BERKSHIRE HATHAWAY INC.
To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 1991 was $2.1 billion, or
39.6%. Over the last 27 years (that is, since present management
took over) our per-share book value has grown from $19 to $6,437,
or at a rate of 23.7% compounded annually.
The size of our equity capital - which now totals $7.4
billion - makes it certain that we cannot maintain our past rate
of gain or, for that matter, come close to doing so. As Berkshire
grows, the universe of opportunities that can significantly
influence the company's performance constantly shrinks. When we
were working with capital of $20 million, an idea or business
producing $1 million of profit added five percentage points to
our return for the year. Now we need a $370 million idea (i.e.,
one contributing over $550 million of pre-tax profit) to achieve
the same result. And there are many more ways to make $1 million
than to make $370 million.
Charlie Munger, Berkshire's Vice Chairman, and I have set a
goal of attaining a 15% average annual increase in Berkshire's
intrinsic value. If our growth in book value is to keep up with a
15% pace, we must earn $22 billion during the next decade. Wish
us luck - we'll need it.
Our outsized gain in book value in 1991 resulted from a
phenomenon not apt to be repeated: a dramatic rise in the price-
earnings ratios of Coca-Cola and Gillette. These two stocks
accounted for nearly $1.6 billion of our $2.1 billion growth in
net worth last year. When we loaded up on Coke three years ago,
Berkshire's net worth was $3.4 billion; now our Coke stock alone
is worth more than that.
Coca-Cola and Gillette are two of the best companies in the
world and we expect their earnings to grow at hefty rates in the
years ahead. Over time, also, the value of our holdings in these
stocks should grow in rough proportion. Last year, however, the
valuations of these two companies rose far faster than their
earnings. In effect, we got a double-dip benefit, delivered
partly by the excellent earnings growth and even more so by the
market's reappraisal of these stocks. We believe this reappraisal
was warranted. But it can't recur annually: We'll have to settle
for a single dip in the future.
A Second Job
In 1989 when I - a happy consumer of five cans of Cherry
Coke daily - announced our purchase of $1 billion worth of Coca-
Cola stock, I described the move as a rather extreme example of
putting our money where my mouth was. On August 18 of last year,
when I was elected Interim Chairman of Salomon Inc, it was a
different story: I put my mouth where our money was.
You've all read of the events that led to my appointment. My
decision to take the job carried with it an implicit but
important message: Berkshire's operating managers are so
outstanding that I knew I could materially reduce the time I was
spending at the company and yet remain confident that its
economic progress would not skip a beat. The Blumkins, the
Friedman family, Mike Goldberg, the Heldmans, Chuck Huggins, Stan
Lipsey, Ralph Schey and Frank Rooney (CEO of H.H. Brown, our
latest acquisition, which I will describe later) are all masters
of their operations and need no help from me. My job is merely to
treat them right and to allocate the capital they generate.
Neither function is impeded by my work at Salomon.
The role that Charlie and I play in the success of our
operating units can be illustrated by a story about George Mira,
the one-time quarterback of the University of Miami, and his
coach, Andy Gustafson. Playing Florida and near its goal line,
Mira dropped back to pass. He spotted an open receiver but found
his right shoulder in the unshakable grasp of a Florida
linebacker. The right-handed Mira thereupon switched the ball to
his other hand and threw the only left-handed pass of his life -
for a touchdown. As the crowd erupted, Gustafson calmly turned to
a reporter and declared: "Now that's what I call coaching."
Given the managerial stars we have at our operating units,
Berkshire's performance is not affected if Charlie or I slip away
from time to time. You should note, however, the "interim" in my
Salomon title. Berkshire is my first love and one that will never
fade: At the Harvard Business School last year, a student asked
me when I planned to retire and I replied, "About five to ten
years after I die."
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.
A large amount of additional information about these
businesses is given on pages 33-47, where you also will find
our segment earnings reported on a GAAP basis. However, we will
not in this letter discuss each of our non-insurance operations,
as we have in the past. Our businesses have grown in number - and
will continue to grow - so it now makes sense to rotate coverage,
discussing one or two in detail each year.
(000s omitted)
----------------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
---------------------- ----------------------
1991 1990 1991 1990
---------- ---------- ---------- ----------
Operating Earnings:
Insurance Group:
Underwriting ............ $(119,593) $ (26,647) $ (77,229) $ (14,936)
Net Investment Income ... 331,846 327,047 285,173 282,613
H. H. Brown (acquired 7/1/91) 13,616 --- 8,611 ---
Buffalo News .............. 37,113 43,954 21,841 25,981
Fechheimer ................ 12,947 12,450 6,843 6,605
Kirby ..................... 35,726 27,445 22,555 17,613
Nebraska Furniture Mart ... 14,384 17,248 6,993 8,485
Scott Fetzer
Manufacturing Group .... 26,123 30,378 15,901 18,458
See's Candies ............. 42,390 39,580 25,575 23,892
Wesco - other than Insurance 12,230 12,441 8,777 9,676
World Book ................ 22,483 31,896 15,487 20,420
Amortization of Goodwill .. (4,113) (3,476) (4,098) (3,461)
Other Purchase-Price
Accounting Charges ..... (6,021) (5,951) (7,019) (6,856)
Interest Expense* ......... (89,250) (76,374) (57,165) (49,726)
Shareholder-Designated
Contributions .......... (6,772) (5,824) (4,388) (3,801)
Other ..................... 77,399 58,310 47,896 35,782
---------- ---------- ---------- ----------
Operating Earnings 400,508 482,477 315,753 370,745
Sales of Securities 192,478 33,989 124,155 23,348
Total Earnings - All Entities $ 592,986 $ 516,466 $ 439,908 $ 394,093
*Excludes interest expense of Scott Fetzer Financial Group and
Mutual Savings & Loan.
"Look-Through" Earnings
We've previously discussed look-through earnings, which
consist of: (1) the operating earnings reported in the previous
section, plus; (2) the retained operating earnings of major
investees that, under GAAP accounting, are not reflected in our
profits, less; (3) an allowance for the tax that would be paid by
Berkshire if these retained earnings of investees had instead been
distributed to us.
I've told you that over time look-through earnings must
increase at about 15% annually if our intrinsic business value is
to grow at that rate. Indeed, since present management took over in
1965, our look-through earnings have grown at almost the identical
23% rate of gain recorded for book value.
Last year, however, our look-through earnings did not grow at
all but rather declined by 14%. To an extent, the decline was
precipitated by two forces that I discussed in last year's report
and that I warned you would have a negative effect on look-through
earnings.
First, I told you that our media earnings - both direct and
look-through - were "sure to decline" and they in fact did. The
second force came into play on April 1, when the call of our
Gillette preferred stock required us to convert it into common. The
after-tax earnings in 1990 from our preferred had been about $45
million, an amount somewhat higher than the combination in 1991 of
three months of dividends on our preferred plus nine months of
look-through earnings on the common.
Two other outcomes that I did not foresee also hurt look-
through earnings in 1991. First, we had a break-even result from
our interest in Wells Fargo (dividends we received from the company
were offset by negative retained earnings). Last year I said that
such a result at Wells was "a low-level possibility - not a
likelihood." Second, we recorded significantly lower - though still
excellent - insurance profits.
The following table shows you how we calculate look-through
earnings, although I warn you that the figures are necessarily very
rough. (The dividends paid to us by these investees have been
included in the operating earnings itemized on page 6, mostly
under "Insurance Group: Net Investment Income.")
Berkshire's Share
of Undistributed
Berkshire's Approximate Operating Earnings
Berkshire's Major Investees Ownership at Yearend (in millions)
--------------------------- ----------------------- ------------------
1991 1990 1991 1990
------ ------ -------- --------
Capital Cities/ABC Inc. ........ 18.1% 17.9% $ 61 $ 85
The Coca-Cola Company .......... 7.0% 7.0% 69 58
Federal Home Loan Mortgage Corp. 3.4%(1) 3.2%(1) 15 10
The Gillette Company ........... 11.0% --- 23(2) ---
GEICO Corp. .................... 48.2% 46.1% 69 76
The Washington Post Company .... 14.6% 14.6% 10 18
Wells Fargo & Company .......... 9.6% 9.7% (17) 19(3)
-------- --------
Berkshire's share of
undistributed earnings of major investees $230 $266
Hypothetical tax on these undistributed investee earnings (30) (35)
Reported operating earnings of Berkshire 316 371
-------- --------
Total look-through earnings of Berkshire $516 $602
======== ========
(1) Net of minority interest at Wesco
(2) For the nine months after Berkshire converted its
preferred on April 1
(3) Calculated on average ownership for the year
* * * * * * * * * * * *
We also believe that investors can benefit by focusing on
their own look-through earnings. To calculate these, they should
determine the underlying earnings attributable to the shares they
hold in their portfolio and total these. The goal of each investor
should be to create a portfolio (in effect, a "company") that will
deliver him or her the highest possible look-through earnings a
decade or so from now.
An approach of this kind will force the investor to think
about long-term business prospects rather than short-term stock
market prospects, a perspective likely to improve results. It's
true, of course, that, in the long run, the scoreboard for
investment decisions is market price. But prices will be determined
by future earnings. In investing, just as in baseball, to put runs
on the scoreboard one must watch the playing field, not the
scoreboard.
A Change in Media Economics and Some Valuation Math
In last year's report, I stated my opinion that the decline in
the profitability of media companies reflected secular as well as
cyclical factors. The events of 1991 have fortified that case: The
economic strength of once-mighty media enterprises continues to
erode as retailing patterns change and advertising and
entertainment choices proliferate. In the business world,
unfortunately, the rear-view mirror is always clearer than the
windshield: A few years back no one linked to the media business -
neither lenders, owners nor financial analysts - saw the economic
deterioration that was in store for the industry. (But give me a
few years and I'll probably convince myself that I did.)
The fact is that newspaper, television, and magazine
properties have begun to resemble businesses more than franchises
in their economic behavior. Let's take a quick look at the
characteristics separating these two classes of enterprise, keeping
in mind, however, that many operations fall in some middle ground
and can best be described as weak franchises or strong businesses.
An economic franchise arises from a product or service that:
(1) is needed or desired; (2) is thought by its customers to have
no close substitute and; (3) is not subject to price regulation.
The existence of all three conditions will be demonstrated by a
company's ability to regularly price its product or service
aggressively and thereby to earn high rates of return on capital.
Moreover, franchises can tolerate mis-management. Inept managers
may diminish a franchise's profitability, but they cannot inflict
mortal damage.
In contrast, "a business" earns exceptional profits only if it
is the low-cost operator or if supply of its product or service is
tight. Tightness in supply usually does not last long. With
superior management, a company may maintain its status as a low-
cost operator for a much longer time, but even then unceasingly
faces the possibility of competitive attack. And a business, unlike
a franchise, can be killed by poor management.
Until recently, media properties possessed the three
characteristics of a franchise and consequently could both price
aggressively and be managed loosely. Now, however, consumers
looking for information and entertainment (their primary interest
being the latter) enjoy greatly broadened choices as to where to
find them. Unfortunately, demand can't expand in response to this
new supply: 500 million American eyeballs and a 24-hour day are all
that's available. The result is that competition has intensified,
markets have fragmented, and the media industry has lost some -
though far from all - of its franchise strength.
* * * * * * * * * * * *
The industry's weakened franchise has an impact on its value
that goes far beyond the immediate effect on earnings. For an
understanding of this phenomenon, let's look at some much over-
simplified, but relevant, math.
A few years ago the conventional wisdom held that a newspaper,
television or magazine property would forever increase its earnings
at 6% or so annually and would do so without the employment of
additional capital, for the reason that depreciation charges would
roughly match capital expenditures and working capital requirements
would be minor. Therefore, reported earnings (before amortization
of intangibles) were also freely-distributable earnings, which
meant that ownership of a media property could be construed as akin
to owning a perpetual annuity set to grow at 6% a year. Say, next,
that a discount rate of 10% was used to determine the present value
of that earnings stream. One could then calculate that it was
appropriate to pay a whopping $25 million for a property with
current after-tax earnings of $1 million. (This after-tax multiplier
of 25 translates to a multiplier on pre-tax earnings of about 16.)
Now change the assumption and posit that the $1 million
represents "normal earning power" and that earnings will bob around
this figure cyclically. A "bob-around" pattern is indeed the lot of
most businesses, whose income stream grows only if their owners are
willing to commit more capital (usually in the form of retained
earnings). Under our revised assumption, $1 million of earnings,
discounted by the same 10%, translates to a $10 million valuation.
Thus a seemingly modest shift in assumptions reduces the property's
valuation to 10 times after-tax earnings (or about 6 1/2 times
pre-tax earnings).
Dollars are dollars whether they are derived from the
operation of media properties or of steel mills. What in the past
caused buyers to value a dollar of earnings from media far higher
than a dollar from steel was that the earnings of a media property
were expected to constantly grow (without the business requiring
much additional capital), whereas steel earnings clearly fell in
the bob-around category. Now, however, expectations for media have
moved toward the bob-around model. And, as our simplified example
illustrates, valuations must change dramatically when expectations
are revised.
We have a significant investment in media - both through our
direct ownership of Buffalo News and our shareholdings in The
Washington Post Company and Capital Cities/ABC - and the intrinsic
value of this investment has declined materially because of the
secular transformation that the industry is experiencing. (Cyclical
factors have also hurt our current look-through earnings, but these
factors do not reduce intrinsic value.) However, as our Business
Principles on page 2-3 note, one of the rules by which we run
Berkshire is that we do not sell businesses - or investee holdings
that we have classified as permanent - simply because we see ways
to use the money more advantageously elsewhere. (We did sell
certain other media holdings sometime back, but these were
relatively small.)
The intrinsic value losses that we have suffered have been
moderated because the Buffalo News, under Stan Lipsey's leadership,
has done far better than most newspapers and because both Cap
Cities and Washington Post are exceptionally well-managed. In
particular, these companies stayed on the sidelines during the late
1980's period in which purchasers of media properties regularly
paid irrational prices. Also, the debt of both Cap Cities and
Washington Post is small and roughly offset by cash that they hold.
As a result, the shrinkage in the value of their assets has not
been accentuated by the effects of leverage. Among publicly-owned
media companies, our two investees are about the only ones
essentially free of debt. Most of the other companies, through a
combination of the aggressive acquisition policies they pursued and
shrinking earnings, find themselves with debt equal to five or more
times their current net income.
The strong balance sheets and strong managements of Cap Cities
and Washington Post leave us more comfortable with these
investments than we would be with holdings in any other media
companies. Moreover, most media properties continue to have far
better economic characteristics than those possessed by the average
American business. But gone are the days of bullet-proof franchises
and cornucopian economics.
Twenty Years in a Candy Store
We've just passed a milestone: Twenty years ago, on January 3,
1972, Blue Chip Stamps (then an affiliate of Berkshire and later
merged into it) bought control of See's Candy Shops, a West Coast
manufacturer and retailer of boxed-chocolates. The nominal price
that the sellers were asking - calculated on the 100% ownership we
ultimately attained - was $40 million. But the company had $10
million of excess cash, and therefore the true offering price was
$30 million. Charlie and I, not yet fully appreciative of the value
of an economic franchise, looked at the company's mere $7 million
of tangible net worth and said $25 million was as high as we would
go (and we meant it). Fortunately, the sellers accepted our offer.
The sales of trading stamps by Blue Chip thereafter declined
from $102.5 million in 1972 to $1.2 million in 1991. But See's
candy sales in the same period increased from $29 million to $196
million. Moreover, profits at See's grew even faster than sales,
from $4.2 million pre-tax in 1972 to $42.4 million last year.
For an increase in profits to be evaluated properly, it must
be compared with the incremental capital investment required to
produce it. On this score, See's has been astounding: The company
now operates comfortably with only $25 million of net worth, which
means that our beginning base of $7 million has had to be
supplemented by only $18 million of reinvested earnings. Meanwhile,
See's remaining pre-tax profits of $410 million were distributed to
Blue Chip/Berkshire during the 20 years for these companies to
deploy (after payment of taxes) in whatever way made most sense.
In our See's purchase, Charlie and I had one important
insight: We saw that the business had untapped pricing power.
Otherwise, we were lucky twice over. First, the transaction was not
derailed by our dumb insistence on a $25 million price. Second, we
found Chuck Huggins, then See's executive vice-president, whom we
instantly put in charge. Both our business and personal experiences
with Chuck have been outstanding. One example: When the purchase
was made, we shook hands with Chuck on a compensation arrangement -
conceived in about five minutes and never reduced to a written
contract - that remains unchanged to this day.
In 1991, See's sales volume, measured in dollars, matched that
of 1990. In pounds, however, volume was down 4%. All of that
slippage took place in the last two months of the year, a period
that normally produces more than 80% of annual profits. Despite the
weakness in sales, profits last year grew 7%, and our pre-tax
profit margin was a record 21.6%.
Almost 80% of See's sales come from California and our
business clearly was hurt by the recession, which hit the state
with particular force late in the year. Another negative, however,
was the mid-year initiation in California of a sales tax of 7%-8«%
(depending on the county involved) on "snack food" that was deemed
applicable to our candy.
Shareholders who are students of epistemological shadings will
enjoy California's classifications of "snack" and "non-snack"
foods:
Taxable "Snack" Foods Non-Taxable "Non-Snack" Foods
--------------------- -----------------------------
Ritz Crackers Soda Crackers
Popped Popcorn Unpopped Popcorn
Granola Bars Granola Cereal
Slice of Pie (Wrapped) Whole Pie
Milky Way Candy Bar Milky Way Ice Cream Bar
What - you are sure to ask - is the tax status of a melted
Milky Way ice cream bar? In that androgynous form, does it more
resemble an ice cream bar or a candy bar that has been left in the
sun? It's no wonder that Brad Sherman, Chairman of California's
State Board of Equalization, who opposed the snack food bill but
must now administer it, has said: "I came to this job as a
specialist in tax law. Now I find my constituents should have
elected Julia Child."
Charlie and I have many reasons to be thankful for our
association with Chuck and See's. The obvious ones are that we've
earned exceptional returns and had a good time in the process.
Equally important, ownership of See's has taught us much about the
evaluation of franchises. We've made significant money in certain
common stocks because of the lessons we learned at See's.
H. H. Brown
We made a sizable acquisition in 1991 - the H. H. Brown
Company - and behind this business is an interesting history. In
1927 a 29-year-old businessman named Ray Heffernan purchased the
company, then located in North Brookfield, Massachusetts, for
$10,000 and began a 62-year career of running it. (He also found
time for other pursuits: At age 90 he was still joining new golf
clubs.) By Mr. Heffernan's retirement in early 1990 H. H. Brown had
three plants in the United States and one in Canada; employed close
to 2,000 people; and earned about $25 million annually before
taxes.
Along the way, Frances Heffernan, one of Ray's daughters,
married Frank Rooney, who was sternly advised by Mr. Heffernan
before the wedding that he had better forget any ideas he might
have about working for his father-in-law. That was one of Mr.
Heffernan's few mistakes: Frank went on to become CEO of Melville
Shoe (now Melville Corp.). During his 23 years as boss, from 1964
through 1986, Melville's earnings averaged more than 20% on equity
and its stock (adjusted for splits) rose from $16 to $960. And a
few years after Frank retired, Mr. Heffernan, who had fallen ill,
asked him to run Brown.
After Mr. Heffernan died late in 1990, his family decided to
sell the company - and here we got lucky. I had known Frank for a
few years but not well enough for him to think of Berkshire as a
possible buyer. He instead gave the assignment of selling Brown to
a major investment banker, which failed also to think of us. But
last spring Frank was playing golf in Florida with John Loomis, a
long-time friend of mine as well as a Berkshire shareholder, who is
always on the alert for something that might fit us. Hearing about
the impending sale of Brown, John told Frank that the company
should be right up Berkshire's alley, and Frank promptly gave me a
call. I thought right away that we would make a deal and before
long it was done.
Much of my enthusiasm for this purchase came from Frank's
willingness to continue as CEO. Like most of our managers, he has
no financial need to work but does so because he loves the game and
likes to excel. Managers of this stripe cannot be "hired" in the
normal sense of the word. What we must do is provide a concert hall
in which business artists of this class will wish to perform.
Brown (which, by the way, has no connection to Brown Shoe of
St. Louis) is the leading North American manufacturer of work shoes
and boots, and it has a history of earning unusually fine margins
on sales and assets. Shoes are a tough business - of the billion
pairs purchased in the United States each year, about 85% are
imported - and most manufacturers in the industry do poorly. The
wide range of styles and sizes that producers offer causes
inventories to be heavy; substantial capital is also tied up in
receivables. In this kind of environment, only outstanding managers
like Frank and the group developed by Mr. Heffernan can prosper.
A distinguishing characteristic of H. H. Brown is one of the
most unusual compensation systems I've encountered - but one that
warms my heart: A number of key managers are paid an annual salary
of $7,800, to which is added a designated percentage of the profits
of the company after these are reduced by a charge for capital
employed. These managers therefore truly stand in the shoes of
owners. In contrast, most managers talk the talk but don't walk the
walk, choosing instead to employ compensation systems that are long
on carrots but short on sticks (and that almost invariably treat
equity capital as if it were cost-free). The arrangement at Brown,
in any case, has served both the company and its managers
exceptionally well, which should be no surprise: Managers eager to
bet heavily on their abilities usually have plenty of ability to
bet on.
* * * * * * * * * * * *
It's discouraging to note that though we have on four
occasions made major purchases of companies whose sellers were
represented by prominent investment banks, we were in only one of
these instances contacted by the investment bank. In the other
three cases, I myself or a friend initiated the transaction at some
point after the investment bank had solicited its own list of
prospects. We would love to see an intermediary earn its fee by
thinking of us - and therefore repeat here 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. (With Brown,
we didn't even need to take five.) 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 pattern
through which we acquired Nebraska Furniture Mart, Fechheimer's and
Borsheim's. 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 and
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. A line from a
country song expresses our feeling about new ventures, turnarounds,
or auction-like sales: "When the phone don't ring, you'll know it's
me."
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, Champion, and
American Express. We are not interested, however, in receiving
suggestions about purchases we might make in the general stock
market.
Insurance Operations
Shown below is an updated version of our usual table
presenting key figures for the property-casualty insurance
industry:
Yearly Change Combined Ratio Yearly Change Inflation Rate
in Premiums After Policyholder in Incurred Measured by
Written (%) Dividends Losses (%) GDP Deflator (%)
------------- ------------------ ------------- ----------------
1981 ..... 3.8 106.0 6.5 10.0
1982 ..... 3.7 109.6 8.4 6.2
1983 ..... 5.0 112.0 6.8 4.0
1984 ..... 8.5 118.0 16.9 4.5
1985 ..... 22.1 116.3 16.1 3.7
1986 ..... 22.2 108.0 13.5 2.7
1987 ..... 9.4 104.6 7.8 3.1
1988 ..... 4.4 105.4 5.5 3.9
1989 ..... 3.2 109.2 7.7 4.4
1990 (Revised) 4.4 109.6 4.8 4.1
1991 (Est.) 3.1 109.1 2.9 3.7
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 higher the ratio, the worse the year.
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 break-even result, exclusive of earnings on the funds
provided by shareholders.
For the reasons laid out in previous reports, we expect the
industry's incurred losses to grow at close to 10% annually, even
in periods when general inflation runs considerably lower. (Over
the last 25 years, incurred losses have in reality grown at a
still faster rate, 11%.) If premium growth meanwhile materially
lags that 10% rate, underwriting losses will mount.
However, the industry's tendency to under-reserve when
business turns bad may obscure the picture for a time - and that
could well describe the situation last year. Though premiums did
not come close to growing 10%, the combined ratio failed to
deteriorate as I had expected but instead slightly improved.
Loss-reserve data for the industry indicate that there is reason
to be skeptical of that outcome, and it may turn out that 1991's
ratio should have been worse than was reported. In the long run,
of course, trouble awaits managements that paper over operating
problems with accounting maneuvers. Eventually, managements of
this kind achieve the same result as the seriously-ill patient
who tells his doctor: "I can't afford the operation, but would
you accept a small payment to touch up the x-rays?"
Berkshire's insurance business has changed in ways that make
combined ratios, our own or the industry's, largely irrelevant
to our performance. What counts with us is the "cost of funds
developed from insurance," or in the vernacular, "the cost of
float."
Float - which we generate in exceptional amounts - is the
total of loss reserves, loss adjustment expense reserves and
unearned premium reserves minus agents balances, prepaid
acquisition costs and deferred charges applicable to assumed
reinsurance. And the cost of float is measured by our
underwriting loss.
The table below shows our cost of float since we entered the
business in 1967.
(1) (2) Yearend Yield
Underwriting Approximate on Long-Term
Loss Average Float Cost of Funds Govt. Bonds
------------ ------------- --------------- -------------
(In $ Millions) (Ratio of 1 to 2)
1967 ........ profit $17.3 less than zero 5.50%
1968 ........ profit 19.9 less than zero 5.90%
1969 ........ profit 23.4 less than zero 6.79%
1970 ........ $0.37 32.4 1.14% 6.25%
1971 ........ profit 52.5 less than zero 5.81%
1972 ........ profit 69.5 less than zero 5.82%
1973 ........ profit 73.3 less than zero 7.27%
1974 ........ 7.36 79.1 9.30% 8.13%
1975 ........ 11.35 87.6 12.96% 8.03%
1976 ........ profit 102.6 less than zero 7.30%
1977 ........ profit 139.0 less than zero 7.97%
1978 ........ profit 190.4 less than zero 8.93%
1979 ........ profit 227.3 less than zero 10.08%
1980 ........ profit 237.0 less than zero 11.94%
1981 ........ profit 228.4 less than zero 13.61%
1982 ........ 21.56 220.6 9.77% 10.64%
1983 ........ 33.87 231.3 14.64% 11.84%
1984 ........ 48.06 253.2 18.98% 11.58%
1985 ........ 44.23 390.2 11.34% 9.34%
1986 ........ 55.84 797.5 7.00% 7.60%
1987 ........ 55.43 1,266.7 4.38% 8.95%
1988 ........ 11.08 1,497.7 0.74% 9.00%
1989 ........ 24.40 1,541.3 1.58% 7.97%
1990 ........ 26.65 1,637.3 1.63% 8.24%
1991 ........ 119.6 1,895.0 6.31% 7.40%
As you can see, our cost of funds in 1991 was well below the
U. S. Government's cost on newly-issued long-term bonds. We have in
fact beat the government's rate in 20 of the 25 years we have been
in the insurance business, often by a wide margin. We have over
that time also substantially increased the amount of funds we hold,
which counts as a favorable development but only because the cost
of funds has been satisfactory. Our float should continue to grow;
the challenge will be to garner these funds at a reasonable cost.
Berkshire continues to be a very large writer - perhaps the
largest in the world - of "super-cat" insurance, which is coverage
that other insurance companies buy to protect themselves against
major catastrophic losses. Profits in this business are enormously
volatile. As I mentioned last year, $100 million in super-cat
premiums, which is roughly our annual expectation, could deliver us
anything from a $100 million profit (in a year with no big
catastrophe) to a $200 million loss (in a year in which a couple of
major hurricanes and/or earthquakes come along).
We price this business expecting to pay out, over the long
term, about 90% of the premiums we receive. In any given year,
however, we are likely to appear either enormously profitable or
enormously unprofitable. That is true in part because GAAP
accounting does not allow us to set up reserves in the catastrophe-
free years for losses that are certain to be experienced in other
years. In effect, a one-year accounting cycle is ill-suited to the
nature of this business - and that is a reality you should be aware
of when you assess our annual results.
Last year there appears to have been, by our definition, one
super-cat, but it will trigger payments from only about 25% of our
policies. Therefore, we currently estimate the 1991 underwriting
profit from our catastrophe business to have been about $11
million. (You may be surprised to learn the identity of the biggest
catastrophe in 1991: It was neither the Oakland fire nor Hurricane
Bob, but rather a September typhoon in Japan that caused the
industry an insured loss now estimated at about $4-$5 billion. At
the higher figure, the loss from the typhoon would surpass that
from Hurricane Hugo, the previous record-holder.)
Insurers will always need huge amounts of reinsurance
protection for marine and aviation disasters as well as for natural
catastrophes. In the 1980's much of this reinsurance was supplied
by "innocents" - that is, by insurers that did not understand the
risks of the business - but they have now been financially burned
beyond recognition. (Berkshire itself was an innocent all too often
when I was personally running the insurance operation.) Insurers,
though, like investors, eventually repeat their mistakes. At some
point - probably after a few catastrophe-scarce years - innocents
will reappear and prices for super-cat policies will plunge to
silly levels.
As long as apparently-adequate rates prevail, however, we will
be a major participant in super-cat coverages. In marketing this
product, we enjoy a significant competitive advantage because of
our premier financial strength. Thinking insurers know that when
"the big one" comes, many reinsurers who found it easy to write
policies will find it difficult to write checks. (Some reinsurers
can say what Jackie Mason does: "I'm fixed for life - as long as I
don't buy anything.") Berkshire's ability to fulfill all its
commitments under conditions of even extreme adversity is
unquestioned.
Overall, insurance offers Berkshire its greatest
opportunities. Mike Goldberg has accomplished wonders with this
operation since he took charge and it has become a very valuable
asset, albeit one that can't be appraised with any precision.
Marketable Common Stocks
On the next page 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%.
12/31/91
Shares Company Cost Market
------ ------- ---------- ----------
(000s omitted)
3,000,000 Capital Cities/ABC, Inc. ............ $ 517,500 $1,300,500
46,700,000 The Coca-Cola Company. .............. 1,023,920 3,747,675
2,495,200 Federal Home Loan Mortgage Corp. .... 77,245 343,090
6,850,000 GEICO Corp. ......................... 45,713 1,363,150
24,000,000 The Gillette Company ................ 600,000 1,347,000
31,247,000 Guinness PLC ........................ 264,782 296,755
1,727,765 The Washington Post Company ......... 9,731 336,050
5,000,000 Wells Fargo & Company 289,431 290,000
As usual the list reflects our Rip Van Winkle approach to
investing. Guinness is a new position. But we held the other seven
stocks a year ago (making allowance for the conversion of our
Gillette position from preferred to common) and in six of those we
hold an unchanged number of shares. The exception is Federal Home
Loan Mortgage ("Freddie Mac"), in which our shareholdings increased
slightly. Our stay-put behavior reflects our view that the stock
market serves as a relocation center at which money is moved from
the active to the patient. (With tongue only partly in check, I
suggest that recent events indicate that the much-maligned "idle
rich" have received a bad rap: They have maintained or increased
their wealth while many of the "energetic rich" - aggressive real
estate operators, corporate acquirers, oil drillers, etc. - have
seen their fortunes disappear.)
Our Guinness holding represents Berkshire's first significant
investment in a company domiciled outside the United States.
Guinness, however, earns its money in much the same fashion as
Coca-Cola and Gillette, U.S.-based companies that garner most of
their profits from international operations. Indeed, in the sense
of where they earn their profits - continent-by-continent - Coca-
Cola and Guinness display strong similarities. (But you'll never
get their drinks confused - and your Chairman remains unmovably in
the Cherry Coke camp.)
We continually search for large businesses with
understandable, enduring and mouth-watering economics that are run
by able and shareholder-oriented managements. This focus doesn't
guarantee results: We both have to buy at a sensible price and get
business performance from our companies that validates our
assessment. But this investment approach - searching for the
superstars - offers us our only chance for real success. Charlie
and I are simply not smart enough, considering the large sums we
work with, to get great results by adroitly buying and selling
portions of far-from-great businesses. Nor do we think many others
can achieve long-term investment success by flitting from flower to
flower. Indeed, we believe that according the name "investors" to
institutions that trade actively is like calling someone who
repeatedly engages in one-night stands a romantic.
If my universe of business possibilities was limited, say, to
private companies in Omaha, I would, first, try to assess the long-
term economic characteristics of each business; second, assess the
quality of the people in charge of running it; and, third, try to
buy into a few of the best operations at a sensible price. I
certainly would not wish to own an equal part of every business in
town. Why, then, should Berkshire take a different tack when
dealing with the larger universe of public companies? And since
finding great businesses and outstanding managers is so difficult,
why should we discard proven products? (I was tempted to say "the
real thing.") Our motto is: "If at first you do succeed, quit
trying."
John Maynard Keynes, whose brilliance as a practicing investor
matched his brilliance in thought, wrote a letter to a business
associate, F. C. Scott, on August 15, 1934 that says it all: "As
time goes on, I get more and more convinced that the right method
in investment is to put fairly large sums into enterprises which
one thinks one knows something about and in the management of which
one thoroughly believes. It is a mistake to think that one limits
one's risk by spreading too much between enterprises about which
one knows little and has no reason for special confidence. . . .
One's knowledge and experience are definitely limited and there are
seldom more than two or three enterprises at any given time in
which I personally feel myself entitled to put full confidence."
Mistake Du Jour
In the 1989 annual report I wrote about "Mistakes of the First
25 Years" and promised you an update in 2015. My experiences in the
first few years of this second "semester" indicate that my backlog
of matters to be discussed will become unmanageable if I stick to
my original plan. Therefore, I will occasionally unburden myself in
these pages in the hope that public confession may deter further
bumblings. (Post-mortems prove useful for hospitals and football
teams; why not for businesses and investors?)
Typically, our most egregious mistakes fall in the omission,
rather than the commission, category. That may spare Charlie and me
some embarrassment, since you don't see these errors; but their
invisibility does not reduce their cost. In this mea culpa, I am
not talking about missing out on some company that depends upon an
esoteric invention (such as Xerox), high-technology (Apple), or
even brilliant merchandising (Wal-Mart). We will never develop the
competence to spot such businesses early. Instead I refer to
business situations that Charlie and I can understand and that seem
clearly attractive - but in which we nevertheless end up sucking
our thumbs rather than buying.
Every writer knows it helps to use striking examples, but I
wish the one I now present wasn't quite so dramatic: In early 1988,
we decided to buy 30 million shares (adjusted for a subsequent
split) of Federal National Mortgage Association (Fannie Mae), which
would have been a $350-$400 million investment. We had owned the
stock some years earlier and understood the company's business.
Furthermore, it was clear to us that David Maxwell, Fannie Mae's
CEO, had dealt superbly with some problems that he had inherited
and had established the company as a financial powerhouse - with
the best yet to come. I visited David in Washington and confirmed
that he would not be uncomfortable if we were to take a large
position.
After we bought about 7 million shares, the price began to
climb. In frustration, I stopped buying (a mistake that,
thankfully, I did not repeat when Coca-Cola stock rose similarly
during our purchase program). In an even sillier move, I
surrendered to my distaste for holding small positions and sold the
7 million shares we owned.
I wish I could give you a halfway rational explanation for my
amateurish behavior vis-a-vis Fannie Mae. But there isn't one.
What I can give you is an estimate as of yearend 1991 of the
approximate gain that Berkshire didn't make because of your
Chairman's mistake: about $1.4 billion.
Fixed-Income Securities
We made several significant changes in our fixed-income
portfolio during 1991. As I noted earlier, our Gillette preferred
was called for redemption, which forced us to convert to common
stock; we eliminated our holdings of an RJR Nabisco issue that was
subject to an exchange offer and subsequent call; and we purchased
fixed-income securities of American Express and First Empire State
Corp., a Buffalo-based bank holding company. We also added to a
small position in ACF Industries that we had established in late
1990. Our largest holdings at yearend were:
(000s omitted)
---------------------------------------
Cost of Preferreds and
Issuer Amortized Value of Bonds Market
------ ------------------------ ------------
ACF Industries ................ $ 93,918(2) $118,683
American Express .............. 300,000 263,265(1)(2)
Champion International ........ 300,000(2) 300,000(1)
First Empire State 40,000 50,000(1)(2)
RJR Nabisco 222,148(2) 285,683
Salomon 700,000(2) 714,000(1)
USAir 358,000(2) 232,700(1)
Washington Public Power Systems 158,553(2) 203,071
(1) Fair value as determined by Charlie and me
(2) Carrying value in our financial statements
Our $40 million of First Empire State preferred carries a 9%
coupon, is non-callable until 1996 and is convertible at $78.91 per
share. Normally I would think a purchase of this size too small for
Berkshire, but I have enormous respect for Bob Wilmers, CEO of
First Empire, and like being his partner on any scale.
Our American Express preferred is not a normal fixed-income
security. Rather it is a "Perc," which carries a fixed dividend of
8.85% on our $300 million cost. Absent one exception mentioned
later, our preferred must be converted three years after issuance,
into a maximum of 12,244,898 shares. If necessary, a downward
adjustment in the conversion ratio will be made in order to limit
to $414 million the total value of the common we receive. Though
there is thus a ceiling on the value of the common stock that we
will receive upon conversion, there is no floor. The terms of the
preferred, however, include a provision allowing us to extend the
conversion date by one year if the common stock is below $24.50 on
the third anniversary of our purchase.
Overall, our fixed-income investments have treated us well,
both over the long term and recently. We have realized large
capital gains from these holdings, including about $152 million in
1991. Additionally, our after-tax yields have considerably exceeded
those earned by most fixed-income portfolios.
Nevertheless, we have had some surprises, none greater than
the need for me to involve myself personally and intensely in the
Salomon situation. As I write this letter, I am also writing a
letter for inclusion in Salomon's annual report and I refer you to
that report for an update on the company. (Write to: Corporate
Secretary, Salomon Inc, Seven World Trade Center, New York, NY
10048) Despite the company's travails, Charlie and I believe our
Salomon preferred stock increased slightly in value during 1991.
Lower interest rates and a higher price for Salomon's common
produced this result.
Last year I told you that our USAir investment "should work
out all right unless the industry is decimated during the next few
years." Unfortunately 1991 was a decimating period for the
industry, as Midway, Pan Am and America West all entered
bankruptcy. (Stretch the period to 14 months and you can add
Continental and TWA.)
The low valuation that we have given USAir in our table
reflects the risk that the industry will remain unprofitable for
virtually all participants in it, a risk that is far from
negligible. The risk is heightened by the fact that the courts have
been encouraging bankrupt carriers to continue operating. These
carriers can temporarily charge fares that are below the industry's
costs because the bankrupts don't incur the capital costs faced by
their solvent brethren and because they can fund their losses - and
thereby stave off shutdown - by selling off assets. This burn-the-
furniture-to-provide-firewood approach to fare-setting by bankrupt
carriers contributes to the toppling of previously-marginal
carriers, creating a domino effect that is perfectly designed to
bring the industry to its knees.
Seth Schofield, who became CEO of USAir in 1991, is making
major adjustments in the airline's operations in order to improve
its chances of being one of the few industry survivors. There is no
tougher job in corporate America than running an airline: Despite
the huge amounts of equity capital that have been injected into it,
the industry, in aggregate, has posted a net loss since its birth
after Kitty Hawk. Airline managers need brains, guts, and
experience - and Seth possesses all three of these attributes.
Miscellaneous
About 97.7% of all eligible shares participated in Berkshire's
1991 shareholder-designated contributions program. Contributions
made through the program were $6.8 million, and 2,630 charities
were recipients.
We suggest that new shareholders read the description of our
shareholder-designated contributions program that appears on pages
48-49. To participate in future programs, you must 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, 1992 will be ineligible for the 1992
program.
In addition to the shareholder-designated contributions that
Berkshire distributes, managers of our operating businesses make
contributions, including merchandise, averaging about $1.5 million
annually. These contributions support local charities, such as The
United Way, and produce roughly commensurate benefits for our
businesses.
However, neither our operating managers nor officers of the
parent company use Berkshire funds to make contributions to broad
national programs or charitable activities of special personal
interest to them, except to the extent they do so as shareholders.
If your employees, including your CEO, wish to give to their alma
maters or other institutions to which they feel a personal
attachment, we believe they should use their own money, not yours.
* * * * * * * * * * * *
The faithful will notice that, for the first time in some
years, Charlie's annual letter to Wesco shareholders is not
reprinted in this report. Since his letter is relatively barebones
this year, Charlie said he saw no point in including it in these
pages; my own recommendation, however, is that you get a copy of
the Wesco report. Simply write: Corporate Secretary, Wesco
Financial Corporation, 315 East Colorado Boulevard, Pasadena, CA
91101.
* * * * * * * * * * * *
Malcolm G. Chace, Jr., now 88, has decided not to stand for
election as a director this year. But the association of the Chace
family with Berkshire will not end: Malcolm III (Kim), Malcolm's
son, will be nominated to replace him.
In 1931, Malcolm went to work for Berkshire Fine Spinning
Associates, which merged with Hathaway Manufacturing Co. in 1955 to
form our present company. Two years later, Malcolm became Berkshire
Hathaway's Chairman, a position he held as well in early 1965 when
he made it possible for Buffett Partnership, Ltd. to buy a key
block of Berkshire stock owned by some of his relatives. This
purchase gave our partnership effective control of the company.
Malcolm's immediate family meanwhile kept its Berkshire stock and
for the last 27 years has had the second-largest holding in the
company, trailing only the Buffett family. Malcolm has been a joy
to work with and we are delighted that the long-running
relationship between the Chace family and Berkshire is continuing
to a new generation.
* * * * * * * * * * * *
The annual meeting this year will be held at the Orpheum
Theater in downtown Omaha at 9:30 a.m. on Monday, April 27, 1992.
Attendance last year grew to a record 1,550, but that still leaves
plenty of room at the Orpheum.
We recommend that you get your hotel reservations early at one
of these hotels: (1) The Radisson-Redick Tower, a small (88 rooms)
but nice hotel across the street from the Orpheum; (2) the much
larger Red Lion Hotel, located about a five-minute walk from the
Orpheum; or (3) the Marriott, located in West Omaha about 100 yards
from Borsheim's and a twenty minute drive from downtown. 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. With
the admission card, we will enclose information about parking
facilities located near the Orpheum. If you are driving, come a
little early. Nearby lots fill up quickly and you may have to
walk a few blocks.
As usual, we will have buses to take you to Nebraska Furniture
Mart and Borsheim's after the meeting and to take you from there to
downtown hotels or 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. While there, stop at the See's
Candy Cart and find out for yourself why Americans ate 26 million
pounds of See's products last year.
Borsheim's normally is closed on Sunday, but we will be open
for shareholders and their guests from noon to 6 p.m. on Sunday,
April 26. Borsheim's will also have a special party the previous
evening at which shareholders are welcome. (You must, however,
write Mrs. Gladys Kaiser at our office for an invitation.) On
display that evening will be a 150-year retrospective of the most
exceptional timepieces made by Patek Philippe, including watches
once owned by Queen Victoria, Pope Pius IX, Rudyard Kipling, Madame
Curie and Albert Einstein. The centerpiece of the exhibition will
be a $5 million watch whose design and manufacture required nine
years of labor by Patek Philippe craftsmen. Along with the rest of
the collection, this watch will be on display at the store on
Sunday - unless Charlie has by then impulsively bought it.
Nicholas Kenner nailed me - again - at last year's meeting,
pointing out that I had said in the 1990 annual report that he was
11 in May 1990, when actually he was 9. So, asked Nicholas rather
caustically: "If you can't get that straight, how do I know the
numbers in the back [the financials] are correct?" I'm still
searching for a snappy response. Nicholas will be at this year's
meeting - he spurned my offer of a trip to Disney World on that
day - so join us to watch a continuation of this lop-sided battle
of wits.
Warren E. Buffett
February 28, 1992 Chairman of the Board