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1341 lines
76 KiB
1341 lines
76 KiB
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<HEAD>
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<TITLE>Chairman's Letter - 1996</title>
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<P ALIGN=CENTER>
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<B>BERKSHIRE HATHAWAY INC.</B>
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<P ALIGN=CENTER>
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<B>Chairman's Letter</B>
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</P>
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<PRE>
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<B>To the Shareholders of Berkshire Hathaway Inc.:</B>
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Our gain in net worth during 1996 was $6.2 billion, or 36.1%. Per-
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share book value, however, grew by less, 31.8%, because the number of
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Berkshire shares increased: We issued stock in acquiring FlightSafety
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International and also sold new Class B shares.* Over the last 32 years
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(that is, since present management took over) per-share book value has
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grown from $19 to $19,011, or at a rate of 23.8% compounded annually.
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<I>
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* Each Class B share has an economic interest equal to 1/30th of
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that possessed by a Class A share, which is the new designation for
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the only stock that Berkshire had outstanding before May 1996.
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Throughout this report, we state all per-share figures in terms of
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"Class A equivalents," which are the sum of the Class A shares
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outstanding and 1/30th of the Class B shares outstanding.
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</I>
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For technical reasons, we have restated our 1995 financial
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statements, a matter that requires me to present one of my less-than-
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thrilling explanations of accounting arcana. I'll make it brief.
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The restatement was required because GEICO became a wholly-owned
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subsidiary of Berkshire on January 2, 1996, whereas it was previously
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classified as an investment. From an economic viewpoint - taking into
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account major tax efficiencies and other benefits we gained - the value
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of the 51% of GEICO we owned at year-end 1995 <I>increased</I> significantly
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when we acquired the remaining 49% of the company two days later.
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Accounting rules applicable to this type of "step acquisition," however,
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required us to <I>write down</I> the value of our 51% at the time we moved to
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100%. That writedown - which also, of course, reduced book value -
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amounted to $478.4 million. As a result, we now carry our original 51%
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of GEICO at a value that is both lower than its market value at the time
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we purchased the remaining 49% of the company and lower than the value at
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which we carry that 49% itself.
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There is an offset, however, to the reduction in book value I have
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just described: Twice during 1996 we issued Berkshire shares at a
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premium to book value, first in May when we sold the B shares for cash
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and again in December when we used both A and B shares as part-payment
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for FlightSafety. In total, the three non-operational items affecting
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book value contributed less than one percentage point to our 31.8% per-
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share gain last year.
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I dwell on this rise in per-share book value because it roughly
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indicates our economic progress during the year. But, as Charlie Munger,
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Berkshire's Vice Chairman, and I have repeatedly told you, what counts at
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Berkshire is intrinsic value, not book value. The last time you got that
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message from us was in the Owner's Manual, sent to you in June after we
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issued the Class B shares. In that manual, we not only defined certain
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key terms - such as intrinsic value - but also set forth our economic
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principles.
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For many years, we have listed these principles in the front of our
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annual report, but in this report, on pages 58 to 67, we reproduce the
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entire Owner's Manual. In this letter, we will occasionally refer to the
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manual so that we can avoid repeating certain definitions and
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explanations. For example, if you wish to brush up on "intrinsic value,"
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see pages 64 and 65.
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Last year, for the first time, we supplied you with a table that
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Charlie and I believe will help anyone trying to estimate Berkshire's
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intrinsic value. In the updated version of that table, which follows, we
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trace two key indices of value. The first column lists our per-share
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ownership of investments (including cash and equivalents) and the second
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column shows our per-share earnings from Berkshire's operating businesses
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before taxes and purchase-accounting adjustments but after all interest
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and corporate overhead expenses. The operating-earnings column excludes
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all dividends, interest and capital gains that we realized from the
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investments presented in the first column. In effect, the two columns
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show what Berkshire would have reported had it been broken into two parts.
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Pre-tax Earnings Per Share
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Investments Excluding All Income from
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Year Per Share Investments
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---- ----------- -------------------------
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1965................................$ 4 $ 4.08
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1975................................ 159 (6.48)
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1985................................ 2,443 18.86
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1995................................ 22,088 258.20
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1996................................ 28,500 421.39
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Annual Growth Rate, 1965-95......... 33.4% 14.7%
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One-Year Growth Rate, 1995-96 ...... 29.0% 63.2%
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As the table tells you, our investments per share increased in 1996
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by 29.0% and our non-investment earnings grew by 63.2%. Our goal is to
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keep the numbers in both columns moving ahead at a reasonable (or, better
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yet, unreasonable) pace.
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Our expectations, however, are tempered by two realities. First,
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our past rates of growth cannot be matched nor even approached:
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Berkshire's equity capital is now large - in fact, fewer than ten
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businesses in America have capital larger - and an abundance of funds
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tends to dampen returns. Second, whatever our rate of progress, it will
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not be smooth: Year-to-year moves in the first column of the table above
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will be influenced in a major way by fluctuations in securities markets;
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the figures in the second column will be affected by wide swings in the
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profitability of our catastrophe-reinsurance business.
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In the table, the donations made pursuant to our shareholder-
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designated contributions program are charged against the second column,
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though we view them as a shareholder benefit rather than as an expense.
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All other corporate expenses are also charged against the second column.
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These costs may be lower than those of any other large American
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corporation: Our after-tax headquarters expense amounts to less than two
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basis points (1/50th of 1%) measured against net worth. Even so, Charlie
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used to think this expense percentage outrageously high, blaming it on my
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use of Berkshire's corporate jet,<I> The Indefensible</I>. But Charlie has
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recently experienced a "counter-revelation": With our purchase of
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FlightSafety, whose major activity is the training of corporate pilots,
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he now rhapsodizes at the mere mention of jets.
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Seriously, costs matter. For example, equity mutual funds incur
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corporate expenses - largely payments to the funds' managers - that
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average about 100 basis points, a levy likely to cut the returns their
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investors earn by 10% or more over time. Charlie and I make no promises
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about Berkshire's results. We do promise you, however, that virtually
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all of the gains Berkshire makes will end up with shareholders. We are
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here to make money with you, not off you.
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<B>The Relationship of Intrinsic Value to Market Price</B>
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In last year's letter, with Berkshire shares selling at $36,000, I
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told you: (1) Berkshire's gain in market value in recent years had
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outstripped its gain in intrinsic value, even though the latter gain had
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been highly satisfactory; (2) that kind of overperformance could not
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continue indefinitely; (3) Charlie and I did not at that moment consider
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Berkshire to be undervalued.
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Since I set down those cautions, Berkshire's intrinsic value has
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increased very significantly - aided in a major way by a stunning
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performance at GEICO that I will tell you more about later - while the
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market price of our shares has changed little. This, of course, means
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that in 1996 Berkshire's stock underperformed the business.
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Consequently, today's price/value relationship is both much different
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from what it was a year ago and, as Charlie and I see it, more
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appropriate.
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Over time, the aggregate gains made by Berkshire shareholders must
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of necessity match the business gains of the company. When the stock
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temporarily overperforms or underperforms the business, a limited number
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of shareholders - either sellers or buyers - receive outsized benefits at
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the expense of those they trade with. Generally, the sophisticated have
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an edge over the innocents in this game.
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Though our primary goal is to maximize the amount that our
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shareholders, in total, reap from their ownership of Berkshire, we wish
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also to minimize the benefits going to some shareholders at the expense
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of others. These are goals we would have were we managing a family
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partnership, and we believe they make equal sense for the manager of a
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public company. In a partnership, fairness requires that partnership
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interests be valued equitably when partners enter or exit; in a public
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company, fairness prevails when market price and intrinsic value are in
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sync. Obviously, they won't always meet that ideal, but a manager - by
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his policies and communications - can do much to foster equity.
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Of course, the longer a shareholder holds his shares, the more
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bearing Berkshire's business results will have on his financial
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experience - and the less it will matter what premium or discount to
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intrinsic value prevails when he buys and sells his stock. That's one
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reason we hope to attract owners with long-term horizons. Overall, I
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think we have succeeded in that pursuit. Berkshire probably ranks number
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one among large American corporations in the percentage of its shares
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held by owners with a long-term view.
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<B>Acquisitions of 1996</B>
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We made two acquisitions in 1996, both possessing exactly the
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qualities we seek - excellent business economics and an outstanding
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manager.
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The first acquisition was Kansas Bankers Surety (KBS), an insurance
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company whose name describes its specialty. The company, which does
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business in 22 states, has an extraordinary underwriting record, achieved
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through the efforts of Don Towle, an extraordinary manager. Don has
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developed first-hand relationships with hundreds of bankers and knows
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every detail of his operation. He thinks of himself as running a company
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that is "his," an attitude we treasure at Berkshire. Because of its
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relatively small size, we placed KBS with Wesco, our 80%-owned
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subsidiary, which has wanted to expand its insurance operations.
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You might be interested in the carefully-crafted and sophisticated
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acquisition strategy that allowed Berkshire to nab this deal. Early in
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1996 I was invited to the 40th birthday party of my nephew's wife, Jane
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Rogers. My taste for social events being low, I immediately, and in my
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standard, gracious way, began to invent reasons for skipping the event.
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The party planners then countered brilliantly by offering me a seat next
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to a man I always enjoy, Jane's dad, Roy Dinsdale - so I went.
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The party took place on January 26. Though the music was loud - Why
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must bands play as if they will be paid by the decibel? - I just managed
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to hear Roy say he'd come from a directors meeting at Kansas Bankers
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Surety, a company I'd always admired. I shouted back that he should let
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me know if it ever became available for purchase.
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On February 12, I got the following letter from Roy: "Dear Warren:
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Enclosed is the annual financial information on Kansas Bankers Surety.
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This is the company that we talked about at Janie's party. If I can be
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of any further help, please let me know." On February 13, I told Roy we
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would pay $75 million for the company - and before long we had a deal.
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I'm now scheming to get invited to Jane's next party.
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Our other acquisition in 1996 - FlightSafety International, the
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world's leader in the training of pilots - was far larger, at about $1.5
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billion, but had an equally serendipitous origin. The heroes of this
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story are first, Richard Sercer, a Tucson aviation consultant, and
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second, his wife, Alma Murphy, an ophthalmology graduate of Harvard
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Medical School, who in 1990 wore down her husband's reluctance and got
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him to buy Berkshire stock. Since then, the two have attended all our
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Annual Meetings, but I didn't get to know them personally.
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Fortunately, Richard had also been a long-time shareholder of
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FlightSafety, and it occurred to him last year that the two companies
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would make a good fit. He knew our acquisition criteria, and he thought
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that Al Ueltschi, FlightSafety's 79-year-old CEO, might want to make a
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deal that would both give him a home for his company and a security in
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payment that he would feel comfortable owning throughout his lifetime.
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So in July, Richard wrote Bob Denham, CEO of Salomon Inc, suggesting that
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he explore the possibility of a merger.
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Bob took it from there, and on September 18, Al and I met in New
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York. I had long been familiar with FlightSafety's business, and in
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about 60 seconds I knew that Al was exactly our kind of manager. A month
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later, we had a contract. Because Charlie and I wished to minimize the
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issuance of Berkshire shares, the transaction we structured gave
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FlightSafety shareholders a choice of cash or stock but carried terms
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that encouraged those who were tax-indifferent to take cash. This nudge
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led to about 51% of FlightSafety's shares being exchanged for cash, 41%
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for Berkshire A and 8% for Berkshire B.
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Al has had a lifelong love affair with aviation and actually piloted
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Charles Lindbergh. After a barnstorming career in the 1930s, he began
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working for Juan Trippe, Pan Am's legendary chief. In 1951, while still
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at Pan Am, Al founded FlightSafety, subsequently building it into a
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simulator manufacturer and a worldwide trainer of pilots (single-engine,
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helicopter, jet and marine). The company operates in 41 locations,
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outfitted with 175 simulators of planes ranging from the very small, such
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as Cessna 210s, to Boeing 747s. Simulators are not cheap - they can cost
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as much as $19 million - so this business, unlike many of our
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operations, is capital intensive. About half of the company's revenues
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are derived from the training of corporate pilots, with most of the
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balance coming from airlines and the military.
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Al may be 79, but he looks and acts about 55. He will run
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operations just as he has in the past: We never fool with success. I
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have told him that though we don't believe in splitting Berkshire stock,
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we will split his age 2-for-1 when he hits 100.
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An observer might conclude from our hiring practices that Charlie
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and I were traumatized early in life by an EEOC bulletin on age
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discrimination. The real explanation, however, is self-interest: It's
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difficult to teach a new dog old tricks. The many Berkshire managers who
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are past 70 hit home runs today at the same pace that long ago gave them
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reputations as young slugging sensations. Therefore, to get a job with
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us, just employ the tactic of the 76-year-old who persuaded a dazzling
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beauty of 25 to marry him. "How did you ever get her to accept?" asked
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his envious contemporaries. The comeback: "I told her I was 86."
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<B> * * * * * * * * * * * *</B>
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And now we pause for our usual commercial: If you own a large
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business with good economic characteristics and wish to become associated
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with an exceptional collection of businesses having similar
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characteristics, Berkshire may well be the home you seek. Our
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requirements are set forth on page 21. If your company meets them - and
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if I fail to make the next birthday party you attend - give me a call.
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<B>Insurance Operations - Overview</B>
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Our insurance business was terrific in 1996. In both primary
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insurance, where GEICO is our main unit, and in our "super-cat"
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reinsurance business, results were outstanding.
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As we've explained in past reports, what counts in our insurance
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business is, first, the amount of "float" we generate and, second, its
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cost to us. These are matters that are important for you to understand
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because float is a major component of Berkshire's intrinsic value that is
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not reflected in book value.
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To begin with, float is money we hold but don't own. In an
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insurance operation, float arises because premiums are received before
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losses are paid. Secondly, the premiums that an insurer takes in
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typically do not cover the losses and expenses it eventually must pay.
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That leaves it running an "underwriting loss," which is the cost of
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float. An insurance business has value if its cost of float over time is
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less than the cost the company would otherwise incur to obtain funds.
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But the business is an albatross if the cost of its float is higher than
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market rates for money.
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As the numbers in the following table show, Berkshire's insurance
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business has been a huge winner. For the table, we have calculated our
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float - which we generate in large amounts relative to our premium
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volume - by adding loss reserves, loss adjustment reserves, funds held
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under reinsurance assumed and unearned premium reserves, and then
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subtracting agents' balances, prepaid acquisition costs, prepaid taxes
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and deferred charges applicable to assumed reinsurance. Our cost of
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float is determined by our underwriting loss or profit. In those years
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when we have had an underwriting profit, such as the last four, our cost
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of float has been negative. In effect, we have been paid for holding
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money.
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(1) (2) Yearend Yield
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Underwriting Approximat on Long-Term
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Loss Average Float Cost of Funds Govt. Bonds
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------------ ------------- ---------------- -------------
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(In $ Millions) (Ratio of 1 to 2)
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1967.......... profit 17.3 less than zero 5.50%
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1968.......... profit 19.9 less than zero 5.90%
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1969.......... profit 23.4 less than zero 6.79%
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1970.......... 0.37 32.4 1.14% 6.25%
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1971.......... profit 52.5 less than zero 5.81%
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1972.......... profit 69.5 less than zero 5.82%
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1973.......... profit 73.3 less than zero 7.27%
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1974.......... 7.36 79.1 9.30% 8.13%
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1975.......... 11.35 87.6 12.96% 8.03%
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1976.......... profit 102.6 less than zero 7.30%
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1977.......... profit 139.0 less than zero 7.97%
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1978.......... profit 190.4 less than zero 8.93%
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1979.......... profit 227.3 less than zero 10.08%
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1980.......... profit 237.0 less than zero 11.94%
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1981.......... profit 228.4 less than zero 13.61%
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1982.......... 21.56 220.6 9.77% 10.64%
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1983.......... 33.87 231.3 14.64% 11.84%
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1984.......... 48.06 253.2 18.98% 11.58%
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1985.......... 44.23 390.2 11.34% 9.34%
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1986.......... 55.84 797.5 7.00% 7.60%
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1987.......... 55.43 1,266.7 4.38% 8.95%
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1988.......... 11.08 1,497.7 0.74% 9.00%
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1989.......... 24.40 1,541.3 1.58% 7.97%
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1990.......... 26.65 1,637.3 1.63% 8.24%
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1991.......... 119.59 1,895.0 6.31% 7.40%
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1992.......... 108.96 2,290.4 4.76% 7.39%
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1993.......... profit 2,624.7 less than zero 6.35%
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1994.......... profit 3,056.6 less than zero 7.88%
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1995.......... profit 3,607.2 less than zero 5.95%
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1996.......... profit 6,702.0 less than zero 6.64%
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Since 1967, when we entered the insurance business, our float has
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grown at an annual compounded rate of 22.3%. In more years than not, our
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cost of funds has been less than nothing. This access to "free" money has
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boosted Berkshire's performance in a major way. Moreover, our acquisition
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of GEICO materially increases the probability that we can continue to
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obtain "free" funds in increasing amounts.
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<B>Super-Cat Insurance</B>
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As in the past three years, we once again stress that the good results
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we are reporting for Berkshire stem in part from our super-cat business
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having a lucky year. In this operation, we sell policies that insurance
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and reinsurance companies buy to protect themselves from the effects of
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mega-catastrophes. Since truly major catastrophes are rare occurrences,
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our super-cat business can be expected to show large profits in most years
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- and to record a huge loss occasionally. In other words, the
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attractiveness of our super-cat business will take a great many years to
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measure. <I> What you must understand, however, is that a truly terrible year
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in the super-cat business is not a possibility - it's a certainty. The
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only question is when it will come.</I>
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I emphasize this lugubrious point because I would not want you to
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panic and sell your Berkshire stock upon hearing that some large
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catastrophe had cost us a significant amount. If you would tend to react
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that way, you should not own Berkshire shares now, just as you should
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entirely avoid owning stocks if a crashing market would lead you to panic
|
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and sell. Selling fine businesses on "scary" news is usually a bad
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decision. (Robert Woodruff, the business genius who built Coca-Cola over
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many decades and who owned a huge position in the company, was once asked
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when it might be a good time to sell Coke stock. Woodruff had a simple
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answer: "I don't know. I've never sold any.")
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In our super-cat operation, our customers are insurers that are
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exposed to major earnings volatility and that wish to reduce it. The
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product we sell - for what we hope is an appropriate price - is our
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willingness to shift that volatility to our own books. Gyrations in
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Berkshire's earnings don't bother us in the least: Charlie and I would
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much rather earn a lumpy 15% over time than a smooth 12%. (After all, our
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earnings swing wildly on a daily and weekly basis - why should we demand
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that smoothness accompany each orbit that the earth makes of the sun?) We
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are most comfortable with that thinking, however, when we have
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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<I> then</I> 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.
|
|
|
|
|
|
<B>Insurance - GEICO and Other Primary Operations</B>
|
|
|
|
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. <I> Everyone</I> 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.
|
|
|
|
<B> * * * * * * * * * * * *</B>
|
|
|
|
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.
|
|
|
|
|
|
<B>Taxes</B>
|
|
|
|
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 $860 million in income taxes to the U.S.
|
|
Treasury.
|
|
|
|
Here's a little perspective on that figure: If an equal amount had
|
|
been paid by only 2,000 other taxpayers, the government would have had a
|
|
balanced budget in 1996 without needing a dime of taxes - income or Social
|
|
Security or what have you - from <I>any</I> other American. Berkshire
|
|
shareholders can truly say, "I gave at the office."
|
|
|
|
Charlie and I believe that large tax payments by Berkshire are
|
|
entirely fitting. The contribution we thus make to society's well-being is
|
|
at most only proportional to its contribution to ours. Berkshire prospers
|
|
in America as it would nowhere else.
|
|
|
|
|
|
<B>Sources of Reported Earnings</B>
|
|
|
|
The table that follows shows the main sources of Berkshire's reported
|
|
earnings. In this presentation, purchase-accounting adjustments are not
|
|
assigned to the specific businesses to which they apply, but are instead
|
|
aggregated and shown separately. This procedure lets you view the earnings
|
|
of our businesses as they would have been reported had we not purchased
|
|
them. For the reasons discussed on pages 65 and 66, this form of
|
|
presentation seems to us to be more useful to investors and managers than
|
|
one utilizing generally-accepted accounting principles (GAAP), which
|
|
require purchase-premiums to be charged off business-by-business. The
|
|
total earnings we show in the table are, of course, identical to the GAAP
|
|
total in our audited financial statements.
|
|
|
|
|
|
|
|
<I> (in millions)
|
|
--------------------------------------
|
|
Berkshire's Share
|
|
of Net Earnings
|
|
(after taxes and
|
|
Pre-tax Earnings minority interests)
|
|
</I> ---------------- -------------------
|
|
1996 1995(1) 1996 1995(1)
|
|
------- -------- ------- -------
|
|
Operating Earnings:
|
|
Insurance Group:
|
|
Underwriting.....................$ 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
|
|
======= ======== ======== =======
|
|
<I>
|
|
(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.
|
|
</I>
|
|
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.
|
|
|
|
<B>"Look-Through" Earnings</B>
|
|
|
|
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
|
|
|
|
|
|
<B>Common Stock Investments</B>
|
|
|
|
Below we present our common stock investments. Those with a market
|
|
value of more than $500 million are itemized.
|
|
|
|
12/31/96
|
|
<I> Shares Company Cost* Market</I>
|
|
----------- --------------------------------- -------- ---------
|
|
(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
|
|
======== =========
|
|
|
|
<I> * Represents tax-basis cost which, in aggregate, is $1.2 billion
|
|
less than GAAP cost.
|
|
</I>
|
|
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
|
|
<I>you</I> 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.
|
|
<B>
|
|
* * * * * * * * * * * *
|
|
</B>
|
|
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.
|
|
|
|
|
|
<B>USAir</B>
|
|
|
|
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.
|
|
|
|
|
|
<B>Financings</B>
|
|
|
|
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.
|
|
|
|
|
|
<B>Miscellaneous</B>
|
|
|
|
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.
|
|
|
|
<B> * * * * * * * * * * * *</B>
|
|
|
|
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.
|
|
|
|
<I> 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.</I>
|
|
|
|
|
|
<B>The Annual Meeting</B>
|
|
|
|
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
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rooms. This year, our new Class B shares have caused a doubling of our
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stockholder count, and we are therefore moving the meeting to the
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Aksarben Coliseum, which holds about 10,000 and also has a huge parking
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lot. The doors will open for the meeting at 7:00 a.m., and at 8:30 we
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will - upon popular demand - show a new Berkshire movie produced by Marc
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Hamburg, our CFO. (In this company, no one gets by with doing only a
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single job.)
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Overcoming our legendary repugnance for activities even faintly
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commercial, we will also have an abundant array of Berkshire products<I> for
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sale</I> in the halls outside the meeting room. Last year we broke all
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records, selling 1,270 pounds of See's candy, 1,143 pairs of Dexter
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shoes, $29,000 of World Books and related publications, and 700 sets of
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knives manufactured by our Quikut subsidiary. Additionally, many
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shareholders made inquiries about GEICO auto policies. If you would like
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to investigate possible insurance savings, bring your present policy to
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the meeting. We estimate that about 40% of our shareholders can save
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money by insuring with us. (We'd like to say 100%, but the insurance
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business doesn't work that way: Because insurers differ in their
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underwriting judgments, some of our shareholders are currently paying
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rates that are lower than GEICO's.)
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An attachment to the proxy material enclosed with this report
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explains how you can obtain the card you will need for admission to the
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meeting. We expect a large crowd, so get both plane and hotel
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reservations promptly. American Express (800-799-6634) will be happy to
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help you with arrangements. As usual, we will have buses servicing the
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larger hotels to take you to and from the meeting, and also to take you
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to Nebraska Furniture Mart, Borsheim's and the airport after it is over.
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NFM's main store, located on a 75-acre site about a mile from
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Aksarben, is open from 10 a.m. to 9 p.m. on weekdays, 10 a.m. to 6 p.m.
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on Saturdays, and noon to 6 p.m. on Sundays. Come by and say hello to
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"Mrs. B" (Rose Blumkin). She's 103 now and sometimes operates with an
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oxygen mask that is attached to a tank on her cart. But if you try to
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keep pace with her, it will be you who needs oxygen. NFM did about $265
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|
million of business last year - a record for a single-location home
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furnishings operation - and you'll see why once you check out its
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merchandise and prices.
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Borsheim's normally is closed on Sunday but will be open for
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shareholders from 10 a.m. to 6 p.m. on May 4th. Last year on
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"Shareholder Sunday" we broke every Borsheim's record in terms of
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tickets, dollar volume and, no doubt, attendees per square inch. Because
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we expect a capacity crowd this year as well, all shareholders attending
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|
on Sunday must bring their admission cards. Shareholders who prefer a
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somewhat less frenzied experience will get the same special treatment on
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Saturday, when the store is open from 10 a.m. to 5:30 p.m., or on Monday
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|
between 10 a.m. and 8 p.m. Come by at any time this year and let Susan
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Jacques, Borsheim's CEO, and her skilled associates perform a painless
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walletectomy on you.
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My favorite steakhouse, Gorat's, was sold out last year on the
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weekend of the annual meeting, even though it added an additional seating
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at 4 p.m. on Sunday. You can make reservations beginning on April 1st
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<I>(but not earlier)</I> by calling 402-551-3733. I will be at Gorat's on
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Sunday after Borsheim's, having my usual rare T-bone and double order of
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hashbrowns. I can also recommend - this is the standard fare when Debbie
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Bosanek, my invaluable assistant, and I go to lunch - the hot roast beef
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|
sandwich with mashed potatoes and gravy. Mention Debbie's name and you
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|
will be given an extra boat of gravy.
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The Omaha Royals and Indianapolis Indians will play baseball on
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Saturday evening, May 3rd, at Rosenblatt Stadium. Pitching in my normal
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rotation - one throw a year - I will start.
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Though Rosenblatt is normal in appearance, it is anything but: The
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|
field sits on a unique geological structure that occasionally emits short
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|
gravitational waves causing even the most smoothly-delivered pitch to
|
|
sink violently. I have been the victim of this weird phenomenon several
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|
times in the past but am hoping for benign conditions this year. There
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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.
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Our proxy statement includes information about obtaining tickets to
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|
the game. We will also provide an information packet listing restaurants
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that will be open on Sunday night and describing various things that you
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|
can do in Omaha on the weekend. The entire gang at Berkshire looks
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forward to seeing you.
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Warren E. Buffett
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February 28, 1997 Chairman of the Board
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