BERKSHIRE HATHAWAY INC.
To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 1988 was $569 million, or
20.0%. Over the last 24 years (that is, since present management
took over), our per-share book value has grown from $19.46 to
$2,974.52, or at a rate of 23.0% compounded annually.
We’ve emphasized in past reports that what counts, however,
is intrinsic business value - the figure, necessarily an
estimate, indicating what all of our constituent businesses are
worth. By our calculations, Berkshire’s intrinsic business value
significantly exceeds its book value. Over the 24 years,
business value has grown somewhat faster than book value; in
1988, however, book value grew the faster, by a bit.
Berkshire’s past rates of gain in both book value and
business value were achieved under circumstances far different
from those that now exist. Anyone ignoring these differences
makes the same mistake that a baseball manager would were he to
judge the future prospects of a 42-year-old center fielder on the
basis of his lifetime batting average.
Important negatives affecting our prospects today are: (1) a
less attractive stock market than generally existed over the past
24 years; (2) higher corporate tax rates on most forms of
investment income; (3) a far more richly-priced market for the
acquisition of businesses; and (4) industry conditions for
Capital Cities/ABC, Inc., GEICO Corporation, and The Washington
Post Company - Berkshire’s three permanent investments,
constituting about one-half of our net worth - that range from
slightly to materially less favorable than those existing five to
ten years ago. All of these companies have superb management and
strong properties. But, at current prices, their upside
potential looks considerably less exciting to us today than it
did some years ago.
The major problem we face, however, is a growing capital
base. You’ve heard that from us before, but this problem, like
age, grows in significance each year. (And also, just as with
age, it’s better to have this problem continue to grow rather
than to have it “solved.”)
Four years ago I told you that we needed profits of $3.9
billion to achieve a 15% annual return over the decade then
ahead. Today, for the next decade, a 15% return demands profits
of $10.3 billion. That seems like a very big number to me and to
Charlie Munger, Berkshire’s Vice Chairman and my partner. (Should
that number indeed prove too big, Charlie will find himself, in
future reports, retrospectively identified as the senior
partner.)
As a partial offset to the drag that our growing capital
base exerts upon returns, we have a very important advantage now
that we lacked 24 years ago. Then, all our capital was tied up
in a textile business with inescapably poor economic
characteristics. Today part of our capital is invested in some
really exceptional businesses.
Last year we dubbed these operations the Sainted Seven:
Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott
Fetzer Manufacturing Group, See’s, and World Book. In 1988 the
Saints came marching in. You can see just how extraordinary
their returns on capital were by examining the historical-cost
financial statements on page 45, which combine the figures of the
Sainted Seven with those of several smaller units. With no
benefit from financial leverage, this group earned about 67% on
average equity capital.
In most cases the remarkable performance of these units
arises partially from an exceptional business franchise; in all
cases an exceptional management is a vital factor. The
contribution Charlie and I make is to leave these managers alone.
In my judgment, these businesses, in aggregate, will
continue to produce superb returns. We’ll need these: Without
this help Berkshire would not have a chance of achieving our 15%
goal. You can be sure that our operating managers will deliver;
the question mark in our future is whether Charlie and I can
effectively employ the funds that they generate.
In that respect, we took a step in the right direction early
in 1989 when we purchased an 80% interest in Borsheim’s, a
jewelry business in Omaha. This purchase, described later in
this letter, delivers exactly what we look for: an outstanding
business run by people we like, admire, and trust. It’s a great
way to start the year.
Accounting Changes
We have made a significant accounting change that was
mandated for 1988, and likely will have another to make in 1990.
When we move figures around from year to year, without any change
in economic reality, one of our always-thrilling discussions of
accounting is necessary.
First, I’ll offer my customary disclaimer: Despite the
shortcomings of generally accepted accounting principles (GAAP),
I would hate to have the job of devising a better set of rules.
The limitations of the existing set, however, need not be
inhibiting: CEOs are free to treat GAAP statements as a beginning
rather than an end to their obligation to inform owners and
creditors - and indeed they should. After all, any manager of a
subsidiary company would find himself in hot water if he reported
barebones GAAP numbers that omitted key information needed by his
boss, the parent corporation’s CEO. Why, then, should the CEO
himself withhold information vitally useful to his bosses - the
shareholder-owners of the corporation?
What needs to be reported is data - whether GAAP, non-GAAP,
or extra-GAAP - that helps financially-literate readers answer
three key questions: (1) Approximately how much is this company
worth? (2) What is the likelihood that it can meet its future
obligations? and (3) How good a job are its managers doing, given
the hand they have been dealt?
In most cases, answers to one or more of these questions are
somewhere between difficult and impossible to glean from the
minimum GAAP presentation. The business world is simply too
complex for a single set of rules to effectively describe
economic reality for all enterprises, particularly those
operating in a wide variety of businesses, such as Berkshire.
Further complicating the problem is the fact that many
managements view GAAP not as a standard to be met, but as an
obstacle to overcome. Too often their accountants willingly
assist them. (“How much,” says the client, “is two plus two?”
Replies the cooperative accountant, “What number did you have in
mind?”) Even honest and well-intentioned managements sometimes
stretch GAAP a bit in order to present figures they think will
more appropriately describe their performance. Both the
smoothing of earnings and the “big bath” quarter are “white lie”
techniques employed by otherwise upright managements.
Then there are managers who actively use GAAP to deceive and
defraud. They know that many investors and creditors accept GAAP
results as gospel. So these charlatans interpret the rules
“imaginatively” and record business transactions in ways that
technically comply with GAAP but actually display an economic
illusion to the world.
As long as investors - including supposedly sophisticated
institutions - place fancy valuations on reported “earnings” that
march steadily upward, you can be sure that some managers and
promoters will exploit GAAP to produce such numbers, no matter
what the truth may be. Over the years, Charlie and I have
observed many accounting-based frauds of staggering size. Few of
the perpetrators have been punished; many have not even been
censured. It has been far safer to steal large sums with a pen
than small sums with a gun.
Under one major change mandated by GAAP for 1988, we have
been required to fully consolidate all our subsidiaries in our
balance sheet and earnings statement. In the past, Mutual
Savings and Loan, and Scott Fetzer Financial (a credit company
that primarily finances installment sales of World Book and Kirby
products) were consolidated on a “one-line” basis. That meant we
(1) showed our equity in their combined net worths as a single-
entry asset on Berkshire’s consolidated balance sheet and (2)
included our equity in their combined annual earnings as a
single-line income entry in our consolidated statement of
earnings. Now the rules require that we consolidate each asset
and liability of these companies in our balance sheet and each
item of their income and expense in our earnings statement.
This change underscores the need for companies also to
report segmented data: The greater the number of economically
diverse business operations lumped together in conventional
financial statements, the less useful those presentations are and
the less able investors are to answer the three questions posed
earlier. Indeed, the only reason we ever prepare consolidated
figures at Berkshire is to meet outside requirements. On the
other hand, Charlie and I constantly study our segment data.
Now that we are required to bundle more numbers in our GAAP
statements, we have decided to publish additional supplementary
information that we think will help you measure both business
value and managerial performance. (Berkshire’s ability to
discharge its obligations to creditors - the third question we
listed - should be obvious, whatever statements you examine.) In
these supplementary presentations, we will not necessarily follow
GAAP procedures, or even corporate structure. Rather, we will
attempt to lump major business activities in ways that aid
analysis but do not swamp you with detail. Our goal is to give
you important information in a form that we would wish to get it
if our roles were reversed.
On pages 41-47 we show separate combined balance sheets and
earnings statements for: (1) our subsidiaries engaged in finance-
type operations, which are Mutual Savings and Scott Fetzer
Financial; (2) our insurance operations, with their major
investment positions itemized; (3) our manufacturing, publishing
and retailing businesses, leaving aside certain non-operating
assets and purchase-price accounting adjustments; and (4) an all-
other category that includes the non-operating assets (primarily
marketable securities) held by the companies in (3) as well as
various assets and debts of the Wesco and Berkshire parent
companies.
If you combine the earnings and the net worths of these four
segments, you will derive totals matching those shown on our GAAP
statements. However, we want to emphasize that our new
presentation does not fall within the purview of our auditors,
who in no way bless it. (In fact, they may be horrified; I don’t
want to ask.)
I referred earlier to a major change in GAAP that is
expected in 1990. This change relates to the calculation of
deferred taxes, and is both complicated and controversial - so
much so that its imposition, originally scheduled for 1989, was
postponed for a year.
When implemented, the new rule will affect us in various
ways. Most important, we will be required to change the way we
calculate our liability for deferred taxes on the unrealized
appreciation of stocks held by our insurance companies.
Right now, our liability is layered. For the unrealized
appreciation that dates back to 1986 and earlier years, $1.2
billion, we have booked a 28% tax liability. For the unrealized
appreciation built up since, $600 million, the tax liability has
been booked at 34%. The difference reflects the increase in tax
rates that went into effect in 1987.
It now appears, however, that the new accounting rule will
require us to establish the entire liability at 34% in 1990,
taking the charge against our earnings. Assuming no change in
tax rates by 1990, this step will reduce our earnings in that
year (and thereby our reported net worth) by $71 million. The
proposed rule will also affect other items on our balance sheet,
but these changes will have only a minor impact on earnings and
net worth.
We have no strong views about the desirability of this
change in calculation of deferred taxes. We should point out,
however, that neither a 28% nor a 34% tax liability precisely
depicts economic reality at Berkshire since we have no plans to
sell the stocks in which we have the great bulk of our gains.
To those of you who are uninterested in accounting, I
apologize for this dissertation. I realize that many of you do
not pore over our figures, but instead hold Berkshire primarily
because you know that: (1) Charlie and I have the bulk of our
money in Berkshire; (2) we intend to run things so that your
gains or losses are in direct proportion to ours; and (3) the
record has so far been satisfactory. There is nothing
necessarily wrong with this kind of “faith” approach to
investing. Other shareholders, however, prefer an “analysis”
approach and we want to supply the information they need. In our
own investing, we search for situations in which both approaches
give us the same answer.
Sources of Reported Earnings
In addition to supplying you with our new four-sector
accounting material, we will continue to list the major sources
of Berkshire’s reported earnings just as we have in the past.
In the following table, amortization of Goodwill and other
major purchase-price accounting adjustments are not charged
against 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. I’ve explained in past
reports why this form of presentation seems to us to be more
useful to investors and managers than the standard GAAP
presentation, which makes purchase-price adjustments on a
business-by-business basis. The total net earnings we show in
the table are, of course, identical to the GAAP total in our
audited financial statements.
Further information about these businesses is given in the
Business Segment section on pages 32-34, and in the Management’s
Discussion section on pages 36-40. In these sections you also
will find our segment earnings reported on a GAAP basis. For
information on Wesco’s businesses, I urge you to read Charlie
Munger’s letter, which starts on page 52. It contains the best
description I have seen of the events that produced the present
savings-and-loan crisis. Also, take special note of Dave
Hillstrom’s performance at Precision Steel Warehouse, a Wesco
subsidiary. Precision operates in an extremely competitive
industry, yet Dave consistently achieves good returns on invested
capital. Though data is lacking to prove the point, I think it
is likely that his performance, both in 1988 and years past,
would rank him number one among his peers.
(000s omitted)
------------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
------------------- -------------------
1988 1987 1988 1987
-------- -------- -------- --------
Operating Earnings:
Insurance Group:
Underwriting ............... $(11,081) $(55,429) $ (1,045) $(20,696)
Net Investment Income ...... 231,250 152,483 197,779 136,658
Buffalo News ................. 42,429 39,410 25,462 21,304
Fechheimer ................... 14,152 13,332 7,720 6,580
Kirby ........................ 26,891 22,408 17,842 12,891
Nebraska Furniture Mart ...... 18,439 16,837 9,099 7,554
Scott Fetzer
Manufacturing Group ....... 28,542 30,591 17,640 17,555
See’s Candies ................ 32,473 31,693 19,671 17,363
Wesco - other than Insurance 16,133 6,209 10,650 4,978
World Book ................... 27,890 25,745 18,021 15,136
Amortization of Goodwill ..... (2,806) (2,862) (2,806) (2,862)
Other Purchase-Price
Accounting Charges ........ (6,342) (5,546) (7,340) (6,544)
Interest on Debt* ............ (35,613) (11,474) (23,212) (5,905)
Shareholder-Designated
Contributions ............. (4,966) (4,938) (3,217) (2,963)
Other ........................ 41,059 23,217 27,177 13,697
-------- -------- -------- --------
Operating Earnings ............. 418,450 281,676 313,441 214,746
Sales of Securities ............ 131,671 28,838 85,829 19,806
-------- -------- -------- --------
Total Earnings - All Entities .. $550,121 $310,514 $399,270 $234,552
*Excludes interest expense of Scott Fetzer Financial Group.
The earnings achieved by our operating businesses are
superb, whether measured on an absolute basis or against those of
their competitors. For that we thank our operating managers: You
and I are fortunate to be associated with them.
At Berkshire, associations like these last a long time. We
do not remove superstars from our lineup merely because they have
attained a specified age - whether the traditional 65, or the 95
reached by Mrs. B on the eve of Hanukkah in 1988. Superb
managers are too scarce a resource to be discarded simply because
a cake gets crowded with candles. Moreover, our experience with
newly-minted MBAs has not been that great. Their academic
records always look terrific and the candidates always know just
what to say; but too often they are short on personal commitment
to the company and general business savvy. It’s difficult to
teach a new dog old tricks.
Here’s an update on our major non-insurance operations:
o At Nebraska Furniture Mart, Mrs. B (Rose Blumkin) and her
cart roll on and on. She’s been the boss for 51 years, having
started the business at 44 with $500. (Think what she would have
done with $1,000!) With Mrs. B, old age will always be ten years
away.
The Mart, long the largest home furnishings store in the
country, continues to grow. In the fall, the store opened a
detached 20,000 square foot Clearance Center, which expands our
ability to offer bargains in all price ranges.
Recently Dillard’s, one of the most successful department
store operations in the country, entered the Omaha market. In
many of its stores, Dillard’s runs a full furniture department,
undoubtedly doing well in this line. Shortly before opening in
Omaha, however, William Dillard, chairman of the company,
announced that his new store would not sell furniture. Said he,
referring to NFM: “We don’t want to compete with them. We think
they are about the best there is.”
At the Buffalo News we extol the value of advertising, and
our policies at NFM prove that we practice what we preach. Over
the past three years NFM has been the largest ROP advertiser in
the Omaha World-Herald. (ROP advertising is the kind printed in
the paper, as contrasted to the preprinted-insert kind.) In no
other major market, to my knowledge, is a home furnishings
operation the leading customer of the newspaper. At times, we
also run large ads in papers as far away as Des Moines, Sioux
City and Kansas City - always with good results. It truly does
pay to advertise, as long as you have something worthwhile to
offer.
Mrs. B’s son, Louie, and his boys, Ron and Irv, complete the
winning Blumkin team. It’s a joy to work with this family. All
its members have character that matches their extraordinary
abilities.
o Last year I stated unequivocally that pre-tax margins at
The Buffalo News would fall in 1988. That forecast would have
proved correct at almost any other newspaper our size or larger.
But Stan Lipsey - bless him - has managed to make me look
foolish.
Though we increased our prices a bit less than the industry
average last year, and though our newsprint costs and wage rates
rose in line with industry norms, Stan actually improved margins
a tad. No one in the newspaper business has a better managerial
record. He has achieved it, furthermore, while running a paper
that gives readers an extraordinary amount of news. We believe
that our “newshole” percentage - the portion of the paper devoted
to news - is bigger than that of any other dominant paper of our
size or larger. The percentage was 49.5% in 1988 versus 49.8% in
1987. We are committed to keeping it around 50%, whatever the
level or trend of profit margins.
Charlie and I have loved the newspaper business since we
were youngsters, and we have had great fun with the News in the
12 years since we purchased it. We were fortunate to find Murray
Light, a top-flight editor, on the scene when we arrived and he
has made us proud of the paper ever since.
o See’s Candies sold a record 25.1 million pounds in 1988.
Prospects did not look good at the end of October, but excellent
Christmas volume, considerably better than the record set in
1987, turned the tide.
As we’ve told you before, See’s business continues to become
more Christmas-concentrated. In 1988, the Company earned a
record 90% of its full-year profits in December: $29 million out
of $32.5 million before tax. (It’s enough to make you believe in
Santa Claus.) December’s deluge of business produces a modest
seasonal bulge in Berkshire’s corporate earnings. Another small
bulge occurs in the first quarter, when most World Book annuals
are sold.
Charlie and I put Chuck Huggins in charge of See’s about
five minutes after we bought the company. Upon reviewing his
record, you may wonder what took us so long.
o At Fechheimer, the Heldmans - Bob, George, Gary, Roger and
Fred - are the Cincinnati counterparts of the Blumkins. Neither
furniture retailing nor uniform manufacturing has inherently
attractive economics. In these businesses, only exceptional
managements can deliver high returns on invested capital. And
that’s exactly what the five Heldmans do. (As Mets announcer
Ralph Kiner once said when comparing pitcher Steve Trout to his
father, Dizzy Trout, the famous Detroit Tigers pitcher: “There’s
a lot of heredity in that family.”)
Fechheimer made a fairly good-sized acquisition in 1988.
Charlie and I have such confidence in the business savvy of the
Heldman family that we okayed the deal without even looking at
it. There are very few managements anywhere - including those
running the top tier companies of the Fortune 500 - in which we
would exhibit similar confidence.
Because of both this acquisition and some internal growth,
sales at Fechheimer should be up significantly in 1989.
o All of the operations managed by Ralph Schey - World Book,
Kirby, and The Scott Fetzer Manufacturing Group - performed
splendidly in 1988. Returns on the capital entrusted to Ralph
continue to be exceptional.
Within the Scott Fetzer Manufacturing Group, particularly
fine progress was recorded at its largest unit, Campbell
Hausfeld. This company, the country’s leading producer of small
and medium-sized air compressors, has more than doubled earnings
since 1986.
Unit sales at both Kirby and World Book were up
significantly in 1988, with export business particularly strong.
World Book became available in the Soviet Union in September,
when that country’s largest American book store opened in Moscow.
Ours is the only general encyclopedia offered at the store.
Ralph’s personal productivity is amazing: In addition to
running 19 businesses in superb fashion, he is active at The
Cleveland Clinic, Ohio University, Case Western Reserve, and a
venture capital operation that has spawned sixteen Ohio-based
companies and resurrected many others. Both Ohio and Berkshire
are fortunate to have Ralph on their side.
Borsheim’s
It was in 1983 that Berkshire purchased an 80% interest in
The Nebraska Furniture Mart. Your Chairman blundered then by
neglecting to ask Mrs. B a question any schoolboy would have
thought of: “Are there any more at home like you?” Last month I
corrected the error: We are now 80% partners with another branch
of the family.
After Mrs. B came over from Russia in 1917, her parents and
five siblings followed. (Her two other siblings had preceded
her.) Among the sisters was Rebecca Friedman who, with her
husband, Louis, escaped in 1922 to the west through Latvia in a
journey as perilous as Mrs. B’s earlier odyssey to the east
through Manchuria. When the family members reunited in Omaha
they had no tangible assets. However, they came equipped with an
extraordinary combination of brains, integrity, and enthusiasm
for work - and that’s all they needed. They have since proved
themselves invincible.
In 1948 Mr. Friedman purchased Borsheim’s, a small Omaha
jewelry store. He was joined in the business by his son, Ike, in
1950 and, as the years went by, Ike’s son, Alan, and his sons-in-
law, Marvin Cohn and Donald Yale, came in also.
You won’t be surprised to learn that this family brings to
the jewelry business precisely the same approach that the
Blumkins bring to the furniture business. The cornerstone for
both enterprises is Mrs. B’s creed: “Sell cheap and tell the
truth.” Other fundamentals at both businesses are: (1) single
store operations featuring huge inventories that provide
customers with an enormous selection across all price ranges, (2)
daily attention to detail by top management, (3) rapid turnover,
(4) shrewd buying, and (5) incredibly low expenses. The
combination of the last three factors lets both stores offer
everyday prices that no one in the country comes close to
matching.
Most people, no matter how sophisticated they are in other
matters, feel like babes in the woods when purchasing jewelry.
They can judge neither quality nor price. For them only one rule
makes sense: If you don’t know jewelry, know the jeweler.
I can assure you that those who put their trust in Ike
Friedman and his family will never be disappointed. The way in
which we purchased our interest in their business is the ultimate
testimonial. Borsheim’s had no audited financial statements;
nevertheless, we didn’t take inventory, verify receivables or
audit the operation in any way. Ike simply told us what was so -
- and on that basis we drew up a one-page contract and wrote a
large check.
Business at Borsheim’s has mushroomed in recent years as the
reputation of the Friedman family has spread. Customers now come
to the store from all over the country. Among them have been
some friends of mine from both coasts who thanked me later for
getting them there.
Borsheim’s new links to Berkshire will change nothing in the
way this business is run. All members of the Friedman family
will continue to operate just as they have before; Charlie and I
will stay on the sidelines where we belong. And when we say “all
members,” the words have real meaning. Mr. and Mrs. Friedman, at
88 and 87, respectively, are in the store daily. The wives of
Ike, Alan, Marvin and Donald all pitch in at busy times, and a
fourth generation is beginning to learn the ropes.
It is great fun to be in business with people you have long
admired. The Friedmans, like the Blumkins, have achieved success
because they have deserved success. Both families focus on
what’s right for the customer and that, inevitably, works out
well for them, also. We couldn’t have better partners.
Insurance Operations
Shown below is an updated version of our usual table
presenting key figures for the insurance industry:
Statutory
Yearly Change Combined Ratio Yearly Change Inflation Rate
in Premiums After Policyholder in Incurred Measured by
Written (%) Dividends Losses (%) GNP Deflator (%)
------------- ------------------ ------------- ----------------
1981 ..... 3.8 106.0 6.5 9.6
1982 ..... 3.7 109.6 8.4 6.4
1983 ..... 5.0 112.0 6.8 3.8
1984 ..... 8.5 118.0 16.9 3.7
1985 ..... 22.1 116.3 16.1 3.2
1986 ..... 22.2 108.0 13.5 2.7
1987 ..... 9.4 104.6 7.8 3.3
1988 (Est.) 3.9 105.4 4.2 3.6
Source: A.M. Best Co.
The combined ratio represents total insurance costs (losses
incurred plus expenses) compared to revenue from premiums: A
ratio below 100 indicates an underwriting profit, and one above
100 indicates a loss. When the investment income that an insurer
earns from holding on to policyholders’ funds (“the float”) is
taken into account, a combined ratio in the 107-111 range
typically produces an overall break-even result, exclusive of
earnings on the funds provided by shareholders.
For the reasons laid out in previous reports, we expect the
industry’s incurred losses to grow by about 10% annually, even in
years when general inflation runs considerably lower. If premium
growth meanwhile materially lags that 10% rate, underwriting
losses will mount, though the industry’s tendency to underreserve
when business turns bad may obscure their size for a time. As
the table shows, the industry’s underwriting loss grew in 1988.
This trend is almost certain to continue - and probably will
accelerate - for at least two more years.
The property-casualty insurance industry is not only
subnormally profitable, it is subnormally popular. (As Sam
Goldwyn philosophized: “In life, one must learn to take the
bitter with the sour.”) One of the ironies of business is that
many relatively-unprofitable industries that are plagued by
inadequate prices habitually find themselves beat upon by irate
customers even while other, hugely profitable industries are
spared complaints, no matter how high their prices.
Take the breakfast cereal industry, whose return on invested
capital is more than double that of the auto insurance industry
(which is why companies like Kellogg and General Mills sell at
five times book value and most large insurers sell close to
book). The cereal companies regularly impose price increases,
few of them related to a significant jump in their costs. Yet
not a peep is heard from consumers. But when auto insurers raise
prices by amounts that do not even match cost increases,
customers are outraged. If you want to be loved, it’s clearly
better to sell high-priced corn flakes than low-priced auto
insurance.
The antagonism that the public feels toward the industry can
have serious consequences: Proposition 103, a California
initiative passed last fall, threatens to push auto insurance
prices down sharply, even though costs have been soaring. The
price cut has been suspended while the courts review the
initiative, but the resentment that brought on the vote has not
been suspended: Even if the initiative is overturned, insurers
are likely to find it tough to operate profitably in California.
(Thank heavens the citizenry isn’t mad at bonbons: If Proposition
103 applied to candy as well as insurance, See’s would be forced
to sell its product for $5.76 per pound. rather than the $7.60 we
charge - and would be losing money by the bucketful.)
The immediate direct effects on Berkshire from the
initiative are minor, since we saw few opportunities for profit
in the rate structure that existed in California prior to the
vote. However, the forcing down of prices would seriously affect
GEICO, our 44%-owned investee, which gets about 10% of its
premium volume from California. Even more threatening to GEICO
is the possibility that similar pricing actions will be taken in
other states, through either initiatives or legislation.
If voters insist that auto insurance be priced below cost,
it eventually must be sold by government. Stockholders can
subsidize policyholders for a short period, but only taxpayers
can subsidize them over the long term. At most property-casualty
companies, socialized auto insurance would be no disaster for
shareholders. Because of the commodity characteristics of the
industry, most insurers earn mediocre returns and therefore have
little or no economic goodwill to lose if they are forced by
government to leave the auto insurance business. But GEICO,
because it is a low-cost producer able to earn high returns on
equity, has a huge amount of economic goodwill at risk. In turn,
so do we.
At Berkshire, in 1988, our premium volume continued to fall,
and in 1989 we will experience a large decrease for a special
reason: The contract through which we receive 7% of the business
of Fireman’s Fund expires on August 31. At that time, we will
return to Fireman’s Fund the unearned premiums we hold that
relate to the contract. This transfer of funds will show up in
our “premiums written” account as a negative $85 million or so
and will make our third-quarter figures look rather peculiar.
However, the termination of this contract will not have a
significant effect on profits.
Berkshire’s underwriting results continued to be excellent
in 1988. Our combined ratio (on a statutory basis and excluding
structured settlements and financial reinsurance) was 104.
Reserve development was favorable for the second year in a row,
after a string of years in which it was very unsatisfactory.
Details on both underwriting and reserve development appear on
pages 36-38.
Our insurance volume over the next few years is likely to
run very low, since business with a reasonable potential for
profit will almost certainly be scarce. So be it. At Berkshire,
we simply will not write policies at rates that carry the
expectation of economic loss. We encounter enough troubles when
we expect a gain.
Despite - or perhaps because of - low volume, our profit
picture during the next few years is apt to be considerably
brighter than the industry’s. We are sure to have an exceptional
amount of float compared to premium volume, and that augurs well
for profits. In 1989 and 1990 we expect our float/premiums
ratio to be at least three times that of the typical
property/casualty company. Mike Goldberg, with special help from
Ajit Jain, Dinos Iordanou, and the National Indemnity managerial
team, has positioned us well in that respect.
At some point - we don’t know when - we will be deluged with
insurance business. The cause will probably be some major
physical or financial catastrophe. But we could also experience
an explosion in business, as we did in 1985, because large and
increasing underwriting losses at other companies coincide with
their recognition that they are far underreserved. in the
meantime, we will retain our talented professionals, protect our
capital, and try not to make major mistakes.
Marketable Securities
In selecting marketable securities for our insurance
companies, we can choose among five major categories: (1) long-
term common stock investments, (2) medium-term fixed-income
securities, (3) long-term fixed-income securities, (4) short-term
cash equivalents, and (5) short-term arbitrage commitments.
We have no particular bias when it comes to choosing from
these categories. We just continuously search among them for the
highest after-tax returns as measured by “mathematical
expectation,” limiting ourselves always to investment
alternatives we think we understand. Our criteria have nothing
to do with maximizing immediately reportable earnings; our goal,
rather, is to maximize eventual net worth.
o Below we list our common stock holdings having a value over
$100 million, not including arbitrage commitments, which will be
discussed later. A small portion of these investments belongs to
subsidiaries of which Berkshire owns less than 100%.
Shares Company Cost Market
------ ------- ---------- ----------
(000s omitted)
3,000,000 Capital Cities/ABC, Inc. .............. $517,500 $1,086,750
14,172,500 The Coca-Cola Company ................. 592,540 632,448
2,400,000 Federal Home Loan Mortgage
Corporation Preferred* ............. 71,729 121,200
6,850,000 GEICO Corporation ..................... 45,713 849,400
1,727,765 The Washington Post Company ........... 9,731 364,126
*Although nominally a preferred stock, this security is
financially equivalent to a common stock.
Our permanent holdings - Capital Cities/ABC, Inc., GEICO
Corporation, and The Washington Post Company - remain unchanged.
Also unchanged is our unqualified admiration of their
managements: Tom Murphy and Dan Burke at Cap Cities, Bill Snyder
and Lou Simpson at GEICO, and Kay Graham and Dick Simmons at The
Washington Post. Charlie and I appreciate enormously the talent
and integrity these managers bring to their businesses.
Their performance, which we have observed at close range,
contrasts vividly with that of many CEOs, which we have
fortunately observed from a safe distance. Sometimes these CEOs
clearly do not belong in their jobs; their positions,
nevertheless, are usually secure. The supreme irony of business
management is that it is far easier for an inadequate CEO to keep
his job than it is for an inadequate subordinate.
If a secretary, say, is hired for a job that requires typing
ability of at least 80 words a minute and turns out to be capable
of only 50 words a minute, she will lose her job in no time.
There is a logical standard for this job; performance is easily
measured; and if you can’t make the grade, you’re out.
Similarly, if new sales people fail to generate sufficient
business quickly enough, they will be let go. Excuses will not
be accepted as a substitute for orders.
However, a CEO who doesn’t perform is frequently carried
indefinitely. One reason is that performance standards for his
job seldom exist. When they do, they are often fuzzy or they may
be waived or explained away, even when the performance shortfalls
are major and repeated. At too many companies, the boss shoots
the arrow of managerial performance and then hastily paints the
bullseye around the spot where it lands.
Another important, but seldom recognized, distinction
between the boss and the foot soldier is that the CEO has no
immediate superior whose performance is itself getting measured.
The sales manager who retains a bunch of lemons in his sales
force will soon be in hot water himself. It is in his immediate
self-interest to promptly weed out his hiring mistakes.
Otherwise, he himself may be weeded out. An office manager who
has hired inept secretaries faces the same imperative.
But the CEO’s boss is a Board of Directors that seldom
measures itself and is infrequently held to account for
substandard corporate performance. If the Board makes a mistake
in hiring, and perpetuates that mistake, so what? Even if the
company is taken over because of the mistake, the deal will
probably bestow substantial benefits on the outgoing Board
members. (The bigger they are, the softer they fall.)
Finally, relations between the Board and the CEO are
expected to be congenial. At board meetings, criticism of the
CEO’s performance is often viewed as the social equivalent of
belching. No such inhibitions restrain the office manager from
critically evaluating the substandard typist.
These points should not be interpreted as a blanket
condemnation of CEOs or Boards of Directors: Most are able and
hard-working, and a number are truly outstanding. But the
management failings that Charlie and I have seen make us thankful
that we are linked with the managers of our three permanent
holdings. They love their businesses, they think like owners,
and they exude integrity and ability.
o In 1988 we made major purchases of Federal Home Loan
Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold
these securities for a long time. In fact, when we own portions
of outstanding businesses with outstanding managements, our
favorite holding period is forever. We are just the opposite of
those who hurry to sell and book profits when companies perform
well but who tenaciously hang on to businesses that disappoint.
Peter Lynch aptly likens such behavior to cutting the flowers and
watering the weeds. Our holdings of Freddie Mac are the maximum
allowed by law, and are extensively described by Charlie in his
letter. In our consolidated balance sheet these shares are
carried at cost rather than market, since they are owned by
Mutual Savings and Loan, a non-insurance subsidiary.
We continue to concentrate our investments in a very few
companies that we try to understand well. There are only a
handful of businesses about which we have strong long-term
convictions. Therefore, when we find such a business, we want to
participate in a meaningful way. We agree with Mae West: “Too
much of a good thing can be wonderful.”
o We reduced our holdings of medium-term tax-exempt bonds by
about $100 million last year. All of the bonds sold were
acquired after August 7, 1986. When such bonds are held by
property-casualty insurance companies, 15% of the “tax-exempt”
interest earned is subject to tax.
The $800 million position we still hold consists almost
entirely of bonds “grandfathered” under the Tax Reform Act of
1986, which means they are entirely tax-exempt. Our sales
produced a small profit and our remaining bonds, which have an
average maturity of about six years, are worth modestly more than
carrying value.
Last year we described our holdings of short-term and
intermediate-term bonds of Texaco, which was then in bankruptcy.
During 1988, we sold practically all of these bonds at a pre-tax
profit of about $22 million. This sale explains close to $100
million of the reduction in fixed-income securities on our
balance sheet.
We also told you last year about our holdings of another
security whose predominant characteristics are those of an
intermediate fixed-income issue: our $700 million position in
Salomon Inc 9% convertible preferred. This preferred has a
sinking fund that will retire it in equal annual installments
from 1995 to 1999. Berkshire carries this holding at cost. For
reasons discussed by Charlie on page 69, the estimated market
value of our holding has improved from moderately under cost at
the end of last year to moderately over cost at 1988 year end.
The close association we have had with John Gutfreund, CEO
of Salomon, during the past year has reinforced our admiration
for him. But we continue to have no great insights about the
near, intermediate or long-term economics of the investment
banking business: This is not an industry in which it is easy to
forecast future levels of profitability. We continue to believe
that our conversion privilege could well have important value
over the life of our preferred. However, the overwhelming
portion of the preferred’s value resides in its fixed-income
characteristics, not its equity characteristics.
o We have not lost our aversion to long-term bonds. We will
become enthused about such securities only when we become
enthused about prospects for long-term stability in the
purchasing power of money. And that kind of stability isn’t in
the cards: Both society and elected officials simply have too
many higher-ranking priorities that conflict with purchasing-
power stability. The only long-term bonds we hold are those of
Washington Public Power Supply Systems (WPPSS). A few of our
WPPSS bonds have short maturities and many others, because of
their high coupons, are likely to be refunded and paid off in a
few years. Overall, our WPPSS holdings are carried on our
balance sheet at $247 million and have a market value of about
$352 million.
We explained the reasons for our WPPSS purchases in the 1983
annual report, and are pleased to tell you that this commitment
has worked out about as expected. At the time of purchase, most
of our bonds were yielding around 17% after taxes and carried no
ratings, which had been suspended. Recently, the bonds were
rated AA- by Standard & Poor’s. They now sell at levels only
slightly below those enjoyed by top-grade credits.
In the 1983 report, we compared the economics of our WPPSS
purchase to those involved in buying a business. As it turned
out, this purchase actually worked out better than did the
general run of business acquisitions made in 1983, assuming both
are measured on the basis of unleveraged, after tax returns
achieved through 1988.
Our WPPSS experience, though pleasant, does nothing to alter
our negative opinion about long-term bonds. It only makes us
hope that we run into some other large stigmatized issue, whose
troubles have caused it to be significantly misappraised by the
market.
Arbitrage
In past reports we have told you that our insurance
subsidiaries sometimes engage in arbitrage as an alternative to
holding short-term cash equivalents. We prefer, of course, to
make major long-term commitments, but we often have more cash
than good ideas. At such times, arbitrage sometimes promises
much greater returns than Treasury Bills and, equally important,
cools any temptation we may have to relax our standards for long-
term investments. (Charlie’s sign off after we’ve talked about
an arbitrage commitment is usually: “Okay, at least it will keep
you out of bars.”)
During 1988 we made unusually large profits from arbitrage,
measured both by absolute dollars and rate of return. Our pre-
tax gain was about $78 million on average invested funds of about
$147 million.
This level of activity makes some detailed discussion of
arbitrage and our approach to it appropriate. Once, the word
applied only to the simultaneous purchase and sale of securities
or foreign exchange in two different markets. The goal was to
exploit tiny price differentials that might exist between, say,
Royal Dutch stock trading in guilders in Amsterdam, pounds in
London, and dollars in New York. Some people might call this
scalping; it won’t surprise you that practitioners opted for the
French term, arbitrage.
Since World War I the definition of arbitrage - or “risk
arbitrage,” as it is now sometimes called - has expanded to
include the pursuit of profits from an announced corporate event
such as sale of the company, merger, recapitalization,
reorganization, liquidation, self-tender, etc. In most cases the
arbitrageur expects to profit regardless of the behavior of the
stock market. The major risk he usually faces instead is that
the announced event won’t happen.
Some offbeat opportunities occasionally arise in the
arbitrage field. I participated in one of these when I was 24
and working in New York for Graham-Newman Corp. Rockwood & Co.,
a Brooklyn based chocolate products company of limited
profitability, had adopted LIFO inventory valuation in 1941
when cocoa was selling for 5¢ per pound. In 1954 a
temporary shortage of cocoa caused the price to soar to over
60¢. Consequently Rockwood wished to unload its valuable
inventory - quickly, before the price dropped. But if the cocoa
had simply been sold off, the company would have owed close to
a 50% tax on the proceeds.
The 1954 Tax Code came to the rescue. It contained an
arcane provision that eliminated the tax otherwise due on LIFO
profits if inventory was distributed to shareholders as part of a
plan reducing the scope of a corporation’s business. Rockwood
decided to terminate one of its businesses, the sale of cocoa
butter, and said 13 million pounds of its cocoa bean inventory
was attributable to that activity. Accordingly, the company
offered to repurchase its stock in exchange for the cocoa beans
it no longer needed, paying 80 pounds of beans for each share.
For several weeks I busily bought shares, sold beans, and
made periodic stops at Schroeder Trust to exchange stock
certificates for warehouse receipts. The profits were good and
my only expense was subway tokens.
The architect of Rockwood’s restructuring was an unknown,
but brilliant Chicagoan, Jay Pritzker, then 32. If you’re
familiar with Jay’s subsequent record, you won’t be surprised to
hear the action worked out rather well for Rockwood’s continuing
shareholders also. From shortly before the tender until shortly
after it, Rockwood stock appreciated from 15 to 100, even though
the company was experiencing large operating losses. Sometimes
there is more to stock valuation than price-earnings ratios.
In recent years, most arbitrage operations have involved
takeovers, friendly and unfriendly. With acquisition fever
rampant, with anti-trust challenges almost non-existent, and with
bids often ratcheting upward, arbitrageurs have prospered
mightily. They have not needed special talents to do well; the
trick, a la Peter Sellers in the movie, has simply been “Being
There.” In Wall Street the old proverb has been reworded: “Give a
man a fish and you feed him for a day. Teach him how to
arbitrage and you feed him forever.” (If, however, he studied at
the Ivan Boesky School of Arbitrage, it may be a state
institution that supplies his meals.)
To evaluate arbitrage situations you must answer four
questions: (1) How likely is it that the promised event will
indeed occur? (2) How long will your money be tied up? (3) What
chance is there that something still better will transpire - a
competing takeover bid, for example? and (4) What will happen if
the event does not take place because of anti-trust action,
financing glitches, etc.?
Arcata Corp., one of our more serendipitous arbitrage
experiences, illustrates the twists and turns of the business.
On September 28, 1981 the directors of Arcata agreed in principle
to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR),
then and now a major leveraged-buy out firm. Arcata was in the
printing and forest products businesses and had one other thing
going for it: In 1978 the U.S. Government had taken title to
10,700 acres of Arcata timber, primarily old-growth redwood, to
expand Redwood National Park. The government had paid $97.9
million, in several installments, for this acreage, a sum Arcata
was contesting as grossly inadequate. The parties also disputed
the interest rate that should apply to the period between the
taking of the property and final payment for it. The enabling
legislation stipulated 6% simple interest; Arcata argued for a
much higher and compounded rate.
Buying a company with a highly-speculative, large-sized
claim in litigation creates a negotiating problem, whether the
claim is on behalf of or against the company. To solve this
problem, KKR offered $37.00 per Arcata share plus two-thirds of
any additional amounts paid by the government for the redwood
lands.
Appraising this arbitrage opportunity, we had to ask
ourselves whether KKR would consummate the transaction since,
among other things, its offer was contingent upon its obtaining
“satisfactory financing.” A clause of this kind is always
dangerous for the seller: It offers an easy exit for a suitor
whose ardor fades between proposal and marriage. However, we
were not particularly worried about this possibility because
KKR’s past record for closing had been good.
We also had to ask ourselves what would happen if the KKR
deal did fall through, and here we also felt reasonably
comfortable: Arcata’s management and directors had been shopping
the company for some time and were clearly determined to sell.
If KKR went away, Arcata would likely find another buyer, though
of course, the price might be lower.
Finally, we had to ask ourselves what the redwood claim
might be worth. Your Chairman, who can’t tell an elm from an
oak, had no trouble with that one: He coolly evaluated the claim
at somewhere between zero and a whole lot.
We started buying Arcata stock, then around $33.50, on
September 30 and in eight weeks purchased about 400,000 shares,
or 5% of the company. The initial announcement said that the
$37.00 would be paid in January, 1982. Therefore, if everything
had gone perfectly, we would have achieved an annual rate of
return of about 40% - not counting the redwood claim, which would
have been frosting.
All did not go perfectly. In December it was announced that
the closing would be delayed a bit. Nevertheless, a definitive
agreement was signed on January 4. Encouraged, we raised our
stake, buying at around $38.00 per share and increasing our
holdings to 655,000 shares, or over 7% of the company. Our
willingness to pay up - even though the closing had been
postponed - reflected our leaning toward “a whole lot” rather
than “zero” for the redwoods.
Then, on February 25 the lenders said they were taking a
“second look” at financing terms “ in view of the severely
depressed housing industry and its impact on Arcata’s outlook.”
The stockholders’ meeting was postponed again, to April. An
Arcata spokesman said he “did not think the fate of the
acquisition itself was imperiled.” When arbitrageurs hear such
reassurances, their minds flash to the old saying: “He lied like
a finance minister on the eve of devaluation.”
On March 12 KKR said its earlier deal wouldn’t work, first
cutting its offer to $33.50, then two days later raising it to
$35.00. On March 15, however, the directors turned this bid down
and accepted another group’s offer of $37.50 plus one-half of any
redwood recovery. The shareholders okayed the deal, and the
$37.50 was paid on June 4.
We received $24.6 million versus our cost of $22.9 million;
our average holding period was close to six months. Considering
the trouble this transaction encountered, our 15% annual rate of
return excluding any value for the redwood claim - was more than
satisfactory.
But the best was yet to come. The trial judge appointed two
commissions, one to look at the timber’s value, the other to
consider the interest rate questions. In January 1987, the first
commission said the redwoods were worth $275.7 million and the
second commission recommended a compounded, blended rate of
return working out to about 14%.
In August 1987 the judge upheld these conclusions, which
meant a net amount of about $600 million would be due Arcata.
The government then appealed. In 1988, though, before this
appeal was heard, the claim was settled for $519 million.
Consequently, we received an additional $29.48 per share, or
about $19.3 million. We will get another $800,000 or so in 1989.
Berkshire’s arbitrage activities differ from those of many
arbitrageurs. First, we participate in only a few, and usually
very large, transactions each year. Most practitioners buy into
a great many deals perhaps 50 or more per year. With that many
irons in the fire, they must spend most of their time monitoring
both the progress of deals and the market movements of the
related stocks. This is not how Charlie nor I wish to spend our
lives. (What’s the sense in getting rich just to stare at a
ticker tape all day?)
Because we diversify so little, one particularly profitable
or unprofitable transaction will affect our yearly result from
arbitrage far more than it will the typical arbitrage operation.
So far, Berkshire has not had a really bad experience. But we
will - and when it happens we’ll report the gory details to you.
The other way we differ from some arbitrage operations is
that we participate only in transactions that have been publicly
announced. We do not trade on rumors or try to guess takeover
candidates. We just read the newspapers, think about a few of
the big propositions, and go by our own sense of probabilities.
At yearend, our only major arbitrage position was 3,342,000
shares of RJR Nabisco with a cost of $281.8 million and a market
value of $304.5 million. In January we increased our holdings to
roughly four million shares and in February we eliminated our
position. About three million shares were accepted when we
tendered our holdings to KKR, which acquired RJR, and the
returned shares were promptly sold in the market. Our pre-tax
profit was a better-than-expected $64 million.
Earlier, another familiar face turned up in the RJR bidding
contest: Jay Pritzker, who was part of a First Boston group that
made a tax-oriented offer. To quote Yogi Berra; “It was deja vu
all over again.”
During most of the time when we normally would have been
purchasers of RJR, our activities in the stock were restricted
because of Salomon’s participation in a bidding group.
Customarily, Charlie and I, though we are directors of Salomon,
are walled off from information about its merger and acquisition
work. We have asked that it be that way: The information would
do us no good and could, in fact, occasionally inhibit
Berkshire’s arbitrage operations.
However, the unusually large commitment that Salomon
proposed to make in the RJR deal required that all directors be
fully informed and involved. Therefore, Berkshire’s purchases of
RJR were made at only two times: first, in the few days
immediately following management’s announcement of buyout plans,
before Salomon became involved; and considerably later, after the
RJR board made its decision in favor of KKR. Because we could
not buy at other times, our directorships cost Berkshire
significant money.
Considering Berkshire’s good results in 1988, you might
expect us to pile into arbitrage during 1989. Instead, we expect
to be on the sidelines.
One pleasant reason is that our cash holdings are down -
because our position in equities that we expect to hold for a
very long time is substantially up. As regular readers of this
report know, our new commitments are not based on a judgment
about short-term prospects for the stock market. Rather, they
reflect an opinion about long-term business prospects for
specific companies. We do not have, never have had, and never
will have an opinion about where the stock market, interest
rates, or business activity will be a year from now.
Even if we had a lot of cash we probably would do little in
arbitrage in 1989. Some extraordinary excesses have developed in
the takeover field. As Dorothy says: “Toto, I have a feeling
we’re not in Kansas any more.”
We have no idea how long the excesses will last, nor do we
know what will change the attitudes of government, lender and
buyer that fuel them. But we do know that the less the prudence
with which others conduct their affairs, the greater the prudence
with which we should conduct our own affairs. We have no desire
to arbitrage transactions that reflect the unbridled - and, in
our view, often unwarranted - optimism of both buyers and
lenders. In our activities, we will heed the wisdom of Herb
Stein: “If something can’t go on forever, it will end.”
Efficient Market Theory
The preceding discussion about arbitrage makes a small
discussion of “efficient market theory” (EMT) also seem relevant.
This doctrine became highly fashionable - indeed, almost holy
scripture in academic circles during the 1970s. Essentially, it
said that analyzing stocks was useless because all public
information about them was appropriately reflected in their
prices. In other words, the market always knew everything. As a
corollary, the professors who taught EMT said that someone
throwing darts at the stock tables could select a stock portfolio
having prospects just as good as one selected by the brightest,
most hard-working security analyst. Amazingly, EMT was embraced
not only by academics, but by many investment professionals and
corporate managers as well. Observing correctly that the market
was frequently efficient, they went on to conclude incorrectly
that it was always efficient. The difference between these
propositions is night and day.
In my opinion, the continuous 63-year arbitrage experience
of Graham-Newman Corp. Buffett Partnership, and Berkshire
illustrates just how foolish EMT is. (There’s plenty of other
evidence, also.) While at Graham-Newman, I made a study of its
earnings from arbitrage during the entire 1926-1956 lifespan of
the company. Unleveraged returns averaged 20% per year.
Starting in 1956, I applied Ben Graham’s arbitrage principles,
first at Buffett Partnership and then Berkshire. Though I’ve not
made an exact calculation, I have done enough work to know that
the 1956-1988 returns averaged well over 20%. (Of course, I
operated in an environment far more favorable than Ben’s; he had
1929-1932 to contend with.)
All of the conditions are present that are required for a
fair test of portfolio performance: (1) the three organizations
traded hundreds of different securities while building this 63-
year record; (2) the results are not skewed by a few fortunate
experiences; (3) we did not have to dig for obscure facts or
develop keen insights about products or managements - we simply
acted on highly-publicized events; and (4) our arbitrage
positions were a clearly identified universe - they have not been
selected by hindsight.
Over the 63 years, the general market delivered just under a
10% annual return, including dividends. That means $1,000 would
have grown to $405,000 if all income had been reinvested. A 20%
rate of return, however, would have produced $97 million. That
strikes us as a statistically-significant differential that
might, conceivably, arouse one’s curiosity.
Yet proponents of the theory have never seemed interested in
discordant evidence of this type. True, they don’t talk quite as
much about their theory today as they used to. But no one, to my
knowledge, has ever said he was wrong, no matter how many
thousands of students he has sent forth misinstructed. EMT,
moreover, continues to be an integral part of the investment
curriculum at major business schools. Apparently, a reluctance
to recant, and thereby to demystify the priesthood, is not
limited to theologians.
Naturally the disservice done students and gullible
investment professionals who have swallowed EMT has been an
extraordinary service to us and other followers of Graham. In
any sort of a contest - financial, mental, or physical - it’s an
enormous advantage to have opponents who have been taught that
it’s useless to even try. From a selfish point of view,
Grahamites should probably endow chairs to ensure the perpetual
teaching of EMT.
All this said, a warning is appropriate. Arbitrage has
looked easy recently. But this is not a form of investing that
guarantees profits of 20% a year or, for that matter, profits of
any kind. As noted, the market is reasonably efficient much of
the time: For every arbitrage opportunity we seized in that 63-
year period, many more were foregone because they seemed
properly-priced.
An investor cannot obtain superior profits from stocks by
simply committing to a specific investment category or style. He
can earn them only by carefully evaluating facts and continuously
exercising discipline. Investing in arbitrage situations, per
se, is no better a strategy than selecting a portfolio by
throwing darts.
New York Stock Exchange Listing
Berkshire’s shares were listed on the New York Stock
Exchange on November 29, 1988. On pages 50-51 we reproduce the
letter we sent to shareholders concerning the listing.
Let me clarify one point not dealt with in the letter:
Though our round lot for trading on the NYSE is ten shares, any
number of shares from one on up can be bought or sold.
As the letter explains, our primary goal in listing was to
reduce transaction costs, and we believe this goal is being
achieved. Generally, the spread between the bid and asked price
on the NYSE has been well below the spread that prevailed in the
over-the-counter market.
Henderson Brothers, Inc., the specialist in our shares, is
the oldest continuing specialist firm on the Exchange; its
progenitor, William Thomas Henderson, bought his seat for $500 on
September 8, 1861. (Recently, seats were selling for about
$625,000.) Among the 54 firms acting as specialists, HBI ranks
second in number of stocks assigned, with 83. We were pleased
when Berkshire was allocated to HBI, and have been delighted with
the firm’s performance. Jim Maguire, Chairman of HBI, personally
manages the trading in Berkshire, and we could not be in better
hands.
In two respects our goals probably differ somewhat from
those of most listed companies. First, we do not want to
maximize the price at which Berkshire shares trade. We wish
instead for them to trade in a narrow range centered at intrinsic
business value (which we hope increases at a reasonable - or,
better yet, unreasonable - rate). Charlie and I are bothered as
much by significant overvaluation as significant undervaluation.
Both extremes will inevitably produce results for many
shareholders that will differ sharply from Berkshire’s business
results. If our stock price instead consistently mirrors
business value, each of our shareholders will receive an
investment result that roughly parallels the business results of
Berkshire during his holding period.
Second, we wish for very little trading activity. If we ran
a private business with a few passive partners, we would be
disappointed if those partners, and their replacements,
frequently wanted to leave the partnership. Running a public
company, we feel the same way.
Our goal is to attract long-term owners who, at the time of
purchase, have no timetable or price target for sale but plan
instead to stay with us indefinitely. We don’t understand the
CEO who wants lots of stock activity, for that can be achieved
only if many of his owners are constantly exiting. At what other
organization - school, club, church, etc. - do leaders cheer when
members leave? (However, if there were a broker whose livelihood
depended upon the membership turnover in such organizations, you
could be sure that there would be at least one proponent of
activity, as in: “There hasn’t been much going on in Christianity
for a while; maybe we should switch to Buddhism next week.“)
Of course, some Berkshire owners will need or want to sell
from time to time, and we wish for good replacements who will pay
them a fair price. Therefore we try, through our policies,
performance, and communications, to attract new shareholders who
understand our operations, share our time horizons, and measure
us as we measure ourselves. If we can continue to attract this
sort of shareholder - and, just as important, can continue to be
uninteresting to those with short-term or unrealistic
expectations - Berkshire shares should consistently sell at
prices reasonably related to business value.
David L. Dodd
Dave Dodd, my friend and teacher for 38 years, died last
year at age 93. Most of you don’t know of him. Yet any long-
time shareholder of Berkshire is appreciably wealthier because of
the indirect influence he had upon our company.
Dave spent a lifetime teaching at Columbia University, and
he co-authored Security Analysis with Ben Graham. From the
moment I arrived at Columbia, Dave personally encouraged and
educated me; one influence was as important as the other.
Everything he taught me, directly or through his book, made
sense. Later, through dozens of letters, he continued my
education right up until his death.
I have known many professors of finance and investments but
I have never seen any, except for Ben Graham, who was the match
of Dave. The proof of his talent is the record of his students:
No other teacher of investments has sent forth so many who have
achieved unusual success.
When students left Dave’s classroom, they were equipped to
invest intelligently for a lifetime because the principles he
taught were simple, sound, useful, and enduring. Though these
may appear to be unremarkable virtues, the teaching of principles
embodying them has been rare.
It’s particularly impressive that Dave could practice as
well as preach. just as Keynes became wealthy by applying his
academic ideas to a very small purse, so, too, did Dave. Indeed,
his financial performance far outshone that of Keynes, who began
as a market-timer (leaning on business and credit-cycle theory)
and converted, after much thought, to value investing. Dave was
right from the start.
In Berkshire’s investments, Charlie and I have employed the
principles taught by Dave and Ben Graham. Our prosperity is the
fruit of their intellectual tree.
Miscellaneous
We hope to buy more businesses that are similar to the ones
we have, and we can use some help. If you have a business that
fits the following criteria, call me or, preferably, write.
Here’s what we’re looking for:
(1) large purchases (at least $10 million of after-tax
earnings),
(2) demonstrated consistent earning power (future projections
are of little interest to us, nor are “turnaround”
situations),
(3) businesses earning good returns on equity while employing
little or no debt,
(4) management in place (we can’t supply it),
(5) simple businesses (if there’s lots of technology, we won’t
understand it),
(6) an offering price (we don’t want to waste our time or that
of the seller by talking, even preliminarily, about a
transaction when price is unknown).
We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we’re interested. We prefer
to buy for cash, but will consider issuing stock when we receive
as much in intrinsic business value as we give.
Our favorite form of purchase is one fitting the Blumkin-
Friedman-Heldman mold. In cases like these, the company’s owner-
managers wish to generate significant amounts of cash, sometimes
for themselves, but often for their families or inactive
shareholders. However, these managers also wish to remain
significant owners who continue to run their companies just as
they have in the past. We think we offer a particularly good fit
for owners with these objectives and invite potential sellers to
check us out by contacting people with whom we have done business
in the past.
Charlie and I frequently get approached about acquisitions
that don’t come close to meeting our tests: We’ve found that if
you advertise an interest in buying collies, a lot of people will
call hoping to sell you their cocker spaniels. Our interest in
new ventures, turnarounds, or auction-like sales can best be
expressed by another Goldwynism: “Please include me out.”
Besides being interested in the purchase of businesses as
described above, we are also interested in the negotiated
purchase of large, but not controlling, blocks of stock
comparable to those we hold in Cap Cities and Salomon. We have a
special interest in purchasing convertible preferreds as a long-
term investment, as we did at Salomon.
* * *
We received some good news a few weeks ago: Standard &
Poor’s raised our credit rating to AAA, which is the highest
rating it bestows. Only 15 other U.S. industrial or property-
casualty companies are rated AAA, down from 28 in 1980.
Corporate bondholders have taken their lumps in the past few
years from “event risk.” This term refers to the overnight
degradation of credit that accompanies a heavily-leveraged
purchase or recapitalization of a business whose financial
policies, up to then, had been conservative. In a world of
takeovers inhabited by few owner-managers, most corporations
present such a risk. Berkshire does not. Charlie and I promise
bondholders the same respect we afford shareholders.
* * *
About 97.4% of all eligible shares participated in
Berkshire’s 1988 shareholder-designated contributions program.
Contributions made through the program were $5 million, and 2,319
charities were recipients. If we achieve reasonable business
results, we plan to increase the per-share contributions in 1989.
We urge new shareholders to read the description of our
shareholder-designated contributions program that appears on
pages 48-49. If you wish to participate in future programs, we
strongly urge that you immediately make sure your shares are
registered in the name of the actual owner, not in the nominee
name of a broker, bank or depository. Shares not so registered
on September 30, 1989 will be ineligible for the 1989 program.
* * *
Berkshire’s annual meeting will be held in Omaha on Monday,
April 24, 1989, and I hope you will come. The meeting provides
the forum for you to ask any owner-related questions you may
have, and we will keep answering until all (except those dealing
with portfolio activities or other proprietary information) have
been dealt with.
After the meeting we will have several buses available to
take you to visit Mrs. B at The Nebraska Furniture Mart and Ike
Friedman at Borsheim’s. Be prepared for bargains.
Out-of-towners may prefer to arrive early and visit Mrs. B
during the Sunday store hours of noon to five. (These Sunday
hours seem ridiculously short to Mrs. B, who feels they scarcely
allow her time to warm up; she much prefers the days on which the
store remains open from 10 a.m. to 9 p.m.) Borsheims, however, is
not open on Sunday.
Ask Mrs. B the secret of her astonishingly low carpet
prices. She will confide to you - as she does to everyone - how
she does it: “I can sell so cheap ‘cause I work for this dummy
who doesn’t know anything about carpet.”
Warren E. Buffett
February 28, 1989 Chairman of the Board