BERKSHIRE HATHAWAY INC.
To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 1989 was $1.515 billion, or
44.4%. Over the last 25 years (that is, since present management
took over) our per-share book value has grown from $19.46 to
$4,296.01, or at a rate of 23.8% compounded annually.
What counts, however, is intrinsic value - the figure
indicating what all of our constituent businesses are rationally
worth. With perfect foresight, this number can be calculated by
taking all future cash flows of a business - in and out - and
discounting them at prevailing interest rates. So valued, all
businesses, from manufacturers of buggy whips to operators of
cellular phones, become economic equals.
Back when Berkshire's book value was $19.46, intrinsic
value was somewhat less because the book value was entirely tied
up in a textile business not worth the figure at which it was
carried. Now most of our businesses are worth far more than their
carrying values. This agreeable evolution from a discount to a
premium means that Berkshire's intrinsic business value has
compounded at a rate that somewhat exceeds our 23.8% annual
growth in book value.
The rear-view mirror is one thing; the windshield is
another. A large portion of our book value is represented by
equity securities that, with minor exceptions, are carried on our
balance sheet at current market values. At yearend these
securities were valued at higher prices, relative to their own
intrinsic business values, than has been the case in the past.
One reason is the buoyant 1989 stock market. More important, the
virtues of these businesses have been widely recognized. Whereas
once their stock prices were inappropriately low, they are not
now.
We will keep most of our major holdings, regardless of how
they are priced relative to intrinsic business value. This 'til-
death-do-us-part attitude, combined with the full prices these
holdings command, means that they cannot be expected to push up
Berkshire's value in the future as sharply as in the past. In
other words, our performance to date has benefited from a double-
dip: (1) the exceptional gains in intrinsic value that our
portfolio companies have achieved; (2) the additional bonus we
realized as the market appropriately "corrected" the prices of
these companies, raising their valuations in relation to those of
the average business. We will continue to benefit from good gains
in business value that we feel confident our portfolio companies
will make. But our "catch-up" rewards have been realized, which
means we'll have to settle for a single-dip in the future.
We face another obstacle: In a finite world, high growth
rates must self-destruct. If the base from which the growth is
taking place is tiny, this law may not operate for a time. But
when the base balloons, the party ends: A high growth rate
eventually forges its own anchor.
Carl Sagan has entertainingly described this phenomenon,
musing about the destiny of bacteria that reproduce by dividing
into two every 15 minutes. Says Sagan: "That means four doublings
an hour, and 96 doublings a day. Although a bacterium weighs only
about a trillionth of a gram, its descendants, after a day of
wild asexual abandon, will collectively weigh as much as a
mountain...in two days, more than the sun - and before very long,
everything in the universe will be made of bacteria." Not to
worry, says Sagan: Some obstacle always impedes this kind of
exponential growth. "The bugs run out of food, or they poison
each other, or they are shy about reproducing in public."
Even on bad days, Charlie Munger (Berkshire's Vice Chairman
and my partner) and I do not think of Berkshire as a bacterium.
Nor, to our unending sorrow, have we found a way to double its
net worth every 15 minutes. Furthermore, we are not the least bit
shy about reproducing - financially - in public. Nevertheless,
Sagan's observations apply. From Berkshire's present base of $4.9
billion in net worth, we will find it much more difficult to
average 15% annual growth in book value than we did to average
23.8% from the $22 million we began with.
Taxes
Our 1989 gain of $1.5 billion was achieved after we took a
charge of about $712 million for income taxes. In addition,
Berkshire's share of the income taxes paid by its five major
investees totaled about $175 million.
Of this year's tax charge, about $172 million will be paid
currently; the remainder, $540 million, is deferred. Almost all
of the deferred portion relates to the 1989 increase in
unrealized profits in our common stock holdings. Against this
increase, we have reserved a 34% tax.
We also carry reserves at that rate against all unrealized
profits generated in 1987 and 1988. But, as we explained last
year, the unrealized gains we amassed before 1987 - about $1.2
billion - carry reserves booked at the 28% tax rate that then
prevailed.
A new accounting rule is likely to be adopted that will
require companies to reserve against all gains at the current tax
rate, whatever it may be. With the rate at 34%, such a rule would
increase our deferred tax liability, and decrease our net worth,
by about $71 million - the result of raising the reserve on our
pre-1987 gain by six percentage points. Because the proposed rule
has sparked widespread controversy and its final form is unclear,
we have not yet made this change.
As you can see from our balance sheet on page 27, we would
owe taxes of more than $1.1 billion were we to sell all of our
securities at year-end market values. Is this $1.1 billion
liability equal, or even similar, to a $1.1 billion liability
payable to a trade creditor 15 days after the end of the year?
Obviously not - despite the fact that both items have exactly the
same effect on audited net worth, reducing it by $1.1 billion.
On the other hand, is this liability for deferred taxes a
meaningless accounting fiction because its payment can be
triggered only by the sale of stocks that, in very large part, we
have no intention of selling? Again, the answer is no.
In economic terms, the liability resembles an interest-free
loan from the U.S. Treasury that comes due only at our election
(unless, of course, Congress moves to tax gains before they are
realized). This "loan" is peculiar in other respects as well: It
can be used only to finance the ownership of the particular,
appreciated stocks and it fluctuates in size - daily as market
prices change and periodically if tax rates change. In effect,
this deferred tax liability is equivalent to a very large
transfer tax that is payable only if we elect to move from one
asset to another. Indeed, we sold some relatively small holdings
in 1989, incurring about $76 million of "transfer" tax on $224
million of gains.
Because of the way the tax law works, the Rip Van Winkle
style of investing that we favor - if successful - has an
important mathematical edge over a more frenzied approach. Let's
look at an extreme comparison.
Imagine that Berkshire had only $1, which we put in a
security that doubled by yearend and was then sold. Imagine
further that we used the after-tax proceeds to repeat this
process in each of the next 19 years, scoring a double each time.
At the end of the 20 years, the 34% capital gains tax that we
would have paid on the profits from each sale would have
delivered about $13,000 to the government and we would be left
with about $25,250. Not bad. If, however, we made a single
fantastic investment that itself doubled 20 times during the 20
years, our dollar would grow to $1,048,576. Were we then to cash
out, we would pay a 34% tax of roughly $356,500 and be left with
about $692,000.
The sole reason for this staggering difference in results
would be the timing of tax payments. Interestingly, the
government would gain from Scenario 2 in exactly the same 27:1
ratio as we - taking in taxes of $356,500 vs. $13,000 - though,
admittedly, it would have to wait for its money.
We have not, we should stress, adopted our strategy
favoring long-term investment commitments because of these
mathematics. Indeed, it is possible we could earn greater after-
tax returns by moving rather frequently from one investment to
another. Many years ago, that's exactly what Charlie and I did.
Now we would rather stay put, even if that means slightly
lower returns. Our reason is simple: We have found splendid
business relationships to be so rare and so enjoyable that we
want to retain all we develop. This decision is particularly
easy for us because we feel that these relationships will produce
good - though perhaps not optimal - financial results.
Considering that, we think it makes little sense for us to give
up time with people we know to be interesting and admirable for
time with others we do not know and who are likely to have human
qualities far closer to average. That would be akin to marrying
for money - a mistake under most circumstances, insanity if one
is already rich.
Sources of Reported Earnings
The table below shows the major sources of Berkshire's
reported earnings. In this presentation, 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 one utilizing generally
accepted accounting principles (GAAP), which require purchase-
price adjustments to be made 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 37-39, and in the Management's
Discussion section on pages 40-44. 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 54. In addition, we have
reprinted on page 71 Charlie's May 30, 1989 letter to the U. S.
League of Savings Institutions, which conveyed our disgust with
its policies and our consequent decision to resign.
(000s omitted)
----------------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
---------------------- ----------------------
1989 1988 1989 1988
---------- ---------- ---------- ----------
Operating Earnings:
Insurance Group:
Underwriting ............ $(24,400) $(11,081) $(12,259) $ (1,045)
Net Investment Income ... 243,599 231,250 213,642 197,779
Buffalo News .............. 46,047 42,429 27,771 25,462
Fechheimer ................ 12,621 14,152 6,789 7,720
Kirby ..................... 26,114 26,891 16,803 17,842
Nebraska Furniture Mart ... 17,070 18,439 8,441 9,099
Scott Fetzer
Manufacturing Group .... 33,165 28,542 19,996 17,640
See's Candies ............. 34,235 32,473 20,626 19,671
Wesco - other than Insurance 13,008 16,133 9,810 10,650
World Book ................ 25,583 27,890 16,372 18,021
Amortization of Goodwill .. (3,387) (2,806) (3,372) (2,806)
Other Purchase-Price
Accounting Charges ........ (5,740) (6,342) (6,668) (7,340)
Interest Expense* ......... (42,389) (35,613) (27,098) (23,212)
Shareholder-Designated
Contributions .......... (5,867) (4,966) (3,814) (3,217)
Other ..................... 23,755 41,059 12,863 27,177
---------- ---------- ---------- ----------
Operating Earnings .......... 393,414 418,450 299,902 313,441
Sales of Securities ......... 223,810 131,671 147,575 85,829
---------- ---------- ---------- ----------
Total Earnings - All Entities $617,224 $550,121 $447,477 $399,270
*Excludes interest expense of Scott Fetzer Financial Group and
Mutual Savings & Loan.
We refer you also to pages 45-51, where we have rearranged
Berkshire's financial data into four segments. These correspond
to the way Charlie and I think about the business and should help
you calculate Berkshire's intrinsic value. Shown on these pages
are balance sheets and earnings statements for: (1) our
insurance operations, with their major investment positions
itemized; (2) our manufacturing, publishing and retailing
businesses, leaving aside certain non-operating assets and
purchase-price accounting adjustments; (3) our subsidiaries
engaged in finance-type operations, which are Mutual Savings and
Scott Fetzer Financial; and (4) an all-other category that
includes the non-operating assets (primarily marketable
securities) held by the companies in segment (2), all purchase
price accounting adjustments, and various assets and debts of the
Wesco and Berkshire parent companies.
If you combine the earnings and net worths of these four
segments, you will derive totals matching those shown on our GAAP
statements. However, I want to emphasize that this four-category
presentation does not fall within the purview of our auditors,
who in no way bless it.
In addition to our reported earnings, we also benefit from
significant earnings of investees that standard accounting rules
do not permit us to report. On page 15, we list five major
investees from which we received dividends in 1989 of about $45
million, after taxes. However, our share of the retained earnings
of these investees totaled about $212 million last year, not
counting large capital gains realized by GEICO and Coca-Cola. If
this $212 million had been distributed to us, our own operating
earnings, after the payment of additional taxes, would have been
close to $500 million rather than the $300 million shown in the
table.
The question you must decide is whether these undistributed
earnings are as valuable to us as those we report. We believe
they are - and even think they may be more valuable. The reason
for this a-bird-in-the-bush-may-be-worth-two-in-the-hand
conclusion is that earnings retained by these investees will
be deployed by talented, owner-oriented managers who
sometimes have better uses for these funds in their own
businesses than we would have in ours. I would not make such a
generous assessment of most managements, but it is appropriate in
these cases.
In our view, Berkshire's fundamental earning power is best
measured by a "look-through" approach, in which we append our
share of the operating earnings retained by our investees to our
own reported operating earnings, excluding capital gains in both
instances. For our intrinsic business value to grow at an average
of 15% per year, our "look-through" earnings must grow at about
the same pace. We'll need plenty of help from our present
investees, and also need to add a new one from time to time, in
order to reach this 15% goal.
Non-Insurance Operations
In the past, we have labeled our major manufacturing,
publishing and retail operations "The Sainted Seven." With our
acquisition of Borsheim's early in 1989, the challenge was to
find a new title both alliterative and appropriate. We failed:
Let's call the group "The Sainted Seven Plus One."
This divine assemblage - Borsheim's, The Buffalo News,
Fechheimer Bros., Kirby, Nebraska Furniture Mart, Scott Fetzer
Manufacturing Group, See's Candies, World Book - is a collection
of businesses with economic characteristics that range from good
to superb. Its managers range from superb to superb.
Most of these managers have no need to work for a living;
they show up at the ballpark because they like to hit home runs.
And that's exactly what they do. Their combined financial
statements (including those of some smaller operations), shown on
page 49, illustrate just how outstanding their performance is. On
an historical accounting basis, after-tax earnings of these
operations were 57% on average equity capital. Moreover, this
return was achieved with no net leverage: Cash equivalents have
matched funded debt. When I call off the names of our managers -
the Blumkin, Friedman and Heldman families, Chuck Huggins, Stan
Lipsey, and Ralph Schey - I feel the same glow that Miller
Huggins must have experienced when he announced the lineup of his
1927 New York Yankees.
Let's take a look, business by business:
o In its first year with Berkshire, Borsheim's met all
expectations. Sales rose significantly and are now considerably
better than twice what they were four years ago when the company
moved to its present location. In the six years prior to the
move, sales had also doubled. Ike Friedman, Borsheim's managing
genius - and I mean that - has only one speed: fast-forward.
If you haven't been there, you've never seen a jewelry store
like Borsheim's. Because of the huge volume it does at one
location, the store can maintain an enormous selection across all
price ranges. For the same reason, it can hold its expense ratio
to about one-third that prevailing at jewelry stores offering
comparable merchandise. The store's tight control of expenses,
accompanied by its unusual buying power, enable it to offer
prices far lower than those of other jewelers. These prices, in
turn, generate even more volume, and so the circle goes 'round
and 'round. The end result is store traffic as high as 4,000
people on seasonally-busy days.
Ike Friedman is not only a superb businessman and a great
showman but also a man of integrity. We bought the business
without an audit, and all of our surprises have been on the plus
side. "If you don't know jewelry, know your jeweler" makes sense
whether you are buying the whole business or a tiny diamond.
A story will illustrate why I enjoy Ike so much: Every two
years I'm part of an informal group that gathers to have fun and
explore a few subjects. Last September, meeting at Bishop's Lodge
in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come
by and educate us on jewels and the jewelry business.
Ike decided to dazzle the group, so he brought from Omaha
about $20 million of particularly fancy merchandise. I was
somewhat apprehensive - Bishop's Lodge is no Fort Knox - and I
mentioned my concern to Ike at our opening party the evening
before his presentation. Ike took me aside. "See that safe?" he
said. "This afternoon we changed the combination and now even the
hotel management doesn't know what it is." I breathed easier. Ike
went on: "See those two big fellows with guns on their hips?
They'll be guarding the safe all night." I now was ready to
rejoin the party. But Ike leaned closer: "And besides, Warren,"
he confided, "the jewels aren't in the safe."
How can we miss with a fellow like that - particularly when
he comes equipped with a talented and energetic family, Alan,
Marvin Cohn, and Don Yale.
o At See's Candies we had an 8% increase in pounds sold, even
though 1988 was itself a record year. Included in the 1989
performance were excellent same-store poundage gains, our first
in many years.
Advertising played an important role in this outstanding
performance. We increased total advertising expenditures from $4
million to $5 million and also got copy from our agency, Hal
Riney & Partners, Inc., that was 100% on the money in conveying
the qualities that make See's special.
In our media businesses, such as the Buffalo News, we sell
advertising. In other businesses, such as See's, we are buyers.
When we buy, we practice exactly what we preach when we sell. At
See's, we more than tripled our expenditures on newspaper
advertising last year, to the highest percentage of sales that I
can remember. The payoff was terrific, and we thank both Hal
Riney and the power of well-directed newspaper advertising for
this result.
See's splendid performances have become routine. But there
is nothing routine about the management of Chuck Huggins: His
daily involvement with all aspects of production and sales
imparts a quality-and-service message to the thousands of
employees we need to produce and distribute over 27 million
pounds of candy annually. In a company with 225 shops and a
massive mail order and phone business, it is no small trick to
run things so that virtually every customer leaves happy. Chuck
makes it look easy.
o The Nebraska Furniture Mart had record sales and excellent
earnings in 1989, but there was one sad note. Mrs. B - Rose
Blumkin, who started the company 52 years ago with $500 - quit in
May, after disagreeing with other members of the Blumkin
family/management about the remodeling and operation of the
carpet department.
Mrs. B probably has made more smart business decisions than
any living American, but in this particular case I believe the
other members of the family were entirely correct: Over the past
three years, while the store's other departments increased sales
by 24%, carpet sales declined by 17% (but not because of any lack
of sales ability by Mrs. B, who has always personally sold far
more merchandise than any other salesperson in the store).
You will be pleased to know that Mrs. B continues to make
Horatio Alger's heroes look like victims of tired blood. At age
96 she has started a new business selling - what else? - carpet
and furniture. And as always, she works seven days a week.
At the Mart Louie, Ron, and Irv Blumkin continue to propel
what is by far the largest and most successful home furnishings
store in the country. They are outstanding merchants, outstanding
managers, and a joy to be associated with. One reading on their
acumen: In the fourth quarter of 1989, the carpet department
registered a 75.3% consumer share in the Omaha market, up from
67.7% a year earlier and over six times that of its nearest
competitor.
NFM and Borsheim's follow precisely the same formula for
success: (1) unparalleled depth and breadth of merchandise at one
location; (2) the lowest operating costs in the business; (3) the
shrewdest of buying, made possible in part by the huge volumes
purchased; (4) gross margins, and therefore prices, far below
competitors'; and (5) friendly personalized service with family
members on hand at all times.
Another plug for newspapers: NFM increased its linage in the
local paper by over 20% in 1989 - off a record 1988 - and remains
the paper's largest ROP advertiser by far. (ROP advertising is
the kind printed in the paper, as opposed to that in preprinted
inserts.) To my knowledge, Omaha is the only city in which a home
furnishings store is the advertising leader. Many retailers cut
space purchases in 1989; our experience at See's and NFM would
indicate they made a major mistake.
o The Buffalo News continued to star in 1989 in three
important ways: First, among major metropolitan papers, both
daily and Sunday, the News is number one in household penetration
- the percentage of local households that purchase it each day.
Second, in "news hole" - the portion of the paper devoted to news
- the paper stood at 50.1% in 1989 vs. 49.5% in 1988, a level
again making it more news-rich than any comparable American
paper. Third, in a year that saw profits slip at many major
papers, the News set its seventh consecutive profit record.
To some extent, these three factors are related, though
obviously a high-percentage news hole, by itself, reduces profits
significantly. A large and intelligently-utilized news hole,
however, attracts a wide spectrum of readers and thereby boosts
penetration. High penetration, in turn, makes a newspaper
particularly valuable to retailers since it allows them to talk
to the entire community through a single "megaphone." A low-
penetration paper is a far less compelling purchase for many
advertisers and will eventually suffer in both ad rates and
profits.
It should be emphasized that our excellent penetration is
neither an accident nor automatic. The population of Erie County,
home territory of the News, has been falling - from 1,113,000 in
1970 to 1,015,000 in 1980 to an estimated 966,000 in 1988.
Circulation figures tell a different story. In 1975, shortly
before we started our Sunday edition, the Courier-Express, a
long-established Buffalo paper, was selling 207,500 Sunday copies
in Erie County. Last year - with population at least 5% lower -
the News sold an average of 292,700 copies. I believe that in no
other major Sunday market has there been anything close to that
increase in penetration.
When this kind of gain is made - and when a paper attains an
unequaled degree of acceptance in its home town - someone is
doing something right. In this case major credit clearly belongs
to Murray Light, our long-time editor who daily creates an
informative, useful, and interesting product. Credit should go
also to the Circulation and Production Departments: A paper that
is frequently late, because of production problems or
distribution weaknesses, will lose customers, no matter how
strong its editorial content.
Stan Lipsey, publisher of the News, has produced profits
fully up to the strength of our product. I believe Stan's
managerial skills deliver at least five extra percentage points
in profit margin compared to the earnings that would be achieved
by an average manager given the same circumstances. That is an
amazing performance, and one that could only be produced by a
talented manager who knows - and cares - about every nut and bolt
of the business.
Stan's knowledge and talents, it should be emphasized,
extend to the editorial product. His early years in the business
were spent on the news side and he played a key role in
developing and editing a series of stories that in 1972 won a
Pulitzer Prize for the Sun Newspaper of Omaha. Stan and I have
worked together for over 20 years, through some bad times as well
as good, and I could not ask for a better partner.
o At Fechheimer, the Heldman clan - Bob, George, Gary,
Roger and Fred - continue their extraordinary performance. Profits
in 1989 were down somewhat because of problems the business
experienced in integrating a major 1988 acquisition. These
problems will be ironed out in time. Meanwhile, return on invested
capital at Fechheimer remains splendid.
Like all of our managers, the Heldmans have an exceptional
command of the details of their business. At last year's annual
meeting I mentioned that when a prisoner enters San Quentin, Bob
and George probably know his shirt size. That's only a slight
exaggeration: No matter what area of the country is being
discussed, they know exactly what is going on with major
customers and with the competition.
Though we purchased Fechheimer four years ago, Charlie and I
have never visited any of its plants or the home office in
Cincinnati. We're much like the lonesome Maytag repairman: The
Heldman managerial product is so good that a service call is
never needed.
o Ralph Schey continues to do a superb job in managing
our largest group - World Book, Kirby, and the Scott Fetzer
Manufacturing Companies. Aggregate earnings of these businesses
have increased every year since our purchase and returns on
invested capital continue to be exceptional. Ralph is running an
enterprise large enough, were it standing alone, to be on the
Fortune 500. And he's running it in a fashion that would put him
high in the top decile, measured by return on equity.
For some years, World Book has operated out of a single
location in Chicago's Merchandise Mart. Anticipating the imminent
expiration of its lease, the business is now decentralizing into
four locations. The expenses of this transition are significant;
nevertheless profits in 1989 held up well. It will be another
year before costs of the move are fully behind us.
Kirby's business was particularly strong last year,
featuring large gains in export sales. International business has
more than doubled in the last two years and quintupled in the
past four; its share of unit sales has risen from 5% to 20%. Our
largest capital expenditures in 1989 were at Kirby, in
preparation for a major model change in 1990.
Ralph's operations contribute about 40% of the total
earnings of the non-insurance group whose results are shown on
page 49. When we bought Scott Fetzer at the start of 1986, our
acquisition of Ralph as a manager was fully as important as our
acquisition of the businesses. In addition to generating
extraordinary earnings, Ralph also manages capital extremely
well. These abilities have produced funds for Berkshire that, in
turn, have allowed us to make many other profitable commitments.
And that completes our answer to the 1927 Yankees.
Insurance Operations
Shown below is an updated version of our usual table
presenting key figures for the property-casualty 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 6.5
1983 5.0 112.0 6.8 3.8
1984 8.5 118.0 16.9 3.8
1985 22.1 116.3 16.1 3.0
1986 22.2 108.0 13.5 2.6
1987 9.4 104.6 7.8 3.1
1988 4.4 105.4 5.5 3.3
1989 (Est.) 2.1 110.4 8.7 4.2
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 policyholders' funds ("the float") is taken
into account, a combined ratio in the 107-111 range typically
produces an overall breakeven 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. (Actually,
over the last 25 years, incurred losses have grown at a still
faster rate, 11%.) 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.
Last year we said the climb in the combined ratio was
"almost certain to continue - and probably will accelerate - for
at least two more years." This year we will not predict
acceleration, but otherwise must repeat last year's forecast.
Premium growth is running far below the 10% required annually.
Remember also that a 10% rate would only stabilize the combined
ratio, not bring it down.
The increase in the combined ratio in 1989 was a little more
than we had expected because catastrophes (led by Hurricane Hugo)
were unusually severe. These abnormalities probably accounted for
about two points of the increase. If 1990 is more of a "normal"
year, the combined ratio should rise only minimally from the
catastrophe-swollen base of 1989. In 1991, though, the ratio is
apt to climb by a greater degree.
Commentators frequently discuss the "underwriting cycle" and
speculate about its next turn. If that term is used to connote
rhythmic qualities, it is in our view a misnomer that leads to
faulty thinking about the industry's fundamental economics.
The term was appropriate some decades ago when the industry
and regulators cooperated to conduct the business in cartel
fashion. At that time, the combined ratio fluctuated
rhythmically for two reasons, both related to lags. First, data
from the past were analyzed and then used to set new "corrected"
rates, which were subsequently put into effect by virtually all
insurers. Second, the fact that almost all policies were then
issued for a one-to three-year term - which meant that it took a
considerable time for mispriced policies to expire - delayed the
impact of new rates on revenues. These two lagged responses made
combined ratios behave much like alternating current. Meanwhile,
the absence of significant price competition guaranteed that
industry profits, averaged out over the cycle, would be
satisfactory.
The cartel period is long gone. Now the industry has
hundreds of participants selling a commodity-like product at
independently-established prices. Such a configuration - whether
the product being sold is steel or insurance policies - is
certain to cause subnormal profitability in all circumstances but
one: a shortage of usable capacity. Just how often these periods
occur and how long they last determines the average profitability
of the industry in question.
In most industries, capacity is described in physical terms.
In the insurance world, however, capacity is customarily
described in financial terms; that is, it's considered
appropriate for a company to write no more than X dollars of
business if it has Y dollars of net worth. In practice, however,
constraints of this sort have proven ineffective. Regulators,
insurance brokers, and customers are all slow to discipline
companies that strain their resources. They also acquiesce when
companies grossly overstate their true capital. Hence, a company
can write a great deal of business with very little capital if it
is so inclined. At bottom, therefore, the amount of industry
capacity at any particular moment primarily depends on the mental
state of insurance managers.
All this understood, it is not very difficult to
prognosticate the industry's profits. Good profits will be
realized only when there is a shortage of capacity. Shortages
will occur only when insurers are frightened. That happens rarely
- and most assuredly is not happening now.
Some analysts have argued that the more onerous taxes
recently imposed on the insurance industry and 1989's
catastrophes - Hurricane Hugo and the California earthquake -
will cause prices to strengthen significantly. We disagree. These
adversities have not destroyed the eagerness of insurers to write
business at present prices. Therefore, premium volume won't grow
by 10% in 1990, which means the negative underwriting trend will
not reverse.
The industry will meantime say it needs higher prices to
achieve profitability matching that of the average American
business. Of course it does. So does the steel business. But
needs and desires have nothing to do with the long-term
profitability of industries. Instead, economic fundamentals
determine the outcome. Insurance profitability will improve only
when virtually all insurers are turning away business despite
higher prices. And we're a long way from that point.
Berkshire's premium volume may drop to $150 million or so in
1990 (from a high of $1 billion in 1986), partly because our
traditional business continues to shrink and partly because the
contract under which we received 7% of the business of Fireman's
Fund expired last August. Whatever the size of the drop, it will
not disturb us. We have no interest in writing insurance that
carries a mathematical expectation of loss; we experience enough
disappointments doing transactions we believe to carry an
expectation of profit.
However, our appetite for appropriately-priced business is
ample, as one tale from 1989 will tell. It concerns "CAT covers,"
which are reinsurance contracts that primary insurance companies
(and also reinsurers themselves) buy to protect themselves
against a single catastrophe, such as a tornado or hurricane,
that produces losses from a large number of policies. In these
contracts, the primary insurer might retain the loss from a
single event up to a maximum of, say, $10 million, buying various
layers of reinsurance above that level. When losses exceed the
retained amount, the reinsurer typically pays 95% of the excess
up to its contractual limit, with the primary insurer paying the
remainder. (By requiring the primary insurer to keep 5% of each
layer, the reinsurer leaves him with a financial stake in each
loss settlement and guards against his throwing away the
reinsurer's money.)
CAT covers are usually one-year policies that also provide
for one automatic reinstatement, which requires a primary insurer
whose coverage has been exhausted by a catastrophe to buy a
second cover for the balance of the year in question by paying
another premium. This provision protects the primary company from
being "bare" for even a brief period after a first catastrophic
event. The duration of "an event" is usually limited by contract
to any span of 72 hours designated by the primary company. Under
this definition, a wide-spread storm, causing damage for three
days, will be classified as a single event if it arises from a
single climatic cause. If the storm lasts four days, however, the
primary company will file a claim carving out the 72 consecutive
hours during which it suffered the greatest damage. Losses that
occurred outside that period will be treated as arising from a
separate event.
In 1989, two unusual things happened. First, Hurricane Hugo
generated $4 billion or more of insured loss, at a pace, however,
that caused the vast damage in the Carolinas to occur slightly
more than 72 hours after the equally severe damage in the
Caribbean. Second, the California earthquake hit within weeks,
causing insured damage that was difficult to estimate, even well
after the event. Slammed by these two - or possibly three - major
catastrophes, some primary insurers, and also many reinsurers
that had themselves bought CAT protection, either used up their
automatic second cover or became uncertain as to whether they had
done so.
At that point sellers of CAT policies had lost a huge amount
of money - perhaps twice because of the reinstatements - and not
taken in much in premiums. Depending upon many variables, a CAT
premium might generally have run 3% to 15% of the amount of
protection purchased. For some years, we've thought premiums of
that kind inadequate and have stayed away from the business.
But because the 1989 disasters left many insurers either
actually or possibly bare, and also left most CAT writers licking
their wounds, there was an immediate shortage after the
earthquake of much-needed catastrophe coverage. Prices instantly
became attractive, particularly for the reinsurance that CAT
writers themselves buy. Just as instantly, Berkshire Hathaway
offered to write up to $250 million of catastrophe coverage,
advertising that proposition in trade publications. Though we did
not write all the business we sought, we did in a busy ten days
book a substantial amount.
Our willingness to put such a huge sum on the line for a
loss that could occur tomorrow sets us apart from any reinsurer
in the world. There are, of course, companies that sometimes
write $250 million or even far more of catastrophe coverage. But
they do so only when they can, in turn, reinsure a large
percentage of the business with other companies. When they can't
"lay off" in size, they disappear from the market.
Berkshire's policy, conversely, is to retain the business we
write rather than lay it off. When rates carry an expectation of
profit, we want to assume as much risk as is prudent. And in our
case, that's a lot.
We will accept more reinsurance risk for our own account
than any other company because of two factors: (1) by the
standards of regulatory accounting, we have a net worth in our
insurance companies of about $6 billion - the second highest
amount in the United States; and (2) we simply don't care what
earnings we report quarterly, or even annually, just as long as
the decisions leading to those earnings (or losses) were reached
intelligently.
Obviously, if we write $250 million of catastrophe coverage
and retain it all ourselves, there is some probability that we
will lose the full $250 million in a single quarter. That
probability is low, but it is not zero. If we had a loss of that
magnitude, our after-tax cost would be about $165 million. Though
that is far more than Berkshire normally earns in a quarter, the
damage would be a blow only to our pride, not to our well-being.
This posture is one few insurance managements will assume.
Typically, they are willing to write scads of business on terms
that almost guarantee them mediocre returns on equity. But they
do not want to expose themselves to an embarrassing single-
quarter loss, even if the managerial strategy that causes the
loss promises, over time, to produce superior results. I can
understand their thinking: What is best for their owners is not
necessarily best for the managers. Fortunately Charlie and I have
both total job security and financial interests that are
identical with those of our shareholders. We are willing to look
foolish as long as we don't feel we have acted foolishly.
Our method of operation, incidentally, makes us a
stabilizing force in the industry. We add huge capacity when
capacity is short and we become less competitive only when
capacity is abundant. Of course, we don't follow this policy in
the interest of stabilization - we follow it because we believe
it to be the most sensible and profitable course of action.
Nevertheless, our behavior steadies the market. In this case,
Adam Smith's invisible hand works as advertised.
Currently, we hold an exceptional amount of float compared
to premium volume. This circumstance should produce quite
favorable insurance results for us during the next few years as
it did in 1989. Our underwriting losses should be tolerable and
our investment income from policyholder funds large. This
pleasant situation, however, will gradually deteriorate as our
float runs off.
At some point, however, there will be an opportunity for us
to write large amounts of profitable business. Mike Goldberg and
his management team of Rod Eldred, Dinos Iordanou, Ajit Jain,
Phil Urban, and Don Wurster continue to position us well for this
eventuality.
Marketable Securities
In selecting marketable securities for our insurance
companies, we generally 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
of over $100 million. A small portion of these investments belongs
to subsidiaries of which Berkshire owns less than 100%.
12/31/89
Shares Company Cost Market
------ ------- ---------- ----------
(000s omitted)
3,000,000 Capital Cities/ABC, Inc. ................ $ 517,500 $1,692,375
23,350,000 The Coca-Cola Co. ....................... 1,023,920 1,803,787
2,400,000 Federal Home Loan Mortgage Corp. ........ 71,729 161,100
6,850,000 GEICO Corp. ............................. 45,713 1,044,625
1,727,765 The Washington Post Company ............. 9,731 486,366
This list of companies is the same as last year's and in
only one case has the number of shares changed: Our holdings of
Coca-Cola increased from 14,172,500 shares at the end of 1988 to
23,350,000.
This Coca-Cola investment provides yet another example of
the incredible speed with which your Chairman responds to
investment opportunities, no matter how obscure or well-disguised
they may be. I believe I had my first Coca-Cola in either 1935 or
1936. Of a certainty, it was in 1936 that I started buying Cokes
at the rate of six for 25 cents from Buffett & Son, the family
grocery store, to sell around the neighborhood for 5 cents each.
In this excursion into high-margin retailing, I duly observed
the extraordinary consumer attractiveness and commercial
possibilities of the product.
I continued to note these qualities for the next 52 years as
Coke blanketed the world. During this period, however, I
carefully avoided buying even a single share, instead allocating
major portions of my net worth to street railway companies,
windmill manufacturers, anthracite producers, textile businesses,
trading-stamp issuers, and the like. (If you think I'm making
this up, I can supply the names.) Only in the summer of 1988 did
my brain finally establish contact with my eyes.
What I then perceived was both clear and fascinating. After
drifting somewhat in the 1970's, Coca-Cola had in 1981 become a
new company with the move of Roberto Goizueta to CEO. Roberto,
along with Don Keough, once my across-the-street neighbor in
Omaha, first rethought and focused the company's policies and
then energetically carried them out. What was already the world's
most ubiquitous product gained new momentum, with sales overseas
virtually exploding.
Through a truly rare blend of marketing and financial
skills, Roberto has maximized both the growth of his product and
the rewards that this growth brings to shareholders. Normally,
the CEO of a consumer products company, drawing on his natural
inclinations or experience, will cause either marketing or
finance to dominate the business at the expense of the other
discipline. With Roberto, the mesh of marketing and finance is
perfect and the result is a shareholder's dream.
Of course, we should have started buying Coke much earlier,
soon after Roberto and Don began running things. In fact, if I
had been thinking straight I would have persuaded my grandfather
to sell the grocery store back in 1936 and put all of the
proceeds into Coca-Cola stock. I've learned my lesson: My
response time to the next glaringly attractive idea will be
slashed to well under 50 years.
As I mentioned earlier, the yearend prices of our major
investees were much higher relative to their intrinsic values
than theretofore. While those prices may not yet cause
nosebleeds, they are clearly vulnerable to a general market
decline. A drop in their prices would not disturb us at all - it
might in fact work to our eventual benefit - but it would cause
at least a one-year reduction in Berkshire's net worth. We think
such a reduction is almost certain in at least one of the next
three years. Indeed, it would take only about a 10% year-to-year
decline in the aggregate value of our portfolio investments to
send Berkshire's net worth down.
We continue to be blessed with extraordinary managers at our
portfolio companies. They are high-grade, talented, and
shareholder-oriented. The exceptional results we have achieved
while investing with them accurately reflect their exceptional
personal qualities.
o We told you last year that we expected to do little in
arbitrage during 1989, and that's the way it turned out.
Arbitrage positions are a substitute for short-term cash
equivalents, and during part of the year we held relatively low
levels of cash. In the rest of the year we had a fairly good-
sized cash position and even so chose not to engage in arbitrage.
The main reason was corporate transactions that made no economic
sense to us; arbitraging such deals comes too close to playing
the greater-fool game. (As Wall Streeter Ray DeVoe says: "Fools
rush in where angels fear to trade.") We will engage in arbitrage
from time to time - sometimes on a large scale - but only when we
like the odds.
o Leaving aside the three convertible preferreds discussed in
the next section, we substantially reduced our holdings in both
medium- and long-term fixed-income securities. In the long-terms,
just about our only holdings have been Washington Public Power
Supply Systems (WPPSS) bonds carrying coupons ranging from low to
high. During the year we sold a number of the low-coupon issues,
which we originally bought at very large discounts. Many of these
issues had approximately doubled in price since we purchased them
and in addition had paid us 15%-17% annually, tax-free. Our
prices upon sale were only slightly cheaper than typical high-
grade tax-exempts then commanded. We have kept all of our high-
coupon WPPSS issues. Some have been called for redemption in 1991
and 1992, and we expect the rest to be called in the early to
mid-1990s.
We also sold many of our medium-term tax-exempt bonds during
the year. When we bought these bonds we said we would be happy to
sell them - regardless of whether they were higher or lower than
at our time of purchase - if something we liked better came
along. Something did - and concurrently we unloaded most of these
issues at modest gains. Overall, our 1989 profit from the sale of
tax-exempt bonds was about $51 million pre-tax.
o The proceeds from our bond sales, along with our excess cash
at the beginning of the year and that generated later through
earnings, went into the purchase of three convertible preferred
stocks. In the first transaction, which took place in July, we
purchased $600 million of The Gillette Co. preferred with an 8
3/4% dividend, a mandatory redemption in ten years, and the right
to convert into common at $50 per share. We next purchased $358
million of USAir Group, Inc. preferred stock with mandatory
redemption in ten years, a dividend of 9 1/4%, and the right to
convert into common at $60 per share. Finally, late in the year
we purchased $300 million of Champion International Corp.
preferred with mandatory redemption in ten years, a 9 1/4%
dividend, and the right to convert into common at $38 per share.
Unlike standard convertible preferred stocks, the issues we
own are either non-salable or non-convertible for considerable
periods of time and there is consequently no way we can gain from
short-term price blips in the common stock. I have gone on the
board of Gillette, but I am not on the board of USAir or
Champion. (I thoroughly enjoy the boards I am on, but can't
handle any more.)
Gillette's business is very much the kind we like. Charlie
and I think we understand the company's economics and therefore
believe we can make a reasonably intelligent guess about its
future. (If you haven't tried Gillette's new Sensor razor, go
right out and get one.) However, we have no ability to forecast
the economics of the investment banking business (in which we
have a position through our 1987 purchase of Salomon convertible
preferred), the airline industry, or the paper industry. This
does not mean that we predict a negative future for these
industries: we're agnostics, not atheists. Our lack of strong
convictions about these businesses, however, means that we must
structure our investments in them differently from what we do
when we invest in a business appearing to have splendid economic
characteristics.
In one major respect, however, these purchases are not
different: We only want to link up with people whom we like,
admire, and trust. John Gutfreund at Salomon, Colman Mockler, Jr.
at Gillette, Ed Colodny at USAir, and Andy Sigler at Champion
meet this test in spades.
They in turn have demonstrated some confidence in us,
insisting in each case that our preferreds have unrestricted
voting rights on a fully-converted basis, an arrangement that is
far from standard in corporate finance. In effect they are
trusting us to be intelligent owners, thinking about tomorrow
instead of today, just as we are trusting them to be intelligent
managers, thinking about tomorrow as well as today.
The preferred-stock structures we have negotiated will
provide a mediocre return for us if industry economics hinder the
performance of our investees, but will produce reasonably
attractive results for us if they can earn a return comparable to
that of American industry in general. We believe that Gillette,
under Colman's management, will far exceed that return and
believe that John, Ed, and Andy will reach it unless industry
conditions are harsh.
Under almost any conditions, we expect these preferreds to
return us our money plus dividends. If that is all we get,
though, the result will be disappointing, because we will have
given up flexibility and consequently will have missed some
significant opportunities that are bound to present themselves
during the decade. Under that scenario, we will have obtained
only a preferred-stock yield during a period when the typical
preferred stock will have held no appeal for us whatsoever. The
only way Berkshire can achieve satisfactory results from its four
preferred issues is to have the common stocks of the investee
companies do well.
Good management and at least tolerable industry conditions
will be needed if that is to happen. But we believe Berkshire's
investment will also help and that the other shareholders of each
investee will profit over the years ahead from our preferred-
stock purchase. The help will come from the fact that each
company now has a major, stable, and interested shareholder whose
Chairman and Vice Chairman have, through Berkshire's investments,
indirectly committed a very large amount of their own money to
these undertakings. In dealing with our investees, Charlie and I
will be supportive, analytical, and objective. We recognize that
we are working with experienced CEOs who are very much in command
of their own businesses but who nevertheless, at certain moments,
appreciate the chance to test their thinking on someone without
ties to their industry or to decisions of the past.
As a group, these convertible preferreds will not produce
the returns we can achieve when we find a business with wonderful
economic prospects that is unappreciated by the market. Nor will
the returns be as attractive as those produced when we make our
favorite form of capital deployment, the acquisition of 80% or
more of a fine business with a fine management. But both
opportunities are rare, particularly in a size befitting our
present and anticipated resources.
In summation, Charlie and I feel that our preferred stock
investments should produce returns moderately above those
achieved by most fixed-income portfolios and that we can play a
minor but enjoyable and constructive role in the investee
companies.
Zero-Coupon Securities
In September, Berkshire issued $902.6 million principal
amount of Zero-Coupon Convertible Subordinated Debentures, which
are now listed on the New York Stock Exchange. Salomon Brothers
handled the underwriting in superb fashion, providing us helpful
advice and a flawless execution.
Most bonds, of course, require regular payments of interest,
usually semi-annually. A zero-coupon bond, conversely, requires
no current interest payments; instead, the investor receives his
yield by purchasing the security at a significant discount from
maturity value. The effective interest rate is determined by the
original issue price, the maturity value, and the amount of time
between issuance and maturity.
In our case, the bonds were issued at 44.314% of maturity
value and are due in 15 years. For investors purchasing the
bonds, that is the mathematical equivalent of a 5.5% current
payment compounded semi-annually. Because we received only
44.31 cents on the dollar, our proceeds from this offering were
$400 million (less about $9.5 million of offering expenses).
The bonds were issued in denominations of $10,000 and each
bond is convertible into .4515 shares of Berkshire Hathaway.
Because a $10,000 bond cost $4,431, this means that the
conversion price was $9,815 per Berkshire share, a 15% premium to
the market price then existing. Berkshire can call the bonds at
any time after September 28, 1992 at their accreted value (the
original issue price plus 5.5% compounded semi-annually) and on
two specified days, September 28 of 1994 and 1999, the
bondholders can require Berkshire to buy the securities at their
accreted value.
For tax purposes, Berkshire is entitled to deduct the 5.5%
interest accrual each year, even though we make no payments to
the bondholders. Thus the net effect to us, resulting from the
reduced taxes, is positive cash flow. That is a very significant
benefit. Some unknowable variables prevent us from calculating
our exact effective rate of interest, but under all circumstances
it will be well below 5.5%. There is meanwhile a symmetry to the
tax law: Any taxable holder of the bonds must pay tax each year
on the 5.5% interest, even though he receives no cash.
Neither our bonds nor those of certain other companies that
issued similar bonds last year (notably Loews and Motorola)
resemble the great bulk of zero-coupon bonds that have been
issued in recent years. Of these, Charlie and I have been, and
will continue to be, outspoken critics. As I will later explain,
such bonds have often been used in the most deceptive of ways and
with deadly consequences to investors. But before we tackle that
subject, let's travel back to Eden, to a time when the apple had
not yet been bitten.
If you're my age you bought your first zero-coupon bonds
during World War II, by purchasing the famous Series E U. S.
Savings Bond, the most widely-sold bond issue in history. (After
the war, these bonds were held by one out of two U. S.
households.) Nobody, of course, called the Series E a zero-coupon
bond, a term in fact that I doubt had been invented. But that's
precisely what the Series E was.
These bonds came in denominations as small as $18.75. That
amount purchased a $25 obligation of the United States government
due in 10 years, terms that gave the buyer a compounded annual
return of 2.9%. At the time, this was an attractive offer: the
2.9% rate was higher than that generally available on Government
bonds and the holder faced no market-fluctuation risk, since he
could at any time cash in his bonds with only a minor reduction
in interest.
A second form of zero-coupon U. S. Treasury issue, also
benign and useful, surfaced in the last decade. One problem with
a normal bond is that even though it pays a given interest rate -
say 10% - the holder cannot be assured that a compounded 10%
return will be realized. For that rate to materialize, each semi-
annual coupon must be reinvested at 10% as it is received. If
current interest rates are, say, only 6% or 7% when these coupons
come due, the holder will be unable to compound his money over
the life of the bond at the advertised rate. For pension funds or
other investors with long-term liabilities, "reinvestment risk"
of this type can be a serious problem. Savings Bonds might have
solved it, except that they are issued only to individuals and
are unavailable in large denominations. What big buyers needed
was huge quantities of "Savings Bond Equivalents."
Enter some ingenious and, in this case, highly useful
investment bankers (led, I'm happy to say, by Salomon Brothers).
They created the instrument desired by "stripping" the semi-
annual coupons from standard Government issues. Each coupon, once
detached, takes on the essential character of a Savings Bond
since it represents a single sum due sometime in the future. For
example, if you strip the 40 semi-annual coupons from a U. S.
Government Bond due in the year 2010, you will have 40 zero-
coupon bonds, with maturities from six months to 20 years, each
of which can then be bundled with other coupons of like maturity
and marketed. If current interest rates are, say, 10% for all
maturities, the six-month issue will sell for 95.24% of maturity
value and the 20-year issue will sell for 14.20%. The purchaser
of any given maturity is thus guaranteed a compounded rate of 10%
for his entire holding period. Stripping of government bonds has
occurred on a large scale in recent years, as long-term
investors, ranging from pension funds to individual IRA accounts,
recognized these high-grade, zero-coupon issues to be well suited
to their needs.
But as happens in Wall Street all too often, what the wise
do in the beginning, fools do in the end. In the last few years
zero-coupon bonds (and their functional equivalent, pay-in-kind
bonds, which distribute additional PIK bonds semi-annually as
interest instead of paying cash) have been issued in enormous
quantities by ever-junkier credits. To these issuers, zero (or
PIK) bonds offer one overwhelming advantage: It is impossible to
default on a promise to pay nothing. Indeed, if LDC governments
had issued no debt in the 1970's other than long-term zero-coupon
obligations, they would now have a spotless record as debtors.
This principle at work - that you need not default for a
long time if you solemnly promise to pay nothing for a long time
- has not been lost on promoters and investment bankers seeking
to finance ever-shakier deals. But its acceptance by lenders took
a while: When the leveraged buy-out craze began some years back,
purchasers could borrow only on a reasonably sound basis, in
which conservatively-estimated free cash flow - that is,
operating earnings plus depreciation and amortization less
normalized capital expenditures - was adequate to cover both
interest and modest reductions in debt.
Later, as the adrenalin of deal-makers surged, businesses
began to be purchased at prices so high that all free cash flow
necessarily had to be allocated to the payment of interest. That
left nothing for the paydown of debt. In effect, a Scarlett
O'Hara "I'll think about it tomorrow" position in respect to
principal payments was taken by borrowers and accepted by a new
breed of lender, the buyer of original-issue junk bonds. Debt now
became something to be refinanced rather than repaid. The change
brings to mind a New Yorker cartoon in which the grateful
borrower rises to shake the hand of the bank's lending officer
and gushes: "I don't know how I'll ever repay you."
Soon borrowers found even the new, lax standards intolerably
binding. To induce lenders to finance even sillier transactions,
they introduced an abomination, EBDIT - Earnings Before
Depreciation, Interest and Taxes - as the test of a company's
ability to pay interest. Using this sawed-off yardstick, the
borrower ignored depreciation as an expense on the theory that it
did not require a current cash outlay.
Such an attitude is clearly delusional. At 95% of American
businesses, capital expenditures that over time roughly
approximate depreciation are a necessity and are every bit as
real an expense as labor or utility costs. Even a high school
dropout knows that to finance a car he must have income that
covers not only interest and operating expenses, but also
realistically-calculated depreciation. He would be laughed out of
the bank if he started talking about EBDIT.
Capital outlays at a business can be skipped, of course, in
any given month, just as a human can skip a day or even a week of
eating. But if the skipping becomes routine and is not made up,
the body weakens and eventually dies. Furthermore, a start-and-
stop feeding policy will over time produce a less healthy
organism, human or corporate, than that produced by a steady
diet. As businessmen, Charlie and I relish having competitors who
are unable to fund capital expenditures.
You might think that waving away a major expense such as
depreciation in an attempt to make a terrible deal look like a
good one hits the limits of Wall Street's ingenuity. If so, you
haven't been paying attention during the past few years.
Promoters needed to find a way to justify even pricier
acquisitions. Otherwise, they risked - heaven forbid! - losing
deals to other promoters with more "imagination."
So, stepping through the Looking Glass, promoters and their
investment bankers proclaimed that EBDIT should now be measured
against cash interest only, which meant that interest accruing on
zero-coupon or PIK bonds could be ignored when the financial
feasibility of a transaction was being assessed. This approach
not only relegated depreciation expense to the let's-ignore-it
corner, but gave similar treatment to what was usually a
significant portion of interest expense. To their shame, many
professional investment managers went along with this nonsense,
though they usually were careful to do so only with clients'
money, not their own. (Calling these managers "professionals" is
actually too kind; they should be designated "promotees.")
Under this new standard, a business earning, say, $100
million pre-tax and having debt on which $90 million of interest
must be paid currently, might use a zero-coupon or PIK issue to
incur another $60 million of annual interest that would accrue
and compound but not come due for some years. The rate on these
issues would typically be very high, which means that the
situation in year 2 might be $90 million cash interest plus $69
million accrued interest, and so on as the compounding proceeds.
Such high-rate reborrowing schemes, which a few years ago were
appropriately confined to the waterfront, soon became models of
modern finance at virtually all major investment banking houses.
When they make these offerings, investment bankers display
their humorous side: They dispense income and balance sheet
projections extending five or more years into the future for
companies they barely had heard of a few months earlier. If you
are shown such schedules, I suggest that you join in the fun:
Ask the investment banker for the one-year budgets that his own
firm prepared as the last few years began and then compare these
with what actually happened.
Some time ago Ken Galbraith, in his witty and insightful
The Great Crash, coined a new economic term: "the bezzle,"
defined as the current amount of undiscovered embezzlement. This
financial creature has a magical quality: The embezzlers are richer
by the amount of the bezzle, while the embezzlees do not yet feel
poorer.
Professor Galbraith astutely pointed out that this sum
should be added to the National Wealth so that we might know the
Psychic National Wealth. Logically, a society that wanted to feel
enormously prosperous would both encourage its citizens to
embezzle and try not to detect the crime. By this means, "wealth"
would balloon though not an erg of productive work had been done.
The satirical nonsense of the bezzle is dwarfed by the real-
world nonsense of the zero-coupon bond. With zeros, one party to
a contract can experience "income" without his opposite
experiencing the pain of expenditure. In our illustration, a
company capable of earning only $100 million dollars annually -
and therefore capable of paying only that much in interest -
magically creates "earnings" for bondholders of $150 million. As
long as major investors willingly don their Peter Pan wings and
repeatedly say "I believe," there is no limit to how much
"income" can be created by the zero-coupon bond.
Wall Street welcomed this invention with the enthusiasm
less-enlightened folk might reserve for the wheel or the plow.
Here, finally, was an instrument that would let the Street make
deals at prices no longer limited by actual earning power. The
result, obviously, would be more transactions: Silly prices will
always attract sellers. And, as Jesse Unruh might have put it,
transactions are the mother's milk of finance.
The zero-coupon or PIK bond possesses one additional
attraction for the promoter and investment banker, which is that
the time elapsing between folly and failure can be stretched out.
This is no small benefit. If the period before all costs must be
faced is long, promoters can create a string of foolish deals -
and take in lots of fees - before any chickens come home to roost
from their earlier ventures.
But in the end, alchemy, whether it is metallurgical or
financial, fails. A base business can not be transformed into a
golden business by tricks of accounting or capital structure. The
man claiming to be a financial alchemist may become rich. But
gullible investors rather than business achievements will usually
be the source of his wealth.
Whatever their weaknesses, we should add, many zero-coupon
and PIK bonds will not default. We have in fact owned some and
may buy more if their market becomes sufficiently distressed.
(We've not, however, even considered buying a new issue from a
weak credit.) No financial instrument is evil per se; it's just
that some variations have far more potential for mischief than
others.
The blue ribbon for mischief-making should go to the zero-
coupon issuer unable to make its interest payments on a current
basis. Our advice: Whenever an investment banker starts talking
about EBDIT - or whenever someone creates a capital structure
that does not allow all interest, both payable and accrued, to be
comfortably met out of current cash flow net of ample capital
expenditures - zip up your wallet. Turn the tables by suggesting
that the promoter and his high-priced entourage accept zero-
coupon fees, deferring their take until the zero-coupon bonds
have been paid in full. See then how much enthusiasm for the deal
endures.
Our comments about investment bankers may seem harsh. But
Charlie and I - in our hopelessly old-fashioned way - believe
that they should perform a gatekeeping role, guarding investors
against the promoter's propensity to indulge in excess.
Promoters, after all, have throughout time exercised the same
judgment and restraint in accepting money that alcoholics have
exercised in accepting liquor. At a minimum, therefore, the
banker's conduct should rise to that of a responsible bartender
who, when necessary, refuses the profit from the next drink to
avoid sending a drunk out on the highway. In recent years,
unfortunately, many leading investment firms have found bartender
morality to be an intolerably restrictive standard. Lately, those
who have traveled the high road in Wall Street have not
encountered heavy traffic.
One distressing footnote: The cost of the zero-coupon folly
will not be borne solely by the direct participants. Certain
savings and loan associations were heavy buyers of such bonds,
using cash that came from FSLIC-insured deposits. Straining to
show splendid earnings, these buyers recorded - but did not
receive - ultra-high interest income on these issues. Many of
these associations are now in major trouble. Had their loans to
shaky credits worked, the owners of the associations would have
pocketed the profits. In the many cases in which the loans will
fail, the taxpayer will pick up the bill. To paraphrase Jackie
Mason, at these associations it was the managers who should have
been wearing the ski masks.
Mistakes of the First Twenty-five Years (A Condensed Version)
To quote Robert Benchley, "Having a dog teaches a boy
fidelity, perseverance, and to turn around three times before
lying down." Such are the shortcomings of experience.
Nevertheless, it's a good idea to review past mistakes before
committing new ones. So let's take a quick look at the last 25
years.
o My first mistake, of course, was in buying control of
Berkshire. Though I knew its business - textile manufacturing -
to be unpromising, I was enticed to buy because the price looked
cheap. Stock purchases of that kind had proved reasonably
rewarding in my early years, though by the time Berkshire came
along in 1965 I was becoming aware that the strategy was not
ideal.
If you buy a stock at a sufficiently low price, there will
usually be some hiccup in the fortunes of the business that gives
you a chance to unload at a decent profit, even though the long-
term performance of the business may be terrible. I call this the
"cigar butt" approach to investing. A cigar butt found on the
street that has only one puff left in it may not offer much of a
smoke, but the "bargain purchase" will make that puff all profit.
Unless you are a liquidator, that kind of approach to buying
businesses is foolish. First, the original "bargain" price
probably will not turn out to be such a steal after all. In a
difficult business, no sooner is one problem solved than another
surfaces - never is there just one cockroach in the kitchen.
Second, any initial advantage you secure will be quickly eroded
by the low return that the business earns. For example, if you
buy a business for $8 million that can be sold or liquidated for
$10 million and promptly take either course, you can realize a
high return. But the investment will disappoint if the business
is sold for $10 million in ten years and in the interim has
annually earned and distributed only a few percent on cost. Time
is the friend of the wonderful business, the enemy of the
mediocre.
You might think this principle is obvious, but I had to
learn it the hard way - in fact, I had to learn it several times
over. Shortly after purchasing Berkshire, I acquired a Baltimore
department store, Hochschild Kohn, buying through a company
called Diversified Retailing that later merged with Berkshire. I
bought at a substantial discount from book value, the people were
first-class, and the deal included some extras - unrecorded real
estate values and a significant LIFO inventory cushion. How could
I miss? So-o-o - three years later I was lucky to sell the
business for about what I had paid. After ending our corporate
marriage to Hochschild Kohn, I had memories like those of the
husband in the country song, "My Wife Ran Away With My Best
Friend and I Still Miss Him a Lot."
I could give you other personal examples of "bargain-
purchase" folly but I'm sure you get the picture: It's far
better to buy a wonderful company at a fair price than a fair
company at a wonderful price. Charlie understood this early; I
was a slow learner. But now, when buying companies or common
stocks, we look for first-class businesses accompanied by first-
class managements.
o That leads right into a related lesson: Good jockeys will
do well on good horses, but not on broken-down nags. Both
Berkshire's textile business and Hochschild, Kohn had able and
honest people running them. The same managers employed in a
business with good economic characteristics would have achieved
fine records. But they were never going to make any progress
while running in quicksand.
I've said many times that when a management with a
reputation for brilliance tackles a business with a reputation
for bad economics, it is the reputation of the business that
remains intact. I just wish I hadn't been so energetic in
creating examples. My behavior has matched that admitted by Mae
West: "I was Snow White, but I drifted."
o A further related lesson: Easy does it. After 25 years of
buying and supervising a great variety of businesses, Charlie and
I have not learned how to solve difficult business problems. What
we have learned is to avoid them. To the extent we have been
successful, it is because we concentrated on identifying one-foot
hurdles that we could step over rather than because we acquired
any ability to clear seven-footers.
The finding may seem unfair, but in both business and
investments it is usually far more profitable to simply stick
with the easy and obvious than it is to resolve the difficult. On
occasion, tough problems must be tackled as was the case when we
started our Sunday paper in Buffalo. In other instances, a great
investment opportunity occurs when a marvelous business
encounters a one-time huge, but solvable, problem as was the case
many years back at both American Express and GEICO. Overall,
however, we've done better by avoiding dragons than by slaying
them.
o My most surprising discovery: the overwhelming importance in
business of an unseen force that we might call "the institutional
imperative." In business school, I was given no hint of the
imperative's existence and I did not intuitively understand it
when I entered the business world. I thought then that decent,
intelligent, and experienced managers would automatically make
rational business decisions. But I learned over time that isn't
so. Instead, rationality frequently wilts when the institutional
imperative comes into play.
For example: (1) As if governed by Newton's First Law of
Motion, an institution will resist any change in its current
direction; (2) Just as work expands to fill available time,
corporate projects or acquisitions will materialize to soak up
available funds; (3) Any business craving of the leader, however
foolish, will be quickly supported by detailed rate-of-return and
strategic studies prepared by his troops; and (4) The behavior of
peer companies, whether they are expanding, acquiring, setting
executive compensation or whatever, will be mindlessly imitated.
Institutional dynamics, not venality or stupidity, set
businesses on these courses, which are too often misguided. After
making some expensive mistakes because I ignored the power of the
imperative, I have tried to organize and manage Berkshire in ways
that minimize its influence. Furthermore, Charlie and I have
attempted to concentrate our investments in companies that appear
alert to the problem.
o After some other mistakes, I learned to go into business
only with people whom I like, trust, and admire. As I noted
before, this policy of itself will not ensure success: A second-
class textile or department-store company won't prosper simply
because its managers are men that you would be pleased to see
your daughter marry. However, an owner - or investor - can
accomplish wonders if he manages to associate himself with such
people in businesses that possess decent economic
characteristics. Conversely, we do not wish to join with managers
who lack admirable qualities, no matter how attractive the
prospects of their business. We've never succeeded in making a
good deal with a bad person.
o Some of my worst mistakes were not publicly visible. These
were stock and business purchases whose virtues I understood and
yet didn't make. It's no sin to miss a great opportunity outside
one's area of competence. But I have passed on a couple of really
big purchases that were served up to me on a platter and that I
was fully capable of understanding. For Berkshire's shareholders,
myself included, the cost of this thumb-sucking has been huge.
o Our consistently-conservative financial policies may appear
to have been a mistake, but in my view were not. In retrospect,
it is clear that significantly higher, though still conventional,
leverage ratios at Berkshire would have produced considerably
better returns on equity than the 23.8% we have actually
averaged. Even in 1965, perhaps we could have judged there to be
a 99% probability that higher leverage would lead to nothing but
good. Correspondingly, we might have seen only a 1% chance that
some shock factor, external or internal, would cause a
conventional debt ratio to produce a result falling somewhere
between temporary anguish and default.
We wouldn't have liked those 99:1 odds - and never will. A
small chance of distress or disgrace cannot, in our view, be
offset by a large chance of extra returns. If your actions are
sensible, you are certain to get good results; in most such
cases, leverage just moves things along faster. Charlie and I
have never been in a big hurry: We enjoy the process far more
than the proceeds - though we have learned to live with those
also.
* * * * * * * * * * * *
We hope in another 25 years to report on the mistakes of the
first 50. If we are around in 2015 to do that, you can count on
this section occupying many more pages than it does here.
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. At the same time, these managers 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 such objectives. We 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 a 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 Capital Cities, Salomon, Gillette,
USAir and Champion. Last year we said we had a special interest
in large purchases of convertible preferreds. We still have an
appetite of that kind, but it is limited since we now are close
to the maximum position we feel appropriate for this category of
investment.
* * * * * * * * * * * *
Two years ago, I told you about Harry Bottle, who in 1962
quickly cured a major business mess at the first industrial
company I controlled, Dempster Mill Manufacturing (one of my
"bargain" purchases) and who 24 years later had reappeared to
again rescue me, this time from problems at K&W Products, a small
Berkshire subsidiary that produces automotive compounds. As I
reported, in short order Harry reduced capital employed at K&W,
rationalized production, cut costs, and quadrupled profits. You
might think he would then have paused for breath. But last year
Harry, now 70, attended a bankruptcy auction and, for a pittance,
acquired a product line that is a natural for K&W. That company's
profitability may well be increased 50% by this coup. Watch this
space for future bulletins on Harry's triumphs.
* * * * * * * * * * * *
With more than a year behind him of trading Berkshire's
stock on the New York Stock Exchange, our specialist, Jim Maguire
of Henderson Brothers, Inc. ("HBI"), continues his outstanding
performance. Before we listed, dealer spreads often were 3% or
more of market price. Jim has maintained the spread at 50 points
or less, which at current prices is well under 1%. Shareholders
who buy or sell benefit significantly from this reduction in
transaction costs.
Because we are delighted by our experience with Jim, HBI and
the NYSE, I said as much in ads that have been run in a series
placed by the NYSE. Normally I shun testimonials, but I was
pleased in this instance to publicly compliment the Exchange.
* * * * * * * * * * * *
Last summer we sold the corporate jet that we purchased for
$850,000 three years ago and bought another used jet for $6.7
million. Those of you who recall the mathematics of the
multiplying bacteria on page 5 will understandably panic: If our
net worth continues to increase at current rates, and the cost of
replacing planes also continues to rise at the now-established
rate of 100% compounded annually, it will not be long before
Berkshire's entire net worth is consumed by its jet.
Charlie doesn't like it when I equate the jet with bacteria;
he feels it's degrading to the bacteria. His idea of traveling in
style is an air-conditioned bus, a luxury he steps up to only
when bargain fares are in effect. My own attitude toward the jet
can be summarized by the prayer attributed, apocryphally I'm
sure, to St. Augustine as he contemplated leaving a life of
secular pleasures to become a priest. Battling the conflict
between intellect and glands, he pled: "Help me, Oh Lord, to
become chaste - but not yet."
Naming the plane has not been easy. I initially suggested
"The Charles T. Munger." Charlie countered with "The Aberration."
We finally settled on "The Indefensible."
* * * * * * * * * * * *
About 96.9% of all eligible shares participated in
Berkshire's 1989 shareholder-designated contributions program.
Contributions made through the program were $5.9 million, and
2,550 charities were recipients.
We urge new shareholders to read the description of our
shareholder-designated contributions program that appears on
pages 52-53. 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
August 31, 1990 will be ineligible for the 1990 program.
* * * * * * * * * * * *
The annual meeting this year will take place at 9:30 a.m. on
Monday, April 30, 1990. Attendance grew last year to about 1,000,
very close to the seating capacity of the Witherspoon Hall at
Joslyn Museum. So this year's meeting will be moved to the
Orpheum Theatre, which is in downtown Omaha, about one-quarter of
a mile from the Red Lion Hotel. The Radisson-Redick Tower, a much
smaller but nice hotel, is located across the street from the
Orpheum. Or you may wish to stay at the Marriott, which is in
west Omaha, about 100 yards from Borsheim's. We will have buses
at the Marriott that will leave at 8:30 and 8:45 for the meeting
and return after it ends.
Charlie and I always enjoy the meeting, and we hope you can
make it. The quality of our shareholders is reflected in the
quality of the questions we get: We have never attended an annual
meeting anywhere that features such a consistently high level of
intelligent, owner-related questions.
An attachment to our proxy material explains how you can
obtain the card you will need for admission to the meeting.
Because weekday parking can be tight around the Orpheum, we have
lined up a number of nearby lots for our shareholders to use. The
attachment also contains information about them.
As usual, we will have buses to take you to Nebraska
Furniture Mart and Borsheim's after the meeting and to take you
to downtown hotels or to the airport later. I hope that you will
allow plenty of time to fully explore the attractions of both
stores. Those of you arriving early can visit the Furniture Mart
any day of the week; it is open from 10 a.m. to 5:30 p.m. on
Saturdays, and from noon to 5:30 p.m. on Sundays.
Borsheim's normally is closed on Sunday, but we will open
for shareholders and their guests from noon to 6 p.m. on Sunday,
April 29th. Ike likes to put on a show, and you can rely on him
to produce something very special for our shareholders.
In this letter we've had a lot to say about rates of
compounding. If you can bear having your own rate turn negative
for a day - not a pretty thought, I admit - visit Ike on the
29th.
Warren E. Buffett
March 2, 1990 Chairman of the Board