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1523 lines
80 KiB
1523 lines
80 KiB
Chairman's Letter - 1987
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BERKSHIRE HATHAWAY INC.
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To the Shareholders of Berkshire Hathaway Inc.:
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Our gain in net worth during 1987 was $464 million, or
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19.5%. Over the last 23 years (that is, since present management
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took over), our per-share book value has grown from $19.46 to
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$2,477.47, or at a rate of 23.1% compounded annually.
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What counts, of course, is the rate of gain in per-share
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business value, not book value. In many cases, a corporation's
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book value and business value are almost totally unrelated. For
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example, just before they went bankrupt, LTV and Baldwin-United
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published yearend audits showing their book values to be $652
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million and $397 million, respectively. Conversely, Belridge Oil
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was sold to Shell in 1979 for $3.6 billion although its book
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value was only $177 million.
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At Berkshire, however, the two valuations have tracked
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rather closely, with the growth rate in business value over the
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last decade moderately outpacing the growth rate in book value.
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This good news continued in 1987.
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Our premium of business value to book value has widened for
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two simple reasons: We own some remarkable businesses and they
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are run by even more remarkable managers.
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You have a right to question that second assertion. After
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all, CEOs seldom tell their shareholders that they have assembled
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a bunch of turkeys to run things. Their reluctance to do so
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makes for some strange annual reports. Oftentimes, in his
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shareholders' letter, a CEO will go on for pages detailing
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corporate performance that is woefully inadequate. He will
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nonetheless end with a warm paragraph describing his managerial
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comrades as "our most precious asset." Such comments sometimes
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make you wonder what the other assets can possibly be.
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At Berkshire, however, my appraisal of our operating
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managers is, if anything, understated. To understand why, first
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take a look at page 7, where we show the earnings (on an
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historical-cost accounting basis) of our seven largest non-
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financial units: Buffalo News, Fechheimer, Kirby, Nebraska
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Furniture Mart, Scott Fetzer Manufacturing Group, See's Candies,
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and World Book. In 1987, these seven business units had combined
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operating earnings before interest and taxes of $180 million.
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By itself, this figure says nothing about economic
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performance. To evaluate that, we must know how much total
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capital - debt and equity - was needed to produce these earnings.
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Debt plays an insignificant role at our seven units: Their net
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interest expense in 1987 was only $2 million. Thus, pre-tax
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earnings on the equity capital employed by these businesses
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amounted to $178 million. And this equity - again on an
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historical-cost basis - was only $175 million.
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If these seven business units had operated as a single
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company, their 1987 after-tax earnings would have been
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approximately $100 million - a return of about 57% on equity
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capital. You'll seldom see such a percentage anywhere, let alone
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at large, diversified companies with nominal leverage. Here's a
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benchmark: In its 1988 Investor's Guide issue, Fortune reported
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that among the 500 largest industrial companies and 500 largest
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service companies, only six had averaged a return on equity of
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over 30% during the previous decade. The best performer among
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the 1000 was Commerce Clearing House at 40.2%.
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Of course, the returns that Berkshire earns from these seven
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units are not as high as their underlying returns because, in
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aggregate, we bought the businesses at a substantial premium to
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underlying equity capital. Overall, these operations are carried
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on our books at about $222 million above the historical
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accounting values of the underlying assets. However, the
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managers of the units should be judged by the returns they
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achieve on the underlying assets; what we pay for a business does
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not affect the amount of capital its manager has to work with.
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(If, to become a shareholder and part owner of Commerce Clearing
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House, you pay, say, six times book value, that does not change
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CCH's return on equity.)
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Three important inferences can be drawn from the figures I
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have cited. First, the current business value of these seven
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units is far above their historical book value and also far above
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the value at which they are carried on Berkshire's balance sheet.
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Second, because so little capital is required to run these
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businesses, they can grow while concurrently making almost all of
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their earnings available for deployment in new opportunities.
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Third, these businesses are run by truly extraordinary managers.
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The Blumkins, the Heldmans, Chuck Huggins, Stan Lipsey, and Ralph
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Schey all meld unusual talent, energy and character to achieve
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exceptional financial results.
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For good reasons, we had very high expectations when we
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joined with these managers. In every case, however, our
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experience has greatly exceeded those expectations. We have
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received far more than we deserve, but we are willing to accept
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such inequities. (We subscribe to the view Jack Benny expressed
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upon receiving an acting award: "I don't deserve this, but then,
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I have arthritis and I don't deserve that either.")
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Beyond the Sainted Seven, we have our other major unit,
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insurance, which I believe also has a business value well above
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the net assets employed in it. However, appraising the business
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value of a property-casualty insurance company is a decidedly
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imprecise process. The industry is volatile, reported earnings
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oftentimes are seriously inaccurate, and recent changes in the
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Tax Code will severely hurt future profitability. Despite these
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problems, we like the business and it will almost certainly
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remain our largest operation. Under Mike Goldberg's management,
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the insurance business should treat us well over time.
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With managers like ours, my partner, Charlie Munger, and I
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have little to do with operations. in fact, it is probably fair
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to say that if we did more, less would be accomplished. We have
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no corporate meetings, no corporate budgets, and no performance
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reviews (though our managers, of course, oftentimes find such
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procedures useful at their operating units). After all, what can
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we tell the Blumkins about home furnishings, or the Heldmans
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about uniforms?
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Our major contribution to the operations of our subsidiaries
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is applause. But it is not the indiscriminate applause of a
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Pollyanna. Rather it is informed applause based upon the two
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long careers we have spent intensively observing business
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performance and managerial behavior. Charlie and I have seen so
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much of the ordinary in business that we can truly appreciate a
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virtuoso performance. Only one response to the 1987 performance
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of our operating managers is appropriate: sustained, deafening
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applause.
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Sources of Reported Earnings
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The table on the following page shows the major sources of
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Berkshire's reported earnings. In the table, amortization of
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Goodwill and other major purchase-price accounting adjustments
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are not charged against the specific businesses to which they
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apply but, instead, are aggregated and shown separately. In
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effect, this procedure presents the earnings of our businesses as
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they would have been reported had we not purchased them. In
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appendixes to my letters in the 1983 and 1986 annual reports, I
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explained why this form of presentation seems to us to be more
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useful to investors and managers than the standard GAAP
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presentation, which makes purchase-price adjustments on a
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business-by business basis. The total net earnings we show in
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the table are, of course, identical to the GAAP figures in our
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audited financial statements.
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In the Business Segment Data on pages 36-38 and in the
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Management's Discussion section on pages 40-44 you will find much
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additional information about our businesses. In these sections
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you will also find our segment earnings reported on a GAAP basis.
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I urge you to read that material, as well as Charlie Munger's
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letter to Wesco shareholders, describing the various businesses
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of that subsidiary, which starts on page 45.
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(000s omitted)
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------------------------------------------
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Berkshire's Share
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of Net Earnings
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(after taxes and
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Pre-Tax Earnings minority interests)
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------------------- -------------------
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1987 1986 1987 1986
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-------- -------- -------- --------
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Operating Earnings:
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Insurance Group:
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Underwriting ............... $(55,429) $(55,844) $(20,696) $(29,864)
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Net Investment Income ...... 152,483 107,143 136,658 96,440
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Buffalo News ................. 39,410 34,736 21,304 16,918
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Fechheimer (Acquired 6/3/86) 13,332 8,400 6,580 3,792
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Kirby ........................ 22,408 20,218 12,891 10,508
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Nebraska Furniture Mart ...... 16,837 17,685 7,554 7,192
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Scott Fetzer Mfg. Group ...... 30,591 25,358 17,555 13,354
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See's Candies ................ 31,693 30,347 17,363 15,176
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Wesco - other than Insurance 6,209 5,542 4,978 5,550
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World Book ................... 25,745 21,978 15,136 11,670
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Amortization of Goodwill ..... (2,862) (2,555) (2,862) (2,555)
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Other Purchase-Price
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Accounting Adjustments .... (5,546) (10,033) (6,544) (11,031)
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Interest on Debt and
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Pre-Payment Penalty ....... (11,474) (23,891) (5,905) (12,213)
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Shareholder-Designated
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Contributions ............. (4,938) (3,997) (2,963) (2,158)
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Other ........................ 22,460 20,770 13,696 8,685
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-------- -------- -------- --------
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Operating Earnings ........... 280,919 195,857 214,745 131,464
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Sales of Securities .......... 27,319 216,242 19,807 150,897
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-------- -------- -------- --------
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Total Earnings - All Entities .. $308,238 $412,099 $234,552 $282,361
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======== ======== ======== ========
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Gypsy Rose Lee announced on one of her later birthdays: "I
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have everything I had last year; it's just that it's all two
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inches lower." As the table shows, during 1987 almost all of our
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businesses aged in a more upbeat way.
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There's not a lot new to report about these businesses - and
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that's good, not bad. Severe change and exceptional returns
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usually don't mix. Most investors, of course, behave as if just
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the opposite were true. That is, they usually confer the highest
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price-earnings ratios on exotic-sounding businesses that hold out
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the promise of feverish change. That prospect lets investors
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fantasize about future profitability rather than face today's
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business realities. For such investor-dreamers, any blind date
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is preferable to one with the girl next door, no matter how
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desirable she may be.
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Experience, however, indicates that the best business
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returns are usually achieved by companies that are doing
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something quite similar today to what they were doing five or ten
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years ago. That is no argument for managerial complacency.
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Businesses always have opportunities to improve service, product
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lines, manufacturing techniques, and the like, and obviously
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these opportunities should be seized. But a business that
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constantly encounters major change also encounters many chances
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for major error. Furthermore, economic terrain that is forever
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shifting violently is ground on which it is difficult to build a
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fortress-like business franchise. Such a franchise is usually
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the key to sustained high returns.
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The Fortune study I mentioned earlier supports our view.
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Only 25 of the 1,000 companies met two tests of economic
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excellence - an average return on equity of over 20% in the ten
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years, 1977 through 1986, and no year worse than 15%. These
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business superstars were also stock market superstars: During the
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decade, 24 of the 25 outperformed the S&P 500.
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The Fortune champs may surprise you in two respects. First,
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most use very little leverage compared to their interest-paying
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capacity. Really good businesses usually don't need to borrow.
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Second, except for one company that is "high-tech" and several
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others that manufacture ethical drugs, the companies are in
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businesses that, on balance, seem rather mundane. Most sell non-
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sexy products or services in much the same manner as they did ten
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years ago (though in larger quantities now, or at higher prices,
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or both). The record of these 25 companies confirms that making
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the most of an already strong business franchise, or
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concentrating on a single winning business theme, is what usually
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produces exceptional economics.
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Berkshire's experience has been similar. Our managers have
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produced extraordinary results by doing rather ordinary things -
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but doing them exceptionally well. Our managers protect their
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franchises, they control costs, they search for new products and
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markets that build on their existing strengths and they don't get
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diverted. They work exceptionally hard at the details of their
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businesses, and it shows.
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Here's an update:
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o Agatha Christie, whose husband was an archaeologist, said
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that was the perfect profession for one's spouse: "The older you
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become, the more interested they are in you." It is students of
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business management, not archaeologists, who should be interested
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in Mrs. B (Rose Blumkin), the 94-year-old chairman of Nebraska
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Furniture Mart.
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Fifty years ago Mrs. B started the business with $500, and
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today NFM is far and away the largest home furnishings store in
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the country. Mrs. B continues to work seven days a week at the
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job from the opening of each business day until the close. She
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buys, she sells, she manages - and she runs rings around the
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competition. It's clear to me that she's gathering speed and may
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well reach her full potential in another five or ten years.
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Therefore, I've persuaded the Board to scrap our mandatory
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retirement-at-100 policy. (And it's about time: With every
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passing year, this policy has seemed sillier to me.)
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Net sales of NFM were $142.6 million in 1987, up 8% from
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1986. There's nothing like this store in the country, and
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there's nothing like the family Mrs. B has produced to carry on:
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Her son Louie, and his three boys, Ron, Irv and Steve, possess
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the business instincts, integrity and drive of Mrs. B. They work
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as a team and, strong as each is individually, the whole is far
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greater than the sum of the parts.
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The superb job done by the Blumkins benefits us as owners,
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but even more dramatically benefits NFM's customers. They saved
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about $30 million in 1987 by buying from NFM. In other words,
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the goods they bought would have cost that much more if purchased
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elsewhere.
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You'll enjoy an anonymous letter I received last August:
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"Sorry to see Berkshire profits fall in the second quarter. One
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way you may gain back part of your lost. (sic) Check the pricing
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at The Furniture Mart. You will find that they are leaving 10%
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to 20% on the table. This additional profit on $140 million of
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sells (sic) is $28 million. Not small change in anyone's pocket!
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Check out other furniture, carpet, appliance and T.V. dealers.
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Your raising prices to a reasonable profit will help. Thank you.
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/signed/ A Competitor."
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NFM will continue to grow and prosper by following Mrs. B's
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maxim: "Sell cheap and tell the truth."
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o Among dominant papers of its size or larger, the Buffalo
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News continues to be the national leader in two important ways:
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(1) its weekday and Sunday penetration rate (the percentage of
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households in the paper's primary market area that purchase it);
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and (2) its "news-hole" percentage (the portion of the paper
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devoted to news).
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It may not be coincidence that one newspaper leads in both
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categories: an exceptionally "newsrich" product makes for broad
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audience appeal, which in turn leads to high penetration. Of
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course, quantity must be matched by quality. This not only
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means good reporting and good writing; it means freshness and
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relevance. To be indispensable, a paper must promptly tell its
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readers many things they want to know but won't otherwise learn
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until much later, if ever.
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At the News, we put out seven fresh editions every 24 hours,
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each one extensively changed in content. Here's a small example
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that may surprise you: We redo the obituary page in every edition
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of the News, or seven times a day. Any obituary added runs
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through the next six editions until the publishing cycle has been
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completed.
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It's vital, of course, for a newspaper to cover national and
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international news well and in depth. But it is also vital for
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it to do what only a local newspaper can: promptly and
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extensively chronicle the personally-important, otherwise-
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unreported details of community life. Doing this job well
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requires a very broad range of news - and that means lots of
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space, intelligently used.
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Our news hole was about 50% in 1987, just as it has been
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year after year. If we were to cut it to a more typical 40%, we
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would save approximately $4 million annually in newsprint costs.
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That interests us not at all - and it won't interest us even if,
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for one reason or another, our profit margins should
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significantly shrink.
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Charlie and I do not believe in flexible operating budgets,
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as in "Non-direct expenses can be X if revenues are Y, but must
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be reduced if revenues are Y - 5%." Should we really cut our news
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hole at the Buffalo News, or the quality of product and service
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at See's, simply because profits are down during a given year or
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quarter? Or, conversely, should we add a staff economist, a
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corporate strategist, an institutional advertising campaign or
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something else that does Berkshire no good simply because the
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money currently is rolling in?
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That makes no sense to us. We neither understand the adding
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of unneeded people or activities because profits are booming, nor
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the cutting of essential people or activities because
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profitability is shrinking. That kind of yo-yo approach is
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neither business-like nor humane. Our goal is to do what makes
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sense for Berkshire's customers and employees at all times, and
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never to add the unneeded. ("But what about the corporate jet?"
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you rudely ask. Well, occasionally a man must rise above
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principle.)
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Although the News' revenues have grown only moderately since
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1984, superb management by Stan Lipsey, its publisher, has
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produced excellent profit growth. For several years, I have
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incorrectly predicted that profit margins at the News would fall.
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This year I will not let vou down: Margins will, without
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question, shrink in 1988 and profit may fall as well.
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Skyrocketing newsprint costs will be the major cause.
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o Fechheimer Bros. Company is another of our family
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businesses - and, like the Blumkins, what a family. Three
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generations of Heldmans have for decades consistently, built the
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sales and profits of this manufacturer and distributor of
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uniforms. In the year that Berkshire acquired its controlling
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interest in Fechheimer - 1986 - profits were a record. The
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Heldmans didn't slow down after that. Last year earnings
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increased substantially and the outlook is good for 1988.
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There's nothing magic about the Uniform business; the only
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magic is in the Heldmans. Bob, George, Gary, Roger and Fred know
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the business inside and out, and they have fun running it. We
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are fortunate to be in partnership with them.
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o Chuck Huggins continues to set new records at See's, just as
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he has ever since we put him in charge on the day of our purchase
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some 16 years ago. In 1987, volume hit a new high at slightly
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Under 25 million pounds. For the second year in a row, moreover,
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same-store sales, measured in pounds, were virtually unchanged.
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In case you are wondering, that represents improvement: In each
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of the previous six years, same-store sales had fallen.
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Although we had a particularly strong 1986 Christmas season,
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we racked up better store-for-store comparisons in the 1987
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Christmas season than at any other time of the year. Thus, the
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seasonal factor at See's becomes even more extreme. In 1987,
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about 85% of our profit was earned during December.
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Candy stores are fun to visit, but most have not been fun
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for their owners. From what we can learn, practically no one
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besides See's has made significant profits in recent years from
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the operation of candy shops. Clearly, Chuck's record at See's
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is not due to a rising industry tide. Rather, it is a one-of-a-
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kind performance.
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His achievement requires an excellent product - which we
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have - but it also requires genuine affection for the customer.
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Chuck is 100% customer-oriented, and his attitude sets the tone
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for the rest of the See's organization.
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Here's an example of Chuck in action: At See's we regularly
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add new pieces of candy to our mix and also cull a few to keep
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our product line at about 100 varieties. Last spring we selected
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14 items for elimination. Two, it turned out, were badly missed
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by our customers, who wasted no time in letting us know what they
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thought of our judgment: "A pox on all in See's who participated
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in the abominable decision...;" "May your new truffles melt in
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transit, may they sour in people's mouths, may your costs go up
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and your profits go down...;" "We are investigating the
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possibility of obtaining a mandatory injunction requiring you to
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supply...;" You get the picture. In all, we received many hundreds of
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letters.
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Chuck not only reintroduced the pieces, he turned this
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miscue into an opportunity. Each person who had written got a
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complete and honest explanation in return. Said Chuck's letter:
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"Fortunately, when I make poor decisions, good things often
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happen as a result...;" And with the letter went a special gift
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certificate.
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See's increased prices only slightly in the last two years.
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In 1988 we have raised prices somewhat more, though still
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moderately. To date, sales have been weak and it may be
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difficult for See's to improve its earnings this year.
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o World Book, Kirby, and the Scott Fetzer Manufacturing Group
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are all under the management of Ralph Schey. And what a lucky
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thing for us that they are. I told you last year that Scott
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Fetzer performance in 1986 had far exceeded the expectations that
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Charlie and I had at the time of our purchase. Results in 1987
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were even better. Pre-tax earnings rose 10% while average
|
|
capital employed declined significantly.
|
|
|
|
Ralph's mastery of the 19 businesses for which he is
|
|
responsible is truly amazing, and he has also attracted some
|
|
outstanding managers to run them. We would love to find a few
|
|
additional units that could be put under Ralph's wing.
|
|
|
|
The businesses of Scott Fetzer are too numerous to describe
|
|
in detail. Let's just update you on one of our favorites: At the
|
|
end of 1987, World Book introduced its most dramatically-revised
|
|
edition since 1962. The number of color photos was increased
|
|
from 14,000 to 24,000; over 6,000 articles were revised; 840 new
|
|
contributors were added. Charlie and I recommend this product to
|
|
you and your family, as we do World Book's products for younger
|
|
children, Childcraft and Early World of Learning.
|
|
|
|
In 1987, World Book unit sales in the United States
|
|
increased for the fifth consecutive year. International sales
|
|
and profits also grew substantially. The outlook is good for
|
|
Scott Fetzer operations in aggregate, and for World Book in
|
|
particular.
|
|
|
|
Insurance Operations
|
|
|
|
Shown below is an updated version of our usual table
|
|
presenting key figures for the insurance industry:
|
|
|
|
Statutory
|
|
Yearly Change Combined Ratio Yearly Change Inflation Rate
|
|
in Premiums After Policyholder in Incurred Measured by
|
|
Written (%) Dividends Losses (%) GNP Deflator (%)
|
|
------------- ------------------ ------------- ----------------
|
|
1981 ..... 3.8 106.0 6.5 9.6
|
|
1982 ..... 4.4 109.8 8.4 6.4
|
|
1983 ..... 4.6 112.0 6.8 3.8
|
|
1984 ..... 9.2 117.9 16.9 3.7
|
|
1985 ..... 22.1 116.3 16.1 3.2
|
|
1986 (Rev.) 22.2 108.0 13.5 2.6
|
|
1987 (Est.) 8.7 104.7 6.8 3.0
|
|
|
|
Source: Best's Insurance Management Reports
|
|
|
|
|
|
The combined ratio represents total insurance costs (losses
|
|
incurred plus expenses) compared to revenue from premiums: A
|
|
ratio below 100 indicates an underwriting profit, and one above
|
|
100 indicates a loss. When the investment income that an insurer
|
|
earns from holding on to policyholders' funds ("the float") is
|
|
taken into account, a combined ratio in the 107-111 range
|
|
typically produces an overall break-even result, exclusive of
|
|
earnings on the funds provided by shareholders.
|
|
|
|
The math of the insurance business, encapsulated by the
|
|
table, is not very complicated. In years when the industry's
|
|
annual gain in revenues (premiums) pokes along at 4% or 5%,
|
|
underwriting losses are sure to mount. That is not because auto
|
|
accidents, fires, windstorms and the like are occurring more
|
|
frequently, nor has it lately been the fault of general
|
|
inflation. Today, social and judicial inflation are the major
|
|
culprits; the cost of entering a courtroom has simply ballooned.
|
|
Part of the jump in cost arises from skyrocketing verdicts, and
|
|
part from the tendency of judges and juries to expand the
|
|
coverage of insurance policies beyond that contemplated by the
|
|
insurer when the policies were written. Seeing no let-up in
|
|
either trend, we continue to believe that the industry's revenues
|
|
must grow at about 10% annually for it to just hold its own in
|
|
terms of profitability, even though general inflation may be
|
|
running at a considerably lower rate.
|
|
|
|
The strong revenue gains of 1985-87 almost guaranteed the
|
|
industry an excellent underwriting performance in 1987 and,
|
|
indeed, it was a banner year. But the news soured as the
|
|
quarters rolled by: Best's estimates that year-over-year volume
|
|
increases were 12.9%, 11.1%, 5.7%, and 5.6%. In 1988, the
|
|
revenue gain is certain to be far below our 10% "equilibrium"
|
|
figure. Clearly, the party is over.
|
|
|
|
However, earnings will not immediately sink. A lag factor
|
|
exists in this industry: Because most policies are written for a
|
|
one-year term, higher or lower insurance prices do not have their
|
|
full impact on earnings until many months after they go into
|
|
effect. Thus, to resume our metaphor, when the party ends and
|
|
the bar is closed, you are allowed to finish your drink. If
|
|
results are not hurt by a major natural catastrophe, we predict a
|
|
small climb for the industry's combined ratio in 1988, followed
|
|
by several years of larger increases.
|
|
|
|
The insurance industry is cursed with a set of dismal
|
|
economic characteristics that make for a poor long-term outlook:
|
|
hundreds of competitors, ease of entry, and a product that cannot
|
|
be differentiated in any meaningful way. In such a commodity-
|
|
like business, only a very low-cost operator or someone operating
|
|
in a protected, and usually small, niche can sustain high
|
|
profitability levels.
|
|
|
|
When shortages exist, however, even commodity businesses
|
|
flourish. The insurance industry enjoyed that kind of climate
|
|
for a while but it is now gone. One of the ironies of capitalism
|
|
is that most managers in commodity industries abhor shortage
|
|
conditions - even though those are the only circumstances
|
|
permitting them good returns. Whenever shortages appear, the
|
|
typical manager simply can't wait to expand capacity and thereby
|
|
plug the hole through which money is showering upon him. This is
|
|
precisely what insurance managers did in 1985-87, confirming
|
|
again Disraeli's observation: "What we learn from history is that
|
|
we do not learn from history."
|
|
|
|
At Berkshire, we work to escape the industry's commodity
|
|
economics in two ways. First, we differentiate our product by our
|
|
financial strength, which exceeds that of all others in the
|
|
industry. This strength, however, is limited in its usefulness.
|
|
It means nothing in the personal insurance field: The buyer of
|
|
an auto or homeowners policy is going to get his claim paid even
|
|
if his insurer fails (as many have). It often means nothing in
|
|
the commercial insurance arena: When times are good, many major
|
|
corporate purchasers of insurance and their brokers pay scant
|
|
attention to the insurer's ability to perform under the more
|
|
adverse conditions that may exist, say, five years later when a
|
|
complicated claim is finally resolved. (Out of sight, out of mind
|
|
- and, later on, maybe out-of-pocket.)
|
|
|
|
Periodically, however, buyers remember Ben Franklin's
|
|
observation that it is hard for an empty sack to stand upright
|
|
and recognize their need to buy promises only from insurers that
|
|
have enduring financial strength. It is then that we have a
|
|
major competitive advantage. When a buyer really focuses on
|
|
whether a $10 million claim can be easily paid by his insurer
|
|
five or ten years down the road, and when he takes into account
|
|
the possibility that poor underwriting conditions may then
|
|
coincide with depressed financial markets and defaults by
|
|
reinsurer, he will find only a few companies he can trust.
|
|
Among those, Berkshire will lead the pack.
|
|
|
|
Our second method of differentiating ourselves is the total
|
|
indifference to volume that we maintain. In 1989, we will be
|
|
perfectly willing to write five times as much business as we
|
|
write in 1988 - or only one-fifth as much. We hope, of course,
|
|
that conditions will allow us large volume. But we cannot
|
|
control market prices. If they are unsatisfactory, we will
|
|
simply do very little business. No other major insurer acts with
|
|
equal restraint.
|
|
|
|
Three conditions that prevail in insurance, but not in most
|
|
businesses, allow us our flexibility. First, market share is not
|
|
an important determinant of profitability: In this business, in
|
|
contrast to the newspaper or grocery businesses, the economic
|
|
rule is not survival of the fattest. Second, in many sectors of
|
|
insurance, including most of those in which we operate,
|
|
distribution channels are not proprietary and can be easily
|
|
entered: Small volume this year does not preclude huge volume
|
|
next year. Third, idle capacity - which in this industry largely
|
|
means people - does not result in intolerable costs. In a way
|
|
that industries such as printing or steel cannot, we can operate
|
|
at quarter-speed much of the time and still enjoy long-term
|
|
prosperity.
|
|
|
|
We follow a price-based-on-exposure, not-on-competition
|
|
policy because it makes sense for our shareholders. But we're
|
|
happy to report that it is also pro-social. This policy means
|
|
that we are always available, given prices that we believe are
|
|
adequate, to write huge volumes of almost any type of property-
|
|
casualty insurance. Many other insurers follow an in-and-out
|
|
approach. When they are "out" - because of mounting losses,
|
|
capital inadequacy, or whatever - we are available. Of course,
|
|
when others are panting to do business we are also available -
|
|
but at such times we often find ourselves priced above the
|
|
market. In effect, we supply insurance buyers and brokers with a
|
|
large reservoir of standby capacity.
|
|
|
|
One story from mid-1987 illustrates some consequences of our
|
|
pricing policy: One of the largest family-owned insurance
|
|
brokers in the country is headed by a fellow who has long been a
|
|
shareholder of Berkshire. This man handles a number of large
|
|
risks that are candidates for placement with our New York office.
|
|
Naturally, he does the best he can for his clients. And, just as
|
|
naturally, when the insurance market softened dramatically in
|
|
1987 he found prices at other insurers lower than we were willing
|
|
to offer. His reaction was, first, to place all of his business
|
|
elsewhere and, second, to buy more stock in Berkshire. Had we
|
|
been really competitive, he said, we would have gotten his
|
|
insurance business but he would not have bought our stock.
|
|
|
|
Berkshire's underwriting experience was excellent in 1987,
|
|
in part because of the lag factor discussed earlier. Our
|
|
combined ratio (on a statutory basis and excluding structured
|
|
settlements and financial reinsurance) was 105. Although the
|
|
ratio was somewhat less favorable than in 1986, when it was 103,
|
|
our profitability improved materially in 1987 because we had the
|
|
use of far more float. This trend will continue to run in our
|
|
favor: Our ratio of float to premium volume will increase very
|
|
significantly during the next few years. Thus, Berkshire's
|
|
insurance profits are quite likely to improve during 1988 and
|
|
1989, even though we expect our combined ratio to rise.
|
|
|
|
Our insurance business has also made some important non-
|
|
financial gains during the last few years. Mike Goldberg, its
|
|
manager, has assembled a group of talented professionals to write
|
|
larger risks and unusual coverages. His operation is now well
|
|
equipped to handle the lines of business that will occasionally
|
|
offer us major opportunities.
|
|
|
|
Our loss reserve development, detailed on pages 41-42, looks
|
|
better this year than it has previously. But we write lots of
|
|
"long-tail" business - that is, policies generating claims that
|
|
often take many years to resolve. Examples would be product
|
|
liability, or directors and officers liability coverages. With a
|
|
business mix like this, one year of reserve development tells you
|
|
very little.
|
|
|
|
You should be very suspicious of any earnings figures
|
|
reported by insurers (including our own, as we have unfortunately
|
|
proved to you in the past). The record of the last decade shows
|
|
that a great many of our best-known insurers have reported
|
|
earnings to shareholders that later proved to be wildly
|
|
erroneous. In most cases, these errors were totally innocent:
|
|
The unpredictability of our legal system makes it impossible for
|
|
even the most conscientious insurer to come close to judging the
|
|
eventual cost of long-tail claims.
|
|
|
|
Nevertheless, auditors annually certify the numbers given
|
|
them by management and in their opinions unqualifiedly state that
|
|
these figures "present fairly" the financial position of their
|
|
clients. The auditors use this reassuring language even though
|
|
they know from long and painful experience that the numbers so
|
|
certified are likely to differ dramatically from the true
|
|
earnings of the period. Despite this history of error, investors
|
|
understandably rely upon auditors' opinions. After all, a
|
|
declaration saying that "the statements present fairly" hardly
|
|
sounds equivocal to the non-accountant.
|
|
|
|
The wording in the auditor's standard opinion letter is
|
|
scheduled to change next year. The new language represents
|
|
improvement, but falls far short of describing the limitations of
|
|
a casualty-insurer audit. If it is to depict the true state of
|
|
affairs, we believe the standard opinion letter to shareholders
|
|
of a property-casualty company should read something like: "We
|
|
have relied upon representations of management in respect to the
|
|
liabilities shown for losses and loss adjustment expenses, the
|
|
estimate of which, in turn, very materially affects the earnings
|
|
and financial condition herein reported. We can express no
|
|
opinion about the accuracy of these figures. Subject to that
|
|
important reservation, in our opinion, etc."
|
|
|
|
If lawsuits develop in respect to wildly inaccurate
|
|
financial statements (which they do), auditors will definitely
|
|
say something of that sort in court anyway. Why should they not
|
|
be forthright about their role and its limitations from the
|
|
outset?
|
|
|
|
We want to emphasize that we are not faulting auditors for
|
|
their inability to accurately assess loss reserves (and therefore
|
|
earnings). We fault them only for failing to publicly
|
|
acknowledge that they can't do this job.
|
|
|
|
From all appearances, the innocent mistakes that are
|
|
constantly made in reserving are accompanied by others that are
|
|
deliberate. Various charlatans have enriched themselves at the
|
|
expense of the investing public by exploiting, first, the
|
|
inability of auditors to evaluate reserve figures and, second,
|
|
the auditors' willingness to confidently certify those figures as
|
|
if they had the expertise to do so. We will continue to see such
|
|
chicanery in the future. Where "earnings" can be created by the
|
|
stroke of a pen, the dishonest will gather. For them, long-tail
|
|
insurance is heaven. The audit wording we suggest would at least
|
|
serve to put investors on guard against these predators.
|
|
|
|
The taxes that insurance companies pay - which increased
|
|
materially, though on a delayed basis, upon enactment of the Tax
|
|
Reform Act of 1986 - took a further turn for the worse at the end
|
|
of 1987. We detailed the 1986 changes in last year's report. We
|
|
also commented on the irony of a statute that substantially
|
|
increased 1987 reported earnings for insurers even as it
|
|
materially reduced both their long-term earnings potential and
|
|
their business value. At Berkshire, the temporarily-helpful
|
|
"fresh start" adjustment inflated 1987 earnings by $8.2 million.
|
|
|
|
In our opinion, the 1986 Act was the most important economic
|
|
event affecting the insurance industry over the past decade. The
|
|
1987 Bill further reduced the intercorporate dividends-received
|
|
credit from 80% to 70%, effective January 1, 1988, except for
|
|
cases in which the taxpayer owns at least 20% of an investee.
|
|
|
|
Investors who have owned stocks or bonds through corporate
|
|
intermediaries other than qualified investment companies have
|
|
always been disadvantaged in comparison to those owning the same
|
|
securities directly. The penalty applying to indirect ownership
|
|
was greatly increased by the 1986 Tax Bill and, to a lesser
|
|
extent, by the 1987 Bill, particularly in instances where the
|
|
intermediary is an insurance company. We have no way of
|
|
offsetting this increased level of taxation. It simply means
|
|
that a given set of pre-tax investment returns will now translate
|
|
into much poorer after-tax results for our shareholders.
|
|
|
|
All in all, we expect to do well in the insurance business,
|
|
though our record is sure to be uneven. The immediate outlook is
|
|
for substantially lower volume but reasonable earnings
|
|
improvement. The decline in premium volume will accelerate after
|
|
our quota-share agreement with Fireman's Fund expires in 1989.
|
|
At some point, likely to be at least a few years away, we may see
|
|
some major opportunities, for which we are now much better
|
|
prepared than we were in 1985.
|
|
|
|
Marketable Securities - Permanent Holdings
|
|
|
|
Whenever Charlie and I buy common stocks for Berkshire's
|
|
insurance companies (leaving aside arbitrage purchases, discussed
|
|
later) we approach the transaction as if we were buying into a
|
|
private business. We look at the economic prospects of the
|
|
business, the people in charge of running it, and the price we
|
|
must pay. We do not have in mind any time or price for sale.
|
|
Indeed, we are willing to hold a stock indefinitely so long as we
|
|
expect the business to increase in intrinsic value at a
|
|
satisfactory rate. When investing, we view ourselves as business
|
|
analysts - not as market analysts, not as macroeconomic analysts,
|
|
and not even as security analysts.
|
|
|
|
Our approach makes an active trading market useful, since it
|
|
periodically presents us with mouth-watering opportunities. But
|
|
by no means is it essential: a prolonged suspension of trading in
|
|
the securities we hold would not bother us any more than does the
|
|
lack of daily quotations on World Book or Fechheimer.
|
|
Eventually, our economic fate will be determined by the economic
|
|
fate of the business we own, whether our ownership is partial or
|
|
total.
|
|
|
|
Ben Graham, my friend and teacher, long ago described the
|
|
mental attitude toward market fluctuations that I believe to be
|
|
most conducive to investment success. He said that you should
|
|
imagine market quotations as coming from a remarkably
|
|
accommodating fellow named Mr. Market who is your partner in a
|
|
private business. Without fail, Mr. Market appears daily and
|
|
names a price at which he will either buy your interest or sell
|
|
you his.
|
|
|
|
Even though the business that the two of you own may have
|
|
economic characteristics that are stable, Mr. Market's quotations
|
|
will be anything but. For, sad to say, the poor fellow has
|
|
incurable emotional problems. At times he feels euphoric and can
|
|
see only the favorable factors affecting the business. When in
|
|
that mood, he names a very high buy-sell price because he fears
|
|
that you will snap up his interest and rob him of imminent gains.
|
|
At other times he is depressed and can see nothing but trouble
|
|
ahead for both the business and the world. On these occasions he
|
|
will name a very low price, since he is terrified that you will
|
|
unload your interest on him.
|
|
|
|
Mr. Market has another endearing characteristic: He doesn't
|
|
mind being ignored. If his quotation is uninteresting to you
|
|
today, he will be back with a new one tomorrow. Transactions are
|
|
strictly at your option. Under these conditions, the more manic-
|
|
depressive his behavior, the better for you.
|
|
|
|
But, like Cinderella at the ball, you must heed one warning
|
|
or everything will turn into pumpkins and mice: Mr. Market is
|
|
there to serve you, not to guide you. It is his pocketbook, not
|
|
his wisdom, that you will find useful. If he shows up some day
|
|
in a particularly foolish mood, you are free to either ignore him
|
|
or to take advantage of him, but it will be disastrous if you
|
|
fall under his influence. Indeed, if you aren't certain that you
|
|
understand and can value your business far better than Mr.
|
|
Market, you don't belong in the game. As they say in poker, "If
|
|
you've been in the game 30 minutes and you don't know who the
|
|
patsy is, you're the patsy."
|
|
|
|
Ben's Mr. Market allegory may seem out-of-date in today's
|
|
investment world, in which most professionals and academicians
|
|
talk of efficient markets, dynamic hedging and betas. Their
|
|
interest in such matters is understandable, since techniques
|
|
shrouded in mystery clearly have value to the purveyor of
|
|
investment advice. After all, what witch doctor has ever
|
|
achieved fame and fortune by simply advising "Take two aspirins"?
|
|
|
|
The value of market esoterica to the consumer of investment
|
|
advice is a different story. In my opinion, investment success
|
|
will not be produced by arcane formulae, computer programs or
|
|
signals flashed by the price behavior of stocks and markets.
|
|
Rather an investor will succeed by coupling good business
|
|
judgment with an ability to insulate his thoughts and behavior
|
|
from the super-contagious emotions that swirl about the
|
|
marketplace. In my own efforts to stay insulated, I have found
|
|
it highly useful to keep Ben's Mr. Market concept firmly in mind.
|
|
|
|
Following Ben's teachings, Charlie and I let our marketable
|
|
equities tell us by their operating results - not by their daily,
|
|
or even yearly, price quotations - whether our investments are
|
|
successful. The market may ignore business success for a while,
|
|
but eventually will confirm it. As Ben said: "In the short run,
|
|
the market is a voting machine but in the long run it is a
|
|
weighing machine." The speed at which a business's success is
|
|
recognized, furthermore, is not that important as long as the
|
|
company's intrinsic value is increasing at a satisfactory rate.
|
|
In fact, delayed recognition can be an advantage: It may give us
|
|
the chance to buy more of a good thing at a bargain price.
|
|
|
|
Sometimes, of course, the market may judge a business to be
|
|
more valuable than the underlying facts would indicate it is. In
|
|
such a case, we will sell our holdings. Sometimes, also, we will
|
|
sell a security that is fairly valued or even undervalued because
|
|
we require funds for a still more undervalued investment or one
|
|
we believe we understand better.
|
|
|
|
We need to emphasize, however, that we do not sell holdings
|
|
just because they have appreciated or because we have held them
|
|
for a long time. (Of Wall Street maxims the most foolish may be
|
|
"You can't go broke taking a profit.") We are quite content to
|
|
hold any security indefinitely, so long as the prospective return
|
|
on equity capital of the underlying business is satisfactory,
|
|
management is competent and honest, and the market does not
|
|
overvalue the business.
|
|
|
|
However, our insurance companies own three marketable common
|
|
stocks that we would not sell even though they became far
|
|
overpriced in the market. In effect, we view these investments
|
|
exactly like our successful controlled businesses - a permanent
|
|
part of Berkshire rather than merchandise to be disposed of once
|
|
Mr. Market offers us a sufficiently high price. To that, I will
|
|
add one qualifier: These stocks are held by our insurance
|
|
companies and we would, if absolutely necessary, sell portions of
|
|
our holdings to pay extraordinary insurance losses. We intend,
|
|
however, to manage our affairs so that sales are never required.
|
|
|
|
A determination to have and to hold, which Charlie and I
|
|
share, obviously involves a mixture of personal and financial
|
|
considerations. To some, our stand may seem highly eccentric.
|
|
(Charlie and I have long followed David Oglivy's advice: "Develop
|
|
your eccentricities while you are young. That way, when you get
|
|
old, people won't think you're going ga-ga.") Certainly, in the
|
|
transaction-fixated Wall Street of recent years, our posture must
|
|
seem odd: To many in that arena, both companies and stocks are
|
|
seen only as raw material for trades.
|
|
|
|
Our attitude, however, fits our personalities and the way we
|
|
want to live our lives. Churchill once said, "You shape your
|
|
houses and then they shape you." We know the manner in which we
|
|
wish to be shaped. For that reason, we would rather achieve a
|
|
return of X while associating with people whom we strongly like
|
|
and admire than realize 110% of X by exchanging these
|
|
relationships for uninteresting or unpleasant ones. And we will
|
|
never find people we like and admire more than some of the main
|
|
participants at the three companies - our permanent holdings -
|
|
shown below:
|
|
|
|
No. of Shares Cost Market
|
|
------------- ---------- ----------
|
|
(000s omitted)
|
|
3,000,000 Capital Cities/ABC, Inc. ........... $517,500 $1,035,000
|
|
6,850,000 GEICO Corporation .................. 45,713 756,925
|
|
1,727,765 The Washington Post Company ........ 9,731 323,092
|
|
|
|
We really don't see many fundamental differences between the
|
|
purchase of a controlled business and the purchase of marketable
|
|
holdings such as these. In each case we try to buy into
|
|
businesses with favorable long-term economics. Our goal is to
|
|
find an outstanding business at a sensible price, not a mediocre
|
|
business at a bargain price. Charlie and I have found that
|
|
making silk purses out of silk is the best that we can do; with
|
|
sow's ears, we fail.
|
|
|
|
(It must be noted that your Chairman, always a quick study,
|
|
required only 20 years to recognize how important it was to buy
|
|
good businesses. In the interim, I searched for "bargains" - and
|
|
had the misfortune to find some. My punishment was an education
|
|
in the economics of short-line farm implement manufacturers,
|
|
third-place department stores, and New England textile
|
|
manufacturers.)
|
|
|
|
Of course, Charlie and I may misread the fundamental
|
|
economics of a business. When that happens, we will encounter
|
|
problems whether that business is a wholly-owned subsidiary or a
|
|
marketable security, although it is usually far easier to exit
|
|
from the latter. (Indeed, businesses can be misread: Witness the
|
|
European reporter who, after being sent to this country to
|
|
profile Andrew Carnegie, cabled his editor, "My God, you'll never
|
|
believe the sort of money there is in running libraries.")
|
|
|
|
In making both control purchases and stock purchases, we try
|
|
to buy not only good businesses, but ones run by high-grade,
|
|
talented and likeable managers. If we make a mistake about the
|
|
managers we link up with, the controlled company offers a certain
|
|
advantage because we have the power to effect change. In
|
|
practice, however, this advantage is somewhat illusory:
|
|
Management changes, like marital changes, are painful, time-
|
|
consuming and chancy. In any event, at our three marketable-but
|
|
permanent holdings, this point is moot: With Tom Murphy and Dan
|
|
Burke at Cap Cities, Bill Snyder and Lou Simpson at GEICO, and
|
|
Kay Graham and Dick Simmons at The Washington Post, we simply
|
|
couldn't be in better hands.
|
|
|
|
I would say that the controlled company offers two main
|
|
advantages. First, when we control a company we get to allocate
|
|
capital, whereas we are likely to have little or nothing to say
|
|
about this process with marketable holdings. This point can be
|
|
important because the heads of many companies are not skilled in
|
|
capital allocation. Their inadequacy is not surprising. Most
|
|
bosses rise to the top because they have excelled in an area such
|
|
as marketing, production, engineering, administration or,
|
|
sometimes, institutional politics.
|
|
|
|
Once they become CEOs, they face new responsibilities. They
|
|
now must make capital allocation decisions, a critical job that
|
|
they may have never tackled and that is not easily mastered. To
|
|
stretch the point, it's as if the final step for a highly-
|
|
talented musician was not to perform at Carnegie Hall but,
|
|
instead, to be named Chairman of the Federal Reserve.
|
|
|
|
The lack of skill that many CEOs have at capital allocation
|
|
is no small matter: After ten years on the job, a CEO whose
|
|
company annually retains earnings equal to 10% of net worth will
|
|
have been responsible for the deployment of more than 60% of all
|
|
the capital at work in the business.
|
|
|
|
CEOs who recognize their lack of capital-allocation skills
|
|
(which not all do) will often try to compensate by turning to
|
|
their staffs, management consultants, or investment bankers.
|
|
Charlie and I have frequently observed the consequences of such
|
|
"help." On balance, we feel it is more likely to accentuate the
|
|
capital-allocation problem than to solve it.
|
|
|
|
In the end, plenty of unintelligent capital allocation takes
|
|
place in corporate America. (That's why you hear so much about
|
|
"restructuring.") Berkshire, however, has been fortunate. At the
|
|
companies that are our major non-controlled holdings, capital has
|
|
generally been well-deployed and, in some cases, brilliantly so.
|
|
|
|
The second advantage of a controlled company over a
|
|
marketable security has to do with taxes. Berkshire, as a
|
|
corporate holder, absorbs some significant tax costs through the
|
|
ownership of partial positions that we do not when our ownership
|
|
is 80%, or greater. Such tax disadvantages have long been with
|
|
us, but changes in the tax code caused them to increase
|
|
significantly during the past year. As a consequence, a given
|
|
business result can now deliver Berkshire financial results that
|
|
are as much as 50% better if they come from an 80%-or-greater
|
|
holding rather than from a lesser holding.
|
|
|
|
The disadvantages of owning marketable securities are
|
|
sometimes offset by a huge advantage: Occasionally the stock
|
|
market offers us the chance to buy non-controlling pieces of
|
|
extraordinary businesses at truly ridiculous prices -
|
|
dramatically below those commanded in negotiated transactions
|
|
that transfer control. For example, we purchased our Washington
|
|
Post stock in 1973 at $5.63 per share, and per-share operating
|
|
earnings in 1987 after taxes were $10.30. Similarly, Our GEICO
|
|
stock was purchased in 1976, 1979 and 1980 at an average of $6.67
|
|
per share, and after-tax operating earnings per share last year
|
|
were $9.01. In cases such as these, Mr. Market has proven to be a
|
|
mighty good friend.
|
|
|
|
An interesting accounting irony overlays a comparison of the
|
|
reported financial results of our controlled companies with those
|
|
of the permanent minority holdings listed above. As you can see,
|
|
those three stocks have a market value of over $2 billion. Yet
|
|
they produced only $11 million in reported after-tax earnings for
|
|
Berkshire in 1987.
|
|
|
|
Accounting rules dictate that we take into income only the
|
|
dividends these companies pay us - which are little more than
|
|
nominal - rather than our share of their earnings, which in 1987
|
|
amounted to well over $100 million. On the other hand,
|
|
accounting rules provide that the carrying value of these three
|
|
holdings - owned, as they are, by insurance companies - must be
|
|
recorded on our balance sheet at current market prices. The
|
|
result: GAAP accounting lets us reflect in our net worth the up-
|
|
to-date underlying values of the businesses we partially own, but
|
|
does not let us reflect their underlying earnings in our income
|
|
account.
|
|
|
|
In the case of our controlled companies, just the opposite
|
|
is true. Here, we show full earnings in our income account but
|
|
never change asset values on our balance sheet, no matter how
|
|
much the value of a business might have increased since we
|
|
purchased it.
|
|
|
|
Our mental approach to this accounting schizophrenia is to
|
|
ignore GAAP figures and to focus solely on the future earning
|
|
power of both our controlled and non-controlled businesses.
|
|
Using this approach, we establish our own ideas of business
|
|
value, keeping these independent from both the accounting values
|
|
shown on our books for controlled companies and the values placed
|
|
by a sometimes foolish market on our partially-owned companies.
|
|
It is this business value that we hope to increase at a
|
|
reasonable (or, preferably, unreasonable) rate in the years
|
|
ahead.
|
|
|
|
Marketable Securities - Other
|
|
|
|
In addition to our three permanent common stock holdings, we
|
|
hold large quantities of marketable securities in our insurance
|
|
companies. In selecting these, we can choose among five major
|
|
categories: (1) long-term common stock investments, (2) medium-
|
|
term fixed-income securities, (3) long-term fixed income
|
|
securities, (4) short-term cash equivalents, and (5) short-term
|
|
arbitrage commitments.
|
|
|
|
We have no particular bias when it comes to choosing from
|
|
these categories. We just continuously search among them for the
|
|
highest after-tax returns as measured by "mathematical
|
|
expectation," limiting ourselves always to investment
|
|
alternatives we think we understand. Our criteria have nothing
|
|
to do with maximizing immediately reportable earnings; our goal,
|
|
rather, is to maximize eventual net worth.
|
|
|
|
o Let's look first at common stocks. During 1987 the stock
|
|
market was an area of much excitement but little net movement:
|
|
The Dow advanced 2.3% for the year. You are aware, of course, of
|
|
the roller coaster ride that produced this minor change. Mr.
|
|
Market was on a manic rampage until October and then experienced
|
|
a sudden, massive seizure.
|
|
|
|
We have "professional" investors, those who manage many
|
|
billions, to thank for most of this turmoil. Instead of focusing
|
|
on what businesses will do in the years ahead, many prestigious
|
|
money managers now focus on what they expect other money managers
|
|
to do in the days ahead. For them, stocks are merely tokens in a
|
|
game, like the thimble and flatiron in Monopoly.
|
|
|
|
An extreme example of what their attitude leads to is
|
|
"portfolio insurance," a money-management strategy that many
|
|
leading investment advisors embraced in 1986-1987. This strategy
|
|
- which is simply an exotically-labeled version of the small
|
|
speculator's stop-loss order dictates that ever increasing
|
|
portions of a stock portfolio, or their index-future equivalents,
|
|
be sold as prices decline. The strategy says nothing else
|
|
matters: A downtick of a given magnitude automatically produces a
|
|
huge sell order. According to the Brady Report, $60 billion to
|
|
$90 billion of equities were poised on this hair trigger in mid-
|
|
October of 1987.
|
|
|
|
If you've thought that investment advisors were hired to
|
|
invest, you may be bewildered by this technique. After buying a
|
|
farm, would a rational owner next order his real estate agent to
|
|
start selling off pieces of it whenever a neighboring property
|
|
was sold at a lower price? Or would you sell your house to
|
|
whatever bidder was available at 9:31 on some morning merely
|
|
because at 9:30 a similar house sold for less than it would have
|
|
brought on the previous day?
|
|
|
|
Moves like that, however, are what portfolio insurance tells
|
|
a pension fund or university to make when it owns a portion of
|
|
enterprises such as Ford or General Electric. The less these
|
|
companies are being valued at, says this approach, the more
|
|
vigorously they should be sold. As a "logical" corollary, the
|
|
approach commands the institutions to repurchase these companies
|
|
- I'm not making this up - once their prices have rebounded
|
|
significantly. Considering that huge sums are controlled by
|
|
managers following such Alice-in-Wonderland practices, is it any
|
|
surprise that markets sometimes behave in aberrational fashion?
|
|
|
|
Many commentators, however, have drawn an incorrect
|
|
conclusion upon observing recent events: They are fond of saying
|
|
that the small investor has no chance in a market now dominated
|
|
by the erratic behavior of the big boys. This conclusion is dead
|
|
wrong: Such markets are ideal for any investor - small or large -
|
|
so long as he sticks to his investment knitting. Volatility
|
|
caused by money managers who speculate irrationally with huge
|
|
sums will offer the true investor more chances to make
|
|
intelligent investment moves. He can be hurt by such volatility
|
|
only if he is forced, by either financial or psychological
|
|
pressures, to sell at untoward times.
|
|
|
|
At Berkshire, we have found little to do in stocks during
|
|
the past few years. During the break in October, a few stocks
|
|
fell to prices that interested us, but we were unable to make
|
|
meaningful purchases before they rebounded. At yearend 1987 we
|
|
had no major common stock investments (that is, over $50 million)
|
|
other than those we consider permanent or arbitrage holdings.
|
|
However, Mr. Market will offer us opportunities - you can be sure
|
|
of that - and, when he does, we will be willing and able to
|
|
participate.
|
|
|
|
o In the meantime, our major parking place for money is
|
|
medium-term tax-exempt bonds, whose limited virtues I explained
|
|
in last year's annual report. Though we both bought and sold
|
|
some of these bonds in 1987, our position changed little overall,
|
|
holding around $900 million. A large portion of our bonds are
|
|
"grandfathered" under the Tax Reform Act of 1986, which means
|
|
they are fully tax-exempt. Bonds currently purchased by
|
|
insurance companies are not.
|
|
|
|
As an alternative to short-term cash equivalents, our
|
|
medium-term tax-exempts have - so far served us well. They have
|
|
produced substantial extra income for us and are currently worth
|
|
a bit above our cost. Regardless of their market price, we are
|
|
ready to dispose of our bonds whenever something better comes
|
|
along.
|
|
|
|
o We continue to have an aversion to long-term bonds (and may
|
|
be making a serious mistake by not disliking medium-term bonds as
|
|
well). Bonds are no better than the currency in which they are
|
|
denominated, and nothing we have seen in the past year - or past
|
|
decade - makes us enthusiastic about the long-term future of U.S.
|
|
currency.
|
|
|
|
Our enormous trade deficit is causing various forms of
|
|
"claim checks" - U.S. government and corporate bonds, bank
|
|
deposits, etc. - to pile up in the hands of foreigners at a
|
|
distressing rate. By default, our government has adopted an
|
|
approach to its finances patterned on that of Blanche DuBois, of
|
|
A Streetcar Named Desire, who said, "I have always depended on
|
|
the kindness of strangers." In this case, of course, the
|
|
"strangers" are relying on the integrity of our claim checks
|
|
although the plunging dollar has already made that proposition
|
|
expensive for them.
|
|
|
|
The faith that foreigners are placing in us may be
|
|
misfounded. When the claim checks outstanding grow sufficiently
|
|
numerous and when the issuing party can unilaterally determine
|
|
their purchasing power, the pressure on the issuer to dilute
|
|
their value by inflating the currency becomes almost
|
|
irresistible. For the debtor government, the weapon of inflation
|
|
is the economic equivalent of the "H" bomb, and that is why very
|
|
few countries have been allowed to swamp the world with debt
|
|
denominated in their own currency. Our past, relatively good
|
|
record for fiscal integrity has let us break this rule, but the
|
|
generosity accorded us is likely to intensify, rather than
|
|
relieve, the eventual pressure on us to inflate. If we do
|
|
succumb to that pressure, it won't be just the foreign holders of
|
|
our claim checks who will suffer. It will be all of us as well.
|
|
|
|
Of course, the U.S. may take steps to stem our trade deficit
|
|
well before our position as a net debtor gets out of hand. (In
|
|
that respect, the falling dollar will help, though unfortunately
|
|
it will hurt in other ways.) Nevertheless, our government's
|
|
behavior in this test of its mettle is apt to be consistent with
|
|
its Scarlett O'Hara approach generally: "I'll think about it
|
|
tomorrow." And, almost inevitably, procrastination in facing up
|
|
to fiscal problems will have inflationary consequences.
|
|
|
|
Both the timing and the sweep of those consequences are
|
|
unpredictable. But our inability to quantify or time the risk
|
|
does not mean we should ignore it. While recognizing the
|
|
possibility that we may be wrong and that present interest rates
|
|
may adequately compensate for the inflationary risk, we retain a
|
|
general fear of long-term bonds.
|
|
|
|
We are, however, willing to invest a moderate portion of our
|
|
funds in this category if we think we have a significant edge in
|
|
a specific security. That willingness explains our holdings of
|
|
the Washington Public Power Supply Systems #1, #2 and #3 issues,
|
|
discussed in our 1984 report. We added to our WPPSS position
|
|
during 1987. At yearend, we had holdings with an amortized cost
|
|
of $240 million and a market value of $316 million, paying us
|
|
tax-exempt income of $34 million annually.
|
|
|
|
o We continued to do well in arbitrage last year, though - or
|
|
perhaps because - we operated on a very limited scale. We enter
|
|
into only a few arbitrage commitments each year and restrict
|
|
ourselves to large transactions that have been publicly
|
|
announced. We do not participate in situations in which green-
|
|
mailers are attempting to put a target company "in play."
|
|
|
|
We have practiced arbitrage on an opportunistic basis for
|
|
decades and, to date, our results have been quite good. Though
|
|
we've never made an exact calculation, I believe that overall we
|
|
have averaged annual pre-tax returns of at least 25% from
|
|
arbitrage. I'm quite sure we did better than that in 1987. But
|
|
it should be emphasized that a really bad experience or two -
|
|
such as many arbitrage operations suffered in late 1987 - could
|
|
change the figures dramatically.
|
|
|
|
Our only $50 million-plus arbitrage position at yearend 1987
|
|
was 1,096,200 shares of Allegis, with a cost of $76 million and a
|
|
market value of $78 million.
|
|
|
|
o We had two other large holdings at yearend that do not fit
|
|
precisely into any of our five categories. One was various
|
|
Texaco, Inc. bonds with short maturities, all purchased after
|
|
Texaco went into bankruptcy. Were it not for the extraordinarily
|
|
strong capital position of our insurance companies, it would be
|
|
inappropriate for us to buy defaulted bonds. At prices
|
|
prevailing after Texaco's bankruptcy filing, however, we regarded
|
|
these issues as by far the most attractive bond investment
|
|
available to us.
|
|
|
|
On a worst-case basis with respect to the Pennzoil
|
|
litigation, we felt the bonds were likely to be worth about what
|
|
we paid for them. Given a sensible settlement, which seemed
|
|
likely, we expected the bonds to be worth considerably more. At
|
|
yearend our Texaco bonds were carried on our books at $104
|
|
million and had a market value of $119 million.
|
|
|
|
By far our largest - and most publicized - investment in
|
|
1987 was a $700 million purchase of Salomon Inc 9% preferred
|
|
stock. This preferred is convertible after three years into
|
|
Salomon common stock at $38 per share and, if not converted, will
|
|
be redeemed ratably over five years beginning October 31, 1995.
|
|
From most standpoints, this commitment fits into the medium-term
|
|
fixed-income securities category. In addition, we have an
|
|
interesting conversion possibility.
|
|
|
|
We, of course, have no special insights regarding the
|
|
direction or future profitability of investment banking. By
|
|
their nature, the economics of this industry are far less
|
|
predictable than those of most other industries in which we have
|
|
major Commitments. This unpredictability is one of the reasons
|
|
why our participation is in the form of a convertible preferred.
|
|
|
|
What we do have a strong feeling about is the ability and
|
|
integrity of John Gutfreund, CEO of Salomon Inc. Charlie and I
|
|
like, admire and trust John. We first got to know him in 1976
|
|
when he played a key role in GEICO's escape from near-bankruptcy.
|
|
Several times since, we have seen John steer clients away from
|
|
transactions that would have been unwise, but that the client
|
|
clearly wanted to make - even though his advice provided no fee
|
|
to Salomon and acquiescence would have delivered a large fee.
|
|
Such service-above-self behavior is far from automatic in Wall
|
|
Street.
|
|
|
|
For the reasons Charlie outlines on page 50, at yearend we
|
|
valued our Salomon investment at 98% of par, $14 million less
|
|
than our cost. However, we believe there is a reasonable
|
|
likelihood that a leading, high-quality capital-raising and
|
|
market-making operation can average good returns on equity. If
|
|
so, our conversion right will eventually prove to be valuable.
|
|
|
|
Two further comments about our investments in marketable
|
|
securities are appropriate. First, we give you our usual
|
|
warning: Our holdings have changed since yearend and will
|
|
continue to do so without notice.
|
|
|
|
The second comment is related: During 1987, as in some
|
|
earlier years, there was speculation in the press from time to
|
|
time about our purchase or sale of various securities. These
|
|
stories were sometimes true, sometimes partially true, and other
|
|
times completely untrue. Interestingly, there has been no
|
|
correlation between the size and prestige of the publication and
|
|
the accuracy of the report. One dead-wrong rumor was given
|
|
considerable prominence by a major national magazine, and another
|
|
leading publication misled its readers by writing about an
|
|
arbitrage position as if it were a long-term investment
|
|
commitment. (In not naming names, I am observing the old warning
|
|
that it's not wise to pick fights with people who buy ink by the
|
|
barrel.)
|
|
|
|
You should understand that we simply don't comment in any
|
|
way on rumors, whether they are true or false. If we were to
|
|
deny the incorrect reports and refuse comment on the correct
|
|
ones, we would in effect be commenting on all.
|
|
|
|
In a world in which big investment ideas are both limited
|
|
and valuable, we have no interest in telling potential
|
|
competitors what we are doing except to the extent required by
|
|
law. We certainly don't expect others to tell us of their
|
|
investment ideas. Nor would we expect a media company to
|
|
disclose news of acquisitions it was privately pursuing or a
|
|
journalist to tell his competitors about stories on which he is
|
|
working or sources he is using.
|
|
|
|
I find it uncomfortable when friends or acquaintances
|
|
mention that they are buying X because it has been reported -
|
|
incorrectly - that Berkshire is a buyer. However, I do not set
|
|
them straight. If they want to participate in whatever Berkshire
|
|
actually is buying, they can always purchase Berkshire stock.
|
|
But perhaps that is too simple. Usually, I suspect, they find it
|
|
more exciting to buy what is being talked about. Whether that
|
|
strategy is more profitable is another question.
|
|
|
|
Financing
|
|
|
|
Shortly after yearend, Berkshire sold two issues of
|
|
debentures, totaling $250 million. Both issues mature in 2018
|
|
and will be retired at an even pace through sinking fund
|
|
operations that begin in 1999. Our overall interest cost, after
|
|
allowing for expenses of issuance, is slightly over 10%. Salomon
|
|
was our investment banker, and its service was excellent.
|
|
|
|
Despite our pessimistic views about inflation, our taste for
|
|
debt is quite limited. To be sure, it is likely that Berkshire
|
|
could improve its return on equity by moving to a much higher,
|
|
though still conventional, debt-to-business-value ratio. It's
|
|
even more likely that we could handle such a ratio, without
|
|
problems, under economic conditions far worse than any that have
|
|
prevailed since the early 1930s.
|
|
|
|
But we do not wish it to be only likely that we can meet our
|
|
obligations; we wish that to be certain. Thus we adhere to
|
|
policies - both in regard to debt and all other matters - that
|
|
will allow us to achieve acceptable long-term results under
|
|
extraordinarily adverse conditions, rather than optimal results
|
|
under a normal range of conditions.
|
|
|
|
Good business or investment decisions will eventually
|
|
produce quite satisfactory economic results, with no aid from
|
|
leverage. Therefore, it seems to us to be both foolish and
|
|
improper to risk what is important (including, necessarily, the
|
|
welfare of innocent bystanders such as policyholders and
|
|
employees) for some extra returns that are relatively
|
|
unimportant. This view is not the product of either our
|
|
advancing age or prosperity: Our opinions about debt have
|
|
remained constant.
|
|
|
|
However, we are not phobic about borrowing. (We're far from
|
|
believing that there is no fate worse than debt.) We are willing
|
|
to borrow an amount that we believe - on a worst-case basis -
|
|
will pose no threat to Berkshire's well-being. Analyzing what
|
|
that amount might be, we can look to some important strengths
|
|
that would serve us well if major problems should engulf our
|
|
economy: Berkshire's earnings come from many diverse and well-
|
|
entrenched businesses; these businesses seldom require much
|
|
capital investment; what debt we have is structured well; and we
|
|
maintain major holdings of liquid assets. Clearly, we could be
|
|
comfortable with a higher debt-to-business-value ratio than we
|
|
now have.
|
|
|
|
One further aspect of our debt policy deserves comment:
|
|
Unlike many in the business world, we prefer to finance in
|
|
anticipation of need rather than in reaction to it. A business
|
|
obtains the best financial results possible by managing both
|
|
sides of its balance sheet well. This means obtaining the
|
|
highest-possible return on assets and the lowest-possible cost on
|
|
liabilities. It would be convenient if opportunities for
|
|
intelligent action on both fronts coincided. However, reason
|
|
tells us that just the opposite is likely to be the case: Tight
|
|
money conditions, which translate into high costs for
|
|
liabilities, will create the best opportunities for acquisitions,
|
|
and cheap money will cause assets to be bid to the sky. Our
|
|
conclusion: Action on the liability side should sometimes be
|
|
taken independent of any action on the asset side.
|
|
|
|
Alas, what is "tight" and "cheap" money is far from clear at
|
|
any particular time. We have no ability to forecast interest
|
|
rates and - maintaining our usual open-minded spirit - believe
|
|
that no one else can. Therefore, we simply borrow when
|
|
conditions seem non-oppressive and hope that we will later find
|
|
intelligent expansion or acquisition opportunities, which - as we
|
|
have said - are most likely to pop up when conditions in the debt
|
|
market are clearly oppressive. Our basic principle is that if
|
|
you want to shoot rare, fast-moving elephants, you should always
|
|
carry a loaded gun.
|
|
|
|
Our fund-first, buy-or-expand-later policy almost always
|
|
penalizes near-term earnings. For example, we are now earning
|
|
about 6 1/2% on the $250 million we recently raised at 10%, a
|
|
disparity that is currently costing us about $160,000 per week.
|
|
This negative spread is unimportant to us and will not cause us
|
|
to stretch for either acquisitions or higher-yielding short-term
|
|
instruments. If we find the right sort of business elephant
|
|
within the next five years or so, the wait will have been
|
|
worthwhile.
|
|
|
|
Miscellaneous
|
|
|
|
We hope to buy more businesses that are similar to the ones
|
|
we have, and we can use some help. If you have a business that
|
|
fits the following criteria, call me or, preferably, write.
|
|
|
|
Here's what we're looking for:
|
|
|
|
(1) large purchases (at least $10 million of after-tax
|
|
earnings),
|
|
|
|
(2) demonstrated consistent earning power (future
|
|
projections are of little interest to us, nor are
|
|
"turnaround" situations),
|
|
|
|
(3) businesses earning good returns on equity while
|
|
employing little or no debt,
|
|
|
|
(4) management in place (we can't supply it),
|
|
|
|
(5) simple businesses (if there's lots of technology,
|
|
we won't understand it),
|
|
|
|
(6) an offering price (we don't want to waste our time
|
|
or that of the seller by talking, even preliminarily,
|
|
about a transaction when price is unknown).
|
|
|
|
We will not engage in unfriendly takeovers. We can promise
|
|
complete confidentiality and a very fast answer - customarily
|
|
within five minutes - as to whether we're interested. We prefer
|
|
to buy for cash, but will consider issuing stock when we receive
|
|
as much in intrinsic business value as we give. We invite
|
|
potential sellers to check us out by contacting people with whom
|
|
we have done business in the past. For the right business - and
|
|
the right people - we can provide a good home.
|
|
|
|
On the other hand, we frequently get approached about
|
|
acquisitions that don't come close to meeting our tests: new
|
|
ventures, turnarounds, auction-like sales, and the ever-popular
|
|
(among brokers) "I'm-sure-something-will-work-out-if-you-people-
|
|
get-to-know-each-other." None of these attracts us in the least.
|
|
|
|
Besides being interested in the purchases of entire
|
|
businesses as described above, we are also interested in the
|
|
negotiated purchase of large, but not controlling, blocks of
|
|
stock comparable to those we hold in Cap Cities and Salomon. We
|
|
have a special interest in purchasing convertible preferreds as a
|
|
long-term investment, as we did at Salomon.
|
|
|
|
* * *
|
|
|
|
And now a bit of deja vu. Most of Berkshire's major
|
|
stockholders received their shares at yearend 1969 in a
|
|
liquidating distribution from Buffett Partnership, Ltd. Some of
|
|
these former partners will remember that in 1962 I encountered
|
|
severe managerial problems at Dempster Mill Manufacturing Co., a
|
|
pump and farm implement manufacturing company that BPL
|
|
controlled.
|
|
|
|
At that time, like now, I went to Charlie with problems that
|
|
were too tough for me to solve. Charlie suggested the solution
|
|
might lie in a California friend of his, Harry Bottle, whose
|
|
special knack was never forgetting the fundamental. I met Harry
|
|
in Los Angeles on April 17, 1962, and on April 23 he was in
|
|
Beatrice, Nebraska, running Dempster. Our problems disappeared
|
|
almost immediately. In my 1962 annual letter to partners, I
|
|
named Harry "Man of the Year."
|
|
|
|
Fade to 24 years later: The scene is K & W Products, a small
|
|
Berkshire subsidiary that produces automotive compounds. For
|
|
years K & W did well, but in 1985-86 it stumbled badly, as it
|
|
pursued the unattainable to the neglect of the achievable.
|
|
Charlie, who oversees K & W, knew there was no need to consult
|
|
me. Instead, he called Harry, now 68 years old, made him CEO,
|
|
and sat back to await the inevitable. He didn't wait long. In
|
|
1987 K & W's profits set a record, up more than 300% from 1986.
|
|
And, as profits went up, capital employed went down: K & W's
|
|
investment in accounts receivable and inventories has decreased
|
|
20%.
|
|
|
|
If we run into another managerial problem ten or twenty
|
|
years down the road, you know whose phone will ring.
|
|
|
|
* * *
|
|
|
|
About 97.2% of all eligible shares participated in
|
|
Berkshire's 1987 shareholder-designated contributions program.
|
|
Contributions made through the program were $4.9 million, and
|
|
2,050 charities were recipients.
|
|
|
|
A recent survey reported that about 50% of major American
|
|
companies match charitable contributions made by directors
|
|
(sometimes by a factor of three to one). In effect, these
|
|
representatives of the owners direct funds to their favorite
|
|
charities, and never consult the owners as to their charitable
|
|
preferences. (I wonder how they would feel if the process were
|
|
reversed and shareholders could invade the directors' pockets for
|
|
charities favored by the shareholders.) When A takes money from B
|
|
to give to C and A is a legislator, the process is called
|
|
taxation. But when A is an officer or director of a corporation,
|
|
it is called philanthropy. We continue to believe that
|
|
contributions, aside from those with quite clear direct benefits
|
|
to the company, should reflect the charitable preferences of
|
|
owners rather than those of officers and directors.
|
|
|
|
We urge new shareholders to read the description of our
|
|
shareholder-designated contributions program that appears on
|
|
pages 54 and 55. If you wish to participate in future programs,
|
|
we strongly urge that you immediately make sure your shares are
|
|
registered in the name of the actual owner, not in "street" name
|
|
or nominee name. Shares not so registered on September 30, l988
|
|
will be ineligible for the 1988 program.
|
|
|
|
* * *
|
|
|
|
Last year we again had about 450 shareholders at our annual
|
|
meeting. The 60 or so questions they asked were, as always,
|
|
excellent. At many companies, the annual meeting is a waste of
|
|
time because exhibitionists turn it into a sideshow. Ours,
|
|
however, is different. It is informative for shareholders and
|
|
fun for us. (At Berkshire's meetings, the exhibitionists are on
|
|
the dais.)
|
|
|
|
This year our meeting will be on May 23, 1988 in Omaha, and
|
|
we hope that you come. The meeting provides the forum for you to
|
|
ask any owner-related questions you may have, and we will keep
|
|
answering until all (except those dealing with portfolio
|
|
activities or other proprietary information) have been dealt
|
|
with.
|
|
|
|
Last year we rented two buses - for $100 - to take
|
|
shareholders interested in the trip to the Furniture Mart. Your
|
|
actions demonstrated your good judgment: You snapped up about
|
|
$40,000 of bargains. Mrs. B regards this expense/sales ratio as
|
|
on the high side and attributes it to my chronic inattention to
|
|
costs and generally sloppy managerial practices. But, gracious
|
|
as always, she has offered me another chance and we will again
|
|
have buses available following the meeting. Mrs. B says you must
|
|
beat last year's sales figures, and I have told her she won't be
|
|
disappointed.
|
|
|
|
|
|
|
|
Warren E. Buffett
|
|
February 29, 1988 Chairman of the Board |