You can not select more than 25 topics
Topics must start with a letter or number, can include dashes ('-') and can be up to 35 characters long.
1637 lines
88 KiB
1637 lines
88 KiB
Chairman's Letter - 1985
|
|
|
|
|
|
|
|
BERKSHIRE HATHAWAY INC.
|
|
|
|
|
|
|
|
|
|
To the Shareholders of Berkshire Hathaway Inc.:
|
|
|
|
You may remember the wildly upbeat message of last years
|
|
report: nothing much was in the works but our experience had been
|
|
that something big popped up occasionally. This carefully-
|
|
crafted corporate strategy paid off in 1985. Later sections of
|
|
this report discuss (a) our purchase of a major position in
|
|
Capital Cities/ABC, (b) our acquisition of Scott & Fetzer, (c)
|
|
our entry into a large, extended term participation in the
|
|
insurance business of Firemans Fund, and (d) our sale of our
|
|
stock in General Foods.
|
|
|
|
Our gain in net worth during the year was $613.6 million, or
|
|
48.2%. It is fitting that the visit of Halleys Comet coincided
|
|
with this percentage gain: neither will be seen again in my
|
|
lifetime. Our gain in per-share book value over the last twenty-
|
|
one years (that is, since present management took over) has been
|
|
from $19.46 to $1643.71, or 23.2% compounded annually, another
|
|
percentage that will not be repeated.
|
|
|
|
Two factors make anything approaching this rate of gain
|
|
unachievable in the future. One factor probably transitory - is
|
|
a stock market that offers very little opportunity compared to
|
|
the markets that prevailed throughout much of the 1964-1984
|
|
period. Today we cannot find significantly-undervalued equities
|
|
to purchase for our insurance company portfolios. The current
|
|
situation is 180 degrees removed from that existing about a
|
|
decade ago, when the only question was which bargain to choose.
|
|
|
|
This change in the market also has negative implications for
|
|
our present portfolio. In our 1974 annual report I could say:
|
|
We consider several of our major holdings to have great
|
|
potential for significantly increased values in future years. I
|
|
cant say that now. Its true that our insurance companies
|
|
currently hold major positions in companies with exceptional
|
|
underlying economics and outstanding managements, just as they
|
|
did in 1974. But current market prices generously appraise these
|
|
attributes, whereas they were ignored in 1974. Todays
|
|
valuations mean that our insurance companies have no chance for
|
|
future portfolio gains on the scale of those achieved in the
|
|
past.
|
|
|
|
The second negative factor, far more telling, is our size.
|
|
Our equity capital is more than twenty times what it was only ten
|
|
years ago. And an iron law of business is that growth eventually
|
|
dampens exceptional economics. just look at the records of high-
|
|
return companies once they have amassed even $1 billion of equity
|
|
capital. None that I know of has managed subsequently, over a
|
|
ten-year period, to keep on earning 20% or more on equity while
|
|
reinvesting all or substantially all of its earnings. Instead,
|
|
to sustain their high returns, such companies have needed to shed
|
|
a lot of capital by way of either dividends or repurchases of
|
|
stock. Their shareholders would have been far better off if all
|
|
earnings could have been reinvested at the fat returns earned by
|
|
these exceptional businesses. But the companies simply couldnt
|
|
turn up enough high-return opportunities to make that possible.
|
|
|
|
Their problem is our problem. Last year I told you that we
|
|
needed profits of $3.9 billion over the ten years then coming up
|
|
to earn 15% annually. The comparable figure for the ten years
|
|
now ahead is $5.7 billion, a 48% increase that corresponds - as
|
|
it must mathematically - to the growth in our capital base during
|
|
1985. (Heres a little perspective: leaving aside oil companies,
|
|
only about 15 U.S. businesses have managed to earn over $5.7
|
|
billion during the past ten years.)
|
|
|
|
Charlie Munger, my partner in managing Berkshire, and I are
|
|
reasonably optimistic about Berkshires ability to earn returns
|
|
superior to those earned by corporate America generally, and you
|
|
will benefit from the companys retention of all earnings as long
|
|
as those returns are forthcoming. We have several things going
|
|
for us: (1) we dont have to worry about quarterly or annual
|
|
figures but, instead, can focus on whatever actions will maximize
|
|
long-term value; (2) we can expand the business into any areas
|
|
that make sense - our scope is not circumscribed by history,
|
|
structure, or concept; and (3) we love our work. All of these
|
|
help. Even so, we will also need a full measure of good fortune
|
|
to average our hoped-for 15% - far more good fortune than was
|
|
required for our past 23.2%.
|
|
|
|
We need to mention one further item in the investment
|
|
equation that could affect recent purchasers of our stock.
|
|
Historically, Berkshire shares have sold modestly below intrinsic
|
|
business value. With the price there, purchasers could be
|
|
certain (as long as they did not experience a widening of this
|
|
discount) that their personal investment experience would at
|
|
least equal the financial experience of the business. But
|
|
recently the discount has disappeared, and occasionally a modest
|
|
premium has prevailed.
|
|
|
|
The elimination of the discount means that Berkshires
|
|
market value increased even faster than business value (which,
|
|
itself, grew at a pleasing pace). That was good news for any
|
|
owner holding while that move took place, but it is bad news for
|
|
the new or prospective owner. If the financial experience of new
|
|
owners of Berkshire is merely to match the future financial
|
|
experience of the company, any premium of market value over
|
|
intrinsic business value that they pay must be maintained.
|
|
|
|
Management cannot determine market prices, although it can,
|
|
by its disclosures and policies, encourage rational behavior by
|
|
market participants. My own preference, as perhaps youd guess,
|
|
is for a market price that consistently approximates business
|
|
value. Given that relationship, all owners prosper precisely as
|
|
the business prospers during their period of ownership. Wild
|
|
swings in market prices far above and below business value do not
|
|
change the final gains for owners in aggregate; in the end,
|
|
investor gains must equal business gains. But long periods of
|
|
substantial undervaluation and/or overvaluation will cause the
|
|
gains of the business to be inequitably distributed among various
|
|
owners, with the investment result of any given owner largely
|
|
depending upon how lucky, shrewd, or foolish he happens to be.
|
|
|
|
Over the long term there has been a more consistent
|
|
relationship between Berkshires market value and business value
|
|
than has existed for any other publicly-traded equity with which
|
|
I am familiar. This is a tribute to you. Because you have been
|
|
rational, interested, and investment-oriented, the market price
|
|
for Berkshire stock has almost always been sensible. This
|
|
unusual result has been achieved by a shareholder group with
|
|
unusual demographics: virtually all of our shareholders are
|
|
individuals, not institutions. No other public company our size
|
|
can claim the same.
|
|
|
|
You might think that institutions, with their large staffs
|
|
of highly-paid and experienced investment professionals, would be
|
|
a force for stability and reason in financial markets. They are
|
|
not: stocks heavily owned and constantly monitored by
|
|
institutions have often been among the most inappropriately
|
|
valued.
|
|
|
|
Ben Graham told a story 40 years ago that illustrates why
|
|
investment professionals behave as they do: An oil prospector,
|
|
moving to his heavenly reward, was met by St. Peter with bad
|
|
news. Youre qualified for residence, said St. Peter, but, as
|
|
you can see, the compound reserved for oil men is packed.
|
|
Theres no way to squeeze you in. After thinking a moment, the
|
|
prospector asked if he might say just four words to the present
|
|
occupants. That seemed harmless to St. Peter, so the prospector
|
|
cupped his hands and yelled, Oil discovered in hell.
|
|
Immediately the gate to the compound opened and all of the oil
|
|
men marched out to head for the nether regions. Impressed, St.
|
|
Peter invited the prospector to move in and make himself
|
|
comfortable. The prospector paused. No, he said, I think
|
|
Ill go along with the rest of the boys. There might be some
|
|
truth to that rumor after all.
|
|
|
|
Sources of Reported Earnings
|
|
|
|
The table on the next page shows the major sources of
|
|
Berkshires reported earnings. These numbers, along with far
|
|
more detailed sub-segment numbers, are the ones that Charlie and
|
|
I focus upon. We do not find consolidated figures an aid in
|
|
either managing or evaluating Berkshire and, in fact, never
|
|
prepare them for internal use.
|
|
|
|
Segment information is equally essential for investors
|
|
wanting to know what is going on in a multi-line business.
|
|
Corporate managers always have insisted upon such information
|
|
before making acquisition decisions but, until a few years ago,
|
|
seldom made it available to investors faced with acquisition and
|
|
disposition decisions of their own. Instead, when owners wishing
|
|
to understand the economic realities of their business asked for
|
|
data, managers usually gave them a we-cant-tell-you-what-is-
|
|
going-on-because-it-would-hurt-the-company answer. Ultimately
|
|
the SEC ordered disclosure of segment data and management began
|
|
supplying real answers. The change in their behavior recalls an
|
|
insight of Al Capone: You can get much further with a kind word
|
|
and a gun than you can with a kind word alone.
|
|
|
|
In the table, amortization of Goodwill is not charged against the
|
|
specific businesses but, for reasons outlined in the Appendix to
|
|
my letter in the 1983 annual report, is aggregated as a separate
|
|
item. (A compendium of the 1977-1984 letters is available upon
|
|
request.) In the Business Segment Data and Managements
|
|
Discussion sections on pages 39-41 and 49-55, much additional
|
|
information regarding our businesses is provided, including
|
|
Goodwill and Goodwill Amortization figures for each of the
|
|
segments. I urge you to read those sections as well as Charlie
|
|
Mungers letter to Wesco shareholders, which starts on page 56.
|
|
|
|
(000s omitted)
|
|
-----------------------------------------
|
|
Berkshire's Share
|
|
of Net Earnings
|
|
(after taxes and
|
|
Pre-Tax Earnings minority interests)
|
|
------------------- -------------------
|
|
1985 1984 1985 1984
|
|
-------- -------- -------- --------
|
|
Operating Earnings:
|
|
Insurance Group:
|
|
Underwriting ................ $(44,230) $(48,060) $(23,569) $(25,955)
|
|
Net Investment Income ....... 95,217 68,903 79,716 62,059
|
|
Associated Retail Stores ...... 270 (1,072) 134 (579)
|
|
Blue Chip Stamps .............. 5,763 (1,843) 2,813 (899)
|
|
Buffalo News .................. 29,921 27,328 14,580 13,317
|
|
Mutual Savings and Loan ....... 2,622 1,456 4,016 3,151
|
|
Nebraska Furniture Mart ....... 12,686 14,511 5,181 5,917
|
|
Precision Steel ............... 3,896 4,092 1,477 1,696
|
|
Sees Candies ................. 28,989 26,644 14,558 13,380
|
|
Textiles ...................... (2,395) 418 (1,324) 226
|
|
Wesco Financial ............... 9,500 9,777 4,191 4,828
|
|
Amortization of Goodwill ...... (1,475) (1,434) (1,475) (1,434)
|
|
Interest on Debt .............. (14,415) (14,734) (7,288) (7,452)
|
|
Shareholder-Designated
|
|
Contributions .............. (4,006) (3,179) (2,164) (1,716)
|
|
Other ......................... 3,106 4,932 2,102 3,475
|
|
-------- -------- -------- --------
|
|
Operating Earnings .............. 125,449 87,739 92,948 70,014
|
|
Special General Foods Distribution 4,127 8,111 3,779 7,294
|
|
Special Washington Post
|
|
Distribution ................. 14,877 --- 13,851 ---
|
|
Sales of Securities ............. 468,903 104,699 325,237 71,587
|
|
-------- -------- -------- --------
|
|
Total Earnings - all entities ... $613,356 $200,549 $435,815 $148,895
|
|
======== ======== ======== ========
|
|
|
|
Our 1985 results include unusually large earnings from the
|
|
sale of securities. This fact, in itself, does not mean that we
|
|
had a particularly good year (though, of course, we did).
|
|
Security profits in a given year bear similarities to a college
|
|
graduation ceremony in which the knowledge gained over four years
|
|
is recognized on a day when nothing further is learned. We may
|
|
hold a stock for a decade or more, and during that period it may
|
|
grow quite consistently in both business and market value. In
|
|
the year in which we finally sell it there may be no increase in
|
|
value, or there may even be a decrease. But all growth in value
|
|
since purchase will be reflected in the accounting earnings of
|
|
the year of sale. (If the stock owned is in our insurance
|
|
subsidiaries, however, any gain or loss in market value will be
|
|
reflected in net worth annually.) Thus, reported capital gains or
|
|
losses in any given year are meaningless as a measure of how well
|
|
we have done in the current year.
|
|
|
|
A large portion of the realized gain in 1985 ($338 million
|
|
pre-tax out of a total of $488 million) came about through the
|
|
sale of our General Foods shares. We held most of these shares
|
|
since 1980, when we had purchased them at a price far below what
|
|
we felt was their per/share business value. Year by year, the
|
|
managerial efforts of Jim Ferguson and Phil Smith substantially
|
|
increased General Foods business value and, last fall, Philip
|
|
Morris made an offer for the company that reflected the increase.
|
|
We thus benefited from four factors: a bargain purchase price, a
|
|
business with fine underlying economics, an able management
|
|
concentrating on the interests of shareholders, and a buyer
|
|
willing to pay full business value. While that last factor is
|
|
the only one that produces reported earnings, we consider
|
|
identification of the first three to be the key to building value
|
|
for Berkshire shareholders. In selecting common stocks, we
|
|
devote our attention to attractive purchases, not to the
|
|
possibility of attractive sales.
|
|
|
|
We have again reported substantial income from special
|
|
distributions, this year from Washington Post and General Foods.
|
|
(The General Foods transactions obviously took place well before
|
|
the Philip Morris offer.) Distributions of this kind occur when
|
|
we sell a portion of our shares in a company back to it
|
|
simultaneously with its purchase of shares from other
|
|
shareholders. The number of shares we sell is contractually set
|
|
so as to leave our percentage ownership in the company precisely
|
|
the same after the sale as before. Such a transaction is quite
|
|
properly regarded by the IRS as substantially equivalent to a
|
|
dividend since we, as a shareholder, receive cash while
|
|
maintaining an unchanged ownership interest. This tax treatment
|
|
benefits us because corporate taxpayers, unlike individual
|
|
taxpayers, incur much lower taxes on dividend income than on
|
|
income from long-term capital gains. (This difference will be
|
|
widened further if the House-passed tax bill becomes law: under
|
|
its provisions, capital gains realized by corporations will be
|
|
taxed at the same rate as ordinary income.) However, accounting
|
|
rules are unclear as to proper treatment for shareholder
|
|
reporting. To conform with last years treatment, we have shown
|
|
these transactions as capital gains.
|
|
|
|
Though we have not sought out such transactions, we have
|
|
agreed to them on several occasions when managements initiated
|
|
the idea. In each case we have felt that non-selling
|
|
shareholders (all of whom had an opportunity to sell at the same
|
|
price we received) benefited because the companies made their
|
|
repurchases at prices below intrinsic business value. The tax
|
|
advantages we receive and our wish to cooperate with managements
|
|
that are increasing values for all shareholders have sometimes
|
|
led us to sell - but only to the extent that our proportional
|
|
share of the business was undiminished.
|
|
|
|
At this point we usually turn to a discussion of some of our
|
|
major business units. Before doing so, however, we should first
|
|
look at a failure at one of our smaller businesses. Our Vice
|
|
Chairman, Charlie Munger, has always emphasized the study of
|
|
mistakes rather than successes, both in business and other
|
|
aspects of life. He does so in the spirit of the man who said:
|
|
All I want to know is where Im going to die so Ill never go
|
|
there. Youll immediately see why we make a good team: Charlie
|
|
likes to study errors and I have generated ample material for
|
|
him, particularly in our textile and insurance businesses.
|
|
|
|
Shutdown of Textile Business
|
|
|
|
In July we decided to close our textile operation, and by
|
|
yearend this unpleasant job was largely completed. The history
|
|
of this business is instructive.
|
|
|
|
When Buffett Partnership, Ltd., an investment partnership of
|
|
which I was general partner, bought control of Berkshire Hathaway
|
|
21 years ago, it had an accounting net worth of $22 million, all
|
|
devoted to the textile business. The companys intrinsic
|
|
business value, however, was considerably less because the
|
|
textile assets were unable to earn returns commensurate with
|
|
their accounting value. Indeed, during the previous nine years
|
|
(the period in which Berkshire and Hathaway operated as a merged
|
|
company) aggregate sales of $530 million had produced an
|
|
aggregate loss of $10 million. Profits had been reported from
|
|
time to time but the net effect was always one step forward, two
|
|
steps back.
|
|
|
|
At the time we made our purchase, southern textile plants -
|
|
largely non-union - were believed to have an important
|
|
competitive advantage. Most northern textile operations had
|
|
closed and many people thought we would liquidate our business as
|
|
well.
|
|
|
|
We felt, however, that the business would be run much better
|
|
by a long-time employee whom. we immediately selected to be
|
|
president, Ken Chace. In this respect we were 100% correct: Ken
|
|
and his recent successor, Garry Morrison, have been excellent
|
|
managers, every bit the equal of managers at our more profitable
|
|
businesses.
|
|
|
|
In early 1967 cash generated by the textile operation was
|
|
used to fund our entry into insurance via the purchase of
|
|
National Indemnity Company. Some of the money came from earnings
|
|
and some from reduced investment in textile inventories,
|
|
receivables, and fixed assets. This pullback proved wise:
|
|
although much improved by Kens management, the textile business
|
|
never became a good earner, not even in cyclical upturns.
|
|
|
|
Further diversification for Berkshire followed, and
|
|
gradually the textile operations depressing effect on our
|
|
overall return diminished as the business became a progressively
|
|
smaller portion of the corporation. We remained in the business
|
|
for reasons that I stated in the 1978 annual report (and
|
|
summarized at other times also): (1) our textile businesses are
|
|
very important employers in their communities, (2) management has
|
|
been straightforward in reporting on problems and energetic in
|
|
attacking them, (3) labor has been cooperative and understanding
|
|
in facing our common problems, and (4) the business should
|
|
average modest cash returns relative to investment. I further
|
|
said, As long as these conditions prevail - and we expect that
|
|
they will - we intend to continue to support our textile business
|
|
despite more attractive alternative uses for capital.
|
|
|
|
It turned out that I was very wrong about (4). Though 1979
|
|
was moderately profitable, the business thereafter consumed major
|
|
amounts of cash. By mid-1985 it became clear, even to me, that
|
|
this condition was almost sure to continue. Could we have found
|
|
a buyer who would continue operations, I would have certainly
|
|
preferred to sell the business rather than liquidate it, even if
|
|
that meant somewhat lower proceeds for us. But the economics
|
|
that were finally obvious to me were also obvious to others, and
|
|
interest was nil.
|
|
|
|
I wont close down businesses of sub-normal profitability
|
|
merely to add a fraction of a point to our corporate rate of
|
|
return. However, I also feel it inappropriate for even an
|
|
exceptionally profitable company to fund an operation once it
|
|
appears to have unending losses in prospect. Adam Smith would
|
|
disagree with my first proposition, and Karl Marx would disagree
|
|
with my second; the middle ground is the only position that
|
|
leaves me comfortable.
|
|
|
|
I should reemphasize that Ken and Garry have been
|
|
resourceful, energetic and imaginative in attempting to make our
|
|
textile operation a success. Trying to achieve sustainable
|
|
profitability, they reworked product lines, machinery
|
|
configurations and distribution arrangements. We also made a
|
|
major acquisition, Waumbec Mills, with the expectation of
|
|
important synergy (a term widely used in business to explain an
|
|
acquisition that otherwise makes no sense). But in the end
|
|
nothing worked and I should be faulted for not quitting sooner.
|
|
A recent Business Week article stated that 250 textile mills have
|
|
closed since 1980. Their owners were not privy to any
|
|
information that was unknown to me; they simply processed it more
|
|
objectively. I ignored Comtes advice - the intellect should be
|
|
the servant of the heart, but not its slave - and believed what
|
|
I preferred to believe.
|
|
|
|
The domestic textile industry operates in a commodity
|
|
business, competing in a world market in which substantial excess
|
|
capacity exists. Much of the trouble we experienced was
|
|
attributable, both directly and indirectly, to competition from
|
|
foreign countries whose workers are paid a small fraction of the
|
|
U.S. minimum wage. But that in no way means that our labor force
|
|
deserves any blame for our closing. In fact, in comparison with
|
|
employees of American industry generally, our workers were poorly
|
|
paid, as has been the case throughout the textile business. In
|
|
contract negotiations, union leaders and members were sensitive
|
|
to our disadvantageous cost position and did not push for
|
|
unrealistic wage increases or unproductive work practices. To
|
|
the contrary, they tried just as hard as we did to keep us
|
|
competitive. Even during our liquidation period they performed
|
|
superbly. (Ironically, we would have been better off financially
|
|
if our union had behaved unreasonably some years ago; we then
|
|
would have recognized the impossible future that we faced,
|
|
promptly closed down, and avoided significant future losses.)
|
|
|
|
Over the years, we had the option of making large capital
|
|
expenditures in the textile operation that would have allowed us
|
|
to somewhat reduce variable costs. Each proposal to do so looked
|
|
like an immediate winner. Measured by standard return-on-
|
|
investment tests, in fact, these proposals usually promised
|
|
greater economic benefits than would have resulted from
|
|
comparable expenditures in our highly-profitable candy and
|
|
newspaper businesses.
|
|
|
|
But the promised benefits from these textile investments
|
|
were illusory. Many of our competitors, both domestic and
|
|
foreign, were stepping up to the same kind of expenditures and,
|
|
once enough companies did so, their reduced costs became the
|
|
baseline for reduced prices industrywide. Viewed individually,
|
|
each companys capital investment decision appeared cost-
|
|
effective and rational; viewed collectively, the decisions
|
|
neutralized each other and were irrational (just as happens when
|
|
each person watching a parade decides he can see a little better
|
|
if he stands on tiptoes). After each round of investment, all
|
|
the players had more money in the game and returns remained
|
|
anemic.
|
|
|
|
Thus, we faced a miserable choice: huge capital investment
|
|
would have helped to keep our textile business alive, but would
|
|
have left us with terrible returns on ever-growing amounts of
|
|
capital. After the investment, moreover, the foreign competition
|
|
would still have retained a major, continuing advantage in labor
|
|
costs. A refusal to invest, however, would make us increasingly
|
|
non-competitive, even measured against domestic textile
|
|
manufacturers. I always thought myself in the position described
|
|
by Woody Allen in one of his movies: More than any other time in
|
|
history, mankind faces a crossroads. One path leads to despair
|
|
and utter hopelessness, the other to total extinction. Let us
|
|
pray we have the wisdom to choose correctly.
|
|
|
|
For an understanding of how the to-invest-or-not-to-invest
|
|
dilemma plays out in a commodity business, it is instructive to
|
|
look at Burlington Industries, by far the largest U.S. textile
|
|
company both 21 years ago and now. In 1964 Burlington had sales
|
|
of $1.2 billion against our $50 million. It had strengths in
|
|
both distribution and production that we could never hope to
|
|
match and also, of course, had an earnings record far superior to
|
|
ours. Its stock sold at 60 at the end of 1964; ours was 13.
|
|
|
|
Burlington made a decision to stick to the textile business,
|
|
and in 1985 had sales of about $2.8 billion. During the 1964-85
|
|
period, the company made capital expenditures of about $3
|
|
billion, far more than any other U.S. textile company and more
|
|
than $200-per-share on that $60 stock. A very large part of the
|
|
expenditures, I am sure, was devoted to cost improvement and
|
|
expansion. Given Burlingtons basic commitment to stay in
|
|
textiles, I would also surmise that the companys capital
|
|
decisions were quite rational.
|
|
|
|
Nevertheless, Burlington has lost sales volume in real
|
|
dollars and has far lower returns on sales and equity now than 20
|
|
years ago. Split 2-for-1 in 1965, the stock now sells at 34 --
|
|
on an adjusted basis, just a little over its $60 price in 1964.
|
|
Meanwhile, the CPI has more than tripled. Therefore, each share
|
|
commands about one-third the purchasing power it did at the end
|
|
of 1964. Regular dividends have been paid but they, too, have
|
|
shrunk significantly in purchasing power.
|
|
|
|
This devastating outcome for the shareholders indicates what
|
|
can happen when much brain power and energy are applied to a
|
|
faulty premise. The situation is suggestive of Samuel Johnsons
|
|
horse: A horse that can count to ten is a remarkable horse - not
|
|
a remarkable mathematician. Likewise, a textile company that
|
|
allocates capital brilliantly within its industry is a remarkable
|
|
textile company - but not a remarkable business.
|
|
|
|
My conclusion from my own experiences and from much
|
|
observation of other businesses is that a good managerial record
|
|
(measured by economic returns) is far more a function of what
|
|
business boat you get into than it is of how effectively you row
|
|
(though intelligence and effort help considerably, of course, in
|
|
any business, good or bad). Some years ago I wrote: When a
|
|
management with a reputation for brilliance tackles a business
|
|
with a reputation for poor fundamental economics, it is the
|
|
reputation of the business that remains intact. Nothing has
|
|
since changed my point of view on that matter. Should you find
|
|
yourself in a chronically-leaking boat, energy devoted to
|
|
changing vessels is likely to be more productive than energy
|
|
devoted to patching leaks.
|
|
|
|
* * *
|
|
|
|
There is an investment postscript in our textile saga. Some
|
|
investors weight book value heavily in their stock-buying
|
|
decisions (as I, in my early years, did myself). And some
|
|
economists and academicians believe replacement values are of
|
|
considerable importance in calculating an appropriate price level
|
|
for the stock market as a whole. Those of both persuasions would
|
|
have received an education at the auction we held in early 1986
|
|
to dispose of our textile machinery.
|
|
|
|
The equipment sold (including some disposed of in the few
|
|
months prior to the auction) took up about 750,000 square feet of
|
|
factory space in New Bedford and was eminently usable. It
|
|
originally cost us about $13 million, including $2 million spent
|
|
in 1980-84, and had a current book value of $866,000 (after
|
|
accelerated depreciation). Though no sane management would have
|
|
made the investment, the equipment could have been replaced new
|
|
for perhaps $30-$50 million.
|
|
|
|
Gross proceeds from our sale of this equipment came to
|
|
$163,122. Allowing for necessary pre- and post-sale costs, our
|
|
net was less than zero. Relatively modern looms that we bought
|
|
for $5,000 apiece in 1981 found no takers at $50. We finally
|
|
sold them for scrap at $26 each, a sum less than removal costs.
|
|
|
|
Ponder this: the economic goodwill attributable to two paper
|
|
routes in Buffalo - or a single Sees candy store - considerably
|
|
exceeds the proceeds we received from this massive collection of
|
|
tangible assets that not too many years ago, under different
|
|
competitive conditions, was able to employ over 1,000 people.
|
|
|
|
Three Very Good Businesses (and a Few Thoughts About Incentive
|
|
Compensation)
|
|
|
|
When I was 12, I lived with my grandfather for about four
|
|
months. A grocer by trade, he was also working on a book and
|
|
each night he dictated a few pages to me. The title - brace
|
|
yourself - was How to Run a Grocery Store and a Few Things I
|
|
Have Learned About Fishing. My grandfather was sure that
|
|
interest in these two subjects was universal and that the world
|
|
awaited his views. You may conclude from this sections title
|
|
and contents that I was overexposed to Grandpas literary style
|
|
(and personality).
|
|
|
|
I am merging the discussion of Nebraska Furniture Mart,
|
|
Sees Candy Shops, and Buffalo Evening News here because the
|
|
economic strengths, weaknesses, and prospects of these businesses
|
|
have changed little since I reported to you a year ago. The
|
|
shortness of this discussion, however, is in no way meant to
|
|
minimize the importance of these businesses to us: in 1985 they
|
|
earned an aggregate of $72 million pre-tax. Fifteen years ago,
|
|
before we had acquired any of them, their aggregate earnings were
|
|
about $8 million pre-tax.
|
|
|
|
While an increase in earnings from $8 million to $72 million
|
|
sounds terrific - and usually is - you should not automatically
|
|
assume that to be the case. You must first make sure that
|
|
earnings were not severely depressed in the base year. If they
|
|
were instead substantial in relation to capital employed, an even
|
|
more important point must be examined: how much additional
|
|
capital was required to produce the additional earnings?
|
|
|
|
In both respects, our group of three scores well. First,
|
|
earnings 15 years ago were excellent compared to capital then
|
|
employed in the businesses. Second, although annual earnings are
|
|
now $64 million greater, the businesses require only about $40
|
|
million more in invested capital to operate than was the case
|
|
then.
|
|
|
|
The dramatic growth in earning power of these three
|
|
businesses, accompanied by their need for only minor amounts of
|
|
capital, illustrates very well the power of economic goodwill
|
|
during an inflationary period (a phenomenon explained in detail
|
|
in the 1983 annual report). The financial characteristics of
|
|
these businesses have allowed us to use a very large portion of
|
|
the earnings they generate elsewhere. Corporate America,
|
|
however, has had a different experience: in order to increase
|
|
earnings significantly, most companies have needed to increase
|
|
capital significantly also. The average American business has
|
|
required about $5 of additional capital to generate an additional
|
|
$1 of annual pre-tax earnings. That business, therefore, would
|
|
have required over $300 million in additional capital from its
|
|
owners in order to achieve an earnings performance equal to our
|
|
group of three.
|
|
|
|
When returns on capital are ordinary, an earn-more-by-
|
|
putting-up-more record is no great managerial achievement. You
|
|
can get the same result personally while operating from your
|
|
rocking chair. just quadruple the capital you commit to a savings
|
|
account and you will quadruple your earnings. You would hardly
|
|
expect hosannas for that particular accomplishment. Yet,
|
|
retirement announcements regularly sing the praises of CEOs who
|
|
have, say, quadrupled earnings of their widget company during
|
|
their reign - with no one examining whether this gain was
|
|
attributable simply to many years of retained earnings and the
|
|
workings of compound interest.
|
|
|
|
If the widget company consistently earned a superior return
|
|
on capital throughout the period, or if capital employed only
|
|
doubled during the CEOs reign, the praise for him may be well
|
|
deserved. But if return on capital was lackluster and capital
|
|
employed increased in pace with earnings, applause should be
|
|
withheld. A savings account in which interest was reinvested
|
|
would achieve the same year-by-year increase in earnings - and,
|
|
at only 8% interest, would quadruple its annual earnings in 18
|
|
years.
|
|
|
|
The power of this simple math is often ignored by companies
|
|
to the detriment of their shareholders. Many corporate
|
|
compensation plans reward managers handsomely for earnings
|
|
increases produced solely, or in large part, by retained earnings
|
|
- i.e., earnings withheld from owners. For example, ten-year,
|
|
fixed-price stock options are granted routinely, often by
|
|
companies whose dividends are only a small percentage of
|
|
earnings.
|
|
|
|
An example will illustrate the inequities possible under
|
|
such circumstances. Lets suppose that you had a $100,000
|
|
savings account earning 8% interest and managed by a trustee
|
|
who could decide each year what portion of the interest you were
|
|
to be paid in cash. Interest not paid out would be retained
|
|
earnings added to the savings account to compound. And lets
|
|
suppose that your trustee, in his superior wisdom, set the pay-
|
|
out ratio at one-quarter of the annual earnings.
|
|
|
|
Under these assumptions, your account would be worth
|
|
$179,084 at the end of ten years. Additionally, your annual
|
|
earnings would have increased about 70% from $8,000 to $13,515
|
|
under this inspired management. And, finally, your dividends
|
|
would have increased commensurately, rising regularly from $2,000
|
|
in the first year to $3,378 in the tenth year. Each year, when
|
|
your managers public relations firm prepared his annual report
|
|
to you, all of the charts would have had lines marching skyward.
|
|
|
|
Now, just for fun, lets push our scenario one notch further
|
|
and give your trustee-manager a ten-year fixed-price option on
|
|
part of your business (i.e., your savings account) based on its
|
|
fair value in the first year. With such an option, your manager
|
|
would reap a substantial profit at your expense - just from
|
|
having held on to most of your earnings. If he were both
|
|
Machiavellian and a bit of a mathematician, your manager might
|
|
also have cut the pay-out ratio once he was firmly entrenched.
|
|
|
|
This scenario is not as farfetched as you might think. Many
|
|
stock options in the corporate world have worked in exactly that
|
|
fashion: they have gained in value simply because management
|
|
retained earnings, not because it did well with the capital in
|
|
its hands.
|
|
|
|
Managers actually apply a double standard to options.
|
|
Leaving aside warrants (which deliver the issuing corporation
|
|
immediate and substantial compensation), I believe it is fair to
|
|
say that nowhere in the business world are ten-year fixed-price
|
|
options on all or a portion of a business granted to outsiders.
|
|
Ten months, in fact, would be regarded as extreme. It would be
|
|
particularly unthinkable for managers to grant a long-term option
|
|
on a business that was regularly adding to its capital. Any
|
|
outsider wanting to secure such an option would be required to
|
|
pay fully for capital added during the option period.
|
|
|
|
The unwillingness of managers to do-unto-outsiders, however,
|
|
is not matched by an unwillingness to do-unto-themselves.
|
|
(Negotiating with ones self seldom produces a barroom brawl.)
|
|
Managers regularly engineer ten-year, fixed-price options for
|
|
themselves and associates that, first, totally ignore the fact
|
|
that retained earnings automatically build value and, second,
|
|
ignore the carrying cost of capital. As a result, these managers
|
|
end up profiting much as they would have had they had an option
|
|
on that savings account that was automatically building up in
|
|
value.
|
|
|
|
Of course, stock options often go to talented, value-adding
|
|
managers and sometimes deliver them rewards that are perfectly
|
|
appropriate. (Indeed, managers who are really exceptional almost
|
|
always get far less than they should.) But when the result is
|
|
equitable, it is accidental. Once granted, the option is blind
|
|
to individual performance. Because it is irrevocable and
|
|
unconditional (so long as a manager stays in the company), the
|
|
sluggard receives rewards from his options precisely as does the
|
|
star. A managerial Rip Van Winkle, ready to doze for ten years,
|
|
could not wish for a better incentive system.
|
|
|
|
(I cant resist commenting on one long-term option given an
|
|
outsider: that granted the U.S. Government on Chrysler shares
|
|
as partial consideration for the governments guarantee of some
|
|
lifesaving loans. When these options worked out well for the
|
|
government, Chrysler sought to modify the payoff, arguing that
|
|
the rewards to the government were both far greater than intended
|
|
and outsize in relation to its contribution to Chryslers
|
|
recovery. The companys anguish over what it saw as an imbalance
|
|
between payoff and performance made national news. That anguish
|
|
may well be unique: to my knowledge, no managers - anywhere -
|
|
have been similarly offended by unwarranted payoffs arising from
|
|
options granted to themselves or their colleagues.)
|
|
|
|
Ironically, the rhetoric about options frequently describes
|
|
them as desirable because they put managers and owners in the
|
|
same financial boat. In reality, the boats are far different.
|
|
No owner has ever escaped the burden of capital costs, whereas a
|
|
holder of a fixed-price option bears no capital costs at all. An
|
|
owner must weigh upside potential against downside risk; an
|
|
option holder has no downside. In fact, the business project in
|
|
which you would wish to have an option frequently is a project in
|
|
which you would reject ownership. (Ill be happy to accept a
|
|
lottery ticket as a gift - but Ill never buy one.)
|
|
|
|
In dividend policy also, the option holders interests are
|
|
best served by a policy that may ill serve the owner. Think back
|
|
to the savings account example. The trustee, holding his option,
|
|
would benefit from a no-dividend policy. Conversely, the owner
|
|
of the account should lean to a total payout so that he can
|
|
prevent the option-holding manager from sharing in the accounts
|
|
retained earnings.
|
|
|
|
Despite their shortcomings, options can be appropriate under
|
|
some circumstances. My criticism relates to their indiscriminate
|
|
use and, in that connection, I would like to emphasize three
|
|
points:
|
|
|
|
First, stock options are inevitably tied to the overall
|
|
performance of a corporation. Logically, therefore, they should
|
|
be awarded only to those managers with overall responsibility.
|
|
Managers with limited areas of responsibility should have
|
|
incentives that pay off in relation to results under their
|
|
control. The .350 hitter expects, and also deserves, a big
|
|
payoff for his performance - even if he plays for a cellar-
|
|
dwelling team. And the .150 hitter should get no reward - even
|
|
if he plays for a pennant winner. Only those with overall
|
|
responsibility for the team should have their rewards tied to its
|
|
results.
|
|
|
|
Second, options should be structured carefully. Absent
|
|
special factors, they should have built into them a retained-
|
|
earnings or carrying-cost factor. Equally important, they should
|
|
be priced realistically. When managers are faced with offers for
|
|
their companies, they unfailingly point out how unrealistic
|
|
market prices can be as an index of real value. But why, then,
|
|
should these same depressed prices be the valuations at which
|
|
managers sell portions of their businesses to themselves? (They
|
|
may go further: officers and directors sometimes consult the Tax
|
|
Code to determine the lowest prices at which they can, in effect,
|
|
sell part of the business to insiders. While theyre at it, they
|
|
often elect plans that produce the worst tax result for the
|
|
company.) Except in highly unusual cases, owners are not well
|
|
served by the sale of part of their business at a bargain price -
|
|
whether the sale is to outsiders or to insiders. The obvious
|
|
conclusion: options should be priced at true business value.
|
|
|
|
Third, I want to emphasize that some managers whom I admire
|
|
enormously - and whose operating records are far better than mine
|
|
- disagree with me regarding fixed-price options. They have
|
|
built corporate cultures that work, and fixed-price options have
|
|
been a tool that helped them. By their leadership and example,
|
|
and by the use of options as incentives, these managers have
|
|
taught their colleagues to think like owners. Such a Culture is
|
|
rare and when it exists should perhaps be left intact - despite
|
|
inefficiencies and inequities that may infest the option program.
|
|
If it aint broke, dont fix it is preferable to purity at any
|
|
price.
|
|
|
|
At Berkshire, however, we use an incentive@compensation
|
|
system that rewards key managers for meeting targets in their own
|
|
bailiwicks. If Sees does well, that does not produce incentive
|
|
compensation at the News - nor vice versa. Neither do we look at
|
|
the price of Berkshire stock when we write bonus checks. We
|
|
believe good unit performance should be rewarded whether
|
|
Berkshire stock rises, falls, or stays even. Similarly, we think
|
|
average performance should earn no special rewards even if our
|
|
stock should soar. Performance, furthermore, is defined in
|
|
different ways depending upon the underlying economics of the
|
|
business: in some our managers enjoy tailwinds not of their own
|
|
making, in others they fight unavoidable headwinds.
|
|
|
|
The rewards that go with this system can be large. At our
|
|
various business units, top managers sometimes receive incentive
|
|
bonuses of five times their base salary, or more, and it would
|
|
appear possible that one managers bonus could top $2 million in
|
|
1986. (I hope so.) We do not put a cap on bonuses, and the
|
|
potential for rewards is not hierarchical. The manager of a
|
|
relatively small unit can earn far more than the manager of a
|
|
larger unit if results indicate he should. We believe, further,
|
|
that such factors as seniority and age should not affect
|
|
incentive compensation (though they sometimes influence basic
|
|
compensation). A 20-year-old who can hit .300 is as valuable to
|
|
us as a 40-year-old performing as well.
|
|
|
|
Obviously, all Berkshire managers can use their bonus money
|
|
(or other funds, including borrowed money) to buy our stock in
|
|
the market. Many have done just that - and some now have large
|
|
holdings. By accepting both the risks and the carrying costs
|
|
that go with outright purchases, these managers truly walk in the
|
|
shoes of owners.
|
|
|
|
Now lets get back - at long last - to our three businesses:
|
|
|
|
At Nebraska Furniture Mart our basic strength is an
|
|
exceptionally low-cost operation that allows the business to
|
|
regularly offer customers the best values available in home
|
|
furnishings. NFM is the largest store of its kind in the
|
|
country. Although the already-depressed farm economy worsened
|
|
considerably in 1985, the store easily set a new sales record. I
|
|
also am happy to report that NFMs Chairman, Rose Blumkin (the
|
|
legendary Mrs. B), continues at age 92 to set a pace at the
|
|
store that none of us can keep up with. Shes there wheeling and
|
|
dealing seven days a week, and I hope that any of you who visit
|
|
Omaha will go out to the Mart and see her in action. It will
|
|
inspire you, as it does me.
|
|
|
|
At Sees we continue to get store volumes that are far
|
|
beyond those achieved by any competitor we know of. Despite the
|
|
unmatched consumer acceptance we enjoy, industry trends are not
|
|
good, and we continue to experience slippage in poundage sales on
|
|
a same-store basis. This puts pressure on per-pound costs. We
|
|
now are willing to increase prices only modestly and, unless we
|
|
can stabilize per-shop poundage, profit margins will narrow.
|
|
|
|
At the News volume gains are also difficult to achieve.
|
|
Though linage increased during 1985, the gain was more than
|
|
accounted for by preprints. ROP linage (advertising printed on
|
|
our own pages) declined. Preprints are far less profitable than
|
|
ROP ads, and also more vulnerable to competition. In 1985, the
|
|
News again controlled costs well and our household penetration
|
|
continues to be exceptional.
|
|
|
|
One problem these three operations do not have is
|
|
management. At Sees we have Chuck Huggins, the man we put in
|
|
charge the day we bought the business. Selecting him remains one
|
|
of our best business decisions. At the News we have Stan Lipsey,
|
|
a manager of equal caliber. Stan has been with us 17 years, and
|
|
his unusual business talents have become more evident with every
|
|
additional level of responsibility he has tackled. And, at the
|
|
Mart, we have the amazing Blumkins - Mrs. B, Louie, Ron, Irv, and
|
|
Steve - a three-generation miracle of management.
|
|
|
|
I consider myself extraordinarily lucky to be able to work
|
|
with managers such as these. I like them personally as much as I
|
|
admire them professionally.
|
|
|
|
Insurance Operations
|
|
|
|
Shown below is an updated version of our usual table,
|
|
listing two key figures for the insurance industry:
|
|
|
|
Yearly Change Combined Ratio
|
|
in Premiums after Policyholder
|
|
Written (%) Dividends
|
|
------------- ------------------
|
|
1972 ............... 10.2 96.2
|
|
1973 ............... 8.0 99.2
|
|
1974 ............... 6.2 105.4
|
|
1975 ............... 11.0 107.9
|
|
1976 ............... 21.9 102.4
|
|
1977 ............... 19.8 97.2
|
|
1978 ............... 12.8 97.5
|
|
1979 ............... 10.3 100.6
|
|
1980 ............... 6.0 103.1
|
|
1981 ............... 3.9 106.0
|
|
1982 ............... 4.4 109.7
|
|
1983 ............... 4.5 111.9
|
|
1984 (Revised) ..... 9.2 117.9
|
|
1985 (Estimated) ... 20.9 118.0
|
|
|
|
Source: Bests Aggregates and Averages
|
|
|
|
The combined ratio represents total insurance costs (losses
|
|
incurred plus expenses) compared to revenue from premiums: a
|
|
ratio below 100 indicates an underwriting profit, and one above
|
|
100 indicates a loss.
|
|
|
|
The industrys 1985 results were highly unusual. The
|
|
revenue gain was exceptional, and had insured losses grown at
|
|
their normal rate of most recent years - that is, a few points
|
|
above the inflation rate - a significant drop in the combined
|
|
ratio would have occurred. But losses in 1985 didnt cooperate,
|
|
as they did not in 1984. Though inflation slowed considerably in
|
|
these years, insured losses perversely accelerated, growing by
|
|
16% in 1984 and by an even more startling 17% in 1985. The
|
|
years growth in losses therefore exceeds the inflation rate by
|
|
over 13 percentage points, a modern record.
|
|
|
|
Catastrophes were not the culprit in this explosion of loss
|
|
cost. True, there were an unusual number of hurricanes in 1985,
|
|
but the aggregate damage caused by all catastrophes in 1984 and
|
|
1985 was about 2% of premium volume, a not unusual proportion.
|
|
Nor was there any burst in the number of insured autos, houses,
|
|
employers, or other kinds of exposure units.
|
|
|
|
A partial explanation for the surge in the loss figures is
|
|
all the additions to reserves that the industry made in 1985. As
|
|
results for the year were reported, the scene resembled a revival
|
|
meeting: shouting Ive sinned, Ive sinned, insurance managers
|
|
rushed forward to confess they had under reserved in earlier
|
|
years. Their corrections significantly affected 1985 loss
|
|
numbers.
|
|
|
|
A more disturbing ingredient in the loss surge is the
|
|
acceleration in social or judicial inflation. The insurers
|
|
ability to pay has assumed overwhelming importance with juries
|
|
and judges in the assessment of both liability and damages. More
|
|
and more, the deep pocket is being sought and found, no matter
|
|
what the policy wording, the facts, or the precedents.
|
|
|
|
This judicial inflation represents a wild card in the
|
|
industrys future, and makes forecasting difficult.
|
|
Nevertheless, the short-term outlook is good. Premium growth
|
|
improved as 1985 went along (quarterly gains were an estimated
|
|
15%, 19%, 24%, and 22%) and, barring a supercatastrophe, the
|
|
industrys combined ratio should fall sharply in 1986.
|
|
|
|
The profit improvement, however, is likely to be of short
|
|
duration. Two economic principles will see to that. First,
|
|
commodity businesses achieve good levels of profitability only
|
|
when prices are fixed in some manner or when capacity is short.
|
|
Second, managers quickly add to capacity when prospects start to
|
|
improve and capital is available.
|
|
|
|
In my 1982 report to you, I discussed the commodity nature
|
|
of the insurance industry extensively. The typical policyholder
|
|
does not differentiate between products but concentrates instead
|
|
on price. For many decades a cartel-like procedure kept prices
|
|
up, but this arrangement has disappeared for good. The insurance
|
|
product now is priced as any other commodity for which a free
|
|
market exists: when capacity is tight, prices will be set
|
|
remuneratively; otherwise, they will not be.
|
|
|
|
Capacity currently is tight in many lines of insurance -
|
|
though in this industry, unlike most, capacity is an attitudinal
|
|
concept, not a physical fact. Insurance managers can write
|
|
whatever amount of business they feel comfortable writing,
|
|
subject only to pressures applied by regulators and Bests, the
|
|
industrys authoritative rating service. The comfort level of
|
|
both managers and regulators is tied to capital. More capital
|
|
means more comfort, which in turn means more capacity. In the
|
|
typical commodity business, furthermore, such as aluminum or
|
|
steel, a long gestation precedes the birth of additional
|
|
capacity. In the insurance industry, capital can be secured
|
|
instantly. Thus, any capacity shortage can be eliminated in
|
|
short order.
|
|
|
|
Thats exactly whats going on right now. In 1985, about 15
|
|
insurers raised well over $3 billion, piling up capital so that
|
|
they can write all the business possible at the better prices now
|
|
available. The capital-raising trend has accelerated
|
|
dramatically so far in 1986.
|
|
|
|
If capacity additions continue at this rate, it wont be
|
|
long before serious price-cutting appears and next a fall in
|
|
profitability. When the fall comes, it will be the fault of the
|
|
capital-raisers of 1985 and 1986, not the price-cutters of 198X.
|
|
(Critics should be understanding, however: as was the case in our
|
|
textile example, the dynamics of capitalism cause each insurer to
|
|
make decisions that for itself appear sensible, but that
|
|
collectively slash profitability.)
|
|
|
|
In past reports, I have told you that Berkshires strong
|
|
capital position - the best in the industry - should one day
|
|
allow us to claim a distinct competitive advantage in the
|
|
insurance market. With the tightening of the market, that day
|
|
arrived. Our premium volume more than tripled last year,
|
|
following a long period of stagnation. Berkshires financial
|
|
strength (and our record of maintaining unusual strength through
|
|
thick and thin) is now a major asset for us in securing good
|
|
business.
|
|
|
|
We correctly foresaw a flight to quality by many large
|
|
buyers of insurance and reinsurance who belatedly recognized that
|
|
a policy is only an IOU - and who, in 1985, could not collect on
|
|
many of their IOUs. These buyers today are attracted to
|
|
Berkshire because of its strong capital position. But, in a
|
|
development we did not foresee, we also are finding buyers drawn
|
|
to us because our ability to insure substantial risks sets us
|
|
apart from the crowd.
|
|
|
|
To understand this point, you need a few background facts
|
|
about large risks. Traditionally, many insurers have wanted to
|
|
write this kind of business. However, their willingness to do so
|
|
has been almost always based upon reinsurance arrangements that
|
|
allow the insurer to keep just a small portion of the risk itself
|
|
while passing on (laying off) most of the risk to its
|
|
reinsurers. Imagine, for example, a directors and officers
|
|
(D & O) liability policy providing $25 million of coverage.
|
|
By various excess-of-loss reinsurance contracts, the company
|
|
issuing that policy might keep the liability for only the first
|
|
$1 million of any loss that occurs. The liability for any loss
|
|
above that amount up to $24 million would be borne by the
|
|
reinsurers of the issuing insurer. In trade parlance, a company
|
|
that issues large policies but retains relatively little of the
|
|
risk for its own account writes a large gross line but a small
|
|
net line.
|
|
|
|
In any reinsurance arrangement, a key question is how the
|
|
premiums paid for the policy should be divided among the various
|
|
layers of risk. In our D & O policy, for example. what part of
|
|
the premium received should be kept by the issuing company to
|
|
compensate it fairly for taking the first $1 million of risk and
|
|
how much should be passed on to the reinsurers to compensate them
|
|
fairly for taking the risk between $1 million and $25 million?
|
|
|
|
One way to solve this problem might be deemed the Patrick
|
|
Henry approach: I have but one lamp by which my feet are guided,
|
|
and that is the lamp of experience. In other words, how much of
|
|
the total premium would reinsurers have needed in the past to
|
|
compensate them fairly for the losses they actually had to bear?
|
|
|
|
Unfortunately, the lamp of experience has always provided
|
|
imperfect illumination for reinsurers because so much of their
|
|
business is long-tail, meaning it takes many years before they
|
|
know what their losses are. Lately, however, the light has not
|
|
only been dim but also grossly misleading in the images it has
|
|
revealed. That is, the courts tendency to grant awards that are
|
|
both huge and lacking in precedent makes reinsurers usual
|
|
extrapolations or inferences from past data a formula for
|
|
disaster. Out with Patrick Henry and in with Pogo: The future
|
|
aint what it used to be.
|
|
|
|
The burgeoning uncertainties of the business, coupled with
|
|
the entry into reinsurance of many unsophisticated participants,
|
|
worked in recent years in favor of issuing companies writing a
|
|
small net line: they were able to keep a far greater percentage
|
|
of the premiums than the risk. By doing so, the issuing
|
|
companies sometimes made money on business that was distinctly
|
|
unprofitable for the issuing and reinsuring companies combined.
|
|
(This result was not necessarily by intent: issuing companies
|
|
generally knew no more than reinsurers did about the ultimate
|
|
costs that would be experienced at higher layers of risk.)
|
|
Inequities of this sort have been particularly pronounced in
|
|
lines of insurance in which much change was occurring and losses
|
|
were soaring; e.g., professional malpractice, D & 0, products
|
|
liability, etc. Given these circumstances, it is not surprising
|
|
that issuing companies remained enthusiastic about writing
|
|
business long after premiums became woefully inadequate on a
|
|
gross basis.
|
|
|
|
An example of just how disparate results have been for
|
|
issuing companies versus their reinsurers is provided by the 1984
|
|
financials of one of the leaders in large and unusual risks. In
|
|
that year the company wrote about $6 billion of business and kept
|
|
around $2 1/2 billion of the premiums, or about 40%. It gave the
|
|
remaining $3 1/2 billion to reinsurers. On the part of the
|
|
business kept, the companys underwriting loss was less than $200
|
|
million - an excellent result in that year. Meanwhile, the part
|
|
laid off produced a loss of over $1.5 billion for the reinsurers.
|
|
Thus, the issuing company wrote at a combined ratio of well under
|
|
110 while its reinsurers, participating in precisely the same
|
|
policies, came in considerably over 140. This result was not
|
|
attributable to natural catastrophes; it came from run-of-the-
|
|
mill insurance losses (occurring, however, in surprising
|
|
frequency and size). The issuing companys 1985 report is not
|
|
yet available, but I would predict it will show that dramatically
|
|
unbalanced results continued.
|
|
|
|
A few years such as this, and even slow-witted reinsurers
|
|
can lose interest, particularly in explosive lines where the
|
|
proper split in premium between issuer and reinsurer remains
|
|
impossible to even roughly estimate. The behavior of reinsurers
|
|
finally becomes like that of Mark Twains cat: having once sat on
|
|
a hot stove, it never did so again - but it never again sat on a
|
|
cold stove, either. Reinsurers have had so many unpleasant
|
|
surprises in long-tail casualty lines that many have decided
|
|
(probably correctly) to give up the game entirely, regardless of
|
|
price inducements. Consequently, there has been a dramatic pull-
|
|
back of reinsurance capacity in certain important lines.
|
|
|
|
This development has left many issuing companies under
|
|
pressure. They can no longer commit their reinsurers, time after
|
|
time, for tens of millions per policy as they so easily could do
|
|
only a year or two ago, and they do not have the capital and/or
|
|
appetite to take on large risks for their own account. For many
|
|
issuing companies, gross capacity has shrunk much closer to net
|
|
capacity - and that is often small, indeed.
|
|
|
|
At Berkshire we have never played the lay-it-off-at-a-profit
|
|
game and, until recently, that put us at a severe disadvantage in
|
|
certain lines. Now the tables are turned: we have the
|
|
underwriting capability whereas others do not. If we believe the
|
|
price to be right, we are willing to write a net line larger than
|
|
that of any but the largest insurers. For instance, we are
|
|
perfectly willing to risk losing $10 million of our own money on
|
|
a single event, as long as we believe that the price is right and
|
|
that the risk of loss is not significantly correlated with other
|
|
risks we are insuring. Very few insurers are willing to risk
|
|
half that much on single events - although, just a short while
|
|
ago, many were willing to lose five or ten times that amount as
|
|
long as virtually all of the loss was for the account of their
|
|
reinsurers.
|
|
|
|
In mid-1985 our largest insurance company, National
|
|
Indemnity Company, broadcast its willingness to underwrite large
|
|
risks by running an ad in three issues of an insurance weekly.
|
|
The ad solicited policies of only large size: those with a
|
|
minimum premium of $1 million. This ad drew a remarkable 600
|
|
replies and ultimately produced premiums totaling about $50
|
|
million. (Hold the applause: its all long-tail business and it
|
|
will be at least five years before we know whether this marketing
|
|
success was also an underwriting success.) Today, our insurance
|
|
subsidiaries continue to be sought out by brokers searching for
|
|
large net capacity.
|
|
|
|
As I have said, this period of tightness will pass; insurers
|
|
and reinsurers will return to underpricing. But for a year or
|
|
two we should do well in several segments of our insurance
|
|
business. Mike Goldberg has made many important improvements in
|
|
the operation (prior mismanagement by your Chairman having
|
|
provided him ample opportunity to do so). He has been
|
|
particularly successful recently in hiring young managers with
|
|
excellent potential. They will have a chance to show their stuff
|
|
in 1986.
|
|
|
|
Our combined ratio has improved - from 134 in 1984 to 111 in
|
|
1985 - but continues to reflect past misdeeds. Last year I told
|
|
you of the major mistakes I had made in loss-reserving, and
|
|
promised I would update you annually on loss-development figures.
|
|
Naturally, I made this promise thinking my future record would be
|
|
much improved. So far this has not been the case. Details on
|
|
last years loss development are on pages 50-52. They reveal
|
|
significant underreserving at the end of 1984, as they did in the
|
|
several years preceding.
|
|
|
|
The only bright spot in this picture is that virtually all
|
|
of the underreserving revealed in 1984 occurred in the
|
|
reinsurance area - and there, in very large part, in a few
|
|
contracts that were discontinued several years ago. This
|
|
explanation, however, recalls all too well a story told me many
|
|
years ago by the then Chairman of General Reinsurance Company.
|
|
He said that every year his managers told him that except for
|
|
the Florida hurricane or except for Midwestern tornadoes, they
|
|
would have had a terrific year. Finally he called the group
|
|
together and suggested that they form a new operation - the
|
|
Except-For Insurance Company - in which they would henceforth
|
|
place all of the business that they later wouldnt want to count.
|
|
|
|
In any business, insurance or otherwise, except for should
|
|
be excised from the lexicon. If you are going to play the game,
|
|
you must count the runs scored against you in all nine innings.
|
|
Any manager who consistently says except for and then reports
|
|
on the lessons he has learned from his mistakes may be missing
|
|
the only important lesson - namely, that the real mistake is not
|
|
the act, but the actor.
|
|
|
|
Inevitably, of course, business errors will occur and the
|
|
wise manager will try to find the proper lessons in them. But
|
|
the trick is to learn most lessons from the experiences of
|
|
others. Managers who have learned much from personal experience
|
|
in the past usually are destined to learn much from personal
|
|
experience in the future.
|
|
|
|
GEICO, 38%-owned by Berkshire, reported an excellent year in
|
|
1985 in premium growth and investment results, but a poor year -
|
|
by its lofty standards - in underwriting. Private passenger auto
|
|
and homeowners insurance were the only important lines in the
|
|
industry whose results deteriorated significantly during the
|
|
year. GEICO did not escape the trend, although its record was
|
|
far better than that of virtually all its major competitors.
|
|
|
|
Jack Byrne left GEICO at mid-year to head Firemans Fund,
|
|
leaving behind Bill Snyder as Chairman and Lou Simpson as Vice
|
|
Chairman. Jacks performance in reviving GEICO from near-
|
|
bankruptcy was truly extraordinary, and his work resulted in
|
|
enormous gains for Berkshire. We owe him a great deal for that.
|
|
|
|
We are equally indebted to Jack for an achievement that
|
|
eludes most outstanding leaders: he found managers to succeed him
|
|
who have talents as valuable as his own. By his skill in
|
|
identifying, attracting and developing Bill and Lou, Jack
|
|
extended the benefits of his managerial stewardship well beyond
|
|
his tenure.
|
|
|
|
Firemans Fund Quota-Share Contract
|
|
|
|
Never one to let go of a meal ticket, we have followed Jack
|
|
Byrne to Firemans Fund (FFIC) where he is Chairman and CEO of
|
|
the holding company.
|
|
|
|
On September 1, 1985 we became a 7% participant in all of
|
|
the business in force of the FFIC group, with the exception of
|
|
reinsurance they write for unaffiliated companies. Our contract
|
|
runs for four years, and provides that our losses and costs will
|
|
be proportionate to theirs throughout the contract period. If
|
|
there is no extension, we will thereafter have no participation
|
|
in any ongoing business. However, for a great many years in the
|
|
future, we will be reimbursing FFIC for our 7% of the losses that
|
|
occurred in the September 1, 1985 - August 31, 1989 period.
|
|
|
|
Under the contract FFIC remits premiums to us promptly and
|
|
we reimburse FFIC promptly for expenses and losses it has paid.
|
|
Thus, funds generated by our share of the business are held by us
|
|
for investment. As part of the deal, Im available to FFIC for
|
|
consultation about general investment strategy. Im not
|
|
involved, however, in specific investment decisions of FFIC, nor
|
|
is Berkshire involved in any aspect of the companys underwriting
|
|
activities.
|
|
|
|
Currently FFIC is doing about $3 billion of business, and it
|
|
will probably do more as rates rise. The companys September 1,
|
|
1985 unearned premium reserve was $1.324 billion, and it
|
|
therefore transferred 7% of this, or $92.7 million, to us at
|
|
initiation of the contract. We concurrently paid them $29.4
|
|
million representing the underwriting expenses that they had
|
|
incurred on the transferred premium. All of the FFIC business is
|
|
written by National Indemnity Company, but two-sevenths of it is
|
|
passed along to Wesco-Financial Insurance Company (Wes-FIC), a
|
|
new company organized by our 80%-owned subsidiary, Wesco
|
|
Financial Corporation. Charlie Munger has some interesting
|
|
comments about Wes-FIC and the reinsurance business on pages 60-
|
|
62.
|
|
|
|
To the Insurance Segment tables on page 41, we have added a
|
|
new line, labeled Major Quota Share Contracts. The 1985 results
|
|
of the FFIC contract are reported there, though the newness of
|
|
the arrangement makes these results only very rough
|
|
approximations.
|
|
|
|
After the end of the year, we secured another quota-share
|
|
contract, whose 1986 volume should be over $50 million. We hope
|
|
to develop more of this business, and industry conditions suggest
|
|
that we could: a significant number of companies are generating
|
|
more business than they themselves can prudently handle. Our
|
|
financial strength makes us an attractive partner for such
|
|
companies.
|
|
|
|
Marketable Securities
|
|
|
|
We show below our 1985 yearend net holdings in marketable
|
|
equities. All positions with a market value over $25 million are
|
|
listed, and the interests attributable to minority shareholders
|
|
of Wesco and Nebraska Furniture Mart are excluded.
|
|
|
|
No. of Shares Cost Market
|
|
------------- ---------- ----------
|
|
(000s omitted)
|
|
1,036,461 Affiliated Publications, Inc. ....... $ 3,516 $ 55,710
|
|
900,800 American Broadcasting Companies, Inc. 54,435 108,997
|
|
2,350,922 Beatrice Companies, Inc. ............ 106,811 108,142
|
|
6,850,000 GEICO Corporation ................... 45,713 595,950
|
|
2,379,200 Handy & Harman ...................... 27,318 43,718
|
|
847,788 Time, Inc. .......................... 20,385 52,669
|
|
1,727,765 The Washington Post Company ......... 9,731 205,172
|
|
---------- ----------
|
|
267,909 1,170,358
|
|
All Other Common Stockholdings ...... 7,201 27,963
|
|
---------- ----------
|
|
Total Common Stocks $275,110 $1,198,321
|
|
========== ==========
|
|
|
|
We mentioned earlier that in the past decade the investment
|
|
environment has changed from one in which great businesses were
|
|
totally unappreciated to one in which they are appropriately
|
|
recognized. The Washington Post Company (WPC) provides an
|
|
excellent example.
|
|
|
|
We bought all of our WPC holdings in mid-1973 at a price of
|
|
not more than one-fourth of the then per-share business value of
|
|
the enterprise. Calculating the price/value ratio required no
|
|
unusual insights. Most security analysts, media brokers, and
|
|
media executives would have estimated WPCs intrinsic business
|
|
value at $400 to $500 million just as we did. And its $100
|
|
million stock market valuation was published daily for all to
|
|
see. Our advantage, rather, was attitude: we had learned from
|
|
Ben Graham that the key to successful investing was the purchase
|
|
of shares in good businesses when market prices were at a large
|
|
discount from underlying business values.
|
|
|
|
Most institutional investors in the early 1970s, on the
|
|
other hand, regarded business value as of only minor relevance
|
|
when they were deciding the prices at which they would buy or
|
|
sell. This now seems hard to believe. However, these
|
|
institutions were then under the spell of academics at
|
|
prestigious business schools who were preaching a newly-fashioned
|
|
theory: the stock market was totally efficient, and therefore
|
|
calculations of business value - and even thought, itself - were
|
|
of no importance in investment activities. (We are enormously
|
|
indebted to those academics: what could be more advantageous in
|
|
an intellectual contest - whether it be bridge, chess, or stock
|
|
selection than to have opponents who have been taught that
|
|
thinking is a waste of energy?)
|
|
|
|
Through 1973 and 1974, WPC continued to do fine as a
|
|
business, and intrinsic value grew. Nevertheless, by yearend
|
|
1974 our WPC holding showed a loss of about 25%, with market
|
|
value at $8 million against our cost of $10.6 million. What we
|
|
had thought ridiculously cheap a year earlier had become a good
|
|
bit cheaper as the market, in its infinite wisdom, marked WPC
|
|
stock down to well below 20 cents on the dollar of intrinsic
|
|
value.
|
|
|
|
You know the happy outcome. Kay Graham, CEO of WPC, had the
|
|
brains and courage to repurchase large quantities of stock for
|
|
the company at those bargain prices, as well as the managerial
|
|
skills necessary to dramatically increase business values.
|
|
Meanwhile, investors began to recognize the exceptional economics
|
|
of the business and the stock price moved closer to underlying
|
|
value. Thus, we experienced a triple dip: the companys business
|
|
value soared upward, per-share business value increased
|
|
considerably faster because of stock repurchases and, with a
|
|
narrowing of the discount, the stock price outpaced the gain in
|
|
per-share business value.
|
|
|
|
We hold all of the WPC shares we bought in 1973, except for
|
|
those sold back to the company in 1985s proportionate
|
|
redemption. Proceeds from the redemption plus yearend market
|
|
value of our holdings total $221 million.
|
|
|
|
If we had invested our $10.6 million in any of a half-dozen
|
|
media companies that were investment favorites in mid-1973, the
|
|
value of our holdings at yearend would have been in the area of
|
|
$40 - $60 million. Our gain would have far exceeded the gain in
|
|
the general market, an outcome reflecting the exceptional
|
|
economics of the media business. The extra $160 million or so we
|
|
gained through ownership of WPC came, in very large part, from
|
|
the superior nature of the managerial decisions made by Kay as
|
|
compared to those made by managers of most media companies. Her
|
|
stunning business success has in large part gone unreported but
|
|
among Berkshire shareholders it should not go unappreciated.
|
|
|
|
Our Capital Cities purchase, described in the next section,
|
|
required me to leave the WPC Board early in 1986. But we intend
|
|
to hold indefinitely whatever WPC stock FCC rules allow us to.
|
|
We expect WPCs business values to grow at a reasonable rate, and
|
|
we know that management is both able and shareholder-oriented.
|
|
However, the market now values the company at over $1.8 billion,
|
|
and there is no way that the value can progress from that level
|
|
at a rate anywhere close to the rate possible when the companys
|
|
valuation was only $100 million. Because market prices have also
|
|
been bid up for our other holdings, we face the same vastly-
|
|
reduced potential throughout our portfolio.
|
|
|
|
You will notice that we had a significant holding in
|
|
Beatrice Companies at yearend. This is a short-term arbitrage
|
|
holding - in effect, a parking place for money (though not a
|
|
totally safe one, since deals sometimes fall through and create
|
|
substantial losses). We sometimes enter the arbitrage field when
|
|
we have more money than ideas, but only to participate in
|
|
announced mergers and sales. We would be a lot happier if the
|
|
funds currently employed on this short-term basis found a long-
|
|
term home. At the moment, however, prospects are bleak.
|
|
|
|
At yearend our insurance subsidiaries had about $400 million
|
|
in tax-exempt bonds, of which $194 million at amortized cost were
|
|
issues of Washington Public Power Supply System (WPPSS)
|
|
Projects 1, 2, and 3. 1 discussed this position fully last year,
|
|
and explained why we would not disclose further purchases or
|
|
sales until well after the fact (adhering to the policy we follow
|
|
on stocks). Our unrealized gain on the WPPSS bonds at yearend
|
|
was $62 million, perhaps one-third arising from the upward
|
|
movement of bonds generally, and the remainder from a more
|
|
positive investor view toward WPPSS 1, 2, and 3s. Annual tax-
|
|
exempt income from our WPPSS issues is about $30 million.
|
|
|
|
Capital Cities/ABC, Inc.
|
|
|
|
Right after yearend, Berkshire purchased 3 million shares of
|
|
Capital Cities/ABC, Inc. (Cap Cities) at $172.50 per share, the
|
|
market price of such shares at the time the commitment was made
|
|
early in March, 1985. Ive been on record for many years about
|
|
the management of Cap Cities: I think it is the best of any
|
|
publicly-owned company in the country. And Tom Murphy and Dan
|
|
Burke are not only great managers, they are precisely the sort of
|
|
fellows that you would want your daughter to marry. It is a
|
|
privilege to be associated with them - and also a lot of fun, as
|
|
any of you who know them will understand.
|
|
|
|
Our purchase of stock helped Cap Cities finance the $3.5
|
|
billion acquisition of American Broadcasting Companies. For Cap
|
|
Cities, ABC is a major undertaking whose economics are likely to
|
|
be unexciting over the next few years. This bothers us not an
|
|
iota; we can be very patient. (No matter how great the talent or
|
|
effort, some things just take time: you cant produce a baby in
|
|
one month by getting nine women pregnant.)
|
|
|
|
As evidence of our confidence, we have executed an unusual
|
|
agreement: for an extended period Tom, as CEO (or Dan, should he
|
|
be CEO) votes our stock. This arrangement was initiated by
|
|
Charlie and me, not by Tom. We also have restricted ourselves in
|
|
various ways regarding sale of our shares. The object of these
|
|
restrictions is to make sure that our block does not get sold to
|
|
anyone who is a large holder (or intends to become a large
|
|
holder) without the approval of management, an arrangement
|
|
similar to ones we initiated some years ago at GEICO and
|
|
Washington Post.
|
|
|
|
Since large blocks frequently command premium prices, some
|
|
might think we have injured Berkshire financially by creating
|
|
such restrictions. Our view is just the opposite. We feel the
|
|
long-term economic prospects for these businesses - and, thus,
|
|
for ourselves as owners - are enhanced by the arrangements. With
|
|
them in place, the first-class managers with whom we have aligned
|
|
ourselves can focus their efforts entirely upon running the
|
|
businesses and maximizing long-term values for owners. Certainly
|
|
this is much better than having those managers distracted by
|
|
revolving-door capitalists hoping to put the company in play.
|
|
(Of course, some managers place their own interests above those
|
|
of the company and its owners and deserve to be shaken up - but,
|
|
in making investments, we try to steer clear of this type.)
|
|
|
|
Today, corporate instability is an inevitable consequence of
|
|
widely-diffused ownership of voting stock. At any time a major
|
|
holder can surface, usually mouthing reassuring rhetoric but
|
|
frequently harboring uncivil intentions. By circumscribing our
|
|
blocks of stock as we often do, we intend to promote stability
|
|
where it otherwise might be lacking. That kind of certainty,
|
|
combined with a good manager and a good business, provides
|
|
excellent soil for a rich financial harvest. Thats the economic
|
|
case for our arrangements.
|
|
|
|
The human side is just as important. We dont want managers
|
|
we like and admire - and who have welcomed a major financial
|
|
commitment by us - to ever lose any sleep wondering whether
|
|
surprises might occur because of our large ownership. I have
|
|
told them there will be no surprises, and these agreements put
|
|
Berkshires signature where my mouth is. That signature also
|
|
means the managers have a corporate commitment and therefore need
|
|
not worry if my personal participation in Berkshires affairs
|
|
ends prematurely (a term I define as any age short of three
|
|
digits).
|
|
|
|
Our Cap Cities purchase was made at a full price, reflecting
|
|
the very considerable enthusiasm for both media stocks and media
|
|
properties that has developed in recent years (and that, in the
|
|
case of some property purchases, has approached a mania). its no
|
|
field for bargains. However, our Cap Cities investment allies us
|
|
with an exceptional combination of properties and people - and we
|
|
like the opportunity to participate in size.
|
|
|
|
Of course, some of you probably wonder why we are now buying
|
|
Cap Cities at $172.50 per share given that your Chairman, in a
|
|
characteristic burst of brilliance, sold Berkshires holdings in
|
|
the same company at $43 per share in 1978-80. Anticipating your
|
|
question, I spent much of 1985 working on a snappy answer that
|
|
would reconcile these acts.
|
|
|
|
A little more time, please.
|
|
|
|
Acquisition of Scott & Fetzer
|
|
|
|
Right after yearend we acquired The Scott & Fetzer Company
|
|
(Scott Fetzer) of Cleveland for about $320 million. (In
|
|
addition, about $90 million of pre-existing Scott Fetzer debt
|
|
remains in place.) In the next section of this report I describe
|
|
the sort of businesses that we wish to buy for Berkshire. Scott
|
|
Fetzer is a prototype - understandable, large, well-managed, a
|
|
good earner.
|
|
|
|
The company has sales of about $700 million derived from 17
|
|
businesses, many leaders in their fields. Return on invested
|
|
capital is good to excellent for most of these businesses. Some
|
|
well-known products are Kirby home-care systems, Campbell
|
|
Hausfeld air compressors, and Wayne burners and water pumps.
|
|
|
|
World Book, Inc. - accounting for about 40% of Scott
|
|
Fetzers sales and a bit more of its income - is by far the
|
|
companys largest operation. It also is by far the leader in its
|
|
industry, selling more than twice as many encyclopedia sets
|
|
annually as its nearest competitor. In fact, it sells more sets
|
|
in the U.S. than its four biggest competitors combined.
|
|
|
|
Charlie and I have a particular interest in the World Book
|
|
operation because we regard its encyclopedia as something
|
|
special. Ive been a fan (and user) for 25 years, and now have
|
|
grandchildren consulting the sets just as my children did. World
|
|
Book is regularly rated the most useful encyclopedia by teachers,
|
|
librarians and consumer buying guides. Yet it sells for less
|
|
than any of its major competitors. Childcraft, another World
|
|
Book, Inc. product, offers similar value. This combination of
|
|
exceptional products and modest prices at World Book, Inc. helped
|
|
make us willing to pay the price demanded for Scott Fetzer,
|
|
despite declining results for many companies in the direct-
|
|
selling industry.
|
|
|
|
An equal attraction at Scott Fetzer is Ralph Schey, its CEO
|
|
for nine years. When Ralph took charge, the company had 31
|
|
businesses, the result of an acquisition spree in the 1960s. He
|
|
disposed of many that did not fit or had limited profit
|
|
potential, but his focus on rationalizing the original potpourri
|
|
was not so intense that he passed by World Book when it became
|
|
available for purchase in 1978. Ralphs operating and capital-
|
|
allocation record is superb, and we are delighted to be
|
|
associated with him.
|
|
|
|
The history of the Scott Fetzer acquisition is interesting,
|
|
marked by some zigs and zags before we became involved. The
|
|
company had been an announced candidate for purchase since early
|
|
1984. A major investment banking firm spent many months
|
|
canvassing scores of prospects, evoking interest from several.
|
|
Finally, in mid-1985 a plan of sale, featuring heavy
|
|
participation by an ESOP (Employee Stock Ownership Plan), was
|
|
approved by shareholders. However, as difficulty in closing
|
|
followed, the plan was scuttled.
|
|
|
|
I had followed this corporate odyssey through the
|
|
newspapers. On October 10, well after the ESOP deal had fallen
|
|
through, I wrote a short letter to Ralph, whom I did not know. I
|
|
said we admired the companys record and asked if he might like
|
|
to talk. Charlie and I met Ralph for dinner in Chicago on
|
|
October 22 and signed an acquisition contract the following week.
|
|
|
|
The Scott Fetzer acquisition, plus major growth in our
|
|
insurance business, should push revenues above $2 billion in
|
|
1986, more than double those of 1985.
|
|
|
|
Miscellaneous
|
|
|
|
The Scott Fetzer purchase illustrates our somewhat haphazard
|
|
approach to acquisitions. We have no master strategy, no
|
|
corporate planners delivering us insights about socioeconomic
|
|
trends, and no staff to investigate a multitude of ideas
|
|
presented by promoters and intermediaries. Instead, we simply
|
|
hope that something sensible comes along - and, when it does, we
|
|
act.
|
|
|
|
To give fate a helping hand, we again repeat our regular
|
|
business wanted ad. The only change from last years copy is
|
|
in (1): because we continue to want any acquisition we make to
|
|
have a measurable impact on Berkshires financial results, we
|
|
have raised our minimum profit requirement.
|
|
|
|
Heres what were looking for:
|
|
(1) large purchases (at least $10 million of after-tax
|
|
earnings),
|
|
(2) demonstrated consistent earning power (future
|
|
projections are of little interest to us, nor are
|
|
turn-around situations),
|
|
(3) businesses earning good returns on equity while
|
|
employing little or no debt,
|
|
(4) management in place (we cant supply it),
|
|
(5) simple businesses (if theres lots of technology, we
|
|
wont understand it),
|
|
(6) an offering price (we dont want to waste our time
|
|
or that of the seller by talking, even preliminarily,
|
|
about a transaction when price is unknown).
|
|
|
|
We will not engage in unfriendly takeovers. We can promise
|
|
complete confidentiality and a very fast answer - customarily
|
|
within five minutes - as to whether were interested. We prefer
|
|
to buy for cash, but will consider issuance of stock when we
|
|
receive as much in intrinsic business value as we give. Indeed,
|
|
following recent advances in the price of Berkshire stock,
|
|
transactions involving stock issuance may be quite feasible. We
|
|
invite potential sellers to check us out by contacting people
|
|
with whom we have done business in the past. For the right
|
|
business - and the right people - we can provide a good home.
|
|
|
|
On the other hand, we frequently get approached about
|
|
acquisitions that dont come close to meeting our tests: new
|
|
ventures, turnarounds, auction-like sales, and the ever-popular
|
|
(among brokers) Im-sure-something-will-work-out-if-you-people-
|
|
get-to-know-each-other. None of these attracts us in the least.
|
|
|
|
* * *
|
|
|
|
Besides being interested in the purchases of entire
|
|
businesses as described above, we are also interested in the
|
|
negotiated purchase of large, but not controlling, blocks of
|
|
stock, as in our Cap Cities purchase. Such purchases appeal to
|
|
us only when we are very comfortable with both the economics of
|
|
the business and the ability and integrity of the people running
|
|
the operation. We prefer large transactions: in the unusual case
|
|
we might do something as small as $50 million (or even smaller),
|
|
but our preference is for commitments many times that size.
|
|
|
|
* * *
|
|
|
|
About 96.8% of all eligible shares participated in
|
|
Berkshires 1985 shareholder-designated contributions program.
|
|
Total contributions made through the program were $4 million, and
|
|
1,724 charities were recipients. We conducted a plebiscite last
|
|
year in order to get your views about this program, as well as
|
|
about our dividend policy. (Recognizing that its possible to
|
|
influence the answers to a question by the framing of it, we
|
|
attempted to make the wording of ours as neutral as possible.) We
|
|
present the ballot and the results in the Appendix on page 69. I
|
|
think its fair to summarize your response as highly supportive
|
|
of present policies and your group preference - allowing for the
|
|
tendency of people to vote for the status quo - to be for
|
|
increasing the annual charitable commitment as our asset values
|
|
build.
|
|
|
|
We urge new shareholders to read the description of our
|
|
shareholder-designated contributions program that appears on
|
|
pages 66 and 67. If you wish to participate in future programs,
|
|
we strongly urge that you immediately make sure that your shares
|
|
are registered in the name of the actual owner, not in street
|
|
name or nominee name. Shares not so registered on September 30,
|
|
1986 will be ineligible for the 1986 program.
|
|
|
|
* * *
|
|
|
|
Five years ago we were required by the Bank Holding Company
|
|
Act of 1969 to dispose of our holdings in The Illinois National
|
|
Bank and Trust Company of Rockford, Illinois. Our method of
|
|
doing so was unusual: we announced an exchange ratio between
|
|
stock of Rockford Bancorp Inc. (the Illinois Nationals holding
|
|
company) and stock of Berkshire, and then let each of our
|
|
shareholders - except me - make the decision as to whether to
|
|
exchange all, part, or none of his Berkshire shares for Rockford
|
|
shares. I took the Rockford stock that was left over and thus my
|
|
own holding in Rockford was determined by your decisions. At the
|
|
time I said, This technique embodies the worlds oldest and most
|
|
elementary system of fairly dividing an object. Just as when you
|
|
were a child and one person cut the cake and the other got first
|
|
choice, I have tried to cut the company fairly, but you get first
|
|
choice as to which piece you want.
|
|
|
|
Last fall Illinois National was sold. When Rockfords
|
|
liquidation is completed, its shareholders will have received
|
|
per-share proceeds about equal to Berkshires per-share intrinsic
|
|
value at the time of the banks sale. Im pleased that this
|
|
five-year result indicates that the division of the cake was
|
|
reasonably equitable.
|
|
|
|
Last year I put in a plug for our annual meeting, and you
|
|
took me up on the invitation. Over 250 of our more than 3,000
|
|
registered shareholders showed up. Those attending behaved just
|
|
as those present in previous years, asking the sort of questions
|
|
you would expect from intelligent and interested owners. You can
|
|
attend a great many annual meetings without running into a crowd
|
|
like ours. (Lester Maddox, when Governor of Georgia, was
|
|
criticized regarding the states abysmal prison system. The
|
|
solution, he said, is simple. All we need is a better class of
|
|
prisoners. Upgrading annual meetings works the same way.)
|
|
|
|
I hope you come to this years meeting, which will be held
|
|
on May 20 in Omaha. There will be only one change: after 48
|
|
years of allegiance to another soft drink, your Chairman, in an
|
|
unprecedented display of behavioral flexibility, has converted to
|
|
the new Cherry Coke. Henceforth, it will be the Official Drink
|
|
of the Berkshire Hathaway Annual Meeting.
|
|
|
|
And bring money: Mrs. B promises to have bargains galore if
|
|
you will pay her a visit at The Nebraska Furniture Mart after the
|
|
meeting.
|
|
|
|
|
|
Warren E. Buffett
|
|
Chairman of the Board
|
|
|
|
March 4, 1986 |