BERKSHIRE HATHAWAY INC.
Chairman's Letter
To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 1996 was $6.2 billion, or 36.1%. Per-
share book value, however, grew by less, 31.8%, because the number of
Berkshire shares increased: We issued stock in acquiring FlightSafety
International and also sold new Class B shares.* Over the last 32 years
(that is, since present management took over) per-share book value has
grown from $19 to $19,011, or at a rate of 23.8% compounded annually.
* Each Class B share has an economic interest equal to 1/30th of
that possessed by a Class A share, which is the new designation for
the only stock that Berkshire had outstanding before May 1996.
Throughout this report, we state all per-share figures in terms of
"Class A equivalents," which are the sum of the Class A shares
outstanding and 1/30th of the Class B shares outstanding.
For technical reasons, we have restated our 1995 financial
statements, a matter that requires me to present one of my less-than-
thrilling explanations of accounting arcana. I'll make it brief.
The restatement was required because GEICO became a wholly-owned
subsidiary of Berkshire on January 2, 1996, whereas it was previously
classified as an investment. From an economic viewpoint - taking into
account major tax efficiencies and other benefits we gained - the value
of the 51% of GEICO we owned at year-end 1995 increased significantly
when we acquired the remaining 49% of the company two days later.
Accounting rules applicable to this type of "step acquisition," however,
required us to write down the value of our 51% at the time we moved to
100%. That writedown - which also, of course, reduced book value -
amounted to $478.4 million. As a result, we now carry our original 51%
of GEICO at a value that is both lower than its market value at the time
we purchased the remaining 49% of the company and lower than the value at
which we carry that 49% itself.
There is an offset, however, to the reduction in book value I have
just described: Twice during 1996 we issued Berkshire shares at a
premium to book value, first in May when we sold the B shares for cash
and again in December when we used both A and B shares as part-payment
for FlightSafety. In total, the three non-operational items affecting
book value contributed less than one percentage point to our 31.8% per-
share gain last year.
I dwell on this rise in per-share book value because it roughly
indicates our economic progress during the year. But, as Charlie Munger,
Berkshire's Vice Chairman, and I have repeatedly told you, what counts at
Berkshire is intrinsic value, not book value. The last time you got that
message from us was in the Owner's Manual, sent to you in June after we
issued the Class B shares. In that manual, we not only defined certain
key terms - such as intrinsic value - but also set forth our economic
principles.
For many years, we have listed these principles in the front of our
annual report, but in this report, on pages 58 to 67, we reproduce the
entire Owner's Manual. In this letter, we will occasionally refer to the
manual so that we can avoid repeating certain definitions and
explanations. For example, if you wish to brush up on "intrinsic value,"
see pages 64 and 65.
Last year, for the first time, we supplied you with a table that
Charlie and I believe will help anyone trying to estimate Berkshire's
intrinsic value. In the updated version of that table, which follows, we
trace two key indices of value. The first column lists our per-share
ownership of investments (including cash and equivalents) and the second
column shows our per-share earnings from Berkshire's operating businesses
before taxes and purchase-accounting adjustments but after all interest
and corporate overhead expenses. The operating-earnings column excludes
all dividends, interest and capital gains that we realized from the
investments presented in the first column. In effect, the two columns
show what Berkshire would have reported had it been broken into two parts.
Pre-tax Earnings Per Share
Investments Excluding All Income from
Year Per Share Investments
---- ----------- -------------------------
1965................................$ 4 $ 4.08
1975................................ 159 (6.48)
1985................................ 2,443 18.86
1995................................ 22,088 258.20
1996................................ 28,500 421.39
Annual Growth Rate, 1965-95......... 33.4% 14.7%
One-Year Growth Rate, 1995-96 ...... 29.0% 63.2%
As the table tells you, our investments per share increased in 1996
by 29.0% and our non-investment earnings grew by 63.2%. Our goal is to
keep the numbers in both columns moving ahead at a reasonable (or, better
yet, unreasonable) pace.
Our expectations, however, are tempered by two realities. First,
our past rates of growth cannot be matched nor even approached:
Berkshire's equity capital is now large - in fact, fewer than ten
businesses in America have capital larger - and an abundance of funds
tends to dampen returns. Second, whatever our rate of progress, it will
not be smooth: Year-to-year moves in the first column of the table above
will be influenced in a major way by fluctuations in securities markets;
the figures in the second column will be affected by wide swings in the
profitability of our catastrophe-reinsurance business.
In the table, the donations made pursuant to our shareholder-
designated contributions program are charged against the second column,
though we view them as a shareholder benefit rather than as an expense.
All other corporate expenses are also charged against the second column.
These costs may be lower than those of any other large American
corporation: Our after-tax headquarters expense amounts to less than two
basis points (1/50th of 1%) measured against net worth. Even so, Charlie
used to think this expense percentage outrageously high, blaming it on my
use of Berkshire's corporate jet, The Indefensible. But Charlie has
recently experienced a "counter-revelation": With our purchase of
FlightSafety, whose major activity is the training of corporate pilots,
he now rhapsodizes at the mere mention of jets.
Seriously, costs matter. For example, equity mutual funds incur
corporate expenses - largely payments to the funds' managers - that
average about 100 basis points, a levy likely to cut the returns their
investors earn by 10% or more over time. Charlie and I make no promises
about Berkshire's results. We do promise you, however, that virtually
all of the gains Berkshire makes will end up with shareholders. We are
here to make money with you, not off you.
The Relationship of Intrinsic Value to Market Price
In last year's letter, with Berkshire shares selling at $36,000, I
told you: (1) Berkshire's gain in market value in recent years had
outstripped its gain in intrinsic value, even though the latter gain had
been highly satisfactory; (2) that kind of overperformance could not
continue indefinitely; (3) Charlie and I did not at that moment consider
Berkshire to be undervalued.
Since I set down those cautions, Berkshire's intrinsic value has
increased very significantly - aided in a major way by a stunning
performance at GEICO that I will tell you more about later - while the
market price of our shares has changed little. This, of course, means
that in 1996 Berkshire's stock underperformed the business.
Consequently, today's price/value relationship is both much different
from what it was a year ago and, as Charlie and I see it, more
appropriate.
Over time, the aggregate gains made by Berkshire shareholders must
of necessity match the business gains of the company. When the stock
temporarily overperforms or underperforms the business, a limited number
of shareholders - either sellers or buyers - receive outsized benefits at
the expense of those they trade with. Generally, the sophisticated have
an edge over the innocents in this game.
Though our primary goal is to maximize the amount that our
shareholders, in total, reap from their ownership of Berkshire, we wish
also to minimize the benefits going to some shareholders at the expense
of others. These are goals we would have were we managing a family
partnership, and we believe they make equal sense for the manager of a
public company. In a partnership, fairness requires that partnership
interests be valued equitably when partners enter or exit; in a public
company, fairness prevails when market price and intrinsic value are in
sync. Obviously, they won't always meet that ideal, but a manager - by
his policies and communications - can do much to foster equity.
Of course, the longer a shareholder holds his shares, the more
bearing Berkshire's business results will have on his financial
experience - and the less it will matter what premium or discount to
intrinsic value prevails when he buys and sells his stock. That's one
reason we hope to attract owners with long-term horizons. Overall, I
think we have succeeded in that pursuit. Berkshire probably ranks number
one among large American corporations in the percentage of its shares
held by owners with a long-term view.
Acquisitions of 1996
We made two acquisitions in 1996, both possessing exactly the
qualities we seek - excellent business economics and an outstanding
manager.
The first acquisition was Kansas Bankers Surety (KBS), an insurance
company whose name describes its specialty. The company, which does
business in 22 states, has an extraordinary underwriting record, achieved
through the efforts of Don Towle, an extraordinary manager. Don has
developed first-hand relationships with hundreds of bankers and knows
every detail of his operation. He thinks of himself as running a company
that is "his," an attitude we treasure at Berkshire. Because of its
relatively small size, we placed KBS with Wesco, our 80%-owned
subsidiary, which has wanted to expand its insurance operations.
You might be interested in the carefully-crafted and sophisticated
acquisition strategy that allowed Berkshire to nab this deal. Early in
1996 I was invited to the 40th birthday party of my nephew's wife, Jane
Rogers. My taste for social events being low, I immediately, and in my
standard, gracious way, began to invent reasons for skipping the event.
The party planners then countered brilliantly by offering me a seat next
to a man I always enjoy, Jane's dad, Roy Dinsdale - so I went.
The party took place on January 26. Though the music was loud - Why
must bands play as if they will be paid by the decibel? - I just managed
to hear Roy say he'd come from a directors meeting at Kansas Bankers
Surety, a company I'd always admired. I shouted back that he should let
me know if it ever became available for purchase.
On February 12, I got the following letter from Roy: "Dear Warren:
Enclosed is the annual financial information on Kansas Bankers Surety.
This is the company that we talked about at Janie's party. If I can be
of any further help, please let me know." On February 13, I told Roy we
would pay $75 million for the company - and before long we had a deal.
I'm now scheming to get invited to Jane's next party.
Our other acquisition in 1996 - FlightSafety International, the
world's leader in the training of pilots - was far larger, at about $1.5
billion, but had an equally serendipitous origin. The heroes of this
story are first, Richard Sercer, a Tucson aviation consultant, and
second, his wife, Alma Murphy, an ophthalmology graduate of Harvard
Medical School, who in 1990 wore down her husband's reluctance and got
him to buy Berkshire stock. Since then, the two have attended all our
Annual Meetings, but I didn't get to know them personally.
Fortunately, Richard had also been a long-time shareholder of
FlightSafety, and it occurred to him last year that the two companies
would make a good fit. He knew our acquisition criteria, and he thought
that Al Ueltschi, FlightSafety's 79-year-old CEO, might want to make a
deal that would both give him a home for his company and a security in
payment that he would feel comfortable owning throughout his lifetime.
So in July, Richard wrote Bob Denham, CEO of Salomon Inc, suggesting that
he explore the possibility of a merger.
Bob took it from there, and on September 18, Al and I met in New
York. I had long been familiar with FlightSafety's business, and in
about 60 seconds I knew that Al was exactly our kind of manager. A month
later, we had a contract. Because Charlie and I wished to minimize the
issuance of Berkshire shares, the transaction we structured gave
FlightSafety shareholders a choice of cash or stock but carried terms
that encouraged those who were tax-indifferent to take cash. This nudge
led to about 51% of FlightSafety's shares being exchanged for cash, 41%
for Berkshire A and 8% for Berkshire B.
Al has had a lifelong love affair with aviation and actually piloted
Charles Lindbergh. After a barnstorming career in the 1930s, he began
working for Juan Trippe, Pan Am's legendary chief. In 1951, while still
at Pan Am, Al founded FlightSafety, subsequently building it into a
simulator manufacturer and a worldwide trainer of pilots (single-engine,
helicopter, jet and marine). The company operates in 41 locations,
outfitted with 175 simulators of planes ranging from the very small, such
as Cessna 210s, to Boeing 747s. Simulators are not cheap - they can cost
as much as $19 million - so this business, unlike many of our
operations, is capital intensive. About half of the company's revenues
are derived from the training of corporate pilots, with most of the
balance coming from airlines and the military.
Al may be 79, but he looks and acts about 55. He will run
operations just as he has in the past: We never fool with success. I
have told him that though we don't believe in splitting Berkshire stock,
we will split his age 2-for-1 when he hits 100.
An observer might conclude from our hiring practices that Charlie
and I were traumatized early in life by an EEOC bulletin on age
discrimination. The real explanation, however, is self-interest: It's
difficult to teach a new dog old tricks. The many Berkshire managers who
are past 70 hit home runs today at the same pace that long ago gave them
reputations as young slugging sensations. Therefore, to get a job with
us, just employ the tactic of the 76-year-old who persuaded a dazzling
beauty of 25 to marry him. "How did you ever get her to accept?" asked
his envious contemporaries. The comeback: "I told her I was 86."
* * * * * * * * * * * *
And now we pause for our usual commercial: If you own a large
business with good economic characteristics and wish to become associated
with an exceptional collection of businesses having similar
characteristics, Berkshire may well be the home you seek. Our
requirements are set forth on page 21. If your company meets them - and
if I fail to make the next birthday party you attend - give me a call.
Insurance Operations - Overview
Our insurance business was terrific in 1996. In both primary
insurance, where GEICO is our main unit, and in our "super-cat"
reinsurance business, results were outstanding.
As we've explained in past reports, what counts in our insurance
business is, first, the amount of "float" we generate and, second, its
cost to us. These are matters that are important for you to understand
because float is a major component of Berkshire's intrinsic value that is
not reflected in book value.
To begin with, float is money we hold but don't own. In an
insurance operation, float arises because premiums are received before
losses are paid. Secondly, the premiums that an insurer takes in
typically do not cover the losses and expenses it eventually must pay.
That leaves it running an "underwriting loss," which is the cost of
float. An insurance business has value if its cost of float over time is
less than the cost the company would otherwise incur to obtain funds.
But the business is an albatross if the cost of its float is higher than
market rates for money.
As the numbers in the following table show, Berkshire's insurance
business has been a huge winner. For the table, we have calculated our
float - which we generate in large amounts relative to our premium
volume - by adding loss reserves, loss adjustment reserves, funds held
under reinsurance assumed and unearned premium reserves, and then
subtracting agents' balances, prepaid acquisition costs, prepaid taxes
and deferred charges applicable to assumed reinsurance. Our cost of
float is determined by our underwriting loss or profit. In those years
when we have had an underwriting profit, such as the last four, our cost
of float has been negative. In effect, we have been paid for holding
money.
(1) (2) Yearend Yield
Underwriting Approximat on Long-Term
Loss Average Float Cost of Funds Govt. Bonds
------------ ------------- ---------------- -------------
(In $ Millions) (Ratio of 1 to 2)
1967.......... profit 17.3 less than zero 5.50%
1968.......... profit 19.9 less than zero 5.90%
1969.......... profit 23.4 less than zero 6.79%
1970.......... 0.37 32.4 1.14% 6.25%
1971.......... profit 52.5 less than zero 5.81%
1972.......... profit 69.5 less than zero 5.82%
1973.......... profit 73.3 less than zero 7.27%
1974.......... 7.36 79.1 9.30% 8.13%
1975.......... 11.35 87.6 12.96% 8.03%
1976.......... profit 102.6 less than zero 7.30%
1977.......... profit 139.0 less than zero 7.97%
1978.......... profit 190.4 less than zero 8.93%
1979.......... profit 227.3 less than zero 10.08%
1980.......... profit 237.0 less than zero 11.94%
1981.......... profit 228.4 less than zero 13.61%
1982.......... 21.56 220.6 9.77% 10.64%
1983.......... 33.87 231.3 14.64% 11.84%
1984.......... 48.06 253.2 18.98% 11.58%
1985.......... 44.23 390.2 11.34% 9.34%
1986.......... 55.84 797.5 7.00% 7.60%
1987.......... 55.43 1,266.7 4.38% 8.95%
1988.......... 11.08 1,497.7 0.74% 9.00%
1989.......... 24.40 1,541.3 1.58% 7.97%
1990.......... 26.65 1,637.3 1.63% 8.24%
1991.......... 119.59 1,895.0 6.31% 7.40%
1992.......... 108.96 2,290.4 4.76% 7.39%
1993.......... profit 2,624.7 less than zero 6.35%
1994.......... profit 3,056.6 less than zero 7.88%
1995.......... profit 3,607.2 less than zero 5.95%
1996.......... profit 6,702.0 less than zero 6.64%
Since 1967, when we entered the insurance business, our float has
grown at an annual compounded rate of 22.3%. In more years than not, our
cost of funds has been less than nothing. This access to "free" money has
boosted Berkshire's performance in a major way. Moreover, our acquisition
of GEICO materially increases the probability that we can continue to
obtain "free" funds in increasing amounts.
Super-Cat Insurance
As in the past three years, we once again stress that the good results
we are reporting for Berkshire stem in part from our super-cat business
having a lucky year. In this operation, we sell policies that insurance
and reinsurance companies buy to protect themselves from the effects of
mega-catastrophes. 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.
I emphasize this lugubrious point because I would not want you to
panic and sell your Berkshire stock upon hearing that some large
catastrophe had cost us a significant amount. If you would tend to react
that way, you should not own Berkshire shares now, just as you should
entirely avoid owning stocks if a crashing market would lead you to panic
and sell. Selling fine businesses on "scary" news is usually a bad
decision. (Robert Woodruff, the business genius who built Coca-Cola over
many decades and who owned a huge position in the company, was once asked
when it might be a good time to sell Coke stock. Woodruff had a simple
answer: "I don't know. I've never sold any.")
In our super-cat operation, our customers are insurers that are
exposed to major earnings volatility and that wish to reduce it. The
product we sell - for what we hope is an appropriate price - is our
willingness to shift that volatility to our own books. Gyrations in
Berkshire's earnings don't bother us in the least: Charlie and I would
much rather earn a lumpy 15% over time than a smooth 12%. (After all, our
earnings swing wildly on a daily and weekly basis - why should we demand
that smoothness accompany each orbit that the earth makes of the sun?) We
are most comfortable with that thinking, however, when we have
shareholder/partners who can also accept volatility, and that's why we
regularly repeat our cautions.
We took on some major super-cat exposures during 1996. At mid-year we
wrote a contract with Allstate that covers Florida hurricanes, and though
there are no definitive records that would allow us to prove this point, we
believe that to have then been the largest single catastrophe risk ever
assumed by one company for its own account. Later in the year, however, we
wrote a policy for the California Earthquake Authority that goes into
effect on April 1, 1997, and that exposes us to a loss more than twice that
possible under the Florida contract. Again we retained all the risk for
our own account. Large as these coverages are, Berkshire's after-tax
"worst-case" loss from a true mega-catastrophe is probably no more than
$600 million, which is less than 3% of our book value and 1.5% of our market
value. To gain some perspective on this exposure, look at the table on
page 2 and note the much greater volatility that security markets have
delivered us.
In the super-cat business, we have three major competitive advantages.
First, the parties buying reinsurance from us know that we both can and
will pay under the most adverse of circumstances. Were a truly cataclysmic
disaster to occur, it is not impossible that a financial panic would
quickly follow. If that happened, there could well be respected reinsurers
that would have difficulty paying at just the moment that their clients
faced extraordinary needs. Indeed, one reason we never "lay off" part of
the risks we insure is that we have reservations about our ability to
collect from others when disaster strikes. When it's Berkshire promising,
insureds know with certainty that they can collect promptly.
Our second advantage - somewhat related - is subtle but important.
After a mega-catastrophe, insurers might well find it difficult to obtain
reinsurance even though their need for coverage would then be particularly
great. At such a time, Berkshire would without question have very
substantial capacity available - but it will naturally be our long-standing
clients that have first call on it. That business reality has made major
insurers and reinsurers throughout the world realize the desirability of
doing business with us. Indeed, we are currently getting sizable "stand-
by" fees from reinsurers that are simply nailing down their ability to get
coverage from us should the market tighten.
Our final competitive advantage is that we can provide dollar
coverages of a size neither matched nor approached elsewhere in the
industry. Insurers looking for huge covers know that a single call to
Berkshire will produce a firm and immediate offering.
A few facts about our exposure to California earthquakes - our largest
risk - seem in order. The Northridge quake of 1994 laid homeowners' losses
on insurers that greatly exceeded what computer models had told them to
expect. Yet the intensity of that quake was mild compared to the "worst-
case" possibility for California. Understandably, insurers became - ahem -
shaken and started contemplating a retreat from writing earthquake coverage
into their homeowners' policies.
In a thoughtful response, Chuck Quackenbush, California's insurance
commissioner, designed a new residential earthquake policy to be written by
a state-sponsored insurer, The California Earthquake Authority. This
entity, which went into operation on December 1, 1996, needed large layers
of reinsurance - and that's where we came in. Berkshire's layer of
approximately $1 billion will be called upon if the Authority's aggregate
losses in the period ending March 31, 2001 exceed about $5 billion. (The
press originally reported larger figures, but these would have applied only
if all California insurers had entered into the arrangement; instead only
72% signed up.)
So what are the true odds of our having to make a payout during the
policy's term? We don't know - nor do we think computer models will help
us, since we believe the precision they project is a chimera. In fact,
such models can lull decision-makers into a false sense of security and
thereby increase their chances of making a really huge mistake. We've
already seen such debacles in both insurance and investments. Witness
"portfolio insurance," whose destructive effects in the 1987 market crash
led one wag to observe that it was the computers that should have been
jumping out of windows.
Even if perfection in assessing risks is unattainable, insurers can
underwrite sensibly. After all, you need not know a man's precise age to
know that he is old enough to vote nor know his exact weight to recognize
his need to diet. In insurance, it is essential to remember that virtually
all surprises are unpleasant, and with that in mind we try to price our
super-cat exposures so that about 90% of total premiums end up being
eventually paid out in losses and expenses. Over time, we will find out
how smart our pricing has been, but that will not be quickly. The super-
cat business is just like the investment business in that it often takes a
long time to find out whether you knew what you were doing.
What I can state with certainty, however, is that we have the best
person in the world to run our super-cat business: Ajit Jain, whose value
to Berkshire is simply enormous. In the reinsurance field, disastrous
propositions abound. I know that because I personally embraced all too
many of these in the 1970s and also because GEICO has a large runoff
portfolio made up of foolish contracts written in the early-1980s, able
though its then-management was. Ajit, I can assure you, won't make
mistakes of this type.
I have mentioned that a mega-catastrophe might cause a catastrophe in
the financial markets, a possibility that is unlikely but not far-fetched.
Were the catastrophe a quake in California of sufficient magnitude to tap
our coverage, we would almost certainly be damaged in other ways as well.
For example, See's, Wells Fargo and Freddie Mac could be hit hard. All in
all, though, we can handle this aggregation of exposures.
In this respect, as in others, we try to "reverse engineer" our future
at Berkshire, bearing in mind Charlie's dictum: "All I want to know is
where I'm going to die so I'll never go there." (Inverting really works:
Try singing country western songs backwards and you will quickly regain
your house, your car and your wife.) If we can't tolerate a possible
consequence, remote though it may be, we steer clear of planting its seeds.
That is why we don't borrow big amounts and why we make sure that our
super-cat business losses, large though the maximums may sound, will not
put a major dent in Berkshire's intrinsic value.
Insurance - GEICO and Other Primary Operations
When we moved to total ownership of GEICO early last year, our
expectations were high - and they are all being exceeded. That is true
from both a business and personal perspective: GEICO's operating chief,
Tony Nicely, is a superb business manager and a delight to work with.
Under almost any conditions, GEICO would be an exceptionally valuable
asset. With Tony at the helm, it is reaching levels of performance that
the organization would only a few years ago have thought impossible.
There's nothing esoteric about GEICO's success: The company's
competitive strength flows directly from its position as a low-cost
operator. Low costs permit low prices, and low prices attract and retain
good policyholders. The final segment of a virtuous circle is drawn when
policyholders recommend us to their friends. GEICO gets more than one
million referrals annually and these produce more than half of our new
business, an advantage that gives us enormous savings in acquisition
expenses - and that makes our costs still lower.
This formula worked in spades for GEICO in 1996: Its voluntary auto
policy count grew 10%. During the previous 20 years, the company's best-
ever growth for a year had been 8%, a rate achieved only once. Better yet,
the growth in voluntary policies accelerated during the year, led by major
gains in the nonstandard market, which has been an underdeveloped area at
GEICO. I focus here on voluntary policies because the involuntary business
we get from assigned risk pools and the like is unprofitable. Growth in
that sector is most unwelcome.
GEICO's growth would mean nothing if it did not produce reasonable
underwriting profits. Here, too, the news is good: Last year we hit our
underwriting targets and then some. Our goal, however, is not to widen our
profit margin but rather to enlarge the price advantage we offer customers.
Given that strategy, we believe that 1997's growth will easily top that of
last year.
We expect new competitors to enter the direct-response market, and
some of our existing competitors are likely to expand geographically.
Nonetheless, the economies of scale we enjoy should allow us to maintain or
even widen the protective moat surrounding our economic castle. We do best
on costs in geographical areas in which we enjoy high market penetration.
As our policy count grows, concurrently delivering gains in penetration, we
expect to drive costs materially lower. GEICO's sustainable cost advantage
is what attracted me to the company way back in 1951, when the entire
business was valued at $7 million. It is also why I felt Berkshire should
pay $2.3 billion last year for the 49% of the company that we didn't then
own.
Maximizing the results of a wonderful business requires management and
focus. Lucky for us, we have in Tony a superb manager whose business focus
never wavers. Wanting also to get the entire GEICO organization
concentrating as he does, we needed a compensation plan that was itself
sharply focused - and immediately after our purchase, we put one in.
Today, the bonuses received by dozens of top executives, starting with
Tony, are based upon only two key variables: (1) growth in voluntary auto
policies and (2) underwriting profitability on "seasoned" auto business
(meaning policies that have been on the books for more than one year). In
addition, we use the same yardsticks to calculate the annual contribution
to the company's profit-sharing plan. Everyone at GEICO knows what counts.
The GEICO plan exemplifies Berkshire's incentive compensation
principles: Goals should be (1) tailored to the economics of the specific
operating business; (2) simple in character so that the degree to which
they are being realized can be easily measured; and (3) directly related to
the daily activities of plan participants. As a corollary, we shun
"lottery ticket" arrangements, such as options on Berkshire shares, whose
ultimate value - which could range from zero to huge - is totally out of
the control of the person whose behavior we would like to affect. In our
view, a system that produces quixotic payoffs will not only be wasteful for
owners but may actually discourage the focused behavior we value in
managers.
Every quarter, all 9,000 GEICO associates can see the results that
determine our profit-sharing plan contribution. In 1996, they enjoyed the
experience because the plan literally went off the chart that had been
constructed at the start of the year. Even I knew the answer to that
problem: Enlarge the chart. Ultimately, the results called for a record
contribution of 16.9% ($40 million), compared to a five-year average of
less than 10% for the comparable plans previously in effect. Furthermore,
at Berkshire, we never greet good work by raising the bar. If GEICO's
performance continues to improve, we will happily keep on making larger
charts.
Lou Simpson continues to manage GEICO's money in an outstanding
manner: Last year, the equities in his portfolio outdid the S&P 500 by 6.2
percentage points. In Lou's part of GEICO's operation, we again tie
compensation to performance - but to investment performance over a four-
year period, not to underwriting results nor to the performance of GEICO as
a whole. We think it foolish for an insurance company to pay bonuses that
are tied to overall corporate results when great work on one side of the
business - underwriting or investment - could conceivably be completely
neutralized by bad work on the other. If you bat .350 at Berkshire, you
can be sure you will get paid commensurately even if the rest of the team
bats .200. In Lou and Tony, however, we are lucky to have Hall-of-Famers
in both key positions.
* * * * * * * * * * * *
Though they are, of course, smaller than GEICO, our other primary
insurance operations turned in equally stunning results last year.
National Indemnity's traditional business had a combined ratio of 74.2 and,
as usual, developed a large amount of float compared to premium volume.
Over the last three years, this segment of our business, run by Don
Wurster, has had an average combined ratio of 83.0. Our homestate
operation, managed by Rod Eldred, recorded a combined ratio of 87.1 even
though it absorbed the expenses of expanding to new states. Rod's three-
year combined ratio is an amazing 83.2. Berkshire's workers' compensation
business, run out of California by Brad Kinstler, has now moved into six
other states and, despite the costs of that expansion, again achieved an
excellent underwriting profit. Finally, John Kizer, at Central States
Indemnity, set new records for premium volume while generating good
earnings from underwriting. In aggregate, our smaller insurance operations
(now including Kansas Bankers Surety) have an underwriting record virtually
unmatched in the industry. Don, Rod, Brad and John have all created
significant value for Berkshire, and we believe there is more to come.
Taxes
In 1961, President Kennedy said that we should ask not what our
country can do for us, but rather ask what we can do for our country. Last
year we decided to give his suggestion a try - and who says it never hurts
to ask? We were told to mail $860 million in income taxes to the U.S.
Treasury.
Here's a little perspective on that figure: If an equal amount had
been paid by only 2,000 other taxpayers, the government would have had a
balanced budget in 1996 without needing a dime of taxes - income or Social
Security or what have you - from any other American. Berkshire
shareholders can truly say, "I gave at the office."
Charlie and I believe that large tax payments by Berkshire are
entirely fitting. The contribution we thus make to society's well-being is
at most only proportional to its contribution to ours. Berkshire prospers
in America as it would nowhere else.
Sources of Reported Earnings
The table that follows shows the main sources of Berkshire's reported
earnings. In this presentation, purchase-accounting adjustments are not
assigned to the specific businesses to which they apply, but are instead
aggregated and shown separately. This procedure lets you view the earnings
of our businesses as they would have been reported had we not purchased
them. For the reasons discussed on pages 65 and 66, this form of
presentation seems to us to be more useful to investors and managers than
one utilizing generally-accepted accounting principles (GAAP), which
require purchase-premiums to be charged off business-by-business. The
total earnings we show in the table are, of course, identical to the GAAP
total in our audited financial statements.
(in millions)
--------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-tax Earnings minority interests)
---------------- -------------------
1996 1995(1) 1996 1995(1)
------- -------- ------- -------
Operating Earnings:
Insurance Group:
Underwriting.....................$ 222.1 $ 20.5 $ 142.8 $ 11.3
Net Investment Income............ 726.2 501.6 593.1 417.7
Buffalo News........................... 50.4 46.8 29.5 27.3
Fechheimer............................. 17.3 16.9 9.3 8.8
Finance Businesses..................... 23.1 20.8 14.9 12.6
Home Furnishings....................... 43.8 29.7(2) 24.8 16.7(2)
Jewelry................................ 27.8 33.9(3) 16.1 19.1(3)
Kirby.................................. 58.5 50.2 39.9 32.1
Scott Fetzer Manufacturing Group....... 50.6 34.1 32.2 21.2
See's Candies.......................... 51.9 50.2 30.8 29.8
Shoe Group............................. 61.6 58.4 41.0 37.5
World Book............................. 12.6 8.8 9.5 7.0
Purchase-Accounting Adjustments........ (75.7) (27.0) (70.5) (23.4)
Interest Expense(4).................... (94.3) (56.0) (56.6) (34.9)
Shareholder-Designated Contributions... (13.3) (11.6) (8.5) (7.0)
Other.................................. 58.8 37.4 34.8 24.4
------- -------- -------- -------
Operating Earnings.......................1,221.4 814.7 883.1 600.2
Sales of Securities......................2,484.5 194.1 1,605.5 125.0
------- -------- -------- -------
Total Earnings - All Entities...........$3,705.9 $1,008.8 $2,488.6 $ 725.2
======= ======== ======== =======
(1) Before the GEICO-related restatement. (3) Includes Helzberg's from
April 30, 1995.
(2) Includes R.C. Willey from June 29, 1995. (4) Excludes interest expense
of Finance Businesses.
In this section last year, I discussed three businesses that reported
a decline in earnings - Buffalo News, Shoe Group and World Book. All, I'm
happy to say, recorded gains in 1996.
World Book, however, did not find it easy: Despite the operation's
new status as the only direct-seller of encyclopedias in the country
(Encyclopedia Britannica exited the field last year), its unit volume fell.
Additionally, World Book spent heavily on a new CD-ROM product that began
to take in revenues only in early 1997, when it was launched in association
with IBM. In the face of these factors, earnings would have evaporated had
World Book not revamped distribution methods and cut overhead at
headquarters, thereby dramatically reducing its fixed costs. Overall, the
company has gone a long way toward assuring its long-term viability in both
the print and electronic marketplaces.
Our only disappointment last year was in jewelry: Borsheim's did
fine, but Helzberg's suffered a material decline in earnings. Its expense
levels had been geared to a sizable increase in same-store sales,
consistent with the gains achieved in recent years. When sales were
instead flat, profit margins fell. Jeff Comment, CEO of Helzberg's, is
addressing the expense problem in a decisive manner, and the company's
earnings should improve in 1997.
Overall, our operating businesses continue to perform exceptionally,
far outdoing their industry norms. For this, Charlie and I thank our
managers. If you should see any of them at the Annual Meeting, add your
thanks as well.
More information about our various businesses is given on pages 36-
46, where you will also find our segment earnings reported on a GAAP
basis. In addition, on pages 51-57, we have rearranged Berkshire's
financial data into four segments on a non-GAAP basis, a presentation
that corresponds to the way Charlie and I think about the company. Our
intent is to supply you with the financial information that we would wish
you to give us if our positions were reversed.
"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 1996 look-through earnings,
though I warn you that the figures can be no more than approximate, since
they are based on a number of judgment calls. (The dividends paid to us
by these investees have been included in the operating earnings itemized
on page 12, mostly under "Insurance Group: Net Investment Income.")
Berkshire's Share
of Undistributed
Berkshire's Approximate Operating Earnings
Berkshire's Major Investees Ownership at Yearend(1) (in millions)(2)
-------------------------------- ----------------------- ------------------
American Express Company........ 10.5% $ 132
The Coca-Cola Company........... 8.1% 180
The Walt Disney Company......... 3.6% 50
Federal Home Loan Mortgage Corp. 8.4% 77
The Gillette Company............ 8.6% 73
McDonald's Corporation.......... 4.3% 38
The Washington Post Company..... 15.8% 27
Wells Fargo & Company........... 8.0% 84
------
Berkshire's share of undistributed earnings of major investees.. 661
Hypothetical tax on these undistributed investee earnings(3).... (93)
Reported operating earnings of Berkshire........................ 954
------
Total look-through earnings of Berkshire..................$1,522
======
(1) Does not include shares allocable to minority interests
(2) Calculated on average ownership for the year
(3) The tax rate used is 14%, which is the rate Berkshire pays on
the dividends it receives
Common Stock Investments
Below we present our common stock investments. Those with a market
value of more than $500 million are itemized.
12/31/96
Shares Company Cost* Market
----------- --------------------------------- -------- ---------
(dollars in millions)
49,456,900 American Express Company...........$1,392.7 $ 2,794.3
200,000,000 The Coca-Cola Company.............. 1,298.9 10,525.0
24,614,214 The Walt Disney Company............ 577.0 1,716.8
64,246,000 Federal Home Loan Mortgage Corp.... 333.4 1,772.8
48,000,000 The Gillette Company............... 600.0 3,732.0
30,156,600 McDonald's Corporation............. 1,265.3 1,368.4
1,727,765 The Washington Post Company........ 10.6 579.0
7,291,418 Wells Fargo & Company.............. 497.8 1,966.9
Others............................. 1,934.5 3,295.4
-------- ---------
Total Common Stocks................$7,910.2 $27,750.6
======== =========
* Represents tax-basis cost which, in aggregate, is $1.2 billion
less than GAAP cost.
Our portfolio shows little change: We continue to make more money
when snoring than when active.
Inactivity strikes us as intelligent behavior. Neither we nor most
business managers would dream of feverishly trading highly-profitable
subsidiaries because a small move in the Federal Reserve's discount rate
was predicted or because some Wall Street pundit had reversed his views
on the market. Why, then, should we behave differently with our minority
positions in wonderful businesses? The art of investing in public
companies successfully is little different from the art of successfully
acquiring subsidiaries. In each case you simply want to acquire, at a
sensible price, a business with excellent economics and able, honest
management. Thereafter, you need only monitor whether these qualities
are being preserved.
When carried out capably, an investment strategy of that type will
often result in its practitioner owning a few securities that will come
to represent a very large portion of his portfolio. This investor would
get a similar result if he followed a policy of purchasing an interest
in, say, 20% of the future earnings of a number of outstanding college
basketball stars. A handful of these would go on to achieve NBA stardom,
and the investor's take from them would soon dominate his royalty stream.
To suggest that this investor should sell off portions of his most
successful investments simply because they have come to dominate his
portfolio is akin to suggesting that the Bulls trade Michael Jordan
because he has become so important to the team.
In studying the investments we have made in both subsidiary
companies and common stocks, you will see that we favor businesses and
industries unlikely to experience major change. The reason for that is
simple: Making either type of purchase, we are searching for operations
that we believe are virtually certain to possess enormous competitive
strength ten or twenty years from now. A fast-changing industry
environment may offer the chance for huge wins, but it precludes the
certainty we seek.
I should emphasize that, as citizens, Charlie and I welcome change:
Fresh ideas, new products, innovative processes and the like cause our
country's standard of living to rise, and that's clearly good. As
investors, however, our reaction to a fermenting industry is much like
our attitude toward space exploration: We applaud the endeavor but
prefer to skip the ride.
Obviously all businesses change to some extent. Today, See's is
different in many ways from what it was in 1972 when we bought it: It
offers a different assortment of candy, employs different machinery and
sells through different distribution channels. But the reasons why
people today buy boxed chocolates, and why they buy them from us rather
than from someone else, are virtually unchanged from what they were in
the 1920s when the See family was building the business. Moreover, these
motivations are not likely to change over the next 20 years, or even 50.
We look for similar predictability in marketable securities. Take
Coca-Cola: The zeal and imagination with which Coke products are sold
has burgeoned under Roberto Goizueta, who has done an absolutely
incredible job in creating value for his shareholders. Aided by Don
Keough and Doug Ivester, Roberto has rethought and improved every aspect
of the company. But the fundamentals of the business - the qualities
that underlie Coke's competitive dominance and stunning economics - have
remained constant through the years.
I was recently studying the 1896 report of Coke (and you think that
you are behind in your reading!). At that time Coke, though it was
already the leading soft drink, had been around for only a decade. But
its blueprint for the next 100 years was already drawn. Reporting sales
of $148,000 that year, Asa Candler, the company's president, said: "We
have not lagged in our efforts to go into all the world teaching that
Coca-Cola is the article, par excellence, for the health and good feeling
of all people." Though "health" may have been a reach, I love the fact
that Coke still relies on Candler's basic theme today - a century later.
Candler went on to say, just as Roberto could now, "No article of like
character has ever so firmly entrenched itself in public favor." Sales
of syrup that year, incidentally, were 116,492 gallons versus about 3.2
billion in 1996.
I can't resist one more Candler quote: "Beginning this year about
March 1st . . . we employed ten traveling salesmen by means of which,
with systematic correspondence from the office, we covered almost the
territory of the Union." That's my kind of sales force.
Companies such as Coca-Cola and Gillette might well be labeled "The
Inevitables." Forecasters may differ a bit in their predictions of
exactly how much soft drink or shaving-equipment business these companies
will be doing in ten or twenty years. Nor is our talk of inevitability
meant to play down the vital work that these companies must continue to
carry out, in such areas as manufacturing, distribution, packaging and
product innovation. In the end, however, no sensible observer - not even
these companies' most vigorous competitors, assuming they are assessing
the matter honestly - questions that Coke and Gillette will dominate
their fields worldwide for an investment lifetime. Indeed, their
dominance will probably strengthen. Both companies have significantly
expanded their already huge shares of market during the past ten years,
and all signs point to their repeating that performance in the next
decade.
Obviously many companies in high-tech businesses or embryonic
industries will grow much faster in percentage terms than will The
Inevitables. But I would rather be certain of a good result than hopeful
of a great one.
Of course, Charlie and I can identify only a few Inevitables, even
after a lifetime of looking for them. Leadership alone provides no
certainties: Witness the shocks some years back at General Motors, IBM
and Sears, all of which had enjoyed long periods of seeming
invincibility. Though some industries or lines of business exhibit
characteristics that endow leaders with virtually insurmountable
advantages, and that tend to establish Survival of the Fattest as almost
a natural law, most do not. Thus, for every Inevitable, there are dozens
of Impostors, companies now riding high but vulnerable to competitive
attacks. Considering what it takes to be an Inevitable, Charlie and I
recognize that we will never be able to come up with a Nifty Fifty or
even a Twinkling Twenty. To the Inevitables in our portfolio, therefore,
we add a few "Highly Probables."
You can, of course, pay too much for even the best of businesses.
The overpayment risk surfaces periodically and, in our opinion, may now
be quite high for the purchasers of virtually all stocks, The Inevitables
included. Investors making purchases in an overheated market need to
recognize that it may often take an extended period for the value of even
an outstanding company to catch up with the price they paid.
A far more serious problem occurs when the management of a great
company gets sidetracked and neglects its wonderful base business while
purchasing other businesses that are so-so or worse. When that happens,
the suffering of investors is often prolonged. Unfortunately, that is
precisely what transpired years ago at both Coke and Gillette. (Would
you believe that a few decades back they were growing shrimp at Coke and
exploring for oil at Gillette?) Loss of focus is what most worries
Charlie and me when we contemplate investing in businesses that in
general look outstanding. All too often, we've seen value stagnate in
the presence of hubris or of boredom that caused the attention of
managers to wander. That's not going to happen again at Coke and
Gillette, however - not given their current and prospective managements.
* * * * * * * * * * * *
Let me add a few thoughts about your own investments. Most
investors, both institutional and individual, will find that the best way
to own common stocks is through an index fund that charges minimal fees.
Those following this path are sure to beat the net results (after fees
and expenses) delivered by the great majority of investment
professionals.
Should you choose, however, to construct your own portfolio, there
are a few thoughts worth remembering. Intelligent investing is not
complex, though that is far from saying that it is easy. What an
investor needs is the ability to correctly evaluate selected businesses.
Note that word "selected": You don't have to be an expert on every
company, or even many. You only have to be able to evaluate companies
within your circle of competence. The size of that circle is not very
important; knowing its boundaries, however, is vital.
To invest successfully, you need not understand beta, efficient
markets, modern portfolio theory, option pricing or emerging markets.
You may, in fact, be better off knowing nothing of these. That, of
course, is not the prevailing view at most business schools, whose
finance curriculum tends to be dominated by such subjects. In our view,
though, investment students need only two well-taught courses - How to
Value a Business, and How to Think About Market Prices.
Your goal as an investor should simply be to purchase, at a rational
price, a part interest in an easily-understandable business whose
earnings are virtually certain to be materially higher five, ten and
twenty years from now. Over time, you will find only a few companies
that meet these standards - so when you see one that qualifies, you
should buy a meaningful amount of stock. You must also resist the
temptation to stray from your guidelines: If you aren't willing to own a
stock for ten years, don't even think about owning it for ten minutes.
Put together a portfolio of companies whose aggregate earnings march
upward over the years, and so also will the portfolio's market value.
Though it's seldom recognized, this is the exact approach that has
produced gains for Berkshire shareholders: Our look-through earnings
have grown at a good clip over the years, and our stock price has risen
correspondingly. Had those gains in earnings not materialized, there
would have been little increase in Berkshire's value.
The greatly enlarged earnings base we now enjoy will inevitably
cause our future gains to lag those of the past. We will continue,
however, to push in the directions we always have. We will try to build
earnings by running our present businesses well - a job made easy because
of the extraordinary talents of our operating managers - and by
purchasing other businesses, in whole or in part, that are not likely to
be roiled by change and that possess important competitive advantages.
USAir
When Richard Branson, the wealthy owner of Virgin Atlantic Airways,
was asked how to become a millionaire, he had a quick answer: "There's
really nothing to it. Start as a billionaire and then buy an airline."
Unwilling to accept Branson's proposition on faith, your Chairman decided
in 1989 to test it by investing $358 million in a 9.25% preferred stock of
USAir.
I liked and admired Ed Colodny, the company's then-CEO, and I still
do. But my analysis of USAir's business was both superficial and wrong.
I was so beguiled by the company's long history of profitable
operations, and by the protection that ownership of a senior security
seemingly offered me, that I overlooked the crucial point: USAir's
revenues would increasingly feel the effects of an unregulated, fiercely-
competitive market whereas its cost structure was a holdover from the
days when regulation protected profits. These costs, if left unchecked,
portended disaster, however reassuring the airline's past record might
be. (If history supplied all of the answers, the Forbes 400 would
consist of librarians.)
To rationalize its costs, however, USAir needed major improvements
in its labor contracts - and that's something most airlines have found it
extraordinarily difficult to get, short of credibly threatening, or
actually entering, bankruptcy. USAir was to be no exception.
Immediately after we purchased our preferred stock, the imbalance between
the company's costs and revenues began to grow explosively. In the 1990-
1994 period, USAir lost an aggregate of $2.4 billion, a performance that
totally wiped out the book equity of its common stock.
For much of this period, the company paid us our preferred
dividends, but in 1994 payment was suspended. A bit later, with the
situation looking particularly gloomy, we wrote down our investment by
75%, to $89.5 million. Thereafter, during much of 1995, I offered to
sell our shares at 50% of face value. Fortunately, I was unsuccessful.
Mixed in with my many mistakes at USAir was one thing I got right:
Making our investment, we wrote into the preferred contract a somewhat
unusual provision stipulating that "penalty dividends" - to run five
percentage points over the prime rate - would be accrued on any
arrearages. This meant that when our 9.25% dividend was omitted for two
years, the unpaid amounts compounded at rates ranging between 13.25% and
14%.
Facing this penalty provision, USAir had every incentive to pay
arrearages just as promptly as it could. And in the second half of 1996,
when USAir turned profitable, it indeed began to pay, giving us $47.9
million. We owe Stephen Wolf, the company's CEO, a huge thank-you for
extracting a performance from the airline that permitted this payment.
Even so, USAir's performance has recently been helped significantly by an
industry tailwind that may be cyclical in nature. The company still has
basic cost problems that must be solved.
In any event, the prices of USAir's publicly-traded securities tell
us that our preferred stock is now probably worth its par value of $358
million, give or take a little. In addition, we have over the years
collected an aggregate of $240.5 million in dividends (including $30
million received in 1997).
Early in 1996, before any accrued dividends had been paid, I tried
once more to unload our holdings - this time for about $335 million.
You're lucky: I again failed in my attempt to snatch defeat from the
jaws of victory.
In another context, a friend once asked me: "If you're so rich, why
aren't you smart?" After reviewing my sorry performance with USAir, you
may conclude he had a point.
Financings
We wrote four checks to Salomon Brothers last year and in each case
were delighted with the work for which we were paying. I've already
described one transaction: the FlightSafety purchase in which Salomon was
the initiating investment banker. In a second deal, the firm placed a
small debt offering for our finance subsidiary.
Additionally, we made two good-sized offerings through Salomon, both
with interesting aspects. The first was our sale in May of 517,500
shares of Class B Common, which generated net proceeds of $565 million.
As I have told you before, we made this sale in response to the
threatened creation of unit trusts that would have marketed themselves as
Berkshire look-alikes. In the process, they would have used our past,
and definitely nonrepeatable, record to entice naive small investors and
would have charged these innocents high fees and commissions.
I think it would have been quite easy for such trusts to have sold
many billions of dollars worth of units, and I also believe that early
marketing successes by these trusts would have led to the formation of
others. (In the securities business, whatever can be sold will be sold.)
The trusts would have meanwhile indiscriminately poured the proceeds of
their offerings into a supply of Berkshire shares that is fixed and
limited. The likely result: a speculative bubble in our stock. For at
least a time, the price jump would have been self-validating, in that it
would have pulled new waves of naive and impressionable investors into
the trusts and set off still more buying of Berkshire shares.
Some Berkshire shareholders choosing to exit might have found that
outcome ideal, since they could have profited at the expense of the
buyers entering with false hopes. Continuing shareholders, however,
would have suffered once reality set in, for at that point Berkshire
would have been burdened with both hundreds of thousands of unhappy,
indirect owners (trustholders, that is) and a stained reputation.
Our issuance of the B shares not only arrested the sale of the
trusts, but provided a low-cost way for people to invest in Berkshire if
they still wished to after hearing the warnings we issued. To blunt the
enthusiasm that brokers normally have for pushing new issues - because
that's where the money is - we arranged for our offering to carry a
commission of only 1.5%, the lowest payoff that we have ever seen in a
common stock underwriting. Additionally, we made the amount of the
offering open-ended, thereby repelling the typical IPO buyer who looks
for a short-term price spurt arising from a combination of hype and
scarcity.
Overall, we tried to make sure that the B stock would be purchased
only by investors with a long-term perspective. Those efforts were
generally successful: Trading volume in the B shares immediately
following the offering - a rough index of "flipping" - was far below the
norm for a new issue. In the end we added about 40,000 shareholders,
most of whom we believe both understand what they own and share our time
horizons.
Salomon could not have performed better in the handling of this
unusual transaction. Its investment bankers understood perfectly what we
were trying to achieve and tailored every aspect of the offering to meet
these objectives. The firm would have made far more money - perhaps ten
times as much - if our offering had been standard in its make-up. But
the investment bankers involved made no attempt to tweak the specifics in
that direction. Instead they came up with ideas that were counter to
Salomon's financial interest but that made it much more certain
Berkshire's goals would be reached. Terry Fitzgerald captained this
effort, and we thank him for the job that he did.
Given that background, it won't surprise you to learn that we again
went to Terry when we decided late in the year to sell an issue of
Berkshire notes that can be exchanged for a portion of the Salomon shares
that we hold. In this instance, once again, Salomon did an absolutely
first-class job, selling $500 million principal amount of five-year notes
for $447.1 million. Each $1,000 note is exchangeable into 17.65 shares
and is callable in three years at accreted value. Counting the original
issue discount and a 1% coupon, the securities will provide a yield of 3%
to maturity for holders who do not exchange them for Salomon stock. But
it seems quite likely that the notes will be exchanged before their
maturity. If that happens, our interest cost will be about 1.1% for the
period prior to exchange.
In recent years, it has been written that Charlie and I are unhappy
about all investment-banking fees. That's dead wrong. We have paid a
great many fees over the last 30 years - beginning with the check we
wrote to Charlie Heider upon our purchase of National Indemnity in 1967 -
and we are delighted to make payments that are commensurate with
performance. In the case of the 1996 transactions at Salomon Brothers,
we more than got our money's worth.
Miscellaneous
Though it was a close decision, Charlie and I have decided to enter
the 20th Century. Accordingly, we are going to put future quarterly and
annual reports of Berkshire on the Internet, where they can be accessed
via http://www.berkshirehathaway.com. We will always "post" these
reports on a Saturday so that anyone interested will have ample time to
digest the information before trading begins. Our publishing schedule
for the next 12 months is May 17, 1997, August 16, 1997, November 15,
1997, and March 14, 1998. We will also post any press releases that we
issue.
At some point, we may stop mailing our quarterly reports and simply
post these on the Internet. This move would eliminate significant costs.
Also, we have a large number of "street name" holders and have found
that the distribution of our quarterlies to them is highly erratic: Some
holders receive their mailings weeks later than others.
The drawback to Internet-only distribution is that many of our
shareholders lack computers. Most of these holders, however, could
easily obtain printouts at work or through friends. Please let me know
if you prefer that we continue mailing quarterlies. We want your input -
starting with whether you even read these reports - and at a minimum will
make no change in 1997. Also, we will definitely keep delivering the
annual report in its present form in addition to publishing it on the
Internet.
* * * * * * * * * * * *
About 97.2% of all eligible shares participated in Berkshire's 1996
shareholder-designated contributions program. Contributions made were
$13.3 million, and 3,910 charities were recipients. A full description
of the shareholder-designated contributions program appears on pages 48-
49.
Every year a few shareholders miss out on the program because they
don't have their shares registered in their own names on the prescribed
record date or because they fail to get the designation form back to us
within the 60-day period allowed. This is distressing to Charlie and me.
But if replies are received late, we have to reject them because we
can't make exceptions for some shareholders while refusing to make them
for others.
To participate in future programs, you must own Class A shares that
are registered in the name of the actual owner, not the nominee name of a
broker, bank or depository. Shares not so registered on August 31, 1997,
will be ineligible for the 1997 program. When you get the form, return
it promptly so that it does not get put aside or forgotten.
The Annual Meeting
Our capitalist's version of Woodstock -the Berkshire Annual Meeting-
will be held on Monday, May 5. Charlie and I thoroughly enjoy this
event, and we hope that you come. We will start at 9:30 a.m., break for
about 15 minutes at noon (food will be available - but at a price, of
course), and then continue talking to hard-core attendees until at least
3:30. Last year we had representatives from all 50 states, as well as
Australia, Greece, Israel, Portugal, Singapore, Sweden, Switzerland, and
the United Kingdom. The annual meeting is a time for owners to get their
business-related questions answered, and therefore Charlie and I will
stay on stage until we start getting punchy. (When that happens, I hope
you notice a change.)
Last year we had attendance of 5,000 and strained the capacity of
the Holiday Convention Centre, even though we spread out over three
rooms. This year, our new Class B shares have caused a doubling of our
stockholder count, and we are therefore moving the meeting to the
Aksarben Coliseum, which holds about 10,000 and also has a huge parking
lot. The doors will open for the meeting at 7:00 a.m., and at 8:30 we
will - upon popular demand - show a new Berkshire movie produced by Marc
Hamburg, our CFO. (In this company, no one gets by with doing only a
single job.)
Overcoming our legendary repugnance for activities even faintly
commercial, we will also have an abundant array of Berkshire products for
sale in the halls outside the meeting room. Last year we broke all
records, selling 1,270 pounds of See's candy, 1,143 pairs of Dexter
shoes, $29,000 of World Books and related publications, and 700 sets of
knives manufactured by our Quikut subsidiary. Additionally, many
shareholders made inquiries about GEICO auto policies. If you would like
to investigate possible insurance savings, bring your present policy to
the meeting. We estimate that about 40% of our shareholders can save
money by insuring with us. (We'd like to say 100%, but the insurance
business doesn't work that way: Because insurers differ in their
underwriting judgments, some of our shareholders are currently paying
rates that are lower than GEICO's.)
An attachment to the proxy material 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 both plane and hotel
reservations promptly. American Express (800-799-6634) will be happy to
help you with arrangements. As usual, we will have buses servicing the
larger hotels to take you to and from the meeting, and also to take you
to Nebraska Furniture Mart, Borsheim's and the airport after it is over.
NFM's main store, located on a 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. Come by and say hello to
"Mrs. B" (Rose Blumkin). She's 103 now and sometimes operates with an
oxygen mask that is attached to a tank on her cart. But if you try to
keep pace with her, it will be you who needs oxygen. NFM did about $265
million of business last year - a record for a single-location home
furnishings operation - and you'll see why once you check out its
merchandise and prices.
Borsheim's normally is closed on Sunday but will be open for
shareholders from 10 a.m. to 6 p.m. on May 4th. Last year on
"Shareholder Sunday" we broke every Borsheim's record in terms of
tickets, dollar volume and, no doubt, attendees per square inch. Because
we expect a capacity crowd this year as well, all shareholders attending
on Sunday must bring their admission cards. Shareholders who prefer a
somewhat less frenzied experience will get the same special treatment on
Saturday, when the store is open from 10 a.m. to 5:30 p.m., or on Monday
between 10 a.m. and 8 p.m. Come by at any time this year and let Susan
Jacques, Borsheim's CEO, and her skilled associates perform a painless
walletectomy on you.
My favorite steakhouse, Gorat's, was sold out last year on the
weekend of the annual meeting, even though it added an additional seating
at 4 p.m. on Sunday. You can make reservations beginning on April 1st
(but not earlier) by calling 402-551-3733. I will be at Gorat's on
Sunday after Borsheim's, having my usual rare T-bone and double order of
hashbrowns. I can also recommend - this is the standard fare when Debbie
Bosanek, my invaluable assistant, and I go to lunch - the hot roast beef
sandwich with mashed potatoes and gravy. Mention Debbie's name and you
will be given an extra boat of gravy.
The Omaha Royals and Indianapolis Indians will play baseball on
Saturday evening, May 3rd, at Rosenblatt Stadium. Pitching in my normal
rotation - one throw a year - I will start.
Though Rosenblatt is normal in appearance, it is anything but: The
field sits on a unique geological structure that occasionally emits short
gravitational waves causing even the most smoothly-delivered pitch to
sink violently. I have been the victim of this weird phenomenon several
times in the past but am hoping for benign conditions this year. There
will be lots of opportunities for photos at the ball game, but you will
need incredibly fast reflexes to snap my fast ball en route to the plate.
Our proxy statement includes information about obtaining tickets to
the game. We will also provide an information packet listing restaurants
that will be open on Sunday night and describing various things that you
can do in Omaha on the weekend. The entire gang at Berkshire looks
forward to seeing you.
Warren E. Buffett
February 28, 1997 Chairman of the Board