system. “The +solution”, he said, “is simple. All we need is a better class of +prisoners.” Upgrading annual meetings works the same way.) + + I hope you come to this year’s meeting, which will be held +on May 20 in Omaha. There will be only one change: after 48 +years of allegiance to another soft drink, your Chairman, in an +unprecedented display of behavioral flexibility, has converted to +the new Cherry Coke. Henceforth, it will be the Official Drink +of the Berkshire Hathaway Annual Meeting. + + And bring money: Mrs. B promises to have bargains galore if +you will pay her a visit at The Nebraska Furniture Mart after the +meeting. + + + Warren E. Buffett + Chairman of the Board + +March 4, 1986 + ++ + diff --git a/berkshire-hathaway/1986/1-in/berkshire-hathaway-1986-letter.txt b/berkshire-hathaway/1986/1-in/berkshire-hathaway-1986-letter.txt new file mode 100644 index 0000000..873effa --- /dev/null +++ b/berkshire-hathaway/1986/1-in/berkshire-hathaway-1986-letter.txt @@ -0,0 +1,1864 @@ + + + + + + + +
BERKSHIRE HATHAWAY INC.
+
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+ Our gain in net worth during 1986 was $492.5 million, or
+26.1%. Over the last 22 years (that is, since present management
+took over), our per-share book value has grown from $19.46 to
+$2,073.06, or 23.3% compounded annually. Both the numerator and
+denominator are important in the per-share book value
+calculation: during the 22-year period our corporate net worth
+has increased 10,600% while shares outstanding have increased
+less than 1%.
+
+ In past reports I have noted that book value at most
+companies differs widely from intrinsic business value - the
+number that really counts for owners. In our own case, however,
+book value has served for more than a decade as a reasonable if
+somewhat conservative proxy for business value. That is, our
+business value has moderately exceeded our book value, with the
+ratio between the two remaining fairly steady.
+
+ The good news is that in 1986 our percentage gain in
+business value probably exceeded the book value gain. I say
+"probably" because business value is a soft number: in our own
+case, two equally well-informed observers might make judgments
+more than 10% apart.
+
+ A large measure of our improvement in business value
+relative to book value reflects the outstanding performance of
+key managers at our major operating businesses. These managers -
+the Blumkins, Mike Goldberg, the Heldmans, Chuck Huggins, Stan
+Lipsey, and Ralph Schey - have over the years improved the
+earnings of their businesses dramatically while, except in the
+case of insurance, utilizing little additional capital. This
+accomplishment builds economic value, or "Goodwill," that does
+not show up in the net worth figure on our balance sheet, nor in
+our per-share book value. In 1986 this unrecorded gain was
+substantial.
+
+ So much for the good news. The bad news is that my
+performance did not match that of our managers. While they were
+doing a superb job in running our businesses, I was unable to
+skillfully deploy much of the capital they generated.
+
+ Charlie Munger, our Vice Chairman, and I really have only
+two jobs. One is to attract and keep outstanding managers to run
+our various operations. This hasn’t been all that difficult.
+Usually the managers came with the companies we bought, having
+demonstrated their talents throughout careers that spanned a wide
+variety of business circumstances. They were managerial stars
+long before they knew us, and our main contribution has been to
+not get in their way. This approach seems elementary: if my job
+were to manage a golf team - and if Jack Nicklaus or Arnold
+Palmer were willing to play for me - neither would get a lot of
+directives from me about how to swing.
+
+ Some of our key managers are independently wealthy (we hope
+they all become so), but that poses no threat to their continued
+interest: they work because they love what they do and relish the
+thrill of outstanding performance. They unfailingly think like
+owners (the highest compliment we can pay a manager) and find all
+aspects of their business absorbing.
+
+ (Our prototype for occupational fervor is the Catholic
+tailor who used his small savings of many years to finance a
+pilgrimage to the Vatican. When he returned, his parish held a
+special meeting to get his first-hand account of the Pope. "Tell
+us," said the eager faithful, "just what sort of fellow is he?"
+Our hero wasted no words: "He’s a forty-four, medium.")
+
+ Charlie and I know that the right players will make almost
+any team manager look good. We subscribe to the philosophy of
+Ogilvy & Mather’s founding genius, David Ogilvy: "If each of us
+hires people who are smaller than we are, we shall become a
+company of dwarfs. But, if each of us hires people who are
+bigger than we are, we shall become a company of giants."
+
+ A by-product of our managerial style is the ability it gives
+us to easily expand Berkshire’s activities. We’ve read
+management treatises that specify exactly how many people should
+report to any one executive, but they make little sense to us.
+When you have able managers of high character running businesses
+about which they are passionate, you can have a dozen or more
+reporting to you and still have time for an afternoon nap.
+Conversely, if you have even one person reporting to you who is
+deceitful, inept or uninterested, you will find yourself with
+more than you can handle. Charlie and I could work with double
+the number of managers we now have, so long as they had the rare
+qualities of the present ones.
+
+ We intend to continue our practice of working only with
+people whom we like and admire. This policy not only maximizes
+our chances for good results, it also ensures us an
+extraordinarily good time. On the other hand, working with
+people who cause your stomach to churn seems much like marrying
+for money - probably a bad idea under any circumstances, but
+absolute madness if you are already rich.
+
+ The second job Charlie and I must handle is the allocation
+of capital, which at Berkshire is a considerably more important
+challenge than at most companies. Three factors make that so: we
+earn more money than average; we retain all that we earn; and, we
+are fortunate to have operations that, for the most part, require
+little incremental capital to remain competitive and to grow.
+Obviously, the future results of a business earning 23% annually
+and retaining it all are far more affected by today’s capital
+allocations than are the results of a business earning 10% and
+distributing half of that to shareholders. If our retained
+earnings - and those of our major investees, GEICO and Capital
+Cities/ABC, Inc. - are employed in an unproductive manner, the
+economics of Berkshire will deteriorate very quickly. In a
+company adding only, say, 5% to net worth annually, capital-
+allocation decisions, though still important, will change the
+company’s economics far more slowly.
+
+ Capital allocation at Berkshire was tough work in 1986. We
+did make one business acquisition - The Fechheimer Bros.
+Company, which we will discuss in a later section. Fechheimer is
+a company with excellent economics, run by exactly the kind of
+people with whom we enjoy being associated. But it is relatively
+small, utilizing only about 2% of Berkshire’s net worth.
+
+ Meanwhile, we had no new ideas in the marketable equities
+field, an area in which once, only a few years ago, we could
+readily employ large sums in outstanding businesses at very
+reasonable prices. So our main capital allocation moves in 1986
+were to pay off debt and stockpile funds. Neither is a fate
+worse than death, but they do not inspire us to do handsprings
+either. If Charlie and I were to draw blanks for a few years in
+our capital-allocation endeavors, Berkshire’s rate of growth
+would slow significantly.
+
+ We will continue to look for operating businesses that meet
+our tests and, with luck, will acquire such a business every
+couple of years. But an acquisition will have to be large if it
+is to help our performance materially. Under current stock
+market conditions, we have little hope of finding equities to buy
+for our insurance companies. Markets will change significantly -
+you can be sure of that and some day we will again get our turn
+at bat. However, we haven’t the faintest idea when that might
+happen.
+
+ It can’t be said too often (although I’m sure you feel I’ve
+tried) that, even under favorable conditions, our returns are
+certain to drop substantially because of our enlarged size. We
+have told you that we hope to average a return of 15% on equity
+and we maintain that hope, despite some negative tax law changes
+described in a later section of this report. If we are to
+achieve this rate of return, our net worth must increase $7.2
+billion in the next ten years. A gain of that magnitude will be
+possible only if, before too long, we come up with a few very big
+(and good) ideas. Charlie and I can’t promise results, but we do
+promise you that we will keep our efforts focused on our goals.
+
+Sources of Reported Earnings
+
+ The table on the next page shows the major sources of
+Berkshire’s reported earnings. This table differs in several
+ways from the one presented last year. We have added four new
+lines of business because of the Scott Fetzer and Fechheimer
+acquisitions. In the case of Scott Fetzer, the two major units
+acquired were World Book and Kirby, and each is presented
+separately. Fourteen other businesses of Scott Fetzer are
+aggregated in Scott Fetzer - Diversified Manufacturing. SF
+Financial Group, a credit company holding both World Book and
+Kirby receivables, is included in "Other." This year, because
+Berkshire is so much larger, we also have eliminated separate
+reporting for several of our smaller businesses.
+
+ In the table, amortization of Goodwill is not charged
+against the specific businesses but, for reasons outlined in the
+Appendix to my letter in the 1983 Annual Report, is aggregated as
+a separate item. (A Compendium of earlier letters, including the
+Goodwill discussion, is available upon request.) Both the Scott
+Fetzer and Fechheimer acquisitions created accounting Goodwill,
+which is why the amortization charge for Goodwill increased in
+1986.
+
+ Additionally, the Scott Fetzer acquisition required other
+major purchase-price accounting adjustments, as prescribed by
+generally accepted accounting principles (GAAP). The GAAP
+figures, of course, are the ones used in our consolidated
+financial statements. But, in our view, the GAAP figures are not
+necessarily the most useful ones for investors or managers.
+Therefore, the figures shown for specific operating units are
+earnings before purchase-price adjustments are taken into
+account. In effect, these are the earnings that would have been
+reported by the businesses if we had not purchased them.
+
+ A discussion of our reasons for preferring this form of
+presentation is in the Appendix to this letter. This Appendix
+will never substitute for a steamy novel and definitely is not
+required reading. However, I know that among our 6,000
+shareholders there are those who are thrilled by my essays on
+accounting - and I hope that both of you enjoy the Appendix.
+
+ In the Business Segment Data on pages 41-43 and in the
+Management’s Discussion section on pages 45-49, you will find
+much additional information about our businesses. I urge you to
+read those sections, as well as Charlie Munger’s letter to Wesco
+shareholders, describing the various businesses of that
+subsidiary, which starts on page 50.
+
+ (000s omitted)
+ ------------------------------------------
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ------------------- -------------------
+ 1986 1985 1986 1985
+ -------- -------- -------- --------
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............... $(55,844) $(44,230) $(29,864) $(23,569)
+ Net Investment Income ...... 107,143 95,217 96,440 79,716
+ Buffalo News ................. 34,736 29,921 16,918 14,580
+ Fechheimer (Acquired 6/3/86) 8,400 --- 3,792 ---
+ Kirby ........................ 20,218 --- 10,508 ---
+ Nebraska Furniture Mart ...... 17,685 12,686 7,192 5,181
+ Scott Fetzer - Diversified Mfg. 25,358 --- 13,354 ---
+ See’s Candies ................ 30,347 28,989 15,176 14,558
+ Wesco - other than insurance 5,542 16,018 5,550 9,684
+ World Book ................... 21,978 --- 11,670 ---
+ Amortization of Goodwill (2,555) (1,475) (2,555) (1,475)
+ Other purchase-price
+ accounting charges ........ (10,033) --- (11,031) ---
+ Interest on Debt and
+ Pre-Payment penalty ....... (23,891) (14,415) (12,213) (7,288)
+ Shareholder-Designated
+ Contributions ............. (3,997) (4,006) (2,158) (2,164)
+ Other ........................ 20,770 6,744 8,685 3,725
+ -------- -------- -------- --------
+Operating Earnings ............. 195,857 125,449 131,464 92,948
+Special General Foods
+ Distribution ................ --- 4,127 --- 3,779
+Special Washington Post
+ Distribution ................ --- 14,877 --- 13,851
+Sales of securities ............ 216,242 468,903 150,897 325,237
+ -------- -------- -------- --------
+Total Earnings - all entities .. $412,099 $613,356 $282,361 $435,815
+ ======== ======== ======== ========
+
+ As you can see, operating earnings substantially improved
+during 1986. Some of the improvement came from the insurance
+operation, whose results I will discuss in a later section.
+Fechheimer also will be discussed separately. Our other major
+businesses performed as follows:
+
+ o Operating results at The Buffalo News continue to reflect a
+truly superb managerial job by Stan Lipsey. For the third year
+in a row, man-hours worked fell significantly and other costs
+were closely controlled. Consequently, our operating margins
+improved materially in 1986, even though our advertising rate
+increases were well below those of most major newspapers.
+
+ Our cost-control efforts have in no way reduced our
+commitment to news. We continue to deliver a 50% "news hole"
+(the portion of the total space in the paper devoted to news), a
+higher percentage, we believe, than exists at any dominant
+newspaper in this country of our size or larger.
+
+ The average news hole at papers comparable to the News is
+about 40%. The difference between 40% and 50% is more important
+than it might first seem: a paper with 30 pages of ads and a 40%
+news hole delivers 20 pages of news a day, whereas our paper
+matches 30 pages of ads with 30 pages of news. Therefore, given
+ad pages equal in number, we end up delivering our readers no
+less than 50% more news.
+
+ We believe this heavy commitment to news is one of the
+reasons The Buffalo News has the highest weekday penetration rate
+(the percentage of households in the paper’s primary marketing
+area purchasing it each day) among any of the top 50 papers in
+the country. Our Sunday penetration, where we are also number
+one, is even more impressive. Ten years ago, the only Sunday
+paper serving Buffalo (the Courier-Express) had circulation of
+271,000 and a penetration ratio of about 63%. The Courier-
+Express had served the area for many decades and its penetration
+ratio - which was similar to those existing in many metropolitan
+markets - was thought to be a "natural" one, accurately
+reflecting the local citizenry’s appetite for a Sunday product.
+
+ Our Sunday paper was started in late 1977. It now has a
+penetration ratio of 83% and sells about 100,000 copies more each
+Sunday than did the Courier-Express ten years ago - even though
+population in our market area has declined during the decade. In
+recent history, no other city that has long had a local Sunday
+paper has experienced a penetration gain anywhere close to
+Buffalo’s.
+
+ Despite our exceptional market acceptance, our operating
+margins almost certainly have peaked. A major newsprint price
+increase took effect at the end of 1986, and our advertising rate
+increases in 1987 will again be moderate compared to those of the
+industry. However, even if margins should materially shrink, we
+would not reduce our news-hole ratio.
+
+ As I write this, it has been exactly ten years since we
+purchased The News. The financial rewards it has brought us have
+far exceeded our expectations and so, too, have the non-financial
+rewards. Our respect for the News - high when we bought it - has
+grown consistently ever since the purchase, as has our respect
+and admiration for Murray Light, the editor who turns out the
+product that receives such extraordinary community acceptance.
+The efforts of Murray and Stan, which were crucial to the News
+during its dark days of financial reversals and litigation, have
+not in the least been lessened by prosperity. Charlie and I are
+grateful to them.
+
+ o The amazing Blumkins continue to perform business miracles
+at Nebraska Furniture Mart. Competitors come and go (mostly go),
+but Mrs. B. and her progeny roll on. In 1986 net sales increased
+10.2% to $132 million. Ten years ago sales were $44 million and,
+even then, NFM appeared to be doing just about all of the
+business available in the Greater Omaha Area. Given NFM’s
+remarkable dominance, Omaha’s slow growth in population and the
+modest inflation rates that have applied to the goods NFM sells,
+how can this operation continue to rack up such large sales
+gains? The only logical explanation is that the marketing
+territory of NFM’s one-and-only store continues to widen because
+of its ever-growing reputation for rock-bottom everyday prices
+and the broadest of selections. In preparation for further
+gains, NFM is expanding the capacity of its warehouse, located a
+few hundred yards from the store, by about one-third.
+
+ Mrs. B, Chairman of Nebraska Furniture Mart, continues at
+age 93 to outsell and out-hustle any manager I’ve ever seen.
+She’s at the store seven days a week, from opening to close.
+Competing with her represents a triumph of courage over judgment.
+
+ It’s easy to overlook what I consider to be the critical
+lesson of the Mrs. B saga: at 93, Omaha based Board Chairmen have
+yet to reach their peak. Please file this fact away to consult
+before you mark your ballot at the 2024 annual meeting of
+Berkshire.
+
+ o At See’s, sales trends improved somewhat from those of
+recent years. Total pounds sold rose about 2%. (For you
+chocaholics who like to fantasize, one statistic: we sell over
+12,000 tons annually.) Same-store sales, measured in pounds, were
+virtually unchanged. In the previous six years, same store
+poundage fell, and we gained or maintained poundage volume only
+by adding stores. But a particularly strong Christmas season in
+1986 stemmed the decline. By stabilizing same-store volume and
+making a major effort to control costs, See’s was able to
+maintain its excellent profit margin in 1986 though it put
+through only minimal price increases. We have Chuck Huggins, our
+long-time manager at See’s, to thank for this significant
+achievement.
+
+ See’s has a one-of-a-kind product "personality" produced by
+a combination of its candy’s delicious taste and moderate price,
+the company’s total control of the distribution process, and the
+exceptional service provided by store employees. Chuck
+rightfully measures his success by the satisfaction of our
+customers, and his attitude permeates the organization. Few
+major retailing companies have been able to sustain such a
+customer-oriented spirit, and we owe Chuck a great deal for
+keeping it alive and well at See’s.
+
+ See’s profits should stay at about their present level. We
+will continue to increase prices very modestly, merely matching
+prospective cost increases.
+
+ o World Book is the largest of 17 Scott Fetzer operations
+that joined Berkshire at the beginning of 1986. Last year I
+reported to you enthusiastically about the businesses of Scott
+Fetzer and about Ralph Schey, its manager. A year’s experience
+has added to my enthusiasm for both. Ralph is a superb
+businessman and a straight shooter. He also brings exceptional
+versatility and energy to his job: despite the wide array of
+businesses that he manages, he is on top of the operations,
+opportunities and problems of each. And, like our other
+managers, Ralph is a real pleasure to work with. Our good
+fortune continues.
+
+ World Book’s unit volume increased for the fourth
+consecutive year, with encyclopedia sales up 7% over 1985 and 45%
+over 1982. Childcraft’s unit sales also grew significantly.
+
+ World Book continues to dominate the U.S. direct-sales
+encyclopedia market - and for good reasons. Extraordinarily
+well-edited and priced at under 5 cents per page, these books are
+a bargain for youngster and adult alike. You may find one
+editing technique interesting: World Book ranks over 44,000 words
+by difficulty. Longer entries in the encyclopedia include only
+the most easily comprehended words in the opening sections, with
+the difficulty of the material gradually escalating as the
+exposition proceeds. As a result, youngsters can easily and
+profitably read to the point at which subject matter gets too
+difficult, instead of immediately having to deal with a
+discussion that mixes up words requiring college-level
+comprehension with others of fourth-grade level.
+
+ Selling World Book is a calling. Over one-half of our
+active salespeople are teachers or former teachers, and another
+5% have had experience as librarians. They correctly think of
+themselves as educators, and they do a terrific job. If you
+don’t have a World Book set in your house, I recommend one.
+
+ o Kirby likewise recorded its fourth straight year of unit
+volume gains. Worldwide, unit sales grew 4% from 1985 and 33%
+from 1982. While the Kirby product is more expensive than most
+cleaners, it performs in a manner that leaves cheaper units far
+behind ("in the dust," so to speak). Many 30- and 40-year-old
+Kirby cleaners are still in active duty. If you want the best,
+you buy a Kirby.
+
+ Some companies that historically have had great success in
+direct sales have stumbled in recent years. Certainly the era of
+the working woman has created new challenges for direct sales
+organizations. So far, the record shows that both Kirby and
+World Book have responded most successfully.
+
+ The businesses described above, along with the insurance
+operation and Fechheimer, constitute our major business units.
+The brevity of our descriptions is in no way meant to diminish
+the importance of these businesses to us. All have been
+discussed in past annual reports and, because of the tendency of
+Berkshire owners to stay in the fold (about 98% of the stock at
+the end of each year is owned by people who were owners at the
+start of the year), we want to avoid undue repetition of basic
+facts. You can be sure that we will immediately report to you in
+detail if the underlying economics or competitive position of any
+of these businesses should materially change. In general, the
+businesses described in this section can be characterized as
+having very strong market positions, very high returns on capital
+employed, and the best of operating managements.
+
+The Fechheimer Bros. Co.
+
+ Every year in Berkshire’s annual report I include a
+description of the kind of business that we would like to buy.
+This "ad" paid off in 1986.
+
+ On January 15th of last year I received a letter from Bob
+Heldman of Cincinnati, a shareholder for many years and also
+Chairman of Fechheimer Bros. Until I read the letter, however, I
+did not know of either Bob or Fechheimer. Bob wrote that he ran
+a company that met our tests and suggested that we get together,
+which we did in Omaha after their results for 1985 were compiled.
+
+ He filled me in on a little history: Fechheimer, a uniform
+manufacturing and distribution business, began operations in
+1842. Warren Heldman, Bob’s father, became involved in the
+business in 1941 and his sons, Bob and George (now President),
+along with their sons, subsequently joined the company. Under
+the Heldmans’ management, the business was highly successful.
+
+ In 1981 Fechheimer was sold to a group of venture
+capitalists in a leveraged buy out (an LBO), with management
+retaining an equity interest. The new company, as is the case
+with all LBOS, started with an exceptionally high debt/equity
+ratio. After the buy out, however, operations continued to be
+very successful. So by the start of last year debt had been paid
+down substantially and the value of the equity had increased
+dramatically. For a variety of reasons, the venture capitalists
+wished to sell and Bob, having dutifully read Berkshire’s annual
+reports, thought of us.
+
+ Fechheimer is exactly the sort of business we like to buy.
+Its economic record is superb; its managers are talented, high-
+grade, and love what they do; and the Heldman family wanted to
+continue its financial interest in partnership with us.
+Therefore, we quickly purchased about 84% of the stock for a
+price that was based upon a $55 million valuation for the entire
+business.
+
+ The circumstances of this acquisition were similar to those
+prevailing in our purchase of Nebraska Furniture Mart: most of
+the shares were held by people who wished to employ funds
+elsewhere; family members who enjoyed running their business
+wanted to continue both as owners and managers; several
+generations of the family were active in the business, providing
+management for as far as the eye can see; and the managing family
+wanted a purchaser who would not re-sell, regardless of price,
+and who would let the business be run in the future as it had
+been in the past. Both Fechheimer and NFM were right for us, and
+we were right for them.
+
+ You may be amused to know that neither Charlie nor I have
+been to Cincinnati, headquarters for Fechheimer, to see their
+operation. (And, incidentally, it works both ways: Chuck Huggins,
+who has been running See’s for 15 years, has never been to
+Omaha.) If our success were to depend upon insights we developed
+through plant inspections, Berkshire would be in big trouble.
+Rather, in considering an acquisition, we attempt to evaluate the
+economic characteristics of the business - its competitive
+strengths and weaknesses - and the quality of the people we will
+be joining. Fechheimer was a standout in both respects. In
+addition to Bob and George Heldman, who are in their mid-60s -
+spring chickens by our standards - there are three members of the
+next generation, Gary, Roger and Fred, to insure continuity.
+
+ As a prototype for acquisitions, Fechheimer has only one
+drawback: size. We hope our next acquisition is at least several
+times as large but a carbon copy in all other respects. Our
+threshold for minimum annual after-tax earnings of potential
+acquisitions has been moved up to $10 million from the $5 million
+level that prevailed when Bob wrote to me.
+
+ Flushed with success, we repeat our ad. If you have a
+business that fits, call me or, preferably, write.
+
+ Here’s what we’re looking for:
+ (1) large purchases (at least $10 million of after-tax
+ earnings),
+ (2) demonstrated consistent earning power (future
+ projections are of little interest to us, nor are
+ "turn-around" situations),
+ (3) businesses earning good returns on equity while
+ employing little or no debt.
+ (4) management in place (we can’t supply it),
+ (5) simple businesses (if there’s lots of technology, we
+ won’t understand it),
+ (6) an offering price (we don’t want to waste our time
+ or that of the seller by talking, even preliminarily,
+ about a transaction when price is unknown).
+
+ We will not engage in unfriendly takeovers. We can promise
+complete confidentiality and a very fast answer - customarily
+within five minutes - as to whether we’re interested. We prefer
+to buy for cash, but will consider issuing stock when we receive
+as much in intrinsic business value as we give. Indeed,
+following recent advances in the price of Berkshire stock,
+transactions involving stock issuance may be quite feasible. We
+invite potential sellers to check us out by contacting people
+with whom we have done business in the past. For the right
+business - and the right people - we can provide a good home.
+
+ On the other hand, we frequently get approached about
+acquisitions that don’t come close to meeting our tests: new
+ventures, turnarounds, auction-like sales, and the ever-popular
+(among brokers) "I’m-sure-something-will-work-out-if-you-people-
+get-to-know-each-other." None of these attracts us in the least.
+
+ * * *
+
+ Besides being interested in the purchases of entire
+businesses as described above, we are also interested in the
+negotiated purchase of large, but not controlling, blocks of
+stock, as in our Cap Cities purchase. Such purchases appeal to
+us only when we are very comfortable with both the economics of
+the business and the ability and integrity of the people running
+the operation. We prefer large transactions: in the unusual case
+we might do something as small as $50 million (or even smaller),
+but our preference is for commitments many times that size.
+
+Insurance Operations
+
+ We present our usual table of industry figures, expanded
+this year to include data about incurred losses and the GNP
+inflation index. The contrast in 1986 between the growth in
+premiums and growth in incurred losses will show you why
+underwriting results for the year improved materially:
+
+ Statutory
+ Yearly Change Combined Ratio Yearly Change Inflation Rate
+ in Premiums After Policyholder in Incurred Measured by
+ Written (%) Dividends Losses (%) GNP Deflator (%)
+ ------------- ------------------ ------------- ----------------
+1981 ..... 3.8 106.0 6.5 9.7
+1982 ..... 4.4 109.8 8.4 6.4
+1983 ..... 4.6 112.0 6.8 3.9
+1984 ..... 9.2 117.9 16.9 3.8
+1985 ..... 22.1 116.5 16.1 3.3
+1986 (Est.) 22.6 108.5 15.5 2.6
+
+Source: Best’s Insurance Management Reports
+
+ The combined ratio represents total insurance costs (losses
+incurred plus expenses) compared to revenue from premiums: a
+ratio below 100 indicates an underwriting profit, and one above
+100 indicates a loss. When the investment income that an insurer
+earns from holding on to policyholders’ funds ("the float") is
+taken into account, a combined ratio in the 107-112 range
+typically produces an overall break-even result, exclusive of
+earnings on the funds provided by shareholders.
+
+ The math of the insurance business, encapsulated by the
+table, is not very complicated. In years when the industry’s
+annual gain in revenues (premiums) pokes along at 4% or 5%,
+underwriting losses are sure to mount. This is not because auto
+accidents, fires, windstorms and the like are occurring more
+frequently, nor has it lately been the fault of general
+inflation. Today, social and judicial inflation are the major
+culprits; the cost of entering a courtroom has simply ballooned.
+Part of the jump in cost arises from skyrocketing verdicts, and
+part from the tendency of judges and juries to expand the
+coverage of insurance policies beyond that contemplated by the
+insurer when the policies were written. Seeing no let-up in
+either trend, we continue to believe that the industry’s revenues
+must grow at close to 10% annually for it to just hold its own
+in terms of profitability, even though general inflation may be
+running only 2% - 4%.
+
+ In 1986, as noted, the industry’s premium volume soared even
+faster than loss costs. Consequently, the underwriting loss of
+the industry fell dramatically. In last year’s report we
+predicted this sharp improvement but also predicted that
+prosperity would be fleeting. Alas, this second prediction is
+already proving accurate. The rate of gain in the industry’s
+premium volume has slowed significantly (from an estimated 27.1%
+in 1986’s first quarter, to 23.5% in the second, to 21.8% in the
+third, to 18.7% in the fourth), and we expect further slowing in
+1987. Indeed, the rate of gain may well fall below my 10%
+"equilibrium" figure by the third quarter.
+
+ Nevertheless, underwriting results in 1987, assuming they
+are not dragged down by a major natural catastrophe, will again
+improve materially because price increases are recognized in
+revenues on a lagged basis. In effect, the good news in earnings
+follows the good news in prices by six to twelve months. But the
+improving trend in earnings will probably end by late 1988 or
+early 1989. Thereafter the industry is likely to head south in a
+hurry.
+
+ Pricing behavior in the insurance industry continues to be
+exactly what can be expected in a commodity-type business. Only
+under shortage conditions are high profits achieved, and such
+conditions don’t last long. When the profit sun begins to shine,
+long-established insurers shower investors with new shares in
+order to build capital. In addition, newly-formed insurers rush
+to sell shares at the advantageous prices available in the new-
+issue market (prices advantageous, that is, to the insiders
+promoting the company but rarely to the new shareholders). These
+moves guarantee future trouble: capacity soars, competitive
+juices flow, and prices fade.
+
+ It’s interesting to observe insurance leaders beseech their
+colleagues to behave in a more "statesmanlike" manner when
+pricing policies. "Why," they ask, "can’t we learn from history,
+even out the peaks and valleys, and consistently price to make
+reasonable profits?" What they wish, of course, is pricing that
+resembles, say, that of The Wall Street journal, whose prices are
+ample to start with and rise consistently each year.
+
+ Such calls for improved behavior have all of the efficacy of
+those made by a Nebraska corn grower asking his fellow growers,
+worldwide, to market their corn with more statesmanship. What’s
+needed is not more statesmen, but less corn. By raising large
+amounts of capital in the last two years, the insurance industry
+has, to continue our metaphor, vastly expanded its plantings of
+corn. The resulting increase in "crop" - i.e., the proliferation
+of insurance capacity - will have the same effect on prices and
+profits that surplus crops have had since time immemorial.
+
+ Our own insurance operation did well in 1986 and is also
+likely to do well in 1987. We have benefited significantly from
+industry conditions. But much of our prosperity arises from the
+efforts and ability of Mike Goldberg, manager of all insurance
+operations.
+
+ Our combined ratio (on a statutory basis and excluding
+structured settlements and financial reinsurance) fell from 111
+in 1985 to 103 in 1986. In addition, our premium growth has been
+exceptional: although final figures aren’t available, I believe
+that over the past two years we were the fastest growing company
+among the country’s top 100 insurers. Some of our growth, it is
+true, came from our large quota-share contract with Fireman’s
+Fund, described in last year’s report and updated in Charlie’s
+letter on page 54. But even if the premiums from that contract
+are excluded from the calculation, we probably still ranked first
+in growth.
+
+ Interestingly, we were the slowest-growing large insurer in
+the years immediately preceding 1985. In fact, we shrank - and
+we will do so again from time to time in the future. Our large
+swings in volume do not mean that we come and go from the
+insurance marketplace. Indeed, we are its most steadfast
+participant, always standing ready, at prices we believe
+adequate, to write a wide variety of high-limit coverages. The
+swings in our volume arise instead from the here-today, gone-
+tomorrow behavior of other insurers. When most insurers are
+"gone," because their capital is inadequate or they have been
+frightened by losses, insureds rush to us and find us ready to
+do business. But when hordes of insurers are "here," and are
+slashing prices far below expectable costs, many customers
+naturally leave us in order to take advantage of the bargains
+temporarily being offered by our competition.
+
+ Our firmness on prices works no hardship on the consumer: he
+is being bombarded by attractively priced insurance offers at
+those times when we are doing little business. And it works no
+hardship on our employees: we don’t engage in layoffs when we
+experience a cyclical slowdown at one of our generally-profitable
+insurance operations. This no-layoff practice is in our self-
+interest. Employees who fear that large layoffs will accompany
+sizable reductions in premium volume will understandably produce
+scads of business through thick and thin (mostly thin).
+
+ The trends in National Indemnity’s traditional business -
+the writing of commercial auto and general liability policies
+through general agents - suggest how gun-shy other insurers
+became for a while and how brave they are now getting. In the
+last quarter of 1984, NICO’s monthly volume averaged $5 million,
+about what it had been running for several years. By the first
+quarter of 1986, monthly volume had climbed to about $35 million.
+In recent months, a sharp decline has set in. Monthly volume is
+currently about $20 million and will continue to fall as new
+competitors surface and prices are cut. Ironically, the managers
+of certain major new competitors are the very same managers that
+just a few years ago bankrupted insurers that were our old
+competitors. Through state-mandated guaranty funds, we must pay
+some of the losses these managers left unpaid, and now we find
+them writing the same sort of business under a new name. C’est
+la guerre.
+
+ The business we call "large risks" expanded significantly
+during 1986, and will be important to us in the future. In this
+operation, we regularly write policies with annual premiums of $1
+- $3 million, or even higher. This business will necessarily be
+highly volatile - both in volume and profitability - but our
+premier capital position and willingness to write large net lines
+make us a very strong force in the market when prices are right.
+On the other hand, our structured settlement business has become
+near-dormant because present prices make no sense to us.
+
+ The 1986 loss reserve development of our insurance group is
+chronicled on page 46. The figures show the amount of error in
+our yearend 1985 liabilities that a year of settlements and
+further evaluation has revealed. As you can see, what I told you
+last year about our loss liabilities was far from true - and that
+makes three years in a row of error. If the physiological rules
+that applied to Pinocchio were to apply to me, my nose would now
+draw crowds.
+
+ When insurance executives belatedly establish proper
+reserves, they often speak of "reserve strengthening," a term
+that has a rather noble ring to it. They almost make it sound as
+if they are adding extra layers of strength to an already-solid
+balance sheet. That’s not the case: instead the term is a
+euphemism for what should more properly be called "correction of
+previous untruths" (albeit non-intentional ones).
+
+ We made a special effort at the end of 1986 to reserve
+accurately. However, we tried just as hard at the end of 1985.
+Only time will tell whether we have finally succeeded in
+correctly estimating our insurance liabilities.
+
+ Despite the difficulties we have had in reserving and the
+commodity economics of the industry, we expect our insurance
+business to both grow and make significant amounts of money - but
+progress will be distinctly irregular and there will be major
+unpleasant surprises from time to time. It’s a treacherous
+business and a wary attitude is essential. We must heed Woody
+Allen: "While the lamb may lie down with the lion, the lamb
+shouldn’t count on getting a whole lot of sleep."
+
+ In our insurance operations we have an advantage in
+attitude, we have an advantage in capital, and we are developing
+an advantage in personnel. Additionally, I like to think we have
+some long-term edge in investing the float developed from
+policyholder funds. The nature of the business suggests that we
+will need all of these advantages in order to prosper.
+
+ * * *
+
+ GEICO Corporation, 41% owned by Berkshire, had an
+outstanding year in 1986. Industrywide, underwriting experience
+in personal lines did not improve nearly as much as it did in
+commercial lines. But GEICO, writing personal lines almost
+exclusively, improved its combined ratio to 96.9 and recorded a
+16% gain in premium volume. GEICO also continued to repurchase
+its own shares and ended the year with 5.5% fewer shares
+outstanding than it had at the start of the year. Our share of
+GEICO’s premium volume is over $500 million, close to double that
+of only three years ago. GEICO’s book of business is one of the
+best in the world of insurance, far better indeed than
+Berkshire’s own book.
+
+ The most important ingredient in GEICO’s success is rock-
+bottom operating costs, which set the company apart from
+literally hundreds of competitors that offer auto insurance. The
+total of GEICO’s underwriting expense and loss adjustment expense
+in 1986 was only 23.5% of premiums. Many major companies show
+percentages 15 points higher than that. Even such huge direct
+writers as Allstate and State Farm incur appreciably higher costs
+than does GEICO.
+
+ The difference between GEICO’s costs and those of its
+competitors is a kind of moat that protects a valuable and much-
+sought-after business castle. No one understands this moat-
+around-the-castle concept better than Bill Snyder, Chairman of
+GEICO. He continually widens the moat by driving down costs
+still more, thereby defending and strengthening the economic
+franchise. Between 1985 and 1986, GEICO’s total expense ratio
+dropped from 24.1% to the 23.5% mentioned earlier and, under
+Bill’s leadership, the ratio is almost certain to drop further.
+If it does - and if GEICO maintains its service and underwriting
+standards - the company’s future will be brilliant indeed.
+
+ The second stage of the GEICO rocket is fueled by Lou
+Simpson, Vice Chairman, who has run the company’s investments
+since late 1979. Indeed, it’s a little embarrassing for me, the
+fellow responsible for investments at Berkshire, to chronicle
+Lou’s performance at GEICO. Only my ownership of a controlling
+block of Berkshire stock makes me secure enough to give you the
+following figures, comparing the overall return of the equity
+portfolio at GEICO to that of the Standard & Poor’s 500:
+
+ Year GEICO’s Equities S&P 500
+ ---- ---------------- -------
+ 1980 .................. 23.7% 32.3%
+ 1981 .................. 5.4 (5.0)
+ 1982 .................. 45.8 21.4
+ 1983 .................. 36.0 22.4
+ 1984 .................. 21.8 6.2
+ 1985 .................. 45.8 31.6
+ 1986 .................. 38.7 18.6
+
+ These are not only terrific figures but, fully as important,
+they have been achieved in the right way. Lou has consistently
+invested in undervalued common stocks that, individually, were
+unlikely to present him with a permanent loss and that,
+collectively, were close to risk-free.
+
+ In sum, GEICO is an exceptional business run by exceptional
+managers. We are fortunate to be associated with them.
+
+Marketable Securities
+
+ During 1986, our insurance companies purchased about $700
+million of tax-exempt bonds, most having a maturity of 8 to 12
+years. You might think that this commitment indicates a
+considerable enthusiasm for such bonds. Unfortunately, that’s
+not so: at best, the bonds are mediocre investments. They simply
+seemed the least objectionable alternative at the time we bought
+them, and still seem so. (Currently liking neither stocks nor
+bonds, I find myself the polar opposite of Mae West as she
+declared: "I like only two kinds of men - foreign and domestic.")
+
+ We must, of necessity, hold marketable securities in our
+insurance companies and, as money comes in, we have only five
+directions to go: (1) long-term common stock investments; (2)
+long-term fixed-income securities; (3) medium-term fixed-income
+securities; (4) short-term cash equivalents; and (5) short-term
+arbitrage commitments.
+
+ Common stocks, of course, are the most fun. When conditions
+are right that is, when companies with good economics and good
+management sell well below intrinsic business value - stocks
+sometimes provide grand-slam home runs. But we currently find no
+equities that come close to meeting our tests. This statement in
+no way translates into a stock market prediction: we have no idea
+- and never have had - whether the market is going to go up,
+down, or sideways in the near- or intermediate term future.
+
+ What we do know, however, is that occasional outbreaks of
+those two super-contagious diseases, fear and greed, will forever
+occur in the investment community. The timing of these epidemics
+will be unpredictable. And the market aberrations produced by
+them will be equally unpredictable, both as to duration and
+degree. Therefore, we never try to anticipate the arrival or
+departure of either disease. Our goal is more modest: we simply
+attempt to be fearful when others are greedy and to be greedy
+only when others are fearful.
+
+ As this is written, little fear is visible in Wall Street.
+Instead, euphoria prevails - and why not? What could be more
+exhilarating than to participate in a bull market in which the
+rewards to owners of businesses become gloriously uncoupled from
+the plodding performances of the businesses themselves.
+Unfortunately, however, stocks can’t outperform businesses
+indefinitely.
+
+ Indeed, because of the heavy transaction and investment
+management costs they bear, stockholders as a whole and over the
+long term must inevitably underperform the companies they own.
+If American business, in aggregate, earns about 12% on equity
+annually, investors must end up earning significantly less. Bull
+markets can obscure mathematical laws, but they cannot repeal
+them.
+
+ The second category of investments open to our insurance
+companies is long-term bonds. These are unlikely to be of
+interest to us except in very special situations, such as the
+Washington Public Power Supply System #1, #2 and #3 issues,
+discussed in our 1984 report. (At yearend, we owned WPPSS issues
+having an amortized cost of $218 million and a market value of
+$310 million, paying us $31.7 million in annual tax-exempt
+income.) Our aversion to long-term bonds relates to our fear that
+we will see much higher rates of inflation within the next
+decade. Over time, the behavior of our currency will be
+determined by the behavior of our legislators. This relationship
+poses a continuing threat to currency stability - and a
+corresponding threat to the owners of long-term bonds.
+
+ We continue to periodically employ money in the arbitrage
+field. However, unlike most arbitrageurs, who purchase dozens of
+securities each year, we purchase only a few. We restrict
+ourselves to large deals that have been announced publicly and do
+not bet on the come. Therefore, our potential profits are apt to
+be small; but, with luck, our disappointments will also be few.
+
+ Our yearend portfolio shown below includes one arbitrage
+commitment, Lear-Siegler. Our balance sheet also includes a
+receivable for $145 million, representing the money owed us (and
+paid a few days later) by Unilever, then in the process of
+purchasing Chesebrough-Ponds, another of our arbitrage holdings.
+Arbitrage is an alternative to Treasury Bills as a short-term
+parking place for money - a choice that combines potentially
+higher returns with higher risks. To date, our returns from the
+funds committed to arbitrage have been many times higher than
+they would have been had we left those funds in Treasury Bills.
+Nonetheless, one bad experience could change the scorecard
+markedly.
+
+ We also, though it takes some straining, currently view
+medium-term tax-exempt bonds as an alternative to short-term
+Treasury holdings. Buying these bonds, we run a risk of
+significant loss if, as seems probable, we sell many of them well
+before maturity. However, we believe this risk is more than
+counter-balanced first, by the much higher after-tax returns
+currently realizable from these securities as compared to
+Treasury Bills and second, by the possibility that sales will
+produce an overall profit rather than a loss. Our expectation of
+a higher total return, after allowing for the possibility of loss
+and after taking into account all tax effects, is a relatively
+close call and could well be wrong. Even if we sell our bonds at
+a fairly large loss, however, we may end up reaping a higher
+after-tax return than we would have realized by repeatedly
+rolling over Treasury Bills.
+
+ In any event, you should know that our expectations for both
+the stocks and bonds we now hold are exceptionally modest, given
+current market levels. Probably the best thing that could happen
+to us is a market in which we would choose to sell many of our
+bond holdings at a significant loss in order to re-allocate funds
+to the far-better equity values then very likely to exist. The
+bond losses I am talking about would occur if high interest rates
+came along; the same rates would probably depress common stocks
+considerably more than medium-term bonds.
+
+ We show below our 1986 yearend net holdings in marketable
+equities. All positions with a market value of over $25 million
+are listed, and the interests attributable to minority
+shareholdings of Wesco Financial Corp. and Nebraska Furniture
+Mart are excluded.
+
+No. of Shares Cost Market
+------------- ---------- ----------
+ (000s omitted)
+ 2,990,000 Capital Cities/ABC, Inc. ....... $515,775 $ 801,694
+ 6,850,000 GEICO Corporation .............. 45,713 674,725
+ 2,379,200 Handy & Harman ................. 27,318 46,989
+ 489,300 Lear Siegler, Inc. ............. 44,064 44,587
+ 1,727,765 The Washington Post Company .... 9,731 269,531
+ ---------- ----------
+ 642,601 1,837,526
+ All Other Common Stockholdings 12,763 36,507
+ ---------- ----------
+ Total Common Stocks ............ $655,364 $1,874,033
+
+ We should note that we expect to keep permanently our three
+primary holdings, Capital Cities/ABC, Inc., GEICO Corporation,
+and The Washington Post. Even if these securities were to appear
+significantly overpriced, we would not anticipate selling them,
+just as we would not sell See’s or Buffalo Evening News if
+someone were to offer us a price far above what we believe those
+businesses are worth.
+
+ This attitude may seem old-fashioned in a corporate world in
+which activity has become the order of the day. The modern
+manager refers to his "portfolio" of businesses - meaning that
+all of them are candidates for "restructuring" whenever such a
+move is dictated by Wall Street preferences, operating conditions
+or a new corporate "concept." (Restructuring is defined narrowly,
+however: it extends only to dumping offending businesses, not to
+dumping the officers and directors who bought the businesses in
+the first place. "Hate the sin but love the sinner" is a
+theology as popular with the Fortune 500 as it is with the
+Salvation Army.)
+
+ Investment managers are even more hyperkinetic: their
+behavior during trading hours makes whirling dervishes appear
+sedated by comparison. Indeed, the term "institutional investor"
+is becoming one of those self-contradictions called an oxymoron,
+comparable to "jumbo shrimp," "lady mudwrestler" and "inexpensive
+lawyer."
+
+ Despite the enthusiasm for activity that has swept business
+and financial America, we will stick with our ‘til-death-do-us-
+part policy. It’s the only one with which Charlie and I are
+comfortable, it produces decent results, and it lets our managers
+and those of our investees run their businesses free of
+distractions.
+
+NHP, Inc.
+
+ Last year we paid $23.7 million for about 50% of NHP, Inc.,
+a developer, syndicator, owner and manager of multi-family rental
+housing. Should all executive stock options that have been
+authorized be granted and exercised, our equity interest will
+decline to slightly over 45%.
+
+ NHP, Inc. has a most unusual genealogy. In 1967, President
+Johnson appointed a commission of business and civic leaders, led
+by Edgar Kaiser, to study ways to increase the supply of
+multifamily housing for low- and moderate-income tenants.
+Certain members of the commission subsequently formed and
+promoted two business entities to foster this goal. Both are now
+owned by NHP, Inc. and one operates under unusual ground rules:
+three of its directors must be appointed by the President, with
+the advice and consent of the Senate, and it is also required by
+law to submit an annual report to the President.
+
+ Over 260 major corporations, motivated more by the idea of
+public service than profit, invested $42 million in the two
+original entities, which promptly began, through partnerships, to
+develop government-subsidized rental property. The typical
+partnership owned a single property and was largely financed by a
+non-recourse mortgage. Most of the equity money for each
+partnership was supplied by a group of limited partners who were
+primarily attracted by the large tax deductions that went with
+the investment. NHP acted as general partner and also purchased
+a small portion of each partnership’s equity.
+
+ The Government’s housing policy has, of course, shifted and
+NHP has necessarily broadened its activities to include non-
+subsidized apartments commanding market-rate rents. In addition,
+a subsidiary of NHP builds single-family homes in the Washington,
+D.C. area, realizing revenues of about $50 million annually.
+
+ NHP now oversees about 500 partnership properties that are
+located in 40 states, the District of Columbia and Puerto Rico,
+and that include about 80,000 housing units. The cost of these
+properties was more than $2.5 billion and they have been well
+maintained. NHP directly manages about 55,000 of the housing
+units and supervises the management of the rest. The company’s
+revenues from management are about $16 million annually, and
+growing.
+
+ In addition to the equity interests it purchased upon the
+formation of each partnership, NHP owns varying residual
+interests that come into play when properties are disposed of and
+distributions are made to the limited partners. The residuals on
+many of NHP’s "deep subsidy" properties are unlikely to be of
+much value. But residuals on certain other properties could
+prove quite valuable, particularly if inflation should heat up.
+
+ The tax-oriented syndication of properties to individuals
+has been halted by the Tax Reform Act of 1986. In the main, NHP
+is currently trying to develop equity positions or significant
+residual interests in non-subsidized rental properties of quality
+and size (typically 200 to 500 units). In projects of this kind,
+NHP usually works with one or more large institutional investors
+or lenders. NHP will continue to seek ways to develop low- and
+moderate-income apartment housing, but will not likely meet
+success unless government policy changes.
+
+ Besides ourselves, the large shareholders in NHP are
+Weyerhauser (whose interest is about 25%) and a management group
+led by Rod Heller, chief executive of NHP. About 60 major
+corporations also continue to hold small interests, none larger
+than 2%.
+
+Taxation
+
+ The Tax Reform Act of 1986 affects our various businesses in
+important and divergent ways. Although we find much to praise in
+the Act, the net financial effect for Berkshire is negative: our
+rate of increase in business value is likely to be at least
+moderately slower under the new law than under the old. The net
+effect for our shareholders is even more negative: every dollar
+of increase in per-share business value, assuming the increase is
+accompanied by an equivalent dollar gain in the market value of
+Berkshire stock, will produce 72 cents of after-tax gain for our
+shareholders rather than the 80 cents produced under the old law.
+This result, of course, reflects the rise in the maximum tax rate
+on personal capital gains from 20% to 28%.
+
+ Here are the main tax changes that affect Berkshire:
+
+ o The tax rate on corporate ordinary income is scheduled to
+decrease from 46% in 1986 to 34% in 1988. This change obviously
+affects us positively - and it also has a significant positive
+effect on two of our three major investees, Capital Cities/ABC
+and The Washington Post Company.
+
+ I say this knowing that over the years there has been a lot
+of fuzzy and often partisan commentary about who really pays
+corporate taxes - businesses or their customers. The argument,
+of course, has usually turned around tax increases, not
+decreases. Those people resisting increases in corporate rates
+frequently argue that corporations in reality pay none of the
+taxes levied on them but, instead, act as a sort of economic
+pipeline, passing all taxes through to consumers. According to
+these advocates, any corporate-tax increase will simply lead to
+higher prices that, for the corporation, offset the increase.
+Having taken this position, proponents of the "pipeline" theory
+must also conclude that a tax decrease for corporations will not
+help profits but will instead flow through, leading to
+correspondingly lower prices for consumers.
+
+ Conversely, others argue that corporations not only pay the
+taxes levied upon them, but absorb them also. Consumers, this
+school says, will be unaffected by changes in corporate rates.
+
+ What really happens? When the corporate rate is cut, do
+Berkshire, The Washington Post, Cap Cities, etc., themselves soak
+up the benefits, or do these companies pass the benefits along to
+their customers in the form of lower prices? This is an
+important question for investors and managers, as well as for
+policymakers.
+
+ Our conclusion is that in some cases the benefits of lower
+corporate taxes fall exclusively, or almost exclusively, upon the
+corporation and its shareholders, and that in other cases the
+benefits are entirely, or almost entirely, passed through to the
+customer. What determines the outcome is the strength of the
+corporation’s business franchise and whether the profitability of
+that franchise is regulated.
+
+ For example, when the franchise is strong and after-tax
+profits are regulated in a relatively precise manner, as is the
+case with electric utilities, changes in corporate tax rates are
+largely reflected in prices, not in profits. When taxes are cut,
+prices will usually be reduced in short order. When taxes are
+increased, prices will rise, though often not as promptly.
+
+ A similar result occurs in a second arena - in the price-
+competitive industry, whose companies typically operate with very
+weak business franchises. In such industries, the free market
+"regulates" after-tax profits in a delayed and irregular, but
+generally effective, manner. The marketplace, in effect,
+performs much the same function in dealing with the price-
+competitive industry as the Public Utilities Commission does in
+dealing with electric utilities. In these industries, therefore,
+tax changes eventually affect prices more than profits.
+
+ In the case of unregulated businesses blessed with strong
+franchises, however, it’s a different story: the corporation
+and its shareholders are then the major beneficiaries of tax
+cuts. These companies benefit from a tax cut much as the
+electric company would if it lacked a regulator to force down
+prices.
+
+ Many of our businesses, both those we own in whole and in
+part, possess such franchises. Consequently, reductions in their
+taxes largely end up in our pockets rather than the pockets of
+our customers. While this may be impolitic to state, it is
+impossible to deny. If you are tempted to believe otherwise,
+think for a moment of the most able brain surgeon or lawyer in
+your area. Do you really expect the fees of this expert (the
+local "franchise-holder" in his or her specialty) to be reduced
+now that the top personal tax rate is being cut from 50% to 28%?
+
+ Your joy at our conclusion that lower rates benefit a number
+of our operating businesses and investees should be severely
+tempered, however, by another of our convictions: scheduled 1988
+tax rates, both individual and corporate, seem totally
+unrealistic to us. These rates will very likely bestow a fiscal
+problem on Washington that will prove incompatible with price
+stability. We believe, therefore, that ultimately - within, say,
+five years - either higher tax rates or higher inflation rates
+are almost certain to materialize. And it would not surprise us
+to see both.
+
+ o Corporate capital gains tax rates have been increased from
+28% to 34%, effective in 1987. This change will have an
+important adverse effect on Berkshire because we expect much of
+our gain in business value in the future, as in the past, to
+arise from capital gains. For example, our three major
+investment holdings - Cap Cities, GEICO, and Washington Post - at
+yearend had a market value of over $1.7 billion, close to 75% of
+the total net worth of Berkshire, and yet they deliver us only
+about $9 million in annual income. Instead, all three retain a
+very high percentage of their earnings, which we expect to
+eventually deliver us capital gains.
+
+ The new law increases the rate for all gains realized in the
+future, including the unrealized gains that existed before the
+law was enacted. At yearend, we had $1.2 billion of such
+unrealized gains in our equity investments. The effect of the new
+law on our balance sheet will be delayed because a GAAP rule
+stipulates that the deferred tax liability applicable to
+unrealized gains should be stated at last year’s 28% tax rate
+rather than the current 34% rate. This rule is expected to change
+soon. The moment it does, about $73 million will disappear from
+our GAAP net worth and be added to the deferred tax account.
+
+ o Dividend and interest income received by our insurance
+companies will be taxed far more heavily under the new law.
+First, all corporations will be taxed on 20% of the dividends
+they receive from other domestic corporations, up from 15% under
+the old law. Second, there is a change concerning the residual
+80% that applies only to property/casualty companies: 15% of that
+residual will be taxed if the stocks paying the dividends were
+purchased after August 7, 1986. A third change, again applying
+only to property/casualty companies, concerns tax-exempt bonds:
+interest on bonds purchased by insurers after August 7, 1986 will
+only be 85% tax-exempt.
+
+ The last two changes are very important. They mean that our
+income from the investments we make in future years will be
+significantly lower than would have been the case under the old
+law. My best guess is that these changes alone will eventually
+reduce the earning power of our insurance operation by at least
+10% from what we could previously have expected.
+
+ o The new tax law also materially changes the timing of tax
+payments by property/casualty insurance companies. One new rule
+requires us to discount our loss reserves in our tax returns, a
+change that will decrease deductions and increase taxable income.
+Another rule, to be phased in over six years, requires us to
+include 20% of our unearned premium reserve in taxable income.
+
+ Neither rule changes the amount of the annual tax accrual in
+our reports to you, but each materially accelerates the schedule
+of payments. That is, taxes formerly deferred will now be front-
+ended, a change that will significantly cut the profitability of
+our business. An analogy will suggest the toll: if, upon turning
+21, you were required to immediately pay tax on all income you
+were due to receive throughout your life, both your lifetime
+wealth and your estate would be a small fraction of what they
+would be if all taxes on your income were payable only when you
+died.
+
+ Attentive readers may spot an inconsistency in what we say.
+Earlier, discussing companies in price-competitive industries, we
+suggested that tax increases or reductions affect these companies
+relatively little, but instead are largely passed along to their
+customers. But now we are saying that tax increases will affect
+profits of Berkshire’s property/casualty companies even though
+they operate in an intensely price-competitive industry.
+
+ The reason this industry is likely to be an exception to our
+general rule is that not all major insurers will be working with
+identical tax equations. Important differences will exist for
+several reasons: a new alternative minimum tax will materially
+affect some companies but not others; certain major insurers have
+huge loss carry-forwards that will largely shield their income
+from significant taxes for at least a few years; and the results
+of some large insurers will be folded into the consolidated
+returns of companies with non-insurance businesses. These
+disparate conditions will produce widely varying marginal tax
+rates in the property/casualty industry. That will not be the
+case, however, in most other price-competitive industries, such
+as aluminum, autos and department stores, in which the major
+players will generally contend with similar tax equations.
+
+ The absence of a common tax calculus for property/casualty
+companies means that the increased taxes falling on the industry
+will probably not be passed along to customers to the degree that
+they would in a typical price-competitive industry. Insurers, in
+other words, will themselves bear much of the new tax burdens.
+
+ o A partial offset to these burdens is a "fresh start"
+adjustment that occurred on January 1, 1987 when our December 31,
+1986 loss reserve figures were converted for tax purposes to the
+newly-required discounted basis. (In our reports to you, however,
+reserves will remain on exactly the same basis as in the past -
+undiscounted except in special cases such as structured
+settlements.) The net effect of the "fresh start" is to give us a
+double deduction: we will get a tax deduction in 1987 and future
+years for a portion of our-incurred-but-unpaid insurance losses
+that have already been fully deducted as costs in 1986 and
+earlier years.
+
+ The increase in net worth that is produced by this change is
+not yet reflected in our financial statements. Rather, under
+present GAAP rules (which may be changed), the benefit will flow
+into the earnings statement and, consequently, into net worth
+over the next few years by way of reduced tax charges. We expect
+the total benefit from the fresh-start adjustment to be in the
+$30 - $40 million range. It should be noted, however, that this
+is a one-time benefit, whereas the negative impact of the other
+insurance-related tax changes is not only ongoing but, in
+important respects, will become more severe as time passes.
+
+ o The General Utilities Doctrine was repealed by the new tax
+law. This means that in 1987 and thereafter there will be a
+double tax on corporate liquidations, one at the corporate level
+and another at the shareholder level. In the past, the tax at
+the corporate level could be avoided, If Berkshire, for example,
+were to be liquidated - which it most certainly won’t be -
+shareholders would, under the new law, receive far less from the
+sales of our properties than they would have if the properties
+had been sold in the past, assuming identical prices in each
+sale. Though this outcome is theoretical in our case, the change
+in the law will very materially affect many companies.
+Therefore, it also affects our evaluations of prospective
+investments. Take, for example, producing oil and gas
+businesses, selected media companies, real estate companies, etc.
+that might wish to sell out. The values that their shareholders
+can realize are likely to be significantly reduced simply because
+the General Utilities Doctrine has been repealed - though the
+companies’ operating economics will not have changed adversely at
+all. My impression is that this important change in the law has
+not yet been fully comprehended by either investors or managers.
+
+ This section of our report has been longer and more
+complicated than I would have liked. But the changes in the law
+are many and important, particularly for property/casualty
+insurers. As I have noted, the new law will hurt Berkshire’s
+results, but the negative impact is impossible to quantify with
+any precision.
+
+Miscellaneous
+
+ We bought a corporate jet last year. What you have heard about such
+planes is true: they are very expensive and a luxury in
+situations like ours where little travel to out-of-the-way places
+is required. And planes not only cost a lot to operate, they cost
+a lot just to look at. Pre-tax, cost of capital plus depreciation
+on a new $15 million plane probably runs $3 million annually. On
+our own plane, bought for $850,000 used, such costs run close to
+$200,000 annually.
+
+ Cognizant of such figures, your Chairman, unfortunately, has
+in the past made a number of rather intemperate remarks about
+corporate jets. Accordingly, prior to our purchase, I was forced
+into my Galileo mode. I promptly experienced the necessary
+"counter-revelation" and travel is now considerably easier - and
+considerably costlier - than in the past. Whether Berkshire will
+get its money’s worth from the plane is an open question, but I
+will work at achieving some business triumph that I can (no
+matter how dubiously) attribute to it. I’m afraid Ben Franklin
+had my number. Said he: "So convenient a thing it is to be a
+reasonable creature, since it enables one to find or make a
+reason for everything one has a mind to do."
+
+ About 97% of all eligible shares participated in Berkshire’s
+1986 shareholder-designated contributions program. Contributions
+made through the program were $4 million, and 1,934 charities
+were recipients.
+
+ We urge new shareholders to read the description of our
+shareholder-designated contributions program that appears on
+pages 58 and 59. If you wish to participate in future programs,
+we strongly urge that you immediately make sure your shares are
+registered in the name of the actual owner, not in "street" name
+or nominee name. Shares not so registered on September 30, 1987
+will be ineligible for the 1987 program.
+
+ * * *
+
+ Last year almost 450 people attended our shareholders’
+meeting, up from about 250 the year before (and from about a
+dozen ten years ago). I hope you can join us on May 19th in
+Omaha. Charlie and I like to answer owner-related questions
+and I can promise you that our shareholders will pose many good
+ones. Finishing up the questions may take quite a while - we
+had about 65 last year so you should feel free to leave once
+your own have been answered.
+
+ Last year, after the meeting, one shareholder from New
+Jersey and another from New York went to the Furniture Mart,
+where each purchased a $5,000 Oriental rug from Mrs. B. (To be
+precise, they purchased rugs that might cost $10,000 elsewhere
+for which they were charged about $5,000.) Mrs. B was pleased -
+but not satisfied - and she will be looking for you at the store
+after this year’s meeting. Unless our shareholders top last
+year’s record, I’ll be in trouble. So do me (and yourself) a
+favor, and go see her.
+
+
+
+ Warren E. Buffett
+February 27, 1987 Chairman of the Board
+Appendix
+Purchase-Price Accounting Adjustments and the "Cash Flow" Fallacy
++
First a short quiz: below are abbreviated 1986 statements of earnings for two companies. Which business is the more valuable?
+| + | ++ |
+ Company O |
++ |
+ Company N |
++ | |||||||
| + |
+ (000s Omitted) |
++ | ||||||||||
|
+ Revenues………………………. |
++ | + | + |
+ $677,240 |
++ | + | + |
+ $677,240 |
++ | |||
| + | + | + | + | + | + | + | + | + | + | |||
|
+ Costs of Goods Sold: |
++ | + | + | + | + | + | + | + | + | |||
|
+ Historical costs, excluding depreciation……………………. |
++ |
+ $341,170 |
++ | + | + |
+ $341,170 |
++ | + | + | |||
|
+ Special non-cash inventory costs……………………………. |
++ | + | + | + | + |
+ 4,979 |
+
+ (1) |
++ | + | |||
|
+ Depreciation of plant and equipment ……………………... |
++ |
+ 8,301 |
++ | + | + |
+ 13,355 |
+
+ (2) |
++ | + | |||
|
+
|
++ | + | + |
+ 349,471 |
++ | + | + |
+ 359,504 |
++ | |||
| + | + | + | + |
+ $327,769 |
++ | + | + |
+ $317,736 |
++ | |||
|
+ Gross Profit ……………………. |
++ | + | + | + | + | + | + | + | + | |||
|
+ Selling & Admin. Expense........ |
++ |
+ $260,286 |
++ | + | + |
+ $260,286 |
++ | + | + | |||
|
+ Amortization of Goodwill ......... |
++ |
+ ______ |
++ | + | + |
+ ____595 |
+
+ (3) |
++ | + | |||
| + | + | + | + |
+ 260,286 |
++ | + | + |
+ 260,881 |
++ | |||
|
+ Operating Profit .....................… |
++ | + | + |
+ $ 67,483 |
++ | + | + |
+ $ 56,855 |
++ | |||
|
+ Other Income, Net .................… |
++ | + | + |
+ 4,135 |
++ | + | + |
+ 4,135 |
++ | |||
|
+ Pre-Tax Income ......................… |
++ | + | + |
+ $ 71,618 |
++ | + | + |
+ $ 60,990 |
++ | |||
|
+ Applicable Income Tax: |
++ | + | + | + | + | + | + | + | + | |||
|
+ Historical deferred and current tax ………………………………. |
++ |
+ $ 31,387 |
++ | + | + |
+ $ 31,387 |
++ | + | + | |||
|
+ Non-Cash Inter-period Allocation Adjustment ............. |
++ |
+ ______ |
++ | + | + |
+ _____998 |
+
+ (4) |
++ | + | |||
| + | + | + | + |
+ 31,387 |
++ | + | + |
+ 32,385 |
++ | |||
Net Income ............ $40,231 $28,605 + ======= =======+
(Numbers (1) through (4) designate items discussed later in this section.)
+As you've probably guessed, Companies O and N are the same business - Scott Fetzer. In the "O" (for "old") column we have shown what the company's 1986 GAAP earnings would have been if we had not purchased it; in the "N" (for "new") column we have shown Scott Fetzer's GAAP earnings as actually reported by Berkshire.
+It should be emphasized that the two columns depict identical economics - i.e., the same sales, wages, taxes, etc. And both "companies" generate the same amount of cash for owners. Only the accounting is different.
+So, fellow philosophers, which column presents truth? Upon which set of numbers should managers and investors focus?
+Before we tackle those questions, let's look at what produces the disparity between O and N. We will simplify our discussion in some respects, but the simplification should not produce any inaccuracies in analysis or conclusions.
+The contrast between O and N comes about because we paid an amount for Scott Fetzer that was different from its stated net worth. Under GAAP, such differences - such premiums or discounts - must be accounted for by "purchase-price adjustments." In Scott Fetzer's case, we paid $315 million for net assets that were carried on its books at $172.4 million. So we paid a premium of $142.6 million.
+The first step in accounting for any premium paid is to adjust the carrying value of current assets to current values. In practice, this requirement usually does not affect receivables, which are routinely carried at current value, but often affects inventories. Because of a $22.9 million LIFO reserve and other accounting intricacies, Scott Fetzer's inventory account was carried at a $37.3 million discount from current value. So, making our first accounting move, we used $37.3 million of our $142.6 million premium to increase the carrying value of the inventory.
+Assuming any premium is left after current assets are adjusted, the next step is to adjust fixed assets to current value. In our case, this adjustment also required a few accounting acrobatics relating to deferred taxes. Since this has been billed as a simplified discussion, I will skip the details and give you the bottom line: $68.0 million was added to fixed assets and $13.0 million was eliminated from deferred tax liabilities. After making this $81.0 million adjustment, we were left with $24.3 million of premium to allocate.
+Had our situation called for them two steps would next have been required: the adjustment of intangible assets other than Goodwill to current fair values, and the restatement of liabilities to current fair values, a requirement that typically affects only long-term debt and unfunded pension liabilities. In Scott Fetzer's case, however, neither of these steps was necessary.
+The final accounting adjustment we needed to make, after recording fair market values for all assets and liabilities, was the assignment of the residual premium to Goodwill (technically known as "excess of cost over the fair value of net assets acquired"). This residual amounted to $24.3 million. Thus, the balance sheet of Scott Fetzer immediately before the acquisition, which is summarized below in column O, was transformed by the purchase into the balance sheet shown in column N. In real terms, both balance sheets depict the same assets and liabilities - but, as you can see, certain figures differ significantly.
+| + | +
+ Company O |
+
+ Company N |
+
| + |
+ (000s Omitted) |
+|
|
+ Assets |
++ | + |
|
+ Cash and Cash Equivalents …………………………... |
+
+ $ 3,593 |
+
+ $ 3,593 |
+
|
+ Receivables, net ……………………………………….. |
+
+ 90,919 |
+
+ 90,919 |
+
|
+ Inventories …………………………………………… |
+
+ 77,489 |
+
+ 114,764 |
+
|
+ Other ……………………………………………………. |
+
+ 5,954 |
+
+ 5,954 |
+
|
+ Total Current Assets ………………………………….. |
+
+ 177,955 |
+
+ 215,230 |
+
|
+ Property, Plant, and Equipment, net …………………. |
+
+ 80,967 |
+
+ 148,960 |
+
|
+ Investments in and Advances to Unconsolidated Subsidiaries and Joint Ventures ……………………… |
+
+ 93,589 |
+
+ 93,589 |
+
|
+ Other Assets, including Goodwill ……………………. |
+
+ 9,836 |
+
+ 34,210 |
+
| + |
+ $362,347 |
+
+ $491,989 |
+
|
+ Liabilities |
++ | + |
|
+ Notes Payable and Current Portion of Long-term Debt ……………………………………………………… |
+
+ $ 4,650 |
+
+ $ 4,650 |
+
|
+ Accounts Payable ……………………………………... |
+
+ 39,003 |
+
+ 39,003 |
+
|
+ Accrued Liabilities …………………………………….. |
+
+ 84,939 |
+
+ 84,939 |
+
|
+ Total Current Liabilities ……………………………….. |
+
+ 128,592 |
+
+ 128,592 |
+
|
+ Long-term Debt and Capitalized Leases ……………. |
+
+ 34,669 |
+
+ 34,669 |
+
|
+ Deferred Income Taxes ……………………………….. |
+
+ 17,052 |
+
+ 4,075 |
+
|
+ Other Deferred Credits ………………………………… |
+
+ 9,657 |
+
+ 9,657 |
+
|
+ Total Liabilities ………………………………………… |
+
+ 189,970 |
+
+ 176,993 |
+
|
+ Shareholders' Equity …………………………………... |
+
+ 172,377 |
+
+ 314,996 |
+
$362,347 $491,989 + ======== ========+
+
The higher balance sheet figures shown in column N produce the lower income figures shown in column N of the earnings statement presented earlier. This is the result of the asset write-ups and of the fact that some of the written-up assets must be depreciated or amortized. The higher the asset figure, the higher the annual depreciation or amortization charge to earnings must be. The charges that flowed to the earnings statement because of the balance sheet write-ups were numbered in the statement of earnings shown earlier:
+It is important to understand that none of these newly-created accounting costs, totaling $11.6 million, are deductible for income tax purposes. The "new" Scott Fetzer pays exactly the same tax as the "old" Scott Fetzer would have, even though the GAAP earnings of the two entities differ greatly. And, in respect to operating earnings, that would be true in the future also. However, in the unlikely event that Scott Fetzer sells one of its businesses, the tax consequences to the "old" and "new" company might differ widely.
+By the end of 1986 the difference between the net worth of the "old" and "new" Scott Fetzer had been reduced from $142.6 million to $131.0 million by means of the extra $11.6 million that was charged to earnings of the new entity. As the years go by, similar charges to earnings will cause most of the premium to disappear, and the two balance sheets will converge. However, the higher land values and most of the higher inventory values that were established on the new balance sheet will remain unless land is disposed of or inventory levels are further reduced.
+* * *
+What does all this mean for owners? Did the shareholders of Berkshire buy a business that earned $40.2 million in 1986 or did they buy one earning $28.6 million? Were those $11.6 million of new charges a real economic cost to us? Should investors pay more for the stock of Company O than of Company N? And, if a business is worth some given multiple of earnings, was Scott Fetzer worth considerably more the day before we bought it than it was worth the following day?
+If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N's items (1) and (4) less
( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.) ++
+
+
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since
( c) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes - both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes's observation: "I would rather be vaguely right than precisely wrong." +The approach we have outlined produces "owner earnings" for Company O and Company N that are identical, which means valuations are also identical, just as common sense would tell you should be the case. This result is reached because the sum of (a) and (b) is the same in both columns O and N, and because
( c) is necessarily the same in both cases. +And what do Charlie and I, as owners and managers, believe is the correct figure for the owner earnings of Scott Fetzer? Under current circumstances, we believe
( c) is very close to the "old" company's (b) number of $8.3 million and much below the "new" company's (b) number of $19.9 million. Therefore, we believe that owner earnings are far better depicted by the reported earnings in the O column than by those in the N column. In other words, we feel owner earnings of Scott Fetzer are considerably larger than the GAAP figures that we report. +That is obviously a happy state of affairs. But calculations of this sort usually do not provide such pleasant news. Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists - that is, when
( c) exceeds (b) - GAAP earnings overstate owner earnings. Frequently this overstatement is substantial. The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only (b) each year, they would have guaranteed their shrinkage in real terms. +All of this points up the absurdity of the "cash flow" numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) - but do not subtract
( c) . Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids - forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all U.S. corporations were to be offered simultaneously for sale through our leading investment bankers - and if the sales brochures describing them were to be believed - governmental projections of national plant and equipment spending would have to be slashed by 90%. +"Cash Flow", true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other enterprises that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extremely long-lived gas field would be an example. But "cash flow" is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them,
( c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment - or the business decays. +Why, then, are "cash flow" numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable). When (a) - that is, GAAP earnings - looks by itself inadequate to service debt of a junk bond or justify a foolish stock price, how convenient it becomes for salesmen to focus on (a) + (b). But you shouldn't add (b) without subtracting
( c) : though dentists correctly claim that if you ignore your teeth they'll go away, the same is not true for ( c) . The company or investor believing that the debt-servicing ability or the equity valuation of an enterprise can be measured by totaling (a) and (b) while ignoring ( c) is headed for certain trouble. +* * *
+To sum up: in the case of both Scott Fetzer and our other businesses, we feel that (b) on an historical-cost basis - i.e., with both amortization of intangibles and other purchase-price adjustments excluded - is quite close in amount to
( c) . (The two items are not identical, of course. For example, at See's we annually make capitalized expenditures that exceed depreciation by $500,000 to $1 million, simply to hold our ground competitively.) Our conviction about this point is the reason we show our amortization and other purchase-price adjustment items separately in the table on page 8 and is also our reason for viewing the earnings of the individual businesses as reported there as much more closely approximating owner earnings than the GAAP figures. +Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the "truth" about our business. But the accountants' job is to record, not to evaluate. The evaluation job falls to investors and managers.
+Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.
++ diff --git a/berkshire-hathaway/1987/1-in/berkshire-hathaway-1987-letter.txt b/berkshire-hathaway/1987/1-in/berkshire-hathaway-1987-letter.txt new file mode 100644 index 0000000..b717b0b --- /dev/null +++ b/berkshire-hathaway/1987/1-in/berkshire-hathaway-1987-letter.txt @@ -0,0 +1,1540 @@ + + + + + +
+BERKSHIRE HATHAWAY INC. +
+ +
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+ Our gain in net worth during 1987 was $464 million, or
+19.5%. Over the last 23 years (that is, since present management
+took over), our per-share book value has grown from $19.46 to
+$2,477.47, or at a rate of 23.1% compounded annually.
+
+ What counts, of course, is the rate of gain in per-share
+business value, not book value. In many cases, a corporation's
+book value and business value are almost totally unrelated. For
+example, just before they went bankrupt, LTV and Baldwin-United
+published yearend audits showing their book values to be $652
+million and $397 million, respectively. Conversely, Belridge Oil
+was sold to Shell in 1979 for $3.6 billion although its book
+value was only $177 million.
+
+ At Berkshire, however, the two valuations have tracked
+rather closely, with the growth rate in business value over the
+last decade moderately outpacing the growth rate in book value.
+This good news continued in 1987.
+
+ Our premium of business value to book value has widened for
+two simple reasons: We own some remarkable businesses and they
+are run by even more remarkable managers.
+
+ You have a right to question that second assertion. After
+all, CEOs seldom tell their shareholders that they have assembled
+a bunch of turkeys to run things. Their reluctance to do so
+makes for some strange annual reports. Oftentimes, in his
+shareholders' letter, a CEO will go on for pages detailing
+corporate performance that is woefully inadequate. He will
+nonetheless end with a warm paragraph describing his managerial
+comrades as "our most precious asset." Such comments sometimes
+make you wonder what the other assets can possibly be.
+
+ At Berkshire, however, my appraisal of our operating
+managers is, if anything, understated. To understand why, first
+take a look at page 7, where we show the earnings (on an
+historical-cost accounting basis) of our seven largest non-
+financial units: Buffalo News, Fechheimer, Kirby, Nebraska
+Furniture Mart, Scott Fetzer Manufacturing Group, See's Candies,
+and World Book. In 1987, these seven business units had combined
+operating earnings before interest and taxes of $180 million.
+
+ By itself, this figure says nothing about economic
+performance. To evaluate that, we must know how much total
+capital - debt and equity - was needed to produce these earnings.
+Debt plays an insignificant role at our seven units: Their net
+interest expense in 1987 was only $2 million. Thus, pre-tax
+earnings on the equity capital employed by these businesses
+amounted to $178 million. And this equity - again on an
+historical-cost basis - was only $175 million.
+
+ If these seven business units had operated as a single
+company, their 1987 after-tax earnings would have been
+approximately $100 million - a return of about 57% on equity
+capital. You'll seldom see such a percentage anywhere, let alone
+at large, diversified companies with nominal leverage. Here's a
+benchmark: In its 1988 Investor's Guide issue, Fortune reported
+that among the 500 largest industrial companies and 500 largest
+service companies, only six had averaged a return on equity of
+over 30% during the previous decade. The best performer among
+the 1000 was Commerce Clearing House at 40.2%.
+
+ Of course, the returns that Berkshire earns from these seven
+units are not as high as their underlying returns because, in
+aggregate, we bought the businesses at a substantial premium to
+underlying equity capital. Overall, these operations are carried
+on our books at about $222 million above the historical
+accounting values of the underlying assets. However, the
+managers of the units should be judged by the returns they
+achieve on the underlying assets; what we pay for a business does
+not affect the amount of capital its manager has to work with.
+(If, to become a shareholder and part owner of Commerce Clearing
+House, you pay, say, six times book value, that does not change
+CCH's return on equity.)
+
+ Three important inferences can be drawn from the figures I
+have cited. First, the current business value of these seven
+units is far above their historical book value and also far above
+the value at which they are carried on Berkshire's balance sheet.
+Second, because so little capital is required to run these
+businesses, they can grow while concurrently making almost all of
+their earnings available for deployment in new opportunities.
+Third, these businesses are run by truly extraordinary managers.
+The Blumkins, the Heldmans, Chuck Huggins, Stan Lipsey, and Ralph
+Schey all meld unusual talent, energy and character to achieve
+exceptional financial results.
+
+ For good reasons, we had very high expectations when we
+joined with these managers. In every case, however, our
+experience has greatly exceeded those expectations. We have
+received far more than we deserve, but we are willing to accept
+such inequities. (We subscribe to the view Jack Benny expressed
+upon receiving an acting award: "I don't deserve this, but then,
+I have arthritis and I don't deserve that either.")
+
+ Beyond the Sainted Seven, we have our other major unit,
+insurance, which I believe also has a business value well above
+the net assets employed in it. However, appraising the business
+value of a property-casualty insurance company is a decidedly
+imprecise process. The industry is volatile, reported earnings
+oftentimes are seriously inaccurate, and recent changes in the
+Tax Code will severely hurt future profitability. Despite these
+problems, we like the business and it will almost certainly
+remain our largest operation. Under Mike Goldberg's management,
+the insurance business should treat us well over time.
+
+ With managers like ours, my partner, Charlie Munger, and I
+have little to do with operations. in fact, it is probably fair
+to say that if we did more, less would be accomplished. We have
+no corporate meetings, no corporate budgets, and no performance
+reviews (though our managers, of course, oftentimes find such
+procedures useful at their operating units). After all, what can
+we tell the Blumkins about home furnishings, or the Heldmans
+about uniforms?
+
+ Our major contribution to the operations of our subsidiaries
+is applause. But it is not the indiscriminate applause of a
+Pollyanna. Rather it is informed applause based upon the two
+long careers we have spent intensively observing business
+performance and managerial behavior. Charlie and I have seen so
+much of the ordinary in business that we can truly appreciate a
+virtuoso performance. Only one response to the 1987 performance
+of our operating managers is appropriate: sustained, deafening
+applause.
+
+Sources of Reported Earnings
+
+ The table on the following page shows the major sources of
+Berkshire's reported earnings. In the table, amortization of
+Goodwill and other major purchase-price accounting adjustments
+are not charged against the specific businesses to which they
+apply but, instead, are aggregated and shown separately. In
+effect, this procedure presents the earnings of our businesses as
+they would have been reported had we not purchased them. In
+appendixes to my letters in the 1983 and 1986 annual reports, I
+explained why this form of presentation seems to us to be more
+useful to investors and managers than the standard GAAP
+presentation, which makes purchase-price adjustments on a
+business-by business basis. The total net earnings we show in
+the table are, of course, identical to the GAAP figures in our
+audited financial statements.
+
+ In the Business Segment Data on pages 36-38 and in the
+Management's Discussion section on pages 40-44 you will find much
+additional information about our businesses. In these sections
+you will also find our segment earnings reported on a GAAP basis.
+I urge you to read that material, as well as Charlie Munger's
+letter to Wesco shareholders, describing the various businesses
+of that subsidiary, which starts on page 45.
+
+ (000s omitted)
+ ------------------------------------------
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ------------------- -------------------
+ 1987 1986 1987 1986
+ -------- -------- -------- --------
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............... $(55,429) $(55,844) $(20,696) $(29,864)
+ Net Investment Income ...... 152,483 107,143 136,658 96,440
+ Buffalo News ................. 39,410 34,736 21,304 16,918
+ Fechheimer (Acquired 6/3/86) 13,332 8,400 6,580 3,792
+ Kirby ........................ 22,408 20,218 12,891 10,508
+ Nebraska Furniture Mart ...... 16,837 17,685 7,554 7,192
+ Scott Fetzer Mfg. Group ...... 30,591 25,358 17,555 13,354
+ See's Candies ................ 31,693 30,347 17,363 15,176
+ Wesco - other than Insurance 6,209 5,542 4,978 5,550
+ World Book ................... 25,745 21,978 15,136 11,670
+ Amortization of Goodwill ..... (2,862) (2,555) (2,862) (2,555)
+ Other Purchase-Price
+ Accounting Adjustments .... (5,546) (10,033) (6,544) (11,031)
+ Interest on Debt and
+ Pre-Payment Penalty ....... (11,474) (23,891) (5,905) (12,213)
+ Shareholder-Designated
+ Contributions ............. (4,938) (3,997) (2,963) (2,158)
+ Other ........................ 22,460 20,770 13,696 8,685
+ -------- -------- -------- --------
+ Operating Earnings ........... 280,919 195,857 214,745 131,464
+ Sales of Securities .......... 27,319 216,242 19,807 150,897
+ -------- -------- -------- --------
+Total Earnings - All Entities .. $308,238 $412,099 $234,552 $282,361
+ ======== ======== ======== ========
+
+ Gypsy Rose Lee announced on one of her later birthdays: "I
+have everything I had last year; it's just that it's all two
+inches lower." As the table shows, during 1987 almost all of our
+businesses aged in a more upbeat way.
+
+ There's not a lot new to report about these businesses - and
+that's good, not bad. Severe change and exceptional returns
+usually don't mix. Most investors, of course, behave as if just
+the opposite were true. That is, they usually confer the highest
+price-earnings ratios on exotic-sounding businesses that hold out
+the promise of feverish change. That prospect lets investors
+fantasize about future profitability rather than face today's
+business realities. For such investor-dreamers, any blind date
+is preferable to one with the girl next door, no matter how
+desirable she may be.
+
+ Experience, however, indicates that the best business
+returns are usually achieved by companies that are doing
+something quite similar today to what they were doing five or ten
+years ago. That is no argument for managerial complacency.
+Businesses always have opportunities to improve service, product
+lines, manufacturing techniques, and the like, and obviously
+these opportunities should be seized. But a business that
+constantly encounters major change also encounters many chances
+for major error. Furthermore, economic terrain that is forever
+shifting violently is ground on which it is difficult to build a
+fortress-like business franchise. Such a franchise is usually
+the key to sustained high returns.
+
+ The Fortune study I mentioned earlier supports our view.
+Only 25 of the 1,000 companies met two tests of economic
+excellence - an average return on equity of over 20% in the ten
+years, 1977 through 1986, and no year worse than 15%. These
+business superstars were also stock market superstars: During the
+decade, 24 of the 25 outperformed the S&P 500.
+
+ The Fortune champs may surprise you in two respects. First,
+most use very little leverage compared to their interest-paying
+capacity. Really good businesses usually don't need to borrow.
+Second, except for one company that is "high-tech" and several
+others that manufacture ethical drugs, the companies are in
+businesses that, on balance, seem rather mundane. Most sell non-
+sexy products or services in much the same manner as they did ten
+years ago (though in larger quantities now, or at higher prices,
+or both). The record of these 25 companies confirms that making
+the most of an already strong business franchise, or
+concentrating on a single winning business theme, is what usually
+produces exceptional economics.
+
+ Berkshire's experience has been similar. Our managers have
+produced extraordinary results by doing rather ordinary things -
+but doing them exceptionally well. Our managers protect their
+franchises, they control costs, they search for new products and
+markets that build on their existing strengths and they don't get
+diverted. They work exceptionally hard at the details of their
+businesses, and it shows.
+
+ Here's an update:
+
+ o Agatha Christie, whose husband was an archaeologist, said
+that was the perfect profession for one's spouse: "The older you
+become, the more interested they are in you." It is students of
+business management, not archaeologists, who should be interested
+in Mrs. B (Rose Blumkin), the 94-year-old chairman of Nebraska
+Furniture Mart.
+
+ Fifty years ago Mrs. B started the business with $500, and
+today NFM is far and away the largest home furnishings store in
+the country. Mrs. B continues to work seven days a week at the
+job from the opening of each business day until the close. She
+buys, she sells, she manages - and she runs rings around the
+competition. It's clear to me that she's gathering speed and may
+well reach her full potential in another five or ten years.
+Therefore, I've persuaded the Board to scrap our mandatory
+retirement-at-100 policy. (And it's about time: With every
+passing year, this policy has seemed sillier to me.)
+
+ Net sales of NFM were $142.6 million in 1987, up 8% from
+1986. There's nothing like this store in the country, and
+there's nothing like the family Mrs. B has produced to carry on:
+Her son Louie, and his three boys, Ron, Irv and Steve, possess
+the business instincts, integrity and drive of Mrs. B. They work
+as a team and, strong as each is individually, the whole is far
+greater than the sum of the parts.
+
+ The superb job done by the Blumkins benefits us as owners,
+but even more dramatically benefits NFM's customers. They saved
+about $30 million in 1987 by buying from NFM. In other words,
+the goods they bought would have cost that much more if purchased
+elsewhere.
+
+ You'll enjoy an anonymous letter I received last August:
+"Sorry to see Berkshire profits fall in the second quarter. One
+way you may gain back part of your lost. (sic) Check the pricing
+at The Furniture Mart. You will find that they are leaving 10%
+to 20% on the table. This additional profit on $140 million of
+sells (sic) is $28 million. Not small change in anyone's pocket!
+Check out other furniture, carpet, appliance and T.V. dealers.
+Your raising prices to a reasonable profit will help. Thank you.
+/signed/ A Competitor."
+
+ NFM will continue to grow and prosper by following Mrs. B's
+maxim: "Sell cheap and tell the truth."
+
+ o Among dominant papers of its size or larger, the Buffalo
+News continues to be the national leader in two important ways:
+(1) its weekday and Sunday penetration rate (the percentage of
+households in the paper's primary market area that purchase it);
+and (2) its "news-hole" percentage (the portion of the paper
+devoted to news).
+
+ It may not be coincidence that one newspaper leads in both
+categories: an exceptionally "newsrich" product makes for broad
+audience appeal, which in turn leads to high penetration. Of
+course, quantity must be matched by quality. This not only
+means good reporting and good writing; it means freshness and
+relevance. To be indispensable, a paper must promptly tell its
+readers many things they want to know but won't otherwise learn
+until much later, if ever.
+
+ At the News, we put out seven fresh editions every 24 hours,
+each one extensively changed in content. Here's a small example
+that may surprise you: We redo the obituary page in every edition
+of the News, or seven times a day. Any obituary added runs
+through the next six editions until the publishing cycle has been
+completed.
+
+ It's vital, of course, for a newspaper to cover national and
+international news well and in depth. But it is also vital for
+it to do what only a local newspaper can: promptly and
+extensively chronicle the personally-important, otherwise-
+unreported details of community life. Doing this job well
+requires a very broad range of news - and that means lots of
+space, intelligently used.
+
+ Our news hole was about 50% in 1987, just as it has been
+year after year. If we were to cut it to a more typical 40%, we
+would save approximately $4 million annually in newsprint costs.
+That interests us not at all - and it won't interest us even if,
+for one reason or another, our profit margins should
+significantly shrink.
+
+ Charlie and I do not believe in flexible operating budgets,
+as in "Non-direct expenses can be X if revenues are Y, but must
+be reduced if revenues are Y - 5%." Should we really cut our news
+hole at the Buffalo News, or the quality of product and service
+at See's, simply because profits are down during a given year or
+quarter? Or, conversely, should we add a staff economist, a
+corporate strategist, an institutional advertising campaign or
+something else that does Berkshire no good simply because the
+money currently is rolling in?
+
+ That makes no sense to us. We neither understand the adding
+of unneeded people or activities because profits are booming, nor
+the cutting of essential people or activities because
+profitability is shrinking. That kind of yo-yo approach is
+neither business-like nor humane. Our goal is to do what makes
+sense for Berkshire's customers and employees at all times, and
+never to add the unneeded. ("But what about the corporate jet?"
+you rudely ask. Well, occasionally a man must rise above
+principle.)
+
+ Although the News' revenues have grown only moderately since
+1984, superb management by Stan Lipsey, its publisher, has
+produced excellent profit growth. For several years, I have
+incorrectly predicted that profit margins at the News would fall.
+This year I will not let vou down: Margins will, without
+question, shrink in 1988 and profit may fall as well.
+Skyrocketing newsprint costs will be the major cause.
+
+ o Fechheimer Bros. Company is another of our family
+businesses - and, like the Blumkins, what a family. Three
+generations of Heldmans have for decades consistently, built the
+sales and profits of this manufacturer and distributor of
+uniforms. In the year that Berkshire acquired its controlling
+interest in Fechheimer - 1986 - profits were a record. The
+Heldmans didn't slow down after that. Last year earnings
+increased substantially and the outlook is good for 1988.
+
+ There's nothing magic about the Uniform business; the only
+magic is in the Heldmans. Bob, George, Gary, Roger and Fred know
+the business inside and out, and they have fun running it. We
+are fortunate to be in partnership with them.
+
+ o Chuck Huggins continues to set new records at See's, just as
+he has ever since we put him in charge on the day of our purchase
+some 16 years ago. In 1987, volume hit a new high at slightly
+Under 25 million pounds. For the second year in a row, moreover,
+same-store sales, measured in pounds, were virtually unchanged.
+In case you are wondering, that represents improvement: In each
+of the previous six years, same-store sales had fallen.
+
+ Although we had a particularly strong 1986 Christmas season,
+we racked up better store-for-store comparisons in the 1987
+Christmas season than at any other time of the year. Thus, the
+seasonal factor at See's becomes even more extreme. In 1987,
+about 85% of our profit was earned during December.
+
+ Candy stores are fun to visit, but most have not been fun
+for their owners. From what we can learn, practically no one
+besides See's has made significant profits in recent years from
+the operation of candy shops. Clearly, Chuck's record at See's
+is not due to a rising industry tide. Rather, it is a one-of-a-
+kind performance.
+
+ His achievement requires an excellent product - which we
+have - but it also requires genuine affection for the customer.
+Chuck is 100% customer-oriented, and his attitude sets the tone
+for the rest of the See's organization.
+
+ Here's an example of Chuck in action: At See's we regularly
+add new pieces of candy to our mix and also cull a few to keep
+our product line at about 100 varieties. Last spring we selected
+14 items for elimination. Two, it turned out, were badly missed
+by our customers, who wasted no time in letting us know what they
+thought of our judgment: "A pox on all in See's who participated
+in the abominable decision...;" "May your new truffles melt in
+transit, may they sour in people's mouths, may your costs go up
+and your profits go down...;" "We are investigating the
+possibility of obtaining a mandatory injunction requiring you to
+supply...;" You get the picture. In all, we received many hundreds of
+letters.
+
+ Chuck not only reintroduced the pieces, he turned this
+miscue into an opportunity. Each person who had written got a
+complete and honest explanation in return. Said Chuck's letter:
+"Fortunately, when I make poor decisions, good things often
+happen as a result...;" And with the letter went a special gift
+certificate.
+
+ See's increased prices only slightly in the last two years.
+In 1988 we have raised prices somewhat more, though still
+moderately. To date, sales have been weak and it may be
+difficult for See's to improve its earnings this year.
+
+ o World Book, Kirby, and the Scott Fetzer Manufacturing Group
+are all under the management of Ralph Schey. And what a lucky
+thing for us that they are. I told you last year that Scott
+Fetzer performance in 1986 had far exceeded the expectations that
+Charlie and I had at the time of our purchase. Results in 1987
+were even better. Pre-tax earnings rose 10% while average
+capital employed declined significantly.
+
+ Ralph's mastery of the 19 businesses for which he is
+responsible is truly amazing, and he has also attracted some
+outstanding managers to run them. We would love to find a few
+additional units that could be put under Ralph's wing.
+
+ The businesses of Scott Fetzer are too numerous to describe
+in detail. Let's just update you on one of our favorites: At the
+end of 1987, World Book introduced its most dramatically-revised
+edition since 1962. The number of color photos was increased
+from 14,000 to 24,000; over 6,000 articles were revised; 840 new
+contributors were added. Charlie and I recommend this product to
+you and your family, as we do World Book's products for younger
+children, Childcraft and Early World of Learning.
+
+ In 1987, World Book unit sales in the United States
+increased for the fifth consecutive year. International sales
+and profits also grew substantially. The outlook is good for
+Scott Fetzer operations in aggregate, and for World Book in
+particular.
+
+Insurance Operations
+
+ Shown below is an updated version of our usual table
+presenting key figures for the insurance industry:
+
+ Statutory
+ Yearly Change Combined Ratio Yearly Change Inflation Rate
+ in Premiums After Policyholder in Incurred Measured by
+ Written (%) Dividends Losses (%) GNP Deflator (%)
+ ------------- ------------------ ------------- ----------------
+1981 ..... 3.8 106.0 6.5 9.6
+1982 ..... 4.4 109.8 8.4 6.4
+1983 ..... 4.6 112.0 6.8 3.8
+1984 ..... 9.2 117.9 16.9 3.7
+1985 ..... 22.1 116.3 16.1 3.2
+1986 (Rev.) 22.2 108.0 13.5 2.6
+1987 (Est.) 8.7 104.7 6.8 3.0
+
+Source: Best's Insurance Management Reports
+
+
+ The combined ratio represents total insurance costs (losses
+incurred plus expenses) compared to revenue from premiums: A
+ratio below 100 indicates an underwriting profit, and one above
+100 indicates a loss. When the investment income that an insurer
+earns from holding on to policyholders' funds ("the float") is
+taken into account, a combined ratio in the 107-111 range
+typically produces an overall break-even result, exclusive of
+earnings on the funds provided by shareholders.
+
+ The math of the insurance business, encapsulated by the
+table, is not very complicated. In years when the industry's
+annual gain in revenues (premiums) pokes along at 4% or 5%,
+underwriting losses are sure to mount. That is not because auto
+accidents, fires, windstorms and the like are occurring more
+frequently, nor has it lately been the fault of general
+inflation. Today, social and judicial inflation are the major
+culprits; the cost of entering a courtroom has simply ballooned.
+Part of the jump in cost arises from skyrocketing verdicts, and
+part from the tendency of judges and juries to expand the
+coverage of insurance policies beyond that contemplated by the
+insurer when the policies were written. Seeing no let-up in
+either trend, we continue to believe that the industry's revenues
+must grow at about 10% annually for it to just hold its own in
+terms of profitability, even though general inflation may be
+running at a considerably lower rate.
+
+ The strong revenue gains of 1985-87 almost guaranteed the
+industry an excellent underwriting performance in 1987 and,
+indeed, it was a banner year. But the news soured as the
+quarters rolled by: Best's estimates that year-over-year volume
+increases were 12.9%, 11.1%, 5.7%, and 5.6%. In 1988, the
+revenue gain is certain to be far below our 10% "equilibrium"
+figure. Clearly, the party is over.
+
+ However, earnings will not immediately sink. A lag factor
+exists in this industry: Because most policies are written for a
+one-year term, higher or lower insurance prices do not have their
+full impact on earnings until many months after they go into
+effect. Thus, to resume our metaphor, when the party ends and
+the bar is closed, you are allowed to finish your drink. If
+results are not hurt by a major natural catastrophe, we predict a
+small climb for the industry's combined ratio in 1988, followed
+by several years of larger increases.
+
+ The insurance industry is cursed with a set of dismal
+economic characteristics that make for a poor long-term outlook:
+hundreds of competitors, ease of entry, and a product that cannot
+be differentiated in any meaningful way. In such a commodity-
+like business, only a very low-cost operator or someone operating
+in a protected, and usually small, niche can sustain high
+profitability levels.
+
+ When shortages exist, however, even commodity businesses
+flourish. The insurance industry enjoyed that kind of climate
+for a while but it is now gone. One of the ironies of capitalism
+is that most managers in commodity industries abhor shortage
+conditions - even though those are the only circumstances
+permitting them good returns. Whenever shortages appear, the
+typical manager simply can't wait to expand capacity and thereby
+plug the hole through which money is showering upon him. This is
+precisely what insurance managers did in 1985-87, confirming
+again Disraeli's observation: "What we learn from history is that
+we do not learn from history."
+
+ At Berkshire, we work to escape the industry's commodity
+economics in two ways. First, we differentiate our product by our
+financial strength, which exceeds that of all others in the
+industry. This strength, however, is limited in its usefulness.
+It means nothing in the personal insurance field: The buyer of
+an auto or homeowners policy is going to get his claim paid even
+if his insurer fails (as many have). It often means nothing in
+the commercial insurance arena: When times are good, many major
+corporate purchasers of insurance and their brokers pay scant
+attention to the insurer's ability to perform under the more
+adverse conditions that may exist, say, five years later when a
+complicated claim is finally resolved. (Out of sight, out of mind
+- and, later on, maybe out-of-pocket.)
+
+ Periodically, however, buyers remember Ben Franklin's
+observation that it is hard for an empty sack to stand upright
+and recognize their need to buy promises only from insurers that
+have enduring financial strength. It is then that we have a
+major competitive advantage. When a buyer really focuses on
+whether a $10 million claim can be easily paid by his insurer
+five or ten years down the road, and when he takes into account
+the possibility that poor underwriting conditions may then
+coincide with depressed financial markets and defaults by
+reinsurer, he will find only a few companies he can trust.
+Among those, Berkshire will lead the pack.
+
+ Our second method of differentiating ourselves is the total
+indifference to volume that we maintain. In 1989, we will be
+perfectly willing to write five times as much business as we
+write in 1988 - or only one-fifth as much. We hope, of course,
+that conditions will allow us large volume. But we cannot
+control market prices. If they are unsatisfactory, we will
+simply do very little business. No other major insurer acts with
+equal restraint.
+
+ Three conditions that prevail in insurance, but not in most
+businesses, allow us our flexibility. First, market share is not
+an important determinant of profitability: In this business, in
+contrast to the newspaper or grocery businesses, the economic
+rule is not survival of the fattest. Second, in many sectors of
+insurance, including most of those in which we operate,
+distribution channels are not proprietary and can be easily
+entered: Small volume this year does not preclude huge volume
+next year. Third, idle capacity - which in this industry largely
+means people - does not result in intolerable costs. In a way
+that industries such as printing or steel cannot, we can operate
+at quarter-speed much of the time and still enjoy long-term
+prosperity.
+
+ We follow a price-based-on-exposure, not-on-competition
+policy because it makes sense for our shareholders. But we're
+happy to report that it is also pro-social. This policy means
+that we are always available, given prices that we believe are
+adequate, to write huge volumes of almost any type of property-
+casualty insurance. Many other insurers follow an in-and-out
+approach. When they are "out" - because of mounting losses,
+capital inadequacy, or whatever - we are available. Of course,
+when others are panting to do business we are also available -
+but at such times we often find ourselves priced above the
+market. In effect, we supply insurance buyers and brokers with a
+large reservoir of standby capacity.
+
+ One story from mid-1987 illustrates some consequences of our
+pricing policy: One of the largest family-owned insurance
+brokers in the country is headed by a fellow who has long been a
+shareholder of Berkshire. This man handles a number of large
+risks that are candidates for placement with our New York office.
+Naturally, he does the best he can for his clients. And, just as
+naturally, when the insurance market softened dramatically in
+1987 he found prices at other insurers lower than we were willing
+to offer. His reaction was, first, to place all of his business
+elsewhere and, second, to buy more stock in Berkshire. Had we
+been really competitive, he said, we would have gotten his
+insurance business but he would not have bought our stock.
+
+ Berkshire's underwriting experience was excellent in 1987,
+in part because of the lag factor discussed earlier. Our
+combined ratio (on a statutory basis and excluding structured
+settlements and financial reinsurance) was 105. Although the
+ratio was somewhat less favorable than in 1986, when it was 103,
+our profitability improved materially in 1987 because we had the
+use of far more float. This trend will continue to run in our
+favor: Our ratio of float to premium volume will increase very
+significantly during the next few years. Thus, Berkshire's
+insurance profits are quite likely to improve during 1988 and
+1989, even though we expect our combined ratio to rise.
+
+ Our insurance business has also made some important non-
+financial gains during the last few years. Mike Goldberg, its
+manager, has assembled a group of talented professionals to write
+larger risks and unusual coverages. His operation is now well
+equipped to handle the lines of business that will occasionally
+offer us major opportunities.
+
+ Our loss reserve development, detailed on pages 41-42, looks
+better this year than it has previously. But we write lots of
+"long-tail" business - that is, policies generating claims that
+often take many years to resolve. Examples would be product
+liability, or directors and officers liability coverages. With a
+business mix like this, one year of reserve development tells you
+very little.
+
+ You should be very suspicious of any earnings figures
+reported by insurers (including our own, as we have unfortunately
+proved to you in the past). The record of the last decade shows
+that a great many of our best-known insurers have reported
+earnings to shareholders that later proved to be wildly
+erroneous. In most cases, these errors were totally innocent:
+The unpredictability of our legal system makes it impossible for
+even the most conscientious insurer to come close to judging the
+eventual cost of long-tail claims.
+
+ Nevertheless, auditors annually certify the numbers given
+them by management and in their opinions unqualifiedly state that
+these figures "present fairly" the financial position of their
+clients. The auditors use this reassuring language even though
+they know from long and painful experience that the numbers so
+certified are likely to differ dramatically from the true
+earnings of the period. Despite this history of error, investors
+understandably rely upon auditors' opinions. After all, a
+declaration saying that "the statements present fairly" hardly
+sounds equivocal to the non-accountant.
+
+ The wording in the auditor's standard opinion letter is
+scheduled to change next year. The new language represents
+improvement, but falls far short of describing the limitations of
+a casualty-insurer audit. If it is to depict the true state of
+affairs, we believe the standard opinion letter to shareholders
+of a property-casualty company should read something like: "We
+have relied upon representations of management in respect to the
+liabilities shown for losses and loss adjustment expenses, the
+estimate of which, in turn, very materially affects the earnings
+and financial condition herein reported. We can express no
+opinion about the accuracy of these figures. Subject to that
+important reservation, in our opinion, etc."
+
+ If lawsuits develop in respect to wildly inaccurate
+financial statements (which they do), auditors will definitely
+say something of that sort in court anyway. Why should they not
+be forthright about their role and its limitations from the
+outset?
+
+ We want to emphasize that we are not faulting auditors for
+their inability to accurately assess loss reserves (and therefore
+earnings). We fault them only for failing to publicly
+acknowledge that they can't do this job.
+
+ From all appearances, the innocent mistakes that are
+constantly made in reserving are accompanied by others that are
+deliberate. Various charlatans have enriched themselves at the
+expense of the investing public by exploiting, first, the
+inability of auditors to evaluate reserve figures and, second,
+the auditors' willingness to confidently certify those figures as
+if they had the expertise to do so. We will continue to see such
+chicanery in the future. Where "earnings" can be created by the
+stroke of a pen, the dishonest will gather. For them, long-tail
+insurance is heaven. The audit wording we suggest would at least
+serve to put investors on guard against these predators.
+
+ The taxes that insurance companies pay - which increased
+materially, though on a delayed basis, upon enactment of the Tax
+Reform Act of 1986 - took a further turn for the worse at the end
+of 1987. We detailed the 1986 changes in last year's report. We
+also commented on the irony of a statute that substantially
+increased 1987 reported earnings for insurers even as it
+materially reduced both their long-term earnings potential and
+their business value. At Berkshire, the temporarily-helpful
+"fresh start" adjustment inflated 1987 earnings by $8.2 million.
+
+ In our opinion, the 1986 Act was the most important economic
+event affecting the insurance industry over the past decade. The
+1987 Bill further reduced the intercorporate dividends-received
+credit from 80% to 70%, effective January 1, 1988, except for
+cases in which the taxpayer owns at least 20% of an investee.
+
+ Investors who have owned stocks or bonds through corporate
+intermediaries other than qualified investment companies have
+always been disadvantaged in comparison to those owning the same
+securities directly. The penalty applying to indirect ownership
+was greatly increased by the 1986 Tax Bill and, to a lesser
+extent, by the 1987 Bill, particularly in instances where the
+intermediary is an insurance company. We have no way of
+offsetting this increased level of taxation. It simply means
+that a given set of pre-tax investment returns will now translate
+into much poorer after-tax results for our shareholders.
+
+ All in all, we expect to do well in the insurance business,
+though our record is sure to be uneven. The immediate outlook is
+for substantially lower volume but reasonable earnings
+improvement. The decline in premium volume will accelerate after
+our quota-share agreement with Fireman's Fund expires in 1989.
+At some point, likely to be at least a few years away, we may see
+some major opportunities, for which we are now much better
+prepared than we were in 1985.
+
+Marketable Securities - Permanent Holdings
+
+ Whenever Charlie and I buy common stocks for Berkshire's
+insurance companies (leaving aside arbitrage purchases, discussed
+later) we approach the transaction as if we were buying into a
+private business. We look at the economic prospects of the
+business, the people in charge of running it, and the price we
+must pay. We do not have in mind any time or price for sale.
+Indeed, we are willing to hold a stock indefinitely so long as we
+expect the business to increase in intrinsic value at a
+satisfactory rate. When investing, we view ourselves as business
+analysts - not as market analysts, not as macroeconomic analysts,
+and not even as security analysts.
+
+ Our approach makes an active trading market useful, since it
+periodically presents us with mouth-watering opportunities. But
+by no means is it essential: a prolonged suspension of trading in
+the securities we hold would not bother us any more than does the
+lack of daily quotations on World Book or Fechheimer.
+Eventually, our economic fate will be determined by the economic
+fate of the business we own, whether our ownership is partial or
+total.
+
+ Ben Graham, my friend and teacher, long ago described the
+mental attitude toward market fluctuations that I believe to be
+most conducive to investment success. He said that you should
+imagine market quotations as coming from a remarkably
+accommodating fellow named Mr. Market who is your partner in a
+private business. Without fail, Mr. Market appears daily and
+names a price at which he will either buy your interest or sell
+you his.
+
+ Even though the business that the two of you own may have
+economic characteristics that are stable, Mr. Market's quotations
+will be anything but. For, sad to say, the poor fellow has
+incurable emotional problems. At times he feels euphoric and can
+see only the favorable factors affecting the business. When in
+that mood, he names a very high buy-sell price because he fears
+that you will snap up his interest and rob him of imminent gains.
+At other times he is depressed and can see nothing but trouble
+ahead for both the business and the world. On these occasions he
+will name a very low price, since he is terrified that you will
+unload your interest on him.
+
+ Mr. Market has another endearing characteristic: He doesn't
+mind being ignored. If his quotation is uninteresting to you
+today, he will be back with a new one tomorrow. Transactions are
+strictly at your option. Under these conditions, the more manic-
+depressive his behavior, the better for you.
+
+ But, like Cinderella at the ball, you must heed one warning
+or everything will turn into pumpkins and mice: Mr. Market is
+there to serve you, not to guide you. It is his pocketbook, not
+his wisdom, that you will find useful. If he shows up some day
+in a particularly foolish mood, you are free to either ignore him
+or to take advantage of him, but it will be disastrous if you
+fall under his influence. Indeed, if you aren't certain that you
+understand and can value your business far better than Mr.
+Market, you don't belong in the game. As they say in poker, "If
+you've been in the game 30 minutes and you don't know who the
+patsy is, you're the patsy."
+
+ Ben's Mr. Market allegory may seem out-of-date in today's
+investment world, in which most professionals and academicians
+talk of efficient markets, dynamic hedging and betas. Their
+interest in such matters is understandable, since techniques
+shrouded in mystery clearly have value to the purveyor of
+investment advice. After all, what witch doctor has ever
+achieved fame and fortune by simply advising "Take two aspirins"?
+
+ The value of market esoterica to the consumer of investment
+advice is a different story. In my opinion, investment success
+will not be produced by arcane formulae, computer programs or
+signals flashed by the price behavior of stocks and markets.
+Rather an investor will succeed by coupling good business
+judgment with an ability to insulate his thoughts and behavior
+from the super-contagious emotions that swirl about the
+marketplace. In my own efforts to stay insulated, I have found
+it highly useful to keep Ben's Mr. Market concept firmly in mind.
+
+ Following Ben's teachings, Charlie and I let our marketable
+equities tell us by their operating results - not by their daily,
+or even yearly, price quotations - whether our investments are
+successful. The market may ignore business success for a while,
+but eventually will confirm it. As Ben said: "In the short run,
+the market is a voting machine but in the long run it is a
+weighing machine." The speed at which a business's success is
+recognized, furthermore, is not that important as long as the
+company's intrinsic value is increasing at a satisfactory rate.
+In fact, delayed recognition can be an advantage: It may give us
+the chance to buy more of a good thing at a bargain price.
+
+ Sometimes, of course, the market may judge a business to be
+more valuable than the underlying facts would indicate it is. In
+such a case, we will sell our holdings. Sometimes, also, we will
+sell a security that is fairly valued or even undervalued because
+we require funds for a still more undervalued investment or one
+we believe we understand better.
+
+ We need to emphasize, however, that we do not sell holdings
+just because they have appreciated or because we have held them
+for a long time. (Of Wall Street maxims the most foolish may be
+"You can't go broke taking a profit.") We are quite content to
+hold any security indefinitely, so long as the prospective return
+on equity capital of the underlying business is satisfactory,
+management is competent and honest, and the market does not
+overvalue the business.
+
+ However, our insurance companies own three marketable common
+stocks that we would not sell even though they became far
+overpriced in the market. In effect, we view these investments
+exactly like our successful controlled businesses - a permanent
+part of Berkshire rather than merchandise to be disposed of once
+Mr. Market offers us a sufficiently high price. To that, I will
+add one qualifier: These stocks are held by our insurance
+companies and we would, if absolutely necessary, sell portions of
+our holdings to pay extraordinary insurance losses. We intend,
+however, to manage our affairs so that sales are never required.
+
+ A determination to have and to hold, which Charlie and I
+share, obviously involves a mixture of personal and financial
+considerations. To some, our stand may seem highly eccentric.
+(Charlie and I have long followed David Oglivy's advice: "Develop
+your eccentricities while you are young. That way, when you get
+old, people won't think you're going ga-ga.") Certainly, in the
+transaction-fixated Wall Street of recent years, our posture must
+seem odd: To many in that arena, both companies and stocks are
+seen only as raw material for trades.
+
+ Our attitude, however, fits our personalities and the way we
+want to live our lives. Churchill once said, "You shape your
+houses and then they shape you." We know the manner in which we
+wish to be shaped. For that reason, we would rather achieve a
+return of X while associating with people whom we strongly like
+and admire than realize 110% of X by exchanging these
+relationships for uninteresting or unpleasant ones. And we will
+never find people we like and admire more than some of the main
+participants at the three companies - our permanent holdings -
+shown below:
+
+No. of Shares Cost Market
+------------- ---------- ----------
+ (000s omitted)
+ 3,000,000 Capital Cities/ABC, Inc. ........... $517,500 $1,035,000
+ 6,850,000 GEICO Corporation .................. 45,713 756,925
+ 1,727,765 The Washington Post Company ........ 9,731 323,092
+
+ We really don't see many fundamental differences between the
+purchase of a controlled business and the purchase of marketable
+holdings such as these. In each case we try to buy into
+businesses with favorable long-term economics. Our goal is to
+find an outstanding business at a sensible price, not a mediocre
+business at a bargain price. Charlie and I have found that
+making silk purses out of silk is the best that we can do; with
+sow's ears, we fail.
+
+ (It must be noted that your Chairman, always a quick study,
+required only 20 years to recognize how important it was to buy
+good businesses. In the interim, I searched for "bargains" - and
+had the misfortune to find some. My punishment was an education
+in the economics of short-line farm implement manufacturers,
+third-place department stores, and New England textile
+manufacturers.)
+
+ Of course, Charlie and I may misread the fundamental
+economics of a business. When that happens, we will encounter
+problems whether that business is a wholly-owned subsidiary or a
+marketable security, although it is usually far easier to exit
+from the latter. (Indeed, businesses can be misread: Witness the
+European reporter who, after being sent to this country to
+profile Andrew Carnegie, cabled his editor, "My God, you'll never
+believe the sort of money there is in running libraries.")
+
+ In making both control purchases and stock purchases, we try
+to buy not only good businesses, but ones run by high-grade,
+talented and likeable managers. If we make a mistake about the
+managers we link up with, the controlled company offers a certain
+advantage because we have the power to effect change. In
+practice, however, this advantage is somewhat illusory:
+Management changes, like marital changes, are painful, time-
+consuming and chancy. In any event, at our three marketable-but
+permanent holdings, this point is moot: With 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, we simply
+couldn't be in better hands.
+
+ I would say that the controlled company offers two main
+advantages. First, when we control a company we get to allocate
+capital, whereas we are likely to have little or nothing to say
+about this process with marketable holdings. This point can be
+important because the heads of many companies are not skilled in
+capital allocation. Their inadequacy is not surprising. Most
+bosses rise to the top because they have excelled in an area such
+as marketing, production, engineering, administration or,
+sometimes, institutional politics.
+
+ Once they become CEOs, they face new responsibilities. They
+now must make capital allocation decisions, a critical job that
+they may have never tackled and that is not easily mastered. To
+stretch the point, it's as if the final step for a highly-
+talented musician was not to perform at Carnegie Hall but,
+instead, to be named Chairman of the Federal Reserve.
+
+ The lack of skill that many CEOs have at capital allocation
+is no small matter: After ten years on the job, a CEO whose
+company annually retains earnings equal to 10% of net worth will
+have been responsible for the deployment of more than 60% of all
+the capital at work in the business.
+
+ CEOs who recognize their lack of capital-allocation skills
+(which not all do) will often try to compensate by turning to
+their staffs, management consultants, or investment bankers.
+Charlie and I have frequently observed the consequences of such
+"help." On balance, we feel it is more likely to accentuate the
+capital-allocation problem than to solve it.
+
+ In the end, plenty of unintelligent capital allocation takes
+place in corporate America. (That's why you hear so much about
+"restructuring.") Berkshire, however, has been fortunate. At the
+companies that are our major non-controlled holdings, capital has
+generally been well-deployed and, in some cases, brilliantly so.
+
+ The second advantage of a controlled company over a
+marketable security has to do with taxes. Berkshire, as a
+corporate holder, absorbs some significant tax costs through the
+ownership of partial positions that we do not when our ownership
+is 80%, or greater. Such tax disadvantages have long been with
+us, but changes in the tax code caused them to increase
+significantly during the past year. As a consequence, a given
+business result can now deliver Berkshire financial results that
+are as much as 50% better if they come from an 80%-or-greater
+holding rather than from a lesser holding.
+
+ The disadvantages of owning marketable securities are
+sometimes offset by a huge advantage: Occasionally the stock
+market offers us the chance to buy non-controlling pieces of
+extraordinary businesses at truly ridiculous prices -
+dramatically below those commanded in negotiated transactions
+that transfer control. For example, we purchased our Washington
+Post stock in 1973 at $5.63 per share, and per-share operating
+earnings in 1987 after taxes were $10.30. Similarly, Our GEICO
+stock was purchased in 1976, 1979 and 1980 at an average of $6.67
+per share, and after-tax operating earnings per share last year
+were $9.01. In cases such as these, Mr. Market has proven to be a
+mighty good friend.
+
+ An interesting accounting irony overlays a comparison of the
+reported financial results of our controlled companies with those
+of the permanent minority holdings listed above. As you can see,
+those three stocks have a market value of over $2 billion. Yet
+they produced only $11 million in reported after-tax earnings for
+Berkshire in 1987.
+
+ Accounting rules dictate that we take into income only the
+dividends these companies pay us - which are little more than
+nominal - rather than our share of their earnings, which in 1987
+amounted to well over $100 million. On the other hand,
+accounting rules provide that the carrying value of these three
+holdings - owned, as they are, by insurance companies - must be
+recorded on our balance sheet at current market prices. The
+result: GAAP accounting lets us reflect in our net worth the up-
+to-date underlying values of the businesses we partially own, but
+does not let us reflect their underlying earnings in our income
+account.
+
+ In the case of our controlled companies, just the opposite
+is true. Here, we show full earnings in our income account but
+never change asset values on our balance sheet, no matter how
+much the value of a business might have increased since we
+purchased it.
+
+ Our mental approach to this accounting schizophrenia is to
+ignore GAAP figures and to focus solely on the future earning
+power of both our controlled and non-controlled businesses.
+Using this approach, we establish our own ideas of business
+value, keeping these independent from both the accounting values
+shown on our books for controlled companies and the values placed
+by a sometimes foolish market on our partially-owned companies.
+It is this business value that we hope to increase at a
+reasonable (or, preferably, unreasonable) rate in the years
+ahead.
+
+Marketable Securities - Other
+
+ In addition to our three permanent common stock holdings, we
+hold large quantities of marketable securities in our insurance
+companies. In selecting these, 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.
+
+ 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 "mathematical
+expectation," 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.
+
+ o Let's look first at common stocks. During 1987 the stock
+market was an area of much excitement but little net movement:
+The Dow advanced 2.3% for the year. You are aware, of course, of
+the roller coaster ride that produced this minor change. Mr.
+Market was on a manic rampage until October and then experienced
+a sudden, massive seizure.
+
+ We have "professional" investors, those who manage many
+billions, to thank for most of this turmoil. Instead of focusing
+on what businesses will do in the years ahead, many prestigious
+money managers now focus on what they expect other money managers
+to do in the days ahead. For them, stocks are merely tokens in a
+game, like the thimble and flatiron in Monopoly.
+
+ An extreme example of what their attitude leads to is
+"portfolio insurance," a money-management strategy that many
+leading investment advisors embraced in 1986-1987. This strategy
+- which is simply an exotically-labeled version of the small
+speculator's stop-loss order dictates that ever increasing
+portions of a stock portfolio, or their index-future equivalents,
+be sold as prices decline. The strategy says nothing else
+matters: A downtick of a given magnitude automatically produces a
+huge sell order. According to the Brady Report, $60 billion to
+$90 billion of equities were poised on this hair trigger in mid-
+October of 1987.
+
+ If you've thought that investment advisors were hired to
+invest, you may be bewildered by this technique. After buying a
+farm, would a rational owner next order his real estate agent to
+start selling off pieces of it whenever a neighboring property
+was sold at a lower price? Or would you sell your house to
+whatever bidder was available at 9:31 on some morning merely
+because at 9:30 a similar house sold for less than it would have
+brought on the previous day?
+
+ Moves like that, however, are what portfolio insurance tells
+a pension fund or university to make when it owns a portion of
+enterprises such as Ford or General Electric. The less these
+companies are being valued at, says this approach, the more
+vigorously they should be sold. As a "logical" corollary, the
+approach commands the institutions to repurchase these companies
+- I'm not making this up - once their prices have rebounded
+significantly. Considering that huge sums are controlled by
+managers following such Alice-in-Wonderland practices, is it any
+surprise that markets sometimes behave in aberrational fashion?
+
+ Many commentators, however, have drawn an incorrect
+conclusion upon observing recent events: They are fond of saying
+that the small investor has no chance in a market now dominated
+by the erratic behavior of the big boys. This conclusion is dead
+wrong: Such markets are ideal for any investor - small or large -
+so long as he sticks to his investment knitting. Volatility
+caused by money managers who speculate irrationally with huge
+sums will offer the true investor more chances to make
+intelligent investment moves. He can be hurt by such volatility
+only if he is forced, by either financial or psychological
+pressures, to sell at untoward times.
+
+ At Berkshire, we have found little to do in stocks during
+the past few years. During the break in October, a few stocks
+fell to prices that interested us, but we were unable to make
+meaningful purchases before they rebounded. At yearend 1987 we
+had no major common stock investments (that is, over $50 million)
+other than those we consider permanent or arbitrage holdings.
+However, Mr. Market will offer us opportunities - you can be sure
+of that - and, when he does, we will be willing and able to
+participate.
+
+ o In the meantime, our major parking place for money is
+medium-term tax-exempt bonds, whose limited virtues I explained
+in last year's annual report. Though we both bought and sold
+some of these bonds in 1987, our position changed little overall,
+holding around $900 million. A large portion of our bonds are
+"grandfathered" under the Tax Reform Act of 1986, which means
+they are fully tax-exempt. Bonds currently purchased by
+insurance companies are not.
+
+ As an alternative to short-term cash equivalents, our
+medium-term tax-exempts have - so far served us well. They have
+produced substantial extra income for us and are currently worth
+a bit above our cost. Regardless of their market price, we are
+ready to dispose of our bonds whenever something better comes
+along.
+
+ o We continue to have an aversion to long-term bonds (and may
+be making a serious mistake by not disliking medium-term bonds as
+well). Bonds are no better than the currency in which they are
+denominated, and nothing we have seen in the past year - or past
+decade - makes us enthusiastic about the long-term future of U.S.
+currency.
+
+ Our enormous trade deficit is causing various forms of
+"claim checks" - U.S. government and corporate bonds, bank
+deposits, etc. - to pile up in the hands of foreigners at a
+distressing rate. By default, our government has adopted an
+approach to its finances patterned on that of Blanche DuBois, of
+A Streetcar Named Desire, who said, "I have always depended on
+the kindness of strangers." In this case, of course, the
+"strangers" are relying on the integrity of our claim checks
+although the plunging dollar has already made that proposition
+expensive for them.
+
+ The faith that foreigners are placing in us may be
+misfounded. When the claim checks outstanding grow sufficiently
+numerous and when the issuing party can unilaterally determine
+their purchasing power, the pressure on the issuer to dilute
+their value by inflating the currency becomes almost
+irresistible. For the debtor government, the weapon of inflation
+is the economic equivalent of the "H" bomb, and that is why very
+few countries have been allowed to swamp the world with debt
+denominated in their own currency. Our past, relatively good
+record for fiscal integrity has let us break this rule, but the
+generosity accorded us is likely to intensify, rather than
+relieve, the eventual pressure on us to inflate. If we do
+succumb to that pressure, it won't be just the foreign holders of
+our claim checks who will suffer. It will be all of us as well.
+
+ Of course, the U.S. may take steps to stem our trade deficit
+well before our position as a net debtor gets out of hand. (In
+that respect, the falling dollar will help, though unfortunately
+it will hurt in other ways.) Nevertheless, our government's
+behavior in this test of its mettle is apt to be consistent with
+its Scarlett O'Hara approach generally: "I'll think about it
+tomorrow." And, almost inevitably, procrastination in facing up
+to fiscal problems will have inflationary consequences.
+
+ Both the timing and the sweep of those consequences are
+unpredictable. But our inability to quantify or time the risk
+does not mean we should ignore it. While recognizing the
+possibility that we may be wrong and that present interest rates
+may adequately compensate for the inflationary risk, we retain a
+general fear of long-term bonds.
+
+ We are, however, willing to invest a moderate portion of our
+funds in this category if we think we have a significant edge in
+a specific security. That willingness explains our holdings of
+the Washington Public Power Supply Systems #1, #2 and #3 issues,
+discussed in our 1984 report. We added to our WPPSS position
+during 1987. At yearend, we had holdings with an amortized cost
+of $240 million and a market value of $316 million, paying us
+tax-exempt income of $34 million annually.
+
+ o We continued to do well in arbitrage last year, though - or
+perhaps because - we operated on a very limited scale. We enter
+into only a few arbitrage commitments each year and restrict
+ourselves to large transactions that have been publicly
+announced. We do not participate in situations in which green-
+mailers are attempting to put a target company "in play."
+
+ We have practiced arbitrage on an opportunistic basis for
+decades and, to date, our results have been quite good. Though
+we've never made an exact calculation, I believe that overall we
+have averaged annual pre-tax returns of at least 25% from
+arbitrage. I'm quite sure we did better than that in 1987. But
+it should be emphasized that a really bad experience or two -
+such as many arbitrage operations suffered in late 1987 - could
+change the figures dramatically.
+
+ Our only $50 million-plus arbitrage position at yearend 1987
+was 1,096,200 shares of Allegis, with a cost of $76 million and a
+market value of $78 million.
+
+ o We had two other large holdings at yearend that do not fit
+precisely into any of our five categories. One was various
+Texaco, Inc. bonds with short maturities, all purchased after
+Texaco went into bankruptcy. Were it not for the extraordinarily
+strong capital position of our insurance companies, it would be
+inappropriate for us to buy defaulted bonds. At prices
+prevailing after Texaco's bankruptcy filing, however, we regarded
+these issues as by far the most attractive bond investment
+available to us.
+
+ On a worst-case basis with respect to the Pennzoil
+litigation, we felt the bonds were likely to be worth about what
+we paid for them. Given a sensible settlement, which seemed
+likely, we expected the bonds to be worth considerably more. At
+yearend our Texaco bonds were carried on our books at $104
+million and had a market value of $119 million.
+
+ By far our largest - and most publicized - investment in
+1987 was a $700 million purchase of Salomon Inc 9% preferred
+stock. This preferred is convertible after three years into
+Salomon common stock at $38 per share and, if not converted, will
+be redeemed ratably over five years beginning October 31, 1995.
+From most standpoints, this commitment fits into the medium-term
+fixed-income securities category. In addition, we have an
+interesting conversion possibility.
+
+ We, of course, have no special insights regarding the
+direction or future profitability of investment banking. By
+their nature, the economics of this industry are far less
+predictable than those of most other industries in which we have
+major Commitments. This unpredictability is one of the reasons
+why our participation is in the form of a convertible preferred.
+
+ What we do have a strong feeling about is the ability and
+integrity of John Gutfreund, CEO of Salomon Inc. Charlie and I
+like, admire and trust John. We first got to know him in 1976
+when he played a key role in GEICO's escape from near-bankruptcy.
+Several times since, we have seen John steer clients away from
+transactions that would have been unwise, but that the client
+clearly wanted to make - even though his advice provided no fee
+to Salomon and acquiescence would have delivered a large fee.
+Such service-above-self behavior is far from automatic in Wall
+Street.
+
+ For the reasons Charlie outlines on page 50, at yearend we
+valued our Salomon investment at 98% of par, $14 million less
+than our cost. However, we believe there is a reasonable
+likelihood that a leading, high-quality capital-raising and
+market-making operation can average good returns on equity. If
+so, our conversion right will eventually prove to be valuable.
+
+ Two further comments about our investments in marketable
+securities are appropriate. First, we give you our usual
+warning: Our holdings have changed since yearend and will
+continue to do so without notice.
+
+ The second comment is related: During 1987, as in some
+earlier years, there was speculation in the press from time to
+time about our purchase or sale of various securities. These
+stories were sometimes true, sometimes partially true, and other
+times completely untrue. Interestingly, there has been no
+correlation between the size and prestige of the publication and
+the accuracy of the report. One dead-wrong rumor was given
+considerable prominence by a major national magazine, and another
+leading publication misled its readers by writing about an
+arbitrage position as if it were a long-term investment
+commitment. (In not naming names, I am observing the old warning
+that it's not wise to pick fights with people who buy ink by the
+barrel.)
+
+ You should understand that we simply don't comment in any
+way on rumors, whether they are true or false. If we were to
+deny the incorrect reports and refuse comment on the correct
+ones, we would in effect be commenting on all.
+
+ In a world in which big investment ideas are both limited
+and valuable, we have no interest in telling potential
+competitors what we are doing except to the extent required by
+law. We certainly don't expect others to tell us of their
+investment ideas. Nor would we expect a media company to
+disclose news of acquisitions it was privately pursuing or a
+journalist to tell his competitors about stories on which he is
+working or sources he is using.
+
+ I find it uncomfortable when friends or acquaintances
+mention that they are buying X because it has been reported -
+incorrectly - that Berkshire is a buyer. However, I do not set
+them straight. If they want to participate in whatever Berkshire
+actually is buying, they can always purchase Berkshire stock.
+But perhaps that is too simple. Usually, I suspect, they find it
+more exciting to buy what is being talked about. Whether that
+strategy is more profitable is another question.
+
+Financing
+
+ Shortly after yearend, Berkshire sold two issues of
+debentures, totaling $250 million. Both issues mature in 2018
+and will be retired at an even pace through sinking fund
+operations that begin in 1999. Our overall interest cost, after
+allowing for expenses of issuance, is slightly over 10%. Salomon
+was our investment banker, and its service was excellent.
+
+ Despite our pessimistic views about inflation, our taste for
+debt is quite limited. To be sure, it is likely that Berkshire
+could improve its return on equity by moving to a much higher,
+though still conventional, debt-to-business-value ratio. It's
+even more likely that we could handle such a ratio, without
+problems, under economic conditions far worse than any that have
+prevailed since the early 1930s.
+
+ But we do not wish it to be only likely that we can meet our
+obligations; we wish that to be certain. Thus we adhere to
+policies - both in regard to debt and all other matters - that
+will allow us to achieve acceptable long-term results under
+extraordinarily adverse conditions, rather than optimal results
+under a normal range of conditions.
+
+ Good business or investment decisions will eventually
+produce quite satisfactory economic results, with no aid from
+leverage. Therefore, it seems to us to be both foolish and
+improper to risk what is important (including, necessarily, the
+welfare of innocent bystanders such as policyholders and
+employees) for some extra returns that are relatively
+unimportant. This view is not the product of either our
+advancing age or prosperity: Our opinions about debt have
+remained constant.
+
+ However, we are not phobic about borrowing. (We're far from
+believing that there is no fate worse than debt.) We are willing
+to borrow an amount that we believe - on a worst-case basis -
+will pose no threat to Berkshire's well-being. Analyzing what
+that amount might be, we can look to some important strengths
+that would serve us well if major problems should engulf our
+economy: Berkshire's earnings come from many diverse and well-
+entrenched businesses; these businesses seldom require much
+capital investment; what debt we have is structured well; and we
+maintain major holdings of liquid assets. Clearly, we could be
+comfortable with a higher debt-to-business-value ratio than we
+now have.
+
+ One further aspect of our debt policy deserves comment:
+Unlike many in the business world, we prefer to finance in
+anticipation of need rather than in reaction to it. A business
+obtains the best financial results possible by managing both
+sides of its balance sheet well. This means obtaining the
+highest-possible return on assets and the lowest-possible cost on
+liabilities. It would be convenient if opportunities for
+intelligent action on both fronts coincided. However, reason
+tells us that just the opposite is likely to be the case: Tight
+money conditions, which translate into high costs for
+liabilities, will create the best opportunities for acquisitions,
+and cheap money will cause assets to be bid to the sky. Our
+conclusion: Action on the liability side should sometimes be
+taken independent of any action on the asset side.
+
+ Alas, what is "tight" and "cheap" money is far from clear at
+any particular time. We have no ability to forecast interest
+rates and - maintaining our usual open-minded spirit - believe
+that no one else can. Therefore, we simply borrow when
+conditions seem non-oppressive and hope that we will later find
+intelligent expansion or acquisition opportunities, which - as we
+have said - are most likely to pop up when conditions in the debt
+market are clearly oppressive. Our basic principle is that if
+you want to shoot rare, fast-moving elephants, you should always
+carry a loaded gun.
+
+ Our fund-first, buy-or-expand-later policy almost always
+penalizes near-term earnings. For example, we are now earning
+about 6 1/2% on the $250 million we recently raised at 10%, a
+disparity that is currently costing us about $160,000 per week.
+This negative spread is unimportant to us and will not cause us
+to stretch for either acquisitions or higher-yielding short-term
+instruments. If we find the right sort of business elephant
+within the next five years or so, the wait will have been
+worthwhile.
+
+Miscellaneous
+
+ We hope to buy more businesses that are similar to the ones
+we have, and we can use some help. If you have a business that
+fits the following criteria, call me or, preferably, write.
+
+ Here's what we're looking for:
+
+ (1) large purchases (at least $10 million of after-tax
+ earnings),
+
+ (2) demonstrated consistent earning power (future
+ projections are of little interest to us, nor are
+ "turnaround" situations),
+
+ (3) businesses earning good returns on equity while
+ employing little or no debt,
+
+ (4) management in place (we can't supply it),
+
+ (5) simple businesses (if there's lots of technology,
+ we won't understand it),
+
+ (6) an offering price (we don't want to waste our time
+ or that of the seller by talking, even preliminarily,
+ about a transaction when price is unknown).
+
+ We will not engage in unfriendly takeovers. We can promise
+complete confidentiality and a very fast answer - customarily
+within five minutes - as to whether we're interested. We prefer
+to buy for cash, but will consider issuing stock when we receive
+as much in intrinsic business value as we give. We invite
+potential sellers to check us out by contacting people with whom
+we have done business in the past. For the right business - and
+the right people - we can provide a good home.
+
+ On the other hand, we frequently get approached about
+acquisitions that don't come close to meeting our tests: new
+ventures, turnarounds, auction-like sales, and the ever-popular
+(among brokers) "I'm-sure-something-will-work-out-if-you-people-
+get-to-know-each-other." None of these attracts us in the least.
+
+ Besides being interested in the purchases of entire
+businesses as described above, we are also interested in the
+negotiated purchase of large, but not controlling, blocks of
+stock comparable to those we hold in Cap Cities and Salomon. We
+have a special interest in purchasing convertible preferreds as a
+long-term investment, as we did at Salomon.
+
+ * * *
+
+ And now a bit of deja vu. Most of Berkshire's major
+stockholders received their shares at yearend 1969 in a
+liquidating distribution from Buffett Partnership, Ltd. Some of
+these former partners will remember that in 1962 I encountered
+severe managerial problems at Dempster Mill Manufacturing Co., a
+pump and farm implement manufacturing company that BPL
+controlled.
+
+ At that time, like now, I went to Charlie with problems that
+were too tough for me to solve. Charlie suggested the solution
+might lie in a California friend of his, Harry Bottle, whose
+special knack was never forgetting the fundamental. I met Harry
+in Los Angeles on April 17, 1962, and on April 23 he was in
+Beatrice, Nebraska, running Dempster. Our problems disappeared
+almost immediately. In my 1962 annual letter to partners, I
+named Harry "Man of the Year."
+
+ Fade to 24 years later: The scene is K & W Products, a small
+Berkshire subsidiary that produces automotive compounds. For
+years K & W did well, but in 1985-86 it stumbled badly, as it
+pursued the unattainable to the neglect of the achievable.
+Charlie, who oversees K & W, knew there was no need to consult
+me. Instead, he called Harry, now 68 years old, made him CEO,
+and sat back to await the inevitable. He didn't wait long. In
+1987 K & W's profits set a record, up more than 300% from 1986.
+And, as profits went up, capital employed went down: K & W's
+investment in accounts receivable and inventories has decreased
+20%.
+
+ If we run into another managerial problem ten or twenty
+years down the road, you know whose phone will ring.
+
+ * * *
+
+ About 97.2% of all eligible shares participated in
+Berkshire's 1987 shareholder-designated contributions program.
+Contributions made through the program were $4.9 million, and
+2,050 charities were recipients.
+
+ A recent survey reported that about 50% of major American
+companies match charitable contributions made by directors
+(sometimes by a factor of three to one). In effect, these
+representatives of the owners direct funds to their favorite
+charities, and never consult the owners as to their charitable
+preferences. (I wonder how they would feel if the process were
+reversed and shareholders could invade the directors' pockets for
+charities favored by the shareholders.) When A takes money from B
+to give to C and A is a legislator, the process is called
+taxation. But when A is an officer or director of a corporation,
+it is called philanthropy. We continue to believe that
+contributions, aside from those with quite clear direct benefits
+to the company, should reflect the charitable preferences of
+owners rather than those of officers and directors.
+
+ We urge new shareholders to read the description of our
+shareholder-designated contributions program that appears on
+pages 54 and 55. If you wish to participate in future programs,
+we strongly urge that you immediately make sure your shares are
+registered in the name of the actual owner, not in "street" name
+or nominee name. Shares not so registered on September 30, l988
+will be ineligible for the 1988 program.
+
+ * * *
+
+ Last year we again had about 450 shareholders at our annual
+meeting. The 60 or so questions they asked were, as always,
+excellent. At many companies, the annual meeting is a waste of
+time because exhibitionists turn it into a sideshow. Ours,
+however, is different. It is informative for shareholders and
+fun for us. (At Berkshire's meetings, the exhibitionists are on
+the dais.)
+
+ This year our meeting will be on May 23, 1988 in Omaha, and
+we hope that you come. The meeting provides the forum for you to
+ask any owner-related questions you may have, and we will keep
+answering until all (except those dealing with portfolio
+activities or other proprietary information) have been dealt
+with.
+
+ Last year we rented two buses - for $100 - to take
+shareholders interested in the trip to the Furniture Mart. Your
+actions demonstrated your good judgment: You snapped up about
+$40,000 of bargains. Mrs. B regards this expense/sales ratio as
+on the high side and attributes it to my chronic inattention to
+costs and generally sloppy managerial practices. But, gracious
+as always, she has offered me another chance and we will again
+have buses available following the meeting. Mrs. B says you must
+beat last year's sales figures, and I have told her she won't be
+disappointed.
+
+
+
+ Warren E. Buffett
+February 29, 1988 Chairman of the Board
+
+
+
+
diff --git a/berkshire-hathaway/1988/1-in/berkshire-hathaway-1988-letter.txt b/berkshire-hathaway/1988/1-in/berkshire-hathaway-1988-letter.txt
new file mode 100644
index 0000000..9b58c81
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+++ b/berkshire-hathaway/1988/1-in/berkshire-hathaway-1988-letter.txt
@@ -0,0 +1,1483 @@
+
+
+
+
+
+ +BERKSHIRE HATHAWAY INC. +
+ ++ + +To the Shareholders of Berkshire Hathaway Inc.: + + Our gain in net worth during 1988 was $569 million, or +20.0%. Over the last 24 years (that is, since present management +took over), our per-share book value has grown from $19.46 to +$2,974.52, or at a rate of 23.0% compounded annually. + + We’ve emphasized in past reports that what counts, however, +is intrinsic business value - the figure, necessarily an +estimate, indicating what all of our constituent businesses are +worth. By our calculations, Berkshire’s intrinsic business value +significantly exceeds its book value. Over the 24 years, +business value has grown somewhat faster than book value; in +1988, however, book value grew the faster, by a bit. + + Berkshire’s past rates of gain in both book value and +business value were achieved under circumstances far different +from those that now exist. Anyone ignoring these differences +makes the same mistake that a baseball manager would were he to +judge the future prospects of a 42-year-old center fielder on the +basis of his lifetime batting average. + + Important negatives affecting our prospects today are: (1) a +less attractive stock market than generally existed over the past +24 years; (2) higher corporate tax rates on most forms of +investment income; (3) a far more richly-priced market for the +acquisition of businesses; and (4) industry conditions for +Capital Cities/ABC, Inc., GEICO Corporation, and The Washington +Post Company - Berkshire’s three permanent investments, +constituting about one-half of our net worth - that range from +slightly to materially less favorable than those existing five to +ten years ago. All of these companies have superb management and +strong properties. But, at current prices, their upside +potential looks considerably less exciting to us today than it +did some years ago. + + The major problem we face, however, is a growing capital +base. You’ve heard that from us before, but this problem, like +age, grows in significance each year. (And also, just as with +age, it’s better to have this problem continue to grow rather +than to have it “solved.”) + + Four years ago I told you that we needed profits of $3.9 +billion to achieve a 15% annual return over the decade then +ahead. Today, for the next decade, a 15% return demands profits +of $10.3 billion. That seems like a very big number to me and to +Charlie Munger, Berkshire’s Vice Chairman and my partner. (Should +that number indeed prove too big, Charlie will find himself, in +future reports, retrospectively identified as the senior +partner.) + + As a partial offset to the drag that our growing capital +base exerts upon returns, we have a very important advantage now +that we lacked 24 years ago. Then, all our capital was tied up +in a textile business with inescapably poor economic +characteristics. Today part of our capital is invested in some +really exceptional businesses. + + Last year we dubbed these operations the Sainted Seven: +Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott +Fetzer Manufacturing Group, See’s, and World Book. In 1988 the +Saints came marching in. You can see just how extraordinary +their returns on capital were by examining the historical-cost +financial statements on page 45, which combine the figures of the +Sainted Seven with those of several smaller units. With no +benefit from financial leverage, this group earned about 67% on +average equity capital. + + In most cases the remarkable performance of these units +arises partially from an exceptional business franchise; in all +cases an exceptional management is a vital factor. The +contribution Charlie and I make is to leave these managers alone. + + In my judgment, these businesses, in aggregate, will +continue to produce superb returns. We’ll need these: Without +this help Berkshire would not have a chance of achieving our 15% +goal. You can be sure that our operating managers will deliver; +the question mark in our future is whether Charlie and I can +effectively employ the funds that they generate. + + In that respect, we took a step in the right direction early +in 1989 when we purchased an 80% interest in Borsheim’s, a +jewelry business in Omaha. This purchase, described later in +this letter, delivers exactly what we look for: an outstanding +business run by people we like, admire, and trust. It’s a great +way to start the year. + +Accounting Changes + + We have made a significant accounting change that was +mandated for 1988, and likely will have another to make in 1990. +When we move figures around from year to year, without any change +in economic reality, one of our always-thrilling discussions of +accounting is necessary. + + First, I’ll offer my customary disclaimer: Despite the +shortcomings of generally accepted accounting principles (GAAP), +I would hate to have the job of devising a better set of rules. +The limitations of the existing set, however, need not be +inhibiting: CEOs are free to treat GAAP statements as a beginning +rather than an end to their obligation to inform owners and +creditors - and indeed they should. After all, any manager of a +subsidiary company would find himself in hot water if he reported +barebones GAAP numbers that omitted key information needed by his +boss, the parent corporation’s CEO. Why, then, should the CEO +himself withhold information vitally useful to his bosses - the +shareholder-owners of the corporation? + + What needs to be reported is data - whether GAAP, non-GAAP, +or extra-GAAP - that helps financially-literate readers answer +three key questions: (1) Approximately how much is this company +worth? (2) What is the likelihood that it can meet its future +obligations? and (3) How good a job are its managers doing, given +the hand they have been dealt? + + In most cases, answers to one or more of these questions are +somewhere between difficult and impossible to glean from the +minimum GAAP presentation. The business world is simply too +complex for a single set of rules to effectively describe +economic reality for all enterprises, particularly those +operating in a wide variety of businesses, such as Berkshire. + + Further complicating the problem is the fact that many +managements view GAAP not as a standard to be met, but as an +obstacle to overcome. Too often their accountants willingly +assist them. (“How much,” says the client, “is two plus two?” +Replies the cooperative accountant, “What number did you have in +mind?”) Even honest and well-intentioned managements sometimes +stretch GAAP a bit in order to present figures they think will +more appropriately describe their performance. Both the +smoothing of earnings and the “big bath” quarter are “white lie” +techniques employed by otherwise upright managements. + + Then there are managers who actively use GAAP to deceive and +defraud. They know that many investors and creditors accept GAAP +results as gospel. So these charlatans interpret the rules +“imaginatively” and record business transactions in ways that +technically comply with GAAP but actually display an economic +illusion to the world. + + As long as investors - including supposedly sophisticated +institutions - place fancy valuations on reported “earnings” that +march steadily upward, you can be sure that some managers and +promoters will exploit GAAP to produce such numbers, no matter +what the truth may be. Over the years, Charlie and I have +observed many accounting-based frauds of staggering size. Few of +the perpetrators have been punished; many have not even been +censured. It has been far safer to steal large sums with a pen +than small sums with a gun. + + Under one major change mandated by GAAP for 1988, we have +been required to fully consolidate all our subsidiaries in our +balance sheet and earnings statement. In the past, Mutual +Savings and Loan, and Scott Fetzer Financial (a credit company +that primarily finances installment sales of World Book and Kirby +products) were consolidated on a “one-line” basis. That meant we +(1) showed our equity in their combined net worths as a single- +entry asset on Berkshire’s consolidated balance sheet and (2) +included our equity in their combined annual earnings as a +single-line income entry in our consolidated statement of +earnings. Now the rules require that we consolidate each asset +and liability of these companies in our balance sheet and each +item of their income and expense in our earnings statement. + + This change underscores the need for companies also to +report segmented data: The greater the number of economically +diverse business operations lumped together in conventional +financial statements, the less useful those presentations are and +the less able investors are to answer the three questions posed +earlier. Indeed, the only reason we ever prepare consolidated +figures at Berkshire is to meet outside requirements. On the +other hand, Charlie and I constantly study our segment data. + + Now that we are required to bundle more numbers in our GAAP +statements, we have decided to publish additional supplementary +information that we think will help you measure both business +value and managerial performance. (Berkshire’s ability to +discharge its obligations to creditors - the third question we +listed - should be obvious, whatever statements you examine.) In +these supplementary presentations, we will not necessarily follow +GAAP procedures, or even corporate structure. Rather, we will +attempt to lump major business activities in ways that aid +analysis but do not swamp you with detail. Our goal is to give +you important information in a form that we would wish to get it +if our roles were reversed. + + On pages 41-47 we show separate combined balance sheets and +earnings statements for: (1) our subsidiaries engaged in finance- +type operations, which are Mutual Savings and Scott Fetzer +Financial; (2) our insurance operations, with their major +investment positions itemized; (3) our manufacturing, publishing +and retailing businesses, leaving aside certain non-operating +assets and purchase-price accounting adjustments; and (4) an all- +other category that includes the non-operating assets (primarily +marketable securities) held by the companies in (3) as well as +various assets and debts of the Wesco and Berkshire parent +companies. + + If you combine the earnings and the net worths of these four +segments, you will derive totals matching those shown on our GAAP +statements. However, we want to emphasize that our new +presentation does not fall within the purview of our auditors, +who in no way bless it. (In fact, they may be horrified; I don’t +want to ask.) + + I referred earlier to a major change in GAAP that is +expected in 1990. This change relates to the calculation of +deferred taxes, and is both complicated and controversial - so +much so that its imposition, originally scheduled for 1989, was +postponed for a year. + + When implemented, the new rule will affect us in various +ways. Most important, we will be required to change the way we +calculate our liability for deferred taxes on the unrealized +appreciation of stocks held by our insurance companies. + + Right now, our liability is layered. For the unrealized +appreciation that dates back to 1986 and earlier years, $1.2 +billion, we have booked a 28% tax liability. For the unrealized +appreciation built up since, $600 million, the tax liability has +been booked at 34%. The difference reflects the increase in tax +rates that went into effect in 1987. + + It now appears, however, that the new accounting rule will +require us to establish the entire liability at 34% in 1990, +taking the charge against our earnings. Assuming no change in +tax rates by 1990, this step will reduce our earnings in that +year (and thereby our reported net worth) by $71 million. The +proposed rule will also affect other items on our balance sheet, +but these changes will have only a minor impact on earnings and +net worth. + + We have no strong views about the desirability of this +change in calculation of deferred taxes. We should point out, +however, that neither a 28% nor a 34% tax liability precisely +depicts economic reality at Berkshire since we have no plans to +sell the stocks in which we have the great bulk of our gains. + + To those of you who are uninterested in accounting, I +apologize for this dissertation. I realize that many of you do +not pore over our figures, but instead hold Berkshire primarily +because you know that: (1) Charlie and I have the bulk of our +money in Berkshire; (2) we intend to run things so that your +gains or losses are in direct proportion to ours; and (3) the +record has so far been satisfactory. There is nothing +necessarily wrong with this kind of “faith” approach to +investing. Other shareholders, however, prefer an “analysis” +approach and we want to supply the information they need. In our +own investing, we search for situations in which both approaches +give us the same answer. + +Sources of Reported Earnings + + In addition to supplying you with our new four-sector +accounting material, we will continue to list the major sources +of Berkshire’s reported earnings just as we have in the past. + + In the following table, amortization of Goodwill and other +major purchase-price accounting adjustments are not charged +against the specific businesses to which they apply but are +instead aggregated and shown separately. This procedure lets you +view the earnings of our businesses as they would have been +reported had we not purchased them. I’ve explained in past +reports why this form of presentation seems to us to be more +useful to investors and managers than the standard GAAP +presentation, which makes purchase-price adjustments on a +business-by-business basis. The total net earnings we show in +the table are, of course, identical to the GAAP total in our +audited financial statements. + + Further information about these businesses is given in the +Business Segment section on pages 32-34, and in the Management’s +Discussion section on pages 36-40. In these sections you also +will find our segment earnings reported on a GAAP basis. For +information on Wesco’s businesses, I urge you to read Charlie +Munger’s letter, which starts on page 52. It contains the best +description I have seen of the events that produced the present +savings-and-loan crisis. Also, take special note of Dave +Hillstrom’s performance at Precision Steel Warehouse, a Wesco +subsidiary. Precision operates in an extremely competitive +industry, yet Dave consistently achieves good returns on invested +capital. Though data is lacking to prove the point, I think it +is likely that his performance, both in 1988 and years past, +would rank him number one among his peers. + + (000s omitted) + ------------------------------------------ + Berkshire's Share + of Net Earnings + (after taxes and + Pre-Tax Earnings minority interests) + ------------------- ------------------- + 1988 1987 1988 1987 + -------- -------- -------- -------- +Operating Earnings: + Insurance Group: + Underwriting ............... $(11,081) $(55,429) $ (1,045) $(20,696) + Net Investment Income ...... 231,250 152,483 197,779 136,658 + Buffalo News ................. 42,429 39,410 25,462 21,304 + Fechheimer ................... 14,152 13,332 7,720 6,580 + Kirby ........................ 26,891 22,408 17,842 12,891 + Nebraska Furniture Mart ...... 18,439 16,837 9,099 7,554 + Scott Fetzer + Manufacturing Group ....... 28,542 30,591 17,640 17,555 + See’s Candies ................ 32,473 31,693 19,671 17,363 + Wesco - other than Insurance 16,133 6,209 10,650 4,978 + World Book ................... 27,890 25,745 18,021 15,136 + Amortization of Goodwill ..... (2,806) (2,862) (2,806) (2,862) + Other Purchase-Price + Accounting Charges ........ (6,342) (5,546) (7,340) (6,544) + Interest on Debt* ............ (35,613) (11,474) (23,212) (5,905) + Shareholder-Designated + Contributions ............. (4,966) (4,938) (3,217) (2,963) + Other ........................ 41,059 23,217 27,177 13,697 + -------- -------- -------- -------- +Operating Earnings ............. 418,450 281,676 313,441 214,746 +Sales of Securities ............ 131,671 28,838 85,829 19,806 + -------- -------- -------- -------- +Total Earnings - All Entities .. $550,121 $310,514 $399,270 $234,552 + +*Excludes interest expense of Scott Fetzer Financial Group. + + The earnings achieved by our operating businesses are +superb, whether measured on an absolute basis or against those of +their competitors. For that we thank our operating managers: You +and I are fortunate to be associated with them. + + At Berkshire, associations like these last a long time. We +do not remove superstars from our lineup merely because they have +attained a specified age - whether the traditional 65, or the 95 +reached by Mrs. B on the eve of Hanukkah in 1988. Superb +managers are too scarce a resource to be discarded simply because +a cake gets crowded with candles. Moreover, our experience with +newly-minted MBAs has not been that great. Their academic +records always look terrific and the candidates always know just +what to say; but too often they are short on personal commitment +to the company and general business savvy. It’s difficult to +teach a new dog old tricks. + + Here’s an update on our major non-insurance operations: + + o At Nebraska Furniture Mart, Mrs. B (Rose Blumkin) and her +cart roll on and on. She’s been the boss for 51 years, having +started the business at 44 with $500. (Think what she would have +done with $1,000!) With Mrs. B, old age will always be ten years +away. + + The Mart, long the largest home furnishings store in the +country, continues to grow. In the fall, the store opened a +detached 20,000 square foot Clearance Center, which expands our +ability to offer bargains in all price ranges. + + Recently Dillard’s, one of the most successful department +store operations in the country, entered the Omaha market. In +many of its stores, Dillard’s runs a full furniture department, +undoubtedly doing well in this line. Shortly before opening in +Omaha, however, William Dillard, chairman of the company, +announced that his new store would not sell furniture. Said he, +referring to NFM: “We don’t want to compete with them. We think +they are about the best there is.” + + At the Buffalo News we extol the value of advertising, and +our policies at NFM prove that we practice what we preach. Over +the past three years NFM has been the largest ROP advertiser in +the Omaha World-Herald. (ROP advertising is the kind printed in +the paper, as contrasted to the preprinted-insert kind.) In no +other major market, to my knowledge, is a home furnishings +operation the leading customer of the newspaper. At times, we +also run large ads in papers as far away as Des Moines, Sioux +City and Kansas City - always with good results. It truly does +pay to advertise, as long as you have something worthwhile to +offer. + + Mrs. B’s son, Louie, and his boys, Ron and Irv, complete the +winning Blumkin team. It’s a joy to work with this family. All +its members have character that matches their extraordinary +abilities. + + o Last year I stated unequivocally that pre-tax margins at +The Buffalo News would fall in 1988. That forecast would have +proved correct at almost any other newspaper our size or larger. +But Stan Lipsey - bless him - has managed to make me look +foolish. + + Though we increased our prices a bit less than the industry +average last year, and though our newsprint costs and wage rates +rose in line with industry norms, Stan actually improved margins +a tad. No one in the newspaper business has a better managerial +record. He has achieved it, furthermore, while running a paper +that gives readers an extraordinary amount of news. We believe +that our “newshole” percentage - the portion of the paper devoted +to news - is bigger than that of any other dominant paper of our +size or larger. The percentage was 49.5% in 1988 versus 49.8% in +1987. We are committed to keeping it around 50%, whatever the +level or trend of profit margins. + + Charlie and I have loved the newspaper business since we +were youngsters, and we have had great fun with the News in the +12 years since we purchased it. We were fortunate to find Murray +Light, a top-flight editor, on the scene when we arrived and he +has made us proud of the paper ever since. + + o See’s Candies sold a record 25.1 million pounds in 1988. +Prospects did not look good at the end of October, but excellent +Christmas volume, considerably better than the record set in +1987, turned the tide. + + As we’ve told you before, See’s business continues to become +more Christmas-concentrated. In 1988, the Company earned a +record 90% of its full-year profits in December: $29 million out +of $32.5 million before tax. (It’s enough to make you believe in +Santa Claus.) December’s deluge of business produces a modest +seasonal bulge in Berkshire’s corporate earnings. Another small +bulge occurs in the first quarter, when most World Book annuals +are sold. + + Charlie and I put Chuck Huggins in charge of See’s about +five minutes after we bought the company. Upon reviewing his +record, you may wonder what took us so long. + + o At Fechheimer, the Heldmans - Bob, George, Gary, Roger and +Fred - are the Cincinnati counterparts of the Blumkins. Neither +furniture retailing nor uniform manufacturing has inherently +attractive economics. In these businesses, only exceptional +managements can deliver high returns on invested capital. And +that’s exactly what the five Heldmans do. (As Mets announcer +Ralph Kiner once said when comparing pitcher Steve Trout to his +father, Dizzy Trout, the famous Detroit Tigers pitcher: “There’s +a lot of heredity in that family.”) + + Fechheimer made a fairly good-sized acquisition in 1988. +Charlie and I have such confidence in the business savvy of the +Heldman family that we okayed the deal without even looking at +it. There are very few managements anywhere - including those +running the top tier companies of the Fortune 500 - in which we +would exhibit similar confidence. + + Because of both this acquisition and some internal growth, +sales at Fechheimer should be up significantly in 1989. + + o All of the operations managed by Ralph Schey - World Book, +Kirby, and The Scott Fetzer Manufacturing Group - performed +splendidly in 1988. Returns on the capital entrusted to Ralph +continue to be exceptional. + + Within the Scott Fetzer Manufacturing Group, particularly +fine progress was recorded at its largest unit, Campbell +Hausfeld. This company, the country’s leading producer of small +and medium-sized air compressors, has more than doubled earnings +since 1986. + + Unit sales at both Kirby and World Book were up +significantly in 1988, with export business particularly strong. +World Book became available in the Soviet Union in September, +when that country’s largest American book store opened in Moscow. +Ours is the only general encyclopedia offered at the store. + + Ralph’s personal productivity is amazing: In addition to +running 19 businesses in superb fashion, he is active at The +Cleveland Clinic, Ohio University, Case Western Reserve, and a +venture capital operation that has spawned sixteen Ohio-based +companies and resurrected many others. Both Ohio and Berkshire +are fortunate to have Ralph on their side. + +Borsheim’s + + It was in 1983 that Berkshire purchased an 80% interest in +The Nebraska Furniture Mart. Your Chairman blundered then by +neglecting to ask Mrs. B a question any schoolboy would have +thought of: “Are there any more at home like you?” Last month I +corrected the error: We are now 80% partners with another branch +of the family. + + After Mrs. B came over from Russia in 1917, her parents and +five siblings followed. (Her two other siblings had preceded +her.) Among the sisters was Rebecca Friedman who, with her +husband, Louis, escaped in 1922 to the west through Latvia in a +journey as perilous as Mrs. B’s earlier odyssey to the east +through Manchuria. When the family members reunited in Omaha +they had no tangible assets. However, they came equipped with an +extraordinary combination of brains, integrity, and enthusiasm +for work - and that’s all they needed. They have since proved +themselves invincible. + + In 1948 Mr. Friedman purchased Borsheim’s, a small Omaha +jewelry store. He was joined in the business by his son, Ike, in +1950 and, as the years went by, Ike’s son, Alan, and his sons-in- +law, Marvin Cohn and Donald Yale, came in also. + + You won’t be surprised to learn that this family brings to +the jewelry business precisely the same approach that the +Blumkins bring to the furniture business. The cornerstone for +both enterprises is Mrs. B’s creed: “Sell cheap and tell the +truth.” Other fundamentals at both businesses are: (1) single +store operations featuring huge inventories that provide +customers with an enormous selection across all price ranges, (2) +daily attention to detail by top management, (3) rapid turnover, +(4) shrewd buying, and (5) incredibly low expenses. The +combination of the last three factors lets both stores offer +everyday prices that no one in the country comes close to +matching. + + Most people, no matter how sophisticated they are in other +matters, feel like babes in the woods when purchasing jewelry. +They can judge neither quality nor price. For them only one rule +makes sense: If you don’t know jewelry, know the jeweler. + + I can assure you that those who put their trust in Ike +Friedman and his family will never be disappointed. The way in +which we purchased our interest in their business is the ultimate +testimonial. Borsheim’s had no audited financial statements; +nevertheless, we didn’t take inventory, verify receivables or +audit the operation in any way. Ike simply told us what was so - +- and on that basis we drew up a one-page contract and wrote a +large check. + + Business at Borsheim’s has mushroomed in recent years as the +reputation of the Friedman family has spread. Customers now come +to the store from all over the country. Among them have been +some friends of mine from both coasts who thanked me later for +getting them there. + + Borsheim’s new links to Berkshire will change nothing in the +way this business is run. All members of the Friedman family +will continue to operate just as they have before; Charlie and I +will stay on the sidelines where we belong. And when we say “all +members,” the words have real meaning. Mr. and Mrs. Friedman, at +88 and 87, respectively, are in the store daily. The wives of +Ike, Alan, Marvin and Donald all pitch in at busy times, and a +fourth generation is beginning to learn the ropes. + + It is great fun to be in business with people you have long +admired. The Friedmans, like the Blumkins, have achieved success +because they have deserved success. Both families focus on +what’s right for the customer and that, inevitably, works out +well for them, also. We couldn’t have better partners. + +Insurance Operations + + Shown below is an updated version of our usual table +presenting key figures for the insurance industry: + + Statutory + Yearly Change Combined Ratio Yearly Change Inflation Rate + in Premiums After Policyholder in Incurred Measured by + Written (%) Dividends Losses (%) GNP Deflator (%) + ------------- ------------------ ------------- ---------------- +1981 ..... 3.8 106.0 6.5 9.6 +1982 ..... 3.7 109.6 8.4 6.4 +1983 ..... 5.0 112.0 6.8 3.8 +1984 ..... 8.5 118.0 16.9 3.7 +1985 ..... 22.1 116.3 16.1 3.2 +1986 ..... 22.2 108.0 13.5 2.7 +1987 ..... 9.4 104.6 7.8 3.3 +1988 (Est.) 3.9 105.4 4.2 3.6 + +Source: A.M. Best Co. + + The combined ratio represents total insurance costs (losses +incurred plus expenses) compared to revenue from premiums: A +ratio below 100 indicates an underwriting profit, and one above +100 indicates a loss. When the investment income that an insurer +earns from holding on to policyholders’ funds (“the float”) is +taken into account, a combined ratio in the 107-111 range +typically produces an overall break-even result, exclusive of +earnings on the funds provided by shareholders. + + For the reasons laid out in previous reports, we expect the +industry’s incurred losses to grow by about 10% annually, even in +years when general inflation runs considerably lower. If premium +growth meanwhile materially lags that 10% rate, underwriting +losses will mount, though the industry’s tendency to underreserve +when business turns bad may obscure their size for a time. As +the table shows, the industry’s underwriting loss grew in 1988. +This trend is almost certain to continue - and probably will +accelerate - for at least two more years. + + The property-casualty insurance industry is not only +subnormally profitable, it is subnormally popular. (As Sam +Goldwyn philosophized: “In life, one must learn to take the +bitter with the sour.”) One of the ironies of business is that +many relatively-unprofitable industries that are plagued by +inadequate prices habitually find themselves beat upon by irate +customers even while other, hugely profitable industries are +spared complaints, no matter how high their prices. + + Take the breakfast cereal industry, whose return on invested +capital is more than double that of the auto insurance industry +(which is why companies like Kellogg and General Mills sell at +five times book value and most large insurers sell close to +book). The cereal companies regularly impose price increases, +few of them related to a significant jump in their costs. Yet +not a peep is heard from consumers. But when auto insurers raise +prices by amounts that do not even match cost increases, +customers are outraged. If you want to be loved, it’s clearly +better to sell high-priced corn flakes than low-priced auto +insurance. + + The antagonism that the public feels toward the industry can +have serious consequences: Proposition 103, a California +initiative passed last fall, threatens to push auto insurance +prices down sharply, even though costs have been soaring. The +price cut has been suspended while the courts review the +initiative, but the resentment that brought on the vote has not +been suspended: Even if the initiative is overturned, insurers +are likely to find it tough to operate profitably in California. +(Thank heavens the citizenry isn’t mad at bonbons: If Proposition +103 applied to candy as well as insurance, See’s would be forced +to sell its product for $5.76 per pound. rather than the $7.60 we +charge - and would be losing money by the bucketful.) + + The immediate direct effects on Berkshire from the +initiative are minor, since we saw few opportunities for profit +in the rate structure that existed in California prior to the +vote. However, the forcing down of prices would seriously affect +GEICO, our 44%-owned investee, which gets about 10% of its +premium volume from California. Even more threatening to GEICO +is the possibility that similar pricing actions will be taken in +other states, through either initiatives or legislation. + + If voters insist that auto insurance be priced below cost, +it eventually must be sold by government. Stockholders can +subsidize policyholders for a short period, but only taxpayers +can subsidize them over the long term. At most property-casualty +companies, socialized auto insurance would be no disaster for +shareholders. Because of the commodity characteristics of the +industry, most insurers earn mediocre returns and therefore have +little or no economic goodwill to lose if they are forced by +government to leave the auto insurance business. But GEICO, +because it is a low-cost producer able to earn high returns on +equity, has a huge amount of economic goodwill at risk. In turn, +so do we. + + At Berkshire, in 1988, our premium volume continued to fall, +and in 1989 we will experience a large decrease for a special +reason: The contract through which we receive 7% of the business +of Fireman’s Fund expires on August 31. At that time, we will +return to Fireman’s Fund the unearned premiums we hold that +relate to the contract. This transfer of funds will show up in +our “premiums written” account as a negative $85 million or so +and will make our third-quarter figures look rather peculiar. +However, the termination of this contract will not have a +significant effect on profits. + + Berkshire’s underwriting results continued to be excellent +in 1988. Our combined ratio (on a statutory basis and excluding +structured settlements and financial reinsurance) was 104. +Reserve development was favorable for the second year in a row, +after a string of years in which it was very unsatisfactory. +Details on both underwriting and reserve development appear on +pages 36-38. + + Our insurance volume over the next few years is likely to +run very low, since business with a reasonable potential for +profit will almost certainly be scarce. So be it. At Berkshire, +we simply will not write policies at rates that carry the +expectation of economic loss. We encounter enough troubles when +we expect a gain. + + Despite - or perhaps because of - low volume, our profit +picture during the next few years is apt to be considerably +brighter than the industry’s. We are sure to have an exceptional +amount of float compared to premium volume, and that augurs well +for profits. In 1989 and 1990 we expect our float/premiums +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. + + At some point - we don’t know when - we will be deluged with +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. + +Marketable Securities + + 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. + + 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 “mathematical +expectation,” 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. + + o 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 +subsidiaries of which Berkshire owns less than 100%. + + Shares Company Cost Market + ------ ------- ---------- ---------- + (000s omitted) + 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 + +*Although nominally a preferred stock, this security is + financially equivalent to a common stock. + + Our permanent holdings - Capital Cities/ABC, Inc., GEICO +Corporation, and The Washington Post Company - remain unchanged. +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. + + 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. + + If a secretary, say, is hired for a job that requires typing +ability of at least 80 words a minute and turns out to be capable +of only 50 words a minute, she will lose her job in no time. +There is a logical standard for this job; performance is easily +measured; and if you can’t make the grade, you’re out. +Similarly, if new sales people fail to generate sufficient +business quickly enough, they will be let go. Excuses will not +be accepted as a substitute for orders. + + However, a CEO who doesn’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. + + 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’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’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 +that we are linked with the managers of our three permanent +holdings. They love their businesses, they think like owners, +and they exude integrity and ability. + + o In 1988 we made major purchases of Federal Home Loan +Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold +these securities for a long time. In fact, when we own portions +of outstanding businesses with outstanding managements, our +favorite holding period is forever. We are just the opposite of +those who hurry to sell and book profits when companies perform +well but who tenaciously hang on to businesses that disappoint. +Peter Lynch aptly likens such behavior to cutting the flowers and +watering the weeds. Our holdings of Freddie Mac are the maximum +allowed by law, and are extensively described by Charlie in his +letter. In our consolidated balance sheet these shares are +carried at cost rather than market, since they are owned by +Mutual Savings and Loan, a non-insurance subsidiary. + + We continue to concentrate our investments in a very few +companies that we try to understand well. There are only a +handful of businesses about which we have strong long-term +convictions. Therefore, when we find such a business, we want to +participate in a meaningful way. We agree with Mae West: “Too +much of a good thing can be wonderful.” + + o We reduced our holdings of medium-term tax-exempt bonds by +about $100 million last year. All of the bonds sold were +acquired after August 7, 1986. When such bonds are held by +property-casualty insurance companies, 15% of the “tax-exempt” +interest earned is subject to tax. + + The $800 million position we still hold consists almost +entirely of bonds “grandfathered” under the Tax Reform Act of +1986, which means they are entirely tax-exempt. Our sales +produced a small profit and our remaining bonds, which have an +average maturity of about six years, are worth modestly more than +carrying value. + + Last year we described our holdings of short-term and +intermediate-term bonds of Texaco, which was then in bankruptcy. +During 1988, we sold practically all of these bonds at a pre-tax +profit of about $22 million. This sale explains close to $100 +million of the reduction in fixed-income securities on our +balance sheet. + + We also told you last year about our holdings of another +security whose predominant characteristics are those of an +intermediate fixed-income issue: our $700 million position in +Salomon Inc 9% convertible preferred. This preferred has a +sinking fund that will retire it in equal annual installments +from 1995 to 1999. Berkshire carries this holding at cost. For +reasons discussed by Charlie on page 69, the estimated market +value of our holding has improved from moderately under cost at +the end of last year to moderately over cost at 1988 year end. + + The close association we have had with John Gutfreund, CEO +of Salomon, during the past year has reinforced our admiration +for him. But we continue to have no great insights about the +near, intermediate or long-term economics of the investment +banking business: This is not an industry in which it is easy to +forecast future levels of profitability. We continue to believe +that our conversion privilege could well have important value +over the life of our preferred. However, the overwhelming +portion of the preferred’s value resides in its fixed-income +characteristics, not its equity characteristics. + + o We have not lost our aversion to long-term bonds. We will +become enthused about such securities only when we become +enthused about prospects for long-term stability in the +purchasing power of money. And that kind of stability isn’t in +the cards: Both society and elected officials simply have too +many higher-ranking priorities that conflict with purchasing- +power stability. The only long-term bonds we hold are those of +Washington Public Power Supply Systems (WPPSS). A few of our +WPPSS bonds have short maturities and many others, because of +their high coupons, are likely to be refunded and paid off in a +few years. Overall, our WPPSS holdings are carried on our +balance sheet at $247 million and have a market value of about +$352 million. + + We explained the reasons for our WPPSS purchases in the 1983 +annual report, and are pleased to tell you that this commitment +has worked out about as expected. At the time of purchase, most +of our bonds were yielding around 17% after taxes and carried no +ratings, which had been suspended. Recently, the bonds were +rated AA- by Standard & Poor’s. They now sell at levels only +slightly below those enjoyed by top-grade credits. + + In the 1983 report, we compared the economics of our WPPSS +purchase to those involved in buying a business. As it turned +out, this purchase actually worked out better than did the +general run of business acquisitions made in 1983, assuming both +are measured on the basis of unleveraged, after tax returns +achieved through 1988. + + Our WPPSS experience, though pleasant, does nothing to alter +our negative opinion about long-term bonds. It only makes us +hope that we run into some other large stigmatized issue, whose +troubles have caused it to be significantly misappraised by the +market. + +Arbitrage + + In past reports we have told you that our insurance +subsidiaries sometimes engage in arbitrage as an alternative to +holding short-term cash equivalents. We prefer, of course, to +make major long-term commitments, but we often have more cash +than good ideas. At such times, arbitrage sometimes promises +much greater returns than Treasury Bills and, equally important, +cools any temptation we may have to relax our standards for long- +term investments. (Charlie’s sign off after we’ve talked about +an arbitrage commitment is usually: “Okay, at least it will keep +you out of bars.”) + + During 1988 we made unusually large profits from arbitrage, +measured both by absolute dollars and rate of return. Our pre- +tax gain was about $78 million on average invested funds of about +$147 million. + + This level of activity makes some detailed discussion of +arbitrage and our approach to it appropriate. Once, the word +applied only to the simultaneous purchase and sale of securities +or foreign exchange in two different markets. The goal was to +exploit tiny price differentials that might exist between, say, +Royal Dutch stock trading in guilders in Amsterdam, pounds in +London, and dollars in New York. Some people might call this +scalping; it won’t surprise you that practitioners opted for the +French term, arbitrage. + + Since World War I the definition of arbitrage - or “risk +arbitrage,” as it is now sometimes called - has expanded to +include the pursuit of profits from an announced corporate event +such as sale of the company, merger, recapitalization, +reorganization, liquidation, self-tender, etc. In most cases the +arbitrageur expects to profit regardless of the behavior of the +stock market. The major risk he usually faces instead is that +the announced event won’t happen. + + Some offbeat opportunities occasionally arise in the +arbitrage field. I participated in one of these when I was 24 +and working in New York for Graham-Newman Corp. Rockwood & Co., +a Brooklyn based chocolate products company of limited +profitability, had adopted LIFO inventory valuation in 1941 +when cocoa was selling for 5¢ per pound. In 1954 a +temporary shortage of cocoa caused the price to soar to over +60¢. Consequently Rockwood wished to unload its valuable +inventory - quickly, before the price dropped. But if the cocoa +had simply been sold off, the company would have owed close to +a 50% tax on the proceeds. + + The 1954 Tax Code came to the rescue. It contained an +arcane provision that eliminated the tax otherwise due on LIFO +profits if inventory was distributed to shareholders as part of a +plan reducing the scope of a corporation’s business. Rockwood +decided to terminate one of its businesses, the sale of cocoa +butter, and said 13 million pounds of its cocoa bean inventory +was attributable to that activity. Accordingly, the company +offered to repurchase its stock in exchange for the cocoa beans +it no longer needed, paying 80 pounds of beans for each share. + + For several weeks I busily bought shares, sold beans, and +made periodic stops at Schroeder Trust to exchange stock +certificates for warehouse receipts. The profits were good and +my only expense was subway tokens. + + The architect of Rockwood’s restructuring was an unknown, +but brilliant Chicagoan, Jay Pritzker, then 32. If you’re +familiar with Jay’s subsequent record, you won’t be surprised to +hear the action worked out rather well for Rockwood’s continuing +shareholders also. From shortly before the tender until shortly +after it, Rockwood stock appreciated from 15 to 100, even though +the company was experiencing large operating losses. Sometimes +there is more to stock valuation than price-earnings ratios. + + In recent years, most arbitrage operations have involved +takeovers, friendly and unfriendly. With acquisition fever +rampant, with anti-trust challenges almost non-existent, and with +bids often ratcheting upward, arbitrageurs have prospered +mightily. They have not needed special talents to do well; the +trick, a la Peter Sellers in the movie, has simply been “Being +There.” In Wall Street the old proverb has been reworded: “Give a +man a fish and you feed him for a day. Teach him how to +arbitrage and you feed him forever.” (If, however, he studied at +the Ivan Boesky School of Arbitrage, it may be a state +institution that supplies his meals.) + + To evaluate arbitrage situations you must answer four +questions: (1) How likely is it that the promised event will +indeed occur? (2) How long will your money be tied up? (3) What +chance is there that something still better will transpire - a +competing takeover bid, for example? and (4) What will happen if +the event does not take place because of anti-trust action, +financing glitches, etc.? + + Arcata Corp., one of our more serendipitous arbitrage +experiences, illustrates the twists and turns of the business. +On September 28, 1981 the directors of Arcata agreed in principle +to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), +then and now a major leveraged-buy out firm. Arcata was in the +printing and forest products businesses and had one other thing +going for it: In 1978 the U.S. Government had taken title to +10,700 acres of Arcata timber, primarily old-growth redwood, to +expand Redwood National Park. The government had paid $97.9 +million, in several installments, for this acreage, a sum Arcata +was contesting as grossly inadequate. The parties also disputed +the interest rate that should apply to the period between the +taking of the property and final payment for it. The enabling +legislation stipulated 6% simple interest; Arcata argued for a +much higher and compounded rate. + + Buying a company with a highly-speculative, large-sized +claim in litigation creates a negotiating problem, whether the +claim is on behalf of or against the company. To solve this +problem, KKR offered $37.00 per Arcata share plus two-thirds of +any additional amounts paid by the government for the redwood +lands. + + Appraising this arbitrage opportunity, we had to ask +ourselves whether KKR would consummate the transaction since, +among other things, its offer was contingent upon its obtaining +“satisfactory financing.” A clause of this kind is always +dangerous for the seller: It offers an easy exit for a suitor +whose ardor fades between proposal and marriage. However, we +were not particularly worried about this possibility because +KKR’s past record for closing had been good. + + We also had to ask ourselves what would happen if the KKR +deal did fall through, and here we also felt reasonably +comfortable: Arcata’s management and directors had been shopping +the company for some time and were clearly determined to sell. +If KKR went away, Arcata would likely find another buyer, though +of course, the price might be lower. + + Finally, we had to ask ourselves what the redwood claim +might be worth. Your Chairman, who can’t tell an elm from an +oak, had no trouble with that one: He coolly evaluated the claim +at somewhere between zero and a whole lot. + + We started buying Arcata stock, then around $33.50, on +September 30 and in eight weeks purchased about 400,000 shares, +or 5% of the company. The initial announcement said that the +$37.00 would be paid in January, 1982. Therefore, if everything +had gone perfectly, we would have achieved an annual rate of +return of about 40% - not counting the redwood claim, which would +have been frosting. + + All did not go perfectly. In December it was announced that +the closing would be delayed a bit. Nevertheless, a definitive +agreement was signed on January 4. Encouraged, we raised our +stake, buying at around $38.00 per share and increasing our +holdings to 655,000 shares, or over 7% of the company. Our +willingness to pay up - even though the closing had been +postponed - reflected our leaning toward “a whole lot” rather +than “zero” for the redwoods. + + Then, on February 25 the lenders said they were taking a +“second look” at financing terms “ in view of the severely +depressed housing industry and its impact on Arcata’s outlook.” +The stockholders’ meeting was postponed again, to April. An +Arcata spokesman said he “did not think the fate of the +acquisition itself was imperiled.” When arbitrageurs hear such +reassurances, their minds flash to the old saying: “He lied like +a finance minister on the eve of devaluation.” + + On March 12 KKR said its earlier deal wouldn’t work, first +cutting its offer to $33.50, then two days later raising it to +$35.00. On March 15, however, the directors turned this bid down +and accepted another group’s offer of $37.50 plus one-half of any +redwood recovery. The shareholders okayed the deal, and the +$37.50 was paid on June 4. + + We received $24.6 million versus our cost of $22.9 million; +our average holding period was close to six months. Considering +the trouble this transaction encountered, our 15% annual rate of +return excluding any value for the redwood claim - was more than +satisfactory. + + But the best was yet to come. The trial judge appointed two +commissions, one to look at the timber’s value, the other to +consider the interest rate questions. In January 1987, the first +commission said the redwoods were worth $275.7 million and the +second commission recommended a compounded, blended rate of +return working out to about 14%. + + In August 1987 the judge upheld these conclusions, which +meant a net amount of about $600 million would be due Arcata. +The government then appealed. In 1988, though, before this +appeal was heard, the claim was settled for $519 million. +Consequently, we received an additional $29.48 per share, or +about $19.3 million. We will get another $800,000 or so in 1989. + + Berkshire’s arbitrage activities differ from those of many +arbitrageurs. First, we participate in only a few, and usually +very large, transactions each year. Most practitioners buy into +a great many deals perhaps 50 or more per year. With that many +irons in the fire, they must spend most of their time monitoring +both the progress of deals and the market movements of the +related stocks. This is not how Charlie nor I wish to spend our +lives. (What’s the sense in getting rich just to stare at a +ticker tape all day?) + + Because we diversify so little, one particularly profitable +or unprofitable transaction will affect our yearly result from +arbitrage far more than it will the typical arbitrage operation. +So far, Berkshire has not had a really bad experience. But we +will - and when it happens we’ll report the gory details to you. + + The other way we differ from some arbitrage operations is +that we participate only in transactions that have been publicly +announced. We do not trade on rumors or try to guess takeover +candidates. We just read the newspapers, think about a few of +the big propositions, and go by our own sense of probabilities. + + At yearend, our only major arbitrage position was 3,342,000 +shares of RJR Nabisco with a cost of $281.8 million and a market +value of $304.5 million. In January we increased our holdings to +roughly four million shares and in February we eliminated our +position. About three million shares were accepted when we +tendered our holdings to KKR, which acquired RJR, and the +returned shares were promptly sold in the market. Our pre-tax +profit was a better-than-expected $64 million. + + Earlier, another familiar face turned up in the RJR bidding +contest: Jay Pritzker, who was part of a First Boston group that +made a tax-oriented offer. To quote Yogi Berra; “It was deja vu +all over again.” + + During most of the time when we normally would have been +purchasers of RJR, our activities in the stock were restricted +because of Salomon’s participation in a bidding group. +Customarily, Charlie and I, though we are directors of Salomon, +are walled off from information about its merger and acquisition +work. We have asked that it be that way: The information would +do us no good and could, in fact, occasionally inhibit +Berkshire’s arbitrage operations. + + However, the unusually large commitment that Salomon +proposed to make in the RJR deal required that all directors be +fully informed and involved. Therefore, Berkshire’s purchases of +RJR were made at only two times: first, in the few days +immediately following management’s announcement of buyout plans, +before Salomon became involved; and considerably later, after the +RJR board made its decision in favor of KKR. Because we could +not buy at other times, our directorships cost Berkshire +significant money. + + Considering Berkshire’s good results in 1988, you might +expect us to pile into arbitrage during 1989. Instead, we expect +to be on the sidelines. + + One pleasant reason is that our cash holdings are down - +because our position in equities that we expect to hold for a +very long time is substantially up. As regular readers of this +report know, our new commitments are not based on a judgment +about short-term prospects for the stock market. Rather, they +reflect an opinion about long-term business prospects for +specific companies. We do not have, never have had, and never +will have an opinion about where the stock market, interest +rates, or business activity will be a year from now. + + Even if we had a lot of cash we probably would do little in +arbitrage in 1989. Some extraordinary excesses have developed in +the takeover field. As Dorothy says: “Toto, I have a feeling +we’re not in Kansas any more.” + + We have no idea how long the excesses will last, nor do we +know what will change the attitudes of government, lender and +buyer that fuel them. But we do know that the less the prudence +with which others conduct their affairs, the greater the prudence +with which we should conduct our own affairs. We have no desire +to arbitrage transactions that reflect the unbridled - and, in +our view, often unwarranted - optimism of both buyers and +lenders. In our activities, we will heed the wisdom of Herb +Stein: “If something can’t go on forever, it will end.” + +Efficient Market Theory + + The preceding discussion about arbitrage makes a small +discussion of “efficient market theory” (EMT) also seem relevant. +This doctrine became highly fashionable - indeed, almost holy +scripture in academic circles during the 1970s. Essentially, it +said that analyzing stocks was useless because all public +information about them was appropriately reflected in their +prices. In other words, the market always knew everything. As a +corollary, the professors who taught EMT said that someone +throwing darts at the stock tables could select a stock portfolio +having prospects just as good as one selected by the brightest, +most hard-working security analyst. Amazingly, EMT was embraced +not only by academics, but by many investment professionals and +corporate managers as well. Observing correctly that the market +was frequently efficient, they went on to conclude incorrectly +that it was always efficient. The difference between these +propositions is night and day. + + In my opinion, the continuous 63-year arbitrage experience +of Graham-Newman Corp. Buffett Partnership, and Berkshire +illustrates just how foolish EMT is. (There’s plenty of other +evidence, also.) While at Graham-Newman, I made a study of its +earnings from arbitrage during the entire 1926-1956 lifespan of +the company. Unleveraged returns averaged 20% per year. +Starting in 1956, I applied Ben Graham’s arbitrage principles, +first at Buffett Partnership and then Berkshire. Though I’ve not +made an exact calculation, I have done enough work to know that +the 1956-1988 returns averaged well over 20%. (Of course, I +operated in an environment far more favorable than Ben’s; he had +1929-1932 to contend with.) + + All of the conditions are present that are required for a +fair test of portfolio performance: (1) the three organizations +traded hundreds of different securities while building this 63- +year record; (2) the results are not skewed by a few fortunate +experiences; (3) we did not have to dig for obscure facts or +develop keen insights about products or managements - we simply +acted on highly-publicized events; and (4) our arbitrage +positions were a clearly identified universe - they have not been +selected by hindsight. + + Over the 63 years, the general market delivered just under a +10% annual return, including dividends. That means $1,000 would +have grown to $405,000 if all income had been reinvested. A 20% +rate of return, however, would have produced $97 million. That +strikes us as a statistically-significant differential that +might, conceivably, arouse one’s curiosity. + + Yet proponents of the theory have never seemed interested in +discordant evidence of this type. True, they don’t talk quite as +much about their theory today as they used to. But no one, to my +knowledge, has ever said he was wrong, no matter how many +thousands of students he has sent forth misinstructed. EMT, +moreover, continues to be an integral part of the investment +curriculum at major business schools. Apparently, a reluctance +to recant, and thereby to demystify the priesthood, is not +limited to theologians. + + Naturally the disservice done students and gullible +investment professionals who have swallowed EMT has been an +extraordinary service to us and other followers of Graham. In +any sort of a contest - financial, mental, or physical - it’s an +enormous advantage to have opponents who have been taught that +it’s useless to even try. From a selfish point of view, +Grahamites should probably endow chairs to ensure the perpetual +teaching of EMT. + + All this said, a warning is appropriate. Arbitrage has +looked easy recently. But this is not a form of investing that +guarantees profits of 20% a year or, for that matter, profits of +any kind. As noted, the market is reasonably efficient much of +the time: For every arbitrage opportunity we seized in that 63- +year period, many more were foregone because they seemed +properly-priced. + + An investor cannot obtain superior profits from stocks by +simply committing to a specific investment category or style. He +can earn them only by carefully evaluating facts and continuously +exercising discipline. Investing in arbitrage situations, per +se, is no better a strategy than selecting a portfolio by +throwing darts. + +New York Stock Exchange Listing + + Berkshire’s shares were listed on the New York Stock +Exchange on November 29, 1988. On pages 50-51 we reproduce the +letter we sent to shareholders concerning the listing. + + Let me clarify one point not dealt with in the letter: +Though our round lot for trading on the NYSE is ten shares, any +number of shares from one on up can be bought or sold. + + As the letter explains, our primary goal in listing was to +reduce transaction costs, and we believe this goal is being +achieved. Generally, the spread between the bid and asked price +on the NYSE has been well below the spread that prevailed in the +over-the-counter market. + + Henderson Brothers, Inc., the specialist in our shares, is +the oldest continuing specialist firm on the Exchange; its +progenitor, William Thomas Henderson, bought his seat for $500 on +September 8, 1861. (Recently, seats were selling for about +$625,000.) Among the 54 firms acting as specialists, HBI ranks +second in number of stocks assigned, with 83. We were pleased +when Berkshire was allocated to HBI, and have been delighted with +the firm’s performance. Jim Maguire, Chairman of HBI, personally +manages the trading in Berkshire, and we could not be in better +hands. + + In two respects our goals probably differ somewhat from +those of most listed companies. First, we do not want to +maximize the price at which Berkshire shares trade. We wish +instead for them to trade in a narrow range centered at intrinsic +business value (which we hope increases at a reasonable - or, +better yet, unreasonable - rate). Charlie and I are bothered as +much by significant overvaluation as significant undervaluation. +Both extremes will inevitably produce results for many +shareholders that will differ sharply from Berkshire’s business +results. If our stock price instead consistently mirrors +business value, each of our shareholders will receive an +investment result that roughly parallels the business results of +Berkshire during his holding period. + + Second, we wish for very little trading activity. If we ran +a private business with a few passive partners, we would be +disappointed if those partners, and their replacements, +frequently wanted to leave the partnership. Running a public +company, we feel the same way. + + Our goal is to attract long-term owners who, at the time of +purchase, have no timetable or price target for sale but plan +instead to stay with us indefinitely. We don’t understand the +CEO who wants lots of stock activity, for that can be achieved +only if many of his owners are constantly exiting. At what other +organization - school, club, church, etc. - do leaders cheer when +members leave? (However, if there were a broker whose livelihood +depended upon the membership turnover in such organizations, you +could be sure that there would be at least one proponent of +activity, as in: “There hasn’t been much going on in Christianity +for a while; maybe we should switch to Buddhism next week.“) + + Of course, some Berkshire owners will need or want to sell +from time to time, and we wish for good replacements who will pay +them a fair price. Therefore we try, through our policies, +performance, and communications, to attract new shareholders who +understand our operations, share our time horizons, and measure +us as we measure ourselves. If we can continue to attract this +sort of shareholder - and, just as important, can continue to be +uninteresting to those with short-term or unrealistic +expectations - Berkshire shares should consistently sell at +prices reasonably related to business value. + +David L. Dodd + + Dave Dodd, my friend and teacher for 38 years, died last +year at age 93. Most of you don’t know of him. Yet any long- +time shareholder of Berkshire is appreciably wealthier because of +the indirect influence he had upon our company. + + Dave spent a lifetime teaching at Columbia University, and +he co-authored Security Analysis with Ben Graham. From the +moment I arrived at Columbia, Dave personally encouraged and +educated me; one influence was as important as the other. +Everything he taught me, directly or through his book, made +sense. Later, through dozens of letters, he continued my +education right up until his death. + + I have known many professors of finance and investments but +I have never seen any, except for Ben Graham, who was the match +of Dave. The proof of his talent is the record of his students: +No other teacher of investments has sent forth so many who have +achieved unusual success. + + When students left Dave’s classroom, they were equipped to +invest intelligently for a lifetime because the principles he +taught were simple, sound, useful, and enduring. Though these +may appear to be unremarkable virtues, the teaching of principles +embodying them has been rare. + + It’s particularly impressive that Dave could practice as +well as preach. just as Keynes became wealthy by applying his +academic ideas to a very small purse, so, too, did Dave. Indeed, +his financial performance far outshone that of Keynes, who began +as a market-timer (leaning on business and credit-cycle theory) +and converted, after much thought, to value investing. Dave was +right from the start. + + In Berkshire’s investments, Charlie and I have employed the +principles taught by Dave and Ben Graham. Our prosperity is the +fruit of their intellectual tree. + +Miscellaneous + + We hope to buy more businesses that are similar to the ones +we have, and we can use some help. If you have a business that +fits the following criteria, call me or, preferably, write. + + Here’s what we’re looking for: + + (1) large purchases (at least $10 million of after-tax + earnings), + + (2) demonstrated consistent earning power (future projections + are of little interest to us, nor are “turnaround” + situations), + + (3) businesses earning good returns on equity while employing + little or no debt, + + (4) management in place (we can’t supply it), + + (5) simple businesses (if there’s lots of technology, we won’t + understand it), + + (6) an offering price (we don’t want to waste our time or that + of the seller by talking, even preliminarily, about a + transaction when price is unknown). + + We will not engage in unfriendly takeovers. We can promise +complete confidentiality and a very fast answer - customarily +within five minutes - as to whether we’re interested. We prefer +to buy for cash, but will consider issuing stock when we receive +as much in intrinsic business value as we give. + + Our favorite form of purchase is one fitting the Blumkin- +Friedman-Heldman mold. In cases like these, the company’s owner- +managers wish to generate significant amounts of cash, sometimes +for themselves, but often for their families or inactive +shareholders. However, these managers also wish to remain +significant owners who continue to run their companies just as +they have in the past. We think we offer a particularly good fit +for owners with these objectives and invite potential sellers to +check us out by contacting people with whom we have done business +in the past. + + Charlie and I frequently get approached about acquisitions +that don’t come close to meeting our tests: We’ve found that if +you advertise an interest in buying collies, a lot of people will +call hoping to sell you their cocker spaniels. Our interest in +new ventures, turnarounds, or auction-like sales can best be +expressed by another Goldwynism: “Please include me out.” + + Besides being interested in the purchase of businesses as +described above, we are also interested in the negotiated +purchase of large, but not controlling, blocks of stock +comparable to those we hold in Cap Cities and Salomon. We have a +special interest in purchasing convertible preferreds as a long- +term investment, as we did at Salomon. + + * * * + + We received some good news a few weeks ago: Standard & +Poor’s raised our credit rating to AAA, which is the highest +rating it bestows. Only 15 other U.S. industrial or property- +casualty companies are rated AAA, down from 28 in 1980. + + Corporate bondholders have taken their lumps in the past few +years from “event risk.” This term refers to the overnight +degradation of credit that accompanies a heavily-leveraged +purchase or recapitalization of a business whose financial +policies, up to then, had been conservative. In a world of +takeovers inhabited by few owner-managers, most corporations +present such a risk. Berkshire does not. Charlie and I promise +bondholders the same respect we afford shareholders. + + * * * + + About 97.4% of all eligible shares participated in +Berkshire’s 1988 shareholder-designated contributions program. +Contributions made through the program were $5 million, and 2,319 +charities were recipients. If we achieve reasonable business +results, we plan to increase the per-share contributions in 1989. + + We urge new shareholders to read the description of our +shareholder-designated contributions program that appears on +pages 48-49. If you wish to participate in future programs, we +strongly urge that you immediately make sure your shares are +registered in the name of the actual owner, not in the nominee +name of a broker, bank or depository. Shares not so registered +on September 30, 1989 will be ineligible for the 1989 program. + + * * * + + Berkshire’s annual meeting will be held in Omaha on Monday, +April 24, 1989, and I hope you will come. The meeting provides +the forum for you to ask any owner-related questions you may +have, and we will keep answering until all (except those dealing +with portfolio activities or other proprietary information) have +been dealt with. + + After the meeting we will have several buses available to +take you to visit Mrs. B at The Nebraska Furniture Mart and Ike +Friedman at Borsheim’s. Be prepared for bargains. + + Out-of-towners may prefer to arrive early and visit Mrs. B +during the Sunday store hours of noon to five. (These Sunday +hours seem ridiculously short to Mrs. B, who feels they scarcely +allow her time to warm up; she much prefers the days on which the +store remains open from 10 a.m. to 9 p.m.) Borsheims, however, is +not open on Sunday. + + Ask Mrs. B the secret of her astonishingly low carpet +prices. She will confide to you - as she does to everyone - how +she does it: “I can sell so cheap ‘cause I work for this dummy +who doesn’t know anything about carpet.” + + + Warren E. Buffett +February 28, 1989 Chairman of the Board + ++ + diff --git a/berkshire-hathaway/1989/1-in/berkshire-hathaway-1989-letter.txt b/berkshire-hathaway/1989/1-in/berkshire-hathaway-1989-letter.txt new file mode 100644 index 0000000..1a8340b --- /dev/null +++ b/berkshire-hathaway/1989/1-in/berkshire-hathaway-1989-letter.txt @@ -0,0 +1,1753 @@ + + + + + +
+BERKSHIRE HATHAWAY INC. +
+ +
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+ Our gain in net worth during 1989 was $1.515 billion, or
+44.4%. Over the last 25 years (that is, since present management
+took over) our per-share book value has grown from $19.46 to
+$4,296.01, or at a rate of 23.8% compounded annually.
+
+ What counts, however, is intrinsic value - the figure
+indicating what all of our constituent businesses are rationally
+worth. With perfect foresight, this number can be calculated by
+taking all future cash flows of a business - in and out - and
+discounting them at prevailing interest rates. So valued, all
+businesses, from manufacturers of buggy whips to operators of
+cellular phones, become economic equals.
+
+ Back when Berkshire's book value was $19.46, intrinsic
+value was somewhat less because the book value was entirely tied
+up in a textile business not worth the figure at which it was
+carried. Now most of our businesses are worth far more than their
+carrying values. This agreeable evolution from a discount to a
+premium means that Berkshire's intrinsic business value has
+compounded at a rate that somewhat exceeds our 23.8% annual
+growth in book value.
+
+ The rear-view mirror is one thing; the windshield is
+another. A large portion of our book value is represented by
+equity securities that, with minor exceptions, are carried on our
+balance sheet at current market values. At yearend these
+securities were valued at higher prices, relative to their own
+intrinsic business values, than has been the case in the past.
+One reason is the buoyant 1989 stock market. More important, the
+virtues of these businesses have been widely recognized. Whereas
+once their stock prices were inappropriately low, they are not
+now.
+
+ We will keep most of our major holdings, regardless of how
+they are priced relative to intrinsic business value. This 'til-
+death-do-us-part attitude, combined with the full prices these
+holdings command, means that they cannot be expected to push up
+Berkshire's value in the future as sharply as in the past. In
+other words, our performance to date has benefited from a double-
+dip: (1) the exceptional gains in intrinsic value that our
+portfolio companies have achieved; (2) the additional bonus we
+realized as the market appropriately "corrected" the prices of
+these companies, raising their valuations in relation to those of
+the average business. We will continue to benefit from good gains
+in business value that we feel confident our portfolio companies
+will make. But our "catch-up" rewards have been realized, which
+means we'll have to settle for a single-dip in the future.
+
+ We face another obstacle: In a finite world, high growth
+rates must self-destruct. If the base from which the growth is
+taking place is tiny, this law may not operate for a time. But
+when the base balloons, the party ends: A high growth rate
+eventually forges its own anchor.
+
+ Carl Sagan has entertainingly described this phenomenon,
+musing about the destiny of bacteria that reproduce by dividing
+into two every 15 minutes. Says Sagan: "That means four doublings
+an hour, and 96 doublings a day. Although a bacterium weighs only
+about a trillionth of a gram, its descendants, after a day of
+wild asexual abandon, will collectively weigh as much as a
+mountain...in two days, more than the sun - and before very long,
+everything in the universe will be made of bacteria." Not to
+worry, says Sagan: Some obstacle always impedes this kind of
+exponential growth. "The bugs run out of food, or they poison
+each other, or they are shy about reproducing in public."
+
+ Even on bad days, Charlie Munger (Berkshire's Vice Chairman
+and my partner) and I do not think of Berkshire as a bacterium.
+Nor, to our unending sorrow, have we found a way to double its
+net worth every 15 minutes. Furthermore, we are not the least bit
+shy about reproducing - financially - in public. Nevertheless,
+Sagan's observations apply. From Berkshire's present base of $4.9
+billion in net worth, we will find it much more difficult to
+average 15% annual growth in book value than we did to average
+23.8% from the $22 million we began with.
+
+Taxes
+
+ Our 1989 gain of $1.5 billion was achieved after we took a
+charge of about $712 million for income taxes. In addition,
+Berkshire's share of the income taxes paid by its five major
+investees totaled about $175 million.
+
+ Of this year's tax charge, about $172 million will be paid
+currently; the remainder, $540 million, is deferred. Almost all
+of the deferred portion relates to the 1989 increase in
+unrealized profits in our common stock holdings. Against this
+increase, we have reserved a 34% tax.
+
+ We also carry reserves at that rate against all unrealized
+profits generated in 1987 and 1988. But, as we explained last
+year, the unrealized gains we amassed before 1987 - about $1.2
+billion - carry reserves booked at the 28% tax rate that then
+prevailed.
+
+ A new accounting rule is likely to be adopted that will
+require companies to reserve against all gains at the current tax
+rate, whatever it may be. With the rate at 34%, such a rule would
+increase our deferred tax liability, and decrease our net worth,
+by about $71 million - the result of raising the reserve on our
+pre-1987 gain by six percentage points. Because the proposed rule
+has sparked widespread controversy and its final form is unclear,
+we have not yet made this change.
+
+ As you can see from our balance sheet on page 27, we would
+owe taxes of more than $1.1 billion were we to sell all of our
+securities at year-end market values. Is this $1.1 billion
+liability equal, or even similar, to a $1.1 billion liability
+payable to a trade creditor 15 days after the end of the year?
+Obviously not - despite the fact that both items have exactly the
+same effect on audited net worth, reducing it by $1.1 billion.
+
+ On the other hand, is this liability for deferred taxes a
+meaningless accounting fiction because its payment can be
+triggered only by the sale of stocks that, in very large part, we
+have no intention of selling? Again, the answer is no.
+
+ In economic terms, the liability resembles an interest-free
+loan from the U.S. Treasury that comes due only at our election
+(unless, of course, Congress moves to tax gains before they are
+realized). This "loan" is peculiar in other respects as well: It
+can be used only to finance the ownership of the particular,
+appreciated stocks and it fluctuates in size - daily as market
+prices change and periodically if tax rates change. In effect,
+this deferred tax liability is equivalent to a very large
+transfer tax that is payable only if we elect to move from one
+asset to another. Indeed, we sold some relatively small holdings
+in 1989, incurring about $76 million of "transfer" tax on $224
+million of gains.
+
+ Because of the way the tax law works, the Rip Van Winkle
+style of investing that we favor - if successful - has an
+important mathematical edge over a more frenzied approach. Let's
+look at an extreme comparison.
+
+ Imagine that Berkshire had only $1, which we put in a
+security that doubled by yearend and was then sold. Imagine
+further that we used the after-tax proceeds to repeat this
+process in each of the next 19 years, scoring a double each time.
+At the end of the 20 years, the 34% capital gains tax that we
+would have paid on the profits from each sale would have
+delivered about $13,000 to the government and we would be left
+with about $25,250. Not bad. If, however, we made a single
+fantastic investment that itself doubled 20 times during the 20
+years, our dollar would grow to $1,048,576. Were we then to cash
+out, we would pay a 34% tax of roughly $356,500 and be left with
+about $692,000.
+
+ The sole reason for this staggering difference in results
+would be the timing of tax payments. Interestingly, the
+government would gain from Scenario 2 in exactly the same 27:1
+ratio as we - taking in taxes of $356,500 vs. $13,000 - though,
+admittedly, it would have to wait for its money.
+
+ We have not, we should stress, adopted our strategy
+favoring long-term investment commitments because of these
+mathematics. Indeed, it is possible we could earn greater after-
+tax returns by moving rather frequently from one investment to
+another. Many years ago, that's exactly what Charlie and I did.
+
+ Now we would rather stay put, even if that means slightly
+lower returns. Our reason is simple: We have found splendid
+business relationships to be so rare and so enjoyable that we
+want to retain all we develop. This decision is particularly
+easy for us because we feel that these relationships will produce
+good - though perhaps not optimal - financial results.
+Considering that, we think it makes little sense for us to give
+up time with people we know to be interesting and admirable for
+time with others we do not know and who are likely to have human
+qualities far closer to average. That would be akin to marrying
+for money - a mistake under most circumstances, insanity if one
+is already rich.
+
+
+Sources of Reported Earnings
+
+ The table below shows the major sources of Berkshire's
+reported earnings. In this presentation, amortization of Goodwill
+and other major purchase-price accounting adjustments are not
+charged against the specific businesses to which they apply, but
+are instead aggregated and shown separately. This procedure lets
+you view the earnings of our businesses as they would have been
+reported had we not purchased them. I've explained in past
+reports why this form of presentation seems to us to be more
+useful to investors and managers than one utilizing generally
+accepted accounting principles (GAAP), which require purchase-
+price adjustments to be made on a business-by-business basis. The
+total net earnings we show in the table are, of course, identical
+to the GAAP total in our audited financial statements.
+
+ Further information about these businesses is given in the
+Business Segment section on pages 37-39, and in the Management's
+Discussion section on pages 40-44. In these sections you also
+will find our segment earnings reported on a GAAP basis. For
+information on Wesco's businesses, I urge you to read Charlie
+Munger's letter, which starts on page 54. In addition, we have
+reprinted on page 71 Charlie's May 30, 1989 letter to the U. S.
+League of Savings Institutions, which conveyed our disgust with
+its policies and our consequent decision to resign.
+
+ (000s omitted)
+ ----------------------------------------------
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ---------------------- ----------------------
+ 1989 1988 1989 1988
+ ---------- ---------- ---------- ----------
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............ $(24,400) $(11,081) $(12,259) $ (1,045)
+ Net Investment Income ... 243,599 231,250 213,642 197,779
+ Buffalo News .............. 46,047 42,429 27,771 25,462
+ Fechheimer ................ 12,621 14,152 6,789 7,720
+ Kirby ..................... 26,114 26,891 16,803 17,842
+ Nebraska Furniture Mart ... 17,070 18,439 8,441 9,099
+ Scott Fetzer
+ Manufacturing Group .... 33,165 28,542 19,996 17,640
+ See's Candies ............. 34,235 32,473 20,626 19,671
+ Wesco - other than Insurance 13,008 16,133 9,810 10,650
+ World Book ................ 25,583 27,890 16,372 18,021
+ Amortization of Goodwill .. (3,387) (2,806) (3,372) (2,806)
+ Other Purchase-Price
+ Accounting Charges ........ (5,740) (6,342) (6,668) (7,340)
+ Interest Expense* ......... (42,389) (35,613) (27,098) (23,212)
+ Shareholder-Designated
+ Contributions .......... (5,867) (4,966) (3,814) (3,217)
+ Other ..................... 23,755 41,059 12,863 27,177
+ ---------- ---------- ---------- ----------
+Operating Earnings .......... 393,414 418,450 299,902 313,441
+Sales of Securities ......... 223,810 131,671 147,575 85,829
+ ---------- ---------- ---------- ----------
+Total Earnings - All Entities $617,224 $550,121 $447,477 $399,270
+
+*Excludes interest expense of Scott Fetzer Financial Group and
+ Mutual Savings & Loan.
+
+
+ We refer you also to pages 45-51, where we have rearranged
+Berkshire's financial data into four segments. These correspond
+to the way Charlie and I think about the business and should help
+you calculate Berkshire's intrinsic value. Shown on these pages
+are balance sheets and earnings statements for: (1) our
+insurance operations, with their major investment positions
+itemized; (2) our manufacturing, publishing and retailing
+businesses, leaving aside certain non-operating assets and
+purchase-price accounting adjustments; (3) our subsidiaries
+engaged in finance-type operations, which are Mutual Savings and
+Scott Fetzer Financial; and (4) an all-other category that
+includes the non-operating assets (primarily marketable
+securities) held by the companies in segment (2), all purchase
+price accounting adjustments, and various assets and debts of the
+Wesco and Berkshire parent companies.
+
+ If you combine the earnings and net worths of these four
+segments, you will derive totals matching those shown on our GAAP
+statements. However, I want to emphasize that this four-category
+presentation does not fall within the purview of our auditors,
+who in no way bless it.
+
+ In addition to our reported earnings, we also benefit from
+significant earnings of investees that standard accounting rules
+do not permit us to report. On page 15, we list five major
+investees from which we received dividends in 1989 of about $45
+million, after taxes. However, our share of the retained earnings
+of these investees totaled about $212 million last year, not
+counting large capital gains realized by GEICO and Coca-Cola. If
+this $212 million had been distributed to us, our own operating
+earnings, after the payment of additional taxes, would have been
+close to $500 million rather than the $300 million shown in the
+table.
+
+ The question you must decide is whether these undistributed
+earnings are as valuable to us as those we report. We believe
+they are - and even think they may be more valuable. The reason
+for this a-bird-in-the-bush-may-be-worth-two-in-the-hand
+conclusion is that earnings retained by these investees will
+be deployed by talented, owner-oriented managers who
+sometimes have better uses for these funds in their own
+businesses than we would have in ours. I would not make such a
+generous assessment of most managements, but it is appropriate in
+these cases.
+
+ In our view, Berkshire's fundamental earning power is best
+measured by a "look-through" approach, in which we append our
+share of the operating earnings retained by our investees to our
+own reported operating earnings, excluding capital gains in both
+instances. For our intrinsic business value to grow at an average
+of 15% per year, our "look-through" earnings must grow at about
+the same pace. We'll need plenty of help from our present
+investees, and also need to add a new one from time to time, in
+order to reach this 15% goal.
+
+
+Non-Insurance Operations
+
+ In the past, we have labeled our major manufacturing,
+publishing and retail operations "The Sainted Seven." With our
+acquisition of Borsheim's early in 1989, the challenge was to
+find a new title both alliterative and appropriate. We failed:
+Let's call the group "The Sainted Seven Plus One."
+
+ This divine assemblage - Borsheim's, The Buffalo News,
+Fechheimer Bros., Kirby, Nebraska Furniture Mart, Scott Fetzer
+Manufacturing Group, See's Candies, World Book - is a collection
+of businesses with economic characteristics that range from good
+to superb. Its managers range from superb to superb.
+
+ Most of these managers have no need to work for a living;
+they show up at the ballpark because they like to hit home runs.
+And that's exactly what they do. Their combined financial
+statements (including those of some smaller operations), shown on
+page 49, illustrate just how outstanding their performance is. On
+an historical accounting basis, after-tax earnings of these
+operations were 57% on average equity capital. Moreover, this
+return was achieved with no net leverage: Cash equivalents have
+matched funded debt. When I call off the names of our managers -
+the Blumkin, Friedman and Heldman families, Chuck Huggins, Stan
+Lipsey, and Ralph Schey - I feel the same glow that Miller
+Huggins must have experienced when he announced the lineup of his
+1927 New York Yankees.
+
+ Let's take a look, business by business:
+
+o In its first year with Berkshire, Borsheim's met all
+expectations. Sales rose significantly and are now considerably
+better than twice what they were four years ago when the company
+moved to its present location. In the six years prior to the
+move, sales had also doubled. Ike Friedman, Borsheim's managing
+genius - and I mean that - has only one speed: fast-forward.
+
+ If you haven't been there, you've never seen a jewelry store
+like Borsheim's. Because of the huge volume it does at one
+location, the store can maintain an enormous selection across all
+price ranges. For the same reason, it can hold its expense ratio
+to about one-third that prevailing at jewelry stores offering
+comparable merchandise. The store's tight control of expenses,
+accompanied by its unusual buying power, enable it to offer
+prices far lower than those of other jewelers. These prices, in
+turn, generate even more volume, and so the circle goes 'round
+and 'round. The end result is store traffic as high as 4,000
+people on seasonally-busy days.
+
+ Ike Friedman is not only a superb businessman and a great
+showman but also a man of integrity. We bought the business
+without an audit, and all of our surprises have been on the plus
+side. "If you don't know jewelry, know your jeweler" makes sense
+whether you are buying the whole business or a tiny diamond.
+
+ A story will illustrate why I enjoy Ike so much: Every two
+years I'm part of an informal group that gathers to have fun and
+explore a few subjects. Last September, meeting at Bishop's Lodge
+in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come
+by and educate us on jewels and the jewelry business.
+
+ Ike decided to dazzle the group, so he brought from Omaha
+about $20 million of particularly fancy merchandise. I was
+somewhat apprehensive - Bishop's Lodge is no Fort Knox - and I
+mentioned my concern to Ike at our opening party the evening
+before his presentation. Ike took me aside. "See that safe?" he
+said. "This afternoon we changed the combination and now even the
+hotel management doesn't know what it is." I breathed easier. Ike
+went on: "See those two big fellows with guns on their hips?
+They'll be guarding the safe all night." I now was ready to
+rejoin the party. But Ike leaned closer: "And besides, Warren,"
+he confided, "the jewels aren't in the safe."
+
+ How can we miss with a fellow like that - particularly when
+he comes equipped with a talented and energetic family, Alan,
+Marvin Cohn, and Don Yale.
+
+o At See's Candies we had an 8% increase in pounds sold, even
+though 1988 was itself a record year. Included in the 1989
+performance were excellent same-store poundage gains, our first
+in many years.
+
+ Advertising played an important role in this outstanding
+performance. We increased total advertising expenditures from $4
+million to $5 million and also got copy from our agency, Hal
+Riney & Partners, Inc., that was 100% on the money in conveying
+the qualities that make See's special.
+
+ In our media businesses, such as the Buffalo News, we sell
+advertising. In other businesses, such as See's, we are buyers.
+When we buy, we practice exactly what we preach when we sell. At
+See's, we more than tripled our expenditures on newspaper
+advertising last year, to the highest percentage of sales that I
+can remember. The payoff was terrific, and we thank both Hal
+Riney and the power of well-directed newspaper advertising for
+this result.
+
+ See's splendid performances have become routine. But there
+is nothing routine about the management of Chuck Huggins: His
+daily involvement with all aspects of production and sales
+imparts a quality-and-service message to the thousands of
+employees we need to produce and distribute over 27 million
+pounds of candy annually. In a company with 225 shops and a
+massive mail order and phone business, it is no small trick to
+run things so that virtually every customer leaves happy. Chuck
+makes it look easy.
+
+o The Nebraska Furniture Mart had record sales and excellent
+earnings in 1989, but there was one sad note. Mrs. B - Rose
+Blumkin, who started the company 52 years ago with $500 - quit in
+May, after disagreeing with other members of the Blumkin
+family/management about the remodeling and operation of the
+carpet department.
+
+ Mrs. B probably has made more smart business decisions than
+any living American, but in this particular case I believe the
+other members of the family were entirely correct: Over the past
+three years, while the store's other departments increased sales
+by 24%, carpet sales declined by 17% (but not because of any lack
+of sales ability by Mrs. B, who has always personally sold far
+more merchandise than any other salesperson in the store).
+
+ You will be pleased to know that Mrs. B continues to make
+Horatio Alger's heroes look like victims of tired blood. At age
+96 she has started a new business selling - what else? - carpet
+and furniture. And as always, she works seven days a week.
+
+ At the Mart Louie, Ron, and Irv Blumkin continue to propel
+what is by far the largest and most successful home furnishings
+store in the country. They are outstanding merchants, outstanding
+managers, and a joy to be associated with. One reading on their
+acumen: In the fourth quarter of 1989, the carpet department
+registered a 75.3% consumer share in the Omaha market, up from
+67.7% a year earlier and over six times that of its nearest
+competitor.
+
+ NFM and Borsheim's follow precisely the same formula for
+success: (1) unparalleled depth and breadth of merchandise at one
+location; (2) the lowest operating costs in the business; (3) the
+shrewdest of buying, made possible in part by the huge volumes
+purchased; (4) gross margins, and therefore prices, far below
+competitors'; and (5) friendly personalized service with family
+members on hand at all times.
+
+ Another plug for newspapers: NFM increased its linage in the
+local paper by over 20% in 1989 - off a record 1988 - and remains
+the paper's largest ROP advertiser by far. (ROP advertising is
+the kind printed in the paper, as opposed to that in preprinted
+inserts.) To my knowledge, Omaha is the only city in which a home
+furnishings store is the advertising leader. Many retailers cut
+space purchases in 1989; our experience at See's and NFM would
+indicate they made a major mistake.
+
+o The Buffalo News continued to star in 1989 in three
+important ways: First, among major metropolitan papers, both
+daily and Sunday, the News is number one in household penetration
+- the percentage of local households that purchase it each day.
+Second, in "news hole" - the portion of the paper devoted to news
+- the paper stood at 50.1% in 1989 vs. 49.5% in 1988, a level
+again making it more news-rich than any comparable American
+paper. Third, in a year that saw profits slip at many major
+papers, the News set its seventh consecutive profit record.
+
+ To some extent, these three factors are related, though
+obviously a high-percentage news hole, by itself, reduces profits
+significantly. A large and intelligently-utilized news hole,
+however, attracts a wide spectrum of readers and thereby boosts
+penetration. High penetration, in turn, makes a newspaper
+particularly valuable to retailers since it allows them to talk
+to the entire community through a single "megaphone." A low-
+penetration paper is a far less compelling purchase for many
+advertisers and will eventually suffer in both ad rates and
+profits.
+
+ It should be emphasized that our excellent penetration is
+neither an accident nor automatic. The population of Erie County,
+home territory of the News, has been falling - from 1,113,000 in
+1970 to 1,015,000 in 1980 to an estimated 966,000 in 1988.
+Circulation figures tell a different story. In 1975, shortly
+before we started our Sunday edition, the Courier-Express, a
+long-established Buffalo paper, was selling 207,500 Sunday copies
+in Erie County. Last year - with population at least 5% lower -
+the News sold an average of 292,700 copies. I believe that in no
+other major Sunday market has there been anything close to that
+increase in penetration.
+
+ When this kind of gain is made - and when a paper attains an
+unequaled degree of acceptance in its home town - someone is
+doing something right. In this case major credit clearly belongs
+to Murray Light, our long-time editor who daily creates an
+informative, useful, and interesting product. Credit should go
+also to the Circulation and Production Departments: A paper that
+is frequently late, because of production problems or
+distribution weaknesses, will lose customers, no matter how
+strong its editorial content.
+
+ Stan Lipsey, publisher of the News, has produced profits
+fully up to the strength of our product. I believe Stan's
+managerial skills deliver at least five extra percentage points
+in profit margin compared to the earnings that would be achieved
+by an average manager given the same circumstances. That is an
+amazing performance, and one that could only be produced by a
+talented manager who knows - and cares - about every nut and bolt
+of the business.
+
+ Stan's knowledge and talents, it should be emphasized,
+extend to the editorial product. His early years in the business
+were spent on the news side and he played a key role in
+developing and editing a series of stories that in 1972 won a
+Pulitzer Prize for the Sun Newspaper of Omaha. Stan and I have
+worked together for over 20 years, through some bad times as well
+as good, and I could not ask for a better partner.
+
+o At Fechheimer, the Heldman clan - Bob, George, Gary,
+Roger and Fred - continue their extraordinary performance. Profits
+in 1989 were down somewhat because of problems the business
+experienced in integrating a major 1988 acquisition. These
+problems will be ironed out in time. Meanwhile, return on invested
+capital at Fechheimer remains splendid.
+
+ Like all of our managers, the Heldmans have an exceptional
+command of the details of their business. At last year's annual
+meeting I mentioned that when a prisoner enters San Quentin, Bob
+and George probably know his shirt size. That's only a slight
+exaggeration: No matter what area of the country is being
+discussed, they know exactly what is going on with major
+customers and with the competition.
+
+ Though we purchased Fechheimer four years ago, Charlie and I
+have never visited any of its plants or the home office in
+Cincinnati. We're much like the lonesome Maytag repairman: The
+Heldman managerial product is so good that a service call is
+never needed.
+
+o Ralph Schey continues to do a superb job in managing
+our largest group - World Book, Kirby, and the Scott Fetzer
+Manufacturing Companies. Aggregate earnings of these businesses
+have increased every year since our purchase and returns on
+invested capital continue to be exceptional. Ralph is running an
+enterprise large enough, were it standing alone, to be on the
+Fortune 500. And he's running it in a fashion that would put him
+high in the top decile, measured by return on equity.
+
+ For some years, World Book has operated out of a single
+location in Chicago's Merchandise Mart. Anticipating the imminent
+expiration of its lease, the business is now decentralizing into
+four locations. The expenses of this transition are significant;
+nevertheless profits in 1989 held up well. It will be another
+year before costs of the move are fully behind us.
+
+ Kirby's business was particularly strong last year,
+featuring large gains in export sales. International business has
+more than doubled in the last two years and quintupled in the
+past four; its share of unit sales has risen from 5% to 20%. Our
+largest capital expenditures in 1989 were at Kirby, in
+preparation for a major model change in 1990.
+
+ Ralph's operations contribute about 40% of the total
+earnings of the non-insurance group whose results are shown on
+page 49. When we bought Scott Fetzer at the start of 1986, our
+acquisition of Ralph as a manager was fully as important as our
+acquisition of the businesses. In addition to generating
+extraordinary earnings, Ralph also manages capital extremely
+well. These abilities have produced funds for Berkshire that, in
+turn, have allowed us to make many other profitable commitments.
+
+ And that completes our answer to the 1927 Yankees.
+
+
+Insurance Operations
+
+ Shown below is an updated version of our usual table
+presenting key figures for the property-casualty insurance
+industry:
+
+ Statutory
+ Yearly Change Combined Ratio Yearly Change Inflation Rate
+ in Premiums After Policyholder in Incurred Measured by
+ Written (%) Dividends Losses (%) GNP Deflator (%)
+ ------------- ------------------ ------------- ----------------
+
+1981 3.8 106.0 6.5 9.6
+1982 3.7 109.6 8.4 6.5
+1983 5.0 112.0 6.8 3.8
+1984 8.5 118.0 16.9 3.8
+1985 22.1 116.3 16.1 3.0
+1986 22.2 108.0 13.5 2.6
+1987 9.4 104.6 7.8 3.1
+1988 4.4 105.4 5.5 3.3
+1989 (Est.) 2.1 110.4 8.7 4.2
+
+Source: A.M. Best Co.
+
+
+ The combined ratio represents total insurance costs (losses
+incurred plus expenses) compared to revenue from premiums: A
+ratio below 100 indicates an underwriting profit, and one above
+100 indicates a loss. When the investment income that an insurer
+earns from holding policyholders' funds ("the float") is taken
+into account, a combined ratio in the 107-111 range typically
+produces an overall breakeven result, exclusive of earnings on
+the funds provided by shareholders.
+
+ For the reasons laid out in previous reports, we expect the
+industry's incurred losses to grow by about 10% annually, even in
+years when general inflation runs considerably lower. (Actually,
+over the last 25 years, incurred losses have grown at a still
+faster rate, 11%.) If premium growth meanwhile materially lags
+that 10% rate, underwriting losses will mount, though the
+industry's tendency to underreserve when business turns bad may
+obscure their size for a time.
+
+ Last year we said the climb in the combined ratio was
+"almost certain to continue - and probably will accelerate - for
+at least two more years." This year we will not predict
+acceleration, but otherwise must repeat last year's forecast.
+Premium growth is running far below the 10% required annually.
+Remember also that a 10% rate would only stabilize the combined
+ratio, not bring it down.
+
+ The increase in the combined ratio in 1989 was a little more
+than we had expected because catastrophes (led by Hurricane Hugo)
+were unusually severe. These abnormalities probably accounted for
+about two points of the increase. If 1990 is more of a "normal"
+year, the combined ratio should rise only minimally from the
+catastrophe-swollen base of 1989. In 1991, though, the ratio is
+apt to climb by a greater degree.
+
+ Commentators frequently discuss the "underwriting cycle" and
+speculate about its next turn. If that term is used to connote
+rhythmic qualities, it is in our view a misnomer that leads to
+faulty thinking about the industry's fundamental economics.
+
+ The term was appropriate some decades ago when the industry
+and regulators cooperated to conduct the business in cartel
+fashion. At that time, the combined ratio fluctuated
+rhythmically for two reasons, both related to lags. First, data
+from the past were analyzed and then used to set new "corrected"
+rates, which were subsequently put into effect by virtually all
+insurers. Second, the fact that almost all policies were then
+issued for a one-to three-year term - which meant that it took a
+considerable time for mispriced policies to expire - delayed the
+impact of new rates on revenues. These two lagged responses made
+combined ratios behave much like alternating current. Meanwhile,
+the absence of significant price competition guaranteed that
+industry profits, averaged out over the cycle, would be
+satisfactory.
+
+ The cartel period is long gone. Now the industry has
+hundreds of participants selling a commodity-like product at
+independently-established prices. Such a configuration - whether
+the product being sold is steel or insurance policies - is
+certain to cause subnormal profitability in all circumstances but
+one: a shortage of usable capacity. Just how often these periods
+occur and how long they last determines the average profitability
+of the industry in question.
+
+ In most industries, capacity is described in physical terms.
+In the insurance world, however, capacity is customarily
+described in financial terms; that is, it's considered
+appropriate for a company to write no more than X dollars of
+business if it has Y dollars of net worth. In practice, however,
+constraints of this sort have proven ineffective. Regulators,
+insurance brokers, and customers are all slow to discipline
+companies that strain their resources. They also acquiesce when
+companies grossly overstate their true capital. Hence, a company
+can write a great deal of business with very little capital if it
+is so inclined. At bottom, therefore, the amount of industry
+capacity at any particular moment primarily depends on the mental
+state of insurance managers.
+
+ All this understood, it is not very difficult to
+prognosticate the industry's profits. Good profits will be
+realized only when there is a shortage of capacity. Shortages
+will occur only when insurers are frightened. That happens rarely
+- and most assuredly is not happening now.
+
+ Some analysts have argued that the more onerous taxes
+recently imposed on the insurance industry and 1989's
+catastrophes - Hurricane Hugo and the California earthquake -
+will cause prices to strengthen significantly. We disagree. These
+adversities have not destroyed the eagerness of insurers to write
+business at present prices. Therefore, premium volume won't grow
+by 10% in 1990, which means the negative underwriting trend will
+not reverse.
+
+ The industry will meantime say it needs higher prices to
+achieve profitability matching that of the average American
+business. Of course it does. So does the steel business. But
+needs and desires have nothing to do with the long-term
+profitability of industries. Instead, economic fundamentals
+determine the outcome. Insurance profitability will improve only
+when virtually all insurers are turning away business despite
+higher prices. And we're a long way from that point.
+
+ Berkshire's premium volume may drop to $150 million or so in
+1990 (from a high of $1 billion in 1986), partly because our
+traditional business continues to shrink and partly because the
+contract under which we received 7% of the business of Fireman's
+Fund expired last August. Whatever the size of the drop, it will
+not disturb us. We have no interest in writing insurance that
+carries a mathematical expectation of loss; we experience enough
+disappointments doing transactions we believe to carry an
+expectation of profit.
+
+ However, our appetite for appropriately-priced business is
+ample, as one tale from 1989 will tell. It concerns "CAT covers,"
+which are reinsurance contracts that primary insurance companies
+(and also reinsurers themselves) buy to protect themselves
+against a single catastrophe, such as a tornado or hurricane,
+that produces losses from a large number of policies. In these
+contracts, the primary insurer might retain the loss from a
+single event up to a maximum of, say, $10 million, buying various
+layers of reinsurance above that level. When losses exceed the
+retained amount, the reinsurer typically pays 95% of the excess
+up to its contractual limit, with the primary insurer paying the
+remainder. (By requiring the primary insurer to keep 5% of each
+layer, the reinsurer leaves him with a financial stake in each
+loss settlement and guards against his throwing away the
+reinsurer's money.)
+
+ CAT covers are usually one-year policies that also provide
+for one automatic reinstatement, which requires a primary insurer
+whose coverage has been exhausted by a catastrophe to buy a
+second cover for the balance of the year in question by paying
+another premium. This provision protects the primary company from
+being "bare" for even a brief period after a first catastrophic
+event. The duration of "an event" is usually limited by contract
+to any span of 72 hours designated by the primary company. Under
+this definition, a wide-spread storm, causing damage for three
+days, will be classified as a single event if it arises from a
+single climatic cause. If the storm lasts four days, however, the
+primary company will file a claim carving out the 72 consecutive
+hours during which it suffered the greatest damage. Losses that
+occurred outside that period will be treated as arising from a
+separate event.
+
+ In 1989, two unusual things happened. First, Hurricane Hugo
+generated $4 billion or more of insured loss, at a pace, however,
+that caused the vast damage in the Carolinas to occur slightly
+more than 72 hours after the equally severe damage in the
+Caribbean. Second, the California earthquake hit within weeks,
+causing insured damage that was difficult to estimate, even well
+after the event. Slammed by these two - or possibly three - major
+catastrophes, some primary insurers, and also many reinsurers
+that had themselves bought CAT protection, either used up their
+automatic second cover or became uncertain as to whether they had
+done so.
+
+ At that point sellers of CAT policies had lost a huge amount
+of money - perhaps twice because of the reinstatements - and not
+taken in much in premiums. Depending upon many variables, a CAT
+premium might generally have run 3% to 15% of the amount of
+protection purchased. For some years, we've thought premiums of
+that kind inadequate and have stayed away from the business.
+
+ But because the 1989 disasters left many insurers either
+actually or possibly bare, and also left most CAT writers licking
+their wounds, there was an immediate shortage after the
+earthquake of much-needed catastrophe coverage. Prices instantly
+became attractive, particularly for the reinsurance that CAT
+writers themselves buy. Just as instantly, Berkshire Hathaway
+offered to write up to $250 million of catastrophe coverage,
+advertising that proposition in trade publications. Though we did
+not write all the business we sought, we did in a busy ten days
+book a substantial amount.
+
+ Our willingness to put such a huge sum on the line for a
+loss that could occur tomorrow sets us apart from any reinsurer
+in the world. There are, of course, companies that sometimes
+write $250 million or even far more of catastrophe coverage. But
+they do so only when they can, in turn, reinsure a large
+percentage of the business with other companies. When they can't
+"lay off" in size, they disappear from the market.
+
+ Berkshire's policy, conversely, is to retain the business we
+write rather than lay it off. When rates carry an expectation of
+profit, we want to assume as much risk as is prudent. And in our
+case, that's a lot.
+
+ We will accept more reinsurance risk for our own account
+than any other company because of two factors: (1) by the
+standards of regulatory accounting, we have a net worth in our
+insurance companies of about $6 billion - the second highest
+amount in the United States; and (2) we simply don't care what
+earnings we report quarterly, or even annually, just as long as
+the decisions leading to those earnings (or losses) were reached
+intelligently.
+
+ Obviously, if we write $250 million of catastrophe coverage
+and retain it all ourselves, there is some probability that we
+will lose the full $250 million in a single quarter. That
+probability is low, but it is not zero. If we had a loss of that
+magnitude, our after-tax cost would be about $165 million. Though
+that is far more than Berkshire normally earns in a quarter, the
+damage would be a blow only to our pride, not to our well-being.
+
+ This posture is one few insurance managements will assume.
+Typically, they are willing to write scads of business on terms
+that almost guarantee them mediocre returns on equity. But they
+do not want to expose themselves to an embarrassing single-
+quarter loss, even if the managerial strategy that causes the
+loss promises, over time, to produce superior results. I can
+understand their thinking: What is best for their owners is not
+necessarily best for the managers. Fortunately Charlie and I have
+both total job security and financial interests that are
+identical with those of our shareholders. We are willing to look
+foolish as long as we don't feel we have acted foolishly.
+
+ Our method of operation, incidentally, makes us a
+stabilizing force in the industry. We add huge capacity when
+capacity is short and we become less competitive only when
+capacity is abundant. Of course, we don't follow this policy in
+the interest of stabilization - we follow it because we believe
+it to be the most sensible and profitable course of action.
+Nevertheless, our behavior steadies the market. In this case,
+Adam Smith's invisible hand works as advertised.
+
+ Currently, we hold an exceptional amount of float compared
+to premium volume. This circumstance should produce quite
+favorable insurance results for us during the next few years as
+it did in 1989. Our underwriting losses should be tolerable and
+our investment income from policyholder funds large. This
+pleasant situation, however, will gradually deteriorate as our
+float runs off.
+
+ At some point, however, there will be an opportunity for us
+to write large amounts of profitable business. Mike Goldberg and
+his management team of Rod Eldred, Dinos Iordanou, Ajit Jain,
+Phil Urban, and Don Wurster continue to position us well for this
+eventuality.
+
+
+Marketable Securities
+
+ In selecting marketable securities for our insurance
+companies, we generally 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.
+
+ 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 "mathematical
+expectation," 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.
+
+o Below we list our common stock holdings having a value
+of over $100 million. A small portion of these investments belongs
+to subsidiaries of which Berkshire owns less than 100%.
+
+ 12/31/89
+ Shares Company Cost Market
+ ------ ------- ---------- ----------
+ (000s omitted)
+ 3,000,000 Capital Cities/ABC, Inc. ................ $ 517,500 $1,692,375
+23,350,000 The Coca-Cola Co. ....................... 1,023,920 1,803,787
+ 2,400,000 Federal Home Loan Mortgage Corp. ........ 71,729 161,100
+ 6,850,000 GEICO Corp. ............................. 45,713 1,044,625
+ 1,727,765 The Washington Post Company ............. 9,731 486,366
+
+ This list of companies is the same as last year's and in
+only one case has the number of shares changed: Our holdings of
+Coca-Cola increased from 14,172,500 shares at the end of 1988 to
+23,350,000.
+
+ This Coca-Cola investment provides yet another example of
+the incredible speed with which your Chairman responds to
+investment opportunities, no matter how obscure or well-disguised
+they may be. I believe I had my first Coca-Cola in either 1935 or
+1936. Of a certainty, it was in 1936 that I started buying Cokes
+at the rate of six for 25 cents from Buffett & Son, the family
+grocery store, to sell around the neighborhood for 5 cents each.
+In this excursion into high-margin retailing, I duly observed
+the extraordinary consumer attractiveness and commercial
+possibilities of the product.
+
+ I continued to note these qualities for the next 52 years as
+Coke blanketed the world. During this period, however, I
+carefully avoided buying even a single share, instead allocating
+major portions of my net worth to street railway companies,
+windmill manufacturers, anthracite producers, textile businesses,
+trading-stamp issuers, and the like. (If you think I'm making
+this up, I can supply the names.) Only in the summer of 1988 did
+my brain finally establish contact with my eyes.
+
+ What I then perceived was both clear and fascinating. After
+drifting somewhat in the 1970's, Coca-Cola had in 1981 become a
+new company with the move of Roberto Goizueta to CEO. Roberto,
+along with Don Keough, once my across-the-street neighbor in
+Omaha, first rethought and focused the company's policies and
+then energetically carried them out. What was already the world's
+most ubiquitous product gained new momentum, with sales overseas
+virtually exploding.
+
+ Through a truly rare blend of marketing and financial
+skills, Roberto has maximized both the growth of his product and
+the rewards that this growth brings to shareholders. Normally,
+the CEO of a consumer products company, drawing on his natural
+inclinations or experience, will cause either marketing or
+finance to dominate the business at the expense of the other
+discipline. With Roberto, the mesh of marketing and finance is
+perfect and the result is a shareholder's dream.
+
+ Of course, we should have started buying Coke much earlier,
+soon after Roberto and Don began running things. In fact, if I
+had been thinking straight I would have persuaded my grandfather
+to sell the grocery store back in 1936 and put all of the
+proceeds into Coca-Cola stock. I've learned my lesson: My
+response time to the next glaringly attractive idea will be
+slashed to well under 50 years.
+
+ As I mentioned earlier, the yearend prices of our major
+investees were much higher relative to their intrinsic values
+than theretofore. While those prices may not yet cause
+nosebleeds, they are clearly vulnerable to a general market
+decline. A drop in their prices would not disturb us at all - it
+might in fact work to our eventual benefit - but it would cause
+at least a one-year reduction in Berkshire's net worth. We think
+such a reduction is almost certain in at least one of the next
+three years. Indeed, it would take only about a 10% year-to-year
+decline in the aggregate value of our portfolio investments to
+send Berkshire's net worth down.
+
+ We continue to be blessed with extraordinary managers at our
+portfolio companies. They are high-grade, talented, and
+shareholder-oriented. The exceptional results we have achieved
+while investing with them accurately reflect their exceptional
+personal qualities.
+
+o We told you last year that we expected to do little in
+arbitrage during 1989, and that's the way it turned out.
+Arbitrage positions are a substitute for short-term cash
+equivalents, and during part of the year we held relatively low
+levels of cash. In the rest of the year we had a fairly good-
+sized cash position and even so chose not to engage in arbitrage.
+The main reason was corporate transactions that made no economic
+sense to us; arbitraging such deals comes too close to playing
+the greater-fool game. (As Wall Streeter Ray DeVoe says: "Fools
+rush in where angels fear to trade.") We will engage in arbitrage
+from time to time - sometimes on a large scale - but only when we
+like the odds.
+
+o Leaving aside the three convertible preferreds discussed in
+the next section, we substantially reduced our holdings in both
+medium- and long-term fixed-income securities. In the long-terms,
+just about our only holdings have been Washington Public Power
+Supply Systems (WPPSS) bonds carrying coupons ranging from low to
+high. During the year we sold a number of the low-coupon issues,
+which we originally bought at very large discounts. Many of these
+issues had approximately doubled in price since we purchased them
+and in addition had paid us 15%-17% annually, tax-free. Our
+prices upon sale were only slightly cheaper than typical high-
+grade tax-exempts then commanded. We have kept all of our high-
+coupon WPPSS issues. Some have been called for redemption in 1991
+and 1992, and we expect the rest to be called in the early to
+mid-1990s.
+
+ We also sold many of our medium-term tax-exempt bonds during
+the year. When we bought these bonds we said we would be happy to
+sell them - regardless of whether they were higher or lower than
+at our time of purchase - if something we liked better came
+along. Something did - and concurrently we unloaded most of these
+issues at modest gains. Overall, our 1989 profit from the sale of
+tax-exempt bonds was about $51 million pre-tax.
+
+o The proceeds from our bond sales, along with our excess cash
+at the beginning of the year and that generated later through
+earnings, went into the purchase of three convertible preferred
+stocks. In the first transaction, which took place in July, we
+purchased $600 million of The Gillette Co. preferred with an 8
+3/4% dividend, a mandatory redemption in ten years, and the right
+to convert into common at $50 per share. We next purchased $358
+million of USAir Group, Inc. preferred stock with mandatory
+redemption in ten years, a dividend of 9 1/4%, and the right to
+convert into common at $60 per share. Finally, late in the year
+we purchased $300 million of Champion International Corp.
+preferred with mandatory redemption in ten years, a 9 1/4%
+dividend, and the right to convert into common at $38 per share.
+
+ Unlike standard convertible preferred stocks, the issues we
+own are either non-salable or non-convertible for considerable
+periods of time and there is consequently no way we can gain from
+short-term price blips in the common stock. I have gone on the
+board of Gillette, but I am not on the board of USAir or
+Champion. (I thoroughly enjoy the boards I am on, but can't
+handle any more.)
+
+ Gillette's business is very much the kind we like. Charlie
+and I think we understand the company's economics and therefore
+believe we can make a reasonably intelligent guess about its
+future. (If you haven't tried Gillette's new Sensor razor, go
+right out and get one.) However, we have no ability to forecast
+the economics of the investment banking business (in which we
+have a position through our 1987 purchase of Salomon convertible
+preferred), the airline industry, or the paper industry. This
+does not mean that we predict a negative future for these
+industries: we're agnostics, not atheists. Our lack of strong
+convictions about these businesses, however, means that we must
+structure our investments in them differently from what we do
+when we invest in a business appearing to have splendid economic
+characteristics.
+
+ In one major respect, however, these purchases are not
+different: We only want to link up with people whom we like,
+admire, and trust. John Gutfreund at Salomon, Colman Mockler, Jr.
+at Gillette, Ed Colodny at USAir, and Andy Sigler at Champion
+meet this test in spades.
+
+ They in turn have demonstrated some confidence in us,
+insisting in each case that our preferreds have unrestricted
+voting rights on a fully-converted basis, an arrangement that is
+far from standard in corporate finance. In effect they are
+trusting us to be intelligent owners, thinking about tomorrow
+instead of today, just as we are trusting them to be intelligent
+managers, thinking about tomorrow as well as today.
+
+ The preferred-stock structures we have negotiated will
+provide a mediocre return for us if industry economics hinder the
+performance of our investees, but will produce reasonably
+attractive results for us if they can earn a return comparable to
+that of American industry in general. We believe that Gillette,
+under Colman's management, will far exceed that return and
+believe that John, Ed, and Andy will reach it unless industry
+conditions are harsh.
+
+ Under almost any conditions, we expect these preferreds to
+return us our money plus dividends. If that is all we get,
+though, the result will be disappointing, because we will have
+given up flexibility and consequently will have missed some
+significant opportunities that are bound to present themselves
+during the decade. Under that scenario, we will have obtained
+only a preferred-stock yield during a period when the typical
+preferred stock will have held no appeal for us whatsoever. The
+only way Berkshire can achieve satisfactory results from its four
+preferred issues is to have the common stocks of the investee
+companies do well.
+
+ Good management and at least tolerable industry conditions
+will be needed if that is to happen. But we believe Berkshire's
+investment will also help and that the other shareholders of each
+investee will profit over the years ahead from our preferred-
+stock purchase. The help will come from the fact that each
+company now has a major, stable, and interested shareholder whose
+Chairman and Vice Chairman have, through Berkshire's investments,
+indirectly committed a very large amount of their own money to
+these undertakings. In dealing with our investees, Charlie and I
+will be supportive, analytical, and objective. We recognize that
+we are working with experienced CEOs who are very much in command
+of their own businesses but who nevertheless, at certain moments,
+appreciate the chance to test their thinking on someone without
+ties to their industry or to decisions of the past.
+
+ As a group, these convertible preferreds will not produce
+the returns we can achieve when we find a business with wonderful
+economic prospects that is unappreciated by the market. Nor will
+the returns be as attractive as those produced when we make our
+favorite form of capital deployment, the acquisition of 80% or
+more of a fine business with a fine management. But both
+opportunities are rare, particularly in a size befitting our
+present and anticipated resources.
+
+ In summation, Charlie and I feel that our preferred stock
+investments should produce returns moderately above those
+achieved by most fixed-income portfolios and that we can play a
+minor but enjoyable and constructive role in the investee
+companies.
+
+
+Zero-Coupon Securities
+
+ In September, Berkshire issued $902.6 million principal
+amount of Zero-Coupon Convertible Subordinated Debentures, which
+are now listed on the New York Stock Exchange. Salomon Brothers
+handled the underwriting in superb fashion, providing us helpful
+advice and a flawless execution.
+
+ Most bonds, of course, require regular payments of interest,
+usually semi-annually. A zero-coupon bond, conversely, requires
+no current interest payments; instead, the investor receives his
+yield by purchasing the security at a significant discount from
+maturity value. The effective interest rate is determined by the
+original issue price, the maturity value, and the amount of time
+between issuance and maturity.
+
+ In our case, the bonds were issued at 44.314% of maturity
+value and are due in 15 years. For investors purchasing the
+bonds, that is the mathematical equivalent of a 5.5% current
+payment compounded semi-annually. Because we received only
+44.31 cents on the dollar, our proceeds from this offering were
+$400 million (less about $9.5 million of offering expenses).
+
+ The bonds were issued in denominations of $10,000 and each
+bond is convertible into .4515 shares of Berkshire Hathaway.
+Because a $10,000 bond cost $4,431, this means that the
+conversion price was $9,815 per Berkshire share, a 15% premium to
+the market price then existing. Berkshire can call the bonds at
+any time after September 28, 1992 at their accreted value (the
+original issue price plus 5.5% compounded semi-annually) and on
+two specified days, September 28 of 1994 and 1999, the
+bondholders can require Berkshire to buy the securities at their
+accreted value.
+
+ For tax purposes, Berkshire is entitled to deduct the 5.5%
+interest accrual each year, even though we make no payments to
+the bondholders. Thus the net effect to us, resulting from the
+reduced taxes, is positive cash flow. That is a very significant
+benefit. Some unknowable variables prevent us from calculating
+our exact effective rate of interest, but under all circumstances
+it will be well below 5.5%. There is meanwhile a symmetry to the
+tax law: Any taxable holder of the bonds must pay tax each year
+on the 5.5% interest, even though he receives no cash.
+
+ Neither our bonds nor those of certain other companies that
+issued similar bonds last year (notably Loews and Motorola)
+resemble the great bulk of zero-coupon bonds that have been
+issued in recent years. Of these, Charlie and I have been, and
+will continue to be, outspoken critics. As I will later explain,
+such bonds have often been used in the most deceptive of ways and
+with deadly consequences to investors. But before we tackle that
+subject, let's travel back to Eden, to a time when the apple had
+not yet been bitten.
+
+ If you're my age you bought your first zero-coupon bonds
+during World War II, by purchasing the famous Series E U. S.
+Savings Bond, the most widely-sold bond issue in history. (After
+the war, these bonds were held by one out of two U. S.
+households.) Nobody, of course, called the Series E a zero-coupon
+bond, a term in fact that I doubt had been invented. But that's
+precisely what the Series E was.
+
+ These bonds came in denominations as small as $18.75. That
+amount purchased a $25 obligation of the United States government
+due in 10 years, terms that gave the buyer a compounded annual
+return of 2.9%. At the time, this was an attractive offer: the
+2.9% rate was higher than that generally available on Government
+bonds and the holder faced no market-fluctuation risk, since he
+could at any time cash in his bonds with only a minor reduction
+in interest.
+
+ A second form of zero-coupon U. S. Treasury issue, also
+benign and useful, surfaced in the last decade. One problem with
+a normal bond is that even though it pays a given interest rate -
+say 10% - the holder cannot be assured that a compounded 10%
+return will be realized. For that rate to materialize, each semi-
+annual coupon must be reinvested at 10% as it is received. If
+current interest rates are, say, only 6% or 7% when these coupons
+come due, the holder will be unable to compound his money over
+the life of the bond at the advertised rate. For pension funds or
+other investors with long-term liabilities, "reinvestment risk"
+of this type can be a serious problem. Savings Bonds might have
+solved it, except that they are issued only to individuals and
+are unavailable in large denominations. What big buyers needed
+was huge quantities of "Savings Bond Equivalents."
+
+ Enter some ingenious and, in this case, highly useful
+investment bankers (led, I'm happy to say, by Salomon Brothers).
+They created the instrument desired by "stripping" the semi-
+annual coupons from standard Government issues. Each coupon, once
+detached, takes on the essential character of a Savings Bond
+since it represents a single sum due sometime in the future. For
+example, if you strip the 40 semi-annual coupons from a U. S.
+Government Bond due in the year 2010, you will have 40 zero-
+coupon bonds, with maturities from six months to 20 years, each
+of which can then be bundled with other coupons of like maturity
+and marketed. If current interest rates are, say, 10% for all
+maturities, the six-month issue will sell for 95.24% of maturity
+value and the 20-year issue will sell for 14.20%. The purchaser
+of any given maturity is thus guaranteed a compounded rate of 10%
+for his entire holding period. Stripping of government bonds has
+occurred on a large scale in recent years, as long-term
+investors, ranging from pension funds to individual IRA accounts,
+recognized these high-grade, zero-coupon issues to be well suited
+to their needs.
+
+ But as happens in Wall Street all too often, what the wise
+do in the beginning, fools do in the end. In the last few years
+zero-coupon bonds (and their functional equivalent, pay-in-kind
+bonds, which distribute additional PIK bonds semi-annually as
+interest instead of paying cash) have been issued in enormous
+quantities by ever-junkier credits. To these issuers, zero (or
+PIK) bonds offer one overwhelming advantage: It is impossible to
+default on a promise to pay nothing. Indeed, if LDC governments
+had issued no debt in the 1970's other than long-term zero-coupon
+obligations, they would now have a spotless record as debtors.
+
+ This principle at work - that you need not default for a
+long time if you solemnly promise to pay nothing for a long time
+- has not been lost on promoters and investment bankers seeking
+to finance ever-shakier deals. But its acceptance by lenders took
+a while: When the leveraged buy-out craze began some years back,
+purchasers could borrow only on a reasonably sound basis, in
+which conservatively-estimated free cash flow - that is,
+operating earnings plus depreciation and amortization less
+normalized capital expenditures - was adequate to cover both
+interest and modest reductions in debt.
+
+ Later, as the adrenalin of deal-makers surged, businesses
+began to be purchased at prices so high that all free cash flow
+necessarily had to be allocated to the payment of interest. That
+left nothing for the paydown of debt. In effect, a Scarlett
+O'Hara "I'll think about it tomorrow" position in respect to
+principal payments was taken by borrowers and accepted by a new
+breed of lender, the buyer of original-issue junk bonds. Debt now
+became something to be refinanced rather than repaid. The change
+brings to mind a New Yorker cartoon in which the grateful
+borrower rises to shake the hand of the bank's lending officer
+and gushes: "I don't know how I'll ever repay you."
+
+ Soon borrowers found even the new, lax standards intolerably
+binding. To induce lenders to finance even sillier transactions,
+they introduced an abomination, EBDIT - Earnings Before
+Depreciation, Interest and Taxes - as the test of a company's
+ability to pay interest. Using this sawed-off yardstick, the
+borrower ignored depreciation as an expense on the theory that it
+did not require a current cash outlay.
+
+ Such an attitude is clearly delusional. At 95% of American
+businesses, capital expenditures that over time roughly
+approximate depreciation are a necessity and are every bit as
+real an expense as labor or utility costs. Even a high school
+dropout knows that to finance a car he must have income that
+covers not only interest and operating expenses, but also
+realistically-calculated depreciation. He would be laughed out of
+the bank if he started talking about EBDIT.
+
+ Capital outlays at a business can be skipped, of course, in
+any given month, just as a human can skip a day or even a week of
+eating. But if the skipping becomes routine and is not made up,
+the body weakens and eventually dies. Furthermore, a start-and-
+stop feeding policy will over time produce a less healthy
+organism, human or corporate, than that produced by a steady
+diet. As businessmen, Charlie and I relish having competitors who
+are unable to fund capital expenditures.
+
+ You might think that waving away a major expense such as
+depreciation in an attempt to make a terrible deal look like a
+good one hits the limits of Wall Street's ingenuity. If so, you
+haven't been paying attention during the past few years.
+Promoters needed to find a way to justify even pricier
+acquisitions. Otherwise, they risked - heaven forbid! - losing
+deals to other promoters with more "imagination."
+
+ So, stepping through the Looking Glass, promoters and their
+investment bankers proclaimed that EBDIT should now be measured
+against cash interest only, which meant that interest accruing on
+zero-coupon or PIK bonds could be ignored when the financial
+feasibility of a transaction was being assessed. This approach
+not only relegated depreciation expense to the let's-ignore-it
+corner, but gave similar treatment to what was usually a
+significant portion of interest expense. To their shame, many
+professional investment managers went along with this nonsense,
+though they usually were careful to do so only with clients'
+money, not their own. (Calling these managers "professionals" is
+actually too kind; they should be designated "promotees.")
+
+ Under this new standard, a business earning, say, $100
+million pre-tax and having debt on which $90 million of interest
+must be paid currently, might use a zero-coupon or PIK issue to
+incur another $60 million of annual interest that would accrue
+and compound but not come due for some years. The rate on these
+issues would typically be very high, which means that the
+situation in year 2 might be $90 million cash interest plus $69
+million accrued interest, and so on as the compounding proceeds.
+Such high-rate reborrowing schemes, which a few years ago were
+appropriately confined to the waterfront, soon became models of
+modern finance at virtually all major investment banking houses.
+
+ When they make these offerings, investment bankers display
+their humorous side: They dispense income and balance sheet
+projections extending five or more years into the future for
+companies they barely had heard of a few months earlier. If you
+are shown such schedules, I suggest that you join in the fun:
+Ask the investment banker for the one-year budgets that his own
+firm prepared as the last few years began and then compare these
+with what actually happened.
+
+ Some time ago Ken Galbraith, in his witty and insightful
+The Great Crash, coined a new economic term: "the bezzle,"
+defined as the current amount of undiscovered embezzlement. This
+financial creature has a magical quality: The embezzlers are richer
+by the amount of the bezzle, while the embezzlees do not yet feel
+poorer.
+
+ Professor Galbraith astutely pointed out that this sum
+should be added to the National Wealth so that we might know the
+Psychic National Wealth. Logically, a society that wanted to feel
+enormously prosperous would both encourage its citizens to
+embezzle and try not to detect the crime. By this means, "wealth"
+would balloon though not an erg of productive work had been done.
+
+ The satirical nonsense of the bezzle is dwarfed by the real-
+world nonsense of the zero-coupon bond. With zeros, one party to
+a contract can experience "income" without his opposite
+experiencing the pain of expenditure. In our illustration, a
+company capable of earning only $100 million dollars annually -
+and therefore capable of paying only that much in interest -
+magically creates "earnings" for bondholders of $150 million. As
+long as major investors willingly don their Peter Pan wings and
+repeatedly say "I believe," there is no limit to how much
+"income" can be created by the zero-coupon bond.
+
+ Wall Street welcomed this invention with the enthusiasm
+less-enlightened folk might reserve for the wheel or the plow.
+Here, finally, was an instrument that would let the Street make
+deals at prices no longer limited by actual earning power. The
+result, obviously, would be more transactions: Silly prices will
+always attract sellers. And, as Jesse Unruh might have put it,
+transactions are the mother's milk of finance.
+
+ The zero-coupon or PIK bond possesses one additional
+attraction for the promoter and investment banker, which is that
+the time elapsing between folly and failure can be stretched out.
+This is no small benefit. If the period before all costs must be
+faced is long, promoters can create a string of foolish deals -
+and take in lots of fees - before any chickens come home to roost
+from their earlier ventures.
+
+ But in the end, alchemy, whether it is metallurgical or
+financial, fails. A base business can not be transformed into a
+golden business by tricks of accounting or capital structure. The
+man claiming to be a financial alchemist may become rich. But
+gullible investors rather than business achievements will usually
+be the source of his wealth.
+
+ Whatever their weaknesses, we should add, many zero-coupon
+and PIK bonds will not default. We have in fact owned some and
+may buy more if their market becomes sufficiently distressed.
+(We've not, however, even considered buying a new issue from a
+weak credit.) No financial instrument is evil per se; it's just
+that some variations have far more potential for mischief than
+others.
+
+ The blue ribbon for mischief-making should go to the zero-
+coupon issuer unable to make its interest payments on a current
+basis. Our advice: Whenever an investment banker starts talking
+about EBDIT - or whenever someone creates a capital structure
+that does not allow all interest, both payable and accrued, to be
+comfortably met out of current cash flow net of ample capital
+expenditures - zip up your wallet. Turn the tables by suggesting
+that the promoter and his high-priced entourage accept zero-
+coupon fees, deferring their take until the zero-coupon bonds
+have been paid in full. See then how much enthusiasm for the deal
+endures.
+
+ Our comments about investment bankers may seem harsh. But
+Charlie and I - in our hopelessly old-fashioned way - believe
+that they should perform a gatekeeping role, guarding investors
+against the promoter's propensity to indulge in excess.
+Promoters, after all, have throughout time exercised the same
+judgment and restraint in accepting money that alcoholics have
+exercised in accepting liquor. At a minimum, therefore, the
+banker's conduct should rise to that of a responsible bartender
+who, when necessary, refuses the profit from the next drink to
+avoid sending a drunk out on the highway. In recent years,
+unfortunately, many leading investment firms have found bartender
+morality to be an intolerably restrictive standard. Lately, those
+who have traveled the high road in Wall Street have not
+encountered heavy traffic.
+
+ One distressing footnote: The cost of the zero-coupon folly
+will not be borne solely by the direct participants. Certain
+savings and loan associations were heavy buyers of such bonds,
+using cash that came from FSLIC-insured deposits. Straining to
+show splendid earnings, these buyers recorded - but did not
+receive - ultra-high interest income on these issues. Many of
+these associations are now in major trouble. Had their loans to
+shaky credits worked, the owners of the associations would have
+pocketed the profits. In the many cases in which the loans will
+fail, the taxpayer will pick up the bill. To paraphrase Jackie
+Mason, at these associations it was the managers who should have
+been wearing the ski masks.
+
+
+Mistakes of the First Twenty-five Years (A Condensed Version)
+
+ To quote Robert Benchley, "Having a dog teaches a boy
+fidelity, perseverance, and to turn around three times before
+lying down." Such are the shortcomings of experience.
+Nevertheless, it's a good idea to review past mistakes before
+committing new ones. So let's take a quick look at the last 25
+years.
+
+o My first mistake, of course, was in buying control of
+Berkshire. Though I knew its business - textile manufacturing -
+to be unpromising, I was enticed to buy because the price looked
+cheap. Stock purchases of that kind had proved reasonably
+rewarding in my early years, though by the time Berkshire came
+along in 1965 I was becoming aware that the strategy was not
+ideal.
+
+ If you buy a stock at a sufficiently low price, there will
+usually be some hiccup in the fortunes of the business that gives
+you a chance to unload at a decent profit, even though the long-
+term performance of the business may be terrible. I call this the
+"cigar butt" approach to investing. A cigar butt found on the
+street that has only one puff left in it may not offer much of a
+smoke, but the "bargain purchase" will make that puff all profit.
+
+ Unless you are a liquidator, that kind of approach to buying
+businesses is foolish. First, the original "bargain" price
+probably will not turn out to be such a steal after all. In a
+difficult business, no sooner is one problem solved than another
+surfaces - never is there just one cockroach in the kitchen.
+Second, any initial advantage you secure will be quickly eroded
+by the low return that the business earns. For example, if you
+buy a business for $8 million that can be sold or liquidated for
+$10 million and promptly take either course, you can realize a
+high return. But the investment will disappoint if the business
+is sold for $10 million in ten years and in the interim has
+annually earned and distributed only a few percent on cost. Time
+is the friend of the wonderful business, the enemy of the
+mediocre.
+
+ You might think this principle is obvious, but I had to
+learn it the hard way - in fact, I had to learn it several times
+over. Shortly after purchasing Berkshire, I acquired a Baltimore
+department store, Hochschild Kohn, buying through a company
+called Diversified Retailing that later merged with Berkshire. I
+bought at a substantial discount from book value, the people were
+first-class, and the deal included some extras - unrecorded real
+estate values and a significant LIFO inventory cushion. How could
+I miss? So-o-o - three years later I was lucky to sell the
+business for about what I had paid. After ending our corporate
+marriage to Hochschild Kohn, I had memories like those of the
+husband in the country song, "My Wife Ran Away With My Best
+Friend and I Still Miss Him a Lot."
+
+ I could give you other personal examples of "bargain-
+purchase" folly but I'm sure you get the picture: It's far
+better to buy a wonderful company at a fair price than a fair
+company at a wonderful price. Charlie understood this early; I
+was a slow learner. But now, when buying companies or common
+stocks, we look for first-class businesses accompanied by first-
+class managements.
+
+o That leads right into a related lesson: Good jockeys will
+do well on good horses, but not on broken-down nags. Both
+Berkshire's textile business and Hochschild, Kohn had able and
+honest people running them. The same managers employed in a
+business with good economic characteristics would have achieved
+fine records. But they were never going to make any progress
+while running in quicksand.
+
+ I've said many times that when a management with a
+reputation for brilliance tackles a business with a reputation
+for bad economics, it is the reputation of the business that
+remains intact. I just wish I hadn't been so energetic in
+creating examples. My behavior has matched that admitted by Mae
+West: "I was Snow White, but I drifted."
+
+o A further related lesson: Easy does it. After 25 years of
+buying and supervising a great variety of businesses, Charlie and
+I have not learned how to solve difficult business problems. What
+we have learned is to avoid them. To the extent we have been
+successful, it is because we concentrated on identifying one-foot
+hurdles that we could step over rather than because we acquired
+any ability to clear seven-footers.
+
+ The finding may seem unfair, but in both business and
+investments it is usually far more profitable to simply stick
+with the easy and obvious than it is to resolve the difficult. On
+occasion, tough problems must be tackled as was the case when we
+started our Sunday paper in Buffalo. In other instances, a great
+investment opportunity occurs when a marvelous business
+encounters a one-time huge, but solvable, problem as was the case
+many years back at both American Express and GEICO. Overall,
+however, we've done better by avoiding dragons than by slaying
+them.
+
+o My most surprising discovery: the overwhelming importance in
+business of an unseen force that we might call "the institutional
+imperative." In business school, I was given no hint of the
+imperative's existence and I did not intuitively understand it
+when I entered the business world. I thought then that decent,
+intelligent, and experienced managers would automatically make
+rational business decisions. But I learned over time that isn't
+so. Instead, rationality frequently wilts when the institutional
+imperative comes into play.
+
+ For example: (1) As if governed by Newton's First Law of
+Motion, an institution will resist any change in its current
+direction; (2) Just as work expands to fill available time,
+corporate projects or acquisitions will materialize to soak up
+available funds; (3) Any business craving of the leader, however
+foolish, will be quickly supported by detailed rate-of-return and
+strategic studies prepared by his troops; and (4) The behavior of
+peer companies, whether they are expanding, acquiring, setting
+executive compensation or whatever, will be mindlessly imitated.
+
+ Institutional dynamics, not venality or stupidity, set
+businesses on these courses, which are too often misguided. After
+making some expensive mistakes because I ignored the power of the
+imperative, I have tried to organize and manage Berkshire in ways
+that minimize its influence. Furthermore, Charlie and I have
+attempted to concentrate our investments in companies that appear
+alert to the problem.
+
+o After some other mistakes, I learned to go into business
+only with people whom I like, trust, and admire. As I noted
+before, this policy of itself will not ensure success: A second-
+class textile or department-store company won't prosper simply
+because its managers are men that you would be pleased to see
+your daughter marry. However, an owner - or investor - can
+accomplish wonders if he manages to associate himself with such
+people in businesses that possess decent economic
+characteristics. Conversely, we do not wish to join with managers
+who lack admirable qualities, no matter how attractive the
+prospects of their business. We've never succeeded in making a
+good deal with a bad person.
+
+o Some of my worst mistakes were not publicly visible. These
+were stock and business purchases whose virtues I understood and
+yet didn't make. It's no sin to miss a great opportunity outside
+one's area of competence. But I have passed on a couple of really
+big purchases that were served up to me on a platter and that I
+was fully capable of understanding. For Berkshire's shareholders,
+myself included, the cost of this thumb-sucking has been huge.
+
+o Our consistently-conservative financial policies may appear
+to have been a mistake, but in my view were not. In retrospect,
+it is clear that significantly higher, though still conventional,
+leverage ratios at Berkshire would have produced considerably
+better returns on equity than the 23.8% we have actually
+averaged. Even in 1965, perhaps we could have judged there to be
+a 99% probability that higher leverage would lead to nothing but
+good. Correspondingly, we might have seen only a 1% chance that
+some shock factor, external or internal, would cause a
+conventional debt ratio to produce a result falling somewhere
+between temporary anguish and default.
+
+ We wouldn't have liked those 99:1 odds - and never will. A
+small chance of distress or disgrace cannot, in our view, be
+offset by a large chance of extra returns. If your actions are
+sensible, you are certain to get good results; in most such
+cases, leverage just moves things along faster. Charlie and I
+have never been in a big hurry: We enjoy the process far more
+than the proceeds - though we have learned to live with those
+also.
+
+ * * * * * * * * * * * *
+
+ We hope in another 25 years to report on the mistakes of the
+first 50. If we are around in 2015 to do that, you can count on
+this section occupying many more pages than it does here.
+
+
+Miscellaneous
+
+ We hope to buy more businesses that are similar to the ones
+we have, and we can use some help. If you have a business that
+fits the following criteria, call me or, preferably, write.
+
+ Here's what we're looking for:
+
+ (1) Large purchases (at least $10 million of after-tax
+ earnings),
+
+ (2) demonstrated consistent earning power (future
+ projections are of little interest to us, nor are
+ "turnaround" situations),
+
+ (3) businesses earning good returns on equity while
+ employing little or no debt,
+
+ (4) management in place (we can't supply it),
+
+ (5) simple businesses (if there's lots of technology, we
+ won't understand it),
+
+ (6) an offering price (we don't want to waste our time or
+ that of the seller by talking, even preliminarily,
+ about a transaction when price is unknown).
+
+ We will not engage in unfriendly takeovers. We can promise
+complete confidentiality and a very fast answer - customarily
+within five minutes - as to whether we're interested. We prefer
+to buy for cash, but will consider issuing stock when we receive
+as much in intrinsic business value as we give.
+
+ Our favorite form of purchase is one fitting the Blumkin-
+Friedman-Heldman mold. In cases like these, the company's owner-
+managers wish to generate significant amounts of cash, sometimes
+for themselves, but often for their families or inactive
+shareholders. At the same time, these managers wish to remain
+significant owners who continue to run their companies just as
+they have in the past. We think we offer a particularly good fit
+for owners with such objectives. We invite potential sellers to
+check us out by contacting people with whom we have done business
+in the past.
+
+ Charlie and I frequently get approached about acquisitions
+that don't come close to meeting our tests: We've found that if
+you advertise an interest in buying collies, a lot of people will
+call hoping to sell you their cocker spaniels. Our interest in
+new ventures, turnarounds, or auction-like sales can best be
+expressed by a Goldwynism: "Please include me out."
+
+ Besides being interested in the purchase of businesses as
+described above, we are also interested in the negotiated
+purchase of large, but not controlling, blocks of stock
+comparable to those we hold in Capital Cities, Salomon, Gillette,
+USAir and Champion. Last year we said we had a special interest
+in large purchases of convertible preferreds. We still have an
+appetite of that kind, but it is limited since we now are close
+to the maximum position we feel appropriate for this category of
+investment.
+
+ * * * * * * * * * * * *
+
+ Two years ago, I told you about Harry Bottle, who in 1962
+quickly cured a major business mess at the first industrial
+company I controlled, Dempster Mill Manufacturing (one of my
+"bargain" purchases) and who 24 years later had reappeared to
+again rescue me, this time from problems at K&W Products, a small
+Berkshire subsidiary that produces automotive compounds. As I
+reported, in short order Harry reduced capital employed at K&W,
+rationalized production, cut costs, and quadrupled profits. You
+might think he would then have paused for breath. But last year
+Harry, now 70, attended a bankruptcy auction and, for a pittance,
+acquired a product line that is a natural for K&W. That company's
+profitability may well be increased 50% by this coup. Watch this
+space for future bulletins on Harry's triumphs.
+
+ * * * * * * * * * * * *
+
+ With more than a year behind him of trading Berkshire's
+stock on the New York Stock Exchange, our specialist, Jim Maguire
+of Henderson Brothers, Inc. ("HBI"), continues his outstanding
+performance. Before we listed, dealer spreads often were 3% or
+more of market price. Jim has maintained the spread at 50 points
+or less, which at current prices is well under 1%. Shareholders
+who buy or sell benefit significantly from this reduction in
+transaction costs.
+
+ Because we are delighted by our experience with Jim, HBI and
+the NYSE, I said as much in ads that have been run in a series
+placed by the NYSE. Normally I shun testimonials, but I was
+pleased in this instance to publicly compliment the Exchange.
+
+ * * * * * * * * * * * *
+
+ Last summer we sold the corporate jet that we purchased for
+$850,000 three years ago and bought another used jet for $6.7
+million. Those of you who recall the mathematics of the
+multiplying bacteria on page 5 will understandably panic: If our
+net worth continues to increase at current rates, and the cost of
+replacing planes also continues to rise at the now-established
+rate of 100% compounded annually, it will not be long before
+Berkshire's entire net worth is consumed by its jet.
+
+ Charlie doesn't like it when I equate the jet with bacteria;
+he feels it's degrading to the bacteria. His idea of traveling in
+style is an air-conditioned bus, a luxury he steps up to only
+when bargain fares are in effect. My own attitude toward the jet
+can be summarized by the prayer attributed, apocryphally I'm
+sure, to St. Augustine as he contemplated leaving a life of
+secular pleasures to become a priest. Battling the conflict
+between intellect and glands, he pled: "Help me, Oh Lord, to
+become chaste - but not yet."
+
+ Naming the plane has not been easy. I initially suggested
+"The Charles T. Munger." Charlie countered with "The Aberration."
+We finally settled on "The Indefensible."
+
+ * * * * * * * * * * * *
+
+ About 96.9% of all eligible shares participated in
+Berkshire's 1989 shareholder-designated contributions program.
+Contributions made through the program were $5.9 million, and
+2,550 charities were recipients.
+
+ We urge new shareholders to read the description of our
+shareholder-designated contributions program that appears on
+pages 52-53. If you wish to participate in future programs, we
+strongly urge that you immediately make sure your shares are
+registered in the name of the actual owner, not in the nominee
+name of a broker, bank or depository. Shares not so registered on
+August 31, 1990 will be ineligible for the 1990 program.
+
+ * * * * * * * * * * * *
+
+ The annual meeting this year will take place at 9:30 a.m. on
+Monday, April 30, 1990. Attendance grew last year to about 1,000,
+very close to the seating capacity of the Witherspoon Hall at
+Joslyn Museum. So this year's meeting will be moved to the
+Orpheum Theatre, which is in downtown Omaha, about one-quarter of
+a mile from the Red Lion Hotel. The Radisson-Redick Tower, a much
+smaller but nice hotel, is located across the street from the
+Orpheum. Or you may wish to stay at the Marriott, which is in
+west Omaha, about 100 yards from Borsheim's. We will have buses
+at the Marriott that will leave at 8:30 and 8:45 for the meeting
+and return after it ends.
+
+ Charlie and I always enjoy the meeting, and we hope you can
+make it. The quality of our shareholders is reflected in the
+quality of the questions we get: We have never attended an annual
+meeting anywhere that features such a consistently high level of
+intelligent, owner-related questions.
+
+ An attachment to our proxy material explains how you can
+obtain the card you will need for admission to the meeting.
+Because weekday parking can be tight around the Orpheum, we have
+lined up a number of nearby lots for our shareholders to use. The
+attachment also contains information about them.
+
+ As usual, we will have buses to take you to Nebraska
+Furniture Mart and Borsheim's after the meeting and to take you
+to downtown hotels or to the airport later. I hope that you will
+allow plenty of time to fully explore the attractions of both
+stores. Those of you arriving early can visit the Furniture Mart
+any day of the week; it is open from 10 a.m. to 5:30 p.m. on
+Saturdays, and from noon to 5:30 p.m. on Sundays.
+
+ Borsheim's normally is closed on Sunday, but we will open
+for shareholders and their guests from noon to 6 p.m. on Sunday,
+April 29th. Ike likes to put on a show, and you can rely on him
+to produce something very special for our shareholders.
+
+ In this letter we've had a lot to say about rates of
+compounding. If you can bear having your own rate turn negative
+for a day - not a pretty thought, I admit - visit Ike on the
+29th.
+
+
+
+
+ Warren E. Buffett
+March 2, 1990 Chairman of the Board
+
+
+
diff --git a/berkshire-hathaway/1990/1-in/berkshire-hathaway-1990-letter.txt b/berkshire-hathaway/1990/1-in/berkshire-hathaway-1990-letter.txt
new file mode 100644
index 0000000..1fabcf9
--- /dev/null
+++ b/berkshire-hathaway/1990/1-in/berkshire-hathaway-1990-letter.txt
@@ -0,0 +1,607 @@
+
+
+
+
+
+
+
+BERKSHIRE HATHAWAY INC.
+To the Shareholders of Berkshire Hathaway Inc.:
+Last year we made a prediction: "A reduction [in Berkshire's net worth] is almost certain in at least one of the next three years." During much of 1990's second half, we were on the road to quickly proving that forecast accurate. But some strengthening in stock prices late in the year enabled us to close 1990 with net worth up by $362 million, or 7.3%. Over the last 26 years (that is, since present management took over) our per-share book value has grown from $19.46 to $4,612.06, or at a rate of 23.2% compounded annually.
+Our growth rate was lackluster in 1990 because our four major common stock holdings, in aggregate, showed little change in market value. Last year I told you that though these companies - Capital Cities/ABC, Coca-Cola, GEICO, and Washington Post - had fine businesses and superb managements, widespread recognition of these attributes had pushed the stock prices of the four to lofty levels. The market prices of the two media companies have since fallen significantly - for good reasons relating to evolutionary industry developments that I will discuss later - and the price of Coca-Cola stock has increased significantly for what I also believe are good reasons. Overall, yearend 1990 prices of our "permanent four," though far from enticing, were a bit more appealing than they were a year earlier.
+Berkshire's 26-year record is meaningless in forecasting future results; so also, we hope, is the one-year record. We continue to aim for a 15% average annual gain in intrinsic value. But, as we never tire of telling you, this goal becomes ever more difficult to reach as our equity base, now $5.3 billion, increases.
+If we do attain that 15% average, our shareholders should fare well. However, Berkshire's corporate gains will produce an identical gain for a specific shareholder only if he eventually sells his shares at the same relationship to intrinsic value that existed when he bought them. For example, if you buy at a 10% premium to intrinsic value; if intrinsic value subsequently grows at 15% a year; and if you then sell at a 10% premium, your own return will correspondingly be 15% compounded. (The calculation assumes that no dividends are paid.) If, however, you buy at a premium and sell at a smaller premium, your results will be somewhat inferior to those achieved by the company.
+Ideally, the results of every Berkshire shareholder would closely mirror those of the company during his period of ownership. That is why Charlie Munger, Berkshire's Vice Chairman and my partner, and I hope for Berkshire to sell consistently at about intrinsic value. We prefer such steadiness to the value-ignoring volatility of the past two years: In 1989 intrinsic value grew less than did book value, which was up 44%, while the market price rose 85%; in 1990 book value and intrinsic value increased by a small amount, while the market price fell 23%.
+Berkshire's intrinsic value continues to exceed book value by a substantial margin. We can't tell you the exact differential because intrinsic value is necessarily an estimate; Charlie and I might, in fact, differ by 10% in our appraisals. We do know, however, that we own some exceptional businesses that are worth considerably more than the values at which they are carried on our books.
+Much of the extra value that exists in our businesses has been created by the managers now running them. Charlie and I feel free to brag about this group because we had nothing to do with developing the skills they possess: These superstars just came that way. Our job is merely to identify talented managers and provide an environment in which they can do their stuff. Having done it, they send their cash to headquarters and we face our only other task: the intelligent deployment of these funds.
+My own role in operations may best be illustrated by a small tale concerning my granddaughter, Emily, and her fourth birthday party last fall. Attending were other children, adoring relatives, and Beemer the Clown, a local entertainer who includes magic tricks in his act.
+Beginning these, Beemer asked Emily to help him by waving a "magic wand" over "the box of wonders." Green handkerchiefs went into the box, Emily waved the wand, and Beemer removed blue ones. Loose handkerchiefs went in and, upon a magisterial wave by Emily, emerged knotted. After four such transformations, each more amazing than its predecessor, Emily was unable to contain herself. Her face aglow, she exulted: "Gee, I'm really good at this."
+ And that sums up my contribution to the performance of Berkshire's business magicians - the Blumkins, the Friedman family, Mike Goldberg, the Heldmans, Chuck Huggins, Stan Lipsey and Ralph Schey. They deserve your applause.
+
+Sources of Reported Earnings
The table below shows the major sources of Berkshire's reported earnings. In this presentation, amortization of Goodwill and other major purchase-price accounting adjustments are not charged against the specific businesses to which they apply, but are instead aggregated and shown separately. This procedure lets you view the earnings of our businesses as they would have been reported had we not purchased them. I've explained in past reports why this form of presentation seems to us to be more useful to investors and managers than one utilizing generally accepted accounting principles (GAAP), which require purchase-price adjustments to be made on a business-by-business basis. The total net earnings we show in the table are, of course, identical to the GAAP total in our audited financial statements.
+Much additional information about these businesses is given on pages 39-46, where you also will find our segment earnings reported on a GAAP basis. For information on Wesco's businesses, I urge you to read Charlie Munger's letter, which starts on page 56. His letter also contains the clearest and most insightful discussion of the banking industry that I have seen.
++ + (000s omitted) + ----------------------------------------- + Berkshire's Share + of Net Earnings + (after taxes and + Pre-Tax Earnings minority interests) + ------------------- ------------------- + 1990 1989 1990 1989 + -------- -------- -------- -------- +Operating Earnings: + Insurance Group: + Underwriting ................ $(26,647) $(24,400) $(14,936) $(12,259) + Net Investment Income ....... 327,048 243,599 282,613 213,642 + Buffalo News .................. 43,954 46,047 25,981 27,771 + Fechheimer .................... 12,450 12,621 6,605 6,789 + Kirby ......................... 27,445 26,114 17,613 16,803 + Nebraska Furniture Mart ....... 17,248 17,070 8,485 8,441 + Scott Fetzer Manufacturing Group 30,378 33,165 18,458 19,996 + See's Candies ................. 39,580 34,235 23,892 20,626 + Wesco - other than Insurance .. 12,441 13,008 9,676 9,810 + World Book .................... 31,896 25,583 20,420 16,372 + Amortization of Goodwill ...... (3,476) (3,387) (3,461) (3,372) + Other Purchase-Price + Accounting Charges ......... (5,951) (5,740) (6,856) (6,668) + Interest Expense* ............. (76,374) (42,389) (49,726) (27,098) + Shareholder-Designated + Contributions .............. (5,824) (5,867) (3,801) (3,814) + Other ......................... 58,309 23,755 35,782 12,863 + -------- -------- -------- -------- +Operating Earnings .............. 482,477 393,414 370,745 299,902 +Sales of Securities ............. 33,989 223,810 23,348 147,575 + -------- -------- -------- -------- +Total Earnings - All Entities $516,466 $617,224 $394,093 $447,477 + ======== ======== ======== ========+
*Excludes interest expense of Scott Fetzer Financial Group and Mutual Savings & Loan.
+We refer you also to pages 47-53, where we have rearranged Berkshire's financial data into four segments. These correspond to the way Charlie and I think about the business and should help you more in estimating Berkshire's intrinsic value than consolidated figures would do. Shown on these pages are balance sheets and earnings statements for: (1) our insurance operations, with their major investment positions itemized; (2) our manufacturing, publishing and retailing businesses, leaving aside certain non- operating assets and purchase-price accounting adjustments; (3) our subsidiaries engaged in finance-type operations, which are Mutual Savings and Scott Fetzer Financial; and (4) an all-other category that includes the non-operating assets (primarily marketable securities) held by the companies in segment (2), all purchase- price accounting adjustments, and various assets and debts of the Wesco and Berkshire parent companies.
+ If you combine the earnings and net worths of these four segments, you will derive totals matching those shown on our GAAP statements. However, I want to emphasize that this four-category presentation does not fall within the purview of our auditors, who in no way bless it.
+
+"Look-Through" Earnings
The term "earnings" has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor's certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places.
+In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surface, but in the meantime a lot of money can change hands. Indeed, some important American fortunes have been created by the monetization of accounting mirages.
+Funny business in accounting is not new. For connoisseurs of chicanery, I have attached as Appendix A on page 22 a previously unpublished satire on accounting practices written by Ben Graham in 1936. Alas, excesses similar to those he then lampooned have many times since found their way into the financial statements of major American corporations and been duly certified by big-name auditors. Clearly, investors must always keep their guard up and use accounting numbers as a beginning, not an end, in their attempts to calculate true "economic earnings" accruing to them.
+Berkshire's own reported earnings are misleading in a different, but important, way: We have huge investments in companies ("investees") whose earnings far exceed their dividends and in which we record our share of earnings only to the extent of the dividends we receive. The extreme case is Capital Cities/ABC, Inc. Our 17% share of the company's earnings amounted to more than $83 million last year. Yet only about $530,000 ($600,000 of dividends it paid us less some $70,000 of tax) is counted in Berkshire's GAAP earnings. The residual $82 million-plus stayed with Cap Cities as retained earnings, which work for our benefit but go unrecorded on our books.
+Our perspective on such "forgotten-but-not-gone" earnings is simple: The way they are accounted for is of no importance, but their ownership and subsequent utilization is all-important. We care not whether the auditors hear a tree fall in the forest; we do care who owns the tree and what's next done with it.
+When Coca-Cola uses retained earnings to repurchase its shares, the company increases our percentage ownership in what I regard to be the most valuable franchise in the world. (Coke also, of course, uses retained earnings in many other value-enhancing ways.) Instead of repurchasing stock, Coca-Cola could pay those funds to us in dividends, which we could then use to purchase more Coke shares. That would be a less efficient scenario: Because of taxes we would pay on dividend income, we would not be able to increase our proportionate ownership to the degree that Coke can, acting for us. If this less efficient procedure were followed, however, Berkshire would report far greater "earnings."
+I believe the best way to think about our earnings is in terms of "look-through" results, calculated as follows: Take $250 million, which is roughly our share of the 1990 operating earnings retained by our investees; subtract $30 million, for the incremental taxes we would have owed had that $250 million been paid to us in dividends; and add the remainder, $220 million, to our reported operating earnings of $371 million. Thus our 1990 "look-through earnings" were about $590 million.
+ As I mentioned last year, we hope to have look-through earnings grow about 15% annually. In 1990 we substantially exceeded that rate but in 1991 we will fall far short of it. Our Gillette preferred has been called and we will convert it into common stock on April 1. This will reduce reported earnings by about $35 million annually and look-through earnings by a much smaller, but still significant, amount. Additionally, our media earnings - both direct and look-through - appear sure to decline. Whatever the results, we will post you annually on how we are doing on a look-through basis.
+
+Non-Insurance Operations
Take another look at the figures on page 51, which aggregate the earnings and balance sheets of our non-insurance operations. After-tax earnings on average equity in 1990 were 51%, a result that would have placed the group about 20th on the 1989 Fortune 500.
+Two factors make this return even more remarkable. First, leverage did not produce it: Almost all our major facilities are owned, not leased, and such small debt as these operations have is basically offset by cash they hold. In fact, if the measurement was return on assets - a calculation that eliminates the effect of debt upon returns - our group would rank in Fortune's top ten.
+ Equally important, our return was not earned from industries, such as cigarettes or network television stations, possessing spectacular economics for all participating in them. Instead it came from a group of businesses operating in such prosaic fields as furniture retailing, candy, vacuum cleaners, and even steel warehousing. The explanation is clear: Our extraordinary returns flow from outstanding operating managers, not fortuitous industry economics.
+
+Let's look at the larger operations:
o It was a poor year for retailing - particularly for big-ticket items - but someone forgot to tell Ike Friedman at Borsheim's. Sales were up 18%. That's both a same-stores and all-stores percentage, since Borsheim's operates but one establishment.
+But, oh, what an establishment! We can't be sure about the fact (because most fine-jewelry retailers are privately owned) but we believe that this jewelry store does more volume than any other in the U.S., except for Tiffany's New York store.
+Borsheim's could not do nearly that well if our customers came only from the Omaha metropolitan area, whose population is about 600,000. We have long had a huge percentage of greater Omaha's jewelry business, so growth in that market is necessarily limited. But every year business from non-Midwest customers grows dramatically. Many visit the store in person. A large number of others, however, buy through the mail in a manner you will find interesting.
+These customers request a jewelry selection of a certain type and value - say, emeralds in the $10,000 -$20,000 range - and we then send them five to ten items meeting their specifications and from which they can pick. Last year we mailed about 1,500 assortments of all kinds, carrying values ranging from under $1,000 to hundreds of thousands of dollars.
+The selections are sent all over the country, some to people no one at Borsheim's has ever met. (They must always have been well recommended, however.) While the number of mailings in 1990 was a record, Ike has been sending merchandise far and wide for decades. Misanthropes will be crushed to learn how well our "honor-system" works: We have yet to experience a loss from customer dishonesty.
+We attract business nationwide because we have several advantages that competitors can't match. The most important item in the equation is our operating costs, which run about 18% of sales compared to 40% or so at the typical competitor. (Included in the 18% are occupancy and buying costs, which some public companies include in "cost of goods sold.") Just as Wal-Mart, with its 15% operating costs, sells at prices that high-cost competitors can't touch and thereby constantly increases its market share, so does Borsheim's. What works with diapers works with diamonds.
+Our low prices create huge volume that in turn allows us to carry an extraordinarily broad inventory of goods, running ten or more times the size of that at the typical fine-jewelry store. Couple our breadth of selection and low prices with superb service and you can understand how Ike and his family have built a national jewelry phenomenon from an Omaha location.
+ And family it is. Ike's crew always includes son Alan and sons-in-law Marvin Cohn and Donald Yale. And when things are busy - that's often - they are joined by Ike's wife, Roz, and his daughters, Janis and Susie. In addition, Fran Blumkin, wife of Louie (Chairman of Nebraska Furniture Mart and Ike's cousin), regularly pitches in. Finally, you'll find Ike's 89-year-old mother, Rebecca, in the store most afternoons, Wall Street Journal in hand. Given a family commitment like this, is it any surprise that Borsheim's runs rings around competitors whose managers are thinking about how soon 5 o'clock will arrive?
+
+o While Fran Blumkin was helping the Friedman family set records at Borsheim's, her sons, Irv and Ron, along with husband Louie, were setting records at The Nebraska Furniture Mart. Sales at our one-and-only location were $159 million, up 4% from 1989. Though again the fact can't be conclusively proved, we believe NFM does close to double the volume of any other home furnishings store in the country.
The NFM formula for success parallels that of Borsheim's. First, operating costs are rock-bottom - 15% in 1990 against about 40% for Levitz, the country's largest furniture retailer, and 25% for Circuit City Stores, the leading discount retailer of electronics and appliances. Second, NFM's low costs allow the business to price well below all competitors. Indeed, major chains, knowing what they will face, steer clear of Omaha. Third, the huge volume generated by our bargain prices allows us to carry the broadest selection of merchandise available anywhere.
+Some idea of NFM's merchandising power can be gleaned from a recent report of consumer behavior in Des Moines, which showed that NFM was Number 3 in popularity among 20 furniture retailers serving that city. That may sound like no big deal until you consider that 19 of those retailers are located in Des Moines, whereas our store is 130 miles away. This leaves customers driving a distance equal to that between Washington and Philadelphia in order to shop with us, even though they have a multitude of alternatives next door. In effect, NFM, like Borsheim's, has dramatically expanded the territory it serves - not by the traditional method of opening new stores but rather by creating an irresistible magnet that employs price and selection to pull in the crowds.
+ Last year at the Mart there occurred an historic event: I experienced a counterrevelation. Regular readers of this report know that I have long scorned the boasts of corporate executives about synergy, deriding such claims as the last refuge of scoundrels defending foolish acquisitions. But now I know better: In Berkshire's first synergistic explosion, NFM put a See's candy cart in the store late last year and sold more candy than that moved by some of the full-fledged stores See's operates in California. This success contradicts all tenets of retailing. With the Blumkins, though, the impossible is routine.
+
+o At See's, physical volume set a record in 1990 - but only barely and only because of good sales early in the year. After the invasion of Kuwait, mall traffic in the West fell. Our poundage volume at Christmas dropped slightly, though our dollar sales were up because of a 5% price increase.
That increase, and better control of expenses, improved profit margins. Against the backdrop of a weak retailing environment, Chuck Huggins delivered outstanding results, as he has in each of the nineteen years we have owned See's. Chuck's imprint on the business - a virtual fanaticism about quality and service - is visible at all of our 225 stores.
+One happening in 1990 illustrates the close bond between See's and its customers. After 15 years of operation, our store in Albuquerque was endangered: The landlord would not renew our lease, wanting us instead to move to an inferior location in the mall and even so to pay a much higher rent. These changes would have wiped out the store's profit. After extended negotiations got us nowhere, we set a date for closing the store.
+On her own, the store's manager, Ann Filkins, then took action, urging customers to protest the closing. Some 263 responded by sending letters and making phone calls to See's headquarters in San Francisco, in some cases threatening to boycott the mall. An alert reporter at the Albuquerque paper picked up the story. Supplied with this evidence of a consumer uprising, our landlord offered us a satisfactory deal. (He, too, proved susceptible to a counterrevelation.)
+ Chuck subsequently wrote personal letters of thanks to every loyalist and sent each a gift certificate. He repeated his thanks in a newspaper ad that listed the names of all 263. The sequel: Christmas sales in Albuquerque were up substantially.
+
+o Charlie and I were surprised at developments this past year in the media industry, including newspapers such as our Buffalo News. The business showed far more vulnerability to the early stages of a recession than has been the case in the past. The question is whether this erosion is just part of an aberrational cycle - to be fully made up in the next upturn - or whether the business has slipped in a way that permanently reduces intrinsic business values.
Since I didn't predict what has happened, you may question the value of my prediction about what will happen. Nevertheless, I'll proffer a judgment: While many media businesses will remain economic marvels in comparison with American industry generally, they will prove considerably less marvelous than I, the industry, or lenders thought would be the case only a few years ago.
+The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. In addition, retailers that do little or no media advertising (though they sometimes use the Postal Service) have gradually taken market share in certain merchandise categories. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished. These circumstances materially reduce the intrinsic value of our major media investments and also the value of our operating unit, Buffalo News - though all remain fine businesses.
+Notwithstanding the problems, Stan Lipsey's management of the News continues to be superb. During 1990, our earnings held up much better than those of most metropolitan papers, falling only 5%. In the last few months of the year, however, the rate of decrease was far greater.
+I can safely make two promises about the News in 1991: (1) Stan will again rank at the top among newspaper publishers; and (2) earnings will fall substantially. Despite a slowdown in the demand for newsprint, the price per ton will average significantly more in 1991 and the paper's labor costs will also be considerably higher. Since revenues may meanwhile be down, we face a real squeeze.
+ Profits may be off but our pride in the product remains. We continue to have a larger "news hole" - the portion of the paper devoted to news - than any comparable paper. In 1990, the proportion rose to 52.3% against 50.1% in 1989. Alas, the increase resulted from a decline in advertising pages rather than from a gain in news pages. Regardless of earnings pressures, we will maintain at least a 50% news hole. Cutting product quality is not a proper response to adversity.
+
+o The news at Fechheimer, our manufacturer and retailer of uniforms, is all good with one exception: George Heldman, at 69, has decided to retire. I tried to talk him out of it but he had one irrefutable argument: With four other Heldmans - Bob, Fred, Gary and Roger - to carry on, he was leaving us with an abundance of managerial talent.
Fechheimer's operating performance improved considerably in 1990, as many of the problems we encountered in integrating the large acquisition we made in 1988 were moderated or solved. However, several unusual items caused the earnings reported in the "Sources" table to be flat. In the retail operation, we continue to add stores and now have 42 in 22 states. Overall, prospects appear excellent for Fechheimer.
+
+o At Scott Fetzer, Ralph Schey runs 19 businesses with a mastery few bring to running one. In addition to overseeing three entities listed on page 6 - World Book, Kirby, and Scott Fetzer Manufacturing - Ralph directs a finance operation that earned a record $12.2 million pre-tax in 1990.
Were Scott Fetzer an independent company, it would rank close to the top of the Fortune 500 in terms of return on equity, although it is not in businesses that one would expect to be economic champs. The superior results are directly attributable to Ralph.
+At World Book, earnings improved on a small decrease in unit volume. The costs of our decentralization move were considerably less in 1990 than 1989 and the benefits of decentralization are being realized. World Book remains far and away the leader in United States encyclopedia sales and we are growing internationally, though from a small base.
+Kirby unit volume grew substantially in 1990 with the help of our new vacuum cleaner, The Generation 3, which was an unqualified success. Earnings did not grow as fast as sales because of both start-up expenditures and "learning-curve" problems we encountered in manufacturing the new product. International business, whose dramatic growth I described last year, had a further 20% sales gain in 1990. With the aid of a recent price increase, we expect excellent earnings at Kirby in 1991.
+Within the Scott Fetzer Manufacturing Group, Campbell Hausfeld, its largest unit, had a particularly fine year. This company, the country's leading producer of small and medium-sized air compressors, achieved record sales of $109 million, more than 30% of which came from products introduced during the last five years.
+* * * * * * * * * * * *
+In looking at the figures for our non-insurance operations, you will see that net worth increased by only $47 million in 1990 although earnings were $133 million. This does not mean that our managers are in any way skimping on investments that strengthen their business franchises or that promote growth. Indeed, they diligently pursue both goals.
+ But they also never deploy capital without good reason. The result: In the past five years they have funneled well over 80% of their earnings to Charlie and me for use in new business and investment opportunities.
+
+Insurance Operations
Shown below is an updated version of our usual table presenting key figures for the property-casualty insurance industry:
++ Yearly Change Combined Ratio Yearly Change Inflation Rate + in Premiums After Policyholder in Incurred Measured by + Written (%) Dividends Losses (%) GNP Deflator (%) + ------------- ------------------ ------------- ---------------- +1981 ..... 3.8 106.0 6.5 9.6 +1982 ..... 3.7 109.6 8.4 6.5 +1983 ..... 5.0 112.0 6.8 3.8 +1984 ..... 8.5 118.0 16.9 3.8 +1985 ..... 22.1 116.3 16.1 3.0 +1986 ..... 22.2 108.0 13.5 2.6 +1987 ..... 9.4 104.6 7.8 3.1 +1988 ..... 4.4 105.4 5.5 3.3 +1989 (Revised) 3.2 109.2 7.7 4.1 +1990(Est.) 4.5 109.8 5.0 4.1 +
Source: A.M. Best Co.
+The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: A ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss. The higher the ratio, the worse the year. When the investment income that an insurer earns from holding policyholders' funds ("the float") is taken into account, a combined ratio in the 107 - 111 range typically produces an overall breakeven result, exclusive of earnings on the funds provided by shareholders.
+For the reasons laid out in previous reports, we expect the industry's incurred losses to grow at an average of 10% annually, even in periods when general inflation runs considerably lower. (Over the last 25 years, incurred losses have in reality grown at a still faster rate, 11%.) If premium growth meanwhile materially lags that 10% rate, underwriting losses will mount, though the industry's tendency to under-reserve when business turns bad may obscure their size for a time.
+Last year premium growth fell far short of the required 10% and underwriting results therefore worsened. (In our table, however, the severity of the deterioration in 1990 is masked because the industry's 1989 losses from Hurricane Hugo caused the ratio for that year to be somewhat above trendline.) The combined ratio will again increase in 1991, probably by about two points.
+Results will improve only when most insurance managements become so fearful that they run from business, even though it can be done at much higher prices than now exist. At some point these managements will indeed get the message: The most important thing to do when you find yourself in a hole is to stop digging. But so far that point hasn't gotten across: Insurance managers continue to dig - sullenly but vigorously.
+The picture would change quickly if a major physical or financial catastrophe were to occur. Absent such a shock, one to two years will likely pass before underwriting losses become large enough to raise management fear to a level that would spur major price increases. When that moment arrives, Berkshire will be ready - both financially and psychologically - to write huge amounts of business.
+In the meantime, our insurance volume continues to be small but satisfactory. In the next section of this report we will give you a framework for evaluating insurance results. From that discussion, you will gain an understanding of why I am so enthusiastic about the performance of our insurance manager, Mike Goldberg, and his cadre of stars, Rod Eldred, Dinos Iordanou, Ajit Jain, and Don Wurster.
+In assessing our insurance results over the next few years, you should be aware of one type of business we are pursuing that could cause them to be unusually volatile. If this line of business expands, as it may, our underwriting experience will deviate from the trendline you might expect: In most years we will somewhat exceed expectations and in an occasional year we will fall far below them.
+The volatility I predict reflects the fact that we have become a large seller of insurance against truly major catastrophes ("super-cats"), which could for example be hurricanes, windstorms or earthquakes. The buyers of these policies are reinsurance companies that themselves are in the business of writing catastrophe coverage for primary insurers and that wish to "lay off," or rid themselves, of part of their exposure to catastrophes of special severity. Because the need for these buyers to collect on such a policy will only arise at times of extreme stress - perhaps even chaos - in the insurance business, they seek financially strong sellers. And here we have a major competitive advantage: In the industry, our strength is unmatched.
+A typical super-cat contract is complicated. But in a plain- vanilla instance we might write a one-year, $10 million policy providing that the buyer, a reinsurer, would be paid that sum only if a catastrophe caused two results: (1) specific losses for the reinsurer above a threshold amount; and (2) aggregate losses for the insurance industry of, say, more than $5 billion. Under virtually all circumstances, loss levels that satisfy the second condition will also have caused the first to be met.
+For this $10 million policy, we might receive a premium of, say, $3 million. Say, also, that we take in annual premiums of $100 million from super-cat policies of all kinds. In that case we are very likely in any given year to report either a profit of close to $100 million or a loss of well over $200 million. Note that we are not spreading risk as insurers typically do; we are concentrating it. Therefore, our yearly combined ratio on this business will almost never fall in the industry range of 100 - 120, but will instead be close to either zero or 300%.
+Most insurers are financially unable to tolerate such swings. And if they have the ability to do so, they often lack the desire. They may back away, for example, because they write gobs of primary property insurance that would deliver them dismal results at the very time they would be experiencing major losses on super- cat reinsurance. In addition, most corporate managements believe that their shareholders dislike volatility in results.
+We can take a different tack: Our business in primary property insurance is small and we believe that Berkshire shareholders, if properly informed, can handle unusual volatility in profits so long as the swings carry with them the prospect of superior long-term results. (Charlie and I always have preferred a lumpy 15% return to a smooth 12%.)
+We want to emphasize three points: (1) While we expect our super-cat business to produce satisfactory results over, say, a decade, we're sure it will produce absolutely terrible results in at least an occasional year; (2) Our expectations can be based on little more than subjective judgments - for this kind of insurance, historical loss data are of very limited value to us as we decide what rates to charge today; and (3) Though we expect to write significant quantities of super-cat business, we will do so only at prices we believe to be commensurate with risk. If competitors become optimistic, our volume will fall. This insurance has, in fact, tended in recent years to be woefully underpriced; most sellers have left the field on stretchers.
+ At the moment, we believe Berkshire to be the largest U.S. writer of super-cat business. So when a major quake occurs in an urban area or a winter storm rages across Europe, light a candle for us.
+
+Measuring Insurance Performance
In the previous section I mentioned "float," the funds of others that insurers, in the conduct of their business, temporarily hold. Because these funds are available to be invested, the typical property-casualty insurer can absorb losses and expenses that exceed premiums by 7% to 11% and still be able to break even on its business. Again, this calculation excludes the earnings the insurer realizes on net worth - that is, on the funds provided by shareholders.
+However, many exceptions to this 7% to 11% range exist. For example, insurance covering losses to crops from hail damage produces virtually no float at all. Premiums on this kind of business are paid to the insurer just prior to the time hailstorms are a threat, and if a farmer sustains a loss he will be paid almost immediately. Thus, a combined ratio of 100 for crop hail insurance produces no profit for the insurer.
+At the other extreme, malpractice insurance covering the potential liabilities of doctors, lawyers and accountants produces a very high amount of float compared to annual premium volume. The float materializes because claims are often brought long after the alleged wrongdoing takes place and because their payment may be still further delayed by lengthy litigation. The industry calls malpractice and certain other kinds of liability insurance "long- tail" business, in recognition of the extended period during which insurers get to hold large sums that in the end will go to claimants and their lawyers (and to the insurer's lawyers as well).
+In long-tail situations a combined ratio of 115 (or even more) can prove profitable, since earnings produced by the float will exceed the 15% by which claims and expenses overrun premiums. The catch, though, is that "long-tail" means exactly that: Liability business written in a given year and presumed at first to have produced a combined ratio of 115 may eventually smack the insurer with 200, 300 or worse when the years have rolled by and all claims have finally been settled.
+The pitfalls of this business mandate an operating principle that too often is ignored: Though certain long-tail lines may prove profitable at combined ratios of 110 or 115, insurers will invariably find it unprofitable to price using those ratios as targets. Instead, prices must provide a healthy margin of safety against the societal trends that are forever springing expensive surprises on the insurance industry. Setting a target of 100 can itself result in heavy losses; aiming for 110 - 115 is business suicide.
+All of that said, what should the measure of an insurer's profitability be? Analysts and managers customarily look to the combined ratio - and it's true that this yardstick usually is a good indicator of where a company ranks in profitability. We believe a better measure, however, to be a comparison of underwriting loss to float developed.
+This loss/float ratio, like any statistic used in evaluating insurance results, is meaningless over short time periods: Quarterly underwriting figures and even annual ones are too heavily based on estimates to be much good. But when the ratio takes in a period of years, it gives a rough indication of the cost of funds generated by insurance operations. A low cost of funds signifies a good business; a high cost translates into a poor business.
+On the next page we show the underwriting loss, if any, of our insurance group in each year since we entered the business and relate that bottom line to the average float we have held during the year. From this data we have computed a "cost of funds developed from insurance."
++ + (1) (2) Yearend Yield + Underwriting Approximate on Long-Term + Loss Average Float Cost of Funds Govt. Bonds + ------------ ------------- --------------- ------------- + (In $ Millions) (Ratio of 1 to 2) + +1967 ......... profit $17.3 less than zero 5.50% +1968 ......... profit 19.9 less than zero 5.90% +1969 ......... profit 23.4 less than zero 6.79% +1970 ......... $0.37 32.4 1.14% 6.25% +1971 ......... profit 52.5 less than zero 5.81% +1972 ......... profit 69.5 less than zero 5.82% +1973 ......... profit 73.3 less than zero 7.27% +1974 ......... 7.36 79.1 9.30% 8.13% +1975 ......... 11.35 87.6 12.96% 8.03% +1976 ......... profit 102.6 less than zero 7.30% +1977 ......... profit 139.0 less than zero 7.97% +1978 ......... profit 190.4 less than zero 8.93% +1979 ......... profit 227.3 less than zero 10.08% +1980 ......... profit 237.0 less than zero 11.94% +1981 ......... profit 228.4 less than zero 13.61% +1982 ......... 21.56 220.6 9.77% 10.64% +1983 ......... 33.87 231.3 14.64% 11.84% +1984 ......... 48.06 253.2 18.98% 11.58% +1985 ......... 44.23 390.2 11.34% 9.34% +1986 ......... 55.84 797.5 7.00% 7.60% +1987 ......... 55.43 1,266.7 4.38% 8.95% +1988 ......... 11.08 1,497.7 0.74% 9.00% +1989 ......... 24.40 1,541.3 1.58% 7.97% +1990 ......... 26.65 1,637.3 1.63% 8.24%+
The float figures are derived from the total of loss reserves, loss adjustment expense reserves and unearned premium reserves minus agents' balances, prepaid acquisition costs and deferred charges applicable to assumed reinsurance. At some insurers other items should enter into the calculation, but in our case these are unimportant and have been ignored.
+During 1990 we held about $1.6 billion of float slated eventually to find its way into the hands of others. The underwriting loss we sustained during the year was $27 million and thus our insurance operation produced funds for us at a cost of about 1.6%. As the table shows, we managed in some years to underwrite at a profit and in those instances our cost of funds was less than zero. In other years, such as 1984, we paid a very high price for float. In 19 years out of the 24 we have been in insurance, though, we have developed funds at a cost below that paid by the government.
+There are two important qualifications to this calculation. First, the fat lady has yet to gargle, let alone sing, and we won't know our true 1967 - 1990 cost of funds until all losses from this period have been settled many decades from now. Second, the value of the float to shareholders is somewhat undercut by the fact that they must put up their own funds to support the insurance operation and are subject to double taxation on the investment income these funds earn. Direct investments would be more tax-efficient.
+The tax penalty that indirect investments impose on shareholders is in fact substantial. Though the calculation is necessarily imprecise, I would estimate that the owners of the average insurance company would find the tax penalty adds about one percentage point to their cost of float. I also think that approximates the correct figure for Berkshire.
+Figuring a cost of funds for an insurance business allows anyone analyzing it to determine whether the operation has a positive or negative value for shareholders. If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, the value is negative. If the cost is lower, the value is positive - and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.
+So far Berkshire has fallen into the significantly-lower camp. Even more dramatic are the numbers at GEICO, in which our ownership interest is now 48% and which customarily operates at an underwriting profit. GEICO's growth has generated an ever-larger amount of funds for investment that have an effective cost of considerably less than zero. Essentially, GEICO's policyholders, in aggregate, pay the company interest on the float rather than the other way around. (But handsome is as handsome does: GEICO's unusual profitability results from its extraordinary operating efficiency and its careful classification of risks, a package that in turn allows rock-bottom prices for policyholders.)
+Many well-known insurance companies, on the other hand, incur an underwriting loss/float cost that, combined with the tax penalty, produces negative results for owners. In addition, these companies, like all others in the industry, are vulnerable to catastrophe losses that could exceed their reinsurance protection and take their cost of float right off the chart. Unless these companies can materially improve their underwriting performance - and history indicates that is an almost impossible task - their shareholders will experience results similar to those borne by the owners of a bank that pays a higher rate of interest on deposits than it receives on loans.
+All in all, the insurance business has treated us very well. We have expanded our float at a cost that on the average is reasonable, and we have further prospered because we have earned good returns on these low-cost funds. Our shareholders, true, have incurred extra taxes, but they have been more than compensated for this cost (so far) by the benefits produced by the float.
+A particularly encouraging point about our record is that it was achieved despite some colossal mistakes made by your Chairman prior to Mike Goldberg's arrival. Insurance offers a host of opportunities for error, and when opportunity knocked, too often I answered. Many years later, the bills keep arriving for these mistakes: In the insurance business, there is no statute of limitations on stupidity.
+ The intrinsic value of our insurance business will always be far more difficult to calculate than the value of, say, our candy or newspaper companies. By any measure, however, the business is worth far more than its carrying value. Furthermore, despite the problems this operation periodically hands us, it is the one - among all the fine businesses we own - that has the greatest potential.
+
+Marketable Securities
Below we list our common stock holdings having a value of over $100 million. A small portion of these investments belongs to subsidiaries of which Berkshire owns less than 100%.
++ + 12/31/90 + Shares Company Cost Market + ------ ------- ---------- ---------- + (000s omitted) + 3,000,000 Capital Cities/ABC, Inc. ............ $ 517,500 $1,377,375 +46,700,000 The Coca-Cola Co. ................... 1,023,920 2,171,550 + 2,400,000 Federal Home Loan Mortgage Corp. .... 71,729 117,000 + 6,850,000 GEICO Corp. ......................... 45,713 1,110,556 + 1,727,765 The Washington Post Company ......... 9,731 342,097 + 5,000,000 Wells Fargo & Company ............... 289,431 289,375+
Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.
+The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.
+Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.
+With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots - but I stay around those spots.")
+Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.
+Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.
+Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.
+None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.
+A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.
+Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.) Similarly, at the Buffalo News we would cheer lower prices for newsprint - even though it would mean marking down the value of the large inventory of newsprint we always keep on hand - because we know we are going to be perpetually buying the product.
+Identical reasoning guides our thinking about Berkshire's investments. We will be buying businesses - or small parts of businesses, called stocks - year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.
+The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.
+None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."
+* * * * * * * * * * * *
+Our other major portfolio change last year was large additions to our holdings of RJR Nabisco bonds, securities that we first bought in late 1989. At yearend 1990 we had $440 million invested in these securities, an amount that approximated market value. (As I write this, however, their market value has risen by more than $150 million.)
+Just as buying into the banking business is unusual for us, so is the purchase of below-investment-grade bonds. But opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare. Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly. (Woody Allen, in another context, pointed out the advantage of open-mindedness: "I can't understand why more people aren't bi-sexual because it doubles your chances for a date on Saturday night.")
+In the past we have bought a few below-investment-grade bonds with success, though these were all old-fashioned "fallen angels" - bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times. In the 1984 annual report we described our rationale for buying one fallen angel, the Washington Public Power Supply System.
+A kind of bastardized fallen angel burst onto the investment scene in the 1980s - "junk bonds" that were far below investment- grade when issued. As the decade progressed, new offerings of manufactured junk became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name. In 1990 - even before the recession dealt its blows - the financial sky became dark with the bodies of failing corporations.
+The disciples of debt assured us that this collapse wouldn't happen: Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly - and unnecessary - accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.
+In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses as the 1990s began.
+At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. One particularly egregious "kill- 'em-at-birth" case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station's gross revenues. Even if you assume that all labor, programs and services were donated rather than purchased, this capital structure required revenues to explode - or else the station was doomed to go broke. (Many of the bonds that financed the purchase were sold to now-failed savings and loan associations; as a taxpayer, you are picking up the tab for this folly.)
+All of this seems impossible now. When these misdeeds were done, however, dagger-selling investment bankers pointed to the "scholarly" research of academics, which reported that over the years the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds. (Beware of past-performance "proofs" in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.)
+There was a flaw in the salesmen's logic - one that a first- year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues. (That was an error similar to checking the historical death rate from Kool-Aid before drinking the version served at Jonestown.)
+The universes were of course dissimilar in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.
+Wall Street cared little for such distinctions. As usual, the Street's enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn't care to those who didn't think - and there was no shortage of either.
+Junk bonds remain a mine field, even at prices that today are often a small fraction of issue price. As we said last year, we have never bought a new issue of a junk bond. (The only time to buy these is on a day with no "y" in it.) We are, however, willing to look at the field, now that it is in disarray.
+In the case of RJR Nabisco, we feel the Company's credit is considerably better than was generally perceived for a while and that the yield we receive, as well as the potential for capital gain, more than compensates for the risk we incur (though that is far from nil). RJR has made asset sales at favorable prices, has added major amounts of equity, and in general is being run well.
+ However, as we survey the field, most low-grade bonds still look unattractive. The handiwork of the Wall Street of the 1980s is even worse than we had thought: Many important businesses have been mortally wounded. We will, though, keep looking for opportunities as the junk market continues to unravel.
+
+Convertible Preferred Stocks
We continue to hold the convertible preferred stocks described in earlier reports: $700 million of Salomon Inc, $600 million of The Gillette Company, $358 million of USAir Group, Inc. and $300 million of Champion International Corp. Our Gillette holdings will be converted into 12 million shares of common stock on April 1. Weighing interest rates, credit quality and prices of the related common stocks, we can assess our holdings in Salomon and Champion at yearend 1990 as worth about what we paid, Gillette as worth somewhat more, and USAir as worth substantially less.
+In making the USAir purchase, your Chairman displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems. (No one pushed me; in tennis parlance, I committed an "unforced error.") The company's troubles were brought on both by industry conditions and by the post-merger difficulties it encountered in integrating Piedmont, an affliction I should have expected since almost all airline mergers have been followed by operational turmoil.
+In short order, Ed Colodny and Seth Schofield resolved the second problem: The airline now gets excellent marks for service. Industry-wide problems have proved to be far more serious. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor.
+However, unless the industry is decimated during the next few years, our USAir investment should work out all right. Ed and Seth have decisively addressed the current turbulence by making major changes in operations. Even so, our investment is now less secure than at the time I made it.
+Our convertible preferred stocks are relatively simple securities, yet I should warn you that, if the past is any guide, you may from time to time read inaccurate or misleading statements about them. Last year, for example, several members of the press calculated the value of all our preferreds as equal to that of the common stock into which they are convertible. By their logic, that is, our Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80. But there is a small problem with this line of reasoning: Using it, one must conclude that all of the value of a convertible preferred resides in the conversion privilege and that the value of a non-convertible preferred of Salomon would be zero, no matter what its coupon or terms for redemption.
+The point you should keep in mind is that most of the value of our convertible preferreds is derived from their fixed-income characteristics. That means the securities cannot be worth less than the value they would possess as non-convertible preferreds and may be worth more because of their conversion options.
+* * * * * * * * * * * *
+I deeply regret having to end this section of the report with a note about my friend, Colman Mockler, Jr., CEO of Gillette, who died in January. No description better fitted Colman than "gentleman" - a word signifying integrity, courage and modesty. Couple these qualities with the humor and exceptional business ability that Colman possessed and you can understand why I thought it an undiluted pleasure to work with him and why I, and all others who knew him, will miss Colman so much.
+ A few days before Colman died, Gillette was richly praised in a Forbes cover story. Its theme was simple: The company's success in shaving products has come not from marketing savvy (though it exhibits that talent repeatedly) but has instead resulted from its devotion to quality. This mind-set has caused it to consistently focus its energies on coming up with something better, even though its existing products already ranked as the class of the field. In so depicting Gillette, Forbes in fact painted a portrait of Colman.
+
+Help! Help!
Regular readers know that I shamelessly utilize the annual letter in an attempt to acquire businesses for Berkshire. And, as we constantly preach at the Buffalo News, advertising does work: Several businesses have knocked on our door because someone has read in these pages of our interest in making acquisitions. (Any good ad salesman will tell you that trying to sell something without advertising is like winking at a girl in the dark.)
+In Appendix B (on pages 26-27) I've reproduced the essence of a letter I wrote a few years back to the owner/manager of a desirable business. If you have no personal connection with a business that might be of interest to us but have a friend who does, perhaps you can pass this report along to him.
+Here's the sort of business we are looking for:
+(1) Large purchases (at least $10 million of after-tax earnings),
+(2) Demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations),
+(3) Businesses earning good returns on equity while employing little or no debt,
+(4) Management in place (we can't supply it),
+(5) Simple businesses (if there's lots of technology, we won't understand it),
+(6) An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
+We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give.
+Our favorite form of purchase is one fitting the Blumkin- Friedman-Heldman mold. In cases like these, the company's owner- managers wish to generate significant amounts of cash, sometimes for themselves, but often for their families or inactive shareholders. At the same time, these managers wish to remain significant owners who continue to run their companies just as they have in the past. We think we offer a particularly good fit for owners with such objectives. We invite potential sellers to check us out by contacting people with whom we have done business in the past.
+Charlie and I frequently get approached about acquisitions that don't come close to meeting our tests: We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: "When the phone don't ring, you'll know it's me."
+ Besides being interested in the purchase of businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Capital Cities, Salomon, Gillette, USAir, and Champion. We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.
+
+Miscellaneous
Ken Chace has decided not to stand for reelection as a director at our upcoming annual meeting. We have no mandatory retirement age for directors at Berkshire (and won't!), but Ken, at 75 and living in Maine, simply decided to cut back his activities.
+Ken was my immediate choice to run the textile operation after Buffett Partnership, Ltd. assumed control of Berkshire early in 1965. Although I made an economic mistake in sticking with the textile business, I made no mistake in choosing Ken: He ran the operation well, he was always 100% straight with me about its problems, and he generated the funds that allowed us to diversify into insurance.
+My wife, Susan, will be nominated to succeed Ken. She is now the second largest shareholder of Berkshire and if she outlives me will inherit all of my stock and effectively control the company. She knows, and agrees, with my thoughts on successor management and also shares my view that neither Berkshire nor its subsidiary businesses and important investments should be sold simply because some very high bid is received for one or all.
+I feel strongly that the fate of our businesses and their managers should not depend on my health - which, it should be added, is excellent - and I have planned accordingly. Neither my estate plan nor that of my wife is designed to preserve the family fortune; instead, both are aimed at preserving the character of Berkshire and returning the fortune to society.
+Were I to die tomorrow, you could be sure of three things: (1) None of my stock would have to be sold; (2) Both a controlling shareholder and a manager with philosophies similar to mine would follow me; and (3) Berkshire's earnings would increase by $1 million annually, since Charlie would immediately sell our corporate jet, The Indefensible (ignoring my wish that it be buried with me).
+* * * * * * * * * * * *
+About 97.3% of all eligible shares participated in Berkshire's 1990 shareholder-designated contributions program. Contributions made through the program were $5.8 million, and 2,600 charities were recipients.
+We suggest that new shareholders read the description of our shareholder-designated contributions program that appears on pages 54-55. To participate in future programs, you must make sure your shares are registered in the name of the actual owner, not in the nominee name of a broker, bank or depository. Shares not so registered on August 31, 1991 will be ineligible for the 1991 program.
+In addition to the shareholder-designated contributions that Berkshire distributes, managers of our operating businesses make contributions, including merchandise, averaging about $1.5 million annually. These contributions support local charities, such as The United Way, and produce roughly commensurate benefits for our businesses.
+However, neither our operating managers nor officers of the parent company use Berkshire funds to make contributions to broad national programs or charitable activities of special personal interest to them, except to the extent they do so as shareholders. If your employees, including your CEO, wish to give to their alma maters or other institutions to which they feel a personal attachment, we believe they should use their own money, not yours.
+* * * * * * * * * * * *
+The annual meeting this year will be held at the Orpheum Theater in downtown Omaha at 9:30 a.m. on Monday, April 29, 1991. Attendance last year grew to a record 1,300, about a 100-fold increase from ten years ago.
+We recommend getting your hotel reservations early at one of these hotels: (1) The Radisson-Redick Tower, a small (88 rooms) but nice hotel across the street from the Orpheum; (2) the much larger Red Lion Hotel, located about a five-minute walk from the Orpheum; or (3) the Marriott, located in West Omaha about 100 yards from Borsheim's and a twenty minute drive from downtown. We will have buses at the Marriott that will leave at 8:30 and 8:45 for the meeting, and return after it ends.
+Charlie and I always enjoy the meeting, and we hope you can make it. The quality of our shareholders is reflected in the quality of the questions we get: We have never attended an annual meeting anywhere that features such a consistently high level of intelligent, owner-related questions.
+An attachment to our proxy material explains how you can obtain the card you will need for admission to the meeting. Because weekday parking can be tight around the Orpheum, we have lined up a number of nearby lots for our shareholders to use. The attachment also contains information about them.
+As usual, we will have buses to take you to Nebraska Furniture Mart and Borsheim's after the meeting and to take you to downtown hotels or to the airport later. I hope that you will allow plenty of time to fully explore the attractions of both stores. Those of you arriving early can visit the Furniture Mart any day of the week; it is open from 10 a.m. to 5:30 p.m. on Saturdays, and from noon to 5:30 p.m. on Sundays. While there, stop at the See's Candy cart and see for yourself the dawn of synergism at Berkshire.
+Borsheim's normally is closed on Sunday, but we will open for shareholders and their guests from noon to 6 p.m. on Sunday, April 28. At our Sunday opening last year you made Ike very happy: After totaling the day's volume, he suggested to me that we start holding annual meetings quarterly. Join us at Borsheim's even if you just come to watch; it's a show you shouldn't miss.
+Last year the first question at the annual meeting was asked by 11-year-old Nicholas Kenner, a third-generation shareholder from New York City. Nicholas plays rough: "How come the stock is down?" he fired at me. My answer was not memorable.
+We hope that other business engagements won't keep Nicholas away from this year's meeting. If he attends, he will be offered the chance to again ask the first question; Charlie and I want to tackle him while we're fresh. This year, however, it's Charlie's turn to answer.
+|
+ March 1, 1991 |
+
+ Warren E. Buffett |
+
| + | +
+ APPENDIX A |
+
U. S. STEEL ANNOUNCES SWEEPING MODERNIZATION SCHEME*
+| + | +
+ * An unpublished satire by Ben Graham, written in 1936 and given by the author to Warren Buffett in 1954. |
++ |
Myron C. Taylor, Chairman of U. S. Steel Corporation, today announced the long awaited plan for completely modernizing the world's largest industrial enterprise. Contrary to expectations, no changes will be made in the company's manufacturing or selling policies. Instead, the bookkeeping system is to be entirely revamped. By adopting and further improving a number of modern accounting and financial devices the corporation's earning power will be amazingly transformed. Even under the subnormal conditions of 1935, it is estimated that the new bookkeeping methods would have yielded a reported profit of close to $50 per share on the common stock. The scheme of improvement is the result of a comprehensive survey made by Messrs. Price, Bacon, Guthrie & Colpitts; it includes the following six points:
+1. Writing down of Plant Account to Minus $1,000,000,000.
+2. Par value of common stock to be reduced to 1¢.
+3. Payment of all wages and salaries in option warrants.
+4. Inventories to be carried at $1.
+5. Preferred Stock to be replaced by non-interest bearing bonds redeemable at 50% discount.
+6. A $1,000,000,000 Contingency Reserve to be established.
+The official statement of this extraordinary Modernization Plan follows in full:
+The Board of Directors of U. S. Steel Corporation is pleased to announce that after intensive study of the problems arising from changed conditions in the industry, it has approved a comprehensive plan for remodeling the Corporation's accounting methods. A survey by a Special Committee, aided and abetted by Messrs. Price, Bacon, Guthrie & Colpitts, revealed that our company has lagged somewhat behind other American business enterprises in utilizing certain advanced bookkeeping methods, by means of which the earning power may be phenomenally enhanced without requiring any cash outlay or any changes in operating or sales conditions. It has been decided not only to adopt these newer methods, but to develop them to a still higher stage of perfection. The changes adopted by the Board may be summarized under six heads, as follows:
+1. Fixed Assets to be written down to Minus $1,000,000,000.
+Many representative companies have relieved their income accounts of all charges for depreciation by writing down their plant account to $1. The Special Committee points out that if their plants are worth only $1, the fixed assets of U. S. Steel Corporation are worth a good deal less than that sum. It is now a well-recognized fact that many plants are in reality a liability rather than an asset, entailing not only depreciation charges, but taxes, maintenance, and other expenditures. Accordingly, the Board has decided to extend the write-down policy initiated in the 1935 report, and to mark down the Fixed Assets from $1,338,522,858.96 to a round Minus $1,000,000,000.
+The advantages of this move should be evident. As the plant wears out, the liability becomes correspondingly reduced. Hence, instead of the present depreciation charge of some $47,000,000 yearly there will be an annual appreciation credit of 5%, or $50,000,000. This will increase earnings by no less than $97,000,000 per annum.
+2. Reduction of Par Value of Common Stock to 1¢, and
+3. Payment of Salaries and Wages in Option Warrants.
+Many corporations have been able to reduce their overhead expenses substantially by paying a large part of their executive salaries in the form of options to buy stock, which carry no charge against earnings. The full possibilities of this modern device have apparently not been adequately realized. The Board of Directors has adopted the following advanced form of this idea:
+The entire personnel of the Corporation are to receive their compensation in the form of rights to buy common stock at $50 per share, at the rate of one purchase right for each $50 of salary and/or wages in their present amounts. The par value of the common stock is to be reduced to 1¢.
+The almost incredible advantages of this new plan are evident from the following:
+A. The payroll of the Corporation will be entirely eliminated, a saving of $250,000,000 per annum, based on 1935 operations.
+B. At the same time, the effective compensation of all our employees will be increased severalfold. Because of the large earnings per share to be shown on our common stock under the new methods, it is certain that the shares will command a price in the market far above the option level of $50 per share, making the readily realizable value of these option warrants greatly in excess of the present cash wages that they will replace.
+C. The Corporation will realize an additional large annual profit through the exercise of these warrants. Since the par value of the common stock will be fixed at 1¢, there will be a gain of $49.99 on each share subscribed for. In the interest of conservative accounting, however, this profit will not be included in the income account, but will be shown separately as a credit to Capital Surplus.
+D. The Corporation's cash position will be enormously strengthened. In place of the present annual cash outgo of $250,000,000 for wages (1935 basis), there will be annual cash inflow of $250,000,000 through exercise of the subscription warrants for 5,000,000 shares of common stock. The Company's large earnings and strong cash position will permit the payment of a liberal dividend which, in turn, will result in the exercise of these option warrants immediately after issuance which, in turn, will further improve the cash position which, in turn, will permit a higher dividend rate -- and so on, indefinitely.
+4. Inventories to be carried at $1.
+Serious losses have been taken during the depression due to the necessity of adjusting inventory value to market. Various enterprises -- notably in the metal and cotton-textile fields -- have successfully dealt with this problem by carrying all or part of their inventories at extremely low unit prices. The U. S. Steel Corporation has decided to adopt a still more progressive policy, and to carry its entire inventory at $1. This will be effected by an appropriate write-down at the end of each year, the amount of said write-down to be charged to the Contingency Reserve hereinafter referred to.
+The benefits to be derived from this new method are very great. Not only will it obviate all possibility of inventory depreciation, but it will substantially enhance the annual earnings of the Corporation. The inventory on hand at the beginning of the year, valued at $1, will be sold during the year at an excellent profit. It is estimated that our income will be increased by means of this method to the extent of at least $150,000,000 per annum which, by a coincidence, will about equal the amount of the write-down to be made each year against Contingency Reserve.
+A minority report of the Special Committee recommends that Accounts Receivable and Cash also be written down to $1, in the interest of consistency and to gain additional advantages similar to those just discussed. This proposal has been rejected for the time being because our auditors still require that any recoveries of receivables and cash so charged off be credited to surplus instead of to the year's income. It is expected, however, that this auditing rule -- which is rather reminiscent of the horse-and-buggy days -- will soon be changed in line with modern tendencies. Should this occur, the minority report will be given further and favorable consideration.
+5. Replacement of Preferred Stock by Non-Interest-Bearing Bonds Redeemable at 50% Discount.
+During the recent depression many companies have been able to offset their operating losses by including in income profits arising from repurchases of their own bonds at a substantial discount from par. Unfortunately the credit of U. S. Steel Corporation has always stood so high that this lucrative source of revenue has not hitherto been available to it. The Modernization Scheme will remedy this condition.
+It is proposed that each share of preferred stock be exchanged for $300 face value of non-interest-bearing sinking-fund notes, redeemable by lot at 50% of face value in 10 equal annual installments. This will require the issuance of $1,080,000,000 of new notes, of which $108,000,000 will be retired each year at a cost to the Corporation of only $54,000,000, thus creating an annual profit of the same amount.
+Like the wage-and/or-salary plan described under 3. above, this arrangement will benefit both the Corporation and its preferred stockholders. The latter are assured payment for their present shares at 150% of par value over an average period of five years. Since short-term securities yield practically no return at present, the non-interest-bearing feature is of no real importance. The Corporation will convert its present annual charge of $25,000,000 for preferred dividends into an annual bond-retirement profit of $54,000,000 -- an aggregate yearly gain of $79,000,000.
+6. Establishment of a Contingency Reserve of $1,000,000,000.
+The Directors are confident that the improvements hereinbefore described will assure the Corporation of a satisfactory earning power under all conditions in the future. Under modern accounting methods, however, it is unnecessary to incur the slightest risk of loss through adverse business developments of any sort, since all these may be provided for in advance by means of a Contingency Reserve.
+The Special Committee has recommended that the Corporation create such a Contingency Reserve in the fairly substantial amount of $1,000,000,000. As previously set forth, the annual write-down of inventory to $1 will be absorbed by this reserve. To prevent eventual exhaustion of the Contingency Reserve, it has been further decided that it be replenished each year by transfer of an appropriate sum from Capital Surplus. Since the latter is expected to increase each year by not less than $250,000,000 through the exercise of the Stock Option Warrants (see 3. above), it will readily make good any drains on the Contingency Reserve.
+In setting up this arrangement, the Board of Directors must confess regretfully that they have been unable to improve upon the devices already employed by important corporations in transferring large sums between Capital, Capital Surplus, Contingency Reserves and other Balance Sheet Accounts. In fact, it must be admitted that our entries will be somewhat too simple, and will lack that element of extreme mystification that characterizes the most advanced procedure in this field. The Board of Directors, however, have insisted upon clarity and simplicity in framing their Modernization Plan, even at the sacrifice of possible advantage to the Corporation's earning power.
+In order to show the combined effect of the new proposals upon the Corporation's earning power, we submit herewith a condensed Income Account for 1935 on two bases, viz:
+|
+
|
+
+
|
+
+ B. Pro-Forma |
+
|
+
|
+
+
|
+|
|
+
|
+
+ A. As Reported |
+|
|
+ Gross Receipts from all Sources (Including Inter-Company) |
+
+ $765,000,000 |
+
+ $765,000,000 |
+
|
+ Salaries and Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 251,000,000 |
+
+ -- |
+
|
+ Other Operating Expenses and Taxes . . . . . . . . . . . . . . . . . . |
+
+ 461,000,000 |
+
+ 311,000,000 |
+
|
+ Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 47,000,000 |
+
+ (50,000,000) |
+
|
+ Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 5,000,000 |
+
+ 5,000,000 |
+
|
+ Discount on Bonds Retired . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ -- |
+
+ (54,000,000) |
+
|
+ Preferred Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 25,000,000 |
+
+ -- |
+
|
+ Balance for Common . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ (24,000,000) |
+
+ 553,000,000 |
+
|
+ Average Shares Outstanding . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 8,703,252 |
+
+ 11,203,252 |
+
|
+ Earned Per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ ($2.76) |
+
+ $49.80 |
+
In accordance with a somewhat antiquated custom there is appended herewith a condensed pro-forma Balance Sheet of the U. S. Steel Corporation as of December 31, 1935, after giving effect to proposed changes in asset and liability accounts.
+
|
+ ASSETS |
+|
|
+ Fixed Assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ ($1,000,000,000) |
+
|
+ Cash Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 142,000,000 |
+
|
+ Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 56,000,000 |
+
|
+ Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 1 |
+
|
+ Miscellaneous Assets . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 27,000,000 |
+
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ ($774,999,999) |
+
|
+ LIABILITIES |
+|
|
+ Common Stock Par 1¢ (Par Value $87,032.52) Stated Value* |
+
+ ($3,500,000,000) |
+
|
+ Subsidiaries' Bonds and Stocks . . . . . . . . . . . . . . . . . . |
+
+ 113,000,000 |
+
|
+ New Sinking Fund Notes . . . . . . . . . . . . . . . . . . . . . . |
+
+ 1,080,000,000 |
+
|
+ Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 69,000,000 |
+
|
+ Contingency Reserve . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 1,000,000,000 |
+
|
+ Other Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 74,000,000 |
+
|
+ Initial Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ 389,000,001 |
+
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . |
+
+ ($774,999,999) |
+
*Given a Stated Value differing from Par Value, in accordance with the laws of the State of Virginia, where the company will be re-incorporated.
+It is perhaps unnecessary to point out to our stockholders that modern accounting methods give rise to balance sheets differing somewhat in appearance from those of a less advanced period. In view of the very large earning power that will result from these changes in the Corporation's Balance Sheet, it is not expected that undue attention will be paid to the details of assets and liabilities.
+In conclusion, the Board desires to point out that the combined procedure, whereby plant will be carried at a minus figure, our wage bill will be eliminated, and inventory will stand on our books at virtually nothing, will give U. S. Steel Corporation an enormous competitive advantage in the industry. We shall be able to sell our products at exceedingly low prices and still show a handsome margin of profit. It is the considered view of the Board of Directors that under the Modernization Scheme we shall be able to undersell all competitors to such a point that the anti-trust laws will constitute the only barrier to 100% domination of the industry.
+In making this statement, the Board is not unmindful of the possibility that some of our competitors may seek to offset our new advantages by adopting similar accounting improvements. We are confident, however, that U. S. Steel will be able to retain the loyalty of its customers, old and new, through the unique prestige that will accrue to it as the originator and pioneer in these new fields of service to the user of steel. Should necessity arise, moreover, we believe we shall be able to maintain our deserved superiority by introducing still more advanced bookkeeping methods, which are even now under development in our Experimental Accounting Laboratory.
+| + | +
+ APPENDIX B |
+
Some Thoughts on Selling Your Business*
+| + | +
+ *This is an edited version of a letter I sent some years ago to a man who had indicated that he might want to sell his family business. I present it here because it is a message I would like to convey to other prospective sellers. -- W.E.B. |
++ |
Dear _____________:
+Here are a few thoughts pursuant to our conversation of the other day.
+Most business owners spend the better part of their lifetimes building their businesses. By experience built upon endless repetition, they sharpen their skills in merchandising, purchasing, personnel selection, etc. It's a learning process, and mistakes made in one year often contribute to competence and success in succeeding years.
+In contrast, owner-managers sell their business only once -- frequently in an emotionally-charged atmosphere with a multitude of pressures coming from different directions. Often, much of the pressure comes from brokers whose compensation is contingent upon consummation of a sale, regardless of its consequences for both buyer and seller. The fact that the decision is so important, both financially and personally, to the owner can make the process more, rather than less, prone to error. And, mistakes made in the once-in-a-lifetime sale of a business are not reversible.
+Price is very important, but often is not the most critical aspect of the sale. You and your family have an extraordinary business -- one of a kind in your field -- and any buyer is going to recognize that. It's also a business that is going to get more valuable as the years go by. So if you decide not to sell now, you are very likely to realize more money later on. With that knowledge you can deal from strength and take the time required to select the buyer you want.
+If you should decide to sell, I think Berkshire Hathaway offers some advantages that most other buyers do not. Practically all of these buyers will fall into one of two categories:
+(1) A company located elsewhere but operating in your business or in a business somewhat akin to yours. Such a buyer -- no matter what promises are made -- will usually have managers who feel they know how to run your business operations and, sooner or later, will want to apply some hands-on "help." If the acquiring company is much larger, it often will have squads of managers, recruited over the years in part by promises that they will get to run future acquisitions. They will have their own way of doing things and, even though your business record undoubtedly will be far better than theirs, human nature will at some point cause them to believe that their methods of operating are superior. You and your family probably have friends who have sold their businesses to larger companies, and I suspect that their experiences will confirm the tendency of parent companies to take over the running of their subsidiaries, particularly when the parent knows the industry, or thinks it does.
+(2) A financial maneuverer, invariably operating with large amounts of borrowed money, who plans to resell either to the public or to another corporation as soon as the time is favorable. Frequently, this buyer's major contribution will be to change accounting methods so that earnings can be presented in the most favorable light just prior to his bailing out. I'm enclosing a recent article that describes this sort of transaction, which is becoming much more frequent because of a rising stock market and the great supply of funds available for such transactions.
+If the sole motive of the present owners is to cash their chips and put the business behind them -- and plenty of sellers fall in this category -- either type of buyer that I've just described is satisfactory. But if the sellers' business represents the creative work of a lifetime and forms an integral part of their personality and sense of being, buyers of either type have serious flaws.
+Berkshire is another kind of buyer -- a rather unusual one. We buy to keep, but we don't have, and don't expect to have, operating people in our parent organization. All of the businesses we own are run autonomously to an extraordinary degree. In most cases, the managers of important businesses we have owned for many years have not been to Omaha or even met each other. When we buy a business, the sellers go on running it just as they did before the sale; we adapt to their methods rather than vice versa.
+We have no one -- family, recently recruited MBAs, etc. -- to whom we have promised a chance to run businesses we have bought from owner-managers. And we won't have.
+You know of some of our past purchases. I'm enclosing a list of everyone from whom we have ever bought a business, and I invite you to check with them as to our performance versus our promises. You should be particularly interested in checking with the few whose businesses did not do well in order to ascertain how we behaved under difficult conditions.
+Any buyer will tell you that he needs you personally -- and if he has any brains, he most certainly does need you. But a great many buyers, for the reasons mentioned above, don't match their subsequent actions to their earlier words. We will behave exactly as promised, both because we have so promised, and because we need to in order to achieve the best business results.
+This need explains why we would want the operating members of your family to retain a 20% interest in the business. We need 80% to consolidate earnings for tax purposes, which is a step important to us. It is equally important to us that the family members who run the business remain as owners. Very simply, we would not want to buy unless we felt key members of present management would stay on as our partners. Contracts cannot guarantee your continued interest; we would simply rely on your word.
+The areas I get involved in are capital allocation and selection and compensation of the top man. Other personnel decisions, operating strategies, etc. are his bailiwick. Some Berkshire managers talk over some of their decisions with me; some don't. It depends upon their personalities and, to an extent, upon their own personal relationship with me.
+If you should decide to do business with Berkshire, we would pay in cash. Your business would not be used as collateral for any loan by Berkshire. There would be no brokers involved.
+Furthermore, there would be no chance that a deal would be announced and that the buyer would then back off or start suggesting adjustments (with apologies, of course, and with an explanation that banks, lawyers, boards of directors, etc. were to be blamed). And finally, you would know exactly with whom you are dealing. You would not have one executive negotiate the deal only to have someone else in charge a few years later, or have the president regretfully tell you that his board of directors required this change or that (or possibly required sale of your business to finance some new interest of the parent's).
+It's only fair to tell you that you would be no richer after the sale than now. The ownership of your business already makes you wealthy and soundly invested. A sale would change the form of your wealth, but it wouldn't change its amount. If you sell, you will have exchanged a 100%-owned valuable asset that you understand for another valuable asset -- cash -- that will probably be invested in small pieces (stocks) of other businesses that you understand less well. There is often a sound reason to sell but, if the transaction is a fair one, the reason is not so that the seller can become wealthier.
+I will not pester you; if you have any possible interest in selling, I would appreciate your call. I would be extraordinarily proud to have Berkshire, along with the key members of your family, own _______; I believe we would do very well financially; and I believe you would have just as much fun running the business over the next 20 years as you have had during the past 20.
+|
+
|
+
+ Sincerely, |
+
|
+
|
+
+ /s/ Warren E. Buffett |
+
+BERKSHIRE HATHAWAY INC. +
+ +
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+ Our gain in net worth during 1991 was $2.1 billion, or
+39.6%. Over the last 27 years (that is, since present management
+took over) our per-share book value has grown from $19 to $6,437,
+or at a rate of 23.7% compounded annually.
+
+ The size of our equity capital - which now totals $7.4
+billion - makes it certain that we cannot maintain our past rate
+of gain or, for that matter, come close to doing so. As Berkshire
+grows, the universe of opportunities that can significantly
+influence the company's performance constantly shrinks. When we
+were working with capital of $20 million, an idea or business
+producing $1 million of profit added five percentage points to
+our return for the year. Now we need a $370 million idea (i.e.,
+one contributing over $550 million of pre-tax profit) to achieve
+the same result. And there are many more ways to make $1 million
+than to make $370 million.
+
+ Charlie Munger, Berkshire's Vice Chairman, and I have set a
+goal of attaining a 15% average annual increase in Berkshire's
+intrinsic value. If our growth in book value is to keep up with a
+15% pace, we must earn $22 billion during the next decade. Wish
+us luck - we'll need it.
+
+ Our outsized gain in book value in 1991 resulted from a
+phenomenon not apt to be repeated: a dramatic rise in the price-
+earnings ratios of Coca-Cola and Gillette. These two stocks
+accounted for nearly $1.6 billion of our $2.1 billion growth in
+net worth last year. When we loaded up on Coke three years ago,
+Berkshire's net worth was $3.4 billion; now our Coke stock alone
+is worth more than that.
+
+ Coca-Cola and Gillette are two of the best companies in the
+world and we expect their earnings to grow at hefty rates in the
+years ahead. Over time, also, the value of our holdings in these
+stocks should grow in rough proportion. Last year, however, the
+valuations of these two companies rose far faster than their
+earnings. In effect, we got a double-dip benefit, delivered
+partly by the excellent earnings growth and even more so by the
+market's reappraisal of these stocks. We believe this reappraisal
+was warranted. But it can't recur annually: We'll have to settle
+for a single dip in the future.
+
+A Second Job
+
+ In 1989 when I - a happy consumer of five cans of Cherry
+Coke daily - announced our purchase of $1 billion worth of Coca-
+Cola stock, I described the move as a rather extreme example of
+putting our money where my mouth was. On August 18 of last year,
+when I was elected Interim Chairman of Salomon Inc, it was a
+different story: I put my mouth where our money was.
+
+ You've all read of the events that led to my appointment. My
+decision to take the job carried with it an implicit but
+important message: Berkshire's operating managers are so
+outstanding that I knew I could materially reduce the time I was
+spending at the company and yet remain confident that its
+economic progress would not skip a beat. The Blumkins, the
+Friedman family, Mike Goldberg, the Heldmans, Chuck Huggins, Stan
+Lipsey, Ralph Schey and Frank Rooney (CEO of H.H. Brown, our
+latest acquisition, which I will describe later) are all masters
+of their operations and need no help from me. My job is merely to
+treat them right and to allocate the capital they generate.
+Neither function is impeded by my work at Salomon.
+
+ The role that Charlie and I play in the success of our
+operating units can be illustrated by a story about George Mira,
+the one-time quarterback of the University of Miami, and his
+coach, Andy Gustafson. Playing Florida and near its goal line,
+Mira dropped back to pass. He spotted an open receiver but found
+his right shoulder in the unshakable grasp of a Florida
+linebacker. The right-handed Mira thereupon switched the ball to
+his other hand and threw the only left-handed pass of his life -
+for a touchdown. As the crowd erupted, Gustafson calmly turned to
+a reporter and declared: "Now that's what I call coaching."
+
+ Given the managerial stars we have at our operating units,
+Berkshire's performance is not affected if Charlie or I slip away
+from time to time. You should note, however, the "interim" in my
+Salomon title. Berkshire is my first love and one that will never
+fade: At the Harvard Business School last year, a student asked
+me when I planned to retire and I replied, "About five to ten
+years after I die."
+
+Sources of Reported Earnings
+
+ The table below shows the major sources of Berkshire's
+reported earnings. In this presentation, amortization of Goodwill
+and other major purchase-price accounting adjustments are not
+charged against the specific businesses to which they apply, but
+are instead aggregated and shown separately. This procedure lets
+you view the earnings of our businesses as they would have been
+reported had we not purchased them. I've explained in past
+reports why this form of presentation seems to us to be more
+useful to investors and managers than one utilizing generally
+accepted accounting principles (GAAP), which require purchase-
+price adjustments to be made on a business-by-business basis. The
+total net earnings we show in the table are, of course, identical
+to the GAAP total in our audited financial statements.
+
+ A large amount of additional information about these
+businesses is given on pages 33-47, where you also will find
+our segment earnings reported on a GAAP basis. However, we will
+not in this letter discuss each of our non-insurance operations,
+as we have in the past. Our businesses have grown in number - and
+will continue to grow - so it now makes sense to rotate coverage,
+discussing one or two in detail each year.
+
+ (000s omitted)
+ ----------------------------------------------
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ---------------------- ----------------------
+ 1991 1990 1991 1990
+ ---------- ---------- ---------- ----------
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............ $(119,593) $ (26,647) $ (77,229) $ (14,936)
+ Net Investment Income ... 331,846 327,047 285,173 282,613
+ H. H. Brown (acquired 7/1/91) 13,616 --- 8,611 ---
+ Buffalo News .............. 37,113 43,954 21,841 25,981
+ Fechheimer ................ 12,947 12,450 6,843 6,605
+ Kirby ..................... 35,726 27,445 22,555 17,613
+ Nebraska Furniture Mart ... 14,384 17,248 6,993 8,485
+ Scott Fetzer
+ Manufacturing Group .... 26,123 30,378 15,901 18,458
+ See's Candies ............. 42,390 39,580 25,575 23,892
+ Wesco - other than Insurance 12,230 12,441 8,777 9,676
+ World Book ................ 22,483 31,896 15,487 20,420
+ Amortization of Goodwill .. (4,113) (3,476) (4,098) (3,461)
+ Other Purchase-Price
+ Accounting Charges ..... (6,021) (5,951) (7,019) (6,856)
+ Interest Expense* ......... (89,250) (76,374) (57,165) (49,726)
+ Shareholder-Designated
+ Contributions .......... (6,772) (5,824) (4,388) (3,801)
+ Other ..................... 77,399 58,310 47,896 35,782
+ ---------- ---------- ---------- ----------
+Operating Earnings 400,508 482,477 315,753 370,745
+Sales of Securities 192,478 33,989 124,155 23,348
+Total Earnings - All Entities $ 592,986 $ 516,466 $ 439,908 $ 394,093
+
+*Excludes interest expense of Scott Fetzer Financial Group and
+ Mutual Savings & Loan.
+
+
+"Look-Through" Earnings
+
+ We've previously discussed look-through earnings, which
+consist of: (1) the operating earnings reported in the previous
+section, plus; (2) the retained operating earnings of major
+investees that, under GAAP accounting, are not reflected in our
+profits, less; (3) an allowance for the tax that would be paid by
+Berkshire if these retained earnings of investees had instead been
+distributed to us.
+
+ I've told you that over time look-through earnings must
+increase at about 15% annually if our intrinsic business value is
+to grow at that rate. Indeed, since present management took over in
+1965, our look-through earnings have grown at almost the identical
+23% rate of gain recorded for book value.
+
+ Last year, however, our look-through earnings did not grow at
+all but rather declined by 14%. To an extent, the decline was
+precipitated by two forces that I discussed in last year's report
+and that I warned you would have a negative effect on look-through
+earnings.
+
+ First, I told you that our media earnings - both direct and
+look-through - were "sure to decline" and they in fact did. The
+second force came into play on April 1, when the call of our
+Gillette preferred stock required us to convert it into common. The
+after-tax earnings in 1990 from our preferred had been about $45
+million, an amount somewhat higher than the combination in 1991 of
+three months of dividends on our preferred plus nine months of
+look-through earnings on the common.
+
+ Two other outcomes that I did not foresee also hurt look-
+through earnings in 1991. First, we had a break-even result from
+our interest in Wells Fargo (dividends we received from the company
+were offset by negative retained earnings). Last year I said that
+such a result at Wells was "a low-level possibility - not a
+likelihood." Second, we recorded significantly lower - though still
+excellent - insurance profits.
+
+ The following table shows you how we calculate look-through
+earnings, although I warn you that the figures are necessarily very
+rough. (The dividends paid to us by these investees have been
+included in the operating earnings itemized on page 6, mostly
+under "Insurance Group: Net Investment Income.")
+
+ Berkshire's Share
+ of Undistributed
+ Berkshire's Approximate Operating Earnings
+Berkshire's Major Investees Ownership at Yearend (in millions)
+--------------------------- ----------------------- ------------------
+
+ 1991 1990 1991 1990
+ ------ ------ -------- --------
+Capital Cities/ABC Inc. ........ 18.1% 17.9% $ 61 $ 85
+The Coca-Cola Company .......... 7.0% 7.0% 69 58
+Federal Home Loan Mortgage Corp. 3.4%(1) 3.2%(1) 15 10
+The Gillette Company ........... 11.0% --- 23(2) ---
+GEICO Corp. .................... 48.2% 46.1% 69 76
+The Washington Post Company .... 14.6% 14.6% 10 18
+Wells Fargo & Company .......... 9.6% 9.7% (17) 19(3)
+ -------- --------
+Berkshire's share of
+ undistributed earnings of major investees $230 $266
+Hypothetical tax on these undistributed investee earnings (30) (35)
+Reported operating earnings of Berkshire 316 371
+ -------- --------
+ Total look-through earnings of Berkshire $516 $602
+ ======== ========
+
+ (1) Net of minority interest at Wesco
+ (2) For the nine months after Berkshire converted its
+ preferred on April 1
+ (3) Calculated on average ownership for the year
+
+ * * * * * * * * * * * *
+
+ We also believe that investors can benefit by focusing on
+their own look-through earnings. To calculate these, they should
+determine the underlying earnings attributable to the shares they
+hold in their portfolio and total these. The goal of each investor
+should be to create a portfolio (in effect, a "company") that will
+deliver him or her the highest possible look-through earnings a
+decade or so from now.
+
+ An approach of this kind will force the investor to think
+about long-term business prospects rather than short-term stock
+market prospects, a perspective likely to improve results. It's
+true, of course, that, in the long run, the scoreboard for
+investment decisions is market price. But prices will be determined
+by future earnings. In investing, just as in baseball, to put runs
+on the scoreboard one must watch the playing field, not the
+scoreboard.
+
+A Change in Media Economics and Some Valuation Math
+
+ In last year's report, I stated my opinion that the decline in
+the profitability of media companies reflected secular as well as
+cyclical factors. The events of 1991 have fortified that case: The
+economic strength of once-mighty media enterprises continues to
+erode as retailing patterns change and advertising and
+entertainment choices proliferate. In the business world,
+unfortunately, the rear-view mirror is always clearer than the
+windshield: A few years back no one linked to the media business -
+neither lenders, owners nor financial analysts - saw the economic
+deterioration that was in store for the industry. (But give me a
+few years and I'll probably convince myself that I did.)
+
+ The fact is that newspaper, television, and magazine
+properties have begun to resemble businesses more than franchises
+in their economic behavior. Let's take a quick look at the
+characteristics separating these two classes of enterprise, keeping
+in mind, however, that many operations fall in some middle ground
+and can best be described as weak franchises or strong businesses.
+
+ An economic franchise arises from a product or service that:
+(1) is needed or desired; (2) is thought by its customers to have
+no close substitute and; (3) is not subject to price regulation.
+The existence of all three conditions will be demonstrated by a
+company's ability to regularly price its product or service
+aggressively and thereby to earn high rates of return on capital.
+Moreover, franchises can tolerate mis-management. Inept managers
+may diminish a franchise's profitability, but they cannot inflict
+mortal damage.
+
+ In contrast, "a business" earns exceptional profits only if it
+is the low-cost operator or if supply of its product or service is
+tight. Tightness in supply usually does not last long. With
+superior management, a company may maintain its status as a low-
+cost operator for a much longer time, but even then unceasingly
+faces the possibility of competitive attack. And a business, unlike
+a franchise, can be killed by poor management.
+
+ Until recently, media properties possessed the three
+characteristics of a franchise and consequently could both price
+aggressively and be managed loosely. Now, however, consumers
+looking for information and entertainment (their primary interest
+being the latter) enjoy greatly broadened choices as to where to
+find them. Unfortunately, demand can't expand in response to this
+new supply: 500 million American eyeballs and a 24-hour day are all
+that's available. The result is that competition has intensified,
+markets have fragmented, and the media industry has lost some -
+though far from all - of its franchise strength.
+
+ * * * * * * * * * * * *
+
+ The industry's weakened franchise has an impact on its value
+that goes far beyond the immediate effect on earnings. For an
+understanding of this phenomenon, let's look at some much over-
+simplified, but relevant, math.
+
+ A few years ago the conventional wisdom held that a newspaper,
+television or magazine property would forever increase its earnings
+at 6% or so annually and would do so without the employment of
+additional capital, for the reason that depreciation charges would
+roughly match capital expenditures and working capital requirements
+would be minor. Therefore, reported earnings (before amortization
+of intangibles) were also freely-distributable earnings, which
+meant that ownership of a media property could be construed as akin
+to owning a perpetual annuity set to grow at 6% a year. Say, next,
+that a discount rate of 10% was used to determine the present value
+of that earnings stream. One could then calculate that it was
+appropriate to pay a whopping $25 million for a property with
+current after-tax earnings of $1 million. (This after-tax multiplier
+of 25 translates to a multiplier on pre-tax earnings of about 16.)
+
+ Now change the assumption and posit that the $1 million
+represents "normal earning power" and that earnings will bob around
+this figure cyclically. A "bob-around" pattern is indeed the lot of
+most businesses, whose income stream grows only if their owners are
+willing to commit more capital (usually in the form of retained
+earnings). Under our revised assumption, $1 million of earnings,
+discounted by the same 10%, translates to a $10 million valuation.
+Thus a seemingly modest shift in assumptions reduces the property's
+valuation to 10 times after-tax earnings (or about 6 1/2 times
+pre-tax earnings).
+
+ Dollars are dollars whether they are derived from the
+operation of media properties or of steel mills. What in the past
+caused buyers to value a dollar of earnings from media far higher
+than a dollar from steel was that the earnings of a media property
+were expected to constantly grow (without the business requiring
+much additional capital), whereas steel earnings clearly fell in
+the bob-around category. Now, however, expectations for media have
+moved toward the bob-around model. And, as our simplified example
+illustrates, valuations must change dramatically when expectations
+are revised.
+
+ We have a significant investment in media - both through our
+direct ownership of Buffalo News and our shareholdings in The
+Washington Post Company and Capital Cities/ABC - and the intrinsic
+value of this investment has declined materially because of the
+secular transformation that the industry is experiencing. (Cyclical
+factors have also hurt our current look-through earnings, but these
+factors do not reduce intrinsic value.) However, as our Business
+Principles on page 2-3 note, one of the rules by which we run
+Berkshire is that we do not sell businesses - or investee holdings
+that we have classified as permanent - simply because we see ways
+to use the money more advantageously elsewhere. (We did sell
+certain other media holdings sometime back, but these were
+relatively small.)
+
+ The intrinsic value losses that we have suffered have been
+moderated because the Buffalo News, under Stan Lipsey's leadership,
+has done far better than most newspapers and because both Cap
+Cities and Washington Post are exceptionally well-managed. In
+particular, these companies stayed on the sidelines during the late
+1980's period in which purchasers of media properties regularly
+paid irrational prices. Also, the debt of both Cap Cities and
+Washington Post is small and roughly offset by cash that they hold.
+As a result, the shrinkage in the value of their assets has not
+been accentuated by the effects of leverage. Among publicly-owned
+media companies, our two investees are about the only ones
+essentially free of debt. Most of the other companies, through a
+combination of the aggressive acquisition policies they pursued and
+shrinking earnings, find themselves with debt equal to five or more
+times their current net income.
+
+ The strong balance sheets and strong managements of Cap Cities
+and Washington Post leave us more comfortable with these
+investments than we would be with holdings in any other media
+companies. Moreover, most media properties continue to have far
+better economic characteristics than those possessed by the average
+American business. But gone are the days of bullet-proof franchises
+and cornucopian economics.
+
+Twenty Years in a Candy Store
+
+ We've just passed a milestone: Twenty years ago, on January 3,
+1972, Blue Chip Stamps (then an affiliate of Berkshire and later
+merged into it) bought control of See's Candy Shops, a West Coast
+manufacturer and retailer of boxed-chocolates. The nominal price
+that the sellers were asking - calculated on the 100% ownership we
+ultimately attained - was $40 million. But the company had $10
+million of excess cash, and therefore the true offering price was
+$30 million. Charlie and I, not yet fully appreciative of the value
+of an economic franchise, looked at the company's mere $7 million
+of tangible net worth and said $25 million was as high as we would
+go (and we meant it). Fortunately, the sellers accepted our offer.
+
+ The sales of trading stamps by Blue Chip thereafter declined
+from $102.5 million in 1972 to $1.2 million in 1991. But See's
+candy sales in the same period increased from $29 million to $196
+million. Moreover, profits at See's grew even faster than sales,
+from $4.2 million pre-tax in 1972 to $42.4 million last year.
+
+ For an increase in profits to be evaluated properly, it must
+be compared with the incremental capital investment required to
+produce it. On this score, See's has been astounding: The company
+now operates comfortably with only $25 million of net worth, which
+means that our beginning base of $7 million has had to be
+supplemented by only $18 million of reinvested earnings. Meanwhile,
+See's remaining pre-tax profits of $410 million were distributed to
+Blue Chip/Berkshire during the 20 years for these companies to
+deploy (after payment of taxes) in whatever way made most sense.
+
+ In our See's purchase, Charlie and I had one important
+insight: We saw that the business had untapped pricing power.
+Otherwise, we were lucky twice over. First, the transaction was not
+derailed by our dumb insistence on a $25 million price. Second, we
+found Chuck Huggins, then See's executive vice-president, whom we
+instantly put in charge. Both our business and personal experiences
+with Chuck have been outstanding. One example: When the purchase
+was made, we shook hands with Chuck on a compensation arrangement -
+conceived in about five minutes and never reduced to a written
+contract - that remains unchanged to this day.
+
+ In 1991, See's sales volume, measured in dollars, matched that
+of 1990. In pounds, however, volume was down 4%. All of that
+slippage took place in the last two months of the year, a period
+that normally produces more than 80% of annual profits. Despite the
+weakness in sales, profits last year grew 7%, and our pre-tax
+profit margin was a record 21.6%.
+
+ Almost 80% of See's sales come from California and our
+business clearly was hurt by the recession, which hit the state
+with particular force late in the year. Another negative, however,
+was the mid-year initiation in California of a sales tax of 7%-8«%
+(depending on the county involved) on "snack food" that was deemed
+applicable to our candy.
+
+ Shareholders who are students of epistemological shadings will
+enjoy California's classifications of "snack" and "non-snack"
+foods:
+
+ Taxable "Snack" Foods Non-Taxable "Non-Snack" Foods
+ --------------------- -----------------------------
+ Ritz Crackers Soda Crackers
+ Popped Popcorn Unpopped Popcorn
+ Granola Bars Granola Cereal
+ Slice of Pie (Wrapped) Whole Pie
+ Milky Way Candy Bar Milky Way Ice Cream Bar
+
+ What - you are sure to ask - is the tax status of a melted
+Milky Way ice cream bar? In that androgynous form, does it more
+resemble an ice cream bar or a candy bar that has been left in the
+sun? It's no wonder that Brad Sherman, Chairman of California's
+State Board of Equalization, who opposed the snack food bill but
+must now administer it, has said: "I came to this job as a
+specialist in tax law. Now I find my constituents should have
+elected Julia Child."
+
+ Charlie and I have many reasons to be thankful for our
+association with Chuck and See's. The obvious ones are that we've
+earned exceptional returns and had a good time in the process.
+Equally important, ownership of See's has taught us much about the
+evaluation of franchises. We've made significant money in certain
+common stocks because of the lessons we learned at See's.
+
+H. H. Brown
+
+ We made a sizable acquisition in 1991 - the H. H. Brown
+Company - and behind this business is an interesting history. In
+1927 a 29-year-old businessman named Ray Heffernan purchased the
+company, then located in North Brookfield, Massachusetts, for
+$10,000 and began a 62-year career of running it. (He also found
+time for other pursuits: At age 90 he was still joining new golf
+clubs.) By Mr. Heffernan's retirement in early 1990 H. H. Brown had
+three plants in the United States and one in Canada; employed close
+to 2,000 people; and earned about $25 million annually before
+taxes.
+
+ Along the way, Frances Heffernan, one of Ray's daughters,
+married Frank Rooney, who was sternly advised by Mr. Heffernan
+before the wedding that he had better forget any ideas he might
+have about working for his father-in-law. That was one of Mr.
+Heffernan's few mistakes: Frank went on to become CEO of Melville
+Shoe (now Melville Corp.). During his 23 years as boss, from 1964
+through 1986, Melville's earnings averaged more than 20% on equity
+and its stock (adjusted for splits) rose from $16 to $960. And a
+few years after Frank retired, Mr. Heffernan, who had fallen ill,
+asked him to run Brown.
+
+ After Mr. Heffernan died late in 1990, his family decided to
+sell the company - and here we got lucky. I had known Frank for a
+few years but not well enough for him to think of Berkshire as a
+possible buyer. He instead gave the assignment of selling Brown to
+a major investment banker, which failed also to think of us. But
+last spring Frank was playing golf in Florida with John Loomis, a
+long-time friend of mine as well as a Berkshire shareholder, who is
+always on the alert for something that might fit us. Hearing about
+the impending sale of Brown, John told Frank that the company
+should be right up Berkshire's alley, and Frank promptly gave me a
+call. I thought right away that we would make a deal and before
+long it was done.
+
+ Much of my enthusiasm for this purchase came from Frank's
+willingness to continue as CEO. Like most of our managers, he has
+no financial need to work but does so because he loves the game and
+likes to excel. Managers of this stripe cannot be "hired" in the
+normal sense of the word. What we must do is provide a concert hall
+in which business artists of this class will wish to perform.
+
+ Brown (which, by the way, has no connection to Brown Shoe of
+St. Louis) is the leading North American manufacturer of work shoes
+and boots, and it has a history of earning unusually fine margins
+on sales and assets. Shoes are a tough business - of the billion
+pairs purchased in the United States each year, about 85% are
+imported - and most manufacturers in the industry do poorly. The
+wide range of styles and sizes that producers offer causes
+inventories to be heavy; substantial capital is also tied up in
+receivables. In this kind of environment, only outstanding managers
+like Frank and the group developed by Mr. Heffernan can prosper.
+
+ A distinguishing characteristic of H. H. Brown is one of the
+most unusual compensation systems I've encountered - but one that
+warms my heart: A number of key managers are paid an annual salary
+of $7,800, to which is added a designated percentage of the profits
+of the company after these are reduced by a charge for capital
+employed. These managers therefore truly stand in the shoes of
+owners. In contrast, most managers talk the talk but don't walk the
+walk, choosing instead to employ compensation systems that are long
+on carrots but short on sticks (and that almost invariably treat
+equity capital as if it were cost-free). The arrangement at Brown,
+in any case, has served both the company and its managers
+exceptionally well, which should be no surprise: Managers eager to
+bet heavily on their abilities usually have plenty of ability to
+bet on.
+
+ * * * * * * * * * * * *
+
+ It's discouraging to note that though we have on four
+occasions made major purchases of companies whose sellers were
+represented by prominent investment banks, we were in only one of
+these instances contacted by the investment bank. In the other
+three cases, I myself or a friend initiated the transaction at some
+point after the investment bank had solicited its own list of
+prospects. We would love to see an intermediary earn its fee by
+thinking of us - and therefore repeat here what we're looking for:
+
+ (1) Large purchases (at least $10 million of after-tax
+ earnings),
+ (2) Demonstrated consistent earning power (future projections
+ are of little interest to us, nor are "turnaround"
+ situations),
+ (3) Businesses earning good returns on equity while employing
+ little or no debt,
+ (4) Management in place (we can't supply it),
+ (5) Simple businesses (if there's lots of technology, we
+ won't understand it),
+ (6) An offering price (we don't want to waste our time or
+ that of the seller by talking, even preliminarily,
+ about a transaction when price is unknown).
+
+ We will not engage in unfriendly takeovers. We can promise
+complete confidentiality and a very fast answer - customarily
+within five minutes - as to whether we're interested. (With Brown,
+we didn't even need to take five.) We prefer to buy for cash, but
+will consider issuing stock when we receive as much in intrinsic
+business value as we give.
+
+ Our favorite form of purchase is one fitting the pattern
+through which we acquired Nebraska Furniture Mart, Fechheimer's and
+Borsheim's. In cases like these, the company's owner-managers wish
+to generate significant amounts of cash, sometimes for themselves,
+but often for their families or inactive shareholders. At the same
+time, these managers wish to remain significant owners who continue
+to run their companies just as they have in the past. We think we
+offer a particularly good fit for owners with such objectives and
+we invite potential sellers to check us out by contacting people
+with whom we have done business in the past.
+
+ Charlie and I frequently get approached about acquisitions
+that don't come close to meeting our tests: We've found that if
+you advertise an interest in buying collies, a lot of people will
+call hoping to sell you their cocker spaniels. A line from a
+country song expresses our feeling about new ventures, turnarounds,
+or auction-like sales: "When the phone don't ring, you'll know it's
+me."
+
+ Besides being interested in the purchase of businesses as
+described above, we are also interested in the negotiated purchase
+of large, but not controlling, blocks of stock comparable to those
+we hold in Capital Cities, Salomon, Gillette, USAir, Champion, and
+American Express. We are not interested, however, in receiving
+suggestions about purchases we might make in the general stock
+market.
+
+Insurance Operations
+
+ Shown below is an updated version of our usual table
+presenting key figures for the property-casualty insurance
+industry:
+
+ Yearly Change Combined Ratio Yearly Change Inflation Rate
+ in Premiums After Policyholder in Incurred Measured by
+ Written (%) Dividends Losses (%) GDP Deflator (%)
+ ------------- ------------------ ------------- ----------------
+1981 ..... 3.8 106.0 6.5 10.0
+1982 ..... 3.7 109.6 8.4 6.2
+1983 ..... 5.0 112.0 6.8 4.0
+1984 ..... 8.5 118.0 16.9 4.5
+1985 ..... 22.1 116.3 16.1 3.7
+1986 ..... 22.2 108.0 13.5 2.7
+1987 ..... 9.4 104.6 7.8 3.1
+1988 ..... 4.4 105.4 5.5 3.9
+1989 ..... 3.2 109.2 7.7 4.4
+1990 (Revised) 4.4 109.6 4.8 4.1
+1991 (Est.) 3.1 109.1 2.9 3.7
+
+ The combined ratio represents total insurance costs (losses
+incurred plus expenses) compared to revenue from premiums: A
+ratio below 100 indicates an underwriting profit, and one above
+100 indicates a loss. The higher the ratio, the worse the year.
+When the investment income that an insurer earns from holding
+policyholders' funds ("the float") is taken into account, a
+combined ratio in the 107 - 111 range typically produces an
+overall break-even result, exclusive of earnings on the funds
+provided by shareholders.
+
+ For the reasons laid out in previous reports, we expect the
+industry's incurred losses to grow at close to 10% annually, even
+in periods when general inflation runs considerably lower. (Over
+the last 25 years, incurred losses have in reality grown at a
+still faster rate, 11%.) If premium growth meanwhile materially
+lags that 10% rate, underwriting losses will mount.
+
+ However, the industry's tendency to under-reserve when
+business turns bad may obscure the picture for a time - and that
+could well describe the situation last year. Though premiums did
+not come close to growing 10%, the combined ratio failed to
+deteriorate as I had expected but instead slightly improved.
+Loss-reserve data for the industry indicate that there is reason
+to be skeptical of that outcome, and it may turn out that 1991's
+ratio should have been worse than was reported. In the long run,
+of course, trouble awaits managements that paper over operating
+problems with accounting maneuvers. Eventually, managements of
+this kind achieve the same result as the seriously-ill patient
+who tells his doctor: "I can't afford the operation, but would
+you accept a small payment to touch up the x-rays?"
+
+ Berkshire's insurance business has changed in ways that make
+combined ratios, our own or the industry's, largely irrelevant
+to our performance. What counts with us is the "cost of funds
+developed from insurance," or in the vernacular, "the cost of
+float."
+
+ Float - which we generate in exceptional amounts - is the
+total of loss reserves, loss adjustment expense reserves and
+unearned premium reserves minus agents balances, prepaid
+acquisition costs and deferred charges applicable to assumed
+reinsurance. And the cost of float is measured by our
+underwriting loss.
+
+ The table below shows our cost of float since we entered the
+business in 1967.
+
+ (1) (2) Yearend Yield
+ Underwriting Approximate on Long-Term
+ Loss Average Float Cost of Funds Govt. Bonds
+ ------------ ------------- --------------- -------------
+ (In $ Millions) (Ratio of 1 to 2)
+
+1967 ........ profit $17.3 less than zero 5.50%
+1968 ........ profit 19.9 less than zero 5.90%
+1969 ........ profit 23.4 less than zero 6.79%
+1970 ........ $0.37 32.4 1.14% 6.25%
+1971 ........ profit 52.5 less than zero 5.81%
+1972 ........ profit 69.5 less than zero 5.82%
+1973 ........ profit 73.3 less than zero 7.27%
+1974 ........ 7.36 79.1 9.30% 8.13%
+1975 ........ 11.35 87.6 12.96% 8.03%
+1976 ........ profit 102.6 less than zero 7.30%
+1977 ........ profit 139.0 less than zero 7.97%
+1978 ........ profit 190.4 less than zero 8.93%
+1979 ........ profit 227.3 less than zero 10.08%
+1980 ........ profit 237.0 less than zero 11.94%
+1981 ........ profit 228.4 less than zero 13.61%
+1982 ........ 21.56 220.6 9.77% 10.64%
+1983 ........ 33.87 231.3 14.64% 11.84%
+1984 ........ 48.06 253.2 18.98% 11.58%
+1985 ........ 44.23 390.2 11.34% 9.34%
+1986 ........ 55.84 797.5 7.00% 7.60%
+1987 ........ 55.43 1,266.7 4.38% 8.95%
+1988 ........ 11.08 1,497.7 0.74% 9.00%
+1989 ........ 24.40 1,541.3 1.58% 7.97%
+1990 ........ 26.65 1,637.3 1.63% 8.24%
+1991 ........ 119.6 1,895.0 6.31% 7.40%
+
+ As you can see, our cost of funds in 1991 was well below the
+U. S. Government's cost on newly-issued long-term bonds. We have in
+fact beat the government's rate in 20 of the 25 years we have been
+in the insurance business, often by a wide margin. We have over
+that time also substantially increased the amount of funds we hold,
+which counts as a favorable development but only because the cost
+of funds has been satisfactory. Our float should continue to grow;
+the challenge will be to garner these funds at a reasonable cost.
+
+ Berkshire continues to be a very large writer - perhaps the
+largest in the world - of "super-cat" insurance, which is coverage
+that other insurance companies buy to protect themselves against
+major catastrophic losses. Profits in this business are enormously
+volatile. As I mentioned last year, $100 million in super-cat
+premiums, which is roughly our annual expectation, could deliver us
+anything from a $100 million profit (in a year with no big
+catastrophe) to a $200 million loss (in a year in which a couple of
+major hurricanes and/or earthquakes come along).
+
+ We price this business expecting to pay out, over the long
+term, about 90% of the premiums we receive. In any given year,
+however, we are likely to appear either enormously profitable or
+enormously unprofitable. That is true in part because GAAP
+accounting does not allow us to set up reserves in the catastrophe-
+free years for losses that are certain to be experienced in other
+years. In effect, a one-year accounting cycle is ill-suited to the
+nature of this business - and that is a reality you should be aware
+of when you assess our annual results.
+
+ Last year there appears to have been, by our definition, one
+super-cat, but it will trigger payments from only about 25% of our
+policies. Therefore, we currently estimate the 1991 underwriting
+profit from our catastrophe business to have been about $11
+million. (You may be surprised to learn the identity of the biggest
+catastrophe in 1991: It was neither the Oakland fire nor Hurricane
+Bob, but rather a September typhoon in Japan that caused the
+industry an insured loss now estimated at about $4-$5 billion. At
+the higher figure, the loss from the typhoon would surpass that
+from Hurricane Hugo, the previous record-holder.)
+
+ Insurers will always need huge amounts of reinsurance
+protection for marine and aviation disasters as well as for natural
+catastrophes. In the 1980's much of this reinsurance was supplied
+by "innocents" - that is, by insurers that did not understand the
+risks of the business - but they have now been financially burned
+beyond recognition. (Berkshire itself was an innocent all too often
+when I was personally running the insurance operation.) Insurers,
+though, like investors, eventually repeat their mistakes. At some
+point - probably after a few catastrophe-scarce years - innocents
+will reappear and prices for super-cat policies will plunge to
+silly levels.
+
+ As long as apparently-adequate rates prevail, however, we will
+be a major participant in super-cat coverages. In marketing this
+product, we enjoy a significant competitive advantage because of
+our premier financial strength. Thinking insurers know that when
+"the big one" comes, many reinsurers who found it easy to write
+policies will find it difficult to write checks. (Some reinsurers
+can say what Jackie Mason does: "I'm fixed for life - as long as I
+don't buy anything.") Berkshire's ability to fulfill all its
+commitments under conditions of even extreme adversity is
+unquestioned.
+
+ Overall, insurance offers Berkshire its greatest
+opportunities. Mike Goldberg has accomplished wonders with this
+operation since he took charge and it has become a very valuable
+asset, albeit one that can't be appraised with any precision.
+
+Marketable Common Stocks
+
+ On the next page we list our common stock holdings having a
+value of over $100 million. A small portion of these investments
+belongs to subsidiaries of which Berkshire owns less than 100%.
+
+ 12/31/91
+ Shares Company Cost Market
+ ------ ------- ---------- ----------
+ (000s omitted)
+ 3,000,000 Capital Cities/ABC, Inc. ............ $ 517,500 $1,300,500
+46,700,000 The Coca-Cola Company. .............. 1,023,920 3,747,675
+ 2,495,200 Federal Home Loan Mortgage Corp. .... 77,245 343,090
+ 6,850,000 GEICO Corp. ......................... 45,713 1,363,150
+24,000,000 The Gillette Company ................ 600,000 1,347,000
+31,247,000 Guinness PLC ........................ 264,782 296,755
+ 1,727,765 The Washington Post Company ......... 9,731 336,050
+ 5,000,000 Wells Fargo & Company 289,431 290,000
+
+ As usual the list reflects our Rip Van Winkle approach to
+investing. Guinness is a new position. But we held the other seven
+stocks a year ago (making allowance for the conversion of our
+Gillette position from preferred to common) and in six of those we
+hold an unchanged number of shares. The exception is Federal Home
+Loan Mortgage ("Freddie Mac"), in which our shareholdings increased
+slightly. Our stay-put behavior reflects our view that the stock
+market serves as a relocation center at which money is moved from
+the active to the patient. (With tongue only partly in check, I
+suggest that recent events indicate that the much-maligned "idle
+rich" have received a bad rap: They have maintained or increased
+their wealth while many of the "energetic rich" - aggressive real
+estate operators, corporate acquirers, oil drillers, etc. - have
+seen their fortunes disappear.)
+
+ Our Guinness holding represents Berkshire's first significant
+investment in a company domiciled outside the United States.
+Guinness, however, earns its money in much the same fashion as
+Coca-Cola and Gillette, U.S.-based companies that garner most of
+their profits from international operations. Indeed, in the sense
+of where they earn their profits - continent-by-continent - Coca-
+Cola and Guinness display strong similarities. (But you'll never
+get their drinks confused - and your Chairman remains unmovably in
+the Cherry Coke camp.)
+
+ We continually search for large businesses with
+understandable, enduring and mouth-watering economics that are run
+by able and shareholder-oriented managements. This focus doesn't
+guarantee results: We both have to buy at a sensible price and get
+business performance from our companies that validates our
+assessment. But this investment approach - searching for the
+superstars - offers us our only chance for real success. Charlie
+and I are simply not smart enough, considering the large sums we
+work with, to get great results by adroitly buying and selling
+portions of far-from-great businesses. Nor do we think many others
+can achieve long-term investment success by flitting from flower to
+flower. Indeed, we believe that according the name "investors" to
+institutions that trade actively is like calling someone who
+repeatedly engages in one-night stands a romantic.
+
+ If my universe of business possibilities was limited, say, to
+private companies in Omaha, I would, first, try to assess the long-
+term economic characteristics of each business; second, assess the
+quality of the people in charge of running it; and, third, try to
+buy into a few of the best operations at a sensible price. I
+certainly would not wish to own an equal part of every business in
+town. Why, then, should Berkshire take a different tack when
+dealing with the larger universe of public companies? And since
+finding great businesses and outstanding managers is so difficult,
+why should we discard proven products? (I was tempted to say "the
+real thing.") Our motto is: "If at first you do succeed, quit
+trying."
+
+ John Maynard Keynes, whose brilliance as a practicing investor
+matched his brilliance in thought, wrote a letter to a business
+associate, F. C. Scott, on August 15, 1934 that says it all: "As
+time goes on, I get more and more convinced that the right method
+in investment is to put fairly large sums into enterprises which
+one thinks one knows something about and in the management of which
+one thoroughly believes. It is a mistake to think that one limits
+one's risk by spreading too much between enterprises about which
+one knows little and has no reason for special confidence. . . .
+One's knowledge and experience are definitely limited and there are
+seldom more than two or three enterprises at any given time in
+which I personally feel myself entitled to put full confidence."
+
+Mistake Du Jour
+
+ In the 1989 annual report I wrote about "Mistakes of the First
+25 Years" and promised you an update in 2015. My experiences in the
+first few years of this second "semester" indicate that my backlog
+of matters to be discussed will become unmanageable if I stick to
+my original plan. Therefore, I will occasionally unburden myself in
+these pages in the hope that public confession may deter further
+bumblings. (Post-mortems prove useful for hospitals and football
+teams; why not for businesses and investors?)
+
+ Typically, our most egregious mistakes fall in the omission,
+rather than the commission, category. That may spare Charlie and me
+some embarrassment, since you don't see these errors; but their
+invisibility does not reduce their cost. In this mea culpa, I am
+not talking about missing out on some company that depends upon an
+esoteric invention (such as Xerox), high-technology (Apple), or
+even brilliant merchandising (Wal-Mart). We will never develop the
+competence to spot such businesses early. Instead I refer to
+business situations that Charlie and I can understand and that seem
+clearly attractive - but in which we nevertheless end up sucking
+our thumbs rather than buying.
+
+ Every writer knows it helps to use striking examples, but I
+wish the one I now present wasn't quite so dramatic: In early 1988,
+we decided to buy 30 million shares (adjusted for a subsequent
+split) of Federal National Mortgage Association (Fannie Mae), which
+would have been a $350-$400 million investment. We had owned the
+stock some years earlier and understood the company's business.
+Furthermore, it was clear to us that David Maxwell, Fannie Mae's
+CEO, had dealt superbly with some problems that he had inherited
+and had established the company as a financial powerhouse - with
+the best yet to come. I visited David in Washington and confirmed
+that he would not be uncomfortable if we were to take a large
+position.
+
+ After we bought about 7 million shares, the price began to
+climb. In frustration, I stopped buying (a mistake that,
+thankfully, I did not repeat when Coca-Cola stock rose similarly
+during our purchase program). In an even sillier move, I
+surrendered to my distaste for holding small positions and sold the
+7 million shares we owned.
+
+ I wish I could give you a halfway rational explanation for my
+amateurish behavior vis-a-vis Fannie Mae. But there isn't one.
+What I can give you is an estimate as of yearend 1991 of the
+approximate gain that Berkshire didn't make because of your
+Chairman's mistake: about $1.4 billion.
+
+Fixed-Income Securities
+
+ We made several significant changes in our fixed-income
+portfolio during 1991. As I noted earlier, our Gillette preferred
+was called for redemption, which forced us to convert to common
+stock; we eliminated our holdings of an RJR Nabisco issue that was
+subject to an exchange offer and subsequent call; and we purchased
+fixed-income securities of American Express and First Empire State
+Corp., a Buffalo-based bank holding company. We also added to a
+small position in ACF Industries that we had established in late
+1990. Our largest holdings at yearend were:
+
+ (000s omitted)
+ ---------------------------------------
+ Cost of Preferreds and
+ Issuer Amortized Value of Bonds Market
+ ------ ------------------------ ------------
+ ACF Industries ................ $ 93,918(2) $118,683
+ American Express .............. 300,000 263,265(1)(2)
+ Champion International ........ 300,000(2) 300,000(1)
+ First Empire State 40,000 50,000(1)(2)
+ RJR Nabisco 222,148(2) 285,683
+ Salomon 700,000(2) 714,000(1)
+ USAir 358,000(2) 232,700(1)
+ Washington Public Power Systems 158,553(2) 203,071
+
+ (1) Fair value as determined by Charlie and me
+ (2) Carrying value in our financial statements
+
+ Our $40 million of First Empire State preferred carries a 9%
+coupon, is non-callable until 1996 and is convertible at $78.91 per
+share. Normally I would think a purchase of this size too small for
+Berkshire, but I have enormous respect for Bob Wilmers, CEO of
+First Empire, and like being his partner on any scale.
+
+ Our American Express preferred is not a normal fixed-income
+security. Rather it is a "Perc," which carries a fixed dividend of
+8.85% on our $300 million cost. Absent one exception mentioned
+later, our preferred must be converted three years after issuance,
+into a maximum of 12,244,898 shares. If necessary, a downward
+adjustment in the conversion ratio will be made in order to limit
+to $414 million the total value of the common we receive. Though
+there is thus a ceiling on the value of the common stock that we
+will receive upon conversion, there is no floor. The terms of the
+preferred, however, include a provision allowing us to extend the
+conversion date by one year if the common stock is below $24.50 on
+the third anniversary of our purchase.
+
+ Overall, our fixed-income investments have treated us well,
+both over the long term and recently. We have realized large
+capital gains from these holdings, including about $152 million in
+1991. Additionally, our after-tax yields have considerably exceeded
+those earned by most fixed-income portfolios.
+
+ Nevertheless, we have had some surprises, none greater than
+the need for me to involve myself personally and intensely in the
+Salomon situation. As I write this letter, I am also writing a
+letter for inclusion in Salomon's annual report and I refer you to
+that report for an update on the company. (Write to: Corporate
+Secretary, Salomon Inc, Seven World Trade Center, New York, NY
+10048) Despite the company's travails, Charlie and I believe our
+Salomon preferred stock increased slightly in value during 1991.
+Lower interest rates and a higher price for Salomon's common
+produced this result.
+
+ Last year I told you that our USAir investment "should work
+out all right unless the industry is decimated during the next few
+years." Unfortunately 1991 was a decimating period for the
+industry, as Midway, Pan Am and America West all entered
+bankruptcy. (Stretch the period to 14 months and you can add
+Continental and TWA.)
+
+ The low valuation that we have given USAir in our table
+reflects the risk that the industry will remain unprofitable for
+virtually all participants in it, a risk that is far from
+negligible. The risk is heightened by the fact that the courts have
+been encouraging bankrupt carriers to continue operating. These
+carriers can temporarily charge fares that are below the industry's
+costs because the bankrupts don't incur the capital costs faced by
+their solvent brethren and because they can fund their losses - and
+thereby stave off shutdown - by selling off assets. This burn-the-
+furniture-to-provide-firewood approach to fare-setting by bankrupt
+carriers contributes to the toppling of previously-marginal
+carriers, creating a domino effect that is perfectly designed to
+bring the industry to its knees.
+
+ Seth Schofield, who became CEO of USAir in 1991, is making
+major adjustments in the airline's operations in order to improve
+its chances of being one of the few industry survivors. There is no
+tougher job in corporate America than running an airline: Despite
+the huge amounts of equity capital that have been injected into it,
+the industry, in aggregate, has posted a net loss since its birth
+after Kitty Hawk. Airline managers need brains, guts, and
+experience - and Seth possesses all three of these attributes.
+
+Miscellaneous
+
+ About 97.7% of all eligible shares participated in Berkshire's
+1991 shareholder-designated contributions program. Contributions
+made through the program were $6.8 million, and 2,630 charities
+were recipients.
+
+ We suggest that new shareholders read the description of our
+shareholder-designated contributions program that appears on pages
+48-49. To participate in future programs, you must make sure your
+shares are registered in the name of the actual owner, not in the
+nominee name of a broker, bank or depository. Shares not so
+registered on August 31, 1992 will be ineligible for the 1992
+program.
+
+ In addition to the shareholder-designated contributions that
+Berkshire distributes, managers of our operating businesses make
+contributions, including merchandise, averaging about $1.5 million
+annually. These contributions support local charities, such as The
+United Way, and produce roughly commensurate benefits for our
+businesses.
+
+ However, neither our operating managers nor officers of the
+parent company use Berkshire funds to make contributions to broad
+national programs or charitable activities of special personal
+interest to them, except to the extent they do so as shareholders.
+If your employees, including your CEO, wish to give to their alma
+maters or other institutions to which they feel a personal
+attachment, we believe they should use their own money, not yours.
+
+ * * * * * * * * * * * *
+
+ The faithful will notice that, for the first time in some
+years, Charlie's annual letter to Wesco shareholders is not
+reprinted in this report. Since his letter is relatively barebones
+this year, Charlie said he saw no point in including it in these
+pages; my own recommendation, however, is that you get a copy of
+the Wesco report. Simply write: Corporate Secretary, Wesco
+Financial Corporation, 315 East Colorado Boulevard, Pasadena, CA
+91101.
+
+ * * * * * * * * * * * *
+
+ Malcolm G. Chace, Jr., now 88, has decided not to stand for
+election as a director this year. But the association of the Chace
+family with Berkshire will not end: Malcolm III (Kim), Malcolm's
+son, will be nominated to replace him.
+
+ In 1931, Malcolm went to work for Berkshire Fine Spinning
+Associates, which merged with Hathaway Manufacturing Co. in 1955 to
+form our present company. Two years later, Malcolm became Berkshire
+Hathaway's Chairman, a position he held as well in early 1965 when
+he made it possible for Buffett Partnership, Ltd. to buy a key
+block of Berkshire stock owned by some of his relatives. This
+purchase gave our partnership effective control of the company.
+Malcolm's immediate family meanwhile kept its Berkshire stock and
+for the last 27 years has had the second-largest holding in the
+company, trailing only the Buffett family. Malcolm has been a joy
+to work with and we are delighted that the long-running
+relationship between the Chace family and Berkshire is continuing
+to a new generation.
+
+
+ * * * * * * * * * * * *
+
+ The annual meeting this year will be held at the Orpheum
+Theater in downtown Omaha at 9:30 a.m. on Monday, April 27, 1992.
+Attendance last year grew to a record 1,550, but that still leaves
+plenty of room at the Orpheum.
+
+ We recommend that you get your hotel reservations early at one
+of these hotels: (1) The Radisson-Redick Tower, a small (88 rooms)
+but nice hotel across the street from the Orpheum; (2) the much
+larger Red Lion Hotel, located about a five-minute walk from the
+Orpheum; or (3) the Marriott, located in West Omaha about 100 yards
+from Borsheim's and a twenty minute drive from downtown. We will
+have buses at the Marriott that will leave at 8:30 and 8:45 for the
+meeting and return after it ends.
+
+ Charlie and I always enjoy the meeting, and we hope you can
+make it. The quality of our shareholders is reflected in the
+quality of the questions we get: We have never attended an annual
+meeting anywhere that features such a consistently high level of
+intelligent, owner-related questions.
+
+ An attachment to our proxy material explains how you can
+obtain the card you will need for admission to the meeting. With
+the admission card, we will enclose information about parking
+facilities located near the Orpheum. If you are driving, come a
+little early. Nearby lots fill up quickly and you may have to
+walk a few blocks.
+
+ As usual, we will have buses to take you to Nebraska Furniture
+Mart and Borsheim's after the meeting and to take you from there to
+downtown hotels or the airport later. I hope that you will allow
+plenty of time to fully explore the attractions of both stores.
+Those of you arriving early can visit the Furniture Mart any day of
+the week; it is open from 10 a.m. to 5:30 p.m. on Saturdays and
+from noon to 5:30 p.m. on Sundays. While there, stop at the See's
+Candy Cart and find out for yourself why Americans ate 26 million
+pounds of See's products last year.
+
+ Borsheim's normally is closed on Sunday, but we will be open
+for shareholders and their guests from noon to 6 p.m. on Sunday,
+April 26. Borsheim's will also have a special party the previous
+evening at which shareholders are welcome. (You must, however,
+write Mrs. Gladys Kaiser at our office for an invitation.) On
+display that evening will be a 150-year retrospective of the most
+exceptional timepieces made by Patek Philippe, including watches
+once owned by Queen Victoria, Pope Pius IX, Rudyard Kipling, Madame
+Curie and Albert Einstein. The centerpiece of the exhibition will
+be a $5 million watch whose design and manufacture required nine
+years of labor by Patek Philippe craftsmen. Along with the rest of
+the collection, this watch will be on display at the store on
+Sunday - unless Charlie has by then impulsively bought it.
+
+ Nicholas Kenner nailed me - again - at last year's meeting,
+pointing out that I had said in the 1990 annual report that he was
+11 in May 1990, when actually he was 9. So, asked Nicholas rather
+caustically: "If you can't get that straight, how do I know the
+numbers in the back [the financials] are correct?" I'm still
+searching for a snappy response. Nicholas will be at this year's
+meeting - he spurned my offer of a trip to Disney World on that
+day - so join us to watch a continuation of this lop-sided battle
+of wits.
+
+
+
+ Warren E. Buffett
+February 28, 1992 Chairman of the Board
+
+
+
+
diff --git a/berkshire-hathaway/1992/1-in/berkshire-hathaway-1992-letter.txt b/berkshire-hathaway/1992/1-in/berkshire-hathaway-1992-letter.txt
new file mode 100644
index 0000000..5937f3e
--- /dev/null
+++ b/berkshire-hathaway/1992/1-in/berkshire-hathaway-1992-letter.txt
@@ -0,0 +1,1386 @@
+
+
+
+
+
+ +BERKSHIRE HATHAWAY INC. +
+ +
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+
+ Our per-share book value increased 20.3% during 1992. Over
+the last 28 years (that is, since present management took over)
+book value has grown from $19 to $7,745, or at a rate of 23.6%
+compounded annually.
+
+ During the year, Berkshire's net worth increased by $1.52
+billion. More than 98% of this gain came from earnings and
+appreciation of portfolio securities, with the remainder coming
+from the issuance of new stock. These shares were issued as a
+result of our calling our convertible debentures for redemption
+on January 4, 1993, and of some holders electing to receive
+common shares rather than the cash that was their alternative.
+Most holders of the debentures who converted into common waited
+until January to do it, but a few made the move in December and
+therefore received shares in 1992. To sum up what happened to
+the $476 million of bonds we had outstanding: $25 million were
+converted into shares before yearend; $46 million were converted
+in January; and $405 million were redeemed for cash. The
+conversions were made at $11,719 per share, so altogether we
+issued 6,106 shares.
+
+ Berkshire now has 1,152,547 shares outstanding. That
+compares, you will be interested to know, to 1,137,778 shares
+outstanding on October 1, 1964, the beginning of the fiscal year
+during which Buffett Partnership, Ltd. acquired control of the
+company.
+
+ We have a firm policy about issuing shares of Berkshire,
+doing so only when we receive as much value as we give. Equal
+value, however, has not been easy to obtain, since we have always
+valued our shares highly. So be it: We wish to increase
+Berkshire's size only when doing that also increases the wealth
+of its owners.
+
+ Those two objectives do not necessarily go hand-in-hand as an
+amusing but value-destroying experience in our past illustrates.
+On that occasion, we had a significant investment in a bank
+whose management was hell-bent on expansion. (Aren't they all?)
+When our bank wooed a smaller bank, its owner demanded a stock
+swap on a basis that valued the acquiree's net worth and earning
+power at over twice that of the acquirer's. Our management -
+visibly in heat - quickly capitulated. The owner of the acquiree
+then insisted on one other condition: "You must promise me," he
+said in effect, "that once our merger is done and I have become a
+major shareholder, you'll never again make a deal this dumb."
+
+ You will remember that our goal is to increase our per-share
+intrinsic value - for which our book value is a conservative, but
+useful, proxy - at a 15% annual rate. This objective, however,
+cannot be attained in a smooth manner. Smoothness is
+particularly elusive because of the accounting rules that apply
+to the common stocks owned by our insurance companies, whose
+portfolios represent a high proportion of Berkshire's net worth.
+Since 1979, generally accepted accounting principles (GAAP) have
+required that these securities be valued at their market prices
+(less an adjustment for tax on any net unrealized appreciation)
+rather than at the lower of cost or market. Run-of-the-mill
+fluctuations in equity prices therefore cause our annual results
+to gyrate, especially in comparison to those of the typical
+industrial company.
+
+ To illustrate just how volatile our progress has been - and
+to indicate the impact that market movements have on short-term
+results - we show on the facing page our annual change in per-
+share net worth and compare it with the annual results (including
+dividends) of the S&P 500.
+
+ You should keep at least three points in mind as you
+evaluate this data. The first point concerns the many businesses
+we operate whose annual earnings are unaffected by changes in
+stock market valuations. The impact of these businesses on both
+our absolute and relative performance has changed over the years.
+Early on, returns from our textile operation, which then
+represented a significant portion of our net worth, were a major
+drag on performance, averaging far less than would have been the
+case if the money invested in that business had instead been
+invested in the S&P 500. In more recent years, as we assembled
+our collection of exceptional businesses run by equally
+exceptional managers, the returns from our operating businesses
+have been high - usually well in excess of the returns achieved
+by the S&P.
+
+ A second important factor to consider - and one that
+significantly hurts our relative performance - is that both the
+income and capital gains from our securities are burdened by a
+substantial corporate tax liability whereas the S&P returns are
+pre-tax. To comprehend the damage, imagine that Berkshire had
+owned nothing other than the S&P index during the 28-year period
+covered. In that case, the tax bite would have caused our
+corporate performance to be appreciably below the record shown in
+the table for the S&P. Under present tax laws, a gain for the
+S&P of 18% delivers a corporate holder of that index a return
+well short of 13%. And this problem would be intensified if
+corporate tax rates were to rise. This is a structural
+disadvantage we simply have to live with; there is no antidote
+for it.
+
+ The third point incorporates two predictions: Charlie
+Munger, Berkshire's Vice Chairman and my partner, and I are
+virtually certain that the return over the next decade from an
+investment in the S&P index will be far less than that of the
+past decade, and we are dead certain that the drag exerted by
+Berkshire's expanding capital base will substantially reduce our
+historical advantage relative to the index.
+
+ Making the first prediction goes somewhat against our grain:
+We've long felt that the only value of stock forecasters is to
+make fortune tellers look good. Even now, Charlie and I continue
+to believe that short-term market forecasts are poison and should
+be kept locked up in a safe place, away from children and also
+from grown-ups who behave in the market like children. However,
+it is clear that stocks cannot forever overperform their
+underlying businesses, as they have so dramatically done for some
+time, and that fact makes us quite confident of our forecast that
+the rewards from investing in stocks over the next decade will be
+significantly smaller than they were in the last. Our second
+conclusion - that an increased capital base will act as an anchor
+on our relative performance - seems incontestable. The only open
+question is whether we can drag the anchor along at some
+tolerable, though slowed, pace.
+
+ We will continue to experience considerable volatility in
+our annual results. That's assured by the general volatility of
+the stock market, by the concentration of our equity holdings in
+just a few companies, and by certain business decisions we have
+made, most especially our move to commit large resources to
+super-catastrophe insurance. We not only accept this volatility
+but welcome it: A tolerance for short-term swings improves our
+long-term prospects. In baseball lingo, our performance
+yardstick is slugging percentage, not batting average.
+
+The Salomon Interlude
+
+ Last June, I stepped down as Interim Chairman of Salomon Inc
+after ten months in the job. You can tell from Berkshire's 1991-
+92 results that the company didn't miss me while I was gone. But
+the reverse isn't true: I missed Berkshire and am delighted to
+be back full-time. There is no job in the world that is more fun
+than running Berkshire and I count myself lucky to be where I am.
+
+ The Salomon post, though far from fun, was interesting and
+worthwhile: In Fortune's annual survey of America's Most Admired
+Corporations, conducted last September, Salomon ranked second
+among 311 companies in the degree to which it improved its
+reputation. Additionally, Salomon Brothers, the securities
+subsidiary of Salomon Inc, reported record pre-tax earnings last
+year - 34% above the previous high.
+
+ Many people helped in the resolution of Salomon's problems
+and the righting of the firm, but a few clearly deserve special
+mention. It is no exaggeration to say that without the combined
+efforts of Salomon executives Deryck Maughan, Bob Denham, Don
+Howard, and John Macfarlane, the firm very probably would not
+have survived. In their work, these men were tireless,
+effective, supportive and selfless, and I will forever be
+grateful to them.
+
+ Salomon's lead lawyer in its Government matters, Ron Olson
+of Munger, Tolles & Olson, was also key to our success in getting
+through this trouble. The firm's problems were not only severe,
+but complex. At least five authorities - the SEC, the Federal
+Reserve Bank of New York, the U.S. Treasury, the U.S. Attorney
+for the Southern District of New York, and the Antitrust Division
+of the Department of Justice - had important concerns about
+Salomon. If we were to resolve our problems in a coordinated and
+prompt manner, we needed a lawyer with exceptional legal,
+business and human skills. Ron had them all.
+
+Acquisitions
+
+ Of all our activities at Berkshire, the most exhilarating
+for Charlie and me is the acquisition of a business with
+excellent economic characteristics and a management that we like,
+trust and admire. Such acquisitions are not easy to make but we
+look for them constantly. In the search, we adopt the same
+attitude one might find appropriate in looking for a spouse: It
+pays to be active, interested and open-minded, but it does not
+pay to be in a hurry.
+
+ In the past, I've observed that many acquisition-hungry
+managers were apparently mesmerized by their childhood reading of
+the story about the frog-kissing princess. Remembering her
+success, they pay dearly for the right to kiss corporate toads,
+expecting wondrous transfigurations. Initially, disappointing
+results only deepen their desire to round up new toads.
+("Fanaticism," said Santyana, "consists of redoubling your effort
+when you've forgotten your aim.") Ultimately, even the most
+optimistic manager must face reality. Standing knee-deep in
+unresponsive toads, he then announces an enormous "restructuring"
+charge. In this corporate equivalent of a Head Start program,
+the CEO receives the education but the stockholders pay the
+tuition.
+
+ In my early days as a manager I, too, dated a few toads.
+They were cheap dates - I've never been much of a sport - but my
+results matched those of acquirers who courted higher-priced
+toads. I kissed and they croaked.
+
+ After several failures of this type, I finally remembered
+some useful advice I once got from a golf pro (who, like all pros
+who have had anything to do with my game, wishes to remain
+anonymous). Said the pro: "Practice doesn't make perfect;
+practice makes permanent." And thereafter I revised my strategy
+and tried to buy good businesses at fair prices rather than fair
+businesses at good prices.
+
+ Last year, in December, we made an acquisition that is a
+prototype of what we now look for. The purchase was 82% of
+Central States Indemnity, an insurer that makes monthly payments
+for credit-card holders who are unable themselves to pay because
+they have become disabled or unemployed. Currently the company's
+annual premiums are about $90 million and profits about $10
+million. Central States is based in Omaha and managed by Bill
+Kizer, a friend of mine for over 35 years. The Kizer family -
+which includes sons Bill, Dick and John - retains 18% ownership
+of the business and will continue to run things just as it has in
+the past. We could not be associated with better people.
+
+ Coincidentally, this latest acquisition has much in common
+with our first, made 26 years ago. At that time, we purchased
+another Omaha insurer, National Indemnity Company (along with a
+small sister company) from Jack Ringwalt, another long-time
+friend. Jack had built the business from scratch and, as was the
+case with Bill Kizer, thought of me when he wished to sell.
+(Jack's comment at the time: "If I don't sell the company, my
+executor will, and I'd rather pick the home for it.") National
+Indemnity was an outstanding business when we bought it and
+continued to be under Jack's management. Hollywood has had good
+luck with sequels; I believe we, too, will.
+
+ Berkshire's acquisition criteria are described on page 23.
+Beyond purchases made by the parent company, however, our
+subsidiaries sometimes make small "add-on" acquisitions that
+extend their product lines or distribution capabilities. In this
+manner, we enlarge the domain of managers we already know to be
+outstanding - and that's a low-risk and high-return proposition.
+We made five acquisitions of this type in 1992, and one was not
+so small: At yearend, H. H. Brown purchased Lowell Shoe Company,
+a business with $90 million in sales that makes Nursemates, a
+leading line of shoes for nurses, and other kinds of shoes as
+well. Our operating managers will continue to look for add-on
+opportunities, and we would expect these to contribute modestly
+to Berkshire's value in the future.
+
+ Then again, a trend has emerged that may make further
+acquisitions difficult. The parent company made one purchase in
+1991, buying H. H. Brown, which is run by Frank Rooney, who has
+eight children. In 1992 our only deal was with Bill Kizer,
+father of nine. It won't be easy to keep this string going in
+1993.
+
+Sources of Reported Earnings
+
+ The table below shows the major sources of Berkshire's
+reported earnings. In this presentation, amortization of
+Goodwill and other major purchase-price accounting adjustments
+are not charged against the specific businesses to which they
+apply, but are instead aggregated and shown separately. This
+procedure lets you view the earnings of our businesses as they
+would have been reported had we not purchased them. I've
+explained in past reports why this form of presentation seems to
+us to be more useful to investors and managers than one utilizing
+GAAP, which requires purchase-price adjustments to be made on a
+business-by-business basis. The total net earnings we show in
+the table are, of course, identical to the GAAP total in our
+audited financial statements.
+
+ (000s omitted)
+ -----------------------------------------------
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ---------------------- ----------------------
+ 1992 1991 1992 1991
+ ---------- ---------- ---------- ----------
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............ $(108,961) $(119,593) $ (71,141) $ (77,229)
+ Net Investment Income.... 355,067 331,846 305,763 285,173
+ H. H. Brown (acquired 7/1/91) 27,883 13,616 17,340 8,611
+ Buffalo News .............. 47,863 37,113 28,163 21,841
+ Fechheimer ................ 13,698 12,947 7,267 6,843
+ Kirby ..................... 35,653 35,726 22,795 22,555
+ Nebraska Furniture Mart ... 17,110 14,384 8,072 6,993
+ Scott Fetzer
+ Manufacturing Group .... 31,954 26,123 19,883 15,901
+ See's Candies ............. 42,357 42,390 25,501 25,575
+ Wesco - other than Insurance 15,153 12,230 9,195 8,777
+ World Book ................ 29,044 22,483 19,503 15,487
+ Amortization of Goodwill .. (4,702) (4,113) (4,687) (4,098)
+ Other Purchase-Price
+ Accounting Charges ..... (7,385) (6,021) (8,383) (7,019)
+ Interest Expense* ......... (98,643) (89,250) (62,899) (57,165)
+ Shareholder-Designated
+ Contributions .......... (7,634) (6,772) (4,913) (4,388)
+ Other ..................... 72,223 77,399 36,267 47,896
+ ---------- ---------- ---------- ----------
+Operating Earnings .......... 460,680 400,508 347,726 315,753
+Sales of Securities ......... 89,937 192,478 59,559 124,155
+ ---------- ---------- ---------- ----------
+Total Earnings - All Entities $ 550,617 $ 592,986 $ 407,285 $ 439,908
+ ========== ========== ========== ==========
+
+*Excludes interest expense of Scott Fetzer Financial Group and Mutual
+ Savings & Loan. Includes $22.5 million in 1992 and $5.7 million in
+ 1991 of premiums paid on the early redemption of debt.
+
+
+ A large amount of additional information about these
+businesses is given on pages 37-47, where you will also find our
+segment earnings reported on a GAAP basis. Our goal is to give you
+all of the financial information that Charlie and I consider
+significant in making our own evaluation of Berkshire.
+
+"Look-Through" Earnings
+
+ We've previously discussed look-through earnings, which
+consist of: (1) the operating earnings reported in the previous
+section, plus; (2) the retained operating earnings of major
+investees that, under GAAP accounting, are not reflected in our
+profits, less; (3) an allowance for the tax that would be paid by
+Berkshire if these retained earnings of investees had instead been
+distributed to us. Though no single figure can be perfect, we
+believe that the look-through number more accurately portrays the
+earnings of Berkshire than does the GAAP number.
+
+ I've told you that over time look-through earnings must
+increase at about 15% annually if our intrinsic business value is
+to grow at that rate. Our look-through earnings in 1992 were $604
+million, and they will need to grow to more than $1.8 billion by
+the year 2000 if we are to meet that 15% goal. For us to get
+there, our operating subsidiaries and investees must deliver
+excellent performances, and we must exercise some skill in capital
+allocation as well.
+
+ We cannot promise to achieve the $1.8 billion target. Indeed,
+we may not even come close to it. But it does guide our decision-
+making: When we allocate capital today, we are thinking about what
+will maximize look-through earnings in 2000.
+
+ We do not, however, see this long-term focus as eliminating
+the need for us to achieve decent short-term results as well.
+After all, we were thinking long-range thoughts five or ten years
+ago, and the moves we made then should now be paying off. If
+plantings made confidently are repeatedly followed by disappointing
+harvests, something is wrong with the farmer. (Or perhaps with the
+farm: Investors should understand that for certain companies, and
+even for some industries, there simply is no good long-term
+strategy.) Just as you should be suspicious of managers who pump
+up short-term earnings by accounting maneuvers, asset sales and the
+like, so also should you be suspicious of those managers who fail
+to deliver for extended periods and blame it on their long-term
+focus. (Even Alice, after listening to the Queen lecture her about
+"jam tomorrow," finally insisted, "It must come sometimes to jam
+today.")
+
+ The following table shows you how we calculate look-through
+earnings, though I warn you that the figures are necessarily very
+rough. (The dividends paid to us by these investees have been
+included in the operating earnings itemized on page 8, mostly
+under "Insurance Group: Net Investment Income.")
+
+ Berkshire's Share
+ of Undistributed
+ Berkshire's Approximate Operating Earnings
+Berkshire's Major Investees Ownership at Yearend (in millions)
+--------------------------- ----------------------- ------------------
+ 1992 1991 1992 1991
+ -------- -------- -------- --------
+Capital Cities/ABC Inc. ....... 18.2% 18.1% $ 70 $ 61
+The Coca-Cola Company ......... 7.1% 7.0% 82 69
+Federal Home Loan Mortgage Corp. 8.2%(1) 3.4%(1) 29(2) 15
+GEICO Corp. ................... 48.1% 48.2% 34(3) 69(3)
+General Dynamics Corp. ........ 14.1% -- 11(2) --
+The Gillette Company .......... 10.9% 11.0% 38 23(2)
+Guinness PLC .................. 2.0% 1.6% 7 --
+The Washington Post Company ... 14.6% 14.6% 11 10
+Wells Fargo & Company ......... 11.5% 9.6% 16(2) (17)(2)
+ -------- -------- -------- --------
+Berkshire's share of
+ undistributed earnings of major investees $298 $230
+Hypothetical tax on these
+ undistributed investee earnings (42) (30)
+Reported operating earnings of Berkshire 348 316
+ -------- --------
+ Total look-through earnings of Berkshire $604 $516
+
+ (1) Net of minority interest at Wesco
+ (2) Calculated on average ownership for the year
+ (3) Excludes realized capital gains, which have been both
+recurring and significant
+
+Insurance Operations
+
+ Shown below is an updated version of our usual table
+presenting key figures for the property-casualty insurance
+industry:
+
+ Yearly Change Combined Ratio
+ in Premiums After Policyholder
+ Written (%) Dividends
+ ------------- ------------------
+
+1981 ........................... 3.8 106.0
+1982 ........................... 3.7 109.6
+1983 ........................... 5.0 112.0
+1984 ........................... 8.5 118.0
+1985 ........................... 22.1 116.3
+1986 ........................... 22.2 108.0
+1987 ........................... 9.4 104.6
+1988 ........................... 4.5 105.4
+1989 ........................... 3.2 109.2
+1990 ........................... 4.5 109.6
+1991 (Revised) ................. 2.4 108.8
+1992 (Est.) .................... 2.7 114.8
+
+ The combined ratio represents total insurance costs (losses
+incurred plus expenses) compared to revenue from premiums: A
+ratio below 100 indicates an underwriting profit, and one above
+100 indicates a loss. The higher the ratio, the worse the year.
+When the investment income that an insurer earns from holding
+policyholders' funds ("the float") is taken into account, a
+combined ratio in the 106 - 110 range typically produces an
+overall break-even result, exclusive of earnings on the funds
+provided by shareholders.
+
+ About four points in the industry's 1992 combined ratio can
+be attributed to Hurricane Andrew, which caused the largest
+insured loss in history. Andrew destroyed a few small insurers.
+Beyond that, it awakened some larger companies to the fact that
+their reinsurance protection against catastrophes was far from
+adequate. (It's only when the tide goes out that you learn who's
+been swimming naked.) One major insurer escaped insolvency
+solely because it had a wealthy parent that could promptly supply
+a massive transfusion of capital.
+
+ Bad as it was, however, Andrew could easily have been far
+more damaging if it had hit Florida 20 or 30 miles north of where
+it actually did and had hit Louisiana further east than was the
+case. All in all, many companies will rethink their reinsurance
+programs in light of the Andrew experience.
+
+ As you know we are a large writer - perhaps the largest in
+the world - of "super-cat" coverages, which are the policies that
+other insurance companies buy to protect themselves against major
+catastrophic losses. Consequently, we too took our lumps from
+Andrew, suffering losses from it of about $125 million, an amount
+roughly equal to our 1992 super-cat premium income. Our other
+super-cat losses, though, were negligible. This line of business
+therefore produced an overall loss of only $2 million for the
+year. (In addition, our investee, GEICO, suffered a net loss
+from Andrew, after reinsurance recoveries and tax savings, of
+about $50 million, of which our share is roughly $25 million.
+This loss did not affect our operating earnings, but did reduce
+our look-through earnings.)
+
+ In last year's report I told you that I hoped that our
+super-cat business would over time achieve a 10% profit margin.
+But I also warned you that in any given year the line was likely
+to be "either enormously profitable or enormously unprofitable."
+Instead, both 1991 and 1992 have come in close to a break-even
+level. Nonetheless, I see these results as aberrations and stick
+with my prediction of huge annual swings in profitability from
+this business.
+
+ Let me remind you of some characteristics of our super-cat
+policies. Generally, they are activated only when two things
+happen. First, the direct insurer or reinsurer we protect must
+suffer losses of a given amount - that's the policyholder's
+"retention" - from a catastrophe; and second, industry-wide
+insured losses from the catastrophe must exceed some minimum
+level, which usually is $3 billion or more. In most cases, the
+policies we issue cover only a specific geographical area, such
+as a portion of the U.S., the entire U.S., or everywhere other
+than the U.S. Also, many policies are not activated by the first
+super-cat that meets the policy terms, but instead cover only a
+"second-event" or even a third- or fourth-event. Finally, some
+policies are triggered only by a catastrophe of a specific type,
+such as an earthquake. Our exposures are large: We have one
+policy that calls for us to pay $100 million to the policyholder
+if a specified catastrophe occurs. (Now you know why I suffer
+eyestrain: from watching The Weather Channel.)
+
+ Currently, Berkshire is second in the U.S. property-casualty
+industry in net worth (the leader being State Farm, which neither
+buys nor sells reinsurance). Therefore, we have the capacity to
+assume risk on a scale that interests virtually no other company.
+We have the appetite as well: As Berkshire's net worth and
+earnings grow, our willingness to write business increases also.
+But let me add that means good business. The saying, "a fool
+and his money are soon invited everywhere," applies in spades in
+reinsurance, and we actually reject more than 98% of the business
+we are offered. Our ability to choose between good and bad
+proposals reflects a management strength that matches our
+financial strength: Ajit Jain, who runs our reinsurance
+operation, is simply the best in this business. In combination,
+these strengths guarantee that we will stay a major factor in the
+super-cat business so long as prices are appropriate.
+
+ What constitutes an appropriate price, of course, is
+difficult to determine. Catastrophe insurers can't simply
+extrapolate past experience. If there is truly "global warming,"
+for example, the odds would shift, since tiny changes in
+atmospheric conditions can produce momentous changes in weather
+patterns. Furthermore, in recent years there has been a
+mushrooming of population and insured values in U.S. coastal
+areas that are particularly vulnerable to hurricanes, the number
+one creator of super-cats. A hurricane that caused x dollars of
+damage 20 years ago could easily cost 10x now.
+
+ Occasionally, also, the unthinkable happens. Who would have
+guessed, for example, that a major earthquake could occur in
+Charleston, S.C.? (It struck in 1886, registered an estimated 6.6
+on the Richter scale, and caused 60 deaths.) And who could have
+imagined that our country's most serious quake would occur at New
+Madrid, Missouri, which suffered an estimated 8.7 shocker in
+1812. By comparison, the 1989 San Francisco quake was a 7.1 -
+and remember that each one-point Richter increase represents a
+ten-fold increase in strength. Someday, a U.S. earthquake
+occurring far from California will cause enormous losses for
+insurers.
+
+ When viewing our quarterly figures, you should understand
+that our accounting for super-cat premiums differs from our
+accounting for other insurance premiums. Rather than recording
+our super-cat premiums on a pro-rata basis over the life of a
+given policy, we defer recognition of revenue until a loss occurs
+or until the policy expires. We take this conservative approach
+because the likelihood of super-cats causing us losses is
+particularly great toward the end of the year. It is then that
+weather tends to kick up: Of the ten largest insured losses in
+U.S. history, nine occurred in the last half of the year. In
+addition, policies that are not triggered by a first event are
+unlikely, by their very terms, to cause us losses until late in
+the year.
+
+ The bottom-line effect of our accounting procedure for
+super-cats is this: Large losses may be reported in any quarter
+of the year, but significant profits will only be reported in the
+fourth quarter.
+
+ * * * * * * * * * * * *
+
+ As I've told you in each of the last few years, what counts
+in our insurance business is "the cost of funds developed from
+insurance," or in the vernacular, "the cost of float." Float -
+which we generate in exceptional amounts - is the total of loss
+reserves, loss adjustment expense reserves and unearned premium
+reserves minus agents' balances, prepaid acquisition costs and
+deferred charges applicable to assumed reinsurance. The cost of
+float is measured by our underwriting loss.
+
+ The table below shows our cost of float since we entered the
+business in 1967.
+
+ (1) (2) Yearend Yield
+ Underwriting Approximate on Long-Term
+ Loss Average Float Cost of Funds Govt. Bonds
+ ------------ ------------- --------------- -------------
+ (In $ Millions) (Ratio of 1 to 2)
+
+1967 ......... profit $17.3 less than zero 5.50%
+1968 ......... profit 19.9 less than zero 5.90%
+1969 ......... profit 23.4 less than zero 6.79%
+1970 ......... $ 0.37 32.4 1.14% 6.25%
+1971 ......... profit 52.5 less than zero 5.81%
+1972 ......... profit 69.5 less than zero 5.82%
+1973 ......... profit 73.3 less than zero 7.27%
+1974 ......... 7.36 79.1 9.30% 8.13%
+1975 ......... 11.35 87.6 12.96% 8.03%
+1976 ......... profit 102.6 less than zero 7.30%
+1977 ......... profit 139.0 less than zero 7.97%
+1978 ......... profit 190.4 less than zero 8.93%
+1979 ......... profit 227.3 less than zero 10.08%
+1980 ......... profit 237.0 less than zero 11.94%
+1981 ......... profit 228.4 less than zero 13.61%
+1982 ......... 21.56 220.6 9.77% 10.64%
+1983 ......... 33.87 231.3 14.64% 11.84%
+1984 ......... 48.06 253.2 18.98% 11.58%
+1985 ......... 44.23 390.2 11.34% 9.34%
+1986 ......... 55.84 797.5 7.00% 7.60%
+1987 ......... 55.43 1,266.7 4.38% 8.95%
+1988 ......... 11.08 1,497.7 0.74% 9.00%
+1989 ......... 24.40 1,541.3 1.58% 7.97%
+1990 ......... 26.65 1,637.3 1.63% 8.24%
+1991 ......... 119.59 1,895.0 6.31% 7.40%
+1992 ......... 108.96 2,290.4 4.76% 7.39%
+
+ Last year, our insurance operation again generated funds at a
+cost below that incurred by the U.S. Government on its newly-issued
+long-term bonds. This means that in 21 years out of the 26 years
+we have been in the insurance business we have beaten the
+Government's rate, and often we have done so by a wide margin.
+(If, on average, we didn't beat the Government's rate, there would
+be no economic reason for us to be in the business.)
+
+ In 1992, as in previous years, National Indemnity's commercial
+auto and general liability business, led by Don Wurster, and our
+homestate operation, led by Rod Eldred, made excellent
+contributions to our low cost of float. Indeed, both of these
+operations recorded an underwriting profit last year, thereby
+generating float at a less-than-zero cost. The bulk of our float,
+meanwhile, comes from large transactions developed by Ajit. His
+efforts are likely to produce a further growth in float during
+1993.
+
+ Charlie and I continue to like the insurance business, which
+we expect to be our main source of earnings for decades to come.
+The industry is huge; in certain sectors we can compete world-wide;
+and Berkshire possesses an important competitive advantage. We
+will look for ways to expand our participation in the business,
+either indirectly as we have done through GEICO or directly as we
+did by acquiring Central States Indemnity.
+
+
+Common Stock Investments
+
+ Below we list our common stock holdings having a value of over
+$100 million. A small portion of these investments belongs to
+subsidiaries of which Berkshire owns less than 100%.
+
+ 12/31/92
+ Shares Company Cost Market
+ ------ ------- ---------- ----------
+ (000s omitted)
+ 3,000,000 Capital Cities/ABC, Inc. ............. $ 517,500 $1,523,500
+93,400,000 The Coca-Cola Company. ............... 1,023,920 3,911,125
+16,196,700 Federal Home Loan Mortgage Corp.
+ ("Freddie Mac") ................... 414,257 783,515
+34,250,000 GEICO Corp. .......................... 45,713 2,226,250
+ 4,350,000 General Dynamics Corp. ............... 312,438 450,769
+24,000,000 The Gillette Company ................. 600,000 1,365,000
+38,335,000 Guinness PLC ......................... 333,019 299,581
+ 1,727,765 The Washington Post Company .......... 9,731 396,954
+ 6,358,418 Wells Fargo & Company ................ 380,983 485,624
+
+ Leaving aside splits, the number of shares we held in these
+companies changed during 1992 in only four cases: We added
+moderately to our holdings in Guinness and Wells Fargo, we more
+than doubled our position in Freddie Mac, and we established a new
+holding in General Dynamics. We like to buy.
+
+ Selling, however, is a different story. There, our pace of
+activity resembles that forced upon a traveler who found himself
+stuck in tiny Podunk's only hotel. With no T.V. in his room, he
+faced an evening of boredom. But his spirits soared when he spied
+a book on the night table entitled "Things to do in Podunk."
+Opening it, he found just a single sentence: "You're doing it."
+
+ We were lucky in our General Dynamics purchase. I had paid
+little attention to the company until last summer, when it
+announced it would repurchase about 30% of its shares by way of a
+Dutch tender. Seeing an arbitrage opportunity, I began buying the
+stock for Berkshire, expecting to tender our holdings for a small
+profit. We've made the same sort of commitment perhaps a half-
+dozen times in the last few years, reaping decent rates of return
+for the short periods our money has been tied up.
+
+ But then I began studying the company and the accomplishments
+of Bill Anders in the brief time he'd been CEO. And what I saw
+made my eyes pop: Bill had a clearly articulated and rational
+strategy; he had been focused and imbued with a sense of urgency in
+carrying it out; and the results were truly remarkable.
+
+ In short order, I dumped my arbitrage thoughts and decided
+that Berkshire should become a long-term investor with Bill. We
+were helped in gaining a large position by the fact that a tender
+greatly swells the volume of trading in a stock. In a one-month
+period, we were able to purchase 14% of the General Dynamics shares
+that remained outstanding after the tender was completed.
+
+ * * * * * * * * * * * *
+
+ Our equity-investing strategy remains little changed from what
+it was fifteen years ago, when we said in the 1977 annual report:
+"We select our marketable equity securities in much the way we
+would evaluate a business for acquisition in its entirety. We want
+the business to be one (a) that we can understand; (b) with
+favorable long-term prospects; (c) operated by honest and competent
+people; and (d) available at a very attractive price." We have
+seen cause to make only one change in this creed: Because of both
+market conditions and our size, we now substitute "an attractive
+price" for "a very attractive price."
+
+ But how, you will ask, does one decide what's "attractive"?
+In answering this question, most analysts feel they must choose
+between two approaches customarily thought to be in opposition:
+"value" and "growth." Indeed, many investment professionals see
+any mixing of the two terms as a form of intellectual cross-
+dressing.
+
+ We view that as fuzzy thinking (in which, it must be
+confessed, I myself engaged some years ago). In our opinion, the
+two approaches are joined at the hip: Growth is always a component
+in the calculation of value, constituting a variable whose
+importance can range from negligible to enormous and whose impact
+can be negative as well as positive.
+
+ In addition, we think the very term "value investing" is
+redundant. What is "investing" if it is not the act of seeking
+value at least sufficient to justify the amount paid? Consciously
+paying more for a stock than its calculated value - in the hope
+that it can soon be sold for a still-higher price - should be
+labeled speculation (which is neither illegal, immoral nor - in our
+view - financially fattening).
+
+ Whether appropriate or not, the term "value investing" is
+widely used. Typically, it connotes the purchase of stocks having
+attributes such as a low ratio of price to book value, a low price-
+earnings ratio, or a high dividend yield. Unfortunately, such
+characteristics, even if they appear in combination, are far from
+determinative as to whether an investor is indeed buying something
+for what it is worth and is therefore truly operating on the
+principle of obtaining value in his investments. Correspondingly,
+opposite characteristics - a high ratio of price to book value, a
+high price-earnings ratio, and a low dividend yield - are in no way
+inconsistent with a "value" purchase.
+
+ Similarly, business growth, per se, tells us little about
+value. It's true that growth often has a positive impact on value,
+sometimes one of spectacular proportions. But such an effect is
+far from certain. For example, investors have regularly poured
+money into the domestic airline business to finance profitless (or
+worse) growth. For these investors, it would have been far better
+if Orville had failed to get off the ground at Kitty Hawk: The more
+the industry has grown, the worse the disaster for owners.
+
+ Growth benefits investors only when the business in point can
+invest at incremental returns that are enticing - in other words,
+only when each dollar used to finance the growth creates over a
+dollar of long-term market value. In the case of a low-return
+business requiring incremental funds, growth hurts the investor.
+
+ In The Theory of Investment Value, written over 50 years ago,
+John Burr Williams set forth the equation for value, which we
+condense here: The value of any stock, bond or business today is
+determined by the cash inflows and outflows - discounted at an
+appropriate interest rate - that can be expected to occur during
+the remaining life of the asset. Note that the formula is the same
+for stocks as for bonds. Even so, there is an important, and
+difficult to deal with, difference between the two: A bond has a
+coupon and maturity date that define future cash flows; but in the
+case of equities, the investment analyst must himself estimate the
+future "coupons." Furthermore, the quality of management affects
+the bond coupon only rarely - chiefly when management is so inept
+or dishonest that payment of interest is suspended. In contrast,
+the ability of management can dramatically affect the equity
+"coupons."
+
+ The investment shown by the discounted-flows-of-cash
+calculation to be the cheapest is the one that the investor should
+purchase - irrespective of whether the business grows or doesn't,
+displays volatility or smoothness in its earnings, or carries a
+high price or low in relation to its current earnings and book
+value. Moreover, though the value equation has usually shown
+equities to be cheaper than bonds, that result is not inevitable:
+When bonds are calculated to be the more attractive investment,
+they should be bought.
+
+ Leaving the question of price aside, the best business to own
+is one that over an extended period can employ large amounts of
+incremental capital at very high rates of return. The worst
+business to own is one that must, or will, do the opposite - that
+is, consistently employ ever-greater amounts of capital at very low
+rates of return. Unfortunately, the first type of business is very
+hard to find: Most high-return businesses need relatively little
+capital. Shareholders of such a business usually will benefit if
+it pays out most of its earnings in dividends or makes significant
+stock repurchases.
+
+ Though the mathematical calculations required to evaluate
+equities are not difficult, an analyst - even one who is
+experienced and intelligent - can easily go wrong in estimating
+future "coupons." At Berkshire, we attempt to deal with this
+problem in two ways. First, we try to stick to businesses we
+believe we understand. That means they must be relatively simple
+and stable in character. If a business is complex or subject to
+constant change, we're not smart enough to predict future cash
+flows. Incidentally, that shortcoming doesn't bother us. What
+counts for most people in investing is not how much they know, but
+rather how realistically they define what they don't know. An
+investor needs to do very few things right as long as he or she
+avoids big mistakes.
+
+ Second, and equally important, we insist on a margin of safety
+in our purchase price. If we calculate the value of a common stock
+to be only slightly higher than its price, we're not interested in
+buying. We believe this margin-of-safety principle, so strongly
+emphasized by Ben Graham, to be the cornerstone of investment
+success.
+
+Fixed-Income Securities
+
+ Below we list our largest holdings of fixed-income securities:
+
+ (000s omitted)
+ ------------------------------------
+ Cost of Preferreds and
+ Issuer Amortized Value of Bonds Market
+ ------ ------------------------ ----------
+ ACF Industries Debentures ...... $133,065(1) $163,327
+ American Express "Percs" ....... 300,000 309,000(1)(2)
+ Champion International Conv. Pfd. 300,000(1) 309,000(2)
+ First Empire State Conv. Pfd. .. 40,000 68,000(1)(2)
+ Salomon Conv. Pfd. ............. 700,000(1) 756,000(2)
+ USAir Conv. Pfd. ............... 358,000(1) 268,500(2)
+ Washington Public Power Systems Bonds 58,768(1) 81,002
+
+ (1) Carrying value in our financial statements
+ (2) Fair value as determined by Charlie and me
+
+ During 1992 we added to our holdings of ACF debentures, had
+some of our WPPSS bonds called, and sold our RJR Nabisco position.
+
+ Over the years, we've done well with fixed-income investments,
+having realized from them both large capital gains (including $80
+million in 1992) and exceptional current income. Chrysler
+Financial, Texaco, Time-Warner, WPPSS and RJR Nabisco were
+particularly good investments for us. Meanwhile, our fixed-income
+losses have been negligible: We've had thrills but so far no
+spills.
+
+ Despite the success we experienced with our Gillette
+preferred, which converted to common stock in 1991, and despite our
+reasonable results with other negotiated purchases of preferreds,
+our overall performance with such purchases has been inferior to
+that we have achieved with purchases made in the secondary market.
+This is actually the result we expected. It corresponds with our
+belief that an intelligent investor in common stocks will do better
+in the secondary market than he will do buying new issues.
+
+ The reason has to do with the way prices are set in each
+instance. The secondary market, which is periodically ruled by
+mass folly, is constantly setting a "clearing" price. No matter
+how foolish that price may be, it's what counts for the holder of a
+stock or bond who needs or wishes to sell, of whom there are always
+going to be a few at any moment. In many instances, shares worth x
+in business value have sold in the market for 1/2x or less.
+
+ The new-issue market, on the other hand, is ruled by
+controlling stockholders and corporations, who can usually select
+the timing of offerings or, if the market looks unfavorable, can
+avoid an offering altogether. Understandably, these sellers are
+not going to offer any bargains, either by way of a public offering
+or in a negotiated transaction: It's rare you'll find x for
+1/2x here. Indeed, in the case of common-stock offerings, selling
+shareholders are often motivated to unload only when they feel the
+market is overpaying. (These sellers, of course, would state that
+proposition somewhat differently, averring instead that they simply
+resist selling when the market is underpaying for their goods.)
+
+ To date, our negotiated purchases, as a group, have fulfilled
+but not exceeded the expectation we set forth in our 1989 Annual
+Report: "Our preferred stock investments should produce returns
+modestly above those achieved by most fixed-income portfolios." In
+truth, we would have done better if we could have put the money
+that went into our negotiated transactions into open-market
+purchases of the type we like. But both our size and the general
+strength of the markets made that difficult to do.
+
+ There was one other memorable line in the 1989 Annual Report:
+"We have no ability to forecast the economics of the investment
+banking business, the airline industry, or the paper industry." At
+the time some of you may have doubted this confession of ignorance.
+Now, however, even my mother acknowledges its truth.
+
+ In the case of our commitment to USAir, industry economics had
+soured before the ink dried on our check. As I've previously
+mentioned, it was I who happily jumped into the pool; no one pushed
+me. Yes, I knew the industry would be ruggedly competitive, but I
+did not expect its leaders to engage in prolonged kamikaze
+behavior. In the last two years, airline companies have acted as
+if they are members of a competitive tontine, which they wish to
+bring to its conclusion as rapidly as possible.
+
+ Amidst this turmoil, Seth Schofield, CEO of USAir, has done a
+truly extraordinary job in repositioning the airline. He was
+particularly courageous in accepting a strike last fall that, had
+it been lengthy, might well have bankrupted the company.
+Capitulating to the striking union, however, would have been
+equally disastrous: The company was burdened with wage costs and
+work rules that were considerably more onerous than those
+encumbering its major competitors, and it was clear that over time
+any high-cost producer faced extinction. Happily for everyone, the
+strike was settled in a few days.
+
+ A competitively-beset business such as USAir requires far more
+managerial skill than does a business with fine economics.
+Unfortunately, though, the near-term reward for skill in the
+airline business is simply survival, not prosperity.
+
+ In early 1993, USAir took a major step toward assuring
+survival - and eventual prosperity - by accepting British Airways'
+offer to make a substantial, but minority, investment in the
+company. In connection with this transaction, Charlie and I were
+asked to join the USAir board. We agreed, though this makes five
+outside board memberships for me, which is more than I believe
+advisable for an active CEO. Even so, if an investee's management
+and directors believe it particularly important that Charlie and I
+join its board, we are glad to do so. We expect the managers of
+our investees to work hard to increase the value of the businesses
+they run, and there are times when large owners should do their bit
+as well.
+
+Two New Accounting Rules and a Plea for One More
+
+ A new accounting rule having to do with deferred taxes becomes
+effective in 1993. It undoes a dichotomy in our books that I have
+described in previous annual reports and that relates to the
+accrued taxes carried against the unrealized appreciation in our
+investment portfolio. At yearend 1992, that appreciation amounted
+to $7.6 billion. Against $6.4 billion of that, we carried taxes at
+the current 34% rate. Against the remainder of $1.2 billion, we
+carried an accrual of 28%, the tax rate in effect when that portion
+of the appreciation occurred. The new accounting rule says we must
+henceforth accrue all deferred tax at the current rate, which to us
+seems sensible.
+
+ The new marching orders mean that in the first quarter of 1993
+we will apply a 34% rate to all of our unrealized appreciation,
+thereby increasing the tax liability and reducing net worth by $70
+million. The new rule also will cause us to make other minor
+changes in our calculation of deferred taxes.
+
+ Future changes in tax rates will be reflected immediately in
+the liability for deferred taxes and, correspondingly, in net
+worth. The impact could well be substantial. Nevertheless, what
+is important in the end is the tax rate at the time we sell
+securities, when unrealized appreciation becomes realized.
+
+ Another major accounting change, whose implementation is
+required by January 1, 1993, mandates that businesses recognize
+their present-value liability for post-retirement health benefits.
+Though GAAP has previously required recognition of pensions to be
+paid in the future, it has illogically ignored the costs that
+companies will then have to bear for health benefits. The new rule
+will force many companies to record a huge balance-sheet liability
+(and a consequent reduction in net worth) and also henceforth to
+recognize substantially higher costs when they are calculating
+annual profits.
+
+ In making acquisitions, Charlie and I have tended to avoid
+companies with significant post-retirement liabilities. As a
+result, Berkshire's present liability and future costs for post-
+retirement health benefits - though we now have 22,000 employees -
+are inconsequential. I need to admit, though, that we had a near
+miss: In 1982 I made a huge mistake in committing to buy a company
+burdened by extraordinary post-retirement health obligations.
+Luckily, though, the transaction fell through for reasons beyond
+our control. Reporting on this episode in the 1982 annual report,
+I said: "If we were to introduce graphics to this report,
+illustrating favorable business developments of the past year, two
+blank pages depicting this blown deal would be the appropriate
+centerfold." Even so, I wasn't expecting things to get as bad as
+they did. Another buyer appeared, the business soon went bankrupt
+and was shut down, and thousands of workers found those bountiful
+health-care promises to be largely worthless.
+
+ In recent decades, no CEO would have dreamed of going to his
+board with the proposition that his company become an insurer of
+uncapped post-retirement health benefits that other corporations
+chose to install. A CEO didn't need to be a medical expert to know
+that lengthening life expectancies and soaring health costs would
+guarantee an insurer a financial battering from such a business.
+Nevertheless, many a manager blithely committed his own company to
+a self-insurance plan embodying precisely the same promises - and
+thereby doomed his shareholders to suffer the inevitable
+consequences. In health-care, open-ended promises have created
+open-ended liabilities that in a few cases loom so large as to
+threaten the global competitiveness of major American industries.
+
+ I believe part of the reason for this reckless behavior was
+that accounting rules did not, for so long, require the booking of
+post-retirement health costs as they were incurred. Instead, the
+rules allowed cash-basis accounting, which vastly understated the
+liabilities that were building up. In effect, the attitude of both
+managements and their accountants toward these liabilities was
+"out-of-sight, out-of-mind." Ironically, some of these same
+managers would be quick to criticize Congress for employing "cash-
+basis" thinking in respect to Social Security promises or other
+programs creating future liabilities of size.
+
+ Managers thinking about accounting issues should never forget
+one of Abraham Lincoln's favorite riddles: "How many legs does a
+dog have if you call his tail a leg?" The answer: "Four, because
+calling a tail a leg does not make it a leg." It behooves managers
+to remember that Abe's right even if an auditor is willing to
+certify that the tail is a leg.
+
+ * * * * * * * * * * * *
+
+ The most egregious case of let's-not-face-up-to-reality
+behavior by executives and accountants has occurred in the world of
+stock options. In Berkshire's 1985 annual report, I laid out my
+opinions about the use and misuse of options. But even when
+options are structured properly, they are accounted for in ways
+that make no sense. The lack of logic is not accidental: For
+decades, much of the business world has waged war against
+accounting rulemakers, trying to keep the costs of stock options
+from being reflected in the profits of the corporations that issue
+them.
+
+ Typically, executives have argued that options are hard to
+value and that therefore their costs should be ignored. At other
+times managers have said that assigning a cost to options would
+injure small start-up businesses. Sometimes they have even
+solemnly declared that "out-of-the-money" options (those with an
+exercise price equal to or above the current market price) have no
+value when they are issued.
+
+ Oddly, the Council of Institutional Investors has chimed in
+with a variation on that theme, opining that options should not be
+viewed as a cost because they "aren't dollars out of a company's
+coffers." I see this line of reasoning as offering exciting
+possibilities to American corporations for instantly improving
+their reported profits. For example, they could eliminate the cost
+of insurance by paying for it with options. So if you're a CEO and
+subscribe to this "no cash-no cost" theory of accounting, I'll make
+you an offer you can't refuse: Give us a call at Berkshire and we
+will happily sell you insurance in exchange for a bundle of long-
+term options on your company's stock.
+
+ Shareholders should understand that companies incur costs when
+they deliver something of value to another party and not just when
+cash changes hands. Moreover, it is both silly and cynical to say
+that an important item of cost should not be recognized simply
+because it can't be quantified with pinpoint precision. Right now,
+accounting abounds with imprecision. After all, no manager or
+auditor knows how long a 747 is going to last, which means he also
+does not know what the yearly depreciation charge for the plane
+should be. No one knows with any certainty what a bank's annual
+loan loss charge ought to be. And the estimates of losses that
+property-casualty companies make are notoriously inaccurate.
+
+ Does this mean that these important items of cost should be
+ignored simply because they can't be quantified with absolute
+accuracy? Of course not. Rather, these costs should be estimated
+by honest and experienced people and then recorded. When you get
+right down to it, what other item of major but hard-to-precisely-
+calculate cost - other, that is, than stock options - does the
+accounting profession say should be ignored in the calculation of
+earnings?
+
+ Moreover, options are just not that difficult to value.
+Admittedly, the difficulty is increased by the fact that the
+options given to executives are restricted in various ways. These
+restrictions affect value. They do not, however, eliminate it. In
+fact, since I'm in the mood for offers, I'll make one to any
+executive who is granted a restricted option, even though it may be
+out of the money: On the day of issue, Berkshire will pay him or
+her a substantial sum for the right to any future gain he or she
+realizes on the option. So if you find a CEO who says his newly-
+issued options have little or no value, tell him to try us out. In
+truth, we have far more confidence in our ability to determine an
+appropriate price to pay for an option than we have in our ability
+to determine the proper depreciation rate for our corporate jet.
+
+ It seems to me that the realities of stock options can be
+summarized quite simply: If options aren't a form of compensation,
+what are they? If compensation isn't an expense, what is it? And,
+if expenses shouldn't go into the calculation of earnings, where in
+the world should they go?
+
+ The accounting profession and the SEC should be shamed by the
+fact that they have long let themselves be muscled by business
+executives on the option-accounting issue. Additionally, the
+lobbying that executives engage in may have an unfortunate by-
+product: In my opinion, the business elite risks losing its
+credibility on issues of significance to society - about which it
+may have much of value to say - when it advocates the incredible on
+issues of significance to itself.
+
+Miscellaneous
+
+ We have two pieces of regrettable news this year. First,
+Gladys Kaiser, my friend and assistant for twenty-five years, will
+give up the latter post after the 1993 annual meeting, though she
+will certainly remain my friend forever. Gladys and I have been a
+team, and though I knew her retirement was coming, it is still a
+jolt.
+
+ Secondly, in September, Verne McKenzie relinquished his role
+as Chief Financial Officer after a 30-year association with me that
+began when he was the outside auditor of Buffett Partnership, Ltd.
+Verne is staying on as a consultant, and though that job
+description is often a euphemism, in this case it has real meaning.
+I expect Verne to continue to fill an important role at Berkshire
+but to do so at his own pace. Marc Hamburg, Verne's understudy for
+five years, has succeeded him as Chief Financial Officer.
+
+ I recall that one woman, upon being asked to describe the
+perfect spouse, specified an archeologist: "The older I get," she
+said, "the more he'll be interested in me." She would have liked
+my tastes: I treasure those extraordinary Berkshire managers who
+are working well past normal retirement age and who concomitantly
+are achieving results much superior to those of their younger
+competitors. While I understand and empathize with the decision of
+Verne and Gladys to retire when the calendar says it's time, theirs
+is not a step I wish to encourage. It's hard to teach a new dog
+old tricks.
+
+ * * * * * * * * * * * *
+
+ I am a moderate in my views about retirement compared to Rose
+Blumkin, better known as Mrs. B. At 99, she continues to work
+seven days a week. And about her, I have some particularly good
+news.
+
+ You will remember that after her family sold 80% of Nebraska
+Furniture Mart (NFM) to Berkshire in 1983, Mrs. B continued to be
+Chairman and run the carpet operation. In 1989, however, she left
+because of a managerial disagreement and opened up her own
+operation next door in a large building that she had owned for
+several years. In her new business, she ran the carpet section but
+leased out other home-furnishings departments.
+
+ At the end of last year, Mrs. B decided to sell her building
+and land to NFM. She'll continue, however, to run her carpet
+business at its current location (no sense slowing down just when
+you're hitting full stride). NFM will set up shop alongside her,
+in that same building, thereby making a major addition to its
+furniture business.
+
+ I am delighted that Mrs. B has again linked up with us. Her
+business story has no parallel and I have always been a fan of
+hers, whether she was a partner or a competitor. But believe me,
+partner is better.
+
+ This time around, Mrs. B graciously offered to sign a non-
+compete agreement - and I, having been incautious on this point
+when she was 89, snapped at the deal. Mrs. B belongs in the
+Guinness Book of World Records on many counts. Signing a non-
+compete at 99 merely adds one more.
+
+ * * * * * * * * * * * *
+
+ Ralph Schey, CEO of Scott Fetzer and a manager who I hope is
+with us at 99 also, hit a grand slam last year when that company
+earned a record $110 million pre-tax. What's even more impressive
+is that Scott Fetzer achieved such earnings while employing only
+$116 million of equity capital. This extraordinary result is not
+the product of leverage: The company uses only minor amounts of
+borrowed money (except for the debt it employs - appropriately - in
+its finance subsidiary).
+
+ Scott Fetzer now operates with a significantly smaller
+investment in both inventory and fixed assets than it had when we
+bought it in 1986. This means the company has been able to
+distribute more than 100% of its earnings to Berkshire during our
+seven years of ownership while concurrently increasing its earnings
+stream - which was excellent to begin with - by a lot. Ralph just
+keeps on outdoing himself, and Berkshire shareholders owe him a
+great deal.
+
+ * * * * * * * * * * * *
+
+ Those readers with particularly sharp eyes will note that our
+corporate expense fell from $5.6 million in 1991 to $4.2 million in
+1992. Perhaps you will think that I have sold our corporate jet,
+The Indefensible. Forget it! I find the thought of retiring the
+plane even more revolting than the thought of retiring the
+Chairman. (In this matter I've demonstrated uncharacteristic
+flexibility: For years I argued passionately against corporate
+jets. But finally my dogma was run over by my karma.)
+
+ Our reduction in corporate overhead actually came about
+because those expenses were especially high in 1991, when we
+incurred a one-time environmental charge relating to alleged pre-
+1970 actions of our textile operation. Now that things are back to
+normal, our after-tax overhead costs are under 1% of our reported
+operating earnings and less than 1/2 of 1% of our look-through
+earnings. We have no legal, personnel, public relations, investor
+relations, or strategic planning departments. In turn this means
+we don't need support personnel such as guards, drivers,
+messengers, etc. Finally, except for Verne, we employ no
+consultants. Professor Parkinson would like our operation - though
+Charlie, I must say, still finds it outrageously fat.
+
+ At some companies, corporate expense runs 10% or more of
+operating earnings. The tithing that operations thus makes to
+headquarters not only hurts earnings, but more importantly slashes
+capital values. If the business that spends 10% on headquarters'
+costs achieves earnings at its operating levels identical to those
+achieved by the business that incurs costs of only 1%, shareholders
+of the first enterprise suffer a 9% loss in the value of their
+holdings simply because of corporate overhead. Charlie and I have
+observed no correlation between high corporate costs and good
+corporate performance. In fact, we see the simpler, low-cost
+operation as more likely to operate effectively than its
+bureaucratic brethren. We're admirers of the Wal-Mart, Nucor,
+Dover, GEICO, Golden West Financial and Price Co. models.
+
+ * * * * * * * * * * * *
+
+ Late last year Berkshire's stock price crossed $10,000.
+Several shareholders have mentioned to me that the high price
+causes them problems: They like to give shares away each year and
+find themselves impeded by the tax rule that draws a distinction
+between annual gifts of $10,000 or under to a single individual and
+those above $10,000. That is, those gifts no greater than $10,000
+are completely tax-free; those above $10,000 require the donor to
+use up a portion of his or her lifetime exemption from gift and
+estate taxes, or, if that exemption has been exhausted, to pay gift
+taxes.
+
+ I can suggest three ways to address this problem. The first
+would be useful to a married shareholder, who can give up to
+$20,000 annually to a single recipient, as long as the donor files
+a gift tax return containing his or her spouse's written consent to
+gifts made during the year.
+
+ Secondly, a shareholder, married or not, can make a bargain
+sale. Imagine, for example, that Berkshire is selling for $12,000
+and that one wishes to make only a $10,000 gift. In that case,
+sell the stock to the giftee for $2,000. (Caution: You will be
+taxed on the amount, if any, by which the sales price to your
+giftee exceeds your tax basis.)
+
+ Finally, you can establish a partnership with people to whom
+you are making gifts, fund it with Berkshire shares, and simply
+give percentage interests in the partnership away each year. These
+interests can be for any value that you select. If the value is
+$10,000 or less, the gift will be tax-free.
+
+ We issue the customary warning: Consult with your own tax
+advisor before taking action on any of the more esoteric methods of
+gift-making.
+
+ We hold to the view about stock splits that we set forth in
+the 1983 Annual Report. Overall, we believe our owner-related
+policies - including the no-split policy - have helped us assemble
+a body of shareholders that is the best associated with any widely-
+held American corporation. Our shareholders think and behave like
+rational long-term owners and view the business much as Charlie and
+I do. Consequently, our stock consistently trades in a price range
+that is sensibly related to intrinsic value.
+
+ Additionally, we believe that our shares turn over far less
+actively than do the shares of any other widely-held company. The
+frictional costs of trading - which act as a major "tax" on the
+owners of many companies - are virtually non-existent at Berkshire.
+(The market-making skills of Jim Maguire, our New York Stock
+Exchange specialist, definitely help to keep these costs low.)
+Obviously a split would not change this situation dramatically.
+Nonetheless, there is no way that our shareholder group would be
+upgraded by the new shareholders enticed by a split. Instead we
+believe that modest degradation would occur.
+
+ * * * * * * * * * * * *
+
+ As I mentioned earlier, on December 16th we called our zero-
+coupon, convertible debentures for payment on January 4, 1993.
+These obligations bore interest at 5 1/2%, a low cost for funds
+when they were issued in 1989, but an unattractive rate for us at
+the time of call.
+
+ The debentures could have been redeemed at the option of the
+holder in September 1994, and 5 1/2% money available for no longer
+than that is not now of interest to us. Furthermore, Berkshire
+shareholders are disadvantaged by having a conversion option
+outstanding. At the time we issued the debentures, this
+disadvantage was offset by the attractive interest rate they
+carried; by late 1992, it was not.
+
+ In general, we continue to have an aversion to debt,
+particularly the short-term kind. But we are willing to incur
+modest amounts of debt when it is both properly structured and of
+significant benefit to shareholders.
+
+
+ * * * * * * * * * * * *
+
+
+ About 97% of all eligible shares participated in Berkshire's
+1992 shareholder-designated contributions program. Contributions
+made through the program were $7.6 million, and 2,810 charities
+were recipients. I'm considering increasing these contributions in
+the future at a rate greater than the increase in Berkshire's book
+value, and I would be glad to hear from you as to your thinking
+about this idea.
+
+ We suggest that new shareholders read the description of our
+shareholder-designated contributions program that appears on pages
+48-49. To participate in future programs, you must make sure your
+shares are registered in the name of the actual owner, not in the
+nominee name of a broker, bank or depository. Shares not so
+registered on August 31, 1993 will be ineligible for the 1993
+program.
+
+ In addition to the shareholder-designated contributions that
+Berkshire distributes, managers of our operating businesses make
+contributions, including merchandise, averaging about $2.0 million
+annually. These contributions support local charities, such as The
+United Way, and produce roughly commensurate benefits for our
+businesses.
+
+ However, neither our operating managers nor officers of the
+parent company use Berkshire funds to make contributions to broad
+national programs or charitable activities of special personal
+interest to them, except to the extent they do so as shareholders.
+If your employees, including your CEO, wish to give to their alma
+maters or other institutions to which they feel a personal
+attachment, we believe they should use their own money, not yours.
+
+
+ * * * * * * * * * * * *
+
+
+ This year the Annual Meeting will be held at the Orpheum
+Theater in downtown Omaha at 9:30 a.m. on Monday, April 26, 1993.
+A record 1,700 people turned up for the meeting last year, but that
+number still leaves plenty of room at the Orpheum.
+
+ We recommend that you get your hotel reservations early at one
+of these hotels: (1) The Radisson-Redick Tower, a small (88 rooms)
+but nice hotel across the street from the Orpheum; (2) the much
+larger Red Lion Hotel, located about a five-minute walk from the
+Orpheum; or (3) the Marriott, located in West Omaha about 100 yards
+from Borsheim's, which is a twenty minute drive from downtown. We
+will have buses at the Marriott that will leave at 8:30 and 8:45
+for the meeting and return after it ends.
+
+ Charlie and I always enjoy the meeting, and we hope you can
+make it. The quality of our shareholders is reflected in the
+quality of the questions we get: We have never attended an annual
+meeting anywhere that features such a consistently high level of
+intelligent, owner-related questions.
+
+ An attachment to our proxy material explains how you can
+obtain the card you will need for admission to the meeting. With
+the admission card, we will enclose information about parking
+facilities located near the Orpheum. If you are driving, come a
+little early. Nearby lots fill up quickly and you may have to walk
+a few blocks.
+
+ As usual, we will have buses to take you to Nebraska Furniture
+Mart and Borsheim's after the meeting and to take you from there to
+downtown hotels or the airport later. I hope that you will allow
+plenty of time to fully explore the attractions of both stores.
+Those of you arriving early can visit the Furniture Mart any day of
+the week; it is open from 10 a.m. to 5:30 p.m. on Saturdays and
+from noon to 5:30 p.m. on Sundays. While there, stop at the See's
+Candy Cart and find out for yourself why Charlie and I are a good
+bit wider than we were back in 1972 when we bought See's.
+
+ Borsheim's normally is closed on Sunday but will be open for
+shareholders and their guests from noon to 6 p.m. on Sunday, April
+25. Charlie and I will be in attendance, sporting our jeweler's
+loupes, and ready to give advice about gems to anyone foolish
+enough to listen. Also available will be plenty of Cherry Cokes,
+See's candies, and other lesser goodies. I hope you will join us.
+
+
+
+ Warren E. Buffett
+March 1, 1993 Chairman of the Board
+
+
+
+
diff --git a/berkshire-hathaway/1993/1-in/berkshire-hathaway-1993-letter.txt b/berkshire-hathaway/1993/1-in/berkshire-hathaway-1993-letter.txt
new file mode 100644
index 0000000..8877495
--- /dev/null
+++ b/berkshire-hathaway/1993/1-in/berkshire-hathaway-1993-letter.txt
@@ -0,0 +1,1357 @@
+
+
+
+
+
+ +BERKSHIRE HATHAWAY INC. +
+ +
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+
+ Our per-share book value increased 14.3% during 1993. Over
+the last 29 years (that is, since present management took over)
+book value has grown from $19 to $8,854, or at a rate of 23.3%
+compounded annually.
+
+ During the year, Berkshire's net worth increased by $1.5
+billion, a figure affected by two negative and two positive non-
+operating items. For the sake of completeness, I'll explain them
+here. If you aren't thrilled by accounting, however, feel free
+to fast-forward through this discussion:
+
+ 1. The first negative was produced by a change in
+ Generally Accepted Accounting Principles (GAAP)
+ having to do with the taxes we accrue against
+ unrealized appreciation in the securities we
+ carry at market value. The old rule said that
+ the tax rate used should be the one in effect
+ when the appreciation took place. Therefore,
+ at the end of 1992, we were using a rate of 34%
+ on the $6.4 billion of gains generated after
+ 1986 and 28% on the $1.2 billion of gains
+ generated before that. The new rule stipulates
+ that the current tax rate should be applied to
+ all gains. The rate in the first quarter of
+ 1993, when this rule went into effect, was 34%.
+ Applying that rate to our pre-1987 gains
+ reduced net worth by $70 million.
+
+ 2. The second negative, related to the first, came
+ about because the corporate tax rate was raised
+ in the third quarter of 1993 to 35%. This
+ change required us to make an additional charge
+ of 1% against all of our unrealized gains, and
+ that charge penalized net worth by $75 million.
+ Oddly, GAAP required both this charge and the
+ one described above to be deducted from the
+ earnings we report, even though the unrealized
+ appreciation that gave rise to the charges was
+ never included in earnings, but rather was
+ credited directly to net worth.
+
+ 3. Another 1993 change in GAAP affects the value
+ at which we carry the securities that we own.
+ In recent years, both the common stocks and
+ certain common-equivalent securities held by
+ our insurance companies have been valued at
+ market, whereas equities held by our non-
+ insurance subsidiaries or by the parent company
+ were carried at their aggregate cost or market,
+ whichever was lower. Now GAAP says that all
+ common stocks should be carried at market, a
+ rule we began following in the fourth quarter
+ of 1993. This change produced a gain in
+ Berkshire's reported net worth of about $172
+ million.
+
+ 4. Finally, we issued some stock last year. In a
+ transaction described in last year's Annual
+ Report, we issued 3,944 shares in early
+ January, 1993 upon the conversion of $46
+ million convertible debentures that we had
+ called for redemption. Additionally, we issued
+ 25,203 shares when we acquired Dexter Shoe, a
+ purchase discussed later in this report. The
+ overall result was that our shares outstanding
+ increased by 29,147 and our net worth by about
+ $478 million. Per-share book value also grew,
+ because the shares issued in these transactions
+ carried a price above their book value.
+
+ Of course, it's per-share intrinsic value, not book value,
+that counts. Book value is an accounting term that measures the
+capital, including retained earnings, that has been put into a
+business. Intrinsic value is a present-value estimate of the
+cash that can be taken out of a business during its remaining
+life. At most companies, the two values are unrelated.
+Berkshire, however, is an exception: Our book value, though
+significantly below our intrinsic value, serves as a useful
+device for tracking that key figure. In 1993, each measure grew
+by roughly 14%, advances that I would call satisfactory but
+unexciting.
+
+ These gains, however, were outstripped by a much larger gain
+- 39% - in Berkshire's market price. Over time, of course,
+market price and intrinsic value will arrive at about the same
+destination. But in the short run the two often diverge in a
+major way, a phenomenon I've discussed in the past. Two years
+ago, Coca-Cola and Gillette, both large holdings of ours, enjoyed
+market price increases that dramatically outpaced their earnings
+gains. In the 1991 Annual Report, I said that the stocks of
+these companies could not continuously overperform their
+businesses.
+
+ From 1991 to 1993, Coke and Gillette increased their annual
+operating earnings per share by 38% and 37% respectively, but
+their market prices moved up only 11% and 6%. In other words,
+the companies overperformed their stocks, a result that no doubt
+partly reflects Wall Street's new apprehension about brand names.
+Whatever the reason, what will count over time is the earnings
+performance of these companies. If they prosper, Berkshire will
+also prosper, though not in a lock-step manner.
+
+ Let me add a lesson from history: Coke went public in 1919
+at $40 per share. By the end of 1920 the market, coldly
+reevaluating Coke's future prospects, had battered the stock down
+by more than 50%, to $19.50. At yearend 1993, that single share,
+with dividends reinvested, was worth more than $2.1 million. As
+Ben Graham said: "In the short-run, the market is a voting
+machine - reflecting a voter-registration test that requires only
+money, not intelligence or emotional stability - but in the long-
+run, the market is a weighing machine."
+
+ So how should Berkshire's over-performance in the market
+last year be viewed? Clearly, Berkshire was selling at a higher
+percentage of intrinsic value at the end of 1993 than was the
+case at the beginning of the year. On the other hand, in a world
+of 6% or 7% long-term interest rates, Berkshire's market price
+was not inappropriate if - and you should understand that this is
+a huge if - Charlie Munger, Berkshire's Vice Chairman, and I can
+attain our long-standing goal of increasing Berkshire's per-share
+intrinsic value at an average annual rate of 15%. We have not
+retreated from this goal. But we again emphasize, as we have for
+many years, that the growth in our capital base makes 15% an
+ever-more difficult target to hit.
+
+ What we have going for us is a growing collection of good-
+sized operating businesses that possess economic characteristics
+ranging from good to terrific, run by managers whose performance
+ranges from terrific to terrific. You need have no worries about
+this group.
+
+ The capital-allocation work that Charlie and I do at the
+parent company, using the funds that our managers deliver to us,
+has a less certain outcome: It is not easy to find new
+businesses and managers comparable to those we have. Despite
+that difficulty, Charlie and I relish the search, and we are
+happy to report an important success in 1993.
+
+Dexter Shoe
+
+ What we did last year was build on our 1991 purchase of H.
+H. Brown, a superbly-run manufacturer of work shoes, boots and
+other footwear. Brown has been a real winner: Though we had
+high hopes to begin with, these expectations have been
+considerably exceeded thanks to Frank Rooney, Jim Issler and the
+talented managers who work with them. Because of our confidence
+in Frank's team, we next acquired Lowell Shoe, at the end of
+1992. Lowell was a long-established manufacturer of women's and
+nurses' shoes, but its business needed some fixing. Again,
+results have surpassed our expectations. So we promptly jumped
+at the chance last year to acquire Dexter Shoe of Dexter, Maine,
+which manufactures popular-priced men's and women's shoes.
+Dexter, I can assure you, needs no fixing: It is one of the
+best-managed companies Charlie and I have seen in our business
+lifetimes.
+
+ Harold Alfond, who started working in a shoe factory at 25
+cents an hour when he was 20, founded Dexter in 1956 with $10,000
+of capital. He was joined in 1958 by Peter Lunder, his nephew.
+The two of them have since built a business that now produces over
+7.5 million pairs of shoes annually, most of them made in Maine
+and the balance in Puerto Rico. As you probably know, the
+domestic shoe industry is generally thought to be unable to
+compete with imports from low-wage countries. But someone forgot
+to tell this to the ingenious managements of Dexter and H. H.
+Brown and to their skilled labor forces, which together make the
+U.S. plants of both companies highly competitive against all
+comers.
+
+ Dexter's business includes 77 retail outlets, located
+primarily in the Northeast. The company is also a major
+manufacturer of golf shoes, producing about 15% of U.S. output.
+Its bread and butter, though, is the manufacture of traditional
+shoes for traditional retailers, a job at which it excels: Last
+year both Nordstrom and J.C. Penney bestowed special awards upon
+Dexter for its performance as a supplier during 1992.
+
+ Our 1993 results include Dexter only from our date of
+merger, November 7th. In 1994, we expect Berkshire's shoe
+operations to have more than $550 million in sales, and we would
+not be surprised if the combined pre-tax earnings of these
+businesses topped $85 million. Five years ago we had no thought
+of getting into shoes. Now we have 7,200 employees in that
+industry, and I sing "There's No Business Like Shoe Business" as
+I drive to work. So much for strategic plans.
+
+ At Berkshire, we have no view of the future that dictates
+what businesses or industries we will enter. Indeed, we think
+it's usually poison for a corporate giant's shareholders if it
+embarks upon new ventures pursuant to some grand vision. We
+prefer instead to focus on the economic characteristics of
+businesses that we wish to own and the personal characteristics
+of managers with whom we wish to associate - and then to hope we
+get lucky in finding the two in combination. At Dexter, we did.
+
+ * * * * * * * * * * * *
+
+ And now we pause for a short commercial: Though they owned
+a business jewel, we believe that Harold and Peter (who were not
+interested in cash) made a sound decision in exchanging their
+Dexter stock for shares of Berkshire. What they did, in effect,
+was trade a 100% interest in a single terrific business for a
+smaller interest in a large group of terrific businesses. They
+incurred no tax on this exchange and now own a security that can
+be easily used for charitable or personal gifts, or that can be
+converted to cash in amounts, and at times, of their own
+choosing. Should members of their families desire to, they can
+pursue varying financial paths without running into the
+complications that often arise when assets are concentrated in a
+private business.
+
+ For tax and other reasons, private companies also often find
+it difficult to diversify outside their industries. Berkshire,
+in contrast, can diversify with ease. So in shifting their
+ownership to Berkshire, Dexter's shareholders solved a
+reinvestment problem. Moreover, though Harold and Peter now have
+non-controlling shares in Berkshire, rather than controlling
+shares in Dexter, they know they will be treated as partners and
+that we will follow owner-oriented practices. If they elect to
+retain their Berkshire shares, their investment result from the
+merger date forward will exactly parallel my own result. Since I
+have a huge percentage of my net worth committed for life to
+Berkshire shares - and since the company will issue me neither
+restricted shares nor stock options - my gain-loss equation will
+always match that of all other owners.
+
+ Additionally, Harold and Peter know that at Berkshire we can
+keep our promises: There will be no changes of control or
+culture at Berkshire for many decades to come. Finally, and of
+paramount importance, Harold and Peter can be sure that they will
+get to run their business - an activity they dearly love -
+exactly as they did before the merger. At Berkshire, we do not
+tell .400 hitters how to swing.
+
+ What made sense for Harold and Peter probably makes sense
+for a few other owners of large private businesses. So, if you
+have a business that might fit, let me hear from you. Our
+acquisition criteria are set forth in the appendix on page 22.
+
+Sources of Reported Earnings
+
+ The table below shows the major sources of Berkshire's
+reported earnings. In this presentation, amortization of
+Goodwill and other major purchase-price accounting adjustments
+are not charged against the specific businesses to which they
+apply, but are instead aggregated and shown separately. This
+procedure lets you view the earnings of our businesses as they
+would have been reported had we not purchased them. I've
+explained in past reports why this form of presentation seems to
+us to be more useful to investors and managers than one utilizing
+GAAP, which requires purchase-price adjustments to be made on a
+business-by-business basis. The total net earnings we show in
+the table are, of course, identical to the GAAP total in our
+audited financial statements.
+
+ (000s omitted)
+ ------------------------------------------
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ---------------------- ------------------
+ 1993 1992 1993 1992
+ ---------- ---------- -------- --------
+
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............... $ 30,876 $(108,961) $ 20,156 $(71,141)
+ Net Investment Income ...... 375,946 355,067 321,321 305,763
+ H. H. Brown, Lowell,
+ and Dexter ............... 44,025* 27,883 28,829 17,340
+ Buffalo News ................. 50,962 47,863 29,696 28,163
+ Commercial & Consumer Finance 22,695 19,836 14,161 12,664
+ Fechheimer ................... 13,442 13,698 6,931 7,267
+ Kirby ........................ 39,147 35,653 25,056 22,795
+ Nebraska Furniture Mart ...... 21,540 17,110 10,398 8,072
+ Scott Fetzer Manufacturing Group 38,196 31,954 23,809 19,883
+ See's Candies ................ 41,150 42,357 24,367 25,501
+ World Book ................... 19,915 29,044 13,537 19,503
+ Purchase-Price Accounting &
+ Goodwill Charges ......... (17,033) (12,087) (13,996) (13,070)
+ Interest Expense** ........... (56,545) (98,643) (35,614) (62,899)
+ Shareholder-Designated
+ Contributions ............ (9,448) (7,634) (5,994) (4,913)
+ Other ........................ 28,428 67,540 15,094 32,798
+ ---------- ---------- -------- --------
+Operating Earnings ............. 643,296 460,680 477,751 347,726
+Sales of Securities ............ 546,422 89,937 356,702 59,559
+Tax Accruals Caused by
+ New Accounting Rules ........ --- --- (146,332) ---
+ ---------- ---------- -------- --------
+Total Earnings - All Entities .. $1,189,718 $ 550,617 $688,121 $407,285
+
+* Includes Dexter's earnings only from the date it was acquired,
+ November 7, 1993.
+
+**Excludes interest expense of Commercial and Consumer Finance
+ businesses. In 1992 includes $22.5 million of premiums paid on
+ the early redemption of debt.
+
+ A large amount of information about these businesses is given
+on pages 38-49, where you will also find our segment earnings
+reported on a GAAP basis. In addition, on pages 52-59, we have
+rearranged Berkshire's financial data into four segments on a non-
+GAAP basis, a presentation that corresponds to the way Charlie and
+I think about the company. Our intent is to supply you with the
+financial information that we would wish you to give us if our
+positions were reversed.
+
+"Look-Through" Earnings
+
+ We've previously discussed look-through earnings, which we
+believe more accurately portray the earnings of Berkshire than does
+our GAAP result. As we calculate them, look-through earnings
+consist of: (1) the operating earnings reported in the previous
+section, plus; (2) the retained operating earnings of major
+investees that, under GAAP accounting, are not reflected in our
+profits, less; (3) an allowance for the tax that would be paid by
+Berkshire if these retained earnings of investees had instead been
+distributed to us. The "operating earnings" of which we speak here
+exclude capital gains, special accounting items and major
+restructuring charges.
+
+ Over time, our look-through earnings need to increase at about
+15% annually if our intrinsic value is to grow at that rate. Last
+year, I explained that we had to increase these earnings to about
+$1.8 billion in the year 2000, were we to meet the 15% goal.
+Because we issued additional shares in 1993, the amount needed has
+risen to about $1.85 billion.
+
+ That is a tough goal, but one that we expect you to hold us
+to. In the past, we've criticized the managerial practice of
+shooting the arrow of performance and then painting the target,
+centering it on whatever point the arrow happened to hit. We will
+instead risk embarrassment by painting first and shooting later.
+
+ If we are to hit the bull's-eye, we will need markets that
+allow the purchase of businesses and securities on sensible terms.
+Right now, markets are difficult, but they can - and will - change
+in unexpected ways and at unexpected times. In the meantime, we'll
+try to resist the temptation to do something marginal simply
+because we are long on cash. There's no use running if you're on
+the wrong road.
+
+ The following table shows how we calculate look-through
+earnings, though I warn you that the figures are necessarily very
+rough. (The dividends paid to us by these investees have been
+included in the operating earnings itemized on page 8, mostly
+under "Insurance Group: Net Investment Income.")
+
+ Berkshire's Share
+ of Undistributed
+ Berkshire's Approximate Operating Earnings
+Berkshire's Major Investees Ownership at Yearend (in millions)
+--------------------------- ----------------------- --------------------
+
+ 1993 1992 1993 1992
+ ------ ------ ------ ------
+Capital Cities/ABC, Inc. ..... 13.0% 18.2% $ 83(2) $ 70
+The Coca-Cola Company ........ 7.2% 7.1% 94 82
+Federal Home Loan Mortgage Corp. 6.8%(1) 8.2%(1) 41(2) 29(2)
+GEICO Corp. .................. 48.4% 48.1% 76(3) 34(3)
+General Dynamics Corp. ....... 13.9% 14.1% 25 11(2)
+The Gillette Company ......... 10.9% 10.9% 44 38
+Guinness PLC ................. 1.9% 2.0% 8 7
+The Washington Post Company .. 14.8% 14.6% 15 11
+Wells Fargo & Company ........ 12.2% 11.5% 53(2) 16(2)
+
+Berkshire's share of undistributed
+ earnings of major investees $439 $298
+Hypothetical tax on these undistributed
+ investee earnings(4) (61) (42)
+Reported operating earnings of Berkshire 478 348
+ Total look-through earnings of Berkshire $856 $604
+
+ (1) Does not include shares allocable to the minority interest
+ at Wesco
+ (2) Calculated on average ownership for the year
+ (3) Excludes realized capital gains, which have been both
+ recurring and significant
+ (4) The tax rate used is 14%, which is the rate Berkshire pays
+ on the dividends it receives
+
+ We have told you that we expect the undistributed,
+hypothetically-taxed earnings of our investees to produce at least
+equivalent gains in Berkshire's intrinsic value. To date, we have
+far exceeded that expectation. For example, in 1986 we bought
+three million shares of Capital Cities/ABC for $172.50 per share
+and late last year sold one-third of that holding for $630 per
+share. After paying 35% capital gains taxes, we realized a $297
+million profit from the sale. In contrast, during the eight years
+we held these shares, the retained earnings of Cap Cities
+attributable to them - hypothetically taxed at a lower 14% in
+accordance with our look-through method - were only $152 million.
+In other words, we paid a much larger tax bill than our look-
+through presentations to you have assumed and nonetheless realized
+a gain that far exceeded the undistributed earnings allocable to
+these shares.
+
+ We expect such pleasant outcomes to recur often in the future
+and therefore believe our look-through earnings to be a
+conservative representation of Berkshire's true economic earnings.
+
+Taxes
+
+ As our Cap Cities sale emphasizes, Berkshire is a substantial
+payer of federal income taxes. In aggregate, we will pay 1993
+federal income taxes of $390 million, about $200 million of that
+attributable to operating earnings and $190 million to realized
+capital gains. Furthermore, our share of the 1993 federal and
+foreign income taxes paid by our investees is well over $400
+million, a figure you don't see on our financial statements but
+that is nonetheless real. Directly and indirectly, Berkshire's
+1993 federal income tax payments will be about 1/2 of 1% of the total
+paid last year by all American corporations.
+
+ Speaking for our own shares, Charlie and I have absolutely no
+complaint about these taxes. We know we work in a market-based
+economy that rewards our efforts far more bountifully than it does
+the efforts of others whose output is of equal or greater benefit
+to society. Taxation should, and does, partially redress this
+inequity. But we still remain extraordinarily well-treated.
+
+ Berkshire and its shareholders, in combination, would pay a
+much smaller tax if Berkshire operated as a partnership or "S"
+corporation, two structures often used for business activities.
+For a variety of reasons, that's not feasible for Berkshire to do.
+However, the penalty our corporate form imposes is mitigated -
+though far from eliminated - by our strategy of investing for the
+long term. Charlie and I would follow a buy-and-hold policy even
+if we ran a tax-exempt institution. We think it the soundest way
+to invest, and it also goes down the grain of our personalities. A
+third reason to favor this policy, however, is the fact that taxes
+are due only when gains are realized.
+
+ Through my favorite comic strip, Li'l Abner, I got a chance
+during my youth to see the benefits of delayed taxes, though I
+missed the lesson at the time. Making his readers feel superior,
+Li'l Abner bungled happily, but moronically, through life in
+Dogpatch. At one point he became infatuated with a New York
+temptress, Appassionatta Van Climax, but despaired of marrying her
+because he had only a single silver dollar and she was interested
+solely in millionaires. Dejected, Abner took his problem to Old
+Man Mose, the font of all knowledge in Dogpatch. Said the sage:
+Double your money 20 times and Appassionatta will be yours (1, 2,
+4, 8 . . . . 1,048,576).
+
+ My last memory of the strip is Abner entering a roadhouse,
+dropping his dollar into a slot machine, and hitting a jackpot that
+spilled money all over the floor. Meticulously following Mose's
+advice, Abner picked up two dollars and went off to find his next
+double. Whereupon I dumped Abner and began reading Ben Graham.
+
+ Mose clearly was overrated as a guru: Besides failing to
+anticipate Abner's slavish obedience to instructions, he also
+forgot about taxes. Had Abner been subject, say, to the 35%
+federal tax rate that Berkshire pays, and had he managed one double
+annually, he would after 20 years only have accumulated $22,370.
+Indeed, had he kept on both getting his annual doubles and paying a
+35% tax on each, he would have needed 7 1/2 years more to reach the
+$1 million required to win Appassionatta.
+
+ But what if Abner had instead put his dollar in a single
+investment and held it until it doubled the same 27 1/2 times? In
+that case, he would have realized about $200 million pre-tax or,
+after paying a $70 million tax in the final year, about $130
+million after-tax. For that, Appassionatta would have crawled to
+Dogpatch. Of course, with 27 1/2 years having passed, how
+Appassionatta would have looked to a fellow sitting on $130 million
+is another question.
+
+ What this little tale tells us is that tax-paying investors
+will realize a far, far greater sum from a single investment that
+compounds internally at a given rate than from a succession of
+investments compounding at the same rate. But I suspect many
+Berkshire shareholders figured that out long ago.
+
+Insurance Operations
+
+ At this point in the report we've customarily provided you
+with a table showing the annual "combined ratio" of the insurance
+industry for the preceding decade. This ratio compares total
+insurance costs (losses incurred plus expenses) to revenue from
+premiums. For many years, the ratio has been above 100, a level
+indicating an underwriting loss. That is, the industry has taken
+in less money each year from its policyholders than it has had to
+pay for operating expenses and for loss events that occurred during
+the year.
+
+ Offsetting this grim equation is a happier fact: Insurers get
+to hold on to their policyholders' money for a time before paying
+it out. This happens because most policies require that premiums
+be prepaid and, more importantly, because it often takes time to
+resolve loss claims. Indeed, in the case of certain lines of
+insurance, such as product liability or professional malpractice,
+many years may elapse between the loss event and payment.
+
+ To oversimplify the matter somewhat, the total of the funds
+prepaid by policyholders and the funds earmarked for incurred-but-
+not-yet-paid claims is called "the float." In the past, the
+industry was able to suffer a combined ratio of 107 to 111 and
+still break even from its insurance writings because of the
+earnings derived from investing this float.
+
+ As interest rates have fallen, however, the value of float has
+substantially declined. Therefore, the data that we have provided
+in the past are no longer useful for year-to-year comparisons of
+industry profitability. A company writing at the same combined
+ratio now as in the 1980's today has a far less attractive business
+than it did then.
+
+ Only by making an analysis that incorporates both underwriting
+results and the current risk-free earnings obtainable from float
+can one evaluate the true economics of the business that a
+property-casualty insurer writes. Of course, the actual investment
+results that an insurer achieves from the use of both float and
+stockholders' funds is also of major importance and should be
+carefully examined when an investor is assessing managerial
+performance. But that should be a separate analysis from the one
+we are discussing here. The value of float funds - in effect,
+their transfer price as they move from the insurance operation to
+the investment operation - should be determined simply by the risk-
+free, long-term rate of interest.
+
+ On the next page we show the numbers that count in an
+evaluation of Berkshire's insurance business. We calculate our
+float - which we generate in exceptional amounts relative to our
+premium volume - by adding loss reserves, loss adjustment reserves
+and unearned premium reserves and then subtracting agent's
+balances, prepaid acquisition costs and deferred charges applicable
+to assumed reinsurance. Our cost of float is determined by our
+underwriting loss or profit. In those years when we have had an
+underwriting profit, which includes 1993, our cost of float has
+been negative, and we have determined our insurance earnings by
+adding underwriting profit to float income.
+
+ (1) (2) Yearend Yield
+ Underwriting Approximate on Long-Term
+ Loss Average Float Cost of Funds Govt. Bonds
+ ------------ ------------- --------------- -------------
+ (In $ Millions) (Ratio of 1 to 2)
+
+1967 profit $ 17.3 less than zero 5.50%
+1968 profit 19.9 less than zero 5.90%
+1969 profit 23.4 less than zero 6.79%
+1970 $ 0.37 32.4 1.14% 6.25%
+1971 profit 52.5 less than zero 5.81%
+1972 profit 69.5 less than zero 5.82%
+1973 profit 73.3 less than zero 7.27%
+1974 7.36 79.1 9.30% 8.13%
+1975 11.35 87.6 12.96% 8.03%
+1976 profit 102.6 less than zero 7.30%
+1977 profit 139.0 less than zero 7.97%
+1978 profit 190.4 less than zero 8.93%
+1979 profit 227.3 less than zero 10.08%
+1980 profit 237.0 less than zero 11.94%
+1981 profit 228.4 less than zero 13.61%
+1982 21.56 220.6 9.77% 10.64%
+1983 33.87 231.3 14.64% 11.84%
+1984 48.06 253.2 18.98% 11.58%
+1985 44.23 390.2 11.34% 9.34%
+1986 55.84 797.5 7.00% 7.60%
+1987 55.43 1,266.7 4.38% 8.95%
+1988 11.08 1,497.7 0.74% 9.00%
+1989 24.40 1,541.3 1.58% 7.97%
+1990 26.65 1,637.3 1.63% 8.24%
+1991 119.59 1,895.0 6.31% 7.40%
+1992 108.96 2,290.4 4.76% 7.39%
+1993 profit 2,624.7 less than zero 6.35%
+
+ As you can see, in our insurance operation last year we had
+the use of $2.6 billion at no cost; in fact we were paid $31
+million, our underwriting profit, to hold these funds. This sounds
+good - is good - but is far from as good as it sounds.
+
+ We temper our enthusiasm because we write a large volume of
+"super-cat" policies (which other insurance and reinsurance
+companies buy to recover part of the losses they suffer from mega-
+catastrophes) and because last year we had no losses of consequence
+from this activity. As that suggests, the truly catastrophic
+Midwestern floods of 1993 did not trigger super-cat losses, the
+reason being that very few flood policies are purchased from
+private insurers.
+
+ It would be fallacious, however, to conclude from this single-
+year result that the super-cat business is a wonderful one, or even
+a satisfactory one. A simple example will illustrate the fallacy:
+Suppose there is an event that occurs 25 times in every century.
+If you annually give 5-for-1 odds against its occurrence that year,
+you will have many more winning years than losers. Indeed, you may
+go a straight six, seven or more years without loss. You also will
+eventually go broke.
+
+ At Berkshire, we naturally believe we are obtaining adequate
+premiums and giving more like 3 1/2-for-1 odds. But there is no way
+for us - or anyone else - to calculate the true odds on super-cat
+coverages. In fact, it will take decades for us to find out
+whether our underwriting judgment has been sound.
+
+ What we do know is that when a loss comes, it's likely to be a
+lulu. There may well be years when Berkshire will suffer losses
+from the super-cat business equal to three or four times what we
+earned from it in 1993. When Hurricane Andrew blew in 1992, we
+paid out about $125 million. Because we've since expanded our
+super-cat business, a similar storm today could cost us $600
+million.
+
+ So far, we have been lucky in 1994. As I write this letter,
+we are estimating that our losses from the Los Angeles earthquake
+will be nominal. But if the quake had been a 7.5 instead of a 6.8,
+it would have been a different story.
+
+ Berkshire is ideally positioned to write super-cat policies.
+In Ajit Jain, we have by far the best manager in this business.
+Additionally, companies writing these policies need enormous
+capital, and our net worth is ten to twenty times larger than that
+of our main competitors. In most lines of insurance, huge
+resources aren't that important: An insurer can diversify the
+risks it writes and, if necessary, can lay off risks to reduce
+concentration in its portfolio. That isn't possible in the super-
+cat business. So these competitors are forced into offering far
+smaller limits than those we can provide. Were they bolder, they
+would run the risk that a mega-catastrophe - or a confluence of
+smaller catastrophes - would wipe them out.
+
+ One indication of our premier strength and reputation is that
+each of the four largest reinsurance companies in the world buys
+very significant reinsurance coverage from Berkshire. Better than
+anyone else, these giants understand that the test of a reinsurer
+is its ability and willingness to pay losses under trying
+circumstances, not its readiness to accept premiums when things
+look rosy.
+
+ One caution: There has recently been a substantial increase
+in reinsurance capacity. Close to $5 billion of equity capital has
+been raised by reinsurers, almost all of them newly-formed
+entities. Naturally these new entrants are hungry to write
+business so that they can justify the projections they utilized in
+attracting capital. This new competition won't affect our 1994
+operations; we're filled up there, primarily with business written
+in 1993. But we are now seeing signs of price deterioration. If
+this trend continues, we will resign ourselves to much-reduced
+volume, keeping ourselves available, though, for the large,
+sophisticated buyer who requires a super-cat insurer with large
+capacity and a sure ability to pay losses.
+
+ In other areas of our insurance business, our homestate
+operation, led by Rod Eldred; our workers' compensation business,
+headed by Brad Kinstler; our credit-card operation, managed by the
+Kizer family; and National Indemnity's traditional auto and general
+liability business, led by Don Wurster, all achieved excellent
+results. In combination, these four units produced a significant
+underwriting profit and substantial float.
+
+ All in all, we have a first-class insurance business. Though
+its results will be highly volatile, this operation possesses an
+intrinsic value that exceeds its book value by a large amount -
+larger, in fact, than is the case at any other Berkshire business.
+
+Common Stock Investments
+
+ Below we list our common stockholdings having a value of over
+$250 million. A small portion of these investments belongs to
+subsidiaries of which Berkshire owns less than 100%.
+
+ 12/31/93
+ Shares Company Cost Market
+ ------ ------- ---------- ----------
+ (000s omitted)
+ 2,000,000 Capital Cities/ABC, Inc. ............. $ 345,000 $1,239,000
+93,400,000 The Coca-Cola Company. ............... 1,023,920 4,167,975
+13,654,600 Federal Home Loan Mortgage Corp.
+ ("Freddie Mac") ................... 307,505 681,023
+34,250,000 GEICO Corp. .......................... 45,713 1,759,594
+ 4,350,000 General Dynamics Corp. ............... 94,938 401,287
+24,000,000 The Gillette Company ................. 600,000 1,431,000
+38,335,000 Guinness PLC ......................... 333,019 270,822
+ 1,727,765 The Washington Post Company. ......... 9,731 440,148
+ 6,791,218 Wells Fargo & Company ................ 423,680 878,614
+
+ Considering the similarity of this year's list and the last,
+you may decide your management is hopelessly comatose. But we
+continue to think that it is usually foolish to part with an
+interest in a business that is both understandable and durably
+wonderful. Business interests of that kind are simply too hard to
+replace.
+
+ Interestingly, corporate managers have no trouble
+understanding that point when they are focusing on a business they
+operate: A parent company that owns a subsidiary with superb long-
+term economics is not likely to sell that entity regardless of
+price. "Why," the CEO would ask, "should I part with my crown
+jewel?" Yet that same CEO, when it comes to running his personal
+investment portfolio, will offhandedly - and even impetuously -
+move from business to business when presented with no more than
+superficial arguments by his broker for doing so. The worst of
+these is perhaps, "You can't go broke taking a profit." Can you
+imagine a CEO using this line to urge his board to sell a star
+subsidiary? In our view, what makes sense in business also makes
+sense in stocks: An investor should ordinarily hold a small piece
+of an outstanding business with the same tenacity that an owner
+would exhibit if he owned all of that business.
+
+ Earlier I mentioned the financial results that could have been
+achieved by investing $40 in The Coca-Cola Co. in 1919. In 1938,
+more than 50 years after the introduction of Coke, and long after
+the drink was firmly established as an American icon, Fortune did
+an excellent story on the company. In the second paragraph the
+writer reported: "Several times every year a weighty and serious
+investor looks long and with profound respect at Coca-Cola's
+record, but comes regretfully to the conclusion that he is looking
+too late. The specters of saturation and competition rise before
+him."
+
+ Yes, competition there was in 1938 and in 1993 as well. But
+it's worth noting that in 1938 The Coca-Cola Co. sold 207 million
+cases of soft drinks (if its gallonage then is converted into the
+192-ounce cases used for measurement today) and in 1993 it sold
+about 10.7 billion cases, a 50-fold increase in physical volume
+from a company that in 1938 was already dominant in its very major
+industry. Nor was the party over in 1938 for an investor: Though
+the $40 invested in 1919 in one share had (with dividends
+reinvested) turned into $3,277 by the end of 1938, a fresh $40 then
+invested in Coca-Cola stock would have grown to $25,000 by yearend
+1993.
+
+ I can't resist one more quote from that 1938 Fortune story:
+"It would be hard to name any company comparable in size to Coca-
+Cola and selling, as Coca-Cola does, an unchanged product that can
+point to a ten-year record anything like Coca-Cola's." In the 55
+years that have since passed, Coke's product line has broadened
+somewhat, but it's remarkable how well that description still fits.
+
+ Charlie and I decided long ago that in an investment lifetime
+it's just too hard to make hundreds of smart decisions. That
+judgment became ever more compelling as Berkshire's capital
+mushroomed and the universe of investments that could significantly
+affect our results shrank dramatically. Therefore, we adopted a
+strategy that required our being smart - and not too smart at that
+- only a very few times. Indeed, we'll now settle for one good
+idea a year. (Charlie says it's my turn.)
+
+ The strategy we've adopted precludes our following standard
+diversification dogma. Many pundits would therefore say the
+strategy must be riskier than that employed by more conventional
+investors. We disagree. We believe that a policy of portfolio
+concentration may well decrease risk if it raises, as it should,
+both the intensity with which an investor thinks about a business
+and the comfort-level he must feel with its economic characteristics
+before buying into it. In stating this opinion, we define risk,
+using dictionary terms, as "the possibility of loss or injury."
+
+ Academics, however, like to define investment "risk"
+differently, averring that it is the relative volatility of a stock
+or portfolio of stocks - that is, their volatility as compared to
+that of a large universe of stocks. Employing data bases and
+statistical skills, these academics compute with precision the
+"beta" of a stock - its relative volatility in the past - and then
+build arcane investment and capital-allocation theories around this
+calculation. In their hunger for a single statistic to measure
+risk, however, they forget a fundamental principle: It is better
+to be approximately right than precisely wrong.
+
+ For owners of a business - and that's the way we think of
+shareholders - the academics' definition of risk is far off the
+mark, so much so that it produces absurdities. For example, under
+beta-based theory, a stock that has dropped very sharply compared
+to the market - as had Washington Post when we bought it in 1973 -
+becomes "riskier" at the lower price than it was at the higher
+price. Would that description have then made any sense to someone
+who was offered the entire company at a vastly-reduced price?
+
+ In fact, the true investor welcomes volatility. Ben Graham
+explained why in Chapter 8 of The Intelligent Investor. There he
+introduced "Mr. Market," an obliging fellow who shows up every day
+to either buy from you or sell to you, whichever you wish. The
+more manic-depressive this chap is, the greater the opportunities
+available to the investor. That's true because a wildly
+fluctuating market means that irrationally low prices will
+periodically be attached to solid businesses. It is impossible to
+see how the availability of such prices can be thought of as
+increasing the hazards for an investor who is totally free to
+either ignore the market or exploit its folly.
+
+ In assessing risk, a beta purist will disdain examining what a
+company produces, what its competitors are doing, or how much
+borrowed money the business employs. He may even prefer not to
+know the company's name. What he treasures is the price history of
+its stock. In contrast, we'll happily forgo knowing the price
+history and instead will seek whatever information will further our
+understanding of the company's business. After we buy a stock,
+consequently, we would not be disturbed if markets closed for a
+year or two. We don't need a daily quote on our 100% position in
+See's or H. H. Brown to validate our well-being. Why, then, should
+we need a quote on our 7% interest in Coke?
+
+ In our opinion, the real risk that an investor must assess is
+whether his aggregate after-tax receipts from an investment
+(including those he receives on sale) will, over his prospective
+holding period, give him at least as much purchasing power as he
+had to begin with, plus a modest rate of interest on that initial
+stake. Though this risk cannot be calculated with engineering
+precision, it can in some cases be judged with a degree of accuracy
+that is useful. The primary factors bearing upon this evaluation
+are:
+
+ 1) The certainty with which the long-term economic
+ characteristics of the business can be evaluated;
+
+ 2) The certainty with which management can be evaluated,
+ both as to its ability to realize the full potential of
+ the business and to wisely employ its cash flows;
+
+ 3) The certainty with which management can be counted on
+ to channel the rewards from the business to the
+ shareholders rather than to itself;
+
+ 4) The purchase price of the business;
+
+ 5) The levels of taxation and inflation that will be
+ experienced and that will determine the degree by which
+ an investor's purchasing-power return is reduced from his
+ gross return.
+
+ These factors will probably strike many analysts as unbearably
+fuzzy, since they cannot be extracted from a data base of any kind.
+But the difficulty of precisely quantifying these matters does not
+negate their importance nor is it insuperable. Just as Justice
+Stewart found it impossible to formulate a test for obscenity but
+nevertheless asserted, "I know it when I see it," so also can
+investors - in an inexact but useful way - "see" the risks inherent
+in certain investments without reference to complex equations or
+price histories.
+
+ Is it really so difficult to conclude that Coca-Cola and
+Gillette possess far less business risk over the long term than,
+say, any computer company or retailer? Worldwide, Coke sells about
+44% of all soft drinks, and Gillette has more than a 60% share (in
+value) of the blade market. Leaving aside chewing gum, in which
+Wrigley is dominant, I know of no other significant businesses in
+which the leading company has long enjoyed such global power.
+
+ Moreover, both Coke and Gillette have actually increased their
+worldwide shares of market in recent years. The might of their
+brand names, the attributes of their products, and the strength of
+their distribution systems give them an enormous competitive
+advantage, setting up a protective moat around their economic
+castles. The average company, in contrast, does battle daily
+without any such means of protection. As Peter Lynch says, stocks
+of companies selling commodity-like products should come with a
+warning label: "Competition may prove hazardous to human wealth."
+
+ The competitive strengths of a Coke or Gillette are obvious to
+even the casual observer of business. Yet the beta of their stocks
+is similar to that of a great many run-of-the-mill companies who
+possess little or no competitive advantage. Should we conclude
+from this similarity that the competitive strength of Coke and
+Gillette gains them nothing when business risk is being measured?
+Or should we conclude that the risk in owning a piece of a company
+- its stock - is somehow divorced from the long-term risk inherent
+in its business operations? We believe neither conclusion makes
+sense and that equating beta with investment risk also makes no
+sense.
+
+ The theoretician bred on beta has no mechanism for
+differentiating the risk inherent in, say, a single-product toy
+company selling pet rocks or hula hoops from that of another toy
+company whose sole product is Monopoly or Barbie. But it's quite
+possible for ordinary investors to make such distinctions if they
+have a reasonable understanding of consumer behavior and the
+factors that create long-term competitive strength or weakness.
+Obviously, every investor will make mistakes. But by confining
+himself to a relatively few, easy-to-understand cases, a reasonably
+intelligent, informed and diligent person can judge investment
+risks with a useful degree of accuracy.
+
+ In many industries, of course, Charlie and I can't determine
+whether we are dealing with a "pet rock" or a "Barbie." We
+couldn't solve this problem, moreover, even if we were to spend
+years intensely studying those industries. Sometimes our own
+intellectual shortcomings would stand in the way of understanding,
+and in other cases the nature of the industry would be the
+roadblock. For example, a business that must deal with fast-moving
+technology is not going to lend itself to reliable evaluations of
+its long-term economics. Did we foresee thirty years ago what
+would transpire in the television-manufacturing or computer
+industries? Of course not. (Nor did most of the investors and
+corporate managers who enthusiastically entered those industries.)
+Why, then, should Charlie and I now think we can predict the
+future of other rapidly-evolving businesses? We'll stick instead
+with the easy cases. Why search for a needle buried in a haystack
+when one is sitting in plain sight?
+
+ Of course, some investment strategies - for instance, our
+efforts in arbitrage over the years - require wide diversification.
+If significant risk exists in a single transaction, overall risk
+should be reduced by making that purchase one of many mutually-
+independent commitments. Thus, you may consciously purchase a
+risky investment - one that indeed has a significant possibility of
+causing loss or injury - if you believe that your gain, weighted
+for probabilities, considerably exceeds your loss, comparably
+weighted, and if you can commit to a number of similar, but
+unrelated opportunities. Most venture capitalists employ this
+strategy. Should you choose to pursue this course, you should
+adopt the outlook of the casino that owns a roulette wheel, which
+will want to see lots of action because it is favored by
+probabilities, but will refuse to accept a single, huge bet.
+
+ Another situation requiring wide diversification occurs when
+an investor who does not understand the economics of specific
+businesses nevertheless believes it in his interest to be a long-
+term owner of American industry. That investor should both own a
+large number of equities and space out his purchases. By
+periodically investing in an index fund, for example, the know-
+nothing investor can actually out-perform most investment
+professionals. Paradoxically, when "dumb" money acknowledges its
+limitations, it ceases to be dumb.
+
+ On the other hand, if you are a know-something investor, able
+to understand business economics and to find five to ten sensibly-
+priced companies that possess important long-term competitive
+advantages, conventional diversification makes no sense for you.
+It is apt simply to hurt your results and increase your risk. I
+cannot understand why an investor of that sort elects to put money
+into a business that is his 20th favorite rather than simply adding
+that money to his top choices - the businesses he understands best
+and that present the least risk, along with the greatest profit
+potential. In the words of the prophet Mae West: "Too much of a
+good thing can be wonderful."
+
+Corporate Governance
+
+ At our annual meetings, someone usually asks "What happens to
+this place if you get hit by a truck?" I'm glad they are still
+asking the question in this form. It won't be too long before the
+query becomes: "What happens to this place if you don't get hit by
+a truck?"
+
+ Such questions, in any event, raise a reason for me to discuss
+corporate governance, a hot topic during the past year. In
+general, I believe that directors have stiffened their spines
+recently and that shareholders are now being treated somewhat more
+like true owners than was the case not long ago. Commentators on
+corporate governance, however, seldom make any distinction among
+three fundamentally different manager/owner situations that exist
+in publicly-held companies. Though the legal responsibility of
+directors is identical throughout, their ability to effect change
+differs in each of the cases. Attention usually falls on the first
+case, because it prevails on the corporate scene. Since Berkshire
+falls into the second category, however, and will someday fall into
+the third, we will discuss all three variations.
+
+ The first, and by far most common, board situation is one in
+which a corporation has no controlling shareholder. In that case,
+I believe directors should behave as if there is a single absentee
+owner, whose long-term interest they should try to further in all
+proper ways. Unfortunately, "long-term" gives directors a lot of
+wiggle room. If they lack either integrity or the ability to think
+independently, directors can do great violence to shareholders
+while still claiming to be acting in their long-term interest. But
+assume the board is functioning well and must deal with a
+management that is mediocre or worse. Directors then have the
+responsibility for changing that management, just as an intelligent
+owner would do if he were present. And if able but greedy managers
+over-reach and try to dip too deeply into the shareholders'
+pockets, directors must slap their hands.
+
+ In this plain-vanilla case, a director who sees something he
+doesn't like should attempt to persuade the other directors of his
+views. If he is successful, the board will have the muscle to make
+the appropriate change. Suppose, though, that the unhappy director
+can't get other directors to agree with him. He should then feel
+free to make his views known to the absentee owners. Directors
+seldom do that, of course. The temperament of many directors would
+in fact be incompatible with critical behavior of that sort. But I
+see nothing improper in such actions, assuming the issues are
+serious. Naturally, the complaining director can expect a vigorous
+rebuttal from the unpersuaded directors, a prospect that should
+discourage the dissenter from pursuing trivial or non-rational
+causes.
+
+ For the boards just discussed, I believe the directors ought
+to be relatively few in number - say, ten or less - and ought to
+come mostly from the outside. The outside board members should
+establish standards for the CEO's performance and should also
+periodically meet, without his being present, to evaluate his
+performance against those standards.
+
+ The requisites for board membership should be business savvy,
+interest in the job, and owner-orientation. Too often, directors
+are selected simply because they are prominent or add diversity to
+the board. That practice is a mistake. Furthermore, mistakes in
+selecting directors are particularly serious because appointments
+are so hard to undo: The pleasant but vacuous director need never
+worry about job security.
+
+ The second case is that existing at Berkshire, where the
+controlling owner is also the manager. At some companies, this
+arrangement is facilitated by the existence of two classes of stock
+endowed with disproportionate voting power. In these situations,
+it's obvious that the board does not act as an agent between owners
+and management and that the directors cannot effect change except
+through persuasion. Therefore, if the owner/manager is mediocre or
+worse - or is over-reaching - there is little a director can do
+about it except object. If the directors having no connections to
+the owner/manager make a unified argument, it may well have some
+effect. More likely it will not.
+
+ If change does not come, and the matter is sufficiently
+serious, the outside directors should resign. Their resignation
+will signal their doubts about management, and it will emphasize
+that no outsider is in a position to correct the owner/manager's
+shortcomings.
+
+ The third governance case occurs when there is a controlling
+owner who is not involved in management. This case, examples of
+which are Hershey Foods and Dow Jones, puts the outside directors
+in a potentially useful position. If they become unhappy with
+either the competence or integrity of the manager, they can go
+directly to the owner (who may also be on the board) and report
+their dissatisfaction. This situation is ideal for an outside
+director, since he need make his case only to a single, presumably
+interested owner, who can forthwith effect change if the argument
+is persuasive. Even so, the dissatisfied director has only that
+single course of action. If he remains unsatisfied about a
+critical matter, he has no choice but to resign.
+
+ Logically, the third case should be the most effective in
+insuring first-class management. In the second case the owner is
+not going to fire himself, and in the first case, directors often
+find it very difficult to deal with mediocrity or mild over-
+reaching. Unless the unhappy directors can win over a majority of
+the board - an awkward social and logistical task, particularly if
+management's behavior is merely odious, not egregious - their hands
+are effectively tied. In practice, directors trapped in situations
+of this kind usually convince themselves that by staying around
+they can do at least some good. Meanwhile, management proceeds
+unfettered.
+
+ In the third case, the owner is neither judging himself nor
+burdened with the problem of garnering a majority. He can also
+insure that outside directors are selected who will bring useful
+qualities to the board. These directors, in turn, will know that
+the good advice they give will reach the right ears, rather than
+being stifled by a recalcitrant management. If the controlling
+owner is intelligent and self-confident, he will make decisions in
+respect to management that are meritocratic and pro-shareholder.
+Moreover - and this is critically important - he can readily
+correct any mistake he makes.
+
+ At Berkshire we operate in the second mode now and will for as
+long as I remain functional. My health, let me add, is excellent.
+For better or worse, you are likely to have me as an owner/manager
+for some time.
+
+ After my death, all of my stock will go to my wife, Susie,
+should she survive me, or to a foundation if she dies before I do.
+In neither case will taxes and bequests require the sale of
+consequential amounts of stock.
+
+ When my stock is transferred to either my wife or the
+foundation, Berkshire will enter the third governance mode, going
+forward with a vitally interested, but non-management, owner and
+with a management that must perform for that owner. In preparation
+for that time, Susie was elected to the board a few years ago, and
+in 1993 our son, Howard, joined the board. These family members
+will not be managers of the company in the future, but they will
+represent the controlling interest should anything happen to me.
+Most of our other directors are also significant owners of
+Berkshire stock, and each has a strong owner-orientation. All in
+all, we're prepared for "the truck."
+
+Shareholder-Designated Contributions
+
+ About 97% of all eligible shares participated in Berkshire's
+1993 shareholder-designated contributions program. Contributions
+made through the program were $9.4 million and 3,110 charities were
+recipients.
+
+ Berkshire's practice in respect to discretionary philanthropy
+- as contrasted to its policies regarding contributions that are
+clearly related to the company's business activities - differs
+significantly from that of other publicly-held corporations.
+There, most corporate contributions are made pursuant to the wishes
+of the CEO (who often will be responding to social pressures),
+employees (through matching gifts), or directors (through matching
+gifts or requests they make of the CEO).
+
+ At Berkshire, we believe that the company's money is the
+owners' money, just as it would be in a closely-held corporation,
+partnership, or sole proprietorship. Therefore, if funds are to be
+given to causes unrelated to Berkshire's business activities, it is
+the charities favored by our owners that should receive them.
+We've yet to find a CEO who believes he should personally fund the
+charities favored by his shareholders. Why, then, should they foot
+the bill for his picks?
+
+ Let me add that our program is easy to administer. Last fall,
+for two months, we borrowed one person from National Indemnity to
+help us implement the instructions that came from our 7,500
+registered shareholders. I'd guess that the average corporate
+program in which employee gifts are matched incurs far greater
+administrative costs. Indeed, our entire corporate overhead is
+less than half the size of our charitable contributions. (Charlie,
+however, insists that I tell you that $1.4 million of our $4.9 million overhead is
+attributable to our corporate jet, The Indefensible.)
+
+ Below is a list showing the largest categories to which our
+shareholders have steered their contributions.
+
+ (a) 347 churches and synagogues received 569 gifts
+ (b) 283 colleges and universities received 670 gifts
+ (c) 244 K-12 schools (about two-thirds secular, one-
+ third religious) received 525 gifts
+ (d) 288 institutions dedicated to art, culture or the
+ humanities received 447 gifts
+ (e) 180 religious social-service organizations (split
+ about equally between Christian and Jewish) received
+ 411 gifts
+ (f) 445 secular social-service organizations (about 40%
+ youth-related) received 759 gifts
+ (g) 153 hospitals received 261 gifts
+ (h) 186 health-related organizations (American Heart
+ Association, American Cancer Society, etc.) received
+ 320 gifts
+
+ Three things about this list seem particularly interesting to
+me. First, to some degree it indicates what people choose to give
+money to when they are acting of their own accord, free of pressure
+from solicitors or emotional appeals from charities. Second, the
+contributions programs of publicly-held companies almost never
+allow gifts to churches and synagogues, yet clearly these
+institutions are what many shareholders would like to support.
+Third, the gifts made by our shareholders display conflicting
+philosophies: 130 gifts were directed to organizations that
+believe in making abortions readily available for women and 30
+gifts were directed to organizations (other than churches) that
+discourage or are opposed to abortion.
+
+ Last year I told you that I was thinking of raising the amount
+that Berkshire shareholders can give under our designated-
+contributions program and asked for your comments. We received a
+few well-written letters opposing the entire idea, on the grounds
+that it was our job to run the business and not our job to force
+shareholders into making charitable gifts. Most of the
+shareholders responding, however, noted the tax efficiency of the
+plan and urged us to increase the designated amount. Several
+shareholders who have given stock to their children or
+grandchildren told me that they consider the program a particularly
+good way to get youngsters thinking at an early age about the
+subject of giving. These people, in other words, perceive the
+program to be an educational, as well as philanthropic, tool. The
+bottom line is that we did raise the amount in 1993, from $8 per
+share to $10.
+
+ In addition to the shareholder-designated contributions that
+Berkshire distributes, our operating businesses make contributions,
+including merchandise, averaging about $2.5 million annually.
+These contributions support local charities, such as The United
+Way, and produce roughly commensurate benefits for our businesses.
+
+ We suggest that new shareholders read the description of our
+shareholder-designated contributions program that appears on pages
+50-51. To participate in future programs, you must make sure your
+shares are registered in the name of the actual owner, not in the
+nominee name of a broker, bank or depository. Shares not so
+registered on August 31, 1994 will be ineligible for the 1994
+program.
+
+A Few Personal Items
+
+ Mrs. B - Rose Blumkin - had her 100th birthday on December 3,
+1993. (The candles cost more than the cake.) That was a day on
+which the store was scheduled to be open in the evening. Mrs. B,
+who works seven days a week, for however many hours the store
+operates, found the proper decision quite obvious: She simply
+postponed her party until an evening when the store was closed.
+
+ Mrs. B's story is well-known but worth telling again. She
+came to the United States 77 years ago, unable to speak English and
+devoid of formal schooling. In 1937, she founded the Nebraska
+Furniture Mart with $500. Last year the store had sales of $200
+million, a larger amount by far than that recorded by any other
+home furnishings store in the United States. Our part in all of
+this began ten years ago when Mrs. B sold control of the business
+to Berkshire Hathaway, a deal we completed without obtaining
+audited financial statements, checking real estate records, or
+getting any warranties. In short, her word was good enough for us.
+
+ Naturally, I was delighted to attend Mrs. B's birthday party.
+After all, she's promised to attend my 100th.
+
+ * * * * * * * * * * * *
+
+ Katharine Graham retired last year as the chairman of The
+Washington Post Company, having relinquished the CEO title three
+years ago. In 1973, we purchased our stock in her company for
+about $10 million. Our holding now garners $7 million a year in
+dividends and is worth over $400 million. At the time of our
+purchase, we knew that the economic prospects of the company were
+good. But equally important, Charlie and I concluded that Kay
+would prove to be an outstanding manager and would treat all
+shareholders honorably. That latter consideration was particularly
+important because The Washington Post Company has two classes of
+stock, a structure that we've seen some managers abuse.
+
+ All of our judgments about this investment have been validated
+by events. Kay's skills as a manager were underscored this past
+year when she was elected by Fortune's Board of Editors to the
+Business Hall of Fame. On behalf of our shareholders, Charlie and
+I had long ago put her in Berkshire's Hall of Fame.
+
+ * * * * * * * * * * * *
+
+ Another of last year's retirees was Don Keough of Coca-Cola,
+although, as he puts it, his retirement lasted "about 14 hours."
+Don is one of the most extraordinary human beings I've ever known -
+a man of enormous business talent, but, even more important, a man
+who brings out the absolute best in everyone lucky enough to
+associate with him. Coca-Cola wants its product to be present at
+the happy times of a person's life. Don Keough, as an individual,
+invariably increases the happiness of those around him. It's
+impossible to think about Don without feeling good.
+
+ I will edge up to how I met Don by slipping in a plug for my
+neighborhood in Omaha: Though Charlie has lived in California for
+45 years, his home as a boy was about 200 feet away from the house
+where I now live; my wife, Susie, grew up 1 1/2 blocks away; and we
+have about 125 Berkshire shareholders in the zip code. As for Don,
+in 1958 he bought the house directly across the street from mine.
+He was then a coffee salesman with a big family and a small income.
+
+ The impressions I formed in those days about Don were a factor
+in my decision to have Berkshire make a record $1 billion
+investment in Coca-Cola in 1988-89. Roberto Goizueta had become
+CEO of Coke in 1981, with Don alongside as his partner. The two of
+them took hold of a company that had stagnated during the previous
+decade and moved it from $4.4 billion of market value to $58
+billion in less than 13 years. What a difference a pair of
+managers like this makes, even when their product has been around
+for 100 years.
+
+ * * * * * * * * * * * *
+
+ Frank Rooney did double duty last year. In addition to
+leading H. H. Brown to record profits - 35% above the 1992 high -
+he also was key to our merger with Dexter.
+
+ Frank has known Harold Alfond and Peter Lunder for decades,
+and shortly after our purchase of H. H. Brown, told me what a
+wonderful operation they managed. He encouraged us to get together
+and in due course we made a deal. Frank told Harold and Peter that
+Berkshire would provide an ideal corporate "home" for Dexter, and
+that assurance undoubtedly contributed to their decision to join
+with us.
+
+ I've told you in the past of Frank's extraordinary record in
+building Melville Corp. during his 23 year tenure as CEO. Now, at
+72, he's setting an even faster pace at Berkshire. Frank has a
+low-key, relaxed style, but don't let that fool you. When he
+swings, the ball disappears far over the fence.
+
+The Annual Meeting
+
+ This year the Annual Meeting will be held at the Orpheum
+Theater in downtown Omaha at 9:30 a.m. on Monday, April 25, 1994.
+A record 2,200 people turned up for the meeting last year, but the
+theater can handle many more. We will have a display in the lobby
+featuring many of our consumer products - candy, spray guns, shoes,
+cutlery, encyclopedias, and the like. Among my favorites slated to
+be there is a See's candy assortment that commemorates Mrs. B's
+100th birthday and that features her picture, rather than Mrs.
+See's, on the package.
+
+ We recommend that you promptly get hotel reservations at one
+of these hotels: (1) The Radisson-Redick Tower, a small (88 rooms)
+but nice hotel across the street from the Orpheum; (2) the much
+larger Red Lion Hotel, located about a five-minute walk from the
+Orpheum; or (3) the Marriott, located in West Omaha about 100 yards
+from Borsheim's, which is a twenty-minute drive from downtown. We
+will have buses at the Marriott that will leave at 8:30 and 8:45
+for the meeting and return after it ends.
+
+ An attachment to our proxy material explains how you can
+obtain the card you will need for admission to the meeting. With
+the admission card, we will enclose information about parking
+facilities located near the Orpheum. If you are driving, come a
+little early. Nearby lots fill up quickly and you may have to walk
+a few blocks.
+
+ As usual, we will have buses to take you to Nebraska Furniture
+Mart and Borsheim's after the meeting and to take you from there to
+downtown hotels or the airport later. Those of you arriving early
+can visit the Furniture Mart any day of the week; it is open from
+10 a.m. to 5:30 p.m. on Saturdays and from noon to 5:30 p.m. on
+Sundays. Borsheim's normally is closed on Sunday but will be open
+for shareholders and their guests from noon to 6 p.m. on Sunday,
+April 24.
+
+ In past trips to Borsheim's, many of you have met Susan
+Jacques. Early in 1994, Susan was made President and CEO of the
+company, having risen in 11 years from a $4-an-hour job that she
+took at the store when she was 23. Susan will be joined at
+Borsheim's on Sunday by many of the managers of our other
+businesses, and Charlie and I will be there as well.
+
+ On the previous evening, Saturday, April 23, there will be a
+baseball game at Rosenblatt Stadium between the Omaha Royals and
+the Nashville Sounds (which could turn out to be Michael Jordan's
+team). As you may know, a few years ago I bought 25% of the Royals
+(a capital-allocation decision for which I will not become famous)
+and this year the league has cooperatively scheduled a home stand
+at Annual Meeting time.
+
+ I will throw the first pitch on the 23rd, and it's a certainty
+that I will improve on last year's humiliating performance. On
+that occasion, the catcher inexplicably called for my "sinker" and
+I dutifully delivered a pitch that barely missed my foot. This
+year, I will go with my high hard one regardless of what the
+catcher signals, so bring your speed-timing devices. The proxy
+statement will include information about obtaining tickets to the
+game. I regret to report that you won't have to buy them from
+scalpers.
+
+
+
+ Warren E. Buffett
+March 1, 1994 Chairman of the Board
+
+
+
+
diff --git a/berkshire-hathaway/1994/1-in/berkshire-hathaway-1994-letter.txt b/berkshire-hathaway/1994/1-in/berkshire-hathaway-1994-letter.txt
new file mode 100644
index 0000000..09b0627
--- /dev/null
+++ b/berkshire-hathaway/1994/1-in/berkshire-hathaway-1994-letter.txt
@@ -0,0 +1,1206 @@
+
+
+
+
+
+ +BERKSHIRE HATHAWAY INC. +
+ +
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+
+ Our gain in net worth during 1994 was $1.45 billion or 13.9%.
+Over the last 30 years (that is, since present management took
+over) our per-share book value has grown from $19 to $10,083, or
+at a rate of 23% compounded annually.
+
+ Charlie Munger, Berkshire's Vice Chairman and my partner,
+and I make few predictions. One we will confidently offer,
+however, is that the future performance of Berkshire won't come
+close to matching the performance of the past.
+
+ The problem is not that what has worked in the past will
+cease to work in the future. To the contrary, we believe that
+our formula - the purchase at sensible prices of businesses that
+have good underlying economics and are run by honest and able
+people - is certain to produce reasonable success. We expect,
+therefore, to keep on doing well.
+
+ A fat wallet, however, is the enemy of superior investment
+results. And Berkshire now has a net worth of $11.9 billion
+compared to about $22 million when Charlie and I began to manage
+the company. Though there are as many good businesses as ever,
+it is useless for us to make purchases that are inconsequential
+in relation to Berkshire's capital. (As Charlie regularly
+reminds me, "If something is not worth doing at all, it's not
+worth doing well.") We now consider a security for purchase only
+if we believe we can deploy at least $100 million in it. Given
+that minimum, Berkshire's investment universe has shrunk
+dramatically.
+
+ Nevertheless, we will stick with the approach that got us
+here and try not to relax our standards. Ted Williams, in
+The Story of My Life, explains why: "My argument is, to be
+a good hitter, you've got to get a good ball to hit. It's the
+first rule in the book. If I have to bite at stuff that is out
+of my happy zone, I'm not a .344 hitter. I might only be a .250
+hitter." Charlie and I agree and will try to wait for
+opportunities that are well within our own "happy zone."
+
+ We will continue to ignore political and economic forecasts,
+which are an expensive distraction for many investors and
+businessmen. Thirty years ago, no one could have foreseen the
+huge expansion of the Vietnam War, wage and price controls, two
+oil shocks, the resignation of a president, the dissolution of
+the Soviet Union, a one-day drop in the Dow of 508 points, or
+treasury bill yields fluctuating between 2.8% and 17.4%.
+
+ But, surprise - none of these blockbuster events made the
+slightest dent in Ben Graham's investment principles. Nor did
+they render unsound the negotiated purchases of fine businesses
+at sensible prices. Imagine the cost to us, then, if we had let
+a fear of unknowns cause us to defer or alter the deployment of
+capital. Indeed, we have usually made our best purchases when
+apprehensions about some macro event were at a peak. Fear is the
+foe of the faddist, but the friend of the fundamentalist.
+
+ A different set of major shocks is sure to occur in the next
+30 years. We will neither try to predict these nor to profit
+from them. If we can identify businesses similar to those we
+have purchased in the past, external surprises will have little
+effect on our long-term results.
+
+ What we promise you - along with more modest gains - is that
+during your ownership of Berkshire, you will fare just as Charlie
+and I do. If you suffer, we will suffer; if we prosper, so will
+you. And we will not break this bond by introducing compensation
+arrangements that give us a greater participation in the upside
+than the downside.
+
+ We further promise you that our personal fortunes will
+remain overwhelmingly concentrated in Berkshire shares: We will
+not ask you to invest with us and then put our own money
+elsewhere. In addition, Berkshire dominates both the investment
+portfolios of most members of our families and of a great many
+friends who belonged to partnerships that Charlie and I ran in
+the 1960's. We could not be more motivated to do our best.
+
+ Luckily, we have a good base from which to work. Ten years
+ago, in 1984, Berkshire's insurance companies held securities
+having a value of $1.7 billion, or about $1,500 per Berkshire
+share. Leaving aside all income and capital gains from those
+securities, Berkshire's pre-tax earnings that year were only
+about $6 million. We had earnings, yes, from our various
+manufacturing, retailing and service businesses, but they were
+almost entirely offset by the combination of underwriting losses
+in our insurance business, corporate overhead and interest
+expense.
+
+ Now we hold securities worth $18 billion, or over $15,000
+per Berkshire share. If you again exclude all income from these
+securities, our pre-tax earnings in 1994 were about $384 million.
+During the decade, employment has grown from 5,000 to 22,000
+(including eleven people at World Headquarters).
+
+ We achieved our gains through the efforts of a superb corps
+of operating managers who get extraordinary results from some
+ordinary-appearing businesses. Casey Stengel described managing
+a baseball team as "getting paid for home runs other fellows
+hit." That's my formula at Berkshire, also.
+
+ The businesses in which we have partial interests are
+equally important to Berkshire's success. A few statistics will
+illustrate their significance: In 1994, Coca-Cola sold about 280
+billion 8-ounce servings and earned a little less than a penny on
+each. But pennies add up. Through Berkshire's 7.8% ownership of
+Coke, we have an economic interest in 21 billion of its servings,
+which produce "soft-drink earnings" for us of nearly $200
+million. Similarly, by way of its Gillette stock, Berkshire has
+a 7% share of the world's razor and blade market (measured by
+revenues, not by units), a proportion according us about $250
+million of sales in 1994. And, at Wells Fargo, a $53 billion
+bank, our 13% ownership translates into a $7 billion "Berkshire
+Bank" that earned about $100 million during 1994.
+
+ It's far better to own a significant portion of the Hope
+diamond than 100% of a rhinestone, and the companies just
+mentioned easily qualify as rare gems. Best of all, we aren't
+limited to simply a few of this breed, but instead possess a
+growing collection.
+
+ Stock prices will continue to fluctuate - sometimes sharply
+- and the economy will have its ups and down. Over time,
+however, we believe it highly probable that the sort of
+businesses we own will continue to increase in value at a
+satisfactory rate.
+
+
+Book Value and Intrinsic Value
+
+ We regularly report our per-share book value, an easily
+calculable number, though one of limited use. Just as regularly,
+we tell you that what counts is intrinsic value, a number that is
+impossible to pinpoint but essential to estimate.
+
+ For example, in 1964, we could state with certitude that
+Berkshire's per-share book value was $19.46. However, that
+figure considerably overstated the stock's intrinsic value since
+all of the company's resources were tied up in a sub-profitable
+textile business. Our textile assets had neither going-concern
+nor liquidation values equal to their carrying values. In 1964,
+then, anyone inquiring into the soundness of Berkshire's balance
+sheet might well have deserved the answer once offered up by a
+Hollywood mogul of dubious reputation: "Don't worry, the
+liabilities are solid."
+
+ Today, Berkshire's situation has reversed: Many of the
+businesses we control are worth far more than their carrying
+value. (Those we don't control, such as Coca-Cola or Gillette,
+are carried at current market values.) We continue to give you
+book value figures, however, because they serve as a rough,
+albeit significantly understated, tracking measure for Berkshire's
+intrinsic value. Last year, in fact, the two measures moved in
+concert: Book value gained 13.9%, and that was the approximate
+gain in intrinsic value also.
+
+ We define intrinsic value as the discounted value of the
+cash that can be taken out of a business during its remaining
+life. Anyone calculating intrinsic value necessarily comes up
+with a highly subjective figure that will change both as
+estimates of future cash flows are revised and as interest rates
+move. Despite its fuzziness, however, intrinsic value is all-
+important and is the only logical way to evaluate the relative
+attractiveness of investments and businesses.
+
+ To see how historical input (book value) and future output
+(intrinsic value) can diverge, let's look at another form of
+investment, a college education. Think of the education's cost
+as its "book value." If it is to be accurate, the cost should
+include the earnings that were foregone by the student because he
+chose college rather than a job.
+
+ For this exercise, we will ignore the important non-economic
+benefits of an education and focus strictly on its economic
+value. First, we must estimate the earnings that the graduate
+will receive over his lifetime and subtract from that figure an
+estimate of what he would have earned had he lacked his
+education. That gives us an excess earnings figure, which must
+then be discounted, at an appropriate interest rate, back to
+graduation day. The dollar result equals the intrinsic economic
+value of the education.
+
+ Some graduates will find that the book value of their
+education exceeds its intrinsic value, which means that whoever
+paid for the education didn't get his money's worth. In other
+cases, the intrinsic value of an education will far exceed its
+book value, a result that proves capital was wisely deployed. In
+all cases, what is clear is that book value is meaningless as an
+indicator of intrinsic value.
+
+ Now let's get less academic and look at Scott Fetzer, an
+example from Berkshire's own experience. This account will not
+only illustrate how the relationship of book value and intrinsic
+value can change but also will provide an accounting lesson that
+I know you have been breathlessly awaiting. Naturally, I've
+chosen here to talk about an acquisition that has turned out to
+be a huge winner.
+
+ Berkshire purchased Scott Fetzer at the beginning of 1986.
+At the time, the company was a collection of 22 businesses, and
+today we have exactly the same line-up - no additions and no
+disposals. Scott Fetzer's main operations are World Book, Kirby,
+and Campbell Hausfeld, but many other units are important
+contributors to earnings as well.
+
+ We paid $315.2 million for Scott Fetzer, which at the time
+had $172.6 million of book value. The $142.6 million premium we
+handed over indicated our belief that the company's intrinsic
+value was close to double its book value.
+
+ In the table below we trace the book value of Scott Fetzer,
+as well as its earnings and dividends, since our purchase.
+
+ (1) (4)
+ Beginning (2) (3) Ending
+Year Book Value Earnings Dividends Book Value
+---- ---------- -------- --------- ----------
+ (In $ Millions) (1)+(2)-(3)
+
+1986 ............... $172.6 $ 40.3 $125.0 $ 87.9
+1987 ............... 87.9 48.6 41.0 95.5
+1988 ............... 95.5 58.0 35.0 118.6
+1989 ............... 118.6 58.5 71.5 105.5
+1990 ............... 105.5 61.3 33.5 133.3
+1991 ............... 133.3 61.4 74.0 120.7
+1992 ............... 120.7 70.5 80.0 111.2
+1993 ............... 111.2 77.5 98.0 90.7
+1994 ............... 90.7 79.3 76.0 94.0
+
+
+ Because it had excess cash when our deal was made, Scott
+Fetzer was able to pay Berkshire dividends of $125 million in
+1986, though it earned only $40.3 million. I should mention that
+we have not introduced leverage into Scott Fetzer's balance
+sheet. In fact, the company has gone from very modest debt when
+we purchased it to virtually no debt at all (except for debt used
+by its finance subsidiary). Similarly, we have not sold plants
+and leased them back, nor sold receivables, nor the like.
+Throughout our years of ownership, Scott Fetzer has operated as a
+conservatively-financed and liquid enterprise.
+
+ As you can see, Scott Fetzer's earnings have increased
+steadily since we bought it, but book value has not grown
+commensurately. Consequently, return on equity, which was
+exceptional at the time of our purchase, has now become truly
+extraordinary. Just how extraordinary is illustrated by
+comparing Scott Fetzer's performance to that of the Fortune 500,
+a group it would qualify for if it were a stand-alone company.
+
+ Had Scott Fetzer been on the 1993 500 list - the latest
+available for inspection - the company's return on equity would
+have ranked 4th. But that is far from the whole story. The top
+three companies in return on equity were Insilco, LTV and Gaylord
+Container, each of which emerged from bankruptcy in 1993 and none
+of which achieved meaningful earnings that year except for those
+they realized when they were accorded debt forgiveness in
+bankruptcy proceedings. Leaving aside such non-operating
+windfalls, Scott Fetzer's return on equity would have ranked it
+first on the Fortune 500, well ahead of number two. Indeed,
+Scott Fetzer's return on equity was double that of the company
+ranking tenth.
+
+ You might expect that Scott Fetzer's success could only be
+explained by a cyclical peak in earnings, a monopolistic
+position, or leverage. But no such circumstances apply. Rather,
+the company's success comes from the managerial expertise of CEO
+Ralph Schey, of whom I'll tell you more later.
+
+ First, however, the promised accounting lesson: When we
+paid a $142.6 million premium over book value for Scott Fetzer,
+that figure had to be recorded on Berkshire's balance sheet.
+I'll spare you the details of how this worked (these were laid
+out in an appendix to our 1986 Annual Report) and get to the
+bottom line: After a premium is initially recorded, it must in
+almost all cases be written off over time through annual charges
+that are shown as costs in the acquiring company's earnings
+statement.
+
+ The following table shows, first, the annual charges
+Berkshire has made to gradually extinguish the Scott Fetzer
+acquisition premium and, second, the premium that remains on our
+books. These charges have no effect on cash or the taxes we pay,
+and are not, in our view, an economic cost (though many
+accountants would disagree with us). They are merely a way for
+us to reduce the carrying value of Scott Fetzer on our books so
+that the figure will eventually match the net worth that Scott
+Fetzer actually employs in its business.
+
+ Beginning Purchase-Premium Ending
+ Purchase Charge to Purchase
+Year Premium Berkshire Earnings Premium
+---- --------- ------------------ --------
+ (In $ Millions)
+
+1986 ................ $142.6 $ 11.6 $131.0
+1987 ................ 131.0 7.1 123.9
+1988 ................ 123.9 7.9 115.9
+1989 ................ 115.9 7.0 108.9
+1990 ................ 108.9 7.1 101.9
+1991 ................ 101.9 6.9 95.0
+1992 ................ 95.0 7.7 87.2
+1993 ................ 87.2 28.1 59.1
+1994 ................ 59.1 4.9 54.2
+
+ Note that by the end of 1994 the premium was reduced to
+$54.2 million. When this figure is added to Scott Fetzer's year-
+end book value of $94 million, the total is $148.2 million, which
+is the current carrying value of Scott Fetzer on Berkshire's
+books. That amount is less than half of our carrying value for
+the company when it was acquired. Yet Scott Fetzer is now
+earning about twice what it then did. Clearly, the intrinsic
+value of the business has consistently grown, even though we have
+just as consistently marked down its carrying value through
+purchase-premium charges that reduced Berkshire's earnings and
+net worth.
+
+ The difference between Scott Fetzer's intrinsic value and
+its carrying value on Berkshire's books is now huge. As I
+mentioned earlier - but am delighted to mention again - credit
+for this agreeable mismatch goes to Ralph Schey, a focused, smart
+and high-grade manager.
+
+ The reasons for Ralph's success are not complicated. Ben
+Graham taught me 45 years ago that in investing it is not
+necessary to do extraordinary things to get extraordinary
+results. In later life, I have been surprised to find that this
+statement holds true in business management as well. What a
+manager must do is handle the basics well and not get diverted.
+That's precisely Ralph's formula. He establishes the right goals
+and never forgets what he set out to do. On the personal side,
+Ralph is a joy to work with. He's forthright about problems and
+is self-confident without being self-important.
+
+ He is also experienced. Though I don't know Ralph's age, I
+do know that, like many of our managers, he is over 65. At
+Berkshire, we look to performance, not to the calendar. Charlie
+and I, at 71 and 64 respectively, now keep George Foreman's
+picture on our desks. You can make book that our scorn for a
+mandatory retirement age will grow stronger every year.
+
+
+Intrinsic Value and Capital Allocation
+
+ Understanding intrinsic value is as important for managers
+as it is for investors. When managers are making capital
+allocation decisions - including decisions to repurchase shares -
+it's vital that they act in ways that increase per-share
+intrinsic value and avoid moves that decrease it. This principle
+may seem obvious but we constantly see it violated. And, when
+misallocations occur, shareholders are hurt.
+
+ For example, in contemplating business mergers and
+acquisitions, many managers tend to focus on whether the
+transaction is immediately dilutive or anti-dilutive to earnings
+per share (or, at financial institutions, to per-share book
+value). An emphasis of this sort carries great dangers. Going
+back to our college-education example, imagine that a 25-year-old
+first-year MBA student is considering merging his future economic
+interests with those of a 25-year-old day laborer. The MBA
+student, a non-earner, would find that a "share-for-share" merger
+of his equity interest in himself with that of the day laborer
+would enhance his near-term earnings (in a big way!). But what
+could be sillier for the student than a deal of this kind?
+
+ In corporate transactions, it's equally silly for the would-
+be purchaser to focus on current earnings when the prospective
+acquiree has either different prospects, different amounts of
+non-operating assets, or a different capital structure. At
+Berkshire, we have rejected many merger and purchase
+opportunities that would have boosted current and near-term
+earnings but that would have reduced per-share intrinsic value.
+Our approach, rather, has been to follow Wayne Gretzky's advice:
+"Go to where the puck is going to be, not to where it is." As a
+result, our shareholders are now many billions of dollars richer
+than they would have been if we had used the standard catechism.
+
+ The sad fact is that most major acquisitions display an
+egregious imbalance: They are a bonanza for the shareholders of
+the acquiree; they increase the income and status of the
+acquirer's management; and they are a honey pot for the
+investment bankers and other professionals on both sides. But,
+alas, they usually reduce the wealth of the acquirer's shareholders,
+often to a substantial extent. That happens because the acquirer
+typically gives up more intrinsic value than it receives. Do that
+enough, says John Medlin, the retired head of Wachovia Corp., and
+"you are running a chain letter in reverse."
+
+ Over time, the skill with which a company's managers
+allocate capital has an enormous impact on the enterprise's
+value. Almost by definition, a really good business generates
+far more money (at least after its early years) than it can use
+internally. The company could, of course, distribute the money
+to shareholders by way of dividends or share repurchases. But
+often the CEO asks a strategic planning staff, consultants or
+investment bankers whether an acquisition or two might make
+sense. That's like asking your interior decorator whether you
+need a $50,000 rug.
+
+ The acquisition problem is often compounded by a biological
+bias: Many CEO's attain their positions in part because they
+possess an abundance of animal spirits and ego. If an executive
+is heavily endowed with these qualities - which, it should be
+acknowledged, sometimes have their advantages - they won't
+disappear when he reaches the top. When such a CEO is encouraged
+by his advisors to make deals, he responds much as would a
+teenage boy who is encouraged by his father to have a normal sex
+life. It's not a push he needs.
+
+ Some years back, a CEO friend of mine - in jest, it must be
+said - unintentionally described the pathology of many big deals.
+This friend, who ran a property-casualty insurer, was explaining
+to his directors why he wanted to acquire a certain life
+insurance company. After droning rather unpersuasively through
+the economics and strategic rationale for the acquisition, he
+abruptly abandoned the script. With an impish look, he simply
+said: "Aw, fellas, all the other kids have one."
+
+ At Berkshire, our managers will continue to earn
+extraordinary returns from what appear to be ordinary businesses.
+As a first step, these managers will look for ways to deploy
+their earnings advantageously in their businesses. What's left,
+they will send to Charlie and me. We then will try to use those
+funds in ways that build per-share intrinsic value. Our goal
+will be to acquire either part or all of businesses that we
+believe we understand, that have good, sustainable underlying
+economics, and that are run by managers whom we like, admire and
+trust.
+
+
+Compensation
+
+ At Berkshire, we try to be as logical about compensation as
+about capital allocation. For example, we compensate Ralph Schey
+based upon the results of Scott Fetzer rather than those of
+Berkshire. What could make more sense, since he's responsible
+for one operation but not the other? A cash bonus or a stock
+option tied to the fortunes of Berkshire would provide totally
+capricious rewards to Ralph. He could, for example, be hitting
+home runs at Scott Fetzer while Charlie and I rang up mistakes at
+Berkshire, thereby negating his efforts many times over.
+Conversely, why should option profits or bonuses be heaped upon
+Ralph if good things are occurring in other parts of Berkshire
+but Scott Fetzer is lagging?
+
+ In setting compensation, we like to hold out the promise of
+large carrots, but make sure their delivery is tied directly to
+results in the area that a manager controls. When capital
+invested in an operation is significant, we also both charge
+managers a high rate for incremental capital they employ and
+credit them at an equally high rate for capital they release.
+
+ The product of this money's-not-free approach is definitely
+visible at Scott Fetzer. If Ralph can employ incremental funds
+at good returns, it pays him to do so: His bonus increases when
+earnings on additional capital exceed a meaningful hurdle charge.
+But our bonus calculation is symmetrical: If incremental
+investment yields sub-standard returns, the shortfall is costly
+to Ralph as well as to Berkshire. The consequence of this two-
+way arrangement is that it pays Ralph - and pays him well - to
+send to Omaha any cash he can't advantageously use in his
+business.
+
+ It has become fashionable at public companies to describe
+almost every compensation plan as aligning the interests of
+management with those of shareholders. In our book, alignment
+means being a partner in both directions, not just on the upside.
+Many "alignment" plans flunk this basic test, being artful forms
+of "heads I win, tails you lose."
+
+ A common form of misalignment occurs in the typical stock
+option arrangement, which does not periodically increase the
+option price to compensate for the fact that retained earnings
+are building up the wealth of the company. Indeed, the
+combination of a ten-year option, a low dividend payout, and
+compound interest can provide lush gains to a manager who has
+done no more than tread water in his job. A cynic might even
+note that when payments to owners are held down, the profit to
+the option-holding manager increases. I have yet to see this
+vital point spelled out in a proxy statement asking shareholders
+to approve an option plan.
+
+ I can't resist mentioning that our compensation arrangement
+with Ralph Schey was worked out in about five minutes,
+immediately upon our purchase of Scott Fetzer and without the
+"help" of lawyers or compensation consultants. This arrangement
+embodies a few very simple ideas - not the kind of terms favored
+by consultants who cannot easily send a large bill unless they
+have established that you have a large problem (and one, of
+course, that requires an annual review). Our agreement with
+Ralph has never been changed. It made sense to him and to me in
+1986, and it makes sense now. Our compensation arrangements with
+the managers of all our other units are similarly simple, though
+the terms of each agreement vary to fit the economic
+characteristics of the business at issue, the existence in some
+cases of partial ownership of the unit by managers, etc.
+
+ In all instances, we pursue rationality. Arrangements that
+pay off in capricious ways, unrelated to a manager's personal
+accomplishments, may well be welcomed by certain managers. Who,
+after all, refuses a free lottery ticket? But such arrangements
+are wasteful to the company and cause the manager to lose focus
+on what should be his real areas of concern. Additionally,
+irrational behavior at the parent may well encourage imitative
+behavior at subsidiaries.
+
+ At Berkshire, only Charlie and I have the managerial
+responsibility for the entire business. Therefore, we are the
+only parties who should logically be compensated on the basis of
+what the enterprise does as a whole. Even so, that is not a
+compensation arrangement we desire. We have carefully designed
+both the company and our jobs so that we do things we enjoy with
+people we like. Equally important, we are forced to do very few
+boring or unpleasant tasks. We are the beneficiaries as well of
+the abundant array of material and psychic perks that flow to the
+heads of corporations. Under such idyllic conditions, we don't
+expect shareholders to ante up loads of compensation for which we
+have no possible need.
+
+ Indeed, if we were not paid at all, Charlie and I would be
+delighted with the cushy jobs we hold. At bottom, we subscribe
+to Ronald Reagan's creed: "It's probably true that hard work
+never killed anyone, but I figure why take the chance."
+
+
+Sources of Reported Earnings
+
+ The table on the next page shows the main sources of
+Berkshire's reported earnings. In this presentation, purchase-
+premium charges of the type we discussed in our earlier analysis
+of Scott Fetzer are not assigned to the specific businesses to
+which they apply, but are instead aggregated and shown
+separately. This procedure lets you view the earnings of our
+businesses as they would have been reported had we not purchased
+them. This form of presentation seems to us to be more useful to
+investors and managers than one utilizing GAAP, which requires
+purchase premiums to be charged off, business-by-business. The
+total earnings we show in the table are, of course, identical to
+the GAAP total in our audited financial statements.
+
+
+
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ------------------- -------------------
+ 1994 1993 1994 1993
+ -------- -------- -------- --------
+ (000s omitted)
+
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............... $129,926 $ 30,876 $ 80,860 $ 20,156
+ Net Investment Income ...... 419,422 375,946 350,453 321,321
+ Buffalo News ................. 54,238 50,962 31,685 29,696
+ Fechheimer ................... 14,260 13,442 7,107 6,931
+ Finance Businesses ........... 21,568 22,695 14,293 14,161
+ Kirby ........................ 42,349 39,147 27,719 25,056
+ Nebraska Furniture Mart ...... 17,356 21,540 8,652 10,398
+ Scott Fetzer Manufacturing Group 39,435 38,196 24,909 23,809
+ See's Candies ................ 47,539 41,150 28,247 24,367
+ Shoe Group ................... 85,503 44,025* 55,750 28,829
+ World Book ................... 24,662 19,915 17,275 13,537
+ Purchase-Price Premium Charges (22,595) (17,033) (19,355) (13,996)
+ Interest Expense** ........... (60,111) (56,545) (37,264) (35,614)
+ Shareholder-Designated
+ Contributions ............. (10,419) (9,448) (6,668) (5,994)
+ Other ........................ 36,232 28,428 22,576 15,094
+ -------- -------- -------- --------
+Operating Earnings ............. 839,365 643,296 606,239 477,751
+Sales of Securities ............ 91,332 546,422 61,138 356,702
+Decline in Value of
+ USAir Preferred Stock ..... (268,500) --- (172,579) ---
+Tax Accruals Caused by
+ New Accounting Rules ...... --- --- --- (146,332)
+ -------- --------- -------- --------
+Total Earnings - All Entities .. $662,197 $1,189,718 $494,798 $688,121
+ ======== ========= ======== ========
+
+* Includes Dexter's earnings only from the date it was acquired,
+ November 7, 1993.
+
+**Excludes interest expense of Finance Businesses.
+
+
+ A large amount of information about these businesses is given
+on pages 37-48, where you will also find our segment earnings
+reported on a GAAP basis. In addition, on pages 53-59, we have
+rearranged Berkshire's financial data into four segments on a non-
+GAAP basis, a presentation that corresponds to the way Charlie and
+I think about the company. Our intent is to supply you with the
+financial information that we would wish you to give us if our
+positions were reversed.
+
+"Look-Through" Earnings
+
+ In past reports, we've discussed look-through earnings, which
+we believe more accurately portray the earnings of Berkshire than
+does our GAAP result. As we calculate them, look-through earnings
+consist of: (1) the operating earnings reported in the previous
+section, plus; (2) the retained operating earnings of major
+investees that, under GAAP accounting, are not reflected in our
+profits, less; (3) an allowance for the tax that would be paid by
+Berkshire if these retained earnings of investees had instead been
+distributed to us. The "operating earnings" of which we speak here
+exclude capital gains, special accounting items and major
+restructuring charges.
+
+ If our intrinsic value is to grow at our target rate of 15%,
+our look-through earnings, over time, must also increase at about
+that pace. When I first explained this concept a few years back, I
+told you that meeting this 15% goal would require us to generate
+look-through earnings of about $1.8 billion by 2000. Because we've
+since issued about 3% more shares, that figure has grown to $1.85
+billion.
+
+ We are now modestly ahead of schedule in meeting our goal, but
+to a significant degree that is because our super-cat insurance
+business has recently delivered earnings far above trend-line
+expectancy (an outcome I will discuss in the next section). Giving
+due weight to that abnormality, we still expect to hit our target
+but that, of course, is no sure thing.
+
+ The following table shows how we calculate look-through
+earnings, though I warn you that the figures are necessarily very
+rough. (The dividends paid to us by these investees have been
+included in the operating earnings itemized on page 12, mostly
+under "Insurance Group: Net Investment Income.")
+
+ Berkshire's Share
+ of Undistributed
+ Berkshire's Approximate Operating Earnings
+Berkshire's Major Investees Ownership at Yearend (in millions)
+--------------------------- ----------------------- ------------------
+
+ 1994 1993 1994 1993
+ ------ ------ ------ ------
+American Express Company ...... 5.5% 2.4% $ 25(2) $ 16
+Capital Cities/ABC, Inc. ...... 13.0% 13.0% 85 83(2)
+The Coca-Cola Company ......... 7.8% 7.2% 116(2) 94
+Federal Home Loan Mortgage Corp. 6.3%(1) 6.8%(1) 47(2) 41(2)
+Gannett Co., Inc. ............. 4.9% --- 4(2) ---
+GEICO Corp. ................... 50.2% 48.4% 63(3) 76(3)
+The Gillette Company .......... 10.8% 10.9% 51 44
+PNC Bank Corp. ................ 8.3% --- 10(2) ---
+The Washington Post Company ... 15.2% 14.8% 18 15
+Wells Fargo & Company ......... 13.3% 12.2% 73 53(2)
+ ------ ------
+Berkshire's share of undistributed
+ earnings of major investees $ 492 $422
+Hypothetical tax on these undistributed
+ investee earnings(4) (68) (59)
+Reported operating earnings of Berkshire 606 478
+ ------- ------
+ Total look-through earnings of Berkshire $1,030 $ 841
+
+ (1) Does not include shares allocable to the minority interest
+ at Wesco
+ (2) Calculated on average ownership for the year
+ (3) Excludes realized capital gains, which have been both
+ recurring and significant
+ (4) The tax rate used is 14%, which is the rate Berkshire pays
+ on the dividends it receives
+
+Insurance Operations
+
+ As we've explained in past reports, what counts in our
+insurance business is, first, the amount of "float" we develop and,
+second, its cost to us. Float is money we hold but don't own. In
+an insurance operation, float arises because most policies require
+that premiums be prepaid and, more importantly, because it usually
+takes time for an insurer to hear about and resolve loss claims.
+
+ Typically, the premiums that an insurer takes in do not cover
+the losses and expenses it must pay. That leaves it running an
+"underwriting loss" - and that loss is the cost of float.
+
+ An insurance business is profitable over time if its cost of
+float is less than the cost the company would otherwise incur to
+obtain funds. But the business has a negative value if the cost of
+its float is higher than market rates for money.
+
+ As the numbers in the following table show, Berkshire's
+insurance business has been an enormous winner. For the table, we
+have compiled our float - which we generate in exceptional amounts
+relative to our premium volume - by adding loss reserves, loss
+adjustment reserves, funds held under reinsurance assumed and unearned
+premium reserves and then subtracting agents' balances, prepaid
+acquisition costs, prepaid taxes and deferred charges applicable to
+assumed reinsurance. Our cost of float is determined by our
+underwriting loss or profit. In those years when we have had an
+underwriting profit, such as the last two, our cost of float has been
+negative, and we have determined our insurance earnings by adding
+underwriting profit to float income.
+
+ (1) (2) Yearend Yield
+ Underwriting Approximate on Long-Term
+ Loss Average Float Cost of Funds Govt. Bonds
+ ------------ ------------- ------------- -------------
+ (In $ Millions) (Ratio of 1 to 2)
+
+1967 .......... profit $ 17.3 less than zero 5.50%
+1968 .......... profit 19.9 less than zero 5.90%
+1969 .......... profit 23.4 less than zero 6.79%
+1970 .......... $ 0.37 32.4 1.14% 6.25%
+1971 .......... profit 52.5 less than zero 5.81%
+1972 .......... profit 69.5 less than zero 5.82%
+1973 .......... profit 73.3 less than zero 7.27%
+1974 .......... 7.36 79.1 9.30% 8.13%
+1975 .......... 11.35 87.6 12.96% 8.03%
+1976 .......... profit 102.6 less than zero 7.30%
+1977 .......... profit 139.0 less than zero 7.97%
+1978 .......... profit 190.4 less than zero 8.93%
+1979 .......... profit 227.3 less than zero 10.08%
+1980 .......... profit 237.0 less than zero 11.94%
+1981 .......... profit 228.4 less than zero 13.61%
+1982 .......... 21.56 220.6 9.77% 10.64%
+1983 .......... 33.87 231.3 14.64% 11.84%
+1984 .......... 48.06 253.2 18.98% 11.58%
+1985 .......... 44.23 390.2 11.34% 9.34%
+1986 .......... 55.84 797.5 7.00% 7.60%
+1987 .......... 55.43 1,266.7 4.38% 8.95%
+1988 .......... 11.08 1,497.7 0.74% 9.00%
+1989 .......... 24.40 1,541.3 1.58% 7.97%
+1990 .......... 26.65 1,637.3 1.63% 8.24%
+1991 .......... 119.59 1,895.0 6.31% 7.40%
+1992 .......... 108.96 2,290.4 4.76% 7.39%
+1993 .......... profit 2,624.7 less than zero 6.35%
+1994 .......... profit 3,056.6 less than zero 7.88%
+
+ Charlie and I are delighted that our float grew in 1994 and
+are even more pleased that it proved to be cost-free. But our
+message this year echoes the one we delivered in 1993: Though we
+have a fine insurance business, it is not as good as it currently
+looks.
+
+ The reason we must repeat this caution is that our "super-cat"
+business (which sells policies that insurance and reinsurance
+companies buy to protect themselves from the effects of mega-
+catastrophes) was again highly profitable. Since truly major
+catastrophes occur infrequently, our super-cat business can be
+expected to show large profits in most years but occasionally to
+record a huge loss. In other words, the attractiveness of our
+super-cat business will take many years to measure. Certainly 1994
+should be regarded as close to a best-case. Our only significant
+losses arose from the California earthquake in January. I will add
+that we do not expect to suffer a major loss from the early-1995
+Kobe earthquake.
+
+ Super-cat policies are small in number, large in size and non-
+standardized. Therefore, the underwriting of this business
+requires far more judgment than, say, the underwriting of auto
+policies, for which a mass of data is available. Here Berkshire
+has a major advantage: Ajit Jain, our super-cat manager, whose
+underwriting skills are the finest. His value to us is simply
+enormous.
+
+ In addition, Berkshire has a special advantage in the super-
+cat business because of our towering financial strength, which
+helps us in two ways. First, a prudent insurer will want its
+protection against true mega-catastrophes - such as a $50 billion
+windstorm loss on Long Island or an earthquake of similar cost in
+California - to be absolutely certain. But that same insurer knows
+that the disaster making it dependent on a large super-cat recovery
+is also the disaster that could cause many reinsurers to default.
+There's not much sense in paying premiums for coverage that will
+evaporate precisely when it is needed. So the certainty that
+Berkshire will be both solvent and liquid after a catastrophe of
+unthinkable proportions is a major competitive advantage for us.
+
+ The second benefit of our capital strength is that we can
+write policies for amounts that no one else can even consider. For
+example, during 1994, a primary insurer wished to buy a short-term
+policy for $400 million of California earthquake coverage and we
+wrote the policy immediately. We know of no one else in the world
+who would take a $400 million risk, or anything close to it, for
+their own account.
+
+ Generally, brokers attempt to place coverage for large amounts
+by spreading the burden over a number of small policies. But, at
+best, coverage of that sort takes considerable time to arrange. In
+the meantime, the company desiring reinsurance is left holding a
+risk it doesn't want and that may seriously threaten its well-
+being. At Berkshire, on the other hand, we will quote prices for
+coverage as great as $500 million on the same day that we are asked
+to bid. No one else in the industry will do the same.
+
+ By writing coverages in large lumps, we obviously expose
+Berkshire to lumpy financial results. That's totally acceptable to
+us: Too often, insurers (as well as other businesses) follow sub-
+optimum strategies in order to "smooth" their reported earnings.
+By accepting the prospect of volatility, we expect to earn higher
+long-term returns than we would by pursuing predictability.
+
+ Given the risks we accept, Ajit and I constantly focus on our
+"worst case," knowing, of course, that it is difficult to judge
+what this is, since you could conceivably have a Long Island
+hurricane, a California earthquake, and Super Cat X all in the same
+year. Additionally, insurance losses could be accompanied by non-
+insurance troubles. For example, were we to have super-cat losses
+from a large Southern California earthquake, they might well be
+accompanied by a major drop in the value of our holdings in See's,
+Wells Fargo and Freddie Mac.
+
+ All things considered, we believe our worst-case insurance
+loss from a super-cat is now about $600 million after-tax, an
+amount that would slightly exceed Berkshire's annual earnings from
+other sources. If you are not comfortable with this level of
+exposure, the time to sell your Berkshire stock is now, not after
+the inevitable mega-catastrophe.
+
+ Our super-cat volume will probably be down in 1995. Prices
+for garden-variety policies have fallen somewhat, and the torrent
+of capital that was committed to the reinsurance business a few
+years ago will be inclined to chase premiums, irrespective of their
+adequacy. Nevertheless, we have strong relations with an important
+group of clients who will provide us with a substantial amount of
+business in 1995.
+
+ Berkshire's other insurance operations had excellent results
+in 1994. Our homestate operation, led by Rod Eldred; our workers'
+compensation business, headed by Brad Kinstler; our credit card
+operation, managed by the Kizer family; National Indemnity's
+traditional auto and general liability business, led by Don Wurster
+- all of these generated significant underwriting profits
+accompanied by substantial float.
+
+ We can conclude this section as we did last year: All in all,
+we have a first-class insurance business. Though its results will
+be highly volatile, this operation possesses an intrinsic value
+that exceeds its book value by a large amount - larger, in fact,
+than is the case at any other Berkshire business.
+
+Common Stock Investments
+
+ Below we list our common stockholdings having a value of over
+$300 million. A small portion of these investments belongs to
+subsidiaries of which Berkshire owns less than 100%.
+
+ 12/31/94
+ Shares Company Cost Market
+ ------ ------- ---------- ----------
+ (000s omitted)
+ 27,759,941 American Express Company. .......... $ 723,919 $ 818,918
+ 20,000,000 Capital Cities/ABC, Inc. ........... 345,000 1,705,000
+100,000,000 The Coca-Cola Company. ............. 1,298,888 5,150,000
+ 12,761,200 Federal Home Loan Mortgage Corp.
+ ("Freddie Mac") ................. 270,468 644,441
+ 6,854,500 Gannett Co., Inc. .................. 335,216 365,002
+ 34,250,000 GEICO Corp. ........................ 45,713 1,678,250
+ 24,000,000 The Gillette Company ............... 600,000 1,797,000
+ 19,453,300 PNC Bank Corporation ............... 503,046 410,951
+ 1,727,765 The Washington Post Company ........ 9,731 418,983
+ 6,791,218 Wells Fargo & Company .............. 423,680 984,727
+
+ Our investments continue to be few in number and simple in
+concept: The truly big investment idea can usually be explained in
+a short paragraph. We like a business with enduring competitive
+advantages that is run by able and owner-oriented people. When
+these attributes exist, and when we can make purchases at sensible
+prices, it is hard to go wrong (a challenge we periodically manage
+to overcome).
+
+ Investors should remember that their scorecard is not computed
+using Olympic-diving methods: Degree-of-difficulty doesn't count.
+If you are right about a business whose value is largely dependent
+on a single key factor that is both easy to understand and
+enduring, the payoff is the same as if you had correctly analyzed
+an investment alternative characterized by many constantly shifting
+and complex variables.
+
+ We try to price, rather than time, purchases. In our view, it
+is folly to forego buying shares in an outstanding business whose
+long-term future is predictable, because of short-term worries
+about an economy or a stock market that we know to be
+unpredictable. Why scrap an informed decision because of an
+uninformed guess?
+
+ We purchased National Indemnity in 1967, See's in 1972,
+Buffalo News in 1977, Nebraska Furniture Mart in 1983, and Scott
+Fetzer in 1986 because those are the years they became available
+and because we thought the prices they carried were acceptable. In
+each case, we pondered what the business was likely to do, not what
+the Dow, the Fed, or the economy might do. If we see this approach
+as making sense in the purchase of businesses in their entirety,
+why should we change tack when we are purchasing small pieces of
+wonderful businesses in the stock market?
+
+ Before looking at new investments, we consider adding to old
+ones. If a business is attractive enough to buy once, it may well
+pay to repeat the process. We would love to increase our economic
+interest in See's or Scott Fetzer, but we haven't found a way to
+add to a 100% holding. In the stock market, however, an investor
+frequently gets the chance to increase his economic interest in
+businesses he knows and likes. Last year we went that direction by
+enlarging our holdings in Coca-Cola and American Express.
+
+ Our history with American Express goes way back and, in fact,
+fits the pattern of my pulling current investment decisions out of
+past associations. In 1951, for example, GEICO shares comprised
+70% of my personal portfolio and GEICO was also the first stock I
+sold - I was then 20 - as a security salesman (the sale was 100
+shares to my Aunt Alice who, bless her, would have bought anything
+I suggested). Twenty-five years later, Berkshire purchased a major
+stake in GEICO at the time it was threatened with insolvency. In
+another instance, that of the Washington Post, about half of my
+initial investment funds came from delivering the paper in the
+1940's. Three decades later Berkshire purchased a large position
+in the company two years after it went public. As for Coca-Cola,
+my first business venture - this was in the 1930's - was buying a
+six-pack of Coke for 25 cents and selling each bottle for 5 cents.
+It took only fifty years before I finally got it: The real money
+was in the syrup.
+
+ My American Express history includes a couple of episodes: In
+the mid-1960's, just after the stock was battered by the company's
+infamous salad-oil scandal, we put about 40% of Buffett Partnership
+Ltd.'s capital into the stock - the largest investment the
+partnership had ever made. I should add that this commitment gave
+us over 5% ownership in Amex at a cost of $13 million. As I write
+this, we own just under 10%, which has cost us $1.36 billion.
+(Amex earned $12.5 million in 1964 and $1.4 billion in 1994.)
+
+ My history with Amex's IDS unit, which today contributes about
+a third of the earnings of the company, goes back even further. I
+first purchased stock in IDS in 1953 when it was growing rapidly
+and selling at a price-earnings ratio of only 3. (There was a lot
+of low-hanging fruit in those days.) I even produced a long report
+- do I ever write a short one? - on the company that I sold for $1
+through an ad in the Wall Street Journal.
+
+ Obviously American Express and IDS (recently renamed American
+Express Financial Advisors) are far different operations today from
+what they were then. Nevertheless, I find that a long-term
+familiarity with a company and its products is often helpful in
+evaluating it.
+
+Mistake Du Jour
+
+ Mistakes occur at the time of decision. We can only make our
+mistake-du-jour award, however, when the foolishness of the
+decision become obvious. By this measure, 1994 was a vintage year
+with keen competition for the gold medal. Here, I would like to
+tell you that the mistakes I will describe originated with Charlie.
+But whenever I try to explain things that way, my nose begins to
+grow.
+
+ And the nominees are . . .
+
+ Late in 1993 I sold 10 million shares of Cap Cities at $63; at
+year-end 1994, the price was $85.25. (The difference is $222.5
+million for those of you who wish to avoid the pain of calculating
+the damage yourself.) When we purchased the stock at $17.25 in
+1986, I told you that I had previously sold our Cap Cities holdings
+at $4.30 per share during 1978-80, and added that I was at a loss
+to explain my earlier behavior. Now I've become a repeat offender.
+Maybe it's time to get a guardian appointed.
+
+ Egregious as it is, the Cap Cities decision earns only a
+silver medal. Top honors go to a mistake I made five years ago
+that fully ripened in 1994: Our $358 million purchase of USAir
+preferred stock, on which the dividend was suspended in September.
+In the 1990 Annual Report I correctly described this deal as an
+"unforced error," meaning that I was neither pushed into the
+investment nor misled by anyone when making it. Rather, this was a
+case of sloppy analysis, a lapse that may have been caused by the
+fact that we were buying a senior security or by hubris. Whatever
+the reason, the mistake was large.
+
+ Before this purchase, I simply failed to focus on the problems
+that would inevitably beset a carrier whose costs were both high
+and extremely difficult to lower. In earlier years, these life-
+threatening costs posed few problems. Airlines were then protected
+from competition by regulation, and carriers could absorb high
+costs because they could pass them along by way of fares that were
+also high.
+
+ When deregulation came along, it did not immediately change
+the picture: The capacity of low-cost carriers was so small that
+the high-cost lines could, in large part, maintain their existing
+fare structures. During this period, with the longer-term problems
+largely invisible but slowly metastasizing, the costs that were
+non-sustainable became further embedded.
+
+ As the seat capacity of the low-cost operators expanded, their
+fares began to force the old-line, high-cost airlines to cut their
+own. The day of reckoning for these airlines could be delayed by
+infusions of capital (such as ours into USAir), but eventually a
+fundamental rule of economics prevailed: In an unregulated
+commodity business, a company must lower its costs to competitive
+levels or face extinction. This principle should have been obvious
+to your Chairman, but I missed it.
+
+ Seth Schofield, CEO of USAir, has worked diligently to correct
+the company's historical cost problems but, to date, has not
+managed to do so. In part, this is because he has had to deal with
+a moving target, the result of certain major carriers having
+obtained labor concessions and other carriers having benefitted
+from "fresh-start" costs that came out of bankruptcy proceedings.
+(As Herb Kelleher, CEO of Southwest Airlines, has said:
+"Bankruptcy court for airlines has become a health spa.")
+Additionally, it should be no surprise to anyone that those airline
+employees who contractually receive above-market salaries will
+resist any reduction in these as long as their checks continue to
+clear.
+
+ Despite this difficult situation, USAir may yet achieve the
+cost reductions it needs to maintain its viability long-term. But
+it is far from sure that will happen.
+
+ Accordingly, we wrote our USAir investment down to $89.5
+million, 25 cents on the dollar at yearend 1994. This valuation
+reflects both a possibility that our preferred will have its value
+fully or largely restored and an opposite possibility that the
+stock will eventually become worthless. Whatever the outcome, we
+will heed a prime rule of investing: You don't have to make it
+back the way that you lost it.
+
+ The accounting effects of our USAir writedown are complicated.
+Under GAAP accounting, insurance companies are required to carry
+all stocks on their balance sheets at estimated market value.
+Therefore, at the end of last year's third quarter, we were
+carrying our USAir preferred at $89.5 million, or 25% of cost. In
+other words, our net worth was at that time reflecting a value for
+USAir that was far below our $358 million cost.
+
+ But in the fourth quarter, we concluded that the decline in
+value was, in accounting terms, "other than temporary," and that
+judgment required us to send the writedown of $269 million through
+our income statement. The amount will have no other fourth-quarter
+effect. That is, it will not reduce our net worth, because the
+diminution of value had already been reflected.
+
+ Charlie and I will not stand for reelection to USAir's board
+at the upcoming annual meeting. Should Seth wish to consult with
+us, however, we will be pleased to be of any help that we can.
+
+Miscellaneous
+
+ Two CEO's who have done great things for Berkshire
+shareholders retired last year: Dan Burke of Capital Cities/ABC
+and Carl Reichardt of Wells Fargo. Dan and Carl encountered very
+tough industry conditions in recent years. But their skill as
+managers allowed the businesses they ran to emerge from these
+periods with record earnings, added luster, and bright prospects.
+Additionally, Dan and Carl prepared well for their departure and
+left their companies in outstanding hands. We owe them our
+gratitude.
+
+ * * * * * * * * * * * *
+
+ About 95.7% of all eligible shares participated in Berkshire's
+1994 shareholder-designated contributions program. Contributions
+made through the program were $10.4 million and 3,300 charities
+were recipients.
+
+ Every year a few shareholders miss participating in the
+program because they either do not have their shares registered in
+their own names on the prescribed record date or because they fail
+to get the designation form back to us within the 60-day period
+allowed for its return. Since we don't make exceptions when
+requirements aren't met, we urge that both new shareholders and old
+read the description of our shareholder-designated contributions
+program that appears on pages 50-51.
+
+ To participate in future programs, you must make sure your
+shares are registered in the name of the actual owner, not in the
+nominee name of a broker, bank or depository. Shares not so
+registered on August 31, 1995 will be ineligible for the 1995
+program.
+
+ * * * * * * * * * * * *
+
+ We made only one minor acquisition during 1994 - a small
+retail shoe chain - but our interest in finding good candidates
+remains as keen as ever. The criteria we employ for purchases or
+mergers is detailed in the appendix on page 21.
+
+ Last spring, we offered to merge with a large, family-
+controlled business on terms that included a Berkshire convertible
+preferred stock. Though we failed to reach an agreement, this
+episode made me realize that we needed to ask our shareholders to
+authorize preferred shares in case we wanted in the future to move
+quickly if a similar acquisition opportunity were to appear.
+Accordingly, our proxy presents a proposal that you authorize a
+large amount of preferred stock, which will be issuable on terms
+set by the Board of Directors. You can be sure that Charlie and I
+will not use these shares without being completely satisfied that
+we are receiving as much in intrinsic value as we are giving.
+
+ * * * * * * * * * * * *
+
+ Charlie and I hope you can come to the Annual Meeting - at a
+new site. Last year, we slightly overran the Orpheum Theater's
+seating capacity of 2,750, and therefore we will assemble at 9:30
+a.m. on Monday, May 1, 1995, at the Holiday Convention Centre. The
+main ballroom at the Centre can handle 3,300, and if need be, we
+will have audio and video equipment in an adjacent room capable of
+handling another 1,000 people.
+
+ Last year we displayed some of Berkshire's products at the
+meeting, and as a result sold about 800 pounds of candy, 507 pairs
+of shoes, and over $12,000 of World Books and related publications.
+All these goods will be available again this year. Though we like
+to think of the meeting as a spiritual experience, we must remember
+that even the least secular of religions includes the ritual of the
+collection plate.
+
+ Of course, what you really should be purchasing is a video
+tape of the 1995 Orange Bowl. Your Chairman views this classic
+nightly, switching to slow motion for the fourth quarter. Our
+cover color this year is a salute to Nebraska's football coach, Tom
+Osborne, and his Cornhuskers, the country's top college team. I
+urge you to wear Husker red to the annual meeting and promise you
+that at least 50% of your managerial duo will be in appropriate
+attire.
+
+ We recommend that you promptly get hotel reservations for the
+meeting, as we expect a large crowd. Those of you who like to be
+downtown (about six miles from the Centre) may wish to stay at the
+Radisson Redick Tower, a small (88 rooms) but nice hotel or at the
+much larger Red Lion Hotel a few blocks away. In the vicinity of
+the Centre are the Holiday Inn (403 rooms), Homewood Suites (118
+rooms) and Hampton Inn (136 rooms). Another recommended spot is
+the Marriott, whose west Omaha location is about 100 yards from
+Borsheim's and a ten-minute drive from the Centre. There will be
+buses at the Marriott that will leave at 8:45 and 9:00 for the
+meeting and return after it ends.
+
+ An attachment to our proxy material explains how you can
+obtain the card you will need for admission to the meeting. A
+good-sized parking area is available at the Centre, while those who
+stay at the Holiday Inn, Homewood Suites and Hampton Inn will be
+able to walk to the meeting.
+
+ As usual, we will have buses to take you to the Nebraska
+Furniture Mart and Borsheim's after the meeting and to take you
+from there to hotels or the airport later. I hope you make a
+special effort to visit the Nebraska Furniture Mart because it has
+opened the Mega Mart, a true retailing marvel that sells
+electronics, appliances, computers, CD's, cameras and audio
+equipment. Sales have been sensational since the opening, and you
+will be amazed by both the variety of products available and their
+display on the floor.
+
+ The Mega Mart, adjacent to NFM's main store, is on our 64-acre
+site about two miles north of the Centre. The stores are open from
+10 a.m. to 9 p.m. on Fridays, 10 a.m. to 6 p.m. on Saturdays and
+noon to 6 p.m. on Sundays. When you're there be sure to say hello
+to Mrs. B, who, at 101, will be hard at work in our Mrs. B's
+Warehouse. She never misses a day at the store - or, for that
+matter, an hour.
+
+ Borsheim's normally is closed on Sunday but will be open for
+shareholders and their guests from noon to 6 p.m. on Sunday. This
+is always a special day, and we will try to have a few surprises.
+Usually this is the biggest sales day of the year, so for more
+reasons than one Charlie and I hope to see you there.
+
+ On Saturday evening, April 29, there will be a baseball game
+at Rosenblatt Stadium between the Omaha Royals and the Buffalo
+Bisons. The Buffalo team is owned by my friends, Mindy and Bob
+Rich, Jr., and I'm hoping they will attend. If so, I will try to
+entice Bob into a one-pitch duel on the mound. Bob is a
+capitalist's Randy Johnson - young, strong and athletic - and not
+the sort of fellow you want to face early in the season. So I will
+need plenty of vocal support.
+
+ The proxy statement will include information about obtaining
+tickets to the game. About 1,400 shareholders attended the event
+last year. Opening the game that night, I had my stuff and threw a
+strike that the scoreboard reported at eight miles per hour. What
+many fans missed was that I shook off the catcher's call for my
+fast ball and instead delivered my change-up. This year it will be
+all smoke.
+
+
+
+ Warren E. Buffett
+March 7, 1995 Chairman of the Board
+
+
+
diff --git a/berkshire-hathaway/1995/1-in/berkshire-hathaway-1995-letter.txt b/berkshire-hathaway/1995/1-in/berkshire-hathaway-1995-letter.txt
new file mode 100644
index 0000000..b8efe48
--- /dev/null
+++ b/berkshire-hathaway/1995/1-in/berkshire-hathaway-1995-letter.txt
@@ -0,0 +1,1420 @@
+
+
+
+
+
+ +BERKSHIRE HATHAWAY INC. +
+ +
+
+
+To the Shareholders of Berkshire Hathaway Inc.:
+
+
+ Our gain in net worth during 1995 was $5.3 billion, or
+45.0%. Per-share book value grew by a little less, 43.1%,
+because we paid stock for two acquisitions, increasing our shares
+outstanding by 1.3%. Over the last 31 years (that is, since
+present management took over) per-share book value has grown from
+$19 to $14,426, or at a rate of 23.6% compounded annually.
+
+ There's no reason to do handsprings over 1995's gains. This
+was a year in which any fool could make a bundle in the stock
+market. And we did. To paraphrase President Kennedy, a rising
+tide lifts all yachts.
+
+ Putting aside the financial results, there was plenty of
+good news at Berkshire last year: We negotiated three
+acquisitions of exactly the type we desire. Two of these,
+Helzberg's Diamond Shops and R.C. Willey Home Furnishings, are
+included in our 1995 financial statements, while our largest
+transaction, the purchase of GEICO, closed immediately after the
+end of the year. (I'll tell you more about all three
+acquisitions later in the report.)
+
+ These new subsidiaries roughly double our revenues. Even
+so, the acquisitions neither materially increased our shares
+outstanding nor our debt. And, though these three operations
+employ over 11,000 people, our headquarters staff grew only from
+11 to 12. (No sense going crazy.)
+
+ Charlie Munger, Berkshire's Vice Chairman and my partner,
+and I want to build a collection of companies - both wholly- and
+partly-owned - that have excellent economic characteristics and
+that are run by outstanding managers. Our favorite acquisition
+is the negotiated transaction that allows us to purchase 100% of
+such a business at a fair price. But we are almost as happy when
+the stock market offers us the chance to buy a modest percentage
+of an outstanding business at a pro-rata price well below what it
+would take to buy 100%. This double-barrelled approach -
+purchases of entire businesses through negotiation or purchases
+of part-interests through the stock market - gives us an
+important advantage over capital-allocators who stick to a single
+course. Woody Allen once explained why eclecticism works: "The
+real advantage of being bisexual is that it doubles your chances
+for a date on Saturday night."
+
+ Over the years, we've been Woody-like in our thinking,
+attempting to increase our marketable investments in wonderful
+businesses, while simultaneously trying to buy similar businesses
+in their entirety. The following table illustrates our progress
+on both fronts. In the tabulation, we show the marketable
+securities owned per share of Berkshire at ten-year intervals. A
+second column lists our per-share operating earnings (before
+taxes and purchase-price adjustments but after interest and
+corporate overhead) from all other activities. In other words,
+the second column shows what we earned excluding the dividends,
+interest and capital gains that we realized from investments.
+Purchase-price accounting adjustments are ignored for reasons we
+have explained at length in previous reports and which, as an act
+of mercy, we won't repeat. (We'll be glad to send masochists the
+earlier explanations, however.)
+
+ Pre-tax Earnings Per Share
+ Marketable Securities Excluding All Income from
+ Year Per Share Investments
+ ---- --------------------- --------------------------
+
+ 1965 ................ $ 4 $ 4.08
+ 1975 ................ 159 (6.48)
+ 1985 ................ 2,443 18.86
+ 1995 ................ 22,088 258.20
+
+ Yearly Growth Rate: 1965-95 33.4% 14.7%
+
+ These results have not sprung from some master plan that we
+concocted in 1965. In a general way, we knew then what we hoped
+to accomplish but had no idea what specific opportunities might
+make it possible. Today we remain similarly unstructured: Over
+time, we expect to improve the figures in both columns but have
+no road map to tell us how that will come about.
+
+ We proceed with two advantages: First, our operating
+managers are outstanding and, in most cases, have an unusually
+strong attachment to Berkshire. Second, Charlie and I have had
+considerable experience in allocating capital and try to go at
+that job rationally and objectively. The giant disadvantage we
+face is size: In the early years, we needed only good ideas, but
+now we need good big ideas. Unfortunately, the difficulty of
+finding these grows in direct proportion to our financial
+success, a problem that increasingly erodes our strengths.
+
+ I will have more to say about Berkshire's prospects later in
+this report, when I discuss our proposed recapitalization.
+
+Acquisitions
+
+ It may seem strange that we exult over a year in which we
+made three acquisitions, given that we have regularly used these
+pages to question the acquisition activities of most managers.
+Rest assured, Charlie and I haven't lost our skepticism: We
+believe most deals do damage to the shareholders of the acquiring
+company. Too often, the words from HMS Pinafore apply: "Things
+are seldom what they seem, skim milk masquerades as cream."
+Specifically, sellers and their representatives invariably
+present financial projections having more entertainment value
+than educational value. In the production of rosy scenarios,
+Wall Street can hold its own against Washington.
+
+ In any case, why potential buyers even look at projections
+prepared by sellers baffles me. Charlie and I never give them a
+glance, but instead keep in mind the story of the man with an
+ailing horse. Visiting the vet, he said: "Can you help me?
+Sometimes my horse walks just fine and sometimes he limps." The
+vet's reply was pointed: "No problem - when he's walking fine,
+sell him." In the world of mergers and acquisitions, that horse
+would be peddled as Secretariat.
+
+ At Berkshire, we have all the difficulties in perceiving the
+future that other acquisition-minded companies do. Like they
+also, we face the inherent problem that the seller of a business
+practically always knows far more about it than the buyer and
+also picks the time of sale - a time when the business is likely
+to be walking "just fine."
+
+ Even so, we do have a few advantages, perhaps the greatest
+being that we don't have a strategic plan. Thus we feel no need
+to proceed in an ordained direction (a course leading almost
+invariably to silly purchase prices) but can instead simply
+decide what makes sense for our owners. In doing that, we always
+mentally compare any move we are contemplating with dozens of
+other opportunities open to us, including the purchase of small
+pieces of the best businesses in the world via the stock market.
+Our practice of making this comparison - acquisitions against
+passive investments - is a discipline that managers focused
+simply on expansion seldom use.
+
+ Talking to Time Magazine a few years back, Peter Drucker got
+to the heart of things: "I will tell you a secret: Dealmaking
+beats working. Dealmaking is exciting and fun, and working is
+grubby. Running anything is primarily an enormous amount of
+grubby detail work . . . dealmaking is romantic, sexy. That's
+why you have deals that make no sense."
+
+ In making acquisitions, we have a further advantage: As
+payment, we can offer sellers a stock backed by an extraordinary
+collection of outstanding businesses. An individual or a family
+wishing to dispose of a single fine business, but also wishing to
+defer personal taxes indefinitely, is apt to find Berkshire stock
+a particularly comfortable holding. I believe, in fact, that
+this calculus played an important part in the two acquisitions
+for which we paid shares in 1995.
+
+ Beyond that, sellers sometimes care about placing their
+companies in a corporate home that will both endure and provide
+pleasant, productive working conditions for their managers. Here
+again, Berkshire offers something special. Our managers operate
+with extraordinary autonomy. Additionally, our ownership
+structure enables sellers to know that when I say we are buying
+to keep, the promise means something. For our part, we like
+dealing with owners who care what happens to their companies and
+people. A buyer is likely to find fewer unpleasant surprises
+dealing with that type of seller than with one simply auctioning
+off his business.
+
+ In addition to the foregoing being an explanation of our
+acquisition style, it is, of course, a not-so-subtle sales pitch.
+If you own or represent a business earning $25 million or more
+before tax, and it fits the criteria listed on page 23, just
+give me a call. Our discussion will be confidential. And if you
+aren't interested now, file our proposition in the back of your
+mind: We are never going to lose our appetite for buying
+companies with good economics and excellent management.
+
+ Concluding this little dissertation on acquisitions, I can't
+resist repeating a tale told me last year by a corporate
+executive. The business he grew up in was a fine one, with a
+long-time record of leadership in its industry. Its main
+product, however, was distressingly glamorless. So several
+decades ago, the company hired a management consultant who -
+naturally - advised diversification, the then-current fad.
+("Focus" was not yet in style.) Before long, the company
+acquired a number of businesses, each after the consulting firm
+had gone through a long - and expensive - acquisition study. And
+the outcome? Said the executive sadly, "When we started, we were
+getting 100% of our earnings from the original business. After
+ten years, we were getting 150%."
+
+Helzberg's Diamond Shops
+
+ A few years back, management consultants popularized a
+technique called "management by walking around" (MBWA). At
+Berkshire, we've instituted ABWA (acquisitions by walking
+around).
+
+ In May 1994, a week or so after the Annual Meeting, I was
+crossing the street at 58th and Fifth Avenue in New York, when a
+woman called out my name. I listened as she told me she'd been
+to, and had enjoyed, the Annual Meeting. A few seconds later, a
+man who'd heard the woman stop me did so as well. He turned out
+to be Barnett Helzberg, Jr., who owned four shares of Berkshire
+and had also been at our meeting.
+
+ In our few minutes of conversation, Barnett said he had a
+business we might be interested in. When people say that, it
+usually turns out they have a lemonade stand - with potential, of
+course, to quickly grow into the next Microsoft. So I simply
+asked Barnett to send me particulars. That, I thought to myself.
+will be the end of that.
+
+ Not long after, Barnett sent me the financial statements of
+Helzberg's Diamond Shops. The company had been started by his
+grandfather in 1915 from a single store in Kansas City and had
+developed by the time we met into a group with 134 stores in 23
+states. Sales had grown from $10 million in 1974 to $53 million
+in 1984 and $282 million in 1994. We weren't talking lemonade
+stands.
+
+ Barnett, then 60, loved the business but also wanted to feel
+free of it. In 1988, as a step in that direction, he had brought
+in Jeff Comment, formerly President of Wanamaker's, to help him
+run things. The hiring of Jeff turned out to be a homerun, but
+Barnett still found that he couldn't shake a feeling of ultimate
+responsibility. Additionally, he owned a valuable asset that was
+subject to the vagaries of a single, very competitive industry,
+and he thought it prudent to diversify his family's holdings.
+
+ Berkshire was made to order for him. It took us awhile to
+get together on price, but there was never any question in my
+mind that, first, Helzberg's was the kind of business that we
+wanted to own and, second, Jeff was our kind of manager. In
+fact, we would not have bought the business if Jeff had not been
+there to run it. Buying a retailer without good management is
+like buying the Eiffel Tower without an elevator.
+
+ We completed the Helzberg purchase in 1995 by means of a
+tax-free exchange of stock, the only kind of transaction that
+interested Barnett. Though he was certainly under no obligation
+to do so, Barnett shared a meaningful part of his proceeds from
+the sale with a large number of his associates. When someone
+behaves that generously, you know you are going to be treated
+right as a buyer.
+
+ The average Helzberg's store has annual sales of about $2
+million, far more than competitors operating similarly-sized
+stores achieve. This superior per-store productivity is the key
+to Helzberg's excellent profits. If the company continues its
+first-rate performance - and we believe it will - it could grow
+rather quickly to several times its present size.
+
+ Helzberg's, it should be added, is an entirely different
+sort of operation from Borsheim's, our Omaha jewelry business,
+and the two companies will operate independently of each other.
+Borsheim's had an excellent year in 1995, with sales up 11.7%.
+Susan Jacques, its 36-year-old CEO, had an even better year,
+giving birth to her second son at the start of the Christmas
+season. Susan has proved to be a terrific leader in the two
+years since her promotion.
+
+R.C. Willey Home Furnishings
+
+ It was Nebraska Furniture Mart's Irv Blumkin who did the
+walking around in the case of R.C. Willey, long the leading home
+furnishings business in Utah. Over the years, Irv had told me
+about the strengths of that company. And he had also told Bill
+Child, CEO of R.C. Willey, how pleased the Blumkin family had
+been with its Berkshire relationship. So in early 1995, Bill
+mentioned to Irv that for estate tax and diversification reasons,
+he and the other owners of R.C. Willey might be interested in
+selling.
+
+ From that point forward, things could not have been simpler.
+Bill sent me some figures, and I wrote him a letter indicating
+my idea of value. We quickly agreed on a number, and found our
+personal chemistry to be perfect. By mid-year, the merger was
+completed.
+
+ R.C. Willey is an amazing story. Bill took over the
+business from his father-in-law in 1954 when sales were about
+$250,000. From this tiny base, Bill employed Mae West's
+philosophy: "It's not what you've got - it's what you do with
+what you've got." Aided by his brother, Sheldon, Bill has built
+the company to its 1995 sales volume of $257 million, and it now
+accounts for over 50% of the furniture business in Utah. Like
+Nebraska Furniture Mart, R.C. Willey sells appliances,
+electronics, computers and carpets in addition to furniture.
+Both companies have about the same sales volume, but NFM gets all
+of its business from one complex in Omaha, whereas R.C. Willey
+will open its sixth major store in the next few months.
+
+ Retailing is a tough business. During my investment career,
+I have watched a large number of retailers enjoy terrific growth
+and superb returns on equity for a period, and then suddenly
+nosedive, often all the way into bankruptcy. This shooting-star
+phenomenon is far more common in retailing than it is in
+manufacturing or service businesses. In part, this is because a
+retailer must stay smart, day after day. Your competitor is
+always copying and then topping whatever you do. Shoppers are
+meanwhile beckoned in every conceivable way to try a stream of
+new merchants. In retailing, to coast is to fail.
+
+ In contrast to this have-to-be-smart-every-day business,
+there is what I call the have-to-be-smart-once business. For
+example, if you were smart enough to buy a network TV station
+very early in the game, you could put in a shiftless and backward
+nephew to run things, and the business would still do well for
+decades. You'd do far better, of course, if you put in Tom
+Murphy, but you could stay comfortably in the black without him.
+For a retailer, hiring that nephew would be an express ticket to
+bankruptcy.
+
+ The two retailing businesses we purchased this year are
+blessed with terrific managers who love to compete and have done
+so successfully for decades. Like the CEOs of our other
+operating units, they will operate autonomously: We want them to
+feel that the businesses they run are theirs. This means no
+second-guessing by Charlie and me. We avoid the attitude of the
+alumnus whose message to the football coach is "I'm 100% with you
+- win or tie." Our basic goal as an owner is to behave with our
+managers as we like our owners to behave with us.
+
+ As we add more operations, I'm sometimes asked how many
+people I can handle reporting to me. My answer to that is
+simple: If I have one person reporting to me and he is a lemon,
+that's one too many, and if I have managers like those we now
+have, the number can be almost unlimited. We are lucky to have
+Bill and Sheldon associated with us, and we hope that we can
+acquire other businesses that bring with them managers of similar
+caliber.
+
+GEICO Corporation
+
+ Right after yearend, we completed the purchase of 100% of
+GEICO, the seventh largest auto insurer in the United States,
+with about 3.7 million cars insured. I've had a 45-year
+association with GEICO, and though the story has been told
+before, it's worth a short recap here.
+
+ I attended Columbia University's business school in 1950-51,
+not because I cared about the degree it offered, but because I
+wanted to study under Ben Graham, then teaching there. The time
+I spent in Ben's classes was a personal high, and quickly induced
+me to learn all I could about my hero. I turned first to Who's
+Who in America, finding there, among other things, that Ben was
+Chairman of Government Employees Insurance Company, to me an
+unknown company in an unfamiliar industry.
+
+ A librarian next referred me to Best's Fire and Casualty
+insurance manual, where I learned that GEICO was based in
+Washington, DC. So on a Saturday in January, 1951, I took the
+train to Washington and headed for GEICO's downtown headquarters.
+To my dismay, the building was closed, but I pounded on the door
+until a custodian appeared. I asked this puzzled fellow if there
+was anyone in the office I could talk to, and he said he'd seen
+one man working on the sixth floor.
+
+ And thus I met Lorimer Davidson, Assistant to the President,
+who was later to become CEO. Though my only credentials were
+that I was a student of Graham's, "Davy" graciously spent four
+hours or so showering me with both kindness and instruction. No
+one has ever received a better half-day course in how the
+insurance industry functions nor in the factors that enable one
+company to excel over others. As Davy made clear, GEICO's method
+of selling - direct marketing - gave it an enormous cost
+advantage over competitors that sold through agents, a form of
+distribution so ingrained in the business of these insurers that
+it was impossible for them to give it up. After my session with
+Davy, I was more excited about GEICO than I have ever been about
+a stock.
+
+ When I finished at Columbia some months later and returned
+to Omaha to sell securities, I naturally focused almost
+exclusively on GEICO. My first sales call - on my Aunt Alice,
+who always supported me 100% - was successful. But I was then a
+skinny, unpolished 20-year-old who looked about 17, and my pitch
+usually failed. Undaunted, I wrote a short report late in 1951
+about GEICO for "The Security I Like Best" column in The
+Commercial and Financial Chronicle, a leading financial
+publication of the time. More important, I bought stock for my
+own account.
+
+ You may think this odd, but I have kept copies of every tax
+return I filed, starting with the return for 1944. Checking
+back, I find that I purchased GEICO shares on four occasions
+during 1951, the last purchase being made on September 26. This
+pattern of persistence suggests to me that my tendency toward
+self-intoxication was developed early. I probably came back on
+that September day from unsuccessfully trying to sell some
+prospect and decided - despite my already having more than 50% of
+my net worth in GEICO - to load up further. In any event, I
+accumulated 350 shares of GEICO during the year, at a cost of
+$10,282. At yearend, this holding was worth $13,125, more than
+65% of my net worth.
+
+ You can see why GEICO was my first business love. Furthermore,
+just to complete this stroll down memory lane, I should add
+that I earned most of the funds I used to buy GEICO shares by
+delivering The Washington Post, the chief product of a
+company that much later made it possible for Berkshire to turn
+$10 million into $500 million.
+
+ Alas, I sold my entire GEICO position in 1952 for $15,259,
+primarily to switch into Western Insurance Securities. This act
+of infidelity can partially be excused by the fact that Western
+was selling for slightly more than one times its current earnings,
+a p/e ratio that for some reason caught my eye. But in the next
+20 years, the GEICO stock I sold grew in value to about $1.3
+million, which taught me a lesson about the inadvisability of
+selling a stake in an identifiably-wonderful company.
+
+ In the early 1970's, after Davy retired, the executives
+running GEICO made some serious errors in estimating their claims
+costs, a mistake that led the company to underprice its policies
+- and that almost caused it to go bankrupt. The company was
+saved only because Jack Byrne came in as CEO in 1976 and took
+drastic remedial measures.
+
+ Because I believed both in Jack and in GEICO's fundamental
+competitive strength, Berkshire purchased a large interest in the
+company during the second half of 1976, and also made smaller
+purchases later. By yearend 1980, we had put $45.7 million into
+GEICO and owned 33.3% of its shares. During the next 15 years,
+we did not make further purchases. Our interest in the company,
+nonetheless, grew to about 50% because it was a big repurchaser
+of its own shares.
+
+ Then, in 1995, we agreed to pay $2.3 billion for the half of
+the company we didn't own. That is a steep price. But it gives
+us full ownership of a growing enterprise whose business remains
+exceptional for precisely the same reasons that prevailed in
+1951. In addition, GEICO has two extraordinary managers: Tony
+Nicely, who runs the insurance side of the operation, and Lou
+Simpson, who runs investments.
+
+ Tony, 52, has been with GEICO for 34 years. There's no one
+I would rather have managing GEICO's insurance operation. He has
+brains, energy, integrity and focus. If we're lucky, he'll stay
+another 34 years.
+
+ Lou runs investments just as ably. Between 1980 and 1995,
+the equities under Lou's management returned an average of 22.8%
+annually vs. 15.7% for the S&P. Lou takes the same conservative,
+concentrated approach to investments that we do at Berkshire, and
+it is an enormous plus for us to have him on board. One point
+that goes beyond Lou's GEICO work: His presence on the scene
+assures us that Berkshire would have an extraordinary
+professional immediately available to handle its investments if
+something were to happen to Charlie and me.
+
+ GEICO, of course, must continue both to attract good
+policyholders and keep them happy. It must also reserve and
+price properly. But the ultimate key to the company's success is
+its rock-bottom operating costs, which virtually no competitor
+can match. In 1995, moreover, Tony and his management team
+pushed underwriting and loss adjustment expenses down further to
+23.6% of premiums, nearly one percentage point below 1994's
+ratio. In business, I look for economic castles protected by
+unbreachable "moats." Thanks to Tony and his management team,
+GEICO's moat widened in 1995.
+
+ Finally, let me bring you up to date on Davy. He's now 93
+and remains my friend and teacher. He continues to pay close
+attention to GEICO and has always been there when the company's
+CEOs - Jack Byrne, Bill Snyder and Tony - have needed him. Our
+acquisition of 100% of GEICO caused Davy to incur a large tax.
+Characteristically, he still warmly supported the transaction.
+
+ Davy has been one of my heroes for the 45 years I've known
+him, and he's never let me down. You should understand that
+Berkshire would not be where it is today if Davy had not been so
+generous with his time on a cold Saturday in 1951. I've often
+thanked him privately, but it is fitting that I use this report
+to thank him on behalf of Berkshire's shareholders.
+
+Insurance Operations
+
+ In addition to acquiring GEICO, we enjoyed other favorable
+developments in insurance during 1995.
+
+ As we've explained in past reports, what counts in our
+insurance business is, first, the amount of "float" we generate
+and, second, its cost to us. Float is money we hold but don't
+own. In an insurance operation, float arises because most
+policies require that premiums be prepaid and, more importantly,
+because it usually takes time for an insurer to hear about and
+resolve loss claims.
+
+ Typically, the premiums that an insurer takes in do not
+cover the losses and expenses it must pay. That leaves it
+running an "underwriting loss" - and that loss is the cost of
+float. An insurance business is profitable over time if its cost
+of float is less than the cost the company would otherwise incur
+to obtain funds. But the business has a negative value if the
+cost of its float is higher than market rates for money.
+
+ As the numbers in the following table show, Berkshire's
+insurance business has been a huge winner. For the table, we
+have calculated our float - which we generate in exceptional
+amounts relative to our premium volume - by adding loss reserves,
+loss adjustment reserves, funds held under reinsurance assumed
+and unearned premium reserves, and then subtracting agents'
+balances, prepaid acquisition costs, prepaid taxes and deferred
+charges applicable to assumed reinsurance. Our cost of float is
+determined by our underwriting loss or profit. In those years
+when we have had an underwriting profit, such as the last three,
+our cost of float has been negative, which means we have
+calculated our insurance earnings by adding underwriting profit
+to float income.
+
+ (1) (2) Yearend Yield
+ Underwriting Approximate on Long-Term
+ Loss Average Float Cost of Funds Govt. Bonds
+ ------------ ------------- --------------- -------------
+ (In $ Millions) (Ratio of 1 to 2)
+
+1967 ...... profit 17.3 less than zero 5.50%
+1968 ...... profit 19.9 less than zero 5.90%
+1969 ...... profit 23.4 less than zero 6.79%
+1970 ...... 0.37 32.4 1.14% 6.25%
+1971 ...... profit 52.5 less than zero 5.81%
+1972 ...... profit 69.5 less than zero 5.82%
+1973 ...... profit 73.3 less than zero 7.27%
+1974 ...... 7.36 79.1 9.30% 8.13%
+1975 ...... 11.35 87.6 12.96% 8.03%
+1976 ...... profit 102.6 less than zero 7.30%
+1977 ...... profit 139.0 less than zero 7.97%
+1978 ...... profit 190.4 less than zero 8.93%
+1979 ...... profit 227.3 less than zero 10.08%
+1980 ...... profit 237.0 less than zero 11.94%
+1981 ...... profit 228.4 less than zero 13.61%
+1982 ...... 21.56 220.6 9.77% 10.64%
+1983 ...... 33.87 231.3 14.64% 11.84%
+1984 ...... 48.06 253.2 18.98% 11.58%
+1985 ...... 44.23 390.2 11.34% 9.34%
+1986 ...... 55.84 797.5 7.00% 7.60%
+1987 ...... 55.43 1,266.7 4.38% 8.95%
+1988 ...... 11.08 1,497.7 0.74% 9.00%
+1989 ...... 24.40 1,541.3 1.58% 7.97%
+1990 ...... 26.65 1,637.3 1.63% 8.24%
+1991 ...... 119.59 1,895.0 6.31% 7.40%
+1992 ...... 108.96 2,290.4 4.76% 7.39%
+1993 ...... profit 2,624.7 less than zero 6.35%
+1994 ...... profit 3,056.6 less than zero 7.88%
+1995 ...... profit 3,607.2 less than zero 5.95%
+
+ Since 1967, when we entered the insurance business, our float
+has grown at an annual compounded rate of 20.7%. In more years
+than not, our cost of funds has been less than nothing. This
+access to "free" money has boosted Berkshire's performance in a
+major way.
+
+ Any company's level of profitability is determined by three
+items: (1) what its assets earn; (2) what its liabilities cost;
+and (3) its utilization of "leverage" - that is, the degree to
+which its assets are funded by liabilities rather than by equity.
+Over the years, we have done well on Point 1, having produced high
+returns on our assets. But we have also benefitted greatly - to a
+degree that is not generally well-understood - because our
+liabilities have cost us very little. An important reason for this
+low cost is that we have obtained float on very advantageous terms.
+The same cannot be said by many other property and casualty
+insurers, who may generate plenty of float, but at a cost that
+exceeds what the funds are worth to them. In those circumstances,
+leverage becomes a disadvantage.
+
+ Since our float has cost us virtually nothing over the years,
+it has in effect served as equity. Of course, it differs from true
+equity in that it doesn't belong to us. Nevertheless, let's assume
+that instead of our having $3.4 billion of float at the end of
+1994, we had replaced it with $3.4 billion of equity. Under this
+scenario, we would have owned no more assets than we did during
+1995. We would, however, have had somewhat lower earnings because
+the cost of float was negative last year. That is, our float threw
+off profits. And, of course, to obtain the replacement equity, we
+would have needed to sell many new shares of Berkshire. The net
+result - more shares, equal assets and lower earnings - would have
+materially reduced the value of our stock. So you can understand
+why float wonderfully benefits a business - if it is obtained at a
+low cost.
+
+ Our acquisition of GEICO will immediately increase our float
+by nearly $3 billion, with additional growth almost certain. We
+also expect GEICO to operate at a decent underwriting profit in
+most years, a fact that will increase the probability that our
+total float will cost us nothing. Of course, we paid a very
+substantial price for the GEICO float, whereas virtually all of the
+gains in float depicted in the table were developed internally.
+
+ Our enthusiasm over 1995's insurance results must be tempered
+once again because we had our third straight year of good fortune
+in the super-cat business. In this operation, we sell policies
+that insurance and reinsurance companies buy to protect themselves
+from the effects of mega-catastrophes. Since truly major
+catastrophes occur infrequently, our super-cat business can be
+expected to show large profits in most years but occasionally to
+record a huge loss. In other words, the attractiveness of our
+super-cat business will take many years to measure. We know that
+the results of years like the past three will be at least partially
+offset by some truly terrible year in the future. We just hope
+that "partially" turns out to be the proper adverb.
+
+ There were plenty of catastrophes last year, but no super-cats
+of the insured variety. The Southeast had a close call when Opal,
+sporting winds of 150 miles per hour, hovered off Florida.
+However, the storm abated before hitting land, and so a second
+Andrew was dodged. For insurers, the Kobe earthquake was another
+close call: The economic damage was huge - perhaps even a record -
+but only a tiny portion of it was insured. The insurance industry
+won't always be that lucky.
+
+ Ajit Jain is the guiding genius of our super-cat business and
+writes important non-cat business as well. In insurance, the term
+"catastrophe" is applied to an event, such as a hurricane or
+earthquake, that causes a great many insured losses. The other
+deals Ajit enters into usually cover only a single large loss. A
+simplified description of three transactions from last year will
+illustrate both what I mean and Ajit's versatility. We insured: (1)
+The life of Mike Tyson for a sum that is large initially and that,
+fight-by-fight, gradually declines to zero over the next few years;
+(2) Lloyd's against more than 225 of its "names" dying during the
+year; and (3) The launch, and a year of orbit, of two Chinese
+satellites. Happily, both satellites are orbiting, the Lloyd's folk
+avoided abnormal mortality, and if Mike Tyson looked any healthier,
+no one would get in the ring with him.
+
+ Berkshire is sought out for many kinds of insurance, both
+super-cat and large single-risk, because: (1) our financial
+strength is unmatched, and insureds know we can and will pay our
+losses under the most adverse of circumstances; (2) we can supply a
+quote faster than anyone in the business; and (3) we will issue
+policies with limits larger than anyone else is prepared to write.
+Most of our competitors have extensive reinsurance treaties and
+lay off much of their business. While this helps them avoid shock
+losses, it also hurts their flexibility and reaction time. As you
+know, Berkshire moves quickly to seize investment and acquisition
+opportunities; in insurance we respond with the same exceptional
+speed. In another important point, large coverages don't frighten
+us but, on the contrary, intensify our interest. We have offered a
+policy under which we could have lost $1 billion; the largest
+coverage that a client accepted was $400 million.
+
+ We will get hit from time to time with large losses. Charlie
+and I, however, are quite willing to accept relatively volatile
+results in exchange for better long-term earnings than we would
+otherwise have had. In other words, we prefer a lumpy 15% to a
+smooth 12%. Since most managers opt for smoothness, we are left
+with a competitive advantage that we try to maximize. We do,
+though, monitor our aggregate exposure in order to keep our "worst
+case" at a level that leaves us comfortable.
+
+ Indeed, our worst case from a "once-in-a-century" super-cat is
+far less severe - relative to net worth - than that faced by many
+well-known primary companies writing great numbers of property
+policies. These insurers don't issue single huge-limit policies as
+we do, but their small policies, in aggregate, can create a risk of
+staggering size. The "big one" would blow right through the
+reinsurance covers of some of these insurers, exposing them to
+uncapped losses that could threaten their survival. In our case,
+losses would be large, but capped at levels we could easily handle.
+
+ Prices are weakening in the super-cat field. That is
+understandable considering the influx of capital into the
+reinsurance business a few years ago and the natural desire of
+those holding the capital to employ it. No matter what others may
+do, we will not knowingly write business at inadequate rates. We
+unwittingly did this in the early 1970's and, after more than 20
+years, regularly receive significant bills stemming from the
+mistakes of that era. My guess is that we will still be getting
+surprises from that business 20 years from now. A bad reinsurance
+contract is like hell: easy to enter and impossible to exit.
+
+ I actively participated in those early reinsurance decisions,
+and Berkshire paid a heavy tuition for my education in the
+business. Unfortunately, reinsurance students can't attend school
+on scholarship. GEICO, incidentally, suffered a similar,
+disastrous experience in the early 1980's, when it plunged
+enthusiastically into the writing of reinsurance and large risks.
+GEICO's folly was brief, but it will be cleaning things up for at
+least another decade. The well-publicized problems at Lloyd's
+further illustrate the perils of reinsurance and also underscore
+how vital it is that the interests of the people who write
+insurance business be aligned - on the downside as well as the
+upside - with those of the people putting up the capital. When
+that kind of symmetry is missing, insurers almost invariably run
+into trouble, though its existence may remain hidden for some time.
+
+ A small, apocryphal story about an insurance CEO who was
+visited by an analyst tells a lot about this industry. To the
+analyst's questions about his business, the CEO had nothing but
+gloomy answers: Rates were ridiculously low; the reserves on his
+balance sheet weren't adequate for ordinary claims, much less those
+likely to arise from asbestos and environmental problems; most of
+his reinsurers had long since gone broke, leaving him holding the
+sack. But then the CEO brightened: "Still, things could be a lot
+worse," he said. "It could be my money." At Berkshire, it's our
+money.
+
+ Berkshire's other insurance operations, though relatively
+small, performed magnificently in 1995. National Indemnity's
+traditional business had a combined ratio of 84.2 and developed, as
+usual, a large amount of float compared to premium volume. Over
+the last three years, this segment of our business, run by Don
+Wurster, has had an average combined ratio of 85.6. Our homestate
+operation, managed by Rod Eldred, grew at a good rate in 1995 and
+achieved a combined ratio of 81.4. Its three-year combined ratio
+is an amazing 82.4. Berkshire's California workers' compensation
+business, run by Brad Kinstler, faced fierce price-cutting in 1995
+and lost a great many renewals when we refused to accept inadequate
+rates. Though this operation's volume dropped materially, it
+produced an excellent underwriting profit. Finally, John Kizer, at
+Central States Indemnity, continues to do an extraordinary job.
+His premium volume was up 23% in 1995, and underwriting profit grew
+by 59%. Ajit, Don, Rod, Brad and John are all under 45, an
+embarrassing fact demolishing my theory that managers only hit
+their stride after they reach 70.
+
+ To sum up, we entered 1995 with an exceptional insurance
+operation of moderate size. By adding GEICO, we entered 1996 with
+a business still better in quality, much improved in its growth
+prospects, and doubled in size. More than ever, insurance is our
+core strength.
+
+Sources of Reported Earnings
+
+ The table below shows the main sources of Berkshire's reported
+earnings. In this presentation, purchase-premium charges are not
+assigned to the specific businesses to which they apply, but are
+instead aggregated and shown separately. This procedure lets you
+view the earnings of our businesses as they would have been
+reported had we not purchased them. This form of presentation
+seems to us to be more useful to investors and managers than one
+utilizing GAAP, which requires purchase-premiums to be charged off,
+business-by-business. The total earnings we show in the table are,
+of course, identical to the GAAP total in our audited financial
+statements.
+
+ (in millions)
+ ---------------------------------------
+ Berkshire's Share
+ of Net Earnings
+ (after taxes and
+ Pre-Tax Earnings minority interests)
+ ------------------ ------------------
+ 1995 1994 1995 1994
+ -------- -------- -------- --------
+Operating Earnings:
+ Insurance Group:
+ Underwriting ............... $ 20.5 $129.9 $ 11.3 $ 80.9
+ Net Investment Income ...... 501.6 419.4 417.7 350.5
+ Buffalo News ................. 46.8 54.2 27.3 31.7
+ Fechheimer ................... 16.9 14.3 8.8 7.1
+ Finance Businesses ........... 20.8 22.1 12.6 14.6
+ Home Furnishings ............. 29.7(1) 17.4 16.7(1) 8.7
+ Jewelry ...................... 33.9(2) ---(3) 19.1(2) ---(3)
+ Kirby ........................ 50.2 42.3 32.1 27.7
+ Scott Fetzer Manufacturing Group 34.1 39.5 21.2 24.9
+ See's Candies ................ 50.2 47.5 29.8 28.2
+ Shoe Group ................... 58.4 85.5 37.5 55.8
+ World Book ................... 8.8 24.7 7.0 17.3
+ Purchase-Price Premium Charges (27.0) (22.6) (23.4) (19.4)
+ Interest Expense(4) .......... (56.0) (60.1) (34.9) (37.3)
+ Shareholder-Designated
+ Contributions ............ (11.6) (10.4) (7.0) (6.7)
+ Other ........................ 37.4 35.7 24.4 22.3
+ -------- -------- -------- --------
+Operating Earnings ............. 814.7 839.4 600.2 606.2
+Sales of Securities ............ 194.1 91.3 125.0 61.1
+Decline in Value of
+ USAir Preferred Stock ...... --- (268.5) --- (172.6)
+ --------- -------- -------- --------
+Total Earnings - All Entities $1,008.8 $662.2 $725.2 $494.8
+ ========= ======== ======== ========
+
+(1) Includes R.C. Willey from June 29, 1995.
+(2) Includes Helzberg's from April 30, 1995.
+(3) Jewelry earnings were included in "Other" in 1994.
+(4) Excludes interest expense of Finance Businesses.
+
+ A large amount of information about these businesses is given
+on pages 41-52, where you will also find our segment earnings
+reported on a GAAP basis. In addition, on pages 57-63, we have
+rearranged Berkshire's financial data into four segments on a non-
+GAAP basis, a presentation that corresponds to the way Charlie and
+I think about the company. Our intent is to supply you with the
+financial information that we would wish you to give us if our
+positions were reversed.
+
+ At Berkshire, we believe in Charlie's dictum - "Just tell me
+the bad news; the good news will take care of itself" - and that is
+the behavior we expect of our managers when they are reporting to
+us. Consequently, I also owe you - Berkshire's owners - a report
+on three operations that, though they continued to earn decent (or
+better) returns on invested capital, experienced a decline in
+earnings last year. Each encountered a different type of problem.
+
+ Our shoe business operated in an industry that suffered
+depressed earnings throughout last year, and many of our
+competitors made only marginal profits or worse. That means we at
+least maintained, and in some instances widened, our competitive
+superiority. So I have no doubt that our shoe operations will
+climb back to top-grade earnings in the future. In other words,
+though the turn has not yet occurred, we believe you should view
+last year's figures as reflecting a cyclical problem, not a secular
+one.
+
+ The Buffalo News, though still doing very well in comparison
+to other newspapers, is another story. In this case, industry
+trends are not good. In the 1991 Annual Report, I explained that
+newspapers had lost a notch in their economic attractiveness from
+the days when they appeared to have a bullet-proof franchise.
+Today, the industry retains its excellent economics, but has lost
+still another notch. Over time, we expect the competitive strength
+of newspapers to gradually erode, though the industry should
+nevertheless remain a fine business for many years to come.
+
+ Berkshire's most difficult problem is World Book, which
+operates in an industry beset by increasingly tough competition
+from CD-ROM and on-line offerings. True, we are still profitable,
+a claim that perhaps no other print encyclopedia can make. But our
+sales and earnings trends have gone in the wrong direction. At the
+end of 1995, World Book made major changes in the way it
+distributes its product, stepped up its efforts with electronic
+products and sharply reduced its overhead costs. It will take time
+for us to evaluate the effects of these initiatives, but we are
+confident they will significantly improve our viability.
+
+ All of our operations, including those whose earnings fell
+last year, benefit from exceptionally talented and dedicated
+managers. Were we to have the choice of any other executives now
+working in their industries, there is not one of our managers we
+would replace.
+
+ Many of our managers don't have to work for a living, but
+simply go out and perform every day for the same reason that
+wealthy golfers stay on the tour: They love both doing what they
+do and doing it well. To describe them as working may be a
+misnomer - they simply prefer spending much of their time on a
+productive activity at which they excel to spending it on leisure
+activities. Our job is to provide an environment that will keep
+them feeling this way, and so far we seem to have succeeded:
+Thinking back over the 1965-95 period, I can't recall that a single
+key manager has left Berkshire to join another employer.
+
+Common Stock Investments
+
+ Below we present our common stock investments. Those with a
+market value of more than $600 million are itemized.
+
+ 12/31/95
+ Shares Company Cost Market
+ ---------- ------- -------- --------
+ (dollars in millions)
+ 49,456,900 American Express Company ............. $1,392.7 $2,046.3
+ 20,000,000 Capital Cities/ABC, Inc. ............. 345.0 2,467.5
+100,000,000 The Coca-Cola Company ................ 1,298.9 7,425.0
+ 12,502,500 Federal Home Loan Mortgage Corp.
+ ("Freddie Mac") ................... 260.1 1,044.0
+ 34,250,000 GEICO Corp. .......................... 45.7 2,393.2
+ 48,000,000 The Gillette Company ................. 600.0 2,502.0
+ 6,791,218 Wells Fargo & Company ................ 423.7 1,466.9
+ Others ............................... 1,379.0 2,655.4
+ -------- ---------
+ Total Common Stocks .................. $5,745.1 $22,000.3
+ ======== =========
+
+ We continue in our Rip Van Winkle mode: Five of our six top
+positions at yearend 1994 were left untouched during 1995. The
+sixth was American Express, in which we increased our ownership to
+about 10%.
+
+ In early 1996, two major events affected our holdings: First,
+our purchase of the GEICO stock we did not already own caused that
+company to be converted into a wholly-owned subsidiary. Second, we
+exchanged our Cap Cities shares for a combination of cash and
+Disney stock.
+
+ In the Disney merger, Cap Cities shareholders had a choice of
+actions. If they chose, they could exchange each of their Cap
+Cities shares for one share of Disney stock plus $65. Or they
+could ask for - though not necessarily get - all cash or all stock,
+with their ultimate allotment of each depending on the choices made
+by other shareholders and certain decisions made by Disney. For
+our 20 million shares, we sought stock, but do not know, as this
+report goes to press, how much we were allocated. We are certain,
+however, to receive something over 20 million Disney shares. We
+have also recently bought Disney stock in the market.
+
+ One more bit of history: I first became interested in Disney
+in 1966, when its market valuation was less than $90 million, even
+though the company had earned around $21 million pre-tax in 1965
+and was sitting with more cash than debt. At Disneyland, the $17
+million Pirates of the Caribbean ride would soon open. Imagine my
+excitement - a company selling at only five times rides!
+
+ Duly impressed, Buffett Partnership Ltd. bought a significant
+amount of Disney stock at a split-adjusted price of 31› per share.
+That decision may appear brilliant, given that the stock now sells
+for $66. But your Chairman was up to the task of nullifying it:
+In 1967 I sold out at 48› per share.
+
+ Oh well - we're happy to be once again a large owner of a
+business with both unique assets and outstanding management.
+
+Convertible Preferred Stocks
+
+ As many of you will remember, Berkshire made five private
+purchases of convertible preferred stocks during the 1987-91 period
+and the time seems right to discuss their status. Here are the
+particulars:
+
+ Dividend Year of Market
+ Company Rate Purchase Cost Value
+ ------- -------- -------- ------ --------
+ (dollars in millions)
+
+Champion International Corp. ... 9 1/4% 1989 $300 $388(1)
+First Empire State Corp. ....... 9% 1991 40 110
+The Gillette Company ........... 8 3/4% 1989 600 2,502(2)
+Salomon Inc .................... 9% 1987 700 728(3)
+USAir Group, Inc. .............. 9 1/4% 1989 358 215
+
+(1) Proceeds from sale of common we received through conversion in 1995.
+(2) 12/31/95 value of common we received through conversion in 1991.
+(3) Includes $140 we received in 1995 from partial redemption.
+
+ In each case we had the option of sticking with these
+preferreds as fixed-income securities or converting them into
+common stock. Initially, their value to us came primarily from
+their fixed-income characteristics. The option we had to convert
+was a kicker.
+
+ Our $300 million private purchase of American Express "Percs"
+- described in the 1991 Annual Report - is not included in the
+table because that security was a modified form of common stock
+whose fixed-income characteristics contributed only a minor portion
+of its initial value. Three years after we bought them, the Percs
+automatically were converted to common stock. In contrast, the
+five securities in the table were set to become common stocks only
+if we wished them to - a crucial difference.
+
+ When we purchased our convertible securities, I told you that
+we expected to earn after-tax returns from them that "moderately"
+exceeded what we could earn from the medium-term fixed-income
+securities they replaced. We beat this expectation - but only
+because of the performance of a single issue. I also told you that
+these securities, as a group, would "not produce the returns we can
+achieve when we find a business with wonderful economic prospects."
+Unfortunately, that prediction was fulfilled. Finally, I said
+that "under almost any conditions, we expect these preferreds to
+return us our money plus dividends." That's one I would like to
+have back. Winston Churchill once said that "eating my words has
+never given me indigestion." My assertion, however, that it was
+almost impossible for us to lose money on our preferreds has caused
+me some well-deserved heartburn.
+
+ Our best holding has been Gillette, which we told you from the
+start was a superior business. Ironically, though, this is also
+the purchase in which I made my biggest mistake - of a kind,
+however, never recognized on financial statements.
+
+ We paid $600 million in 1989 for Gillette preferred shares
+that were convertible into 48 million (split-adjusted) common
+shares. Taking an alternative route with the $600 million, I
+probably could have purchased 60 million shares of common from the
+company. The market on the common was then about $10.50, and given
+that this would have been a huge private placement carrying
+important restrictions, I probably could have bought the stock at a
+discount of at least 5%. I can't be sure about this, but it's
+likely that Gillette's management would have been just as happy to
+have Berkshire opt for common.
+
+ But I was far too clever to do that. Instead, for less than
+two years, we received some extra dividend income (the difference
+between the preferred's yield and that of the common), at which
+point the company - quite properly - called the issue, moving to do
+that as quickly as was possible. If I had negotiated for common
+rather than preferred, we would have been better off at yearend
+1995 by $625 million, minus the "excess" dividends of about $70
+million.
+
+ In the case of Champion, the ability of the company to call
+our preferred at 115% of cost forced a move out of us last August
+that we would rather have delayed. In this instance, we converted
+our shares just prior to the pending call and offered them to the
+company at a modest discount.
+
+ Charlie and I have never had a conviction about the paper
+industry - actually, I can't remember ever owning the common stock
+of a paper producer in my 54 years of investing - so our choice in
+August was whether to sell in the market or to the company.
+Champion's management had always been candid and honorable in
+dealing with us and wished to repurchase common shares, so we
+offered our stock to the company. Our Champion capital gain was
+moderate - about 19% after tax from a six-year investment - but the
+preferred delivered us a good after-tax dividend yield throughout
+our holding period. (That said, many press accounts have
+overstated the after-tax yields earned by property-casualty
+insurance companies on dividends paid to them. What the press has
+failed to take into account is a change in the tax law that took
+effect in 1987 and that significantly reduced the dividends
+received credit applicable to insurers. For details, see our 1986
+Annual Report.)
+
+ Our First Empire preferred will be called on March 31, 1996,
+the earliest date allowable. We are comfortable owning stock in
+well-run banks, and we will convert and keep our First Empire
+common shares. Bob Wilmers, CEO of the company, is an outstanding
+banker, and we love being associated with him.
+
+ Our other two preferreds have been disappointing, though the
+Salomon preferred has modestly outperformed the fixed-income
+securities for which it was a substitute. However, the amount of
+management time Charlie and I have devoted to this holding has been
+vastly greater than its economic significance to Berkshire.
+Certainly I never dreamed I would take a new job at age 60 -
+Salomon interim chairman, that is - because of an earlier purchase
+of a fixed-income security.
+
+ Soon after our purchase of the Salomon preferred in 1987, I
+wrote that I had "no special insights regarding the direction or
+future profitability of investment banking." Even the most
+charitable commentator would conclude that I have since proved my
+point.
+
+ To date, our option to convert into Salomon common has not
+proven of value. Furthermore, the Dow Industrials have doubled
+since I committed to buy the preferred, and the brokerage group has
+performed equally as well. That means my decision to go with
+Salomon because I saw value in the conversion option must be graded
+as very poor. Even so, the preferred has continued under some
+trying conditions to deliver as a fixed-income security, and the
+9% dividend is currently quite attractive.
+
+ Unless the preferred is converted, its terms require
+redemption of 20% of the issue on October 31 of each year, 1995-99,
+and $140 million of our original $700 million was taken on schedule
+last year. (Some press reports labeled this a sale, but a senior
+security that matures is not "sold.") Though we did not elect to
+convert the preferred that matured last year, we have four more
+bites at the conversion apple, and I believe it quite likely that
+we will yet find value in our right to convert.
+
+ I discussed the USAir investment at length in last year's
+report. The company's results improved in 1995, but it still faces
+significant problems. On the plus side for us is the fact that our
+preferred is structurally well-designed: For example, though we
+have not been paid dividends since June 1994, the amounts owed us
+are compounding at 5% over the prime rate. On the minus side is
+the fact that we are dealing with a weak credit.
+
+ We feel much better about our USAir preferred than we did a
+year ago, but your guess is as good as mine as to its ultimate
+value. (Indeed, considering my record with this investment, it's
+fair to say that your guess may be better than mine.) At yearend
+we carried our preferred (in which there is no public market) at
+60% of par, though USAir also has outstanding a junior preferred
+that is significantly inferior to ours in all respects except
+conversion price and that was then trading at 82% of par. As I
+write this, the junior issue has advanced to 97% of par. Let's
+hope the market is right.
+
+ Overall, our preferreds have performed well, but that is true
+only because of one huge winner, Gillette. Leaving aside Gillette,
+our preferreds as a group have delivered us after-tax returns no
+more than equal to those we could have earned from the medium-term
+fixed-income issues that they replaced.
+
+A Proposed Recapitalization
+
+ At the Annual Meeting you will be asked to approve a
+recapitalization of Berkshire, creating two classes of stock. If
+the plan is adopted, our existing common stock will be designated
+as Class A Common Stock and a new Class B Common Stock will be
+authorized.
+
+ Each share of the "B" will have the rights of 1/30th of an "A"
+share with these exceptions: First, a B share will have 1/200th of
+the vote of an A share (rather than 1/30th of the vote). Second,
+the B will not be eligible to participate in Berkshire's
+shareholder-designated charitable contributions program.
+
+ When the recapitalization is complete, each share of A will
+become convertible, at the holder's option and at any time, into 30
+shares of B. This conversion privilege will not extend in the
+opposite direction. That is, holders of B shares will not be able
+to convert them into A shares.
+
+ We expect to list the B shares on the New York Stock Exchange,
+where they will trade alongside the A stock. To create the
+shareholder base necessary for a listing - and to ensure a liquid
+market in the B stock - Berkshire expects to make a public offering
+for cash of at least $100 million of new B shares. The offering
+will be made only by means of a prospectus.
+
+ The market will ultimately determine the price of the B
+shares. Their price, though, should be in the neighborhood of
+1/30th of the price of the A shares.
+
+ Class A shareholders who wish to give gifts may find it
+convenient to convert a share or two of their stock into Class B
+shares. Additionally, arbitrage-related conversions will occur if
+demand for the B is strong enough to push its price to slightly
+above 1/30th of the price of A.
+
+ However, because the Class A stock will entitle its holders to
+full voting rights and access to Berkshire's contributions program,
+these shares will be superior to the Class B shares and we would
+expect most shareholders to remain holders of the Class A - which
+is precisely what the Buffett and Munger families plan to do,
+except in those instances when we ourselves might convert a few
+shares to facilitate gifts. The prospect that most shareholders
+will stick to the A stock suggests that it will enjoy a somewhat
+more liquid market than the B.
+
+ There are tradeoffs for Berkshire in this recapitalization.
+But they do not arise from the proceeds of the offering - we will
+find constructive uses for the money - nor in any degree from the
+price at which we will sell the B shares. As I write this - with
+Berkshire stock at $36,000 - Charlie and I do not believe it
+undervalued. Therefore, the offering we propose will not diminish
+the per-share intrinsic value of our existing stock. Let me also
+put our thoughts about valuation more baldly: Berkshire is selling
+at a price at which Charlie and I would not consider buying it.
+
+ What Berkshire will incur by way of the B stock are certain
+added costs, including those involving the mechanics of handling a
+larger number of shareholders. On the other hand, the stock should
+be a convenience for people wishing to make gifts. And those of
+you who have hoped for a split have gained a do-it-yourself method
+of bringing one about.
+
+ We are making this move, though, for other reasons - having to
+do with the appearance of expense-laden unit trusts purporting to
+be low-priced "clones" of Berkshire and sure to be aggressively
+marketed. The idea behind these vehicles is not new: In recent
+years, a number of people have told me about their wish to create
+an "all-Berkshire" investment fund to be sold at a low dollar
+price. But until recently, the promoters of these investments
+heard out my objections and backed off.
+
+ I did not discourage these people because I prefer large
+investors over small. Were it possible, Charlie and I would love
+to turn $1,000 into $3,000 for multitudes of people who would find
+that gain an important answer to their immediate problems.
+
+ In order to quickly triple small stakes, however, we would
+have to just as quickly turn our present market capitalization of
+$43 billion into $129 billion (roughly the market cap of General
+Electric, America's most highly valued company). We can't come
+close to doing that. The very best we hope for is - on average - to
+double Berkshire's per-share intrinsic value every five years, and
+we may well fall far short of that goal.
+
+ In the end, Charlie and I do not care whether our shareholders
+own Berkshire in large or small amounts. What we wish for are
+shareholders of any size who are knowledgeable about our
+operations, share our objectives and long-term perspective, and are
+aware of our limitations, most particularly those imposed by our
+large capital base.
+
+ The unit trusts that have recently surfaced fly in the face of
+these goals. They would be sold by brokers working for big
+commissions, would impose other burdensome costs on their
+shareholders, and would be marketed en masse to unsophisticated
+buyers, apt to be seduced by our past record and beguiled by the
+publicity Berkshire and I have received in recent years. The sure
+outcome: a multitude of investors destined to be disappointed.
+
+ Through our creation of the B stock - a low-denomination
+product far superior to Berkshire-only trusts - we hope to make the
+clones unmerchandisable.
+
+ But both present and prospective Berkshire shareholders should
+pay special attention to one point: Though the per-share intrinsic
+value of our stock has grown at an excellent rate during the past
+five years, its market price has grown still faster. The stock, in
+other words, has outperformed the business.
+
+ That kind of market overperformance cannot persist indefinitely,
+neither for Berkshire nor any other stock. Inevitably, there
+will be periods of underperformance as well. The price
+volatility that results, though endemic to public markets, is
+not to our liking. What we would prefer instead is to have the
+market price of Berkshire precisely track its intrinsic value.
+Were the stock to do that, every shareholder would benefit during
+his period of ownership in exact proportion to the progress
+Berkshire itself made in the period.
+
+ Obviously, the market behavior of Berkshire's stock will never
+conform to this ideal. But we will come closer to this goal than
+we would otherwise if our present and prospective shareholders are
+informed, business-oriented and not exposed to high-commission
+salesmanship when making their investment decisions. To that end,
+we are better off if we can blunt the merchandising efforts of the
+unit trusts - and that is the reason we are creating the B stock.
+
+ We look forward to answering your questions about the
+recapitalization at the Annual Meeting.
+
+Miscellaneous
+
+ Berkshire isn't the only American corporation utilizing the
+new, exciting ABWA strategy. At about 1:15 p.m. on July 14, 1995,
+Michael Eisner, CEO of The Walt Disney Company, was walking up
+Wildflower Lane in Sun Valley. At the same time, I was leaving a
+lunch at Herbert Allen's home on that street to meet Tom Murphy,
+CEO of Cap Cities/ABC, for a golf game.
+
+ That morning, speaking to a large group of executives and
+money managers assembled by Allen's investment bank, Michael had
+made a brilliant presentation about Disney, and upon seeing him, I
+offered my congratulations. We chatted briefly - and the subject
+of a possible combination of Disney and Cap Cities came up. This
+wasn't the first time a merger had been discussed, but progress had
+never before been made, in part because Disney wanted to buy with
+cash and Cap Cities desired stock.
+
+ Michael and I waited a few minutes for Murph to arrive, and in
+the short conversation that ensued, both Michael and Murph
+indicated they might bend on the stock/cash question. Within a few
+weeks, they both did, at which point a contract was put together in
+three very busy days.
+
+ The Disney/Cap Cities deal makes so much sense that I'm sure
+it would have occurred without that chance encounter in Sun Valley.
+But when I ran into Michael that day on Wildflower Lane, he was
+heading for his plane, so without that accidental meeting the deal
+certainly wouldn't have happened in the time frame it did. I
+believe both Disney and Cap Cities will benefit from the fact that
+we all serendipitously met that day.
+
+ * * * * * * * * * * * *
+
+ It's appropriate that I say a few words here about Murph. To
+put it simply, he is as fine an executive as I have ever seen in my
+long exposure to business. Equally important, he possesses human
+qualities every bit the equal of his managerial qualities. He's an
+extraordinary friend, parent, husband and citizen. In those rare
+instances in which Murph's personal interests diverged from those
+of shareholders, he unfailingly favored the owners. When I say
+that I like to be associated with managers whom I would love to
+have as a sibling, in-law, or trustee of my will, Murph is the
+exemplar of what I mean.
+
+ If Murph should elect to run another business, don't bother to
+study its value - just buy the stock. And don't later be as dumb
+as I was two years ago when I sold one-third of our holdings in Cap
+Cities for $635 million (versus the $1.27 billion those shares
+would bring in the Disney merger).
+
+ * * * * * * * * * * * *
+
+ About 96.3% of all eligible shares participated in Berkshire's
+1995 shareholder-designated contributions program. Contributions
+made were $11.6 million and 3,600 charities were recipients. A
+full description of the shareholder-designated contributions
+program appears on pages 54-55.
+
+ Every year a few shareholders miss out on the program because
+they don't have their shares registered in their own names on the
+prescribed record date or because they fail to get their
+designation form back to us within the 60-day period allowed. That
+second problem pained me especially this year because two good
+friends with substantial holdings missed the deadline. We had to
+deny their requests to be included because we can't make exceptions
+for some shareholders while refusing to make them for others.
+
+ To participate in future programs, you must own Class A shares
+that are registered in the name of the actual owner, not the
+nominee name of a broker, bank or depository. Shares not so
+registered on August 31, 1996, will be ineligible for the 1996
+program. When you get the form, return it promptly so that it does
+not get put aside or forgotten.
+
+ * * * * * * * * * * * *
+
+
+ When it comes to our Annual Meetings, Charlie and I are
+managerial oddballs: We thoroughly enjoy the event. So come join
+us on Monday, May 6. At Berkshire, we have no investor relations
+department and don't use financial analysts as a channel for
+disseminating information, earnings "guidance," or the like.
+Instead, we prefer direct manager-to-owner communication and
+believe that the Annual Meeting is the ideal place for this
+interchange of ideas. Talking to you there is efficient for us and
+also democratic in that all present simultaneously hear what we
+have to say.
+
+ Last year, for the first time, we had the Annual Meeting at
+the Holiday Convention Centre and the logistics seemed to work.
+The ballroom there was filled with about 3,200 people, and we had a
+video feed into a second room holding another 800 people. Seating
+in the main room was a little tight, so this year we will probably
+configure it to hold 3,000. This year we will also have two rooms
+for the overflow.
+
+ All in all, we will be able to handle 5,000 shareholders. The
+meeting will start at 9:30 a.m., but be warned that last year the
+main ballroom was filled shortly after 8:00 a.m.
+
+ Shareholders from 49 states attended our 1995 meeting - where
+were you, Vermont? - and a number of foreign countries, including
+Australia, Sweden and Germany, were represented. As always, the
+meeting attracted shareholders who were interested in Berkshire's
+business - as contrasted to shareholders who are primarily
+interested in themselves - and the questions were all good.
+Charlie and I ate lunch on stage and answered questions for about
+five hours.
+
+ We feel that if owners come from all over the world, we should
+try to make sure they have an opportunity to ask their questions.
+Most shareholders leave about noon, but a thousand or so hardcore
+types usually stay to see whether we will drop. Charlie and I are
+in training to last at least five hours again this year.
+
+ We will have our usual array of Berkshire products at the
+meeting and this year will add a sales representative from GEICO.
+At the 1995 meeting, we sold 747 pounds of candy, 759 pairs of
+shoes, and over $17,500 of World Books and related publications.
+In a move that might have been dangerous had our stock been weak,
+we added knives last year from our Quikut subsidiary and sold 400
+sets of these. (We draw the line at soft fruit, however.) All of
+these goods will again be available this year. We don't consider a
+cultural event complete unless a little business is mixed in.
+
+ Because we expect a large crowd for the meeting, we recommend
+that you promptly get both plane and hotel reservations. Those of
+you who like to be downtown (about six miles from the Centre) may
+wish to stay at the Radisson Redick Tower, a small (88 rooms) but
+nice hotel, or at the much larger Red Lion Hotel a few blocks away.
+In the vicinity of the Centre are the Holiday Inn (403 rooms),
+Homewood Suites (118 rooms) and Hampton Inn (136 rooms). Another
+recommended spot is the Marriott, whose west Omaha location is
+about 100 yards from Borsheim's and a ten-minute drive from the
+Centre. There will be buses at the Marriott that will leave at
+7:30, 8:00 and 8:30 for the meeting and return after it ends.
+
+ An attachment to our proxy material explains how you can
+obtain the card you will need for admission to the meeting. A
+good-sized parking area is available at the Centre, while those who
+stay at the Holiday Inn, Homewood Suites and Hampton Inn will be
+able to walk to the meeting. As usual, we will have buses to take
+you to the Nebraska Furniture Mart and Borsheim's after the meeting
+and to take you from there to hotels or the airport later.
+
+ NFM's main store, on its 64-acre site about two miles north of
+the Centre, is open from 10 a.m. to 9 p.m. on weekdays, 10 a.m. to
+6 p.m. on Saturdays, and noon to 6 p.m. on Sundays. Rose Blumkin -
+"Mrs. B" - is now 102, but will be hard at work in Mrs. B's
+Warehouse. She was honored in November at the opening of The Rose,
+a classic downtown theater of the 20's that has been magnificently
+restored, but that would have been demolished had she not saved it.
+Ask her to tell you the story.
+
+ Borsheim's normally is closed on Sunday but will be open for
+shareholders and their guests from 10 a.m. to 6 p.m. on May 5th.
+Additionally, we will have a special opening for shareholders on
+Saturday, the 4th, from 6 p.m. to 9 p.m. Last year, on
+Shareholders Day, we wrote 1,733 tickets in the six hours we were
+open - which is a sale every 13 seconds. Remember, though, that
+records are made to be broken.
+
+ At Borsheim's, we will also have the world's largest faceted
+diamond on display. Two years in the cutting, this inconspicuous
+bauble is 545 carats in size. Please inspect this stone and let it
+guide you in determining what size gem is appropriate for the one
+you love.
+
+ On Saturday evening, May 4, there will be a baseball game at
+Rosenblatt Stadium between the Omaha Royals and the Louisville
+Redbirds. I expect to make the opening pitch - owning a quarter of
+the team assures me of one start per year - but our manager, Mike
+Jirschele, will probably make his usual mistake and yank me
+immediately after. About 1,700 shareholders attended last year's
+game. Unfortunately, we had a rain-out, which greatly disappointed
+the many scouts in the stands. But the smart ones will be back
+this year, and I plan to show them my best stuff.
+
+ Our proxy statement will include information about obtaining
+tickets to the game. We will also offer an information packet this
+year listing restaurants that will be open on Sunday night and
+describing various things that you can do in Omaha on the weekend.
+
+ For years, I've unsuccessfully tried to get my grade school
+classmate, "Pal" Gorat, to open his steakhouse for business on the
+Sunday evening preceding the meeting. But this year he's relented.
+Gorat's is a family-owned enterprise that has thrived for 52
+years, and if you like steaks, you'll love this place. I've told
+Pal he will get a good crowd, so call Gorat's at 402-551-3733 for a
+reservation. You'll spot me there - I'll be the one eating the
+rare T-bone with a double order of hash browns.
+
+
+
+ Warren E. Buffett
+March 1, 1996 Chairman of the Board
+
+
+
+
diff --git a/berkshire-hathaway/1996/1-in/berkshire-hathaway-1996-letter.txt b/berkshire-hathaway/1996/1-in/berkshire-hathaway-1996-letter.txt
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@@ -0,0 +1,1340 @@
+
+
+
+
+
+ +BERKSHIRE HATHAWAY INC. +
++Chairman's Letter +
+ ++ + +To the Shareholders of Berkshire Hathaway Inc.: + + Our gain in net worth during 1996 was $6.2 billion, or 36.1%. Per- +share book value, however, grew by less, 31.8%, because the number of +Berkshire shares increased: We issued stock in acquiring FlightSafety +International and also sold new Class B shares.* Over the last 32 years +(that is, since present management took over) per-share book value has +grown from $19 to $19,011, or at a rate of 23.8% compounded annually. + + * Each Class B share has an economic interest equal to 1/30th of + that possessed by a Class A share, which is the new designation for + the only stock that Berkshire had outstanding before May 1996. + Throughout this report, we state all per-share figures in terms of + "Class A equivalents," which are the sum of the Class A shares + outstanding and 1/30th of the Class B shares outstanding. + + For technical reasons, we have restated our 1995 financial +statements, a matter that requires me to present one of my less-than- +thrilling explanations of accounting arcana. I'll make it brief. + + The restatement was required because GEICO became a wholly-owned +subsidiary of Berkshire on January 2, 1996, whereas it was previously +classified as an investment. From an economic viewpoint - taking into +account major tax efficiencies and other benefits we gained - the value +of the 51% of GEICO we owned at year-end 1995 increased significantly +when we acquired the remaining 49% of the company two days later. +Accounting rules applicable to this type of "step acquisition," however, +required us to write down the value of our 51% at the time we moved to +100%. That writedown - which also, of course, reduced book value - +amounted to $478.4 million. As a result, we now carry our original 51% +of GEICO at a value that is both lower than its market value at the time +we purchased the remaining 49% of the company and lower than the value at +which we carry that 49% itself. + + There is an offset, however, to the reduction in book value I have +just described: Twice during 1996 we issued Berkshire shares at a +premium to book value, first in May when we sold the B shares for cash +and again in December when we used both A and B shares as part-payment +for FlightSafety. In total, the three non-operational items affecting +book value contributed less than one percentage point to our 31.8% per- +share gain last year. + + I dwell on this rise in per-share book value because it roughly +indicates our economic progress during the year. But, as Charlie Munger, +Berkshire's Vice Chairman, and I have repeatedly told you, what counts at +Berkshire is intrinsic value, not book value. The last time you got that +message from us was in the Owner's Manual, sent to you in June after we +issued the Class B shares. In that manual, we not only defined certain +key terms - such as intrinsic value - but also set forth our economic +principles. + + For many years, we have listed these principles in the front of our +annual report, but in this report, on pages 58 to 67, we reproduce the +entire Owner's Manual. In this letter, we will occasionally refer to the +manual so that we can avoid repeating certain definitions and +explanations. For example, if you wish to brush up on "intrinsic value," +see pages 64 and 65. + + Last year, for the first time, we supplied you with a table that +Charlie and I believe will help anyone trying to estimate Berkshire's +intrinsic value. In the updated version of that table, which follows, we +trace two key indices of value. The first column lists our per-share +ownership of investments (including cash and equivalents) and the second +column shows our per-share earnings from Berkshire's operating businesses +before taxes and purchase-accounting adjustments but after all interest +and corporate overhead expenses. The operating-earnings column excludes +all dividends, interest and capital gains that we realized from the +investments presented in the first column. In effect, the two columns +show what Berkshire would have reported had it been broken into two parts. + + + Pre-tax Earnings Per Share + Investments Excluding All Income from +Year Per Share Investments +---- ----------- ------------------------- +1965................................$ 4 $ 4.08 +1975................................ 159 (6.48) +1985................................ 2,443 18.86 +1995................................ 22,088 258.20 +1996................................ 28,500 421.39 + +Annual Growth Rate, 1965-95......... 33.4% 14.7% +One-Year Growth Rate, 1995-96 ...... 29.0% 63.2% + + + As the table tells you, our investments per share increased in 1996 +by 29.0% and our non-investment earnings grew by 63.2%. Our goal is to +keep the numbers in both columns moving ahead at a reasonable (or, better +yet, unreasonable) pace. + + Our expectations, however, are tempered by two realities. First, +our past rates of growth cannot be matched nor even approached: +Berkshire's equity capital is now large - in fact, fewer than ten +businesses in America have capital larger - and an abundance of funds +tends to dampen returns. Second, whatever our rate of progress, it will +not be smooth: Year-to-year moves in the first column of the table above +will be influenced in a major way by fluctuations in securities markets; +the figures in the second column will be affected by wide swings in the +profitability of our catastrophe-reinsurance business. + + In the table, the donations made pursuant to our shareholder- +designated contributions program are charged against the second column, +though we view them as a shareholder benefit rather than as an expense. +All other corporate expenses are also charged against the second column. +These costs may be lower than those of any other large American +corporation: Our after-tax headquarters expense amounts to less than two +basis points (1/50th of 1%) measured against net worth. Even so, Charlie +used to think this expense percentage outrageously high, blaming it on my +use of Berkshire's corporate jet, The Indefensible. But Charlie has +recently experienced a "counter-revelation": With our purchase of +FlightSafety, whose major activity is the training of corporate pilots, +he now rhapsodizes at the mere mention of jets. + + Seriously, costs matter. For example, equity mutual funds incur +corporate expenses - largely payments to the funds' managers - that +average about 100 basis points, a levy likely to cut the returns their +investors earn by 10% or more over time. Charlie and I make no promises +about Berkshire's results. We do promise you, however, that virtually +all of the gains Berkshire makes will end up with shareholders. We are +here to make money with you, not off you. + + +The Relationship of Intrinsic Value to Market Price + + In last year's letter, with Berkshire shares selling at $36,000, I +told you: (1) Berkshire's gain in market value in recent years had +outstripped its gain in intrinsic value, even though the latter gain had +been highly satisfactory; (2) that kind of overperformance could not +continue indefinitely; (3) Charlie and I did not at that moment consider +Berkshire to be undervalued. + + Since I set down those cautions, Berkshire's intrinsic value has +increased very significantly - aided in a major way by a stunning +performance at GEICO that I will tell you more about later - while the +market price of our shares has changed little. This, of course, means +that in 1996 Berkshire's stock underperformed the business. +Consequently, today's price/value relationship is both much different +from what it was a year ago and, as Charlie and I see it, more +appropriate. + + Over time, the aggregate gains made by Berkshire shareholders must +of necessity match the business gains of the company. When the stock +temporarily overperforms or underperforms the business, a limited number +of shareholders - either sellers or buyers - receive outsized benefits at +the expense of those they trade with. Generally, the sophisticated have +an edge over the innocents in this game. + + Though our primary goal is to maximize the amount that our +shareholders, in total, reap from their ownership of Berkshire, we wish +also to minimize the benefits going to some shareholders at the expense +of others. These are goals we would have were we managing a family +partnership, and we believe they make equal sense for the manager of a +public company. In a partnership, fairness requires that partnership +interests be valued equitably when partners enter or exit; in a public +company, fairness prevails when market price and intrinsic value are in +sync. Obviously, they won't always meet that ideal, but a manager - by +his policies and communications - can do much to foster equity. + + Of course, the longer a shareholder holds his shares, the more +bearing Berkshire's business results will have on his financial +experience - and the less it will matter what premium or discount to +intrinsic value prevails when he buys and sells his stock. That's one +reason we hope to attract owners with long-term horizons. Overall, I +think we have succeeded in that pursuit. Berkshire probably ranks number +one among large American corporations in the percentage of its shares +held by owners with a long-term view. + + +Acquisitions of 1996 + + We made two acquisitions in 1996, both possessing exactly the +qualities we seek - excellent business economics and an outstanding +manager. + + The first acquisition was Kansas Bankers Surety (KBS), an insurance +company whose name describes its specialty. The company, which does +business in 22 states, has an extraordinary underwriting record, achieved +through the efforts of Don Towle, an extraordinary manager. Don has +developed first-hand relationships with hundreds of bankers and knows +every detail of his operation. He thinks of himself as running a company +that is "his," an attitude we treasure at Berkshire. Because of its +relatively small size, we placed KBS with Wesco, our 80%-owned +subsidiary, which has wanted to expand its insurance operations. + + You might be interested in the carefully-crafted and sophisticated +acquisition strategy that allowed Berkshire to nab this deal. Early in +1996 I was invited to the 40th birthday party of my nephew's wife, Jane +Rogers. My taste for social events being low, I immediately, and in my +standard, gracious way, began to invent reasons for skipping the event. +The party planners then countered brilliantly by offering me a seat next +to a man I always enjoy, Jane's dad, Roy Dinsdale - so I went. + + The party took place on January 26. Though the music was loud - Why +must bands play as if they will be paid by the decibel? - I just managed +to hear Roy say he'd come from a directors meeting at Kansas Bankers +Surety, a company I'd always admired. I shouted back that he should let +me know if it ever became available for purchase. + + On February 12, I got the following letter from Roy: "Dear Warren: +Enclosed is the annual financial information on Kansas Bankers Surety. +This is the company that we talked about at Janie's party. If I can be +of any further help, please let me know." On February 13, I told Roy we +would pay $75 million for the company - and before long we had a deal. +I'm now scheming to get invited to Jane's next party. + + Our other acquisition in 1996 - FlightSafety International, the +world's leader in the training of pilots - was far larger, at about $1.5 +billion, but had an equally serendipitous origin. The heroes of this +story are first, Richard Sercer, a Tucson aviation consultant, and +second, his wife, Alma Murphy, an ophthalmology graduate of Harvard +Medical School, who in 1990 wore down her husband's reluctance and got +him to buy Berkshire stock. Since then, the two have attended all our +Annual Meetings, but I didn't get to know them personally. + + Fortunately, Richard had also been a long-time shareholder of +FlightSafety, and it occurred to him last year that the two companies +would make a good fit. He knew our acquisition criteria, and he thought +that Al Ueltschi, FlightSafety's 79-year-old CEO, might want to make a +deal that would both give him a home for his company and a security in +payment that he would feel comfortable owning throughout his lifetime. +So in July, Richard wrote Bob Denham, CEO of Salomon Inc, suggesting that +he explore the possibility of a merger. + + Bob took it from there, and on September 18, Al and I met in New +York. I had long been familiar with FlightSafety's business, and in +about 60 seconds I knew that Al was exactly our kind of manager. A month +later, we had a contract. Because Charlie and I wished to minimize the +issuance of Berkshire shares, the transaction we structured gave +FlightSafety shareholders a choice of cash or stock but carried terms +that encouraged those who were tax-indifferent to take cash. This nudge +led to about 51% of FlightSafety's shares being exchanged for cash, 41% +for Berkshire A and 8% for Berkshire B. + + Al has had a lifelong love affair with aviation and actually piloted +Charles Lindbergh. After a barnstorming career in the 1930s, he began +working for Juan Trippe, Pan Am's legendary chief. In 1951, while still +at Pan Am, Al founded FlightSafety, subsequently building it into a +simulator manufacturer and a worldwide trainer of pilots (single-engine, +helicopter, jet and marine). The company operates in 41 locations, +outfitted with 175 simulators of planes ranging from the very small, such +as Cessna 210s, to Boeing 747s. Simulators are not cheap - they can cost +as much as $19 million - so this business, unlike many of our +operations, is capital intensive. About half of the company's revenues +are derived from the training of corporate pilots, with most of the +balance coming from airlines and the military. + + Al may be 79, but he looks and acts about 55. He will run +operations just as he has in the past: We never fool with success. I +have told him that though we don't believe in splitting Berkshire stock, +we will split his age 2-for-1 when he hits 100. + + An observer might conclude from our hiring practices that Charlie +and I were traumatized early in life by an EEOC bulletin on age +discrimination. The real explanation, however, is self-interest: It's +difficult to teach a new dog old tricks. The many Berkshire managers who +are past 70 hit home runs today at the same pace that long ago gave them +reputations as young slugging sensations. Therefore, to get a job with +us, just employ the tactic of the 76-year-old who persuaded a dazzling +beauty of 25 to marry him. "How did you ever get her to accept?" asked +his envious contemporaries. The comeback: "I told her I was 86." + + * * * * * * * * * * * * + + And now we pause for our usual commercial: If you own a large +business with good economic characteristics and wish to become associated +with an exceptional collection of businesses having similar +characteristics, Berkshire may well be the home you seek. Our +requirements are set forth on page 21. If your company meets them - and +if I fail to make the next birthday party you attend - give me a call. + + +Insurance Operations - Overview + + Our insurance business was terrific in 1996. In both primary +insurance, where GEICO is our main unit, and in our "super-cat" +reinsurance business, results were outstanding. + + As we've explained in past reports, what counts in our insurance +business is, first, the amount of "float" we generate and, second, its +cost to us. These are matters that are important for you to understand +because float is a major component of Berkshire's intrinsic value that is +not reflected in book value. + + To begin with, float is money we hold but don't own. In an +insurance operation, float arises because premiums are received before +losses are paid. Secondly, the premiums that an insurer takes in +typically do not cover the losses and expenses it eventually must pay. +That leaves it running an "underwriting loss," which is the cost of +float. An insurance business has value if its cost of float over time is +less than the cost the company would otherwise incur to obtain funds. +But the business is an albatross if the cost of its float is higher than +market rates for money. + + As the numbers in the following table show, Berkshire's insurance +business has been a huge winner. For the table, we have calculated our +float - which we generate in large amounts relative to our premium +volume - by adding loss reserves, loss adjustment reserves, funds held +under reinsurance assumed and unearned premium reserves, and then +subtracting agents' balances, prepaid acquisition costs, prepaid taxes +and deferred charges applicable to assumed reinsurance. Our cost of +float is determined by our underwriting loss or profit. In those years +when we have had an underwriting profit, such as the last four, our cost +of float has been negative. In effect, we have been paid for holding +money. + + (1) (2) Yearend Yield + Underwriting Approximat on Long-Term + Loss Average Float Cost of Funds Govt. Bonds + ------------ ------------- ---------------- ------------- + (In $ Millions) (Ratio of 1 to 2) + +1967.......... profit 17.3 less than zero 5.50% +1968.......... profit 19.9 less than zero 5.90% +1969.......... profit 23.4 less than zero 6.79% +1970.......... 0.37 32.4 1.14% 6.25% +1971.......... profit 52.5 less than zero 5.81% +1972.......... profit 69.5 less than zero 5.82% +1973.......... profit 73.3 less than zero 7.27% +1974.......... 7.36 79.1 9.30% 8.13% +1975.......... 11.35 87.6 12.96% 8.03% +1976.......... profit 102.6 less than zero 7.30% +1977.......... profit 139.0 less than zero 7.97% +1978.......... profit 190.4 less than zero 8.93% +1979.......... profit 227.3 less than zero 10.08% +1980.......... profit 237.0 less than zero 11.94% +1981.......... profit 228.4 less than zero 13.61% +1982.......... 21.56 220.6 9.77% 10.64% +1983.......... 33.87 231.3 14.64% 11.84% +1984.......... 48.06 253.2 18.98% 11.58% +1985.......... 44.23 390.2 11.34% 9.34% +1986.......... 55.84 797.5 7.00% 7.60% +1987.......... 55.43 1,266.7 4.38% 8.95% +1988.......... 11.08 1,497.7 0.74% 9.00% +1989.......... 24.40 1,541.3 1.58% 7.97% +1990.......... 26.65 1,637.3 1.63% 8.24% +1991.......... 119.59 1,895.0 6.31% 7.40% +1992.......... 108.96 2,290.4 4.76% 7.39% +1993.......... profit 2,624.7 less than zero 6.35% +1994.......... profit 3,056.6 less than zero 7.88% +1995.......... profit 3,607.2 less than zero 5.95% +1996.......... profit 6,702.0 less than zero 6.64% + + Since 1967, when we entered the insurance business, our float has +grown at an annual compounded rate of 22.3%. In more years than not, our +cost of funds has been less than nothing. This access to "free" money has +boosted Berkshire's performance in a major way. Moreover, our acquisition +of GEICO materially increases the probability that we can continue to +obtain "free" funds in increasing amounts. + + +Super-Cat Insurance + + As in the past three years, we once again stress that the good results +we are reporting for Berkshire stem in part from our super-cat business +having a lucky year. In this operation, we sell policies that insurance +and reinsurance companies buy to protect themselves from the effects of +mega-catastrophes. Since truly major catastrophes are rare occurrences, +our super-cat business can be expected to show large profits in most years +- and to record a huge loss occasionally. In other words, the +attractiveness of our super-cat business will take a great many years to +measure. What you must understand, however, is that a truly terrible year +in the super-cat business is not a possibility - it's a certainty. The +only question is when it will come. + + I emphasize this lugubrious point because I would not want you to +panic and sell your Berkshire stock upon hearing that some large +catastrophe had cost us a significant amount. If you would tend to react +that way, you should not own Berkshire shares now, just as you should +entirely avoid owning stocks if a crashing market would lead you to panic +and sell. Selling fine businesses on "scary" news is usually a bad +decision. (Robert Woodruff, the business genius who built Coca-Cola over +many decades and who owned a huge position in the company, was once asked +when it might be a good time to sell Coke stock. Woodruff had a simple +answer: "I don't know. I've never sold any.") + + In our super-cat operation, our customers are insurers that are +exposed to major earnings volatility and that wish to reduce it. The +product we sell - for what we hope is an appropriate price - is our +willingness to shift that volatility to our own books. Gyrations in +Berkshire's earnings don't bother us in the least: Charlie and I would +much rather earn a lumpy 15% over time than a smooth 12%. (After all, our +earnings swing wildly on a daily and weekly basis - why should we demand +that smoothness accompany each orbit that the earth makes of the sun?) We +are most comfortable with that thinking, however, when we have +shareholder/partners who can also accept volatility, and that's why we +regularly repeat our cautions. + + We took on some major super-cat exposures during 1996. At mid-year we +wrote a contract with Allstate that covers Florida hurricanes, and though +there are no definitive records that would allow us to prove this point, we +believe that to have then been the largest single catastrophe risk ever +assumed by one company for its own account. Later in the year, however, we +wrote a policy for the California Earthquake Authority that goes into +effect on April 1, 1997, and that exposes us to a loss more than twice that +possible under the Florida contract. Again we retained all the risk for +our own account. Large as these coverages are, Berkshire's after-tax +"worst-case" loss from a true mega-catastrophe is probably no more than +$600 million, which is less than 3% of our book value and 1.5% of our market +value. To gain some perspective on this exposure, look at the table on +page 2 and note the much greater volatility that security markets have +delivered us. + + In the super-cat business, we have three major competitive advantages. +First, the parties buying reinsurance from us know that we both can and +will pay under the most adverse of circumstances. Were a truly cataclysmic +disaster to occur, it is not impossible that a financial panic would +quickly follow. If that happened, there could well be respected reinsurers +that would have difficulty paying at just the moment that their clients +faced extraordinary needs. Indeed, one reason we never "lay off" part of +the risks we insure is that we have reservations about our ability to +collect from others when disaster strikes. When it's Berkshire promising, +insureds know with certainty that they can collect promptly. + + Our second advantage - somewhat related - is subtle but important. +After a mega-catastrophe, insurers might well find it difficult to obtain +reinsurance even though their need for coverage would then be particularly +great. At such a time, Berkshire would without question have very +substantial capacity available - but it will naturally be our long-standing +clients that have first call on it. That business reality has made major +insurers and reinsurers throughout the world realize the desirability of +doing business with us. Indeed, we are currently getting sizable "stand- +by" fees from reinsurers that are simply nailing down their ability to get +coverage from us should the market tighten. + + Our final competitive advantage is that we can provide dollar +coverages of a size neither matched nor approached elsewhere in the +industry. Insurers looking for huge covers know that a single call to +Berkshire will produce a firm and immediate offering. + + A few facts about our exposure to California earthquakes - our largest +risk - seem in order. The Northridge quake of 1994 laid homeowners' losses +on insurers that greatly exceeded what computer models had told them to +expect. Yet the intensity of that quake was mild compared to the "worst- +case" possibility for California. Understandably, insurers became - ahem - +shaken and started contemplating a retreat from writing earthquake coverage +into their homeowners' policies. + + In a thoughtful response, Chuck Quackenbush, California's insurance +commissioner, designed a new residential earthquake policy to be written by +a state-sponsored insurer, The California Earthquake Authority. This +entity, which went into operation on December 1, 1996, needed large layers +of reinsurance - and that's where we came in. Berkshire's layer of +approximately $1 billion will be called upon if the Authority's aggregate +losses in the period ending March 31, 2001 exceed about $5 billion. (The +press originally reported larger figures, but these would have applied only +if all California insurers had entered into the arrangement; instead only +72% signed up.) + + So what are the true odds of our having to make a payout during the +policy's term? We don't know - nor do we think computer models will help +us, since we believe the precision they project is a chimera. In fact, +such models can lull decision-makers into a false sense of security and +thereby increase their chances of making a really huge mistake. We've +already seen such debacles in both insurance and investments. Witness +"portfolio insurance," whose destructive effects in the 1987 market crash +led one wag to observe that it was the computers that should have been +jumping out of windows. + + Even if perfection in assessing risks is unattainable, insurers can +underwrite sensibly. After all, you need not know a man's precise age to +know that he is old enough to vote nor know his exact weight to recognize +his need to diet. In insurance, it is essential to remember that virtually +all surprises are unpleasant, and with that in mind we try to price our +super-cat exposures so that about 90% of total premiums end up being +eventually paid out in losses and expenses. Over time, we will find out +how smart our pricing has been, but that will not be quickly. The super- +cat business is just like the investment business in that it often takes a +long time to find out whether you knew what you were doing. + + What I can state with certainty, however, is that we have the best +person in the world to run our super-cat business: Ajit Jain, whose value +to Berkshire is simply enormous. In the reinsurance field, disastrous +propositions abound. I know that because I personally embraced all too +many of these in the 1970s and also because GEICO has a large runoff +portfolio made up of foolish contracts written in the early-1980s, able +though its then-management was. Ajit, I can assure you, won't make +mistakes of this type. + + I have mentioned that a mega-catastrophe might cause a catastrophe in +the financial markets, a possibility that is unlikely but not far-fetched. +Were the catastrophe a quake in California of sufficient magnitude to tap +our coverage, we would almost certainly be damaged in other ways as well. +For example, See's, Wells Fargo and Freddie Mac could be hit hard. All in +all, though, we can handle this aggregation of exposures. + + In this respect, as in others, we try to "reverse engineer" our future +at Berkshire, bearing in mind Charlie's dictum: "All I want to know is +where I'm going to die so I'll never go there." (Inverting really works: +Try singing country western songs backwards and you will quickly regain +your house, your car and your wife.) If we can't tolerate a possible +consequence, remote though it may be, we steer clear of planting its seeds. +That is why we don't borrow big amounts and why we make sure that our +super-cat business losses, large though the maximums may sound, will not +put a major dent in Berkshire's intrinsic value. + + +Insurance - GEICO and Other Primary Operations + + When we moved to total ownership of GEICO early last year, our +expectations were high - and they are all being exceeded. That is true +from both a business and personal perspective: GEICO's operating chief, +Tony Nicely, is a superb business manager and a delight to work with. +Under almost any conditions, GEICO would be an exceptionally valuable +asset. With Tony at the helm, it is reaching levels of performance that +the organization would only a few years ago have thought impossible. + + There's nothing esoteric about GEICO's success: The company's +competitive strength flows directly from its position as a low-cost +operator. Low costs permit low prices, and low prices attract and retain +good policyholders. The final segment of a virtuous circle is drawn when +policyholders recommend us to their friends. GEICO gets more than one +million referrals annually and these produce more than half of our new +business, an advantage that gives us enormous savings in acquisition +expenses - and that makes our costs still lower. + + This formula worked in spades for GEICO in 1996: Its voluntary auto +policy count grew 10%. During the previous 20 years, the company's best- +ever growth for a year had been 8%, a rate achieved only once. Better yet, +the growth in voluntary policies accelerated during the year, led by major +gains in the nonstandard market, which has been an underdeveloped area at +GEICO. I focus here on voluntary policies because the involuntary business +we get from assigned risk pools and the like is unprofitable. Growth in +that sector is most unwelcome. + + GEICO's growth would mean nothing if it did not produce reasonable +underwriting profits. Here, too, the news is good: Last year we hit our +underwriting targets and then some. Our goal, however, is not to widen our +profit margin but rather to enlarge the price advantage we offer customers. +Given that strategy, we believe that 1997's growth will easily top that of +last year. + + We expect new competitors to enter the direct-response market, and +some of our existing competitors are likely to expand geographically. +Nonetheless, the economies of scale we enjoy should allow us to maintain or +even widen the protective moat surrounding our economic castle. We do best +on costs in geographical areas in which we enjoy high market penetration. +As our policy count grows, concurrently delivering gains in penetration, we +expect to drive costs materially lower. GEICO's sustainable cost advantage +is what attracted me to the company way back in 1951, when the entire +business was valued at $7 million. It is also why I felt Berkshire should +pay $2.3 billion last year for the 49% of the company that we didn't then +own. + + Maximizing the results of a wonderful business requires management and +focus. Lucky for us, we have in Tony a superb manager whose business focus +never wavers. Wanting also to get the entire GEICO organization +concentrating as he does, we needed a compensation plan that was itself +sharply focused - and immediately after our purchase, we put one in. + + Today, the bonuses received by dozens of top executives, starting with +Tony, are based upon only two key variables: (1) growth in voluntary auto +policies and (2) underwriting profitability on "seasoned" auto business +(meaning policies that have been on the books for more than one year). In +addition, we use the same yardsticks to calculate the annual contribution +to the company's profit-sharing plan. Everyone at GEICO knows what counts. + + The GEICO plan exemplifies Berkshire's incentive compensation +principles: Goals should be (1) tailored to the economics of the specific +operating business; (2) simple in character so that the degree to which +they are being realized can be easily measured; and (3) directly related to +the daily activities of plan participants. As a corollary, we shun +"lottery ticket" arrangements, such as options on Berkshire shares, whose +ultimate value - which could range from zero to huge - is totally out of +the control of the person whose behavior we would like to affect. In our +view, a system that produces quixotic payoffs will not only be wasteful for +owners but may actually discourage the focused behavior we value in +managers. + + Every quarter, all 9,000 GEICO associates can see the results that +determine our profit-sharing plan contribution. In 1996, they enjoyed the +experience because the plan literally went off the chart that had been +constructed at the start of the year. Even I knew the answer to that +problem: Enlarge the chart. Ultimately, the results called for a record +contribution of 16.9% ($40 million), compared to a five-year average of +less than 10% for the comparable plans previously in effect. Furthermore, +at Berkshire, we never greet good work by raising the bar. If GEICO's +performance continues to improve, we will happily keep on making larger +charts. + + Lou Simpson continues to manage GEICO's money in an outstanding +manner: Last year, the equities in his portfolio outdid the S&P 500 by 6.2 +percentage points. In Lou's part of GEICO's operation, we again tie +compensation to performance - but to investment performance over a four- +year period, not to underwriting results nor to the performance of GEICO as +a whole. We think it foolish for an insurance company to pay bonuses that +are tied to overall corporate results when great work on one side of the +business - underwriting or investment - could conceivably be completely +neutralized by bad work on the other. If you bat .350 at Berkshire, you +can be sure you will get paid commensurately even if the rest of the team +bats .200. In Lou and Tony, however, we are lucky to have Hall-of-Famers +in both key positions. + + * * * * * * * * * * * * + + Though they are, of course, smaller than GEICO, our other primary +insurance operations turned in equally stunning results last year. +National Indemnity's traditional business had a combined ratio of 74.2 and, +as usual, developed a large amount of float compared to premium volume. +Over the last three years, this segment of our business, run by Don +Wurster, has had an average combined ratio of 83.0. Our homestate +operation, managed by Rod Eldred, recorded a combined ratio of 87.1 even +though it absorbed the expenses of expanding to new states. Rod's three- +year combined ratio is an amazing 83.2. Berkshire's workers' compensation +business, run out of California by Brad Kinstler, has now moved into six +other states and, despite the costs of that expansion, again achieved an +excellent underwriting profit. Finally, John Kizer, at Central States +Indemnity, set new records for premium volume while generating good +earnings from underwriting. In aggregate, our smaller insurance operations +(now including Kansas Bankers Surety) have an underwriting record virtually +unmatched in the industry. Don, Rod, Brad and John have all created +significant value for Berkshire, and we believe there is more to come. + + +Taxes + + In 1961, President Kennedy said that we should ask not what our +country can do for us, but rather ask what we can do for our country. Last +year we decided to give his suggestion a try - and who says it never hurts +to ask? We were told to mail $860 million in income taxes to the U.S. +Treasury. + + Here's a little perspective on that figure: If an equal amount had +been paid by only 2,000 other taxpayers, the government would have had a +balanced budget in 1996 without needing a dime of taxes - income or Social +Security or what have you - from any other American. Berkshire +shareholders can truly say, "I gave at the office." + + Charlie and I believe that large tax payments by Berkshire are +entirely fitting. The contribution we thus make to society's well-being is +at most only proportional to its contribution to ours. Berkshire prospers +in America as it would nowhere else. + + +Sources of Reported Earnings + + The table that follows shows the main sources of Berkshire's reported +earnings. In this presentation, purchase-accounting adjustments are not +assigned to the specific businesses to which they apply, but are instead +aggregated and shown separately. This procedure lets you view the earnings +of our businesses as they would have been reported had we not purchased +them. For the reasons discussed on pages 65 and 66, this form of +presentation seems to us to be more useful to investors and managers than +one utilizing generally-accepted accounting principles (GAAP), which +require purchase-premiums to be charged off business-by-business. The +total earnings we show in the table are, of course, identical to the GAAP +total in our audited financial statements. + + + + (in millions) + -------------------------------------- + Berkshire's Share + of Net Earnings + (after taxes and + Pre-tax Earnings minority interests) + ---------------- ------------------- + 1996 1995(1) 1996 1995(1) + ------- -------- ------- ------- +Operating Earnings: + Insurance Group: + Underwriting.....................$ 222.1 $ 20.5 $ 142.8 $ 11.3 + Net Investment Income............ 726.2 501.6 593.1 417.7 + Buffalo News........................... 50.4 46.8 29.5 27.3 + Fechheimer............................. 17.3 16.9 9.3 8.8 + Finance Businesses..................... 23.1 20.8 14.9 12.6 + Home Furnishings....................... 43.8 29.7(2) 24.8 16.7(2) + Jewelry................................ 27.8 33.9(3) 16.1 19.1(3) + Kirby.................................. 58.5 50.2 39.9 32.1 + Scott Fetzer Manufacturing Group....... 50.6 34.1 32.2 21.2 + See's Candies.......................... 51.9 50.2 30.8 29.8 + Shoe Group............................. 61.6 58.4 41.0 37.5 + World Book............................. 12.6 8.8 9.5 7.0 + Purchase-Accounting Adjustments........ (75.7) (27.0) (70.5) (23.4) + Interest Expense(4).................... (94.3) (56.0) (56.6) (34.9) + Shareholder-Designated Contributions... (13.3) (11.6) (8.5) (7.0) + Other.................................. 58.8 37.4 34.8 24.4 + ------- -------- -------- ------- +Operating Earnings.......................1,221.4 814.7 883.1 600.2 +Sales of Securities......................2,484.5 194.1 1,605.5 125.0 + ------- -------- -------- ------- +Total Earnings - All Entities...........$3,705.9 $1,008.8 $2,488.6 $ 725.2 + ======= ======== ======== ======= + +(1) Before the GEICO-related restatement. (3) Includes Helzberg's from + April 30, 1995. +(2) Includes R.C. Willey from June 29, 1995. (4) Excludes interest expense + of Finance Businesses. + + In this section last year, I discussed three businesses that reported +a decline in earnings - Buffalo News, Shoe Group and World Book. All, I'm +happy to say, recorded gains in 1996. + + World Book, however, did not find it easy: Despite the operation's +new status as the only direct-seller of encyclopedias in the country +(Encyclopedia Britannica exited the field last year), its unit volume fell. +Additionally, World Book spent heavily on a new CD-ROM product that began +to take in revenues only in early 1997, when it was launched in association +with IBM. In the face of these factors, earnings would have evaporated had +World Book not revamped distribution methods and cut overhead at +headquarters, thereby dramatically reducing its fixed costs. Overall, the +company has gone a long way toward assuring its long-term viability in both +the print and electronic marketplaces. + + Our only disappointment last year was in jewelry: Borsheim's did +fine, but Helzberg's suffered a material decline in earnings. Its expense +levels had been geared to a sizable increase in same-store sales, +consistent with the gains achieved in recent years. When sales were +instead flat, profit margins fell. Jeff Comment, CEO of Helzberg's, is +addressing the expense problem in a decisive manner, and the company's +earnings should improve in 1997. + + Overall, our operating businesses continue to perform exceptionally, +far outdoing their industry norms. For this, Charlie and I thank our +managers. If you should see any of them at the Annual Meeting, add your +thanks as well. + + More information about our various businesses is given on pages 36- +46, where you will also find our segment earnings reported on a GAAP +basis. In addition, on pages 51-57, we have rearranged Berkshire's +financial data into four segments on a non-GAAP basis, a presentation +that corresponds to the way Charlie and I think about the company. Our +intent is to supply you with the financial information that we would wish +you to give us if our positions were reversed. + +"Look-Through" Earnings + + Reported earnings are a poor measure of economic progress at +Berkshire, in part because the numbers shown in the table presented +earlier include only the dividends we receive from investees - though +these dividends typically represent only a small fraction of the earnings +attributable to our ownership. Not that we mind this division of money, +since on balance we regard the undistributed earnings of investees as +more valuable to us than the portion paid out. The reason is simple: +Our investees often have the opportunity to reinvest earnings at high +rates of return. So why should we want them paid out? + + To depict something closer to economic reality at Berkshire than +reported earnings, though, we employ the concept of "look-through" +earnings. As we calculate these, they consist of: (1) the operating +earnings reported in the previous section, plus; (2) our share of the +retained operating earnings of major investees that, under GAAP +accounting, are not reflected in our profits, less; (3) an allowance for +the tax that would be paid by Berkshire if these retained earnings of +investees had instead been distributed to us. When tabulating "operating +earnings" here, we exclude purchase-accounting adjustments as well as +capital gains and other major non-recurring items. + + The following table sets forth our 1996 look-through earnings, +though I warn you that the figures can be no more than approximate, since +they are based on a number of judgment calls. (The dividends paid to us +by these investees have been included in the operating earnings itemized +on page 12, mostly under "Insurance Group: Net Investment Income.") + + Berkshire's Share + of Undistributed + Berkshire's Approximate Operating Earnings +Berkshire's Major Investees Ownership at Yearend(1) (in millions)(2) +-------------------------------- ----------------------- ------------------ + +American Express Company........ 10.5% $ 132 +The Coca-Cola Company........... 8.1% 180 +The Walt Disney Company......... 3.6% 50 +Federal Home Loan Mortgage Corp. 8.4% 77 +The Gillette Company............ 8.6% 73 +McDonald's Corporation.......... 4.3% 38 +The Washington Post Company..... 15.8% 27 +Wells Fargo & Company........... 8.0% 84 + ------ +Berkshire's share of undistributed earnings of major investees.. 661 +Hypothetical tax on these undistributed investee earnings(3).... (93) +Reported operating earnings of Berkshire........................ 954 + ------ + Total look-through earnings of Berkshire..................$1,522 + ====== + + (1) Does not include shares allocable to minority interests + (2) Calculated on average ownership for the year + (3) The tax rate used is 14%, which is the rate Berkshire pays on + the dividends it receives + + +Common Stock Investments + + Below we present our common stock investments. Those with a market +value of more than $500 million are itemized. + + 12/31/96 + Shares Company Cost* Market + ----------- --------------------------------- -------- --------- + (dollars in millions) + 49,456,900 American Express Company...........$1,392.7 $ 2,794.3 + 200,000,000 The Coca-Cola Company.............. 1,298.9 10,525.0 + 24,614,214 The Walt Disney Company............ 577.0 1,716.8 + 64,246,000 Federal Home Loan Mortgage Corp.... 333.4 1,772.8 + 48,000,000 The Gillette Company............... 600.0 3,732.0 + 30,156,600 McDonald's Corporation............. 1,265.3 1,368.4 + 1,727,765 The Washington Post Company........ 10.6 579.0 + 7,291,418 Wells Fargo & Company.............. 497.8 1,966.9 + Others............................. 1,934.5 3,295.4 + -------- --------- + Total Common Stocks................$7,910.2 $27,750.6 + ======== ========= + + * Represents tax-basis cost which, in aggregate, is $1.2 billion + less than GAAP cost. + + Our portfolio shows little change: We continue to make more money +when snoring than when active. + + Inactivity strikes us as intelligent behavior. Neither we nor most +business managers would dream of feverishly trading highly-profitable +subsidiaries because a small move in the Federal Reserve's discount rate +was predicted or because some Wall Street pundit had reversed his views +on the market. Why, then, should we behave differently with our minority +positions in wonderful businesses? The art of investing in public +companies successfully is little different from the art of successfully +acquiring subsidiaries. In each case you simply want to acquire, at a +sensible price, a business with excellent economics and able, honest +management. Thereafter, you need only monitor whether these qualities +are being preserved. + + When carried out capably, an investment strategy of that type will +often result in its practitioner owning a few securities that will come +to represent a very large portion of his portfolio. This investor would +get a similar result if he followed a policy of purchasing an interest +in, say, 20% of the future earnings of a number of outstanding college +basketball stars. A handful of these would go on to achieve NBA stardom, +and the investor's take from them would soon dominate his royalty stream. +To suggest that this investor should sell off portions of his most +successful investments simply because they have come to dominate his +portfolio is akin to suggesting that the Bulls trade Michael Jordan +because he has become so important to the team. + + In studying the investments we have made in both subsidiary +companies and common stocks, you will see that we favor businesses and +industries unlikely to experience major change. The reason for that is +simple: Making either type of purchase, we are searching for operations +that we believe are virtually certain to possess enormous competitive +strength ten or twenty years from now. A fast-changing industry +environment may offer the chance for huge wins, but it precludes the +certainty we seek. + + I should emphasize that, as citizens, Charlie and I welcome change: +Fresh ideas, new products, innovative processes and the like cause our +country's standard of living to rise, and that's clearly good. As +investors, however, our reaction to a fermenting industry is much like +our attitude toward space exploration: We applaud the endeavor but +prefer to skip the ride. + + Obviously all businesses change to some extent. Today, See's is +different in many ways from what it was in 1972 when we bought it: It +offers a different assortment of candy, employs different machinery and +sells through different distribution channels. But the reasons why +people today buy boxed chocolates, and why they buy them from us rather +than from someone else, are virtually unchanged from what they were in +the 1920s when the See family was building the business. Moreover, these +motivations are not likely to change over the next 20 years, or even 50. + + We look for similar predictability in marketable securities. Take +Coca-Cola: The zeal and imagination with which Coke products are sold +has burgeoned under Roberto Goizueta, who has done an absolutely +incredible job in creating value for his shareholders. Aided by Don +Keough and Doug Ivester, Roberto has rethought and improved every aspect +of the company. But the fundamentals of the business - the qualities +that underlie Coke's competitive dominance and stunning economics - have +remained constant through the years. + + I was recently studying the 1896 report of Coke (and you think that +you are behind in your reading!). At that time Coke, though it was +already the leading soft drink, had been around for only a decade. But +its blueprint for the next 100 years was already drawn. Reporting sales +of $148,000 that year, Asa Candler, the company's president, said: "We +have not lagged in our efforts to go into all the world teaching that +Coca-Cola is the article, par excellence, for the health and good feeling +of all people." Though "health" may have been a reach, I love the fact +that Coke still relies on Candler's basic theme today - a century later. +Candler went on to say, just as Roberto could now, "No article of like +character has ever so firmly entrenched itself in public favor." Sales +of syrup that year, incidentally, were 116,492 gallons versus about 3.2 +billion in 1996. + + I can't resist one more Candler quote: "Beginning this year about +March 1st . . . we employed ten traveling salesmen by means of which, +with systematic correspondence from the office, we covered almost the +territory of the Union." That's my kind of sales force. + + Companies such as Coca-Cola and Gillette might well be labeled "The +Inevitables." Forecasters may differ a bit in their predictions of +exactly how much soft drink or shaving-equipment business these companies +will be doing in ten or twenty years. Nor is our talk of inevitability +meant to play down the vital work that these companies must continue to +carry out, in such areas as manufacturing, distribution, packaging and +product innovation. In the end, however, no sensible observer - not even +these companies' most vigorous competitors, assuming they are assessing +the matter honestly - questions that Coke and Gillette will dominate +their fields worldwide for an investment lifetime. Indeed, their +dominance will probably strengthen. Both companies have significantly +expanded their already huge shares of market during the past ten years, +and all signs point to their repeating that performance in the next +decade. + + Obviously many companies in high-tech businesses or embryonic +industries will grow much faster in percentage terms than will The +Inevitables. But I would rather be certain of a good result than hopeful +of a great one. + + Of course, Charlie and I can identify only a few Inevitables, even +after a lifetime of looking for them. Leadership alone provides no +certainties: Witness the shocks some years back at General Motors, IBM +and Sears, all of which had enjoyed long periods of seeming +invincibility. Though some industries or lines of business exhibit +characteristics that endow leaders with virtually insurmountable +advantages, and that tend to establish Survival of the Fattest as almost +a natural law, most do not. Thus, for every Inevitable, there are dozens +of Impostors, companies now riding high but vulnerable to competitive +attacks. Considering what it takes to be an Inevitable, Charlie and I +recognize that we will never be able to come up with a Nifty Fifty or +even a Twinkling Twenty. To the Inevitables in our portfolio, therefore, +we add a few "Highly Probables." + + You can, of course, pay too much for even the best of businesses. +The overpayment risk surfaces periodically and, in our opinion, may now +be quite high for the purchasers of virtually all stocks, The Inevitables +included. Investors making purchases in an overheated market need to +recognize that it may often take an extended period for the value of even +an outstanding company to catch up with the price they paid. + + A far more serious problem occurs when the management of a great +company gets sidetracked and neglects its wonderful base business while +purchasing other businesses that are so-so or worse. When that happens, +the suffering of investors is often prolonged. Unfortunately, that is +precisely what transpired years ago at both Coke and Gillette. (Would +you believe that a few decades back they were growing shrimp at Coke and +exploring for oil at Gillette?) Loss of focus is what most worries +Charlie and me when we contemplate investing in businesses that in +general look outstanding. All too often, we've seen value stagnate in +the presence of hubris or of boredom that caused the attention of +managers to wander. That's not going to happen again at Coke and +Gillette, however - not given their current and prospective managements. + + * * * * * * * * * * * * + + Let me add a few thoughts about your own investments. Most +investors, both institutional and individual, will find that the best way +to own common stocks is through an index fund that charges minimal fees. +Those following this path are sure to beat the net results (after fees +and expenses) delivered by the great majority of investment +professionals. + + Should you choose, however, to construct your own portfolio, there +are a few thoughts worth remembering. Intelligent investing is not +complex, though that is far from saying that it is easy. What an +investor needs is the ability to correctly evaluate selected businesses. +Note that word "selected": You don't have to be an expert on every +company, or even many. You only have to be able to evaluate companies +within your circle of competence. The size of that circle is not very +important; knowing its boundaries, however, is vital. + + To invest successfully, you need not understand beta, efficient +markets, modern portfolio theory, option pricing or emerging markets. +You may, in fact, be better off knowing nothing of these. That, of +course, is not the prevailing view at most business schools, whose +finance curriculum tends to be dominated by such subjects. In our view, +though, investment students need only two well-taught courses - How to +Value a Business, and How to Think About Market Prices. + + Your goal as an investor should simply be to purchase, at a rational +price, a part interest in an easily-understandable business whose +earnings are virtually certain to be materially higher five, ten and +twenty years from now. Over time, you will find only a few companies +that meet these standards - so when you see one that qualifies, you +should buy a meaningful amount of stock. You must also resist the +temptation to stray from your guidelines: If you aren't willing to own a +stock for ten years, don't even think about owning it for ten minutes. +Put together a portfolio of companies whose aggregate earnings march +upward over the years, and so also will the portfolio's market value. + + Though it's seldom recognized, this is the exact approach that has +produced gains for Berkshire shareholders: Our look-through earnings +have grown at a good clip over the years, and our stock price has risen +correspondingly. Had those gains in earnings not materialized, there +would have been little increase in Berkshire's value. + + The greatly enlarged earnings base we now enjoy will inevitably +cause our future gains to lag those of the past. We will continue, +however, to push in the directions we always have. We will try to build +earnings by running our present businesses well - a job made easy because +of the extraordinary talents of our operating managers - and by +purchasing other businesses, in whole or in part, that are not likely to +be roiled by change and that possess important competitive advantages. + + +USAir + + When Richard Branson, the wealthy owner of Virgin Atlantic Airways, +was asked how to become a millionaire, he had a quick answer: "There's +really nothing to it. Start as a billionaire and then buy an airline." +Unwilling to accept Branson's proposition on faith, your Chairman decided +in 1989 to test it by investing $358 million in a 9.25% preferred stock of +USAir. + + I liked and admired Ed Colodny, the company's then-CEO, and I still +do. But my analysis of USAir's business was both superficial and wrong. +I was so beguiled by the company's long history of profitable +operations, and by the protection that ownership of a senior security +seemingly offered me, that I overlooked the crucial point: USAir's +revenues would increasingly feel the effects of an unregulated, fiercely- +competitive market whereas its cost structure was a holdover from the +days when regulation protected profits. These costs, if left unchecked, +portended disaster, however reassuring the airline's past record might +be. (If history supplied all of the answers, the Forbes 400 would +consist of librarians.) + + To rationalize its costs, however, USAir needed major improvements +in its labor contracts - and that's something most airlines have found it +extraordinarily difficult to get, short of credibly threatening, or +actually entering, bankruptcy. USAir was to be no exception. +Immediately after we purchased our preferred stock, the imbalance between +the company's costs and revenues began to grow explosively. In the 1990- +1994 period, USAir lost an aggregate of $2.4 billion, a performance that +totally wiped out the book equity of its common stock. + + For much of this period, the company paid us our preferred +dividends, but in 1994 payment was suspended. A bit later, with the +situation looking particularly gloomy, we wrote down our investment by +75%, to $89.5 million. Thereafter, during much of 1995, I offered to +sell our shares at 50% of face value. Fortunately, I was unsuccessful. + + Mixed in with my many mistakes at USAir was one thing I got right: +Making our investment, we wrote into the preferred contract a somewhat +unusual provision stipulating that "penalty dividends" - to run five +percentage points over the prime rate - would be accrued on any +arrearages. This meant that when our 9.25% dividend was omitted for two +years, the unpaid amounts compounded at rates ranging between 13.25% and +14%. + + Facing this penalty provision, USAir had every incentive to pay +arrearages just as promptly as it could. And in the second half of 1996, +when USAir turned profitable, it indeed began to pay, giving us $47.9 +million. We owe Stephen Wolf, the company's CEO, a huge thank-you for +extracting a performance from the airline that permitted this payment. +Even so, USAir's performance has recently been helped significantly by an +industry tailwind that may be cyclical in nature. The company still has +basic cost problems that must be solved. + + In any event, the prices of USAir's publicly-traded securities tell +us that our preferred stock is now probably worth its par value of $358 +million, give or take a little. In addition, we have over the years +collected an aggregate of $240.5 million in dividends (including $30 +million received in 1997). + + Early in 1996, before any accrued dividends had been paid, I tried +once more to unload our holdings - this time for about $335 million. +You're lucky: I again failed in my attempt to snatch defeat from the +jaws of victory. + + In another context, a friend once asked me: "If you're so rich, why +aren't you smart?" After reviewing my sorry performance with USAir, you +may conclude he had a point. + + +Financings + + We wrote four checks to Salomon Brothers last year and in each case +were delighted with the work for which we were paying. I've already +described one transaction: the FlightSafety purchase in which Salomon was +the initiating investment banker. In a second deal, the firm placed a +small debt offering for our finance subsidiary. + + Additionally, we made two good-sized offerings through Salomon, both +with interesting aspects. The first was our sale in May of 517,500 +shares of Class B Common, which generated net proceeds of $565 million. +As I have told you before, we made this sale in response to the +threatened creation of unit trusts that would have marketed themselves as +Berkshire look-alikes. In the process, they would have used our past, +and definitely nonrepeatable, record to entice naive small investors and +would have charged these innocents high fees and commissions. + + I think it would have been quite easy for such trusts to have sold +many billions of dollars worth of units, and I also believe that early +marketing successes by these trusts would have led to the formation of +others. (In the securities business, whatever can be sold will be sold.) +The trusts would have meanwhile indiscriminately poured the proceeds of +their offerings into a supply of Berkshire shares that is fixed and +limited. The likely result: a speculative bubble in our stock. For at +least a time, the price jump would have been self-validating, in that it +would have pulled new waves of naive and impressionable investors into +the trusts and set off still more buying of Berkshire shares. + + Some Berkshire shareholders choosing to exit might have found that +outcome ideal, since they could have profited at the expense of the +buyers entering with false hopes. Continuing shareholders, however, +would have suffered once reality set in, for at that point Berkshire +would have been burdened with both hundreds of thousands of unhappy, +indirect owners (trustholders, that is) and a stained reputation. + + Our issuance of the B shares not only arrested the sale of the +trusts, but provided a low-cost way for people to invest in Berkshire if +they still wished to after hearing the warnings we issued. To blunt the +enthusiasm that brokers normally have for pushing new issues - because +that's where the money is - we arranged for our offering to carry a +commission of only 1.5%, the lowest payoff that we have ever seen in a +common stock underwriting. Additionally, we made the amount of the +offering open-ended, thereby repelling the typical IPO buyer who looks +for a short-term price spurt arising from a combination of hype and +scarcity. + + Overall, we tried to make sure that the B stock would be purchased +only by investors with a long-term perspective. Those efforts were +generally successful: Trading volume in the B shares immediately +following the offering - a rough index of "flipping" - was far below the +norm for a new issue. In the end we added about 40,000 shareholders, +most of whom we believe both understand what they own and share our time +horizons. + + Salomon could not have performed better in the handling of this +unusual transaction. Its investment bankers understood perfectly what we +were trying to achieve and tailored every aspect of the offering to meet +these objectives. The firm would have made far more money - perhaps ten +times as much - if our offering had been standard in its make-up. But +the investment bankers involved made no attempt to tweak the specifics in +that direction. Instead they came up with ideas that were counter to +Salomon's financial interest but that made it much more certain +Berkshire's goals would be reached. Terry Fitzgerald captained this +effort, and we thank him for the job that he did. + + Given that background, it won't surprise you to learn that we again +went to Terry when we decided late in the year to sell an issue of +Berkshire notes that can be exchanged for a portion of the Salomon shares +that we hold. In this instance, once again, Salomon did an absolutely +first-class job, selling $500 million principal amount of five-year notes +for $447.1 million. Each $1,000 note is exchangeable into 17.65 shares +and is callable in three years at accreted value. Counting the original +issue discount and a 1% coupon, the securities will provide a yield of 3% +to maturity for holders who do not exchange them for Salomon stock. But +it seems quite likely that the notes will be exchanged before their +maturity. If that happens, our interest cost will be about 1.1% for the +period prior to exchange. + + In recent years, it has been written that Charlie and I are unhappy +about all investment-banking fees. That's dead wrong. We have paid a +great many fees over the last 30 years - beginning with the check we +wrote to Charlie Heider upon our purchase of National Indemnity in 1967 - +and we are delighted to make payments that are commensurate with +performance. In the case of the 1996 transactions at Salomon Brothers, +we more than got our money's worth. + + +Miscellaneous + + Though it was a close decision, Charlie and I have decided to enter +the 20th Century. Accordingly, we are going to put future quarterly and +annual reports of Berkshire on the Internet, where they can be accessed +via http://www.berkshirehathaway.com. We will always "post" these +reports on a Saturday so that anyone interested will have ample time to +digest the information before trading begins. Our publishing schedule +for the next 12 months is May 17, 1997, August 16, 1997, November 15, +1997, and March 14, 1998. We will also post any press releases that we +issue. + + At some point, we may stop mailing our quarterly reports and simply +post these on the Internet. This move would eliminate significant costs. +Also, we have a large number of "street name" holders and have found +that the distribution of our quarterlies to them is highly erratic: Some +holders receive their mailings weeks later than others. + + The drawback to Internet-only distribution is that many of our +shareholders lack computers. Most of these holders, however, could +easily obtain printouts at work or through friends. Please let me know +if you prefer that we continue mailing quarterlies. We want your input - +starting with whether you even read these reports - and at a minimum will +make no change in 1997. Also, we will definitely keep delivering the +annual report in its present form in addition to publishing it on the +Internet. + + * * * * * * * * * * * * + + About 97.2% of all eligible shares participated in Berkshire's 1996 +shareholder-designated contributions program. Contributions made were +$13.3 million, and 3,910 charities were recipients. A full description +of the shareholder-designated contributions program appears on pages 48- +49. + + Every year a few shareholders miss out on the program because they +don't have their shares registered in their own names on the prescribed +record date or because they fail to get the designation form back to us +within the 60-day period allowed. This is distressing to Charlie and me. +But if replies are received late, we have to reject them because we +can't make exceptions for some shareholders while refusing to make them +for others. + + To participate in future programs, you must own Class A shares that +are registered in the name of the actual owner, not the nominee name of a +broker, bank or depository. Shares not so registered on August 31, 1997, +will be ineligible for the 1997 program. When you get the form, return +it promptly so that it does not get put aside or forgotten. + + +The Annual Meeting + + Our capitalist's version of Woodstock -the Berkshire Annual Meeting- +will be held on Monday, May 5. Charlie and I thoroughly enjoy this +event, and we hope that you come. We will start at 9:30 a.m., break for +about 15 minutes at noon (food will be available - but at a price, of +course), and then continue talking to hard-core attendees until at least +3:30. Last year we had representatives from all 50 states, as well as +Australia, Greece, Israel, Portugal, Singapore, Sweden, Switzerland, and +the United Kingdom. The annual meeting is a time for owners to get their +business-related questions answered, and therefore Charlie and I will +stay on stage until we start getting punchy. (When that happens, I hope +you notice a change.) + + Last year we had attendance of 5,000 and strained the capacity of +the Holiday Convention Centre, even though we spread out over three +rooms. This year, our new Class B shares have caused a doubling of our +stockholder count, and we are therefore moving the meeting to the +Aksarben Coliseum, which holds about 10,000 and also has a huge parking +lot. The doors will open for the meeting at 7:00 a.m., and at 8:30 we +will - upon popular demand - show a new Berkshire movie produced by Marc +Hamburg, our CFO. (In this company, no one gets by with doing only a +single job.) + + Overcoming our legendary repugnance for activities even faintly +commercial, we will also have an abundant array of Berkshire products for +sale in the halls outside the meeting room. Last year we broke all +records, selling 1,270 pounds of See's candy, 1,143 pairs of Dexter +shoes, $29,000 of World Books and related publications, and 700 sets of +knives manufactured by our Quikut subsidiary. Additionally, many +shareholders made inquiries about GEICO auto policies. If you would like +to investigate possible insurance savings, bring your present policy to +the meeting. We estimate that about 40% of our shareholders can save +money by insuring with us. (We'd like to say 100%, but the insurance +business doesn't work that way: Because insurers differ in their +underwriting judgments, some of our shareholders are currently paying +rates that are lower than GEICO's.) + + An attachment to the proxy material enclosed with this report +explains how you can obtain the card you will need for admission to the +meeting. We expect a large crowd, so get both plane and hotel +reservations promptly. American Express (800-799-6634) will be happy to +help you with arrangements. As usual, we will have buses servicing the +larger hotels to take you to and from the meeting, and also to take you +to Nebraska Furniture Mart, Borsheim's and the airport after it is over. + + NFM's main store, located on a 75-acre site about a mile from +Aksarben, is open from 10 a.m. to 9 p.m. on weekdays, 10 a.m. to 6 p.m. +on Saturdays, and noon to 6 p.m. on Sundays. Come by and say hello to +"Mrs. B" (Rose Blumkin). She's 103 now and sometimes operates with an +oxygen mask that is attached to a tank on her cart. But if you try to +keep pace with her, it will be you who needs oxygen. NFM did about $265 +million of business last year - a record for a single-location home +furnishings operation - and you'll see why once you check out its +merchandise and prices. + + Borsheim's normally is closed on Sunday but will be open for +shareholders from 10 a.m. to 6 p.m. on May 4th. Last year on +"Shareholder Sunday" we broke every Borsheim's record in terms of +tickets, dollar volume and, no doubt, attendees per square inch. Because +we expect a capacity crowd this year as well, all shareholders attending +on Sunday must bring their admission cards. Shareholders who prefer a +somewhat less frenzied experience will get the same special treatment on +Saturday, when the store is open from 10 a.m. to 5:30 p.m., or on Monday +between 10 a.m. and 8 p.m. Come by at any time this year and let Susan +Jacques, Borsheim's CEO, and her skilled associates perform a painless +walletectomy on you. + + My favorite steakhouse, Gorat's, was sold out last year on the +weekend of the annual meeting, even though it added an additional seating +at 4 p.m. on Sunday. You can make reservations beginning on April 1st +(but not earlier) by calling 402-551-3733. I will be at Gorat's on +Sunday after Borsheim's, having my usual rare T-bone and double order of +hashbrowns. I can also recommend - this is the standard fare when Debbie +Bosanek, my invaluable assistant, and I go to lunch - the hot roast beef +sandwich with mashed potatoes and gravy. Mention Debbie's name and you +will be given an extra boat of gravy. + + The Omaha Royals and Indianapolis Indians will play baseball on +Saturday evening, May 3rd, at Rosenblatt Stadium. Pitching in my normal +rotation - one throw a year - I will start. + + Though Rosenblatt is normal in appearance, it is anything but: The +field sits on a unique geological structure that occasionally emits short +gravitational waves causing even the most smoothly-delivered pitch to +sink violently. I have been the victim of this weird phenomenon several +times in the past but am hoping for benign conditions this year. There +will be lots of opportunities for photos at the ball game, but you will +need incredibly fast reflexes to snap my fast ball en route to the plate. + + Our proxy statement includes information about obtaining tickets to +the game. We will also provide an information packet listing restaurants +that will be open on Sunday night and describing various things that you +can do in Omaha on the weekend. The entire gang at Berkshire looks +forward to seeing you. + + + + Warren E. Buffett +February 28, 1997 Chairman of the Board + + + ++ + + + + + + + + + + + + + diff --git a/berkshire-hathaway/1997/1-in/berkshire-hathaway-1997-letter.txt b/berkshire-hathaway/1997/1-in/berkshire-hathaway-1997-letter.txt new file mode 100644 index 0000000..f0ecf0a --- /dev/null +++ b/berkshire-hathaway/1997/1-in/berkshire-hathaway-1997-letter.txt @@ -0,0 +1,1481 @@ + + + + + + +
BERKSHIRE HATHAWAY INC.
1997 Chairman's Letter
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To the Shareholders of Berkshire Hathaway Inc.:
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Our gain in net worth during 1997 +was $8.0 billion, which increased the per-share book value of both our +Class A and Class B stock by 34.1%. Over the last 33 years (that is, since +present management took over) per-share book value has grown from $19 to +$25,488, a rate of 24.1% compounded annually.(1) +
+ ++ + + +
1. All figures used in this report apply to Berkshire's A shares, + the successor to the only stock that the company had outstanding + before 1996. The B shares have an economic interest equal to 1/30th + that of the A.+ +
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Given our gain of 34.1%, it is +tempting to declare victory and move on. But last year's performance was +no great triumph: Any investor can chalk up large returns when stocks +soar, as they did in 1997. In a bull market, one must avoid the error of +the preening duck that quacks boastfully after a torrential rainstorm, +thinking that its paddling skills have caused it to rise in the world. +A right-thinking duck would instead compare its position after the downpour +to that of the other ducks on the pond.
+ +So what's our duck rating for 1997? +The table on the facing page shows that though we paddled furiously last +year, passive ducks that simply invested in the S&P Index rose almost +as fast as we did. Our appraisal of 1997's performance, then: Quack. +
+ +When the market booms, we tend +to suffer in comparison with the S&P Index. The Index bears no tax +costs, nor do mutual funds, since they pass through all tax liabilities +to their owners. Last year, on the other hand, Berkshire paid or accrued +$4.2 billion for federal income tax, or about 18% of our beginning net +worth.
+ +Berkshire will always have corporate +taxes to pay, which means it needs to overcome their drag in order to justify +its existence. Obviously, Charlie Munger, Berkshire's Vice Chairman and +my partner, and I won't be able to lick that handicap every year. But we +expect over time to maintain a modest advantage over the Index, and that +is the yardstick against which you should measure us. We will not ask you +to adopt the philosophy of the Chicago Cubs fan who reacted to a string +of lackluster seasons by saying, "Why get upset? Everyone has a bad +century now and then."
+ +Gains in book value are, of course, +not the bottom line at Berkshire. What truly counts are gains in per-share +intrinsic business value. Ordinarily, though, the two measures tend to +move roughly in tandem, and in 1997 that was the case: Led by a blow-out +performance at GEICO, Berkshire's intrinsic value (which far exceeds book +value) grew at nearly the same pace as book value.
+ +For more explanation of the term, +intrinsic value, you may wish to refer to our Owner's Manual, reprinted +on pages 62 to 71. This manual sets forth our owner-related business principles, +information that is important to all of Berkshire's shareholders.
+ +In our last two annual reports, +we furnished you a table that Charlie and I believe is central to estimating +Berkshire's intrinsic value. In the updated version of that table, which +follows, we trace our two key components of value. The first column lists +our per-share ownership of investments (including cash and equivalents) +and the second column shows our per-share earnings from Berkshire's operating +businesses before taxes and purchase-accounting adjustments (discussed +on pages 69 and 70), but after all interest and corporate expenses. The +second column excludes all dividends, interest and capital gains that we +realized from the investments presented in the first column. In effect, +the columns show what Berkshire would look like were it split into two +parts, with one entity holding our investments and the other operating +all of our businesses and bearing all corporate costs.
+ +Pre-tax Earnings Per Share + Investments Excluding All Income from + Year Per Share Investments + + 1967 $ 41 $ 1.09 + 1977 372 12.44 + 1987 3,910 108.14 + 1997 38,043 717.82 ++ +
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Pundits who ignore what our 38,000 +employees contribute to the company, and instead simply view Berkshire +as a de facto investment company, should study the figures in the second +column. We made our first business acquisition in 1967, and since then +our pre-tax operating earnings have grown from $1 million to $888 million. +Furthermore, as noted, in this exercise we have assigned all of Berkshire's +corporate expenses -- overhead of $6.6 million, interest of $66.9 million +and shareholder contributions of $15.4 million -- to our business operations, +even though a portion of these could just as well have been assigned to +the investment side.
+ +Here are the growth rates of the +two segments by decade:
+ +Pre-tax Earnings Per Share + Investments Excluding All Income from + Decade Ending Per Share Investments + + 1977 24.6% 27.6% + 1987 26.5% 24.1% + 1997 25.5% 20.8% + Annual Growth + Rate, 1967-1997 25.6% 24.2% ++ +
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During 1997, both parts of our +business grew at a satisfactory rate, with investments increasing by $9,543 +per share, or 33.5%, and operating earnings growing by $296.43 per share, +or 70.3%. One important caveat: Because we were lucky in our super-cat +insurance business (to be discussed later) and because GEICO's underwriting +gain was well above what we can expect in most years, our 1997 operating +earnings were much better than we anticipated and also more than we expect +for 1998.
+ +Our rate of progress in both investments +and operations is certain to fall in the future. For anyone deploying +capital, nothing recedes like success. My own history makes the point: +Back in 1951, when I was attending Ben Graham's class at Columbia, an idea +giving me a $10,000 gain improved my investment performance for the year +by a full 100 percentage points. Today, an idea producing a $500 million +pre-tax profit for Berkshire adds one percentage point to our performance. +It's no wonder that my annual results in the 1950s were better by nearly +thirty percentage points than my annual gains in any subsequent decade. +Charlie's experience was similar. We weren't smarter then, just smaller. +At our present size, any performance superiority we achieve will be minor. +
+ +We will be helped, however, by +the fact that the businesses to which we have already allocated capital +-- both operating subsidiaries and companies in which we are passive investors +-- have splendid long-term prospects. We are also blessed with a managerial +corps that is unsurpassed in ability and focus. Most of these executives +are wealthy and do not need the pay they receive from Berkshire to maintain +their way of life. They are motivated by the joy of accomplishment, not +by fame or fortune.
+ + Though we are delighted with what
+we own, we are not pleased with our prospects for committing incoming funds.
+Prices are high for both businesses and stocks. That does not mean that
+the prices of either will fall -- we have absolutely no view on that matter
+-- but it does mean that we get relatively little in prospective earnings
+when we commit fresh money.
+
+
Under these circumstances, we try +to exert a Ted Williams kind of discipline. In his book The Science +of Hitting, Ted explains that he carved the strike zone into 77 cells, +each the size of a baseball. Swinging only at balls in his "best" +cell, he knew, would allow him to bat .400; reaching for balls in his "worst" +spot, the low outside corner of the strike zone, would reduce him to .230. +In other words, waiting for the fat pitch would mean a trip to the Hall +of Fame; swinging indiscriminately would mean a ticket to the minors.
+ + If they are in the strike zone
+at all, the business "pitches" we now see are just catching the
+lower outside corner. If we swing, we will be locked into low returns.
+But if we let all of today's balls go by, there can be no assurance that
+the next ones we see will be more to our liking. Perhaps the attractive
+prices of the past were the aberrations, not the full prices of today.
+Unlike Ted, we can't be called out if we resist three pitches that are
+barely in the strike zone; nevertheless, just standing there, day after
+day, with my bat on my shoulder is not my idea of fun.
+
+
Unconventional Commitments
+
+
When we can't find our favorite +commitment -- a well-run and sensibly-priced business with fine economics +-- we usually opt to put new money into very short-term instruments of +the highest quality. Sometimes, however, we venture elsewhere. Obviously +we believe that the alternative commitments we make are more likely to +result in profit than loss. But we also realize that they do not offer +the certainty of profit that exists in a wonderful business secured at +an attractive price. Finding that kind of opportunity, we know that +we are going to make money -- the only question being when. With alternative +investments, we think that we are going to make money. But we also +recognize that we will sometimes realize losses, occasionally of substantial +size.
+ +We had three non-traditional positions +at yearend. The first was derivative contracts for 14.0 million barrels +of oil, that being what was then left of a 45.7 million barrel position +we established in 1994-95. Contracts for 31.7 million barrels were settled +in 1995-97, and these supplied us with a pre-tax gain of about $61.9 million. +Our remaining contracts expire during 1998 and 1999. In these, we had an +unrealized gain of $11.6 million at yearend. Accounting rules require that +commodity positions be carried at market value. Therefore, both our annual +and quarterly financial statements reflect any unrealized gain or loss +in these contracts. When we established our contracts, oil for future delivery +seemed modestly underpriced. Today, though, we have no opinion as to its +attractiveness.
+ +Our second non-traditional commitment +is in silver. Last year, we purchased 111.2 million ounces. Marked to market, +that position produced a pre-tax gain of $97.4 million for us in 1997. +In a way, this is a return to the past for me: Thirty years ago, I bought +silver because I anticipated its demonetization by the U.S. Government. +Ever since, I have followed the metal's fundamentals but not owned it. +In recent years, bullion inventories have fallen materially, and last summer +Charlie and I concluded that a higher price would be needed to establish +equilibrium between supply and demand. Inflation expectations, it should +be noted, play no part in our calculation of silver's value.
+ +Finally, our largest non-traditional +position at yearend was $4.6 billion, at amortized cost, of long-term zero-coupon +obligations of the U.S. Treasury. These securities pay no interest. Instead, +they provide their holders a return by way of the discount at which they +are purchased, a characteristic that makes their market prices move rapidly +when interest rates change. If rates rise, you lose heavily with zeros, +and if rates fall, you make outsized gains. Since rates fell in 1997, we +ended the year with an unrealized pre-tax gain of $598.8 million in our +zeros. Because we carry the securities at market value, that gain is reflected +in yearend book value.
+ + In purchasing zeros, rather than
+staying with cash-equivalents, we risk looking very foolish: A macro-based
+commitment such as this never has anything close to a 100% probability
+of being successful. However, you pay Charlie and me to use our best judgment
+-- not to avoid embarrassment -- and we will occasionally make an unconventional
+move when we believe the odds favor it. Try to think kindly of us when
+we blow one. Along with President Clinton, we will be feeling your pain:
+The Munger family has more than 90% of its net worth in Berkshire and the
+Buffetts more than 99%.
+
+
How We Think About Market Fluctuations
+
+
A short quiz: If you plan to eat +hamburgers throughout your life and are not a cattle producer, should you +wish for higher or lower prices for beef? Likewise, if you are going to +buy a car from time to time but are not an auto manufacturer, should you +prefer higher or lower car prices? These questions, of course, answer themselves. +
+ +But now for the final exam: If +you expect to be a net saver during the next five years, should you hope +for a higher or lower stock market during that period? Many investors get +this one wrong. Even though they are going to be net buyers of stocks for +many years to come, they are elated when stock prices rise and depressed +when they fall. In effect, they rejoice because prices have risen for the +"hamburgers" they will soon be buying. This reaction makes no +sense. Only those who will be sellers of equities in the near future should +be happy at seeing stocks rise. Prospective purchasers should much prefer +sinking prices.
+ +For shareholders of Berkshire who +do not expect to sell, the choice is even clearer. To begin with, our owners +are automatically saving even if they spend every dime they personally +earn: Berkshire "saves" for them by retaining all earnings, thereafter +using these savings to purchase businesses and securities. Clearly, the +more cheaply we make these buys, the more profitable our owners' indirect +savings program will be.
+ +Furthermore, through Berkshire +you own major positions in companies that consistently repurchase their +shares. The benefits that these programs supply us grow as prices fall: +When stock prices are low, the funds that an investee spends on repurchases +increase our ownership of that company by a greater amount than is the +case when prices are higher. For example, the repurchases that Coca-Cola, +The Washington Post and Wells Fargo made in past years at very low prices +benefitted Berkshire far more than do today's repurchases, made at loftier +prices.
+ +At the end of every year, about +97% of Berkshire's shares are held by the same investors who owned them +at the start of the year. That makes them savers. They should therefore +rejoice when markets decline and allow both us and our investees to deploy +funds more advantageously.
+ +So smile when you read a headline +that says "Investors lose as market falls." Edit it in your mind +to "Disinvestors lose as market falls -- but investors gain." +Though writers often forget this truism, there is a buyer for every seller +and what hurts one necessarily helps the other. (As they say in golf matches: +"Every putt makes someone happy.")
+ + We gained enormously from the low
+prices placed on many equities and businesses in the 1970s and 1980s. Markets
+that then were hostile to investment transients were friendly to those
+taking up permanent residence. In recent years, the actions we took in
+those decades have been validated, but we have found few new opportunities.
+In its role as a corporate "saver," Berkshire continually looks
+for ways to sensibly deploy capital, but it may be some time before we
+find opportunities that get us truly excited.
+
+
Insurance Operations -- Overview
+
+
What does excite us, however, is +our insurance business. GEICO is flying, and we expect that it will continue +to do so. Before we expound on that, though, let's discuss "float" +and how to measure its cost. Unless you understand this subject, it will +be impossible for you to make an informed judgment about Berkshire's intrinsic +value.
+ + To begin with, float is money we
+hold but don't own. In an insurance operation, float arises because premiums
+are received before losses are paid, an interval that sometimes extends
+over many years. During that time, the insurer invests the money. Typically,
+this pleasant activity carries with it a downside: The premiums that an
+insurer takes in usually do not cover the losses and expenses it eventually
+must pay. That leaves it running an "underwriting loss," which
+is the cost of float. An insurance business has value if its cost of float
+over time is less than the cost the company would otherwise incur to obtain
+funds. But the business is a lemon if its cost of float is higher than
+market rates for money.
+
+
A caution is appropriate here: +Because loss costs must be estimated, insurers have enormous latitude in +figuring their underwriting results, and that makes it very difficult for +investors to calculate a company's true cost of float. Estimating errors, +usually innocent but sometimes not, can be huge. The consequences of these +miscalculations flow directly into earnings. An experienced observer can +usually detect large-scale errors in reserving, but the general public +can typically do no more than accept what's presented, and at times I have +been amazed by the numbers that big-name auditors have implicitly blessed. +As for Berkshire, Charlie and I attempt to be conservative in presenting +its underwriting results to you, because we have found that virtually all +surprises in insurance are unpleasant ones.
+ + As the numbers in the following
+table show, Berkshire's insurance business has been a huge winner. For
+the table, we have calculated our float -- which we generate in large amounts
+relative to our premium volume -- by adding net loss reserves, loss adjustment
+reserves, funds held under reinsurance assumed and unearned premium reserves,
+and then subtracting agents' balances, prepaid acquisition costs, prepaid
+taxes and deferred charges applicable to assumed reinsurance. Our cost
+of float is determined by our underwriting loss or profit. In those years
+when we have had an underwriting profit, such as the last five, our cost
+of float has been negative. In effect, we have been paid for holding money.
+
+
+
(1) (2) Yearend Yield + Underwriting Approximate on Long-Term + Loss Average Float Cost of Funds Govt. Bonds + (In $ Millions) (Ratio of 1 to 2) + + + +1967 profit 17.3 less than zero 5.50% +1968 profit 19.9 less than zero 5.90% +1969 profit 23.4 less than zero 6.79% +1970 0.37 32.4 1.14% 6.25% +1971 profit 52.5 less than zero 5.81% +1972 profit 69.5 less than zero 5.82% +1973 profit 73.3 less than zero 7.27% +1974 7.36 79.1 9.30% 8.13% +1975 11.35 87.6 12.96% 8.03% +1976 profit 102.6 less than zero 7.30% +1977 profit 139.0 less than zero 7.97% +1978 profit 190.4 less than zero 8.93% +1979 profit 227.3 less than zero 10.08% +1980 profit 237.0 less than zero 11.94% +1981 profit 228.4 less than zero 13.61% +1982 21.56 220.6 9.77% 10.64% +1983 33.87 231.3 14.64% 11.84% +1984 48.06 253.2 18.98% 11.58% +1985 44.23 390.2 11.34% 9.34% +1986 55.84 797.5 7.00% 7.60% +1987 55.43 1,266.7 4.38% 8.95% +1988 11.08 1,497.7 0.74% 9.00% +1989 24.40 1,541.3 1.58% 7.97% +1990 26.65 1,637.3 1.63% 8.24% +1991 119.59 1,895.0 6.31% 7.40% +1992 108.96 2,290.4 4.76% 7.39% +1993 profit 2,624.7 less than zero 6.35% +1994 profit 3,056.6 less than zero 7.88% +1995 profit 3,607.2 less than zero 5.95% +1996 profit 6,702.0 less than zero 6.64% +1997 profit 7,093.1 less than zero 5.92% ++ +
+
+
Since 1967, when we entered the +insurance business, our float has grown at an annual compounded rate of +21.7%. Better yet, it has cost us nothing, and in fact has made us money. +Therein lies an accounting irony: Though our float is shown on our balance +sheet as a liability, it has had a value to Berkshire greater than an equal +amount of net worth would have had.
+ + The expiration of several large
+contracts will cause our float to decline during the first quarter of 1998,
+but we expect it to grow substantially over the long term. We also believe
+that our cost of float will continue to be highly favorable.
+
+
Super-Cat Insurance
+
+
Occasionally, however, the cost +of our float will spike severely. That will occur because of our heavy +involvement in the super-cat business, which by its nature is the most +volatile of all insurance lines. In this operation, we sell policies that +insurance and reinsurance companies purchase in order to limit their losses +when mega-catastrophes strike. Berkshire is the preferred market for sophisticated +buyers: When the "big one" hits, the financial strength of super-cat +writers will be tested, and Berkshire has no peer in this respect.
+ +Since truly major catastrophes +are rare occurrences, our super-cat business can be expected to show large +profits in most years -- and to record a huge loss occasionally. In other +words, the attractiveness of our super-cat business will take a great many +years to measure. What you must understand, however, is that a truly +terrible year in the super-cat business is not a possibility -- it's a +certainty. The only question is when it will come.
+ +Last year, we were very lucky in +our super-cat operation. The world suffered no catastrophes that caused +huge amounts of insured damage, so virtually all premiums that we received +dropped to the bottom line. This pleasant result has a dark side, however. +Many investors who are "innocents" -- meaning that they rely +on representations of salespeople rather than on underwriting knowledge +of their own -- have come into the reinsurance business by means of purchasing +pieces of paper that are called "catastrophe bonds." The second +word in this term, though, is an Orwellian misnomer: A true bond obliges +the issuer to pay; these bonds, in effect, are contracts that lay a provisional +promise to pay on the purchaser.
+ +This convoluted arrangement came +into being because the promoters of the contracts wished to circumvent +laws that prohibit the writing of insurance by entities that haven't been +licensed by the state. A side benefit for the promoters is that calling +the insurance contract a "bond" may also cause unsophisticated +buyers to assume that these instruments involve far less risk than is actually +the case.
+ +Truly outsized risks will exist +in these contracts if they are not properly priced. A pernicious aspect +of catastrophe insurance, however, makes it likely that mispricing, even +of a severe variety, will not be discovered for a very long time. Consider, +for example, the odds of throwing a 12 with a pair of dice -- 1 out of +36. Now assume that the dice will be thrown once a year; that you, the +"bond-buyer," agree to pay $50 million if a 12 appears; and that +for "insuring" this risk you take in an annual "premium" +of $1 million. That would mean you had significantly underpriced the risk. +Nevertheless, you could go along for years thinking you were making money +-- indeed, easy money. There is actually a 75.4% probability that you would +go for a decade without paying out a dime. Eventually, however, you would +go broke.
+ +In this dice example, the odds +are easy to figure. Calculations involving monster hurricanes and earthquakes +are necessarily much fuzzier, and the best we can do at Berkshire is to +estimate a range of probabilities for such events. The lack of precise +data, coupled with the rarity of such catastrophes, plays into the hands +of promoters, who typically employ an "expert" to advise the +potential bond-buyer about the probability of losses. The expert puts no +money on the table. Instead, he receives an up-front payment that is forever +his no matter how inaccurate his predictions. Surprise: When the stakes +are high, an expert can invariably be found who will affirm -- to return +to our example -- that the chance of rolling a 12 is not 1 in 36, but more +like 1 in 100. (In fairness, we should add that the expert will probably +believe that his odds are correct, a fact that makes him less reprehensible +-- but more dangerous.)
+ +The influx of "investor" +money into catastrophe bonds -- which may well live up to their name -- +has caused super-cat prices to deteriorate materially. Therefore, we will +write less business in 1998. We have some large multi-year contracts in +force, however, that will mitigate the drop. The largest of these are two +policies that we described in last year's report -- one covering hurricanes +in Florida and the other, signed with the California Earthquake Authority, +covering earthquakes in that state. Our "worst-case" loss remains +about $600 million after-tax, the maximum we could lose under the CEA policy. +Though this loss potential may sound large, it is only about 1% of Berkshire's +market value. Indeed, if we could get appropriate prices, we would be willing +to significantly increase our "worst-case" exposure.
+ + Our super-cat business was developed
+from scratch by Ajit Jain, who has contributed to Berkshire's success in
+a variety of other ways as well. Ajit possesses both the discipline to
+walk away from business that is inadequately priced and the imagination
+to then find other opportunities. Quite simply, he is one of Berkshire's
+major assets. Ajit would have been a star in whatever career he chose;
+fortunately for us, he enjoys insurance.
+
+
Insurance -- GEICO (1-800-555-2756) and Other Primary Operations
+
+
+
Last year I wrote about GEICO's +Tony Nicely and his terrific management skills. If I had known then what +he had in store for us in 1997, I would have searched for still greater +superlatives. Tony, now 54, has been with GEICO for 36 years and last year +was his best. As CEO, he has transmitted vision, energy and enthusiasm +to all members of the GEICO family -- raising their sights from what has +been achieved to what can be achieved.
+ +We measure GEICO's performance +by first, the net increase in its voluntary auto policies (that is, not +including policies assigned us by the state) and, second, the profitability +of "seasoned" auto business, meaning policies that have been +with us for more than a year and are thus past the period in which acquisition +costs cause them to be money-losers. In 1996, in-force business grew 10%, +and I told you how pleased I was, since that rate was well above anything +we had seen in two decades. Then, in 1997, growth jumped to 16%.
+ + Below are the new business and
+in-force figures for the last five years:
+
+
New Voluntary Voluntary Auto + Years Auto Policies Policies in Force + + 1993 354,882 2,011,055 + 1994 396,217 2,147,549 + 1995 461,608 2,310,037 + 1996 617,669 2,543,699 + 1997 913,176 2,949,439 ++ +
Of course, any insurer can grow +rapidly if it gets careless about underwriting. GEICO's underwriting profit +for the year, though, was 8.1% of premiums, far above its average. Indeed, +that percentage was higher than we wish it to be: Our goal is to pass on +most of the benefits of our low-cost operation to our customers, holding +ourselves to about 4% in underwriting profit. With that in mind, we reduced +our average rates a bit during 1997 and may well cut them again this year. +Our rate changes varied, of course, depending on the policyholder and where +he lives; we strive to charge a rate that properly reflects the loss expectancy +of each driver.
+ +GEICO is not the only auto insurer +obtaining favorable results these days. Last year, the industry recorded +profits that were far better than it anticipated or can sustain. Intensified +competition will soon squeeze margins very significantly. But this is a +development we welcome: Long term, a tough market helps the low-cost operator, +which is what we are and intend to remain.
+ + Last year I told you about the
+record 16.9% profit-sharing contribution that GEICO's associates had earned
+and explained that two simple variables set the amount: policy growth and
+profitability of seasoned business. I further explained that 1996's performance
+was so extraordinary that we had to enlarge the chart delineating the possible
+payouts. The new configuration didn't make it through 1997: We enlarged
+the chart's boundaries again and awarded our 10,500 associates a profit-sharing
+contribution amounting to 26.9% of their base compensation, or $71 million.
+In addition, the same two variables -- policy growth and profitability
+of seasoned business -- determined the cash bonuses that we paid to dozens
+of top executives, starting with Tony.
+
+
At GEICO, we are paying in a way +that makes sense for both our owners and our managers. We distribute merit +badges, not lottery tickets: In none of Berkshire's subsidiaries do we +relate compensation to our stock price, which our associates cannot affect +in any meaningful way. Instead, we tie bonuses to each unit's business +performance, which is the direct product of the unit's people. When that +performance is terrific -- as it has been at GEICO -- there is nothing +Charlie and I enjoy more than writing a big check.
+ +GEICO's underwriting profitability +will probably fall in 1998, but the company's growth could accelerate. +We're planning to step on the gas: GEICO's marketing expenditures this +year will top $100 million, up 50% from 1997. Our market share today is +only 3%, a level of penetration that should increase dramatically in the +next decade. The auto insurance industry is huge -- it does about $115 +billion of volume annually -- and there are tens of millions of drivers +who would save substantial money by switching to us.
+ +* * * * * * * * * * * *
In the 1995 report, I described +the enormous debt that you and I owe to Lorimer Davidson. On a Saturday +early in 1951, he patiently explained the ins and outs of both GEICO and +its industry to me -- a 20-year-old stranger who'd arrived at GEICO's headquarters +uninvited and unannounced. Davy later became the company's CEO and has +remained my friend and teacher for 47 years. The huge rewards that GEICO +has heaped on Berkshire would not have materialized had it not been for +his generosity and wisdom. Indeed, had I not met Davy, I might never have +grown to understand the whole field of insurance, which over the years +has played such a key part in Berkshire's success.
+ +Davy turned 95 last year, and it's +difficult for him to travel. Nevertheless, Tony and I hope that we can +persuade him to attend our annual meeting, so that our shareholders can +properly thank him for his important contributions to Berkshire. Wish us +luck.
+ +* * * * * * * * * * * *
Though they are, of course, far +smaller than GEICO, our other primary insurance operations turned in results +last year that, in aggregate, were fully as stunning. National Indemnity's +traditional business had an underwriting profit of 32.9% and, as usual, +developed a large amount of float compared to premium volume. Over the +last three years, this segment of our business, run by Don Wurster, has +had a profit of 24.3%. Our homestate operation, managed by Rod Eldred, +recorded an underwriting profit of 14.1% even though it continued to absorb +the expenses of geographical expansion. Rod's three-year record is an amazing +15.1%. Berkshire's workers' compensation business, run out of California +by Brad Kinstler, had a modest underwriting loss in a difficult environment; +its three-year underwriting record is a positive 1.5%. John Kizer, at Central +States Indemnity, set a new volume record while generating good underwriting +earnings. At Kansas Bankers Surety, Don Towle more than lived up to the +high expectations we had when we purchased the company in 1996.
+ + In aggregate, these five operations
+recorded an underwriting profit of 15.0%. The two Dons, along with Rod,
+Brad and John, have created significant value for Berkshire, and we believe
+there is more to come.
+
+
Sources of Reported Earnings
+
+
The table that follows shows the +main sources of Berkshire's reported earnings. In this presentation, purchase-accounting +adjustments are not assigned to the specific businesses to which they apply, +but are instead aggregated and shown separately. This procedure lets you +view the earnings of our businesses as they would have been reported had +we not purchased them. For the reasons discussed on pages 69 and 70, this +form of presentation seems to us to be more useful to investors and managers +than one utilizing generally-accepted accounting principles (GAAP), which +require purchase-premiums to be charged off business-by-business. The total +earnings we show in the table are, of course, identical to the GAAP total +in our audited financial statements.
+ +(in millions) + Berkshire's Share + of Net Earnings + (after taxes and + Pre-Tax Earnings minority interests) + 1997 1996 1997 1996 +Operating Earnings: + Insurance Group: + Underwriting -- Super-Cat. . . . . . . .$ 283.0 $ 167.0 $ 182.7 $ 107.4 + Underwriting -- Other Reinsurance. . . . (155.2) (174.8) (100.1) (112.4) + Underwriting -- GEICO. . . . . . . . . . 280.7 171.4 181.1 110.2 + Underwriting -- Other Primary. . . . . . 52.9 58.5 34.1 37.6 + Net Investment Income. . . . . . . . . . 882.3 726.2 703.6 593.1 + Buffalo News . . . . . . . . . . . . . . . 55.9 50.4 32.7 29.5 + Finance Businesses . . . . . . . . . . . . 28.1 23.1 18.0 14.9 + FlightSafety . . . . . . . . . . . . . . . 139.5 3.1(1) 84.4 1.9(1) + Home Furnishings . . . . . . . . . . . . . 56.8(2) 43.8 32.2(2) 24.8 + Jewelry. . . . . . . . . . . . . . . . . . 31.6 27.8 18.3 16.1 + Scott Fetzer(excluding finance operation). 118.9 121.7 77.3 81.6 + See's Candies. . . . . . . . . . . . . . . 58.6 51.9 35.0 30.8 + Shoe Group . . . . . . . . . . . . . . . . 48.8 61.6 32.2 41.0 + Purchase-Accounting Adjustments. . . . . . (104.9) (75.7) (97.0) (70.5) + Interest Expense(3). . . . . . . . . . . . (106.6) (94.3) (67.1) (56.6) + Shareholder-Designated Contributions . . . (15.4) (13.3) (9.9) (8.5) + Other. . . . . . . . . . . . . . . . . . . 60.7 73.0 37.0 42.2 + -------- -------- -------- -------- +Operating Earnings . . . . . . . . . . . . . 1,715.7 1,221.4 1,194.5 883.1 +Capital Gains from Investments . . . . . . . 1,111.9 2,484.5 707.1 1,605.5 + -------- -------- -------- -------- +Total Earnings - All Entities. . . . . . . .$2,827.6 $3,705.9 $1,901.6 $2,488.6 + ======== ======== ======== ======== ++ +
(1) From date of acquisition,
+December 23, 1996.
+ (2) Includes Star
+Furniture from July 1, 1997.
+ (3) Excludes interest
+expense of Finance Businesses.
+
+
+
Overall, our operating businesses +continue to perform exceptionally well, far outdoing their industry norms. +We are particularly pleased that profits improved at Helzberg's after a +disappointing 1996. Jeff Comment, Helzberg's CEO, took decisive steps early +in 1997 that enabled the company to gain real momentum by the crucial Christmas +season. In the early part of this year, as well, sales remained strong. +
+ +Casual observers may not appreciate +just how extraordinary the performance of many of our businesses has been: +If the earnings history of, say, Buffalo News or Scott Fetzer is compared +to the records of their publicly-owned peers, their performance might seem +to have been unexceptional. But most public companies retain two-thirds +or more of their earnings to fund their corporate growth. In contrast, +those Berkshire subsidiaries have paid 100% of their earnings to us, their +parent company, to fund our growth.
+ + In effect, the records of the public
+companies reflect the cumulative benefits of the earnings they have retained,
+while the records of our operating subsidiaries get no such boost. Over
+time, however, the earnings these subsidiaries have distributed have created
+truly huge amounts of earning power elsewhere in Berkshire. The News, See's
+and Scott Fetzer have alone paid us $1.8 billion, which we have gainfully
+employed elsewhere. We owe their managements our gratitude for much more
+than the earnings that are detailed in the table.
+
+
Additional information about our
+various businesses is given on pages 36 - 50, where you will also find
+our segment earnings reported on a GAAP basis. In addition, on pages 55
+- 61, we have rearranged Berkshire's financial data into four segments
+on a non-GAAP basis, a presentation that corresponds to the way Charlie
+and I think about the company. Our intent is to supply you with the financial
+information that we would wish you to give us if our positions were reversed.
+
+
+
Look-Through Earnings
+
+
Reported earnings are a poor measure +of economic progress at Berkshire, in part because the numbers shown in +the table presented earlier include only the dividends we receive from +investees -- though these dividends typically represent only a small fraction +of the earnings attributable to our ownership. Not that we mind this division +of money, since on balance we regard the undistributed earnings of investees +as more valuable to us than the portion paid out. The reason is simple: +Our investees often have the opportunity to reinvest earnings at high rates +of return. So why should we want them paid out?
+ +To depict something closer to economic +reality at Berkshire than reported earnings, though, we employ the concept +of "look-through" earnings. As we calculate these, they consist +of: (1) the operating earnings reported in the previous section, plus; +(2) our share of the retained operating earnings of major investees that, +under GAAP accounting, are not reflected in our profits, less; (3) an allowance +for the tax that would be paid by Berkshire if these retained earnings +of investees had instead been distributed to us. When tabulating "operating +earnings" here, we exclude purchase-accounting adjustments as well +as capital gains and other major non-recurring items.
+ + The following table sets forth
+our 1997 look-through earnings, though I warn you that the figures can
+be no more than approximate, since they are based on a number of judgment
+calls. (The dividends paid to us by these investees have been included
+in the operating earnings itemized on page 11, mostly under "Insurance
+Group: Net Investment Income.")
+
+
Berkshire's Share + of Undistributed + Berkshire's Approximate Operating Earnings +Berkshire's Major Investees Ownership at Yearend(1) (in millions)(2) + +American Express Company 10.7% $161 +The Coca-Cola Company 8.1% 216 +The Walt Disney Company 3.2% 65 +Freddie Mac 8.6% 86 +The Gillette Company 8.6% 82 +The Washington Post Company 16.5% 30 +Wells Fargo & Company 7.8% 103 + ------ +Berkshire's share of undistributed earnings of major investees 743 +Hypothetical tax on these undistributed investee earnings(3) (105) +Reported operating earnings of Berkshire 1,292 + ------ + Total look-through earnings of Berkshire $1,930 + ====== + + + + (1) Does not include shares allocable to minority interests + (2) Calculated on average ownership for the year + (3) The tax rate used is 14%, which is the rate Berkshire + pays on the dividends it receives ++ +
Acquisitions of 1997
+
+
In 1997, we agreed to acquire Star +Furniture and International Dairy Queen (a deal that closed early in 1998). +Both businesses fully meet our criteria: They are understandable; possess +excellent economics; and are run by outstanding people.
+ +The Star transaction has an interesting +history. Whenever we buy into an industry whose leading participants aren't +known to me, I always ask our new partners, "Are there any more at +home like you?" Upon our purchase of Nebraska Furniture Mart in 1983, +therefore, the Blumkin family told me about three outstanding furniture +retailers in other parts of the country. At the time, however, none was +for sale.
+ +Many years later, Irv Blumkin learned +that Bill Child, CEO of R.C. Willey -- one of the recommended three -- +might be interested in merging, and we promptly made the deal described +in the 1995 report. We have been delighted with that association -- Bill +is the perfect partner. Furthermore, when we asked Bill about industry +standouts, he came up with the remaining two names given me by the Blumkins, +one of these being Star Furniture of Houston. But time went by without +there being any indication that either of the two was available.
+ +On the Thursday before last year's +annual meeting, however, Bob Denham of Salomon told me that Melvyn Wolff, +the long-time controlling shareholder and CEO of Star, wanted to talk. +At our invitation, Melvyn came to the meeting and spent his time in Omaha +confirming his positive feelings about Berkshire. I, meanwhile, looked +at Star's financials, and liked what I saw.
+ +A few days later, Melvyn and I +met in New York and made a deal in a single, two-hour session. As was the +case with the Blumkins and Bill Child, I had no need to check leases, work +out employment contracts, etc. I knew I was dealing with a man of integrity +and that's what counted.
+ +Though the Wolff family's association +with Star dates back to 1924, the business struggled until Melvyn and his +sister Shirley Toomin took over in 1962. Today Star operates 12 stores +-- ten in Houston and one each in Austin and Bryan -- and will soon move +into San Antonio as well. We won't be surprised if Star is many times its +present size a decade from now.
+ +Here's a story illustrating what +Melvyn and Shirley are like: When they told their associates of the sale, +they also announced that Star would make large, special payments to those +who had helped them succeed -- and then defined that group as everyone +in the business. Under the terms of our deal, it was Melvyn and Shirley's +money, not ours, that funded this distribution. Charlie and I love it when +we become partners with people who behave like that.
+ +The Star transaction closed on +July 1. In the months since, we've watched Star's already-excellent sales +and earnings growth accelerate further. Melvyn and Shirley will be at the +annual meeting, and I hope you get a chance to meet them.
+ +Next acquisition: International +Dairy Queen. There are 5,792 Dairy Queen stores operating in 23 countries +-- all but a handful run by franchisees -- and in addition IDQ franchises +409 Orange Julius operations and 43 Karmelkorn operations. In 190 locations, +"treat centers" provide some combination of the three products. +
+ +For many years IDQ had a bumpy +history. Then, in 1970, a Minneapolis group led by John Mooty and Rudy +Luther took control. The new managers inherited a jumble of different franchising +agreements, along with some unwise financing arrangements that had left +the company in a precarious condition. In the years that followed, management +rationalized the operation, extended food service to many more locations, +and, in general, built a strong organization.
+ +Last summer Mr. Luther died, which +meant his estate needed to sell stock. A year earlier, Dick Kiphart of +William Blair & Co., had introduced me to John Mooty and Mike Sullivan, +IDQ's CEO, and I had been impressed with both men. So, when we got the +chance to merge with IDQ, we offered a proposition patterned on our FlightSafety +acquisition, extending selling shareholders the option of choosing either +cash or Berkshire shares having a slightly lower immediate value. By tilting +the consideration as we did, we encouraged holders to opt for cash, the +type of payment we by far prefer. Even then, only 45% of IDQ shares elected +cash.
+ + Charlie and I bring a modicum of
+product expertise to this transaction: He has been patronizing the Dairy
+Queens in Cass Lake and Bemidji, Minnesota, for decades, and I have been
+a regular in Omaha. We have put our money where our mouth is.
+
+
A Confession
+
+
I've mentioned that we strongly +prefer to use cash rather than Berkshire stock in acquisitions. A study +of the record will tell you why: If you aggregate all of our stock-only +mergers (excluding those we did with two affiliated companies, Diversified +Retailing and Blue Chip Stamps), you will find that our shareholders are +slightly worse off than they would have been had I not done the transactions. +Though it hurts me to say it, when I've issued stock, I've cost you money. +
+ +Be clear about one thing: This +cost has not occurred because we were misled in any way by sellers +or because they thereafter failed to manage with diligence and skill. On +the contrary, the sellers were completely candid when we were negotiating +our deals and have been energetic and effective ever since.
+ +Instead, our problem has been that +we own a truly marvelous collection of businesses, which means that trading +away a portion of them for something new almost never makes sense. When +we issue shares in a merger, we reduce your ownership in all of our businesses +-- partly-owned companies such as Coca-Cola, Gillette and American Express, +and all of our terrific operating companies as well. An example from sports +will illustrate the difficulty we face: For a baseball team, acquiring +a player who can be expected to bat .350 is almost always a wonderful event +-- except when the team must trade a .380 hitter to make the deal. +
+ +Because our roster is filled with +.380 hitters, we have tried to pay cash for acquisitions, and here our +record has been far better. Starting with National Indemnity in 1967, and +continuing with, among others, See's, Buffalo News, Scott Fetzer and GEICO, +we have acquired -- for cash -- a number of large businesses that have +performed incredibly well since we bought them. These acquisitions have +delivered Berkshire tremendous value -- indeed, far more than I anticipated +when we made our purchases.
+ +We believe that it is almost impossible +for us to "trade up" from our present businesses and managements. +Our situation is the opposite of Camelot's Mordred, of whom Guenevere commented, +"The one thing I can say for him is that he is bound to marry well. +Everybody is above him." Marrying well is extremely difficult for +Berkshire.
+ +So you can be sure that Charlie +and I will be very reluctant to issue shares in the future. In those cases +when we simply must do so -- when certain shareholders of a desirable acquiree +insist on getting stock -- we will include an attractive cash option in +order to tempt as many of the sellers to take cash as is possible.
+ + Merging with public companies presents
+a special problem for us. If we are to offer any premium to the
+acquiree, one of two conditions must be present: Either our own stock must
+be overvalued relative to the acquiree's, or the two companies together
+must be expected to earn more than they would if operated separately. Historically,
+Berkshire has seldom been overvalued. In this market, moreover, undervalued
+acquirees are almost impossible to find. That other possibility -- synergy
+gains -- is usually unrealistic, since we expect acquirees to operate after
+we've bought them just as they did before. Joining with Berkshire does
+not normally raise their revenues nor cut their costs.
+
+
Indeed, their reported costs (but +not their true ones) will rise after they are bought by Berkshire +if the acquiree has been granting options as part of its compensation packages. +In these cases, "earnings" of the acquiree have been overstated +because they have followed the standard -- but, in our view, dead wrong +-- accounting practice of ignoring the cost to a business of issuing options. +When Berkshire acquires an option-issuing company, we promptly substitute +a cash compensation plan having an economic value equivalent to that of +the previous option plan. The acquiree's true compensation cost is thereby +brought out of the closet and charged, as it should be, against earnings. +
+ +The reasoning that Berkshire applies +to the merger of public companies should be the calculus for all +buyers. Paying a takeover premium does not make sense for any acquirer +unless a) its stock is overvalued relative to the acquiree's or b) the +two enterprises will earn more combined than they would separately. Predictably, +acquirers normally hew to the second argument because very few are willing +to acknowledge that their stock is overvalued. However, voracious buyers +-- the ones that issue shares as fast as they can print them -- are tacitly +conceding that point. (Often, also, they are running Wall Street's version +of a chain-letter scheme.)
+ + In some mergers there truly are
+major synergies -- though oftentimes the acquirer pays too much to obtain
+them -- but at other times the cost and revenue benefits that are projected
+prove illusory. Of one thing, however, be certain: If a CEO is enthused
+about a particularly foolish acquisition, both his internal staff and his
+outside advisors will come up with whatever projections are needed to justify
+his stance. Only in fairy tales are emperors told that they are naked.
+
+
+
Common Stock Investments
+
+
Below we present our common stock +investments. Those with a market value of more than $750 million are itemized. +
+ +12/31/97 + + Shares Company Cost* Market + (dollars in millions) + + 49,456,900 American Express Company $1,392.7 $ 4,414.0 + 200,000,000 The Coca-Cola Company 1,298.9 13,337.5 + 21,563,414 The Walt Disney Company 381.2 2,134.8 + 63,977,600 Freddie Mac 329.4 2,683.1 + 48,000,000 The Gillette Company 600.0 4,821.0 + 23,733,198 Travelers Group Inc. 604.4 1,278.6 + 1,727,765 The Washington Post Company 10.6 840.6 + 6,690,218 Wells Fargo & Company 412.6 2,270.9 + Others 2,177.1 4,467.2 + -------- ---------- + Total Common Stocks $7,206.9 $ 36,247.7 + ======== ========== ++ +
+
+ *
+Represents tax-basis cost which, in aggregate, is $1.8 billion less than
+GAAP cost.
+
+
We made net sales during the year +that amounted to about 5% of our beginning portfolio. In these, we significantly +reduced a few of our holdings that are below the $750 million threshold +for itemization, and we also modestly trimmed a few of the larger positions +that we detail. Some of the sales we made during 1997 were aimed at changing +our bond-stock ratio moderately in response to the relative values that +we saw in each market, a realignment we have continued in 1998.
+ +Our reported positions, we should +add, sometimes reflect the investment decisions of GEICO's Lou Simpson. +Lou independently runs an equity portfolio of nearly $2 billion that may +at times overlap the portfolio that I manage, and occasionally he makes +moves that differ from mine.
+ +Though we don't attempt to predict +the movements of the stock market, we do try, in a very rough way, to value +it. At the annual meeting last year, with the Dow at 7,071 and long-term +Treasury yields at 6.89%, Charlie and I stated that we did not consider +the market overvalued if 1) interest rates remained where they were +or fell, and 2) American business continued to earn the remarkable returns +on equity that it had recently recorded. So far, interest rates have fallen +-- that's one requisite satisfied -- and returns on equity still remain +exceptionally high. If they stay there -- and if interest rates hold near +recent levels -- there is no reason to think of stocks as generally overvalued. +On the other hand, returns on equity are not a sure thing to remain at, +or even near, their present levels.
+ +In the summer of 1979, when equities +looked cheap to me, I wrote a Forbes article entitled "You +pay a very high price in the stock market for a cheery consensus." +At that time skepticism and disappointment prevailed, and my point was +that investors should be glad of the fact, since pessimism drives down +prices to truly attractive levels. Now, however, we have a very cheery +consensus. That does not necessarily mean this is the wrong time to buy +stocks: Corporate America is now earning far more money than it was just +a few years ago, and in the presence of lower interest rates, every dollar +of earnings becomes more valuable. Today's price levels, though, have materially +eroded the "margin of safety" that Ben Graham identified as the +cornerstone of intelligent investing.
+ +* * * * * * * * * * * *
In last year's annual report, I +discussed Coca-Cola, our largest holding. Coke continues to increase its +market dominance throughout the world, but, tragically, it has lost the +leader responsible for its outstanding performance. Roberto Goizueta, Coke's +CEO since 1981, died in October. After his death, I read every one of the +more than 100 letters and notes he had written me during the past nine +years. Those messages could well serve as a guidebook for success in both +business and life.
+ +In these communications, Roberto +displayed a brilliant and clear strategic vision that was always aimed +at advancing the well-being of Coke shareholders. Roberto knew where he +was leading the company, how he was going to get there, and why this path +made the most sense for his owners -- and, equally important, he had a +burning sense of urgency about reaching his goals. An excerpt from one +handwritten note he sent to me illustrates his mind-set: "By the way, +I have told Olguita that what she refers to as an obsession, you call focus. +I like your term much better." Like all who knew Roberto, I will miss +him enormously.
+ + Consistent with his concern for
+the company, Roberto prepared for a seamless succession long before it
+seemed necessary. Roberto knew that Doug Ivester was the right man to take
+over and worked with Doug over the years to ensure that no momentum would
+be lost when the time for change arrived. The Coca-Cola Company will be
+the same steamroller under Doug as it was under Roberto.
+
+
Convertible Preferreds
+
+
Two years ago, I gave you an update +on the five convertible preferreds that we purchased through private placements +in the 1987-1991 period. At the time of that earlier report, we had realized +a small profit on the sale of our Champion International holding. The four +remaining preferred commitments included two, Gillette and First Empire +State, that we had converted into common stock in which we had large unrealized +gains, and two others, USAir and Salomon, that had been trouble-prone. +At times, the last two had me mouthing a line from a country song: "How +can I miss you if you won't go away?"
+ +Since I delivered that report, +all four holdings have grown significantly in value. The common stocks +of both Gillette and First Empire have risen substantially, in line with +the companies' excellent performance. At yearend, the $600 million we put +into Gillette in 1989 had appreciated to $4.8 billion, and the $40 million +we committed to First Empire in 1991 had risen to $236 million.
+ + Our two laggards, meanwhile, have
+come to life in a very major way. In a transaction that finally rewarded
+its long-suffering shareholders, Salomon recently merged into Travelers
+Group. All of Berkshire's shareholders -- including me, very personally
+-- owe a huge debt to Deryck Maughan and Bob Denham for, first, playing
+key roles in saving Salomon from extinction following its 1991 scandal
+and, second, restoring the vitality of the company to a level that made
+it an attractive acquisition for Travelers. I have often said that I wish
+to work with executives that I like, trust and admire. No two fit that
+description better than Deryck and Bob.
+
+
Berkshire's final results from +its Salomon investment won't be tallied for some time, but it is safe to +say that they will be far better than I anticipated two years ago. Looking +back, I think of my Salomon experience as having been both fascinating +and instructional, though for a time in 1991-92 I felt like the drama critic +who wrote: "I would have enjoyed the play except that I had an unfortunate +seat. It faced the stage."
+ +The resuscitation of US Airways +borders on the miraculous. Those who have watched my moves in this investment +know that I have compiled a record that is unblemished by success. I was +wrong in originally purchasing the stock, and I was wrong later, in repeatedly +trying to unload our holdings at 50 cents on the dollar.
+ +Two changes at the company coincided +with its remarkable rebound: 1) Charlie and I left the board of directors +and 2) Stephen Wolf became CEO. Fortunately for our egos, the second event +was the key: Stephen Wolf's accomplishments at the airline have been phenomenal. +
+ +There still is much to do at US +Airways, but survival is no longer an issue. Consequently, the company +made up the dividend arrearages on our preferred during 1997, adding extra +payments to compensate us for the delay we suffered. The company's common +stock, furthermore, has risen from a low of $4 to a recent high of $73. +
+ +Our preferred has been called for +redemption on March 15. But the rise in the company's stock has given our +conversion rights, which we thought worthless not long ago, great value. +It is now almost certain that our US Airways shares will produce a decent +profit -- that is, if my cost for Maalox is excluded -- and the gain could +even prove indecent.
+ +Next time I make a big, dumb decision, +Berkshire shareholders will know what to do: Phone Mr. Wolf.
+ +* * * * * * * * * * * *
In addition to the convertible +preferreds, we purchased one other private placement in 1991, $300 million +of American Express Percs. This security was essentially a common stock +that featured a tradeoff in its first three years: We received extra dividend +payments during that period, but we were also capped in the price appreciation +we could realize. Despite the cap, this holding has proved extraordinarily +profitable thanks to a move by your Chairman that combined luck and skill +-- 110% luck, the balance skill.
+ +Our Percs were due to convert into +common stock in August 1994, and in the month before I was mulling whether +to sell upon conversion. One reason to hold was Amex's outstanding CEO, +Harvey Golub, who seemed likely to maximize whatever potential the company +had (a supposition that has since been proved -- in spades). But the size +of that potential was in question: Amex faced relentless competition from +a multitude of card-issuers, led by Visa. Weighing the arguments, I leaned +toward sale.
+ +Here's where I got lucky. During +that month of decision, I played golf at Prouts Neck, Maine with Frank +Olson, CEO of Hertz. Frank is a brilliant manager, with intimate knowledge +of the card business. So from the first tee on I was quizzing him about +the industry. By the time we reached the second green, Frank had convinced +me that Amex's corporate card was a terrific franchise, and I had decided +not to sell. On the back nine I turned buyer, and in a few months Berkshire +owned 10% of the company.
+ +We now have a $3 billion gain in +our Amex shares, and I naturally feel very grateful to Frank. But George +Gillespie, our mutual friend, says that I am confused about where my gratitude +should go. After all, he points out, it was he who arranged the game and +assigned me to Frank's foursome.
+ +Quarterly Reports to Shareholders
+ +In last year's letter, I described +the growing costs we incur in mailing quarterly reports and the problems +we have encountered in delivering them to "street-name" shareholders. +I asked for your opinion about the desirability of our continuing to print +reports, given that we now publish our quarterly and annual communications +on the Internet, at our site, www.berkshirehathaway.com. Relatively few +shareholders responded, but it is clear that at least a small number who +want the quarterly information have no interest in getting it off the Internet. +Being a life-long sufferer from technophobia, I can empathize with this +group.
+ +The cost of publishing quarterlies, +however, continues to balloon, and we have therefore decided to send printed +versions only to shareholders who request them. If you wish the quarterlies, +please complete the reply card that is bound into this report. In the meantime, +be assured that all shareholders will continue to receive the annual +report in printed form.
+ +Those of you who enjoy the computer +should check out our home page. It contains a large amount of current information +about Berkshire and also all of our annual letters since 1977. In addition, +our website includes links to the home pages of many Berkshire subsidiaries. +On these sites you can learn more about our subsidiaries' products and +-- yes -- even place orders for them.
+ + We are required to file our quarterly
+information with the SEC no later than 45 days after the end of each quarter.
+One of our goals in posting communications on the Internet is to make this
+material information -- in full detail and in a form unfiltered by the
+media -- simultaneously available to all interested parties at a time when
+markets are closed. Accordingly, we plan to send our 1998 quarterly information
+to the SEC on three Fridays, May 15, August 14, and November 13, and on
+those nights to post the same information on the Internet. This procedure
+will put all of our shareholders, whether they be direct or "street-name,"
+on an equal footing. Similarly, we will post our 1998 annual report on
+the Internet on Saturday, March 13, 1999, and mail it at about the same
+time.
+
+
Shareholder-Designated Contributions
+
+
About 97.7% of all eligible shares +participated in Berkshire's 1997 shareholder-designated contributions program. +Contributions made were $15.4 million, and 3,830 charities were recipients. +A full description of the program appears on pages 52 - 53.
+ +Cumulatively, over the 17 years +of the program, Berkshire has made contributions of $113.1 million pursuant +to the instructions of our shareholders. The rest of Berkshire's giving +is done by our subsidiaries, which stick to the philanthropic patterns +that prevailed before they were acquired (except that their former owners +themselves take on the responsibility for their personal charities). In +aggregate, our subsidiaries made contributions of $8.1 million in 1997, +including in-kind donations of $4.4 million.
+ +Every year a few shareholders miss +out on our contributions program because they don't have their shares registered +in their own names on the prescribed record date or because they fail to +get the designation form back to us within the 60-day period allowed. Charlie +and I regret this. But if replies are received late, we have to reject +them because we can't make exceptions for some shareholders while refusing +to make them for others.
+ +To participate in future programs, +you must own Class A shares that are registered in the name of the actual +owner, not the nominee name of a broker, bank or depository. Shares not +so registered on August 31, 1998, will be ineligible for the 1998 program. +When you get the contributions form from us, return it promptly so that +it does not get put aside or forgotten.
+ +The Annual Meeting
+
+
Woodstock Weekend at Berkshire +will be May 2-4 this year. The finale will be the annual meeting, which +will begin at 9:30 a.m. on Monday, May 4. Last year we met at Aksarben +Coliseum, and both our staff and the crowd were delighted with the venue. +There was only one crisis: The night before the meeting, I lost my voice, +thereby fulfilling Charlie's wildest fantasy. He was crushed when I showed +up the next morning with my speech restored.
+ +Last year about 7,500 attended +the meeting. They represented all 50 states, as well as 16 countries, including +Australia, Brazil, Israel, Saudi Arabia, Singapore and Greece. Taking into +account several overflow rooms, we believe that we can handle more than +11,000 people, and that should put us in good shape this year even though +our shareholder count has risen significantly. Parking is ample at Aksarben; +acoustics are excellent; and seats are comfortable.
+ +The doors will open at 7 a.m. on +Monday and at 8:30 we will again feature the world premiere of a movie +epic produced by Marc Hamburg, our CFO. The meeting will last until 3:30, +with a short break at noon. This interval will permit the exhausted to +leave unnoticed and allow time for the hardcore to lunch at Aksarben's +concession stands. Charlie and I enjoy questions from owners, so bring +up whatever is on your mind.
+ +Berkshire products will again be +for sale in the halls outside the meeting room. Last year -- not +that I pay attention to this sort of thing -- we again set sales records, +moving 2,500 pounds of See's candy, 1,350 pairs of Dexter shoes, $75,000 +of World Books and related publications, and 888 sets of Quikut knives. +We also took orders for a new line of apparel, featuring our Berkshire +logo, and sold about 1,000 polo, sweat, and T-shirts. At this year's meeting, +we will unveil our 1998 collection.
+ +GEICO will again be on hand with +a booth staffed by star associates from its regional offices. Find out +whether you can save money by shifting your auto insurance to GEICO. About +40% of those who check us out learn that savings are possible. The proportion +is not 100% because insurers differ in their underwriting judgments, with +some favoring drivers who live in certain geographical areas and work at +certain occupations more than we do. We believe, however, that we more +frequently offer the low price than does any other national carrier selling +insurance to all comers. In the GEICO informational material that accompanies +this report, you will see that in 38 states we now offer a special discount +of as much as 8% to our shareholders. We also have applications pending +that would extend this discount to drivers in other states.
+ +An attachment to the proxy material +that is enclosed with this report explains how you can obtain the card +you will need for admission to the meeting. We expect a large crowd, so +get plane, hotel and car reservations promptly. American Express (800-799-6634) +will be happy to help you with arrangements. As usual, we will have buses +at the larger hotels that will take you to and from the meeting and also +deliver you to Nebraska Furniture Mart, Borsheim's and the airport after +its conclusion. You are likely, however, to find a car handy.
+ +NFM's main store, located on a +75-acre site about a mile from Aksarben, is open from 10 a.m. to 9 p.m. +on weekdays, 10 a.m. to 6 p.m. on Saturdays, and noon to 6 p.m. on Sundays. +During the period from May 1 to May 5, shareholders who present NFM with +the coupon that will accompany their meeting ticket will be entitled to +a discount that is otherwise restricted to its employees.
+ +Borsheim's normally is closed on +Sunday but will be open for shareholders from 10 a.m. to 6 p.m. on May +3rd. Last year was our second-best shareholder's day, exceeded only by +1996's. I regard this slippage as an anomaly and hope that you will prove +me right this year. Charlie will be available for autographs. He smiles, +however, only if the paper he signs is a Borsheim's sales ticket. Shareholders +who wish to visit on Saturday (10 a.m. to 5:30 p.m.) or on Monday (10 a.m.-8 +p.m.) should be sure to identify themselves as Berkshire owners so that +Susan Jacques, Borsheim's CEO, can make you especially welcome. Susan, +I should add, had a fabulous year in 1997. As a manager, she is everything +that an owner hopes for.
+ +On Sunday afternoon we will also +have a special treat for bridge players in the mall outside of Borsheim's. +There, Bob Hamman -- a legend of the game for more than three decades -- +will take on all comers. Join in and dazzle Bob with your skill.
+ +My favorite steakhouse, Gorat's, +opens one Sunday a year -- for Berkshire shareholders on the night before +the annual meeting. Last year the restaurant started serving at 4 p.m. +and finished about 1:30 a.m, an endurance trial that was the result of +taking 1,100 reservations vs. a seating capacity of 235. If you make a +reservation and then can't attend, be sure to let Gorat's know promptly, +since it goes to great effort to help us and we want to reciprocate. You +can make reservations beginning on April 1st (but not before) by +calling 402-551-3733. Last year I had to leave Gorat's a little early because +of my voice problem, but this year I plan to leisurely savor every bite +of my rare T-bone and double order of hash browns.
+ +After this warmup, Charlie and +I will head for the Dairy Queen on 114th, just south of Dodge. There are +12 great Dairy Queens in metropolitan Omaha, but the 114th Street location +is the best suited to handle the large crowd that we expect. South of the +property, there are hundreds of parking spaces on both sides of the street. +Also, this Dairy Queen will extend its Sunday hours to 11 p.m. in order +to accommodate our shareholders.
+ +The 114th Street operation is now +run by two sisters, Coni Birge and Deb Novotny, whose grandfather put up +the building in 1962 at what was then the outer edge of the city. Their +mother, Jan Noble, took over in 1972, and Coni and Deb continue as third +generation owner-managers. Jan, Coni and Deb will all be on hand Sunday +evening, and I hope that you meet them. Enjoy one of their hamburgers if +you can't get into Gorat's. And then, around eight o'clock, join me in +having a Dusty Sundae for dessert. This item is a personal specialty -- +the Dairy Queen will furnish you a copy of my recipe -- and will be offered +only on Shareholder Sunday.
+ +The Omaha Royals and Albuquerque +Dukes will play baseball on Saturday evening, May 2nd, at Rosenblatt Stadium. +As usual, your Chairman, shamelessly exploiting his 25% ownership of the +team, will take the mound. But this year you will see something new.
+ +In past games, much to the bafflement +of the crowd, I have shaken off the catcher's first call. He has consistently +asked for my sweeping curve, and I have just as regularly resisted. Instead, +I have served up a pathetic fast ball, which on my best day was clocked +at eight miles per hour (with a following wind).
+ +There's a story behind my unwillingness +to throw the curve ball. As some of you may know, Candy Cummings invented +the curve in 1867 and used it to great effect in the National Association, +where he never won less than 28 games in a season. The pitch, however, +drew immediate criticism from the very highest of authorities, namely Charles +Elliott, then president of Harvard University, who declared, "I have +heard that this year we at Harvard won the baseball championship because +we have a pitcher who has a fine curve ball. I am further instructed that +the purpose of the curve ball is to deliberately deceive the batter. Harvard +is not in the business of teaching deception." (I'm not making this +up.)
+ +Ever since I learned of President +Elliott's moral teachings on this subject, I have scrupulously refrained +from using my curve, however devastating its effect might have been on +hapless batters. Now, however, it is time for my karma to run over Elliott's +dogma and for me to quit holding back. Visit the park on Saturday night +and marvel at the majestic arc of my breaking ball.
+ +Our proxy statement includes information +about obtaining tickets to the game. We will also provide an information +packet describing the local hot spots, including, of course, those 12 Dairy +Queens.
+ + Come to Omaha -- the cradle of
+capitalism -- in May and enjoy yourself.
+
+
+
+
+
+
Warren E. Buffett +February 27, 1998 Chairman of the Board ++ +
+
+
--IMPORTANT NOTE--
+The 1998 Chairman's Letter is being presented in both HTML and PDF format. We strongly recommend you review the PDF version which is closer in appearance to our soon to be released printed version in the Annual Report. To view the Chairman's Letter in PDF format you must have an Adobe Acrobat Reader. If you do not have Adobe Acrobat on your computer, use the link to go to Adobe's web site for a free download. Adobe
+1998 Chairman's Letter PDF Version
+1998 Chairman's Letter HTML Version
+ diff --git a/berkshire-hathaway/1999/1-in/berkshire-hathaway-1999-letter.txt b/berkshire-hathaway/1999/1-in/berkshire-hathaway-1999-letter.txt new file mode 100644 index 0000000..41705ad --- /dev/null +++ b/berkshire-hathaway/1999/1-in/berkshire-hathaway-1999-letter.txt @@ -0,0 +1,23 @@ + + + + + + + +--IMPORTANT NOTE--
+The 1999 Chairman's Letter is being presented in both HTML and PDF format. We strongly recommend you review the PDF version which is closer in appearance to our soon to be released printed version in the Annual Report. To view the Chairman's Letter in PDF format you must have an Adobe Acrobat Reader. If you do not have Adobe Acrobat on your computer, use the link to go to Adobe's web site for a free download. Adobe
+1999 Chairman's Letter PDF Version
+1999 Chairman's Letter HTML Version
+ diff --git a/berkshire-hathaway/2000/1-in/berkshire-hathaway-2000-letter.txt b/berkshire-hathaway/2000/1-in/berkshire-hathaway-2000-letter.txt new file mode 100644 index 0000000..c7efd38 --- /dev/null +++ b/berkshire-hathaway/2000/1-in/berkshire-hathaway-2000-letter.txt @@ -0,0 +1,23 @@ + + + + + + + +--IMPORTANT NOTE--
+The 2000 Chairman's Letter is being presented in both HTML and PDF format. We strongly recommend you review the PDF version which is closer in appearance to our soon to be released printed version in the Annual Report. To view the Chairman's Letter in PDF format you must have an Adobe Acrobat Reader. If you do not have Adobe Acrobat on your computer, use the link to go to Adobe's web site for a free download. Adobe
+2000 Chairman's Letter PDF Version
+2000 Chairman's Letter HTML Version
+ diff --git a/berkshire-hathaway/2001/1-in/berkshire-hathaway-2001-letter.txt b/berkshire-hathaway/2001/1-in/berkshire-hathaway-2001-letter.txt new file mode 100644 index 0000000..453d194 --- /dev/null +++ b/berkshire-hathaway/2001/1-in/berkshire-hathaway-2001-letter.txt @@ -0,0 +1,23 @@ + + + + + + + +--IMPORTANT NOTE--
+The 2001 Chairman's Letter is being presented in both HTML and PDF format. We strongly recommend you review the PDF version which is closer in appearance to our soon to be released printed version in the Annual Report. To view the Chairman's Letter in PDF format you must have an Adobe Acrobat Reader. If you do not have Adobe Acrobat on your computer, use the link to go to Adobe's web site for a free download. Adobe
+2001 Chairman's Letter PDF Version
+2001 Chairman's Letter HTML Version
+ diff --git a/berkshire-hathaway/2002/1-in/berkshire-hathaway-2002-letter.txt b/berkshire-hathaway/2002/1-in/berkshire-hathaway-2002-letter.txt new file mode 100644 index 0000000..0d28cd5 --- /dev/null +++ b/berkshire-hathaway/2002/1-in/berkshire-hathaway-2002-letter.txt @@ -0,0 +1,23 @@ + + + + + + + +--IMPORTANT NOTE--
+The 2002 Chairman's Letter is being presented in PDF format only. To view the Chairman's Letter in PDF format you must have an Adobe Acrobat Reader. If you do not have Adobe Acrobat on your computer, use the link to go to Adobe's web site for a free download. Adobe
+ + + diff --git a/berkshire-hathaway/2003/1-in/berkshire-hathaway-2003-letter.txt b/berkshire-hathaway/2003/1-in/berkshire-hathaway-2003-letter.txt new file mode 100644 index 0000000..406f8da --- /dev/null +++ b/berkshire-hathaway/2003/1-in/berkshire-hathaway-2003-letter.txt @@ -0,0 +1,23 @@ + + + + + + + +--IMPORTANT NOTE--
+The 2003 Chairman's Letter is presented in PDF format. To view the Chairman's Letter you must have Adobe Acrobat® Reader® software. If you do not have Adobe Acrobat® software on your computer, use the link to go to Adobe's web site for a free download. Adobe
+ + + diff --git a/berkshire-hathaway/2004/1-in/berkshire-hathaway-2004-letter.txt b/berkshire-hathaway/2004/1-in/berkshire-hathaway-2004-letter.txt new file mode 100644 index 0000000..e15508b --- /dev/null +++ b/berkshire-hathaway/2004/1-in/berkshire-hathaway-2004-letter.txt @@ -0,0 +1,30 @@ + + + + + + + +--IMPORTANT NOTE--
+The 2004 Chairman's Letter is presented in PDF format. To view the Chairman's Letter you must have Adobe Acrobat® Reader® software. If you do not have Adobe Acrobat® software on your computer, use the link to go to Adobe's web site for a free download. Adobe
+In his 2004 letter to shareholders, Mr. Buffett refers to an article which appeared in the November 10, 2003 edition of Fortune Magazine.
+ +The letter also refers to an op-ed piece which appeared in the July 6, 2004 edition of The Washington Post.
+ + + diff --git a/berkshire-hathaway/2005/1-in/berkshire-hathaway-2005-letter.txt b/berkshire-hathaway/2005/1-in/berkshire-hathaway-2005-letter.txt new file mode 100644 index 0000000..781b5b5 --- /dev/null +++ b/berkshire-hathaway/2005/1-in/berkshire-hathaway-2005-letter.txt @@ -0,0 +1,30 @@ + + + + + + + +--IMPORTANT NOTE--
+The 2005 Chairman's Letter is presented in PDF format. To view the Chairman's Letter you must have Adobe Acrobat® Reader® software. If you do not have Adobe Acrobat® software on your computer, use the link to go to Adobe's web site for a free download. Adobe
+In his 2005 letter to shareholders, Mr. Buffett refers to an article which appeared in the December 2005 edition of RV Business Magazine.
+ + + diff --git a/berkshire-hathaway/2006/1-in/berkshire-hathaway-2006-letter.txt b/berkshire-hathaway/2006/1-in/berkshire-hathaway-2006-letter.txt new file mode 100644 index 0000000..7b2b997 --- /dev/null +++ b/berkshire-hathaway/2006/1-in/berkshire-hathaway-2006-letter.txt @@ -0,0 +1,29 @@ + + + + + + + +--IMPORTANT NOTE--
+The 2006 Chairman's Letter is presented in PDF format. To view the Chairman's Letter you must have Adobe Acrobat® Reader® software. If you do not have Adobe Acrobat® software on your computer, use the link to go to Adobe's web site for a free download. Adobe
+The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2008/1-in/berkshire-hathaway-2008-letter.txt b/berkshire-hathaway/2008/1-in/berkshire-hathaway-2008-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2008/1-in/berkshire-hathaway-2008-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2009/1-in/berkshire-hathaway-2009-letter.txt b/berkshire-hathaway/2009/1-in/berkshire-hathaway-2009-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2009/1-in/berkshire-hathaway-2009-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2010/1-in/berkshire-hathaway-2010-letter.txt b/berkshire-hathaway/2010/1-in/berkshire-hathaway-2010-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2010/1-in/berkshire-hathaway-2010-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2011/1-in/berkshire-hathaway-2011-letter.txt b/berkshire-hathaway/2011/1-in/berkshire-hathaway-2011-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2011/1-in/berkshire-hathaway-2011-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2012/1-in/berkshire-hathaway-2012-letter.txt b/berkshire-hathaway/2012/1-in/berkshire-hathaway-2012-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2012/1-in/berkshire-hathaway-2012-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2013/1-in/berkshire-hathaway-2013-letter.txt b/berkshire-hathaway/2013/1-in/berkshire-hathaway-2013-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2013/1-in/berkshire-hathaway-2013-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2014/1-in/berkshire-hathaway-2014-letter.txt b/berkshire-hathaway/2014/1-in/berkshire-hathaway-2014-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2014/1-in/berkshire-hathaway-2014-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2015/1-in/berkshire-hathaway-2015-letter.txt b/berkshire-hathaway/2015/1-in/berkshire-hathaway-2015-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2015/1-in/berkshire-hathaway-2015-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2016/1-in/berkshire-hathaway-2016-letter.txt b/berkshire-hathaway/2016/1-in/berkshire-hathaway-2016-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2016/1-in/berkshire-hathaway-2016-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2017/1-in/berkshire-hathaway-2017-letter.txt b/berkshire-hathaway/2017/1-in/berkshire-hathaway-2017-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2017/1-in/berkshire-hathaway-2017-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2018/1-in/berkshire-hathaway-2018-letter.txt b/berkshire-hathaway/2018/1-in/berkshire-hathaway-2018-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2018/1-in/berkshire-hathaway-2018-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2019/1-in/berkshire-hathaway-2019-letter.txt b/berkshire-hathaway/2019/1-in/berkshire-hathaway-2019-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2019/1-in/berkshire-hathaway-2019-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2020/1-in/berkshire-hathaway-2020-letter.txt b/berkshire-hathaway/2020/1-in/berkshire-hathaway-2020-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2020/1-in/berkshire-hathaway-2020-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2021/1-in/berkshire-hathaway-2021-letter.txt b/berkshire-hathaway/2021/1-in/berkshire-hathaway-2021-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2021/1-in/berkshire-hathaway-2021-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/2022/1-in/berkshire-hathaway-2022-letter.txt b/berkshire-hathaway/2022/1-in/berkshire-hathaway-2022-letter.txt new file mode 100644 index 0000000..321a551 --- /dev/null +++ b/berkshire-hathaway/2022/1-in/berkshire-hathaway-2022-letter.txt @@ -0,0 +1,9 @@ + + +The requested URL was not found on this server.
+Additionally, a 404 Not Found +error was encountered while trying to use an ErrorDocument to handle the request.
+ diff --git a/berkshire-hathaway/download-bh.sh b/berkshire-hathaway/download-bh.sh new file mode 100755 index 0000000..059a49e --- /dev/null +++ b/berkshire-hathaway/download-bh.sh @@ -0,0 +1,8 @@ +#!/bin/sh + +for ((i = 1983; i <= 2022; i ++)); +do + echo "Downloading Berkshire Hathaway letter for ${i}..." + mkdir -p ${i}/1-in + curl "https://www.berkshirehathaway.com/letters/${i}.html" -o ./${i}/1-in/berkshire-hathaway-${i}-letter.txt +done