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