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1997 Chairman's Letter
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BERKSHIRE HATHAWAY INC.
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1997 Chairman's Letter
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To the Shareholders of Berkshire Hathaway Inc.:
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Our gain in net worth during 1997
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was $8.0 billion, which increased the per-share book value of both our
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Class A and Class B stock by 34.1%. Over the last 33 years (that is, since
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present management took over) per-share book value has grown from $19 to
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$25,488, a rate of 24.1% compounded annually.(1)
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1. All figures used in this report apply to Berkshire's A shares,
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the successor to the only stock that the company had outstanding
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before 1996. The B shares have an economic interest equal to 1/30th
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that of the A.
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Given our gain of 34.1%, it is
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tempting to declare victory and move on. But last year's performance was
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no great triumph: Any investor can chalk up large returns when stocks
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soar, as they did in 1997. In a bull market, one must avoid the error of
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the preening duck that quacks boastfully after a torrential rainstorm,
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thinking that its paddling skills have caused it to rise in the world.
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A right-thinking duck would instead compare its position after the downpour
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to that of the other ducks on the pond.
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So what's our duck rating for 1997?
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The table on the facing page shows that though we paddled furiously last
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year, passive ducks that simply invested in the S&P Index rose almost
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as fast as we did. Our appraisal of 1997's performance, then: Quack.
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When the market booms, we tend
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to suffer in comparison with the S&P Index. The Index bears no tax
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costs, nor do mutual funds, since they pass through all tax liabilities
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to their owners. Last year, on the other hand, Berkshire paid or accrued
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$4.2 billion for federal income tax, or about 18% of our beginning net
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worth.
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Berkshire will always have corporate
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taxes to pay, which means it needs to overcome their drag in order to justify
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its existence. Obviously, Charlie Munger, Berkshire's Vice Chairman and
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my partner, and I won't be able to lick that handicap every year. But we
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expect over time to maintain a modest advantage over the Index, and that
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is the yardstick against which you should measure us. We will not ask you
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to adopt the philosophy of the Chicago Cubs fan who reacted to a string
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of lackluster seasons by saying, "Why get upset? Everyone has a bad
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century now and then."
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Gains in book value are, of course,
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not the bottom line at Berkshire. What truly counts are gains in per-share
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intrinsic business value. Ordinarily, though, the two measures tend to
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move roughly in tandem, and in 1997 that was the case: Led by a blow-out
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performance at GEICO, Berkshire's intrinsic value (which far exceeds book
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value) grew at nearly the same pace as book value.
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For more explanation of the term,
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intrinsic value, you may wish to refer to our Owner's Manual, reprinted
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on pages 62 to 71. This manual sets forth our owner-related business principles,
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information that is important to all of Berkshire's shareholders.
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In our last two annual reports,
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we furnished you a table that Charlie and I believe is central to estimating
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Berkshire's intrinsic value. In the updated version of that table, which
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follows, we trace our two key components of value. The first column lists
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our per-share ownership of investments (including cash and equivalents)
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and the second column shows our per-share earnings from Berkshire's operating
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businesses before taxes and purchase-accounting adjustments (discussed
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on pages 69 and 70), but after all interest and corporate expenses. The
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second column excludes all dividends, interest and capital gains that we
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realized from the investments presented in the first column. In effect,
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the columns show what Berkshire would look like were it split into two
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parts, with one entity holding our investments and the other operating
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all of our businesses and bearing all corporate costs.
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Pre-tax Earnings Per Share
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Investments Excluding All Income from
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Year Per Share Investments
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1967 $ 41 $ 1.09
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1977 372 12.44
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1987 3,910 108.14
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1997 38,043 717.82
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Pundits who ignore what our 38,000
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employees contribute to the company, and instead simply view Berkshire
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as a de facto investment company, should study the figures in the second
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column. We made our first business acquisition in 1967, and since then
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our pre-tax operating earnings have grown from $1 million to $888 million.
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Furthermore, as noted, in this exercise we have assigned all of Berkshire's
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corporate expenses -- overhead of $6.6 million, interest of $66.9 million
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and shareholder contributions of $15.4 million -- to our business operations,
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even though a portion of these could just as well have been assigned to
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the investment side.
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Here are the growth rates of the
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two segments by decade:
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Pre-tax Earnings Per Share
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Investments Excluding All Income from
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Decade Ending Per Share Investments
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1977 24.6% 27.6%
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1987 26.5% 24.1%
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1997 25.5% 20.8%
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Annual Growth
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Rate, 1967-1997 25.6% 24.2%
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During 1997, both parts of our
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business grew at a satisfactory rate, with investments increasing by $9,543
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per share, or 33.5%, and operating earnings growing by $296.43 per share,
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or 70.3%. One important caveat: Because we were lucky in our super-cat
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insurance business (to be discussed later) and because GEICO's underwriting
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gain was well above what we can expect in most years, our 1997 operating
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earnings were much better than we anticipated and also more than we expect
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for 1998.
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Our rate of progress in both investments
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and operations is certain to fall in the future. For anyone deploying
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capital, nothing recedes like success. My own history makes the point:
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Back in 1951, when I was attending Ben Graham's class at Columbia, an idea
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giving me a $10,000 gain improved my investment performance for the year
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by a full 100 percentage points. Today, an idea producing a $500 million
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pre-tax profit for Berkshire adds one percentage point to our performance.
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It's no wonder that my annual results in the 1950s were better by nearly
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thirty percentage points than my annual gains in any subsequent decade.
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Charlie's experience was similar. We weren't smarter then, just smaller.
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At our present size, any performance superiority we achieve will be minor.
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We will be helped, however, by
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the fact that the businesses to which we have already allocated capital
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-- both operating subsidiaries and companies in which we are passive investors
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-- have splendid long-term prospects. We are also blessed with a managerial
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corps that is unsurpassed in ability and focus. Most of these executives
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are wealthy and do not need the pay they receive from Berkshire to maintain
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their way of life. They are motivated by the joy of accomplishment, not
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by fame or fortune.
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Though we are delighted with what
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we own, we are not pleased with our prospects for committing incoming funds.
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Prices are high for both businesses and stocks. That does not mean that
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the prices of either will fall -- we have absolutely no view on that matter
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-- but it does mean that we get relatively little in prospective earnings
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when we commit fresh money.
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Under these circumstances, we try
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to exert a Ted Williams kind of discipline. In his book The Science
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of Hitting, Ted explains that he carved the strike zone into 77 cells,
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each the size of a baseball. Swinging only at balls in his "best"
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cell, he knew, would allow him to bat .400; reaching for balls in his "worst"
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spot, the low outside corner of the strike zone, would reduce him to .230.
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In other words, waiting for the fat pitch would mean a trip to the Hall
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of Fame; swinging indiscriminately would mean a ticket to the minors.
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If they are in the strike zone
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at all, the business "pitches" we now see are just catching the
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lower outside corner. If we swing, we will be locked into low returns.
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But if we let all of today's balls go by, there can be no assurance that
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the next ones we see will be more to our liking. Perhaps the attractive
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prices of the past were the aberrations, not the full prices of today.
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Unlike Ted, we can't be called out if we resist three pitches that are
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barely in the strike zone; nevertheless, just standing there, day after
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day, with my bat on my shoulder is not my idea of fun.
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Unconventional Commitments
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When we can't find our favorite
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commitment -- a well-run and sensibly-priced business with fine economics
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-- we usually opt to put new money into very short-term instruments of
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the highest quality. Sometimes, however, we venture elsewhere. Obviously
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we believe that the alternative commitments we make are more likely to
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result in profit than loss. But we also realize that they do not offer
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the certainty of profit that exists in a wonderful business secured at
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an attractive price. Finding that kind of opportunity, we know that
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we are going to make money -- the only question being when. With alternative
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investments, we think that we are going to make money. But we also
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recognize that we will sometimes realize losses, occasionally of substantial
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size.
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We had three non-traditional positions
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at yearend. The first was derivative contracts for 14.0 million barrels
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of oil, that being what was then left of a 45.7 million barrel position
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we established in 1994-95. Contracts for 31.7 million barrels were settled
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in 1995-97, and these supplied us with a pre-tax gain of about $61.9 million.
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Our remaining contracts expire during 1998 and 1999. In these, we had an
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unrealized gain of $11.6 million at yearend. Accounting rules require that
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commodity positions be carried at market value. Therefore, both our annual
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and quarterly financial statements reflect any unrealized gain or loss
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in these contracts. When we established our contracts, oil for future delivery
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seemed modestly underpriced. Today, though, we have no opinion as to its
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attractiveness.
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Our second non-traditional commitment
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is in silver. Last year, we purchased 111.2 million ounces. Marked to market,
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that position produced a pre-tax gain of $97.4 million for us in 1997.
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In a way, this is a return to the past for me: Thirty years ago, I bought
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silver because I anticipated its demonetization by the U.S. Government.
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Ever since, I have followed the metal's fundamentals but not owned it.
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In recent years, bullion inventories have fallen materially, and last summer
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Charlie and I concluded that a higher price would be needed to establish
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equilibrium between supply and demand. Inflation expectations, it should
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be noted, play no part in our calculation of silver's value.
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Finally, our largest non-traditional
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position at yearend was $4.6 billion, at amortized cost, of long-term zero-coupon
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obligations of the U.S. Treasury. These securities pay no interest. Instead,
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they provide their holders a return by way of the discount at which they
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are purchased, a characteristic that makes their market prices move rapidly
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when interest rates change. If rates rise, you lose heavily with zeros,
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and if rates fall, you make outsized gains. Since rates fell in 1997, we
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ended the year with an unrealized pre-tax gain of $598.8 million in our
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zeros. Because we carry the securities at market value, that gain is reflected
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in yearend book value.
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In purchasing zeros, rather than
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staying with cash-equivalents, we risk looking very foolish: A macro-based
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commitment such as this never has anything close to a 100% probability
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of being successful. However, you pay Charlie and me to use our best judgment
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-- not to avoid embarrassment -- and we will occasionally make an unconventional
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move when we believe the odds favor it. Try to think kindly of us when
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we blow one. Along with President Clinton, we will be feeling your pain:
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The Munger family has more than 90% of its net worth in Berkshire and the
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Buffetts more than 99%.
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How We Think About Market Fluctuations
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A short quiz: If you plan to eat
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hamburgers throughout your life and are not a cattle producer, should you
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wish for higher or lower prices for beef? Likewise, if you are going to
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buy a car from time to time but are not an auto manufacturer, should you
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prefer higher or lower car prices? These questions, of course, answer themselves.
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But now for the final exam: If
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you expect to be a net saver during the next five years, should you hope
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for a higher or lower stock market during that period? Many investors get
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this one wrong. Even though they are going to be net buyers of stocks for
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many years to come, they are elated when stock prices rise and depressed
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when they fall. In effect, they rejoice because prices have risen for the
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"hamburgers" they will soon be buying. This reaction makes no
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sense. Only those who will be sellers of equities in the near future should
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be happy at seeing stocks rise. Prospective purchasers should much prefer
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sinking prices.
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For shareholders of Berkshire who
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do not expect to sell, the choice is even clearer. To begin with, our owners
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are automatically saving even if they spend every dime they personally
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earn: Berkshire "saves" for them by retaining all earnings, thereafter
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using these savings to purchase businesses and securities. Clearly, the
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more cheaply we make these buys, the more profitable our owners' indirect
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savings program will be.
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Furthermore, through Berkshire
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you own major positions in companies that consistently repurchase their
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shares. The benefits that these programs supply us grow as prices fall:
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When stock prices are low, the funds that an investee spends on repurchases
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increase our ownership of that company by a greater amount than is the
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case when prices are higher. For example, the repurchases that Coca-Cola,
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The Washington Post and Wells Fargo made in past years at very low prices
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benefitted Berkshire far more than do today's repurchases, made at loftier
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prices.
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At the end of every year, about
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97% of Berkshire's shares are held by the same investors who owned them
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at the start of the year. That makes them savers. They should therefore
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rejoice when markets decline and allow both us and our investees to deploy
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funds more advantageously.
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So smile when you read a headline
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that says "Investors lose as market falls." Edit it in your mind
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to "Disinvestors lose as market falls -- but investors gain."
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Though writers often forget this truism, there is a buyer for every seller
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and what hurts one necessarily helps the other. (As they say in golf matches:
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"Every putt makes someone happy.")
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We gained enormously from the low
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prices placed on many equities and businesses in the 1970s and 1980s. Markets
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that then were hostile to investment transients were friendly to those
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taking up permanent residence. In recent years, the actions we took in
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those decades have been validated, but we have found few new opportunities.
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In its role as a corporate "saver," Berkshire continually looks
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for ways to sensibly deploy capital, but it may be some time before we
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find opportunities that get us truly excited.
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Insurance Operations -- Overview
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What does excite us, however, is
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our insurance business. GEICO is flying, and we expect that it will continue
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to do so. Before we expound on that, though, let's discuss "float"
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and how to measure its cost. Unless you understand this subject, it will
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be impossible for you to make an informed judgment about Berkshire's intrinsic
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value.
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To begin with, float is money we
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hold but don't own. In an insurance operation, float arises because premiums
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are received before losses are paid, an interval that sometimes extends
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over many years. During that time, the insurer invests the money. Typically,
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this pleasant activity carries with it a downside: The premiums that an
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insurer takes in usually do not cover the losses and expenses it eventually
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must pay. That leaves it running an "underwriting loss," which
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is the cost of float. An insurance business has value if its cost of float
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over time is less than the cost the company would otherwise incur to obtain
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funds. But the business is a lemon if its cost of float is higher than
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market rates for money.
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A caution is appropriate here:
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Because loss costs must be estimated, insurers have enormous latitude in
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figuring their underwriting results, and that makes it very difficult for
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investors to calculate a company's true cost of float. Estimating errors,
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usually innocent but sometimes not, can be huge. The consequences of these
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miscalculations flow directly into earnings. An experienced observer can
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usually detect large-scale errors in reserving, but the general public
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can typically do no more than accept what's presented, and at times I have
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been amazed by the numbers that big-name auditors have implicitly blessed.
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As for Berkshire, Charlie and I attempt to be conservative in presenting
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its underwriting results to you, because we have found that virtually all
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surprises in insurance are unpleasant ones.
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As the numbers in the following
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table show, Berkshire's insurance business has been a huge winner. For
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the table, we have calculated our float -- which we generate in large amounts
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relative to our premium volume -- by adding net loss reserves, loss adjustment
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reserves, funds held under reinsurance assumed and unearned premium reserves,
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and then subtracting agents' balances, prepaid acquisition costs, prepaid
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taxes and deferred charges applicable to assumed reinsurance. Our cost
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of float is determined by our underwriting loss or profit. In those years
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when we have had an underwriting profit, such as the last five, our cost
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of float has been negative. In effect, we have been paid for holding money.
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(1) (2) Yearend Yield
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Underwriting Approximate on Long-Term
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Loss Average Float Cost of Funds Govt. Bonds
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(In $ Millions) (Ratio of 1 to 2)
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1967 profit 17.3 less than zero 5.50%
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1968 profit 19.9 less than zero 5.90%
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1969 profit 23.4 less than zero 6.79%
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1970 0.37 32.4 1.14% 6.25%
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1971 profit 52.5 less than zero 5.81%
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1972 profit 69.5 less than zero 5.82%
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1973 profit 73.3 less than zero 7.27%
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1974 7.36 79.1 9.30% 8.13%
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1975 11.35 87.6 12.96% 8.03%
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1976 profit 102.6 less than zero 7.30%
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1977 profit 139.0 less than zero 7.97%
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1978 profit 190.4 less than zero 8.93%
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1979 profit 227.3 less than zero 10.08%
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1980 profit 237.0 less than zero 11.94%
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1981 profit 228.4 less than zero 13.61%
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1982 21.56 220.6 9.77% 10.64%
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1983 33.87 231.3 14.64% 11.84%
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1984 48.06 253.2 18.98% 11.58%
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1985 44.23 390.2 11.34% 9.34%
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1986 55.84 797.5 7.00% 7.60%
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1987 55.43 1,266.7 4.38% 8.95%
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1988 11.08 1,497.7 0.74% 9.00%
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1989 24.40 1,541.3 1.58% 7.97%
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1990 26.65 1,637.3 1.63% 8.24%
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1991 119.59 1,895.0 6.31% 7.40%
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1992 108.96 2,290.4 4.76% 7.39%
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1993 profit 2,624.7 less than zero 6.35%
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1994 profit 3,056.6 less than zero 7.88%
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1995 profit 3,607.2 less than zero 5.95%
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1996 profit 6,702.0 less than zero 6.64%
|
|
|
1997 profit 7,093.1 less than zero 5.92%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Since 1967, when we entered the
|
|
|
insurance business, our float has grown at an annual compounded rate of
|
|
|
21.7%. Better yet, it has cost us nothing, and in fact has made us money.
|
|
|
Therein lies an accounting irony: Though our float is shown on our balance
|
|
|
sheet as a liability, it has had a value to Berkshire greater than an equal
|
|
|
amount of net worth would have had.
|
|
|
The expiration of several large
|
|
|
contracts will cause our float to decline during the first quarter of 1998,
|
|
|
but we expect it to grow substantially over the long term. We also believe
|
|
|
that our cost of float will continue to be highly favorable.
|
|
|
|
|
|
|
|
|
Super-Cat Insurance
|
|
|
|
|
|
|
|
|
Occasionally, however, the cost
|
|
|
of our float will spike severely. That will occur because of our heavy
|
|
|
involvement in the super-cat business, which by its nature is the most
|
|
|
volatile of all insurance lines. In this operation, we sell policies that
|
|
|
insurance and reinsurance companies purchase in order to limit their losses
|
|
|
when mega-catastrophes strike. Berkshire is the preferred market for sophisticated
|
|
|
buyers: When the "big one" hits, the financial strength of super-cat
|
|
|
writers will be tested, and Berkshire has no peer in this respect.
|
|
|
Since truly major catastrophes
|
|
|
are rare occurrences, our super-cat business can be expected to show large
|
|
|
profits in most years -- and to record a huge loss occasionally. In other
|
|
|
words, the attractiveness of our super-cat business will take a great many
|
|
|
years to measure. What you must understand, however, is that a truly
|
|
|
terrible year in the super-cat business is not a possibility -- it's a
|
|
|
certainty. The only question is when it will come.
|
|
|
Last year, we were very lucky in
|
|
|
our super-cat operation. The world suffered no catastrophes that caused
|
|
|
huge amounts of insured damage, so virtually all premiums that we received
|
|
|
dropped to the bottom line. This pleasant result has a dark side, however.
|
|
|
Many investors who are "innocents" -- meaning that they rely
|
|
|
on representations of salespeople rather than on underwriting knowledge
|
|
|
of their own -- have come into the reinsurance business by means of purchasing
|
|
|
pieces of paper that are called "catastrophe bonds." The second
|
|
|
word in this term, though, is an Orwellian misnomer: A true bond obliges
|
|
|
the issuer to pay; these bonds, in effect, are contracts that lay a provisional
|
|
|
promise to pay on the purchaser.
|
|
|
This convoluted arrangement came
|
|
|
into being because the promoters of the contracts wished to circumvent
|
|
|
laws that prohibit the writing of insurance by entities that haven't been
|
|
|
licensed by the state. A side benefit for the promoters is that calling
|
|
|
the insurance contract a "bond" may also cause unsophisticated
|
|
|
buyers to assume that these instruments involve far less risk than is actually
|
|
|
the case.
|
|
|
Truly outsized risks will exist
|
|
|
in these contracts if they are not properly priced. A pernicious aspect
|
|
|
of catastrophe insurance, however, makes it likely that mispricing, even
|
|
|
of a severe variety, will not be discovered for a very long time. Consider,
|
|
|
for example, the odds of throwing a 12 with a pair of dice -- 1 out of
|
|
|
36. Now assume that the dice will be thrown once a year; that you, the
|
|
|
"bond-buyer," agree to pay $50 million if a 12 appears; and that
|
|
|
for "insuring" this risk you take in an annual "premium"
|
|
|
of $1 million. That would mean you had significantly underpriced the risk.
|
|
|
Nevertheless, you could go along for years thinking you were making money
|
|
|
-- indeed, easy money. There is actually a 75.4% probability that you would
|
|
|
go for a decade without paying out a dime. Eventually, however, you would
|
|
|
go broke.
|
|
|
In this dice example, the odds
|
|
|
are easy to figure. Calculations involving monster hurricanes and earthquakes
|
|
|
are necessarily much fuzzier, and the best we can do at Berkshire is to
|
|
|
estimate a range of probabilities for such events. The lack of precise
|
|
|
data, coupled with the rarity of such catastrophes, plays into the hands
|
|
|
of promoters, who typically employ an "expert" to advise the
|
|
|
potential bond-buyer about the probability of losses. The expert puts no
|
|
|
money on the table. Instead, he receives an up-front payment that is forever
|
|
|
his no matter how inaccurate his predictions. Surprise: When the stakes
|
|
|
are high, an expert can invariably be found who will affirm -- to return
|
|
|
to our example -- that the chance of rolling a 12 is not 1 in 36, but more
|
|
|
like 1 in 100. (In fairness, we should add that the expert will probably
|
|
|
believe that his odds are correct, a fact that makes him less reprehensible
|
|
|
-- but more dangerous.)
|
|
|
The influx of "investor"
|
|
|
money into catastrophe bonds -- which may well live up to their name --
|
|
|
has caused super-cat prices to deteriorate materially. Therefore, we will
|
|
|
write less business in 1998. We have some large multi-year contracts in
|
|
|
force, however, that will mitigate the drop. The largest of these are two
|
|
|
policies that we described in last year's report -- one covering hurricanes
|
|
|
in Florida and the other, signed with the California Earthquake Authority,
|
|
|
covering earthquakes in that state. Our "worst-case" loss remains
|
|
|
about $600 million after-tax, the maximum we could lose under the CEA policy.
|
|
|
Though this loss potential may sound large, it is only about 1% of Berkshire's
|
|
|
market value. Indeed, if we could get appropriate prices, we would be willing
|
|
|
to significantly increase our "worst-case" exposure.
|
|
|
Our super-cat business was developed
|
|
|
from scratch by Ajit Jain, who has contributed to Berkshire's success in
|
|
|
a variety of other ways as well. Ajit possesses both the discipline to
|
|
|
walk away from business that is inadequately priced and the imagination
|
|
|
to then find other opportunities. Quite simply, he is one of Berkshire's
|
|
|
major assets. Ajit would have been a star in whatever career he chose;
|
|
|
fortunately for us, he enjoys insurance.
|
|
|
|
|
|
|
|
|
Insurance -- GEICO (1-800-555-2756) and Other Primary Operations
|
|
|
|
|
|
|
|
|
|
|
|
Last year I wrote about GEICO's
|
|
|
Tony Nicely and his terrific management skills. If I had known then what
|
|
|
he had in store for us in 1997, I would have searched for still greater
|
|
|
superlatives. Tony, now 54, has been with GEICO for 36 years and last year
|
|
|
was his best. As CEO, he has transmitted vision, energy and enthusiasm
|
|
|
to all members of the GEICO family -- raising their sights from what has
|
|
|
been achieved to what can be achieved.
|
|
|
We measure GEICO's performance
|
|
|
by first, the net increase in its voluntary auto policies (that is, not
|
|
|
including policies assigned us by the state) and, second, the profitability
|
|
|
of "seasoned" auto business, meaning policies that have been
|
|
|
with us for more than a year and are thus past the period in which acquisition
|
|
|
costs cause them to be money-losers. In 1996, in-force business grew 10%,
|
|
|
and I told you how pleased I was, since that rate was well above anything
|
|
|
we had seen in two decades. Then, in 1997, growth jumped to 16%.
|
|
|
Below are the new business and
|
|
|
in-force figures for the last five years:
|
|
|
|
|
|
|
|
|
New Voluntary Voluntary Auto
|
|
|
Years Auto Policies Policies in Force
|
|
|
|
|
|
1993 354,882 2,011,055
|
|
|
1994 396,217 2,147,549
|
|
|
1995 461,608 2,310,037
|
|
|
1996 617,669 2,543,699
|
|
|
1997 913,176 2,949,439
|
|
|
|
|
|
Of course, any insurer can grow
|
|
|
rapidly if it gets careless about underwriting. GEICO's underwriting profit
|
|
|
for the year, though, was 8.1% of premiums, far above its average. Indeed,
|
|
|
that percentage was higher than we wish it to be: Our goal is to pass on
|
|
|
most of the benefits of our low-cost operation to our customers, holding
|
|
|
ourselves to about 4% in underwriting profit. With that in mind, we reduced
|
|
|
our average rates a bit during 1997 and may well cut them again this year.
|
|
|
Our rate changes varied, of course, depending on the policyholder and where
|
|
|
he lives; we strive to charge a rate that properly reflects the loss expectancy
|
|
|
of each driver.
|
|
|
GEICO is not the only auto insurer
|
|
|
obtaining favorable results these days. Last year, the industry recorded
|
|
|
profits that were far better than it anticipated or can sustain. Intensified
|
|
|
competition will soon squeeze margins very significantly. But this is a
|
|
|
development we welcome: Long term, a tough market helps the low-cost operator,
|
|
|
which is what we are and intend to remain.
|
|
|
Last year I told you about the
|
|
|
record 16.9% profit-sharing contribution that GEICO's associates had earned
|
|
|
and explained that two simple variables set the amount: policy growth and
|
|
|
profitability of seasoned business. I further explained that 1996's performance
|
|
|
was so extraordinary that we had to enlarge the chart delineating the possible
|
|
|
payouts. The new configuration didn't make it through 1997: We enlarged
|
|
|
the chart's boundaries again and awarded our 10,500 associates a profit-sharing
|
|
|
contribution amounting to 26.9% of their base compensation, or $71 million.
|
|
|
In addition, the same two variables -- policy growth and profitability
|
|
|
of seasoned business -- determined the cash bonuses that we paid to dozens
|
|
|
of top executives, starting with Tony.
|
|
|
|
|
|
|
|
|
At GEICO, we are paying in a way
|
|
|
that makes sense for both our owners and our managers. We distribute merit
|
|
|
badges, not lottery tickets: In none of Berkshire's subsidiaries do we
|
|
|
relate compensation to our stock price, which our associates cannot affect
|
|
|
in any meaningful way. Instead, we tie bonuses to each unit's business
|
|
|
performance, which is the direct product of the unit's people. When that
|
|
|
performance is terrific -- as it has been at GEICO -- there is nothing
|
|
|
Charlie and I enjoy more than writing a big check.
|
|
|
GEICO's underwriting profitability
|
|
|
will probably fall in 1998, but the company's growth could accelerate.
|
|
|
We're planning to step on the gas: GEICO's marketing expenditures this
|
|
|
year will top $100 million, up 50% from 1997. Our market share today is
|
|
|
only 3%, a level of penetration that should increase dramatically in the
|
|
|
next decade. The auto insurance industry is huge -- it does about $115
|
|
|
billion of volume annually -- and there are tens of millions of drivers
|
|
|
who would save substantial money by switching to us.
|
|
|
* * * * * * * * * * * *
|
|
|
In the 1995 report, I described
|
|
|
the enormous debt that you and I owe to Lorimer Davidson. On a Saturday
|
|
|
early in 1951, he patiently explained the ins and outs of both GEICO and
|
|
|
its industry to me -- a 20-year-old stranger who'd arrived at GEICO's headquarters
|
|
|
uninvited and unannounced. Davy later became the company's CEO and has
|
|
|
remained my friend and teacher for 47 years. The huge rewards that GEICO
|
|
|
has heaped on Berkshire would not have materialized had it not been for
|
|
|
his generosity and wisdom. Indeed, had I not met Davy, I might never have
|
|
|
grown to understand the whole field of insurance, which over the years
|
|
|
has played such a key part in Berkshire's success.
|
|
|
Davy turned 95 last year, and it's
|
|
|
difficult for him to travel. Nevertheless, Tony and I hope that we can
|
|
|
persuade him to attend our annual meeting, so that our shareholders can
|
|
|
properly thank him for his important contributions to Berkshire. Wish us
|
|
|
luck.
|
|
|
* * * * * * * * * * * *
|
|
|
Though they are, of course, far
|
|
|
smaller than GEICO, our other primary insurance operations turned in results
|
|
|
last year that, in aggregate, were fully as stunning. National Indemnity's
|
|
|
traditional business had an underwriting profit of 32.9% and, as usual,
|
|
|
developed a large amount of float compared to premium volume. Over the
|
|
|
last three years, this segment of our business, run by Don Wurster, has
|
|
|
had a profit of 24.3%. Our homestate operation, managed by Rod Eldred,
|
|
|
recorded an underwriting profit of 14.1% even though it continued to absorb
|
|
|
the expenses of geographical expansion. Rod's three-year record is an amazing
|
|
|
15.1%. Berkshire's workers' compensation business, run out of California
|
|
|
by Brad Kinstler, had a modest underwriting loss in a difficult environment;
|
|
|
its three-year underwriting record is a positive 1.5%. John Kizer, at Central
|
|
|
States Indemnity, set a new volume record while generating good underwriting
|
|
|
earnings. At Kansas Bankers Surety, Don Towle more than lived up to the
|
|
|
high expectations we had when we purchased the company in 1996.
|
|
|
In aggregate, these five operations
|
|
|
recorded an underwriting profit of 15.0%. The two Dons, along with Rod,
|
|
|
Brad and John, have created significant value for Berkshire, and we believe
|
|
|
there is more to come.
|
|
|
|
|
|
|
|
|
Sources of Reported Earnings
|
|
|
|
|
|
|
|
|
The table that follows shows the
|
|
|
main sources of Berkshire's reported earnings. In this presentation, purchase-accounting
|
|
|
adjustments are not assigned to the specific businesses to which they apply,
|
|
|
but are instead aggregated and shown separately. This procedure lets you
|
|
|
view the earnings of our businesses as they would have been reported had
|
|
|
we not purchased them. For the reasons discussed on pages 69 and 70, this
|
|
|
form of presentation seems to us to be more useful to investors and managers
|
|
|
than one utilizing generally-accepted accounting principles (GAAP), which
|
|
|
require purchase-premiums to be charged off business-by-business. The total
|
|
|
earnings we show in the table are, of course, identical to the GAAP total
|
|
|
in our audited financial statements.
|
|
|
(in millions)
|
|
|
Berkshire's Share
|
|
|
of Net Earnings
|
|
|
(after taxes and
|
|
|
Pre-Tax Earnings minority interests)
|
|
|
1997 1996 1997 1996
|
|
|
Operating Earnings:
|
|
|
Insurance Group:
|
|
|
Underwriting -- Super-Cat. . . . . . . .$ 283.0 $ 167.0 $ 182.7 $ 107.4
|
|
|
Underwriting -- Other Reinsurance. . . . (155.2) (174.8) (100.1) (112.4)
|
|
|
Underwriting -- GEICO. . . . . . . . . . 280.7 171.4 181.1 110.2
|
|
|
Underwriting -- Other Primary. . . . . . 52.9 58.5 34.1 37.6
|
|
|
Net Investment Income. . . . . . . . . . 882.3 726.2 703.6 593.1
|
|
|
Buffalo News . . . . . . . . . . . . . . . 55.9 50.4 32.7 29.5
|
|
|
Finance Businesses . . . . . . . . . . . . 28.1 23.1 18.0 14.9
|
|
|
FlightSafety . . . . . . . . . . . . . . . 139.5 3.1(1) 84.4 1.9(1)
|
|
|
Home Furnishings . . . . . . . . . . . . . 56.8(2) 43.8 32.2(2) 24.8
|
|
|
Jewelry. . . . . . . . . . . . . . . . . . 31.6 27.8 18.3 16.1
|
|
|
Scott Fetzer(excluding finance operation). 118.9 121.7 77.3 81.6
|
|
|
See's Candies. . . . . . . . . . . . . . . 58.6 51.9 35.0 30.8
|
|
|
Shoe Group . . . . . . . . . . . . . . . . 48.8 61.6 32.2 41.0
|
|
|
Purchase-Accounting Adjustments. . . . . . (104.9) (75.7) (97.0) (70.5)
|
|
|
Interest Expense(3). . . . . . . . . . . . (106.6) (94.3) (67.1) (56.6)
|
|
|
Shareholder-Designated Contributions . . . (15.4) (13.3) (9.9) (8.5)
|
|
|
Other. . . . . . . . . . . . . . . . . . . 60.7 73.0 37.0 42.2
|
|
|
-------- -------- -------- --------
|
|
|
Operating Earnings . . . . . . . . . . . . . 1,715.7 1,221.4 1,194.5 883.1
|
|
|
Capital Gains from Investments . . . . . . . 1,111.9 2,484.5 707.1 1,605.5
|
|
|
-------- -------- -------- --------
|
|
|
Total Earnings - All Entities. . . . . . . .$2,827.6 $3,705.9 $1,901.6 $2,488.6
|
|
|
======== ======== ======== ========
|
|
|
|
|
|
(1) From date of acquisition,
|
|
|
December 23, 1996.
|
|
|
(2) Includes Star
|
|
|
Furniture from July 1, 1997.
|
|
|
(3) Excludes interest
|
|
|
expense of Finance Businesses.
|
|
|
|
|
|
|
|
|
|
|
|
Overall, our operating businesses
|
|
|
continue to perform exceptionally well, far outdoing their industry norms.
|
|
|
We are particularly pleased that profits improved at Helzberg's after a
|
|
|
disappointing 1996. Jeff Comment, Helzberg's CEO, took decisive steps early
|
|
|
in 1997 that enabled the company to gain real momentum by the crucial Christmas
|
|
|
season. In the early part of this year, as well, sales remained strong.
|
|
|
|
|
|
Casual observers may not appreciate
|
|
|
just how extraordinary the performance of many of our businesses has been:
|
|
|
If the earnings history of, say, Buffalo News or Scott Fetzer is compared
|
|
|
to the records of their publicly-owned peers, their performance might seem
|
|
|
to have been unexceptional. But most public companies retain two-thirds
|
|
|
or more of their earnings to fund their corporate growth. In contrast,
|
|
|
those Berkshire subsidiaries have paid 100% of their earnings to us, their
|
|
|
parent company, to fund our growth.
|
|
|
In effect, the records of the public
|
|
|
companies reflect the cumulative benefits of the earnings they have retained,
|
|
|
while the records of our operating subsidiaries get no such boost. Over
|
|
|
time, however, the earnings these subsidiaries have distributed have created
|
|
|
truly huge amounts of earning power elsewhere in Berkshire. The News, See's
|
|
|
and Scott Fetzer have alone paid us $1.8 billion, which we have gainfully
|
|
|
employed elsewhere. We owe their managements our gratitude for much more
|
|
|
than the earnings that are detailed in the table.
|
|
|
|
|
|
|
|
|
Additional information about our
|
|
|
various businesses is given on pages 36 - 50, where you will also find
|
|
|
our segment earnings reported on a GAAP basis. In addition, on pages 55
|
|
|
- 61, we have rearranged Berkshire's financial data into four segments
|
|
|
on a non-GAAP basis, a presentation that corresponds to the way Charlie
|
|
|
and I think about the company. Our intent is to supply you with the financial
|
|
|
information that we would wish you to give us if our positions were reversed.
|
|
|
|
|
|
|
|
|
|
|
|
Look-Through Earnings
|
|
|
|
|
|
|
|
|
Reported earnings are a poor measure
|
|
|
of economic progress at Berkshire, in part because the numbers shown in
|
|
|
the table presented earlier include only the dividends we receive from
|
|
|
investees -- though these dividends typically represent only a small fraction
|
|
|
of the earnings attributable to our ownership. Not that we mind this division
|
|
|
of money, since on balance we regard the undistributed earnings of investees
|
|
|
as more valuable to us than the portion paid out. The reason is simple:
|
|
|
Our investees often have the opportunity to reinvest earnings at high rates
|
|
|
of return. So why should we want them paid out?
|
|
|
To depict something closer to economic
|
|
|
reality at Berkshire than reported earnings, though, we employ the concept
|
|
|
of "look-through" earnings. As we calculate these, they consist
|
|
|
of: (1) the operating earnings reported in the previous section, plus;
|
|
|
(2) our share of the retained operating earnings of major investees that,
|
|
|
under GAAP accounting, are not reflected in our profits, less; (3) an allowance
|
|
|
for the tax that would be paid by Berkshire if these retained earnings
|
|
|
of investees had instead been distributed to us. When tabulating "operating
|
|
|
earnings" here, we exclude purchase-accounting adjustments as well
|
|
|
as capital gains and other major non-recurring items.
|
|
|
The following table sets forth
|
|
|
our 1997 look-through earnings, though I warn you that the figures can
|
|
|
be no more than approximate, since they are based on a number of judgment
|
|
|
calls. (The dividends paid to us by these investees have been included
|
|
|
in the operating earnings itemized on page 11, mostly under "Insurance
|
|
|
Group: Net Investment Income.")
|
|
|
|
|
|
|
|
|
Berkshire's Share
|
|
|
of Undistributed
|
|
|
Berkshire's Approximate Operating Earnings
|
|
|
Berkshire's Major Investees Ownership at Yearend(1) (in millions)(2)
|
|
|
|
|
|
American Express Company 10.7% $161
|
|
|
The Coca-Cola Company 8.1% 216
|
|
|
The Walt Disney Company 3.2% 65
|
|
|
Freddie Mac 8.6% 86
|
|
|
The Gillette Company 8.6% 82
|
|
|
The Washington Post Company 16.5% 30
|
|
|
Wells Fargo & Company 7.8% 103
|
|
|
------
|
|
|
Berkshire's share of undistributed earnings of major investees 743
|
|
|
Hypothetical tax on these undistributed investee earnings(3) (105)
|
|
|
Reported operating earnings of Berkshire 1,292
|
|
|
------
|
|
|
Total look-through earnings of Berkshire $1,930
|
|
|
======
|
|
|
|
|
|
|
|
|
|
|
|
(1) Does not include shares allocable to minority interests
|
|
|
(2) Calculated on average ownership for the year
|
|
|
(3) The tax rate used is 14%, which is the rate Berkshire
|
|
|
pays on the dividends it receives
|
|
|
|
|
|
Acquisitions of 1997
|
|
|
|
|
|
|
|
|
In 1997, we agreed to acquire Star
|
|
|
Furniture and International Dairy Queen (a deal that closed early in 1998).
|
|
|
Both businesses fully meet our criteria: They are understandable; possess
|
|
|
excellent economics; and are run by outstanding people.
|
|
|
The Star transaction has an interesting
|
|
|
history. Whenever we buy into an industry whose leading participants aren't
|
|
|
known to me, I always ask our new partners, "Are there any more at
|
|
|
home like you?" Upon our purchase of Nebraska Furniture Mart in 1983,
|
|
|
therefore, the Blumkin family told me about three outstanding furniture
|
|
|
retailers in other parts of the country. At the time, however, none was
|
|
|
for sale.
|
|
|
Many years later, Irv Blumkin learned
|
|
|
that Bill Child, CEO of R.C. Willey -- one of the recommended three --
|
|
|
might be interested in merging, and we promptly made the deal described
|
|
|
in the 1995 report. We have been delighted with that association -- Bill
|
|
|
is the perfect partner. Furthermore, when we asked Bill about industry
|
|
|
standouts, he came up with the remaining two names given me by the Blumkins,
|
|
|
one of these being Star Furniture of Houston. But time went by without
|
|
|
there being any indication that either of the two was available.
|
|
|
On the Thursday before last year's
|
|
|
annual meeting, however, Bob Denham of Salomon told me that Melvyn Wolff,
|
|
|
the long-time controlling shareholder and CEO of Star, wanted to talk.
|
|
|
At our invitation, Melvyn came to the meeting and spent his time in Omaha
|
|
|
confirming his positive feelings about Berkshire. I, meanwhile, looked
|
|
|
at Star's financials, and liked what I saw.
|
|
|
A few days later, Melvyn and I
|
|
|
met in New York and made a deal in a single, two-hour session. As was the
|
|
|
case with the Blumkins and Bill Child, I had no need to check leases, work
|
|
|
out employment contracts, etc. I knew I was dealing with a man of integrity
|
|
|
and that's what counted.
|
|
|
Though the Wolff family's association
|
|
|
with Star dates back to 1924, the business struggled until Melvyn and his
|
|
|
sister Shirley Toomin took over in 1962. Today Star operates 12 stores
|
|
|
-- ten in Houston and one each in Austin and Bryan -- and will soon move
|
|
|
into San Antonio as well. We won't be surprised if Star is many times its
|
|
|
present size a decade from now.
|
|
|
Here's a story illustrating what
|
|
|
Melvyn and Shirley are like: When they told their associates of the sale,
|
|
|
they also announced that Star would make large, special payments to those
|
|
|
who had helped them succeed -- and then defined that group as everyone
|
|
|
in the business. Under the terms of our deal, it was Melvyn and Shirley's
|
|
|
money, not ours, that funded this distribution. Charlie and I love it when
|
|
|
we become partners with people who behave like that.
|
|
|
The Star transaction closed on
|
|
|
July 1. In the months since, we've watched Star's already-excellent sales
|
|
|
and earnings growth accelerate further. Melvyn and Shirley will be at the
|
|
|
annual meeting, and I hope you get a chance to meet them.
|
|
|
Next acquisition: International
|
|
|
Dairy Queen. There are 5,792 Dairy Queen stores operating in 23 countries
|
|
|
-- all but a handful run by franchisees -- and in addition IDQ franchises
|
|
|
409 Orange Julius operations and 43 Karmelkorn operations. In 190 locations,
|
|
|
"treat centers" provide some combination of the three products.
|
|
|
|
|
|
For many years IDQ had a bumpy
|
|
|
history. Then, in 1970, a Minneapolis group led by John Mooty and Rudy
|
|
|
Luther took control. The new managers inherited a jumble of different franchising
|
|
|
agreements, along with some unwise financing arrangements that had left
|
|
|
the company in a precarious condition. In the years that followed, management
|
|
|
rationalized the operation, extended food service to many more locations,
|
|
|
and, in general, built a strong organization.
|
|
|
Last summer Mr. Luther died, which
|
|
|
meant his estate needed to sell stock. A year earlier, Dick Kiphart of
|
|
|
William Blair & Co., had introduced me to John Mooty and Mike Sullivan,
|
|
|
IDQ's CEO, and I had been impressed with both men. So, when we got the
|
|
|
chance to merge with IDQ, we offered a proposition patterned on our FlightSafety
|
|
|
acquisition, extending selling shareholders the option of choosing either
|
|
|
cash or Berkshire shares having a slightly lower immediate value. By tilting
|
|
|
the consideration as we did, we encouraged holders to opt for cash, the
|
|
|
type of payment we by far prefer. Even then, only 45% of IDQ shares elected
|
|
|
cash.
|
|
|
Charlie and I bring a modicum of
|
|
|
product expertise to this transaction: He has been patronizing the Dairy
|
|
|
Queens in Cass Lake and Bemidji, Minnesota, for decades, and I have been
|
|
|
a regular in Omaha. We have put our money where our mouth is.
|
|
|
|
|
|
|
|
|
A Confession
|
|
|
|
|
|
|
|
|
I've mentioned that we strongly
|
|
|
prefer to use cash rather than Berkshire stock in acquisitions. A study
|
|
|
of the record will tell you why: If you aggregate all of our stock-only
|
|
|
mergers (excluding those we did with two affiliated companies, Diversified
|
|
|
Retailing and Blue Chip Stamps), you will find that our shareholders are
|
|
|
slightly worse off than they would have been had I not done the transactions.
|
|
|
Though it hurts me to say it, when I've issued stock, I've cost you money.
|
|
|
|
|
|
Be clear about one thing: This
|
|
|
cost has not occurred because we were misled in any way by sellers
|
|
|
or because they thereafter failed to manage with diligence and skill. On
|
|
|
the contrary, the sellers were completely candid when we were negotiating
|
|
|
our deals and have been energetic and effective ever since.
|
|
|
Instead, our problem has been that
|
|
|
we own a truly marvelous collection of businesses, which means that trading
|
|
|
away a portion of them for something new almost never makes sense. When
|
|
|
we issue shares in a merger, we reduce your ownership in all of our businesses
|
|
|
-- partly-owned companies such as Coca-Cola, Gillette and American Express,
|
|
|
and all of our terrific operating companies as well. An example from sports
|
|
|
will illustrate the difficulty we face: For a baseball team, acquiring
|
|
|
a player who can be expected to bat .350 is almost always a wonderful event
|
|
|
-- except when the team must trade a .380 hitter to make the deal.
|
|
|
|
|
|
Because our roster is filled with
|
|
|
.380 hitters, we have tried to pay cash for acquisitions, and here our
|
|
|
record has been far better. Starting with National Indemnity in 1967, and
|
|
|
continuing with, among others, See's, Buffalo News, Scott Fetzer and GEICO,
|
|
|
we have acquired -- for cash -- a number of large businesses that have
|
|
|
performed incredibly well since we bought them. These acquisitions have
|
|
|
delivered Berkshire tremendous value -- indeed, far more than I anticipated
|
|
|
when we made our purchases.
|
|
|
We believe that it is almost impossible
|
|
|
for us to "trade up" from our present businesses and managements.
|
|
|
Our situation is the opposite of Camelot's Mordred, of whom Guenevere commented,
|
|
|
"The one thing I can say for him is that he is bound to marry well.
|
|
|
Everybody is above him." Marrying well is extremely difficult for
|
|
|
Berkshire.
|
|
|
So you can be sure that Charlie
|
|
|
and I will be very reluctant to issue shares in the future. In those cases
|
|
|
when we simply must do so -- when certain shareholders of a desirable acquiree
|
|
|
insist on getting stock -- we will include an attractive cash option in
|
|
|
order to tempt as many of the sellers to take cash as is possible.
|
|
|
Merging with public companies presents
|
|
|
a special problem for us. If we are to offer any premium to the
|
|
|
acquiree, one of two conditions must be present: Either our own stock must
|
|
|
be overvalued relative to the acquiree's, or the two companies together
|
|
|
must be expected to earn more than they would if operated separately. Historically,
|
|
|
Berkshire has seldom been overvalued. In this market, moreover, undervalued
|
|
|
acquirees are almost impossible to find. That other possibility -- synergy
|
|
|
gains -- is usually unrealistic, since we expect acquirees to operate after
|
|
|
we've bought them just as they did before. Joining with Berkshire does
|
|
|
not normally raise their revenues nor cut their costs.
|
|
|
|
|
|
|
|
|
Indeed, their reported costs (but
|
|
|
not their true ones) will rise after they are bought by Berkshire
|
|
|
if the acquiree has been granting options as part of its compensation packages.
|
|
|
In these cases, "earnings" of the acquiree have been overstated
|
|
|
because they have followed the standard -- but, in our view, dead wrong
|
|
|
-- accounting practice of ignoring the cost to a business of issuing options.
|
|
|
When Berkshire acquires an option-issuing company, we promptly substitute
|
|
|
a cash compensation plan having an economic value equivalent to that of
|
|
|
the previous option plan. The acquiree's true compensation cost is thereby
|
|
|
brought out of the closet and charged, as it should be, against earnings.
|
|
|
|
|
|
The reasoning that Berkshire applies
|
|
|
to the merger of public companies should be the calculus for all
|
|
|
buyers. Paying a takeover premium does not make sense for any acquirer
|
|
|
unless a) its stock is overvalued relative to the acquiree's or b) the
|
|
|
two enterprises will earn more combined than they would separately. Predictably,
|
|
|
acquirers normally hew to the second argument because very few are willing
|
|
|
to acknowledge that their stock is overvalued. However, voracious buyers
|
|
|
-- the ones that issue shares as fast as they can print them -- are tacitly
|
|
|
conceding that point. (Often, also, they are running Wall Street's version
|
|
|
of a chain-letter scheme.)
|
|
|
In some mergers there truly are
|
|
|
major synergies -- though oftentimes the acquirer pays too much to obtain
|
|
|
them -- but at other times the cost and revenue benefits that are projected
|
|
|
prove illusory. Of one thing, however, be certain: If a CEO is enthused
|
|
|
about a particularly foolish acquisition, both his internal staff and his
|
|
|
outside advisors will come up with whatever projections are needed to justify
|
|
|
his stance. Only in fairy tales are emperors told that they are naked.
|
|
|
|
|
|
|
|
|
|
|
|
Common Stock Investments
|
|
|
|
|
|
|
|
|
Below we present our common stock
|
|
|
investments. Those with a market value of more than $750 million are itemized.
|
|
|
|
|
|
12/31/97
|
|
|
|
|
|
Shares Company Cost* Market
|
|
|
(dollars in millions)
|
|
|
|
|
|
49,456,900 American Express Company $1,392.7 $ 4,414.0
|
|
|
200,000,000 The Coca-Cola Company 1,298.9 13,337.5
|
|
|
21,563,414 The Walt Disney Company 381.2 2,134.8
|
|
|
63,977,600 Freddie Mac 329.4 2,683.1
|
|
|
48,000,000 The Gillette Company 600.0 4,821.0
|
|
|
23,733,198 Travelers Group Inc. 604.4 1,278.6
|
|
|
1,727,765 The Washington Post Company 10.6 840.6
|
|
|
6,690,218 Wells Fargo & Company 412.6 2,270.9
|
|
|
Others 2,177.1 4,467.2
|
|
|
-------- ----------
|
|
|
Total Common Stocks $7,206.9 $ 36,247.7
|
|
|
======== ==========
|
|
|
|
|
|
|
|
|
|
|
|
*
|
|
|
Represents tax-basis cost which, in aggregate, is $1.8 billion less than
|
|
|
GAAP cost.
|
|
|
|
|
|
|
|
|
We made net sales during the year
|
|
|
that amounted to about 5% of our beginning portfolio. In these, we significantly
|
|
|
reduced a few of our holdings that are below the $750 million threshold
|
|
|
for itemization, and we also modestly trimmed a few of the larger positions
|
|
|
that we detail. Some of the sales we made during 1997 were aimed at changing
|
|
|
our bond-stock ratio moderately in response to the relative values that
|
|
|
we saw in each market, a realignment we have continued in 1998.
|
|
|
Our reported positions, we should
|
|
|
add, sometimes reflect the investment decisions of GEICO's Lou Simpson.
|
|
|
Lou independently runs an equity portfolio of nearly $2 billion that may
|
|
|
at times overlap the portfolio that I manage, and occasionally he makes
|
|
|
moves that differ from mine.
|
|
|
Though we don't attempt to predict
|
|
|
the movements of the stock market, we do try, in a very rough way, to value
|
|
|
it. At the annual meeting last year, with the Dow at 7,071 and long-term
|
|
|
Treasury yields at 6.89%, Charlie and I stated that we did not consider
|
|
|
the market overvalued if 1) interest rates remained where they were
|
|
|
or fell, and 2) American business continued to earn the remarkable returns
|
|
|
on equity that it had recently recorded. So far, interest rates have fallen
|
|
|
-- that's one requisite satisfied -- and returns on equity still remain
|
|
|
exceptionally high. If they stay there -- and if interest rates hold near
|
|
|
recent levels -- there is no reason to think of stocks as generally overvalued.
|
|
|
On the other hand, returns on equity are not a sure thing to remain at,
|
|
|
or even near, their present levels.
|
|
|
In the summer of 1979, when equities
|
|
|
looked cheap to me, I wrote a Forbes article entitled "You
|
|
|
pay a very high price in the stock market for a cheery consensus."
|
|
|
At that time skepticism and disappointment prevailed, and my point was
|
|
|
that investors should be glad of the fact, since pessimism drives down
|
|
|
prices to truly attractive levels. Now, however, we have a very cheery
|
|
|
consensus. That does not necessarily mean this is the wrong time to buy
|
|
|
stocks: Corporate America is now earning far more money than it was just
|
|
|
a few years ago, and in the presence of lower interest rates, every dollar
|
|
|
of earnings becomes more valuable. Today's price levels, though, have materially
|
|
|
eroded the "margin of safety" that Ben Graham identified as the
|
|
|
cornerstone of intelligent investing.
|
|
|
* * * * * * * * * * * *
|
|
|
In last year's annual report, I
|
|
|
discussed Coca-Cola, our largest holding. Coke continues to increase its
|
|
|
market dominance throughout the world, but, tragically, it has lost the
|
|
|
leader responsible for its outstanding performance. Roberto Goizueta, Coke's
|
|
|
CEO since 1981, died in October. After his death, I read every one of the
|
|
|
more than 100 letters and notes he had written me during the past nine
|
|
|
years. Those messages could well serve as a guidebook for success in both
|
|
|
business and life.
|
|
|
In these communications, Roberto
|
|
|
displayed a brilliant and clear strategic vision that was always aimed
|
|
|
at advancing the well-being of Coke shareholders. Roberto knew where he
|
|
|
was leading the company, how he was going to get there, and why this path
|
|
|
made the most sense for his owners -- and, equally important, he had a
|
|
|
burning sense of urgency about reaching his goals. An excerpt from one
|
|
|
handwritten note he sent to me illustrates his mind-set: "By the way,
|
|
|
I have told Olguita that what she refers to as an obsession, you call focus.
|
|
|
I like your term much better." Like all who knew Roberto, I will miss
|
|
|
him enormously.
|
|
|
Consistent with his concern for
|
|
|
the company, Roberto prepared for a seamless succession long before it
|
|
|
seemed necessary. Roberto knew that Doug Ivester was the right man to take
|
|
|
over and worked with Doug over the years to ensure that no momentum would
|
|
|
be lost when the time for change arrived. The Coca-Cola Company will be
|
|
|
the same steamroller under Doug as it was under Roberto.
|
|
|
|
|
|
|
|
|
Convertible Preferreds
|
|
|
|
|
|
|
|
|
Two years ago, I gave you an update
|
|
|
on the five convertible preferreds that we purchased through private placements
|
|
|
in the 1987-1991 period. At the time of that earlier report, we had realized
|
|
|
a small profit on the sale of our Champion International holding. The four
|
|
|
remaining preferred commitments included two, Gillette and First Empire
|
|
|
State, that we had converted into common stock in which we had large unrealized
|
|
|
gains, and two others, USAir and Salomon, that had been trouble-prone.
|
|
|
At times, the last two had me mouthing a line from a country song: "How
|
|
|
can I miss you if you won't go away?"
|
|
|
Since I delivered that report,
|
|
|
all four holdings have grown significantly in value. The common stocks
|
|
|
of both Gillette and First Empire have risen substantially, in line with
|
|
|
the companies' excellent performance. At yearend, the $600 million we put
|
|
|
into Gillette in 1989 had appreciated to $4.8 billion, and the $40 million
|
|
|
we committed to First Empire in 1991 had risen to $236 million.
|
|
|
Our two laggards, meanwhile, have
|
|
|
come to life in a very major way. In a transaction that finally rewarded
|
|
|
its long-suffering shareholders, Salomon recently merged into Travelers
|
|
|
Group. All of Berkshire's shareholders -- including me, very personally
|
|
|
-- owe a huge debt to Deryck Maughan and Bob Denham for, first, playing
|
|
|
key roles in saving Salomon from extinction following its 1991 scandal
|
|
|
and, second, restoring the vitality of the company to a level that made
|
|
|
it an attractive acquisition for Travelers. I have often said that I wish
|
|
|
to work with executives that I like, trust and admire. No two fit that
|
|
|
description better than Deryck and Bob.
|
|
|
|
|
|
|
|
|
Berkshire's final results from
|
|
|
its Salomon investment won't be tallied for some time, but it is safe to
|
|
|
say that they will be far better than I anticipated two years ago. Looking
|
|
|
back, I think of my Salomon experience as having been both fascinating
|
|
|
and instructional, though for a time in 1991-92 I felt like the drama critic
|
|
|
who wrote: "I would have enjoyed the play except that I had an unfortunate
|
|
|
seat. It faced the stage."
|
|
|
The resuscitation of US Airways
|
|
|
borders on the miraculous. Those who have watched my moves in this investment
|
|
|
know that I have compiled a record that is unblemished by success. I was
|
|
|
wrong in originally purchasing the stock, and I was wrong later, in repeatedly
|
|
|
trying to unload our holdings at 50 cents on the dollar.
|
|
|
Two changes at the company coincided
|
|
|
with its remarkable rebound: 1) Charlie and I left the board of directors
|
|
|
and 2) Stephen Wolf became CEO. Fortunately for our egos, the second event
|
|
|
was the key: Stephen Wolf's accomplishments at the airline have been phenomenal.
|
|
|
|
|
|
There still is much to do at US
|
|
|
Airways, but survival is no longer an issue. Consequently, the company
|
|
|
made up the dividend arrearages on our preferred during 1997, adding extra
|
|
|
payments to compensate us for the delay we suffered. The company's common
|
|
|
stock, furthermore, has risen from a low of $4 to a recent high of $73.
|
|
|
|
|
|
Our preferred has been called for
|
|
|
redemption on March 15. But the rise in the company's stock has given our
|
|
|
conversion rights, which we thought worthless not long ago, great value.
|
|
|
It is now almost certain that our US Airways shares will produce a decent
|
|
|
profit -- that is, if my cost for Maalox is excluded -- and the gain could
|
|
|
even prove indecent.
|
|
|
Next time I make a big, dumb decision,
|
|
|
Berkshire shareholders will know what to do: Phone Mr. Wolf.
|
|
|
* * * * * * * * * * * *
|
|
|
In addition to the convertible
|
|
|
preferreds, we purchased one other private placement in 1991, $300 million
|
|
|
of American Express Percs. This security was essentially a common stock
|
|
|
that featured a tradeoff in its first three years: We received extra dividend
|
|
|
payments during that period, but we were also capped in the price appreciation
|
|
|
we could realize. Despite the cap, this holding has proved extraordinarily
|
|
|
profitable thanks to a move by your Chairman that combined luck and skill
|
|
|
-- 110% luck, the balance skill.
|
|
|
Our Percs were due to convert into
|
|
|
common stock in August 1994, and in the month before I was mulling whether
|
|
|
to sell upon conversion. One reason to hold was Amex's outstanding CEO,
|
|
|
Harvey Golub, who seemed likely to maximize whatever potential the company
|
|
|
had (a supposition that has since been proved -- in spades). But the size
|
|
|
of that potential was in question: Amex faced relentless competition from
|
|
|
a multitude of card-issuers, led by Visa. Weighing the arguments, I leaned
|
|
|
toward sale.
|
|
|
Here's where I got lucky. During
|
|
|
that month of decision, I played golf at Prouts Neck, Maine with Frank
|
|
|
Olson, CEO of Hertz. Frank is a brilliant manager, with intimate knowledge
|
|
|
of the card business. So from the first tee on I was quizzing him about
|
|
|
the industry. By the time we reached the second green, Frank had convinced
|
|
|
me that Amex's corporate card was a terrific franchise, and I had decided
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not to sell. On the back nine I turned buyer, and in a few months Berkshire
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owned 10% of the company.
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We now have a $3 billion gain in
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our Amex shares, and I naturally feel very grateful to Frank. But George
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Gillespie, our mutual friend, says that I am confused about where my gratitude
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should go. After all, he points out, it was he who arranged the game and
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assigned me to Frank's foursome.
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Quarterly Reports to Shareholders
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In last year's letter, I described
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the growing costs we incur in mailing quarterly reports and the problems
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we have encountered in delivering them to "street-name" shareholders.
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I asked for your opinion about the desirability of our continuing to print
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reports, given that we now publish our quarterly and annual communications
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on the Internet, at our site, www.berkshirehathaway.com. Relatively few
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shareholders responded, but it is clear that at least a small number who
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want the quarterly information have no interest in getting it off the Internet.
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Being a life-long sufferer from technophobia, I can empathize with this
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group.
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The cost of publishing quarterlies,
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however, continues to balloon, and we have therefore decided to send printed
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|
versions only to shareholders who request them. If you wish the quarterlies,
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please complete the reply card that is bound into this report. In the meantime,
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be assured that all shareholders will continue to receive the annual
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report in printed form.
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|
Those of you who enjoy the computer
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|
should check out our home page. It contains a large amount of current information
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|
about Berkshire and also all of our annual letters since 1977. In addition,
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our website includes links to the home pages of many Berkshire subsidiaries.
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On these sites you can learn more about our subsidiaries' products and
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-- yes -- even place orders for them.
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We are required to file our quarterly
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|
information with the SEC no later than 45 days after the end of each quarter.
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One of our goals in posting communications on the Internet is to make this
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|
material information -- in full detail and in a form unfiltered by the
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|
media -- simultaneously available to all interested parties at a time when
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|
markets are closed. Accordingly, we plan to send our 1998 quarterly information
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|
to the SEC on three Fridays, May 15, August 14, and November 13, and on
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|
those nights to post the same information on the Internet. This procedure
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|
will put all of our shareholders, whether they be direct or "street-name,"
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|
on an equal footing. Similarly, we will post our 1998 annual report on
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|
the Internet on Saturday, March 13, 1999, and mail it at about the same
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|
time.
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|
Shareholder-Designated Contributions
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About 97.7% of all eligible shares
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|
participated in Berkshire's 1997 shareholder-designated contributions program.
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|
Contributions made were $15.4 million, and 3,830 charities were recipients.
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|
A full description of the program appears on pages 52 - 53.
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|
Cumulatively, over the 17 years
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|
of the program, Berkshire has made contributions of $113.1 million pursuant
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|
to the instructions of our shareholders. The rest of Berkshire's giving
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|
is done by our subsidiaries, which stick to the philanthropic patterns
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|
that prevailed before they were acquired (except that their former owners
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|
themselves take on the responsibility for their personal charities). In
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|
aggregate, our subsidiaries made contributions of $8.1 million in 1997,
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|
including in-kind donations of $4.4 million.
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|
Every year a few shareholders miss
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|
out on our contributions program because they don't have their shares registered
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|
in their own names on the prescribed record date or because they fail to
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|
get the designation form back to us within the 60-day period allowed. Charlie
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|
and I regret this. But if replies are received late, we have to reject
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|
them because we can't make exceptions for some shareholders while refusing
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|
to make them for others.
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|
To participate in future programs,
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|
you must own Class A shares that are registered in the name of the actual
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|
owner, not the nominee name of a broker, bank or depository. Shares not
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|
so registered on August 31, 1998, will be ineligible for the 1998 program.
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|
When you get the contributions form from us, return it promptly so that
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|
it does not get put aside or forgotten.
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|
|
The Annual Meeting
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|
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|
Woodstock Weekend at Berkshire
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|
will be May 2-4 this year. The finale will be the annual meeting, which
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|
will begin at 9:30 a.m. on Monday, May 4. Last year we met at Aksarben
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|
Coliseum, and both our staff and the crowd were delighted with the venue.
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|
There was only one crisis: The night before the meeting, I lost my voice,
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|
thereby fulfilling Charlie's wildest fantasy. He was crushed when I showed
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|
up the next morning with my speech restored.
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|
Last year about 7,500 attended
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|
the meeting. They represented all 50 states, as well as 16 countries, including
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|
Australia, Brazil, Israel, Saudi Arabia, Singapore and Greece. Taking into
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|
account several overflow rooms, we believe that we can handle more than
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|
11,000 people, and that should put us in good shape this year even though
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|
our shareholder count has risen significantly. Parking is ample at Aksarben;
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|
acoustics are excellent; and seats are comfortable.
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|
The doors will open at 7 a.m. on
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|
Monday and at 8:30 we will again feature the world premiere of a movie
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|
|
epic produced by Marc Hamburg, our CFO. The meeting will last until 3:30,
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|
with a short break at noon. This interval will permit the exhausted to
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|
|
leave unnoticed and allow time for the hardcore to lunch at Aksarben's
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|
concession stands. Charlie and I enjoy questions from owners, so bring
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|
up whatever is on your mind.
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|
|
Berkshire products will again be
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|
|
for sale in the halls outside the meeting room. Last year -- not
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|
|
that I pay attention to this sort of thing -- we again set sales records,
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|
|
moving 2,500 pounds of See's candy, 1,350 pairs of Dexter shoes, $75,000
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|
|
of World Books and related publications, and 888 sets of Quikut knives.
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|
|
We also took orders for a new line of apparel, featuring our Berkshire
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|
|
logo, and sold about 1,000 polo, sweat, and T-shirts. At this year's meeting,
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|
|
we will unveil our 1998 collection.
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|
|
GEICO will again be on hand with
|
|
|
a booth staffed by star associates from its regional offices. Find out
|
|
|
whether you can save money by shifting your auto insurance to GEICO. About
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|
|
40% of those who check us out learn that savings are possible. The proportion
|
|
|
is not 100% because insurers differ in their underwriting judgments, with
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|
|
some favoring drivers who live in certain geographical areas and work at
|
|
|
certain occupations more than we do. We believe, however, that we more
|
|
|
frequently offer the low price than does any other national carrier selling
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|
|
insurance to all comers. In the GEICO informational material that accompanies
|
|
|
this report, you will see that in 38 states we now offer a special discount
|
|
|
of as much as 8% to our shareholders. We also have applications pending
|
|
|
that would extend this discount to drivers in other states.
|
|
|
An attachment to the proxy material
|
|
|
that is enclosed with this report explains how you can obtain the card
|
|
|
you will need for admission to the meeting. We expect a large crowd, so
|
|
|
get plane, hotel and car reservations promptly. American Express (800-799-6634)
|
|
|
will be happy to help you with arrangements. As usual, we will have buses
|
|
|
at the larger hotels that will take you to and from the meeting and also
|
|
|
deliver you to Nebraska Furniture Mart, Borsheim's and the airport after
|
|
|
its conclusion. You are likely, however, to find a car handy.
|
|
|
NFM's main store, located on a
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|
|
75-acre site about a mile from Aksarben, is open from 10 a.m. to 9 p.m.
|
|
|
on weekdays, 10 a.m. to 6 p.m. on Saturdays, and noon to 6 p.m. on Sundays.
|
|
|
During the period from May 1 to May 5, shareholders who present NFM with
|
|
|
the coupon that will accompany their meeting ticket will be entitled to
|
|
|
a discount that is otherwise restricted to its employees.
|
|
|
Borsheim's normally is closed on
|
|
|
Sunday but will be open for shareholders from 10 a.m. to 6 p.m. on May
|
|
|
3rd. Last year was our second-best shareholder's day, exceeded only by
|
|
|
1996's. I regard this slippage as an anomaly and hope that you will prove
|
|
|
me right this year. Charlie will be available for autographs. He smiles,
|
|
|
however, only if the paper he signs is a Borsheim's sales ticket. Shareholders
|
|
|
who wish to visit on Saturday (10 a.m. to 5:30 p.m.) or on Monday (10 a.m.-8
|
|
|
p.m.) should be sure to identify themselves as Berkshire owners so that
|
|
|
Susan Jacques, Borsheim's CEO, can make you especially welcome. Susan,
|
|
|
I should add, had a fabulous year in 1997. As a manager, she is everything
|
|
|
that an owner hopes for.
|
|
|
On Sunday afternoon we will also
|
|
|
have a special treat for bridge players in the mall outside of Borsheim's.
|
|
|
There, Bob Hamman -- a legend of the game for more than three decades --
|
|
|
will take on all comers. Join in and dazzle Bob with your skill.
|
|
|
My favorite steakhouse, Gorat's,
|
|
|
opens one Sunday a year -- for Berkshire shareholders on the night before
|
|
|
the annual meeting. Last year the restaurant started serving at 4 p.m.
|
|
|
and finished about 1:30 a.m, an endurance trial that was the result of
|
|
|
taking 1,100 reservations vs. a seating capacity of 235. If you make a
|
|
|
reservation and then can't attend, be sure to let Gorat's know promptly,
|
|
|
since it goes to great effort to help us and we want to reciprocate. You
|
|
|
can make reservations beginning on April 1st (but not before) by
|
|
|
calling 402-551-3733. Last year I had to leave Gorat's a little early because
|
|
|
of my voice problem, but this year I plan to leisurely savor every bite
|
|
|
of my rare T-bone and double order of hash browns.
|
|
|
After this warmup, Charlie and
|
|
|
I will head for the Dairy Queen on 114th, just south of Dodge. There are
|
|
|
12 great Dairy Queens in metropolitan Omaha, but the 114th Street location
|
|
|
is the best suited to handle the large crowd that we expect. South of the
|
|
|
property, there are hundreds of parking spaces on both sides of the street.
|
|
|
Also, this Dairy Queen will extend its Sunday hours to 11 p.m. in order
|
|
|
to accommodate our shareholders.
|
|
|
The 114th Street operation is now
|
|
|
run by two sisters, Coni Birge and Deb Novotny, whose grandfather put up
|
|
|
the building in 1962 at what was then the outer edge of the city. Their
|
|
|
mother, Jan Noble, took over in 1972, and Coni and Deb continue as third
|
|
|
generation owner-managers. Jan, Coni and Deb will all be on hand Sunday
|
|
|
evening, and I hope that you meet them. Enjoy one of their hamburgers if
|
|
|
you can't get into Gorat's. And then, around eight o'clock, join me in
|
|
|
having a Dusty Sundae for dessert. This item is a personal specialty --
|
|
|
the Dairy Queen will furnish you a copy of my recipe -- and will be offered
|
|
|
only on Shareholder Sunday.
|
|
|
The Omaha Royals and Albuquerque
|
|
|
Dukes will play baseball on Saturday evening, May 2nd, at Rosenblatt Stadium.
|
|
|
As usual, your Chairman, shamelessly exploiting his 25% ownership of the
|
|
|
team, will take the mound. But this year you will see something new.
|
|
|
In past games, much to the bafflement
|
|
|
of the crowd, I have shaken off the catcher's first call. He has consistently
|
|
|
asked for my sweeping curve, and I have just as regularly resisted. Instead,
|
|
|
I have served up a pathetic fast ball, which on my best day was clocked
|
|
|
at eight miles per hour (with a following wind).
|
|
|
There's a story behind my unwillingness
|
|
|
to throw the curve ball. As some of you may know, Candy Cummings invented
|
|
|
the curve in 1867 and used it to great effect in the National Association,
|
|
|
where he never won less than 28 games in a season. The pitch, however,
|
|
|
drew immediate criticism from the very highest of authorities, namely Charles
|
|
|
Elliott, then president of Harvard University, who declared, "I have
|
|
|
heard that this year we at Harvard won the baseball championship because
|
|
|
we have a pitcher who has a fine curve ball. I am further instructed that
|
|
|
the purpose of the curve ball is to deliberately deceive the batter. Harvard
|
|
|
is not in the business of teaching deception." (I'm not making this
|
|
|
up.)
|
|
|
Ever since I learned of President
|
|
|
Elliott's moral teachings on this subject, I have scrupulously refrained
|
|
|
from using my curve, however devastating its effect might have been on
|
|
|
hapless batters. Now, however, it is time for my karma to run over Elliott's
|
|
|
dogma and for me to quit holding back. Visit the park on Saturday night
|
|
|
and marvel at the majestic arc of my breaking ball.
|
|
|
Our proxy statement includes information
|
|
|
about obtaining tickets to the game. We will also provide an information
|
|
|
packet describing the local hot spots, including, of course, those 12 Dairy
|
|
|
Queens.
|
|
|
Come to Omaha -- the cradle of
|
|
|
capitalism -- in May and enjoy yourself.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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|
|
|
|
Warren E. Buffett
|
|
|
February 27, 1998 Chairman of the Board |
