diff --git a/berkshire-hathaway/1977/bh-1977-letter.txt b/berkshire-hathaway/1977/bh-1977-letter.txt new file mode 100644 index 0000000..e123536 --- /dev/null +++ b/berkshire-hathaway/1977/bh-1977-letter.txt @@ -0,0 +1,384 @@ +BERKSHIRE HATHAWAY INC. + + +To the Stockholders of Berkshire Hathaway Inc.: + + Operating earnings in 1977 of $21,904,000, or $22.54 per +share, were moderately better than anticipated a year ago. Of +these earnings, $1.43 per share resulted from substantial +realized capital gains by Blue Chip Stamps which, to the extent +of our proportional interest in that company, are included in our +operating earnings figure. Capital gains or losses realized +directly by Berkshire Hathaway Inc. or its insurance subsidiaries +are not included in our calculation of operating earnings. While +too much attention should not be paid to the figure for any +single year, over the longer term the record regarding aggregate +capital gains or losses obviously is of significance. + + Textile operations came in well below forecast, while the +results of the Illinois National Bank as well as the operating +earnings attributable to our equity interest in Blue Chip Stamps +were about as anticipated. However, insurance operations, led +again by the truly outstanding results of Phil Liesche’s +managerial group at National Indemnity Company, were even better +than our optimistic expectations. + + Most companies define “record” earnings as a new high in +earnings per share. Since businesses customarily add from year +to year to their equity base, we find nothing particularly +noteworthy in a management performance combining, say, a 10% +increase in equity capital and a 5% increase in earnings per +share. After all, even a totally dormant savings account will +produce steadily rising interest earnings each year because of +compounding. + + Except for special cases (for example, companies with +unusual debt-equity ratios or those with important assets carried +at unrealistic balance sheet values), we believe a more +appropriate measure of managerial economic performance to be +return on equity capital. In 1977 our operating earnings on +beginning equity capital amounted to 19%, slightly better than +last year and above both our own long-term average and that of +American industry in aggregate. But, while our operating +earnings per share were up 37% from the year before, our +beginning capital was up 24%, making the gain in earnings per +share considerably less impressive than it might appear at first +glance. + + We expect difficulty in matching our 1977 rate of return +during the forthcoming year. Beginning equity capital is up 23% +from a year ago, and we expect the trend of insurance +underwriting profit margins to turn down well before the end of +the year. Nevertheless, we expect a reasonably good year and our +present estimate, subject to the usual caveats regarding the +frailties of forecasts, is that operating earnings will improve +somewhat on a per share basis during 1978. + +Textile Operations + + The textile business again had a very poor year in 1977. We +have mistakenly predicted better results in each of the last two +years. This may say something about our forecasting abilities, +the nature of the textile industry, or both. Despite strenuous +efforts, problems in marketing and manufacturing have persisted. +Many difficulties experienced in the marketing area are due +primarily to industry conditions, but some of the problems have +been of our own making. + + A few shareholders have questioned the wisdom of remaining +in the textile business which, over the longer term, is unlikely +to produce returns on capital comparable to those available in +many other businesses. Our reasons are several: (1) Our mills in +both New Bedford and Manchester are among the largest employers +in each town, utilizing a labor force of high average age +possessing relatively non-transferable skills. Our workers and +unions have exhibited unusual understanding and effort in +cooperating with management to achieve a cost structure and +product mix which might allow us to maintain a viable operation. +(2) Management also has been energetic and straightforward in its +approach to our textile problems. In particular, Ken Chace’s +efforts after the change in corporate control took place in 1965 +generated capital from the textile division needed to finance the +acquisition and expansion of our profitable insurance operation. +(3) With hard work and some imagination regarding manufacturing +and marketing configurations, it seems reasonable that at least +modest profits in the textile division can be achieved in the +future. + +Insurance Underwriting + + Our insurance operation continued to grow significantly in +1977. It was early in 1967 that we made our entry into this +industry through the purchase of National Indemnity Company and +National Fire and Marine Insurance Company (sister companies) for +approximately $8.6 million. In that year their premium volume +amounted to $22 million. In 1977 our aggregate insurance premium +volume was $151 million. No additional shares of Berkshire +Hathaway stock have been issued to achieve any of this growth. + + Rather, this almost 600% increase has been achieved through +large gains in National Indemnity’s traditional liability areas +plus the starting of new companies (Cornhusker Casualty Company +in 1970, Lakeland Fire and Casualty Company in 1971, Texas United +Insurance Company in 1972, The Insurance Company of Iowa in 1973, +and Kansas Fire and Casualty Company in late 1977), the purchase +for cash of other insurance companies (Home and Automobile +Insurance Company in 1971, Kerkling Reinsurance Corporation, now +named Central Fire and Casualty Company, in 1976, and Cypress +Insurance Company at yearend 1977), and finally through the +marketing of additional products, most significantly reinsurance, +within the National Indemnity Company corporate structure. + + In aggregate, the insurance business has worked out very +well. But it hasn’t been a one-way street. Some major mistakes +have been made during the decade, both in products and personnel. +We experienced significant problems from (1) a surety operation +initiated in 1969, (2) the 1973 expansion of Home and +Automobile’s urban auto marketing into the Miami, Florida area, +(3) a still unresolved aviation “fronting” arrangement, and (4) +our Worker’s Compensation operation in California, which we +believe retains an interesting potential upon completion of a +reorganization now in progress. It is comforting to be in a +business where some mistakes can be made and yet a quite +satisfactory overall performance can be achieved. In a sense, +this is the opposite case from our textile business where even +very good management probably can average only modest results. +One of the lessons your management has learned - and, +unfortunately, sometimes re-learned - is the importance of being +in businesses where tailwinds prevail rather than headwinds. + + In 1977 the winds in insurance underwriting were squarely +behind us. Very large rate increases were effected throughout +the industry in 1976 to offset the disastrous underwriting +results of 1974 and 1975. But, because insurance policies +typically are written for one-year periods, with pricing mistakes +capable of correction only upon renewal, it was 1977 before the +full impact was felt upon earnings of those earlier rate +increases. + + The pendulum now is beginning to swing the other way. We +estimate that costs involved in the insurance areas in which we +operate rise at close to 1% per month. This is due to continuous +monetary inflation affecting the cost of repairing humans and +property, as well as “social inflation”, a broadening definition +by society and juries of what is covered by insurance policies. +Unless rates rise at a comparable 1% per month, underwriting +profits must shrink. Recently the pace of rate increases has +slowed dramatically, and it is our expectation that underwriting +margins generally will be declining by the second half of the +year. + + We must again give credit to Phil Liesche, greatly assisted +by Roland Miller in Underwriting and Bill Lyons in Claims, for an +extraordinary underwriting achievement in National Indemnity’s +traditional auto and general liability business during 1977. +Large volume gains have been accompanied by excellent +underwriting margins following contraction or withdrawal by many +competitors in the wake of the 1974-75 crisis period. These +conditions will reverse before long. In the meantime, National +Indemnity’s underwriting profitability has increased dramatically +and, in addition, large sums have been made available for +investment. As markets loosen and rates become inadequate, we +again will face the challenge of philosophically accepting +reduced volume. Unusual managerial discipline will be required, +as it runs counter to normal institutional behavior to let the +other fellow take away business - even at foolish prices. + + Our reinsurance department, managed by George Young, +improved its underwriting performance during 1977. Although the +combined ratio (see definition on page 12) of 107.1 was +unsatisfactory, its trend was downward throughout the year. In +addition, reinsurance generates unusually high funds for +investment as a percentage of premium volume. + + At Home and Auto, John Seward continued to make progress on +all fronts. John was a battlefield promotion several years ago +when Home and Auto’s underwriting was awash in red ink and the +company faced possible extinction. Under his management it +currently is sound, profitable, and growing. + + John Ringwalt’s homestate operation now consists of five +companies, with Kansas Fire and Casualty Company becoming +operational late in 1977 under the direction of Floyd Taylor. +The homestate companies had net premium volume of $23 million, up +from $5.5 million just three years ago. All four companies that +operated throughout the year achieved combined ratios below 100, +with Cornhusker Casualty Company, at 93.8, the leader. In +addition to actively supervising the other four homestate +operations, John Ringwalt manages the operations of Cornhusker +which has recorded combined ratios below 100 in six of its seven +full years of existence and, from a standing start in 1970, has +grown to be one of the leading insurance companies operating in +Nebraska utilizing the conventional independent agency system. +Lakeland Fire and Casualty Company, managed by Jim Stodolka, was +the winner of the Chairman’s Cup in 1977 for achieving the lowest +loss ratio among the homestate companies. All in all, the +homestate operation continues to make excellent progress. + + The newest addition to our insurance group is Cypress +Insurance Company of South Pasadena, California. This Worker’s +Compensation insurer was purchased for cash in the final days of +1977 and, therefore, its approximate $12.5 million of volume for +that year was not included in our results. Cypress and National +Indemnity’s present California Worker’s Compensation operation +will not be combined, but will operate independently utilizing +somewhat different marketing strategies. Milt Thornton, +President of Cypress since 1968, runs a first-class operation for +policyholders, agents, employees and owners alike. We look +forward to working with him. + + Insurance companies offer standardized policies which can be +copied by anyone. Their only products are promises. It is not +difficult to be licensed, and rates are an open book. There are +no important advantages from trademarks, patents, location, +corporate longevity, raw material sources, etc., and very little +consumer differentiation to produce insulation from competition. +It is commonplace, in corporate annual reports, to stress the +difference that people make. Sometimes this is true and +sometimes it isn’t. But there is no question that the nature of +the insurance business magnifies the effect which individual +managers have on company performance. We are very fortunate to +have the group of managers that are associated with us. + +Insurance Investments + + During the past two years insurance investments at cost +(excluding the investment in our affiliate, Blue Chip Stamps) +have grown from $134.6 million to $252.8 million. Growth in +insurance reserves, produced by our large gain in premium volume, +plus retained earnings, have accounted for this increase in +marketable securities. In turn, net investment income of the +Insurance Group has improved from $8.4 million pre-tax in 1975 to +$12.3 million pre-tax in 1977. + + In addition to this income from dividends and interest, we +realized capital gains of $6.9 million before tax, about one- +quarter from bonds and the balance from stocks. Our unrealized +gain in stocks at yearend 1977 was approximately $74 million but +this figure, like any other figure of a single date (we had an +unrealized loss of $17 million at the end of 1974), should not be +taken too seriously. Most of our large stock positions are going +to be held for many years and the scorecard on our investment +decisions will be provided by business results over that period, +and not by prices on any given day. Just as it would be foolish +to focus unduly on short-term prospects when acquiring an entire +company, we think it equally unsound to become mesmerized by +prospective near term earnings or recent trends in earnings when +purchasing small pieces of a company; i.e., marketable common +stocks. + + A little digression illustrating this point may be +interesting. Berkshire Fine Spinning Associates and Hathaway +Manufacturing were merged in 1955 to form Berkshire Hathaway Inc. +In 1948, on a pro forma combined basis, they had earnings after +tax of almost $18 million and employed 10,000 people at a dozen +large mills throughout New England. In the business world of +that period they were an economic powerhouse. For example, in +that same year earnings of IBM were $28 million (now $2.7 +billion), Safeway Stores, $10 million, Minnesota Mining, $13 +million, and Time, Inc., $9 million. But, in the decade +following the 1955 merger aggregate sales of $595 million +produced an aggregate loss for Berkshire Hathaway of $10 million. +By 1964 the operation had been reduced to two mills and net worth +had shrunk to $22 million, from $53 million at the time of the +merger. So much for single year snapshots as adequate portrayals +of a business. + + Equity holdings of our insurance companies with a market +value of over $5 million on December 31, 1977 were as follows: + + (Thousands omitted) + +[TABLE] +No. of Shares Company Cost Market + 220,000 Capital Cities Communications, Inc. ..... $ 10,909 $ 13,228 + 1,986,953 Government Employees Insurance + Company Convertible Preferred ........ 19,417 33,033 + 1,294,308 Government Employees Insurance + Company Common Stock ................. 4,116 10,516 + 592,650 The Interpublic Group of Companies, Inc. 4,531 17,187 + 324,580 Kaiser Aluminum& Chemical Corporation ... 11,218 9,981 + 1,305,800 Kaiser Industries, Inc. ................. 778 6,039 + 226,900 Knight-Ridder Newspapers, Inc. .......... 7,534 8,736 + 170,800 Ogilvy & Mather International, Inc. ..... 2,762 6,960 + 934,300 The Washington Post Company Class B ..... 10,628 33,401 + n/a Total ................................... $ 71,893 $139,081 + n/a All Other Holdings ...................... 34,996 41,992 + n/a Total Equities .......................... $106,889 $181,073 +[/TABLE] + + We select our marketable equity securities in much the same +way we would evaluate a business for acquisition in its entirety. +We want the business to be (1) one that we can understand, (2) +with favorable long-term prospects, (3) operated by honest and +competent people, and (4) available at a very attractive price. +We ordinarily make no attempt to buy equities for anticipated +favorable stock price behavior in the short term. In fact, if +their business experience continues to satisfy us, we welcome +lower market prices of stocks we own as an opportunity to acquire +even more of a good thing at a better price. + + Our experience has been that pro-rata portions of truly +outstanding businesses sometimes sell in the securities markets +at very large discounts from the prices they would command in +negotiated transactions involving entire companies. +Consequently, bargains in business ownership, which simply are +not available directly through corporate acquisition, can be +obtained indirectly through stock ownership. When prices are +appropriate, we are willing to take very large positions in +selected companies, not with any intention of taking control and +not foreseeing sell-out or merger, but with the expectation that +excellent business results by corporations will translate over +the long term into correspondingly excellent market value and +dividend results for owners, minority as well as majority. + + Such investments initially may have negligible impact on our +operating earnings. For example, we invested $10.9 million in +Capital Cities Communications during 1977. Earnings attributable +to the shares we purchased totaled about $1.3 million last year. +But only the cash dividend, which currently provides $40,000 +annually, is reflected in our operating earnings figure. + + Capital Cities possesses both extraordinary properties and +extraordinary management. And these management skills extend +equally to operations and employment of corporate capital. To +purchase, directly, properties such as Capital Cities owns would +cost in the area of twice our cost of purchase via the stock +market, and direct ownership would offer no important advantages +to us. While control would give us the opportunity - and the +responsibility - to manage operations and corporate resources, we +would not be able to provide management in either of those +respects equal to that now in place. In effect, we can obtain a +better management result through non-control than control. This +is an unorthodox view, but one we believe to be sound. + +Banking + + In 1977 the Illinois National Bank continued to achieve a +rate of earnings on assets about three times that of most large +banks. As usual, this record was achieved while the bank paid +maximum rates to savers and maintained an asset position +combining low risk and exceptional liquidity. Gene Abegg formed +the bank in 1931 with $250,000. In its first full year of +operation, earnings amounted to $8,782. Since that time, no new +capital has been contributed to the bank; on the contrary, since +our purchase in 1969, dividends of $20 million have been paid. +Earnings in 1977 amounted to $3.6 million, more than achieved by +many banks two or three times its size. + + Late last year Gene, now 80 and still running a banking +operation without peer, asked that a successor be brought in. +Accordingly, Peter Jeffrey, formerly President and Chief +Executive Officer of American National Bank of Omaha, has joined +the Illinois National Bank effective March 1st as President and +Chief Executive Officer. + + Gene continues in good health as Chairman. We expect a +continued successful operation at Rockford’s leading bank. + +Blue Chip Stamps + + We again increased our equity interest in Blue Chip Stamps, +and owned approximately 36 1/2% at the end of 1977. Blue Chip +had a fine year, earning approximately $12.9 million from +operations and, in addition, had realized securities gains of +$4.1 million. + + Both Wesco Financial Corp., an 80% owned subsidiary of Blue +Chip Stamps, managed by Louis Vincenti, and See’s Candies, a 99% +owned subsidiary, managed by Chuck Huggins, made good progress in +1977. Since See’s was purchased by Blue Chip Stamps at the +beginning of 1972, pre-tax operating earnings have grown from +$4.2 million to $12.6 million with little additional capital +investment. See’s achieved this record while operating in an +industry experiencing practically no unit growth. Shareholders +of Berkshire Hathaway Inc. may obtain the annual report of Blue +Chip Stamps by requesting it from Mr. Robert H. Bird, Blue Chip +Stamps, 5801 South Eastern Avenue, Los Angeles, California 90040. + + + Warren E. Buffett, Chairman + +March 14,1978 + +