BERKSHIRE HATHAWAY INC.
To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 1984 was $152.6 million, or
$133 per share. This sounds pretty good but actually it’s
mediocre. Economic gains must be evaluated by comparison with
the capital that produces them. Our twenty-year compounded
annual gain in book value has been 22.1% (from $19.46 in 1964 to
$1108.77 in 1984), but our gain in 1984 was only 13.6%.
As we discussed last year, the gain in per-share intrinsic
business value is the economic measurement that really counts.
But calculations of intrinsic business value are subjective. In
our case, book value serves as a useful, although somewhat
understated, proxy. In my judgment, intrinsic business value and
book value increased during 1984 at about the same rate.
Using my academic voice, I have told you in the past of the
drag that a mushrooming capital base exerts upon rates of return.
Unfortunately, my academic voice is now giving way to a
reportorial voice. Our historical 22% rate is just that -
history. To earn even 15% annually over the next decade
(assuming we continue to follow our present dividend policy,
about which more will be said later in this letter) we would need
profits aggregating about $3.9 billion. Accomplishing this will
require a few big ideas - small ones just won’t do. Charlie
Munger, my partner in general management, and I do not have any
such ideas at present, but our experience has been that they pop
up occasionally. (How’s that for a strategic plan?)
Sources of Reported Earnings
The table on the following page shows the sources of
Berkshire’s reported earnings. Berkshire’s net ownership
interest in many of the constituent businesses changed at midyear
1983 when the Blue Chip merger took place. Because of these
changes, the first two columns of the table provide the best
measure of underlying business performance.
All of the significant gains and losses attributable to
unusual sales of assets by any of the business entities are
aggregated with securities transactions on the line near the
bottom of the table, and are not included in operating earnings.
(We regard any annual figure for realized capital gains or losses
as meaningless, but we regard the aggregate realized and
unrealized capital gains over a period of years as very
important.)
Furthermore, amortization of Goodwill is not charged against
the specific businesses but, for reasons outlined in the Appendix
to my letter in the 1983 annual report, is set forth as a
separate item.
(000s omitted)
----------------------------------------------------------
Net Earnings
Earnings Before Income Taxes After Tax
-------------------------------------- ------------------
Total Berkshire Share Berkshire Share
------------------ ------------------ ------------------
1984 1983 1984 1983 1984 1983
-------- -------- -------- -------- -------- --------
Operating Earnings:
Insurance Group:
Underwriting ............ $(48,060) $(33,872) $(48,060) $(33,872) $(25,955) $(18,400)
Net Investment Income ... 68,903 43,810 68,903 43,810 62,059 39,114
Buffalo News .............. 27,328 19,352 27,328 16,547 13,317 8,832
Nebraska Furniture Mart(1) 14,511 3,812 11,609 3,049 5,917 1,521
See’s Candies ............. 26,644 27,411 26,644 24,526 13,380 12,212
Associated Retail Stores .. (1,072) 697 (1,072) 697 (579) 355
Blue Chip Stamps(2) (1,843) (1,422) (1,843) (1,876) (899) (353)
Mutual Savings and Loan ... 1,456 (798) 1,166 (467) 3,151 1,917
Precision Steel ........... 4,092 3,241 3,278 2,102 1,696 1,136
Textiles .................. 418 (100) 418 (100) 226 (63)
Wesco Financial ........... 9,777 7,493 7,831 4,844 4,828 3,448
Amortization of Goodwill .. (1,434) (532) (1,434) (563) (1,434) (563)
Interest on Debt .......... (14,734) (15,104) (14,097) (13,844) (7,452) (7,346)
Shareholder-Designated
Contributions .......... (3,179) (3,066) (3,179) (3,066) (1,716) (1,656)
Other ..................... 4,932 10,121 4,529 9,623 3,476 8,490
-------- -------- -------- -------- -------- --------
Operating Earnings .......... 87,739 61,043 82,021 51,410 70,015 48,644
Special GEICO Distribution .. -- 19,575 -- 19,575 -- 18,224
Special Gen. Foods Distribution 8,111 -- 7,896 -- 7,294 --
Sales of securities and
unusual sales of assets .. 104,699 67,260 101,376 65,089 71,587 45,298
-------- -------- -------- -------- -------- --------
Total Earnings - all entities $200,549 $147,878 $191,293 $136,074 $148,896 $112,166
======== ======== ======== ======== ======== ========
(1) 1983 figures are those for October through December.
(2) 1984 and 1983 are not comparable; major assets were
transferred in the mid-year 1983 merger of Blue Chip Stamps.
Sharp-eyed shareholders will notice that the amount of the
special GEICO distribution and its location in the table have
been changed from the presentation of last year. Though they
reclassify and reduce “accounting” earnings, the changes are
entirely of form, not of substance. The story behind the
changes, however, is interesting.
As reported last year: (1) in mid-1983 GEICO made a tender
offer to buy its own shares; (2) at the same time, we agreed by
written contract to sell GEICO an amount of its shares that would
be proportionately related to the aggregate number of shares
GEICO repurchased via the tender from all other shareholders; (3)
at completion of the tender, we delivered 350,000 shares to
GEICO, received $21 million cash, and were left owning exactly
the same percentage of GEICO that we owned before the tender; (4)
GEICO’s transaction with us amounted to a proportionate
redemption, an opinion rendered us, without qualification, by a
leading law firm; (5) the Tax Code logically regards such
proportionate redemptions as substantially equivalent to
dividends and, therefore, the $21 million we received was taxed
at only the 6.9% inter-corporate dividend rate; (6) importantly,
that $21 million was far less than the previously-undistributed
earnings that had inured to our ownership in GEICO and, thus,
from the standpoint of economic substance, was in our view
equivalent to a dividend.
Because it was material and unusual, we highlighted the
GEICO distribution last year to you, both in the applicable
quarterly report and in this section of the annual report.
Additionally, we emphasized the transaction to our auditors,
Peat, Marwick, Mitchell & Co. Both the Omaha office of Peat
Marwick and the reviewing Chicago partner, without objection,
concurred with our dividend presentation.
In 1984, we had a virtually identical transaction with
General Foods. The only difference was that General Foods
repurchased its stock over a period of time in the open market,
whereas GEICO had made a “one-shot” tender offer. In the General
Foods case we sold to the company, on each day that it
repurchased shares, a quantity of shares that left our ownership
percentage precisely unchanged. Again our transaction was
pursuant to a written contract executed before repurchases began.
And again the money we received was far less than the retained
earnings that had inured to our ownership interest since our
purchase. Overall we received $21,843,601 in cash from General
Foods, and our ownership remained at exactly 8.75%.
At this point the New York office of Peat Marwick came into
the picture. Late in 1984 it indicated that it disagreed with
the conclusions of the firm’s Omaha office and Chicago reviewing
partner. The New York view was that the GEICO and General Foods
transactions should be treated as sales of stock by Berkshire
rather than as the receipt of dividends. Under this accounting
approach, a portion of the cost of our investment in the stock of
each company would be charged against the redemption payment and
any gain would be shown as a capital gain, not as dividend
income. This is an accounting approach only, having no bearing
on taxes: Peat Marwick agrees that the transactions were
dividends for IRS purposes.
We disagree with the New York position from both the
viewpoint of economic substance and proper accounting. But, to
avoid a qualified auditor’s opinion, we have adopted herein Peat
Marwick’s 1984 view and restated 1983 accordingly. None of this,
however, has any effect on intrinsic business value: our
ownership interests in GEICO and General Foods, our cash, our
taxes, and the market value and tax basis of our holdings all
remain the same.
This year we have again entered into a contract with General
Foods whereby we will sell them shares concurrently with open
market purchases that they make. The arrangement provides that
our ownership interest will remain unchanged at all times. By
keeping it so, we will insure ourselves dividend treatment for
tax purposes. In our view also, the economic substance of this
transaction again is the creation of dividend income. However,
we will account for the redemptions as sales of stock rather than
dividend income unless accounting rules are adopted that speak
directly to this point. We will continue to prominently identify
any such special transactions in our reports to you.
While we enjoy a low tax charge on these proportionate
redemptions, and have participated in several of them, we view
such repurchases as at least equally favorable for shareholders
who do not sell. When companies with outstanding businesses and
comfortable financial positions find their shares selling far
below intrinsic value in the marketplace, no alternative action
can benefit shareholders as surely as repurchases.
(Our endorsement of repurchases is limited to those dictated
by price/value relationships and does not extend to the
“greenmail” repurchase - a practice we find odious and repugnant.
In these transactions, two parties achieve their personal ends by
exploitation of an innocent and unconsulted third party. The
players are: (1) the “shareholder” extortionist who, even before
the ink on his stock certificate dries, delivers his “your-
money-or-your-life” message to managers; (2) the corporate
insiders who quickly seek peace at any price - as long as the
price is paid by someone else; and (3) the shareholders whose
money is used by (2) to make (1) go away. As the dust settles,
the mugging, transient shareholder gives his speech on “free
enterprise”, the muggee management gives its speech on “the best
interests of the company”, and the innocent shareholder standing
by mutely funds the payoff.)
The companies in which we have our largest investments have
all engaged in significant stock repurhases at times when wide
discrepancies existed between price and value. As shareholders,
we find this encouraging and rewarding for two important reasons
- one that is obvious, and one that is subtle and not always
understood. The obvious point involves basic arithmetic: major
repurchases at prices well below per-share intrinsic business
value immediately increase, in a highly significant way, that
value. When companies purchase their own stock, they often find
it easy to get $2 of present value for $1. Corporate acquisition
programs almost never do as well and, in a discouragingly large
number of cases, fail to get anything close to $1 of value for
each $1 expended.
The other benefit of repurchases is less subject to precise
measurement but can be fully as important over time. By making
repurchases when a company’s market value is well below its
business value, management clearly demonstrates that it is given
to actions that enhance the wealth of shareholders, rather than
to actions that expand management’s domain but that do nothing
for (or even harm) shareholders. Seeing this, shareholders and
potential shareholders increase their estimates of future returns
from the business. This upward revision, in turn, produces
market prices more in line with intrinsic business value. These
prices are entirely rational. Investors should pay more for a
business that is lodged in the hands of a manager with
demonstrated pro-shareholder leanings than for one in the hands
of a self-interested manager marching to a different drummer. (To
make the point extreme, how much would you pay to be a minority
shareholder of a company controlled by Robert Wesco?)
The key word is “demonstrated”. A manager who consistently
turns his back on repurchases, when these clearly are in the
interests of owners, reveals more than he knows of his
motivations. No matter how often or how eloquently he mouths
some public relations-inspired phrase such as “maximizing
shareholder wealth” (this season’s favorite), the market
correctly discounts assets lodged with him. His heart is not
listening to his mouth - and, after a while, neither will the
market.
We have prospered in a very major way - as have other
shareholders - by the large share repurchases of GEICO,
Washington Post, and General Foods, our three largest holdings.
(Exxon, in which we have our fourth largest holding, has also
wisely and aggressively repurchased shares but, in this case, we
have only recently established our position.) In each of these
companies, shareholders have had their interests in outstanding
businesses materially enhanced by repurchases made at bargain
prices. We feel very comfortable owning interests in businesses
such as these that offer excellent economics combined with
shareholder-conscious managements.
The following table shows our 1984 yearend net holdings in
marketable equities. All numbers exclude the interests
attributable to minority shareholders of Wesco and Nebraska
Furniture Mart.
No. of Shares Cost Market
------------- ---------- ----------
(000s omitted)
690,975 Affiliated Publications, Inc. ....... $ 3,516 $ 32,908
740,400 American Broadcasting Companies, Inc. 44,416 46,738
3,895,710 Exxon Corporation ................... 173,401 175,307
4,047,191 General Foods Corporation ........... 149,870 226,137
6,850,000 GEICO Corporation ................... 45,713 397,300
2,379,200 Handy & Harman ...................... 27,318 38,662
818,872 Interpublic Group of Companies, Inc. 2,570 28,149
555,949 Northwest Industries 26,581 27,242
2,553,488 Time, Inc. .......................... 89,327 109,162
1,868,600 The Washington Post Company ......... 10,628 149,955
---------- ----------
$573,340 $1,231,560
All Other Common Stockholdings 11,634 37,326
---------- ----------
Total Common Stocks $584,974 $1,268,886
========== ==========
It’s been over ten years since it has been as difficult as
now to find equity investments that meet both our qualitative
standards and our quantitative standards of value versus price.
We try to avoid compromise of these standards, although we find
doing nothing the most difficult task of all. (One English
statesman attributed his country’s greatness in the nineteenth
century to a policy of “masterly inactivity”. This is a strategy
that is far easier for historians to commend than for
participants to follow.)
In addition to the figures supplied at the beginning of this
section, information regarding the businesses we own appears in
Management’s Discussion on pages 42-47. An amplified discussion
of Wesco’s businesses appears in Charlie Munger’s report on pages
50-59. You will find particularly interesting his comments about
conditions in the thrift industry. Our other major controlled
businesses are Nebraska Furniture Mart, See’s, Buffalo Evening
News, and the Insurance Group, to which we will give some special
attention here.
Nebraska Furniture Mart
Last year I introduced you to Mrs. B (Rose Blumkin) and her
family. I told you they were terrific, and I understated the
case. After another year of observing their remarkable talents
and character, I can honestly say that I never have seen a
managerial group that either functions or behaves better than the
Blumkin family.
Mrs. B, Chairman of the Board, is now 91, and recently was
quoted in the local newspaper as saying, “I come home to eat and
sleep, and that’s about it. I can’t wait until it gets daylight
so I can get back to the business”. Mrs. B is at the store seven
days a week, from opening to close, and probably makes more
decisions in a day than most CEOs do in a year (better ones,
too).
In May Mrs. B was granted an Honorary Doctorate in
Commercial Science by New York University. (She’s a “fast track”
student: not one day in her life was spent in a school room prior
to her receipt of the doctorate.) Previous recipients of honorary
degrees in business from NYU include Clifton Garvin, Jr., CEO of
Exxon Corp.; Walter Wriston, then CEO of Citicorp; Frank Cary,
then CEO of IBM; Tom Murphy, then CEO of General Motors; and,
most recently, Paul Volcker. (They are in good company.)
The Blumkin blood did not run thin. Louie, Mrs. B’s son,
and his three boys, Ron, Irv, and Steve, all contribute in full
measure to NFM’s amazing success. The younger generation has
attended the best business school of them all - that conducted by
Mrs. B and Louie - and their training is evident in their
performance.
Last year NFM’s net sales increased by $14.3 million,
bringing the total to $115 million, all from the one store in
Omaha. That is by far the largest volume produced by a single
home furnishings store in the United States. In fact, the gain
in sales last year was itself greater than the annual volume of
many good-sized successful stores. The business achieves this
success because it deserves this success. A few figures will
tell you why.
In its fiscal 1984 10-K, the largest independent specialty
retailer of home furnishings in the country, Levitz Furniture,
described its prices as “generally lower than the prices charged
by conventional furniture stores in its trading area”. Levitz,
in that year, operated at a gross margin of 44.4% (that is, on
average, customers paid it $100 for merchandise that had cost it
$55.60 to buy). The gross margin at NFM is not much more than
half of that. NFM’s low mark-ups are possible because of its
exceptional efficiency: operating expenses (payroll, occupancy,
advertising, etc.) are about 16.5% of sales versus 35.6% at
Levitz.
None of this is in criticism of Levitz, which has a well-
managed operation. But the NFM operation is simply extraordinary
(and, remember, it all comes from a $500 investment by Mrs. B in
1937). By unparalleled efficiency and astute volume purchasing,
NFM is able to earn excellent returns on capital while saving its
customers at least $30 million annually from what, on average, it
would cost them to buy the same merchandise at stores maintaining
typical mark-ups. Such savings enable NFM to constantly widen
its geographical reach and thus to enjoy growth well beyond the
natural growth of the Omaha market.
I have been asked by a number of people just what secrets
the Blumkins bring to their business. These are not very
esoteric. All members of the family: (1) apply themselves with
an enthusiasm and energy that would make Ben Franklin and Horatio
Alger look like dropouts; (2) define with extraordinary realism
their area of special competence and act decisively on all
matters within it; (3) ignore even the most enticing propositions
failing outside of that area of special competence; and, (4)
unfailingly behave in a high-grade manner with everyone they deal
with. (Mrs. B boils it down to “sell cheap and tell the truth”.)
Our evaluation of the integrity of Mrs. B and her family was
demonstrated when we purchased 90% of the business: NFM had never
had an audit and we did not request one; we did not take an
inventory nor verify the receivables; we did not check property
titles. We gave Mrs. B a check for $55 million and she gave us
her word. That made for an even exchange.
You and I are fortunate to be in partnership with the
Blumkin family.
See’s Candy Shops, Inc.
Below is our usual recap of See’s performance since the time
of purchase by Blue Chip Stamps:
52-53 Week Year Operating Number of Number of
Ended About Sales Profits Pounds of Stores Open
December 31 Revenues After Taxes Candy Sold at Year End
------------------- ------------ ----------- ---------- -----------
1984 .............. $135,946,000 $13,380,000 24,759,000 214
1983 (53 weeks) ... 133,531,000 13,699,000 24,651,000 207
1982 .............. 123,662,000 11,875,000 24,216,000 202
1981 .............. 112,578,000 10,779,000 24,052,000 199
1980 .............. 97,715,000 7,547,000 24,065,000 191
1979 .............. 87,314,000 6,330,000 23,985,000 188
1978 .............. 73,653,000 6,178,000 22,407,000 182
1977 .............. 62,886,000 6,154,000 20,921,000 179
1976 (53 weeks) ... 56,333,000 5,569,000 20,553,000 173
1975 .............. 50,492,000 5,132,000 19,134,000 172
1974 .............. 41,248,000 3,021,000 17,883,000 170
1973 .............. 35,050,000 1,940,000 17,813,000 169
1972 .............. 31,337,000 2,083,000 16,954,000 167
This performance has not been produced by a generally rising
tide. To the contrary, many well-known participants in the
boxed-chocolate industry either have lost money in this same
period or have been marginally profitable. To our knowledge,
only one good-sized competitor has achieved high profitability.
The success of See’s reflects the combination of an exceptional
product and an exceptional manager, Chuck Huggins.
During 1984 we increased prices considerably less than has
been our practice in recent years: per-pound realization was
$5.49, up only 1.4% from 1983. Fortunately, we made good
progress on cost control, an area that has caused us problems in
recent years. Per-pound costs - other than those for raw
materials, a segment of expense largely outside of our control -
increased by only 2.2% last year.
Our cost-control problem has been exacerbated by the problem
of modestly declining volume (measured by pounds, not dollars) on
a same-store basis. Total pounds sold through shops in recent
years has been maintained at a roughly constant level only by the
net addition of a few shops annually. This more-shops-to-get-
the-same-volume situation naturally puts heavy pressure on per-
pound selling costs.
In 1984, same-store volume declined 1.1%. Total shop volume,
however, grew 0.6% because of an increase in stores. (Both
percentages are adjusted to compensate for a 53-week fiscal year
in 1983.)
See’s business tends to get a bit more seasonal each year.
In the four weeks prior to Christmas, we do 40% of the year’s
volume and earn about 75% of the year’s profits. We also earn
significant sums in the Easter and Valentine’s Day periods, but
pretty much tread water the rest of the year. In recent years,
shop volume at Christmas has grown in relative importance, and so
have quantity orders and mail orders. The increased
concentration of business in the Christmas period produces a
multitude of managerial problems, all of which have been handled
by Chuck and his associates with exceptional skill and grace.
Their solutions have in no way involved compromises in
either quality of service or quality of product. Most of our
larger competitors could not say the same. Though faced with
somewhat less extreme peaks and valleys in demand than we, they
add preservatives or freeze the finished product in order to
smooth the production cycle and thereby lower unit costs. We
reject such techniques, opting, in effect, for production
headaches rather than product modification.
Our mall stores face a host of new food and snack vendors
that provide particularly strong competition at non-holiday
periods. We need new products to fight back and during 1984 we
introduced six candy bars that, overall, met with a good
reception. Further product introductions are planned.
In 1985 we will intensify our efforts to keep per-pound cost
increases below the rate of inflation. Continued success in
these efforts, however, will require gains in same-store
poundage. Prices in 1985 should average 6% - 7% above those of
1984. Assuming no change in same-store volume, profits should
show a moderate gain.
Buffalo Evening News
Profits at the News in 1984 were considerably greater than
we expected. As at See’s, excellent progress was made in
controlling costs. Excluding hours worked in the newsroom, total
hours worked decreased by about 2.8%. With this productivity
improvement, overall costs increased only 4.9%. This performance
by Stan Lipsey and his management team was one of the best in the
industry.
However, we now face an acceleration in costs. In mid-1984
we entered into new multi-year union contracts that provided for
a large “catch-up” wage increase. This catch-up is entirely
appropriate: the cooperative spirit of our unions during the
unprofitable 1977-1982 period was an important factor in our
success in remaining cost competitive with The Courier-Express.
Had we not kept costs down, the outcome of that struggle might
well have been different.
Because our new union contracts took effect at varying
dates, little of the catch-up increase was reflected in our 1984
costs. But the increase will be almost totally effective in 1985
and, therefore, our unit labor costs will rise this year at a
rate considerably greater than that of the industry. We expect
to mitigate this increase by continued small gains in
productivity, but we cannot avoid significantly higher wage costs
this year. Newsprint price trends also are less favorable now
than they were in 1984. Primarily because of these two factors,
we expect at least a minor contraction in margins at the News.
Working in our favor at the News are two factors of major
economic importance:
(1) Our circulation is concentrated to an unusual degree
in the area of maximum utility to our advertisers.
“Regional” newspapers with wide-ranging circulation, on
the other hand, have a significant portion of their
circulation in areas that are of negligible utility to
most advertisers. A subscriber several hundred miles
away is not much of a prospect for the puppy you are
offering to sell via a classified ad - nor for the
grocer with stores only in the metropolitan area.
“Wasted” circulation - as the advertisers call it -
hurts profitability: expenses of a newspaper are
determined largely by gross circulation while
advertising revenues (usually 70% - 80% of total
revenues) are responsive only to useful circulation;
(2) Our penetration of the Buffalo retail market is
exceptional; advertisers can reach almost all of their
potential customers using only the News.
Last year I told you about this unusual reader acceptance:
among the 100 largest newspapers in the country, we were then
number one, daily, and number three, Sunday, in penetration. The
most recent figures show us number one in penetration on weekdays
and number two on Sunday. (Even so, the number of households in
Buffalo has declined, so our current weekday circulation is down
slightly; on Sundays it is unchanged.)
I told you also that one of the major reasons for this
unusual acceptance by readers was the unusual quantity of news
that we delivered to them: a greater percentage of our paper is
devoted to news than is the case at any other dominant paper in
our size range. In 1984 our “news hole” ratio was 50.9%, (versus
50.4% in 1983), a level far above the typical 35% - 40%. We will
continue to maintain this ratio in the 50% area. Also, though we
last year reduced total hours worked in other departments, we
maintained the level of employment in the newsroom and, again,
will continue to do so. Newsroom costs advanced 9.1% in 1984, a
rise far exceeding our overall cost increase of 4.9%.
Our news hole policy costs us significant extra money for
newsprint. As a result, our news costs (newsprint for the news
hole plus payroll and expenses of the newsroom) as a percentage
of revenue run higher than those of most dominant papers of our
size. There is adequate room, however, for our paper or any
other dominant paper to sustain these costs: the difference
between “high” and “low” news costs at papers of comparable size
runs perhaps three percentage points while pre-tax profit margins
are often ten times that amount.
The economics of a dominant newspaper are excellent, among
the very best in the business world. Owners, naturally, would
like to believe that their wonderful profitability is achieved
only because they unfailingly turn out a wonderful product. That
comfortable theory wilts before an uncomfortable fact. While
first-class newspapers make excellent profits, the profits of
third-rate papers are as good or better - as long as either class
of paper is dominant within its community. Of course, product
quality may have been crucial to the paper in achieving
dominance. We believe this was the case at the News, in very
large part because of people such as Alfred Kirchhofer who
preceded us.
Once dominant, the newspaper itself, not the marketplace,
determines just how good or how bad the paper will be. Good or
bad, it will prosper. That is not true of most businesses:
inferior quality generally produces inferior economics. But even
a poor newspaper is a bargain to most citizens simply because of
its “bulletin board” value. Other things being equal, a poor
product will not achieve quite the level of readership achieved
by a first-class product. A poor product, however, will still
remain essential to most citizens, and what commands their
attention will command the attention of advertisers.
Since high standards are not imposed by the marketplace,
management must impose its own. Our commitment to an above-
average expenditure for news represents an important quantitative
standard. We have confidence that Stan Lipsey and Murray Light
will continue to apply the far-more important qualitative
standards. Charlie and I believe that newspapers are very
special institutions in society. We are proud of the News, and
intend an even greater pride to be justified in the years ahead.
Insurance Operations
Shown below is an updated version of our usual table listing
two key figures for the insurance industry:
Yearly Change Combined Ratio
in Premiums after Policy-holder
Written (%) Dividends
------------- -------------------
1972 .............................. 10.2 96.2
1973 .............................. 8.0 99.2
1974 .............................. 6.2 105.4
1975 .............................. 11.0 107.9
1976 .............................. 21.9 102.4
1977 .............................. 19.8 97.2
1978 .............................. 12.8 97.5
1979 .............................. 10.3 100.6
1980 .............................. 6.0 103.1
1981 .............................. 3.9 106.0
1982 .............................. 4.4 109.7
1983 (Revised) .................... 4.5 111.9
1984 (Estimated) .................. 8.1 117.7
Source: Best’s Aggregates and Averages
Best’s data reflect the experience of practically the entire
industry, including stock, mutual, and reciprocal companies. 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.
For a number of years, we have told you that an annual
increase by the industry of about 10% per year in premiums
written is necessary for the combined ratio to remain roughly
unchanged. We assumed in making that assertion that expenses as
a percentage of premium volume would stay relatively stable and
that losses would grow at about 10% annually because of the
combined influence of unit volume increases, inflation, and
judicial rulings that expand what is covered by the insurance
policy.
Our opinion is proving dismayingly accurate: a premium
increase of 10% per year since 1979 would have produced an
aggregate increase through 1984 of 61% and a combined ratio in
1984 almost identical to the 100.6 of 1979. Instead, the
industry had only a 30% increase in premiums and a 1984 combined
ratio of 117.7. Today, we continue to believe that the key index
to the trend of underwriting profitability is the year-to-year
percentage change in industry premium volume.
It now appears that premium volume in 1985 will grow well
over 10%. Therefore, assuming that catastrophes are at a
“normal” level, we would expect the combined ratio to begin
easing downward toward the end of the year. However, under our
industrywide loss assumptions (i.e., increases of 10% annually),
five years of 15%-per-year increases in premiums would be
required to get the combined ratio back to 100. This would mean
a doubling of industry volume by 1989, an outcome that seems
highly unlikely to us. Instead, we expect several years of
premium gains somewhat above the 10% level, followed by highly-
competitive pricing that generally will produce combined ratios
in the 108-113 range.
Our own combined ratio in 1984 was a humbling 134. (Here, as
throughout this report, we exclude structured settlements and the
assumption of loss reserves in reporting this ratio. Much
additional detail, including the effect of discontinued
operations on the ratio, appears on pages 42-43). This is the
third year in a row that our underwriting performance has been
far poorer than that of the industry. We expect an improvement
in the combined ratio in 1985, and also expect our improvement to
be substantially greater than that of the industry. Mike
Goldberg has corrected many of the mistakes I made before he took
over insurance operations. Moreover, our business is
concentrated in lines that have experienced poorer-than-average
results during the past several years, and that circumstance has
begun to subdue many of our competitors and even eliminate some.
With the competition shaken, we were able during the last half of
1984 to raise prices significantly in certain important lines
with little loss of business.
For some years I have told you that there could be a day
coming when our premier financial strength would make a real
difference in the competitive position of our insurance
operation. That day may have arrived. We are almost without
question the strongest property/casualty insurance operation in
the country, with a capital position far superior to that of
well-known companies of much greater size.
Equally important, our corporate policy is to retain that
superiority. The buyer of insurance receives only a promise in
exchange for his cash. The value of that promise should be
appraised against the possibility of adversity, not prosperity.
At a minimum, the promise should appear able to withstand a
prolonged combination of depressed financial markets and
exceptionally unfavorable underwriting results. Our insurance
subsidiaries are both willing and able to keep their promises in
any such environment - and not too many other companies clearly
are.
Our financial strength is a particular asset in the business
of structured settlements and loss reserve assumptions that we
reported on last year. The claimant in a structured settlement
and the insurance company that has reinsured loss reserves need
to be completely confident that payments will be forthcoming for
decades to come. Very few companies in the property/casualty
field can meet this test of unquestioned long-term strength. (In
fact, only a handful of companies exists with which we will
reinsure our own liabilities.)
We have grown in these new lines of business: funds that we
hold to offset assumed liabilities grew from $16.2 million to
$30.6 million during the year. We expect growth to continue and
perhaps to greatly accelerate. To support this projected growth
we have added substantially to the capital of Columbia Insurance
Company, our reinsurance unit specializing in structured
settlements and loss reserve assumptions. While these businesses
are very competitive, returns should be satisfactory.
At GEICO the news, as usual, is mostly good. That company
achieved excellent unit growth in its primary insurance business
during 1984, and the performance of its investment portfolio
continued to be extraordinary. Though underwriting results
deteriorated late in the year, they still remain far better than
those of the industry. Our ownership in GEICO at yearend
amounted to 36% and thus our interest in their direct
property/casualty volume of $885 million amounted to $320
million, or well over double our own premium volume.
I have reported to you in the past few years that the
performance of GEICO’s stock has considerably exceeded that
company’s business performance, brilliant as the latter has been.
In those years, the carrying value of our GEICO investment on our
balance sheet grew at a rate greater than the growth in GEICO’s
intrinsic business value. I warned you that over performance by
the stock relative to the performance of the business obviously
could not occur every year, and that in some years the stock must
under perform the business. In 1984 that occurred and the
carrying value of our interest in GEICO changed hardly at all,
while the intrinsic business value of that interest increased
substantially. Since 27% of Berkshire’s net worth at the
beginning of 1984 was represented by GEICO, its static market
value had a significant impact upon our rate of gain for the
year. We are not at all unhappy with such a result: we would far
rather have the business value of GEICO increase by X during the
year, while market value decreases, than have the intrinsic value
increase by only 1/2 X with market value soaring. In GEICO’s
case, as in all of our investments, we look to business
performance, not market performance. If we are correct in
expectations regarding the business, the market eventually will
follow along.
You, as shareholders of Berkshire, have benefited in
enormous measure from the talents of GEICO’s Jack Byrne, Bill
Snyder, and Lou Simpson. In its core business - low-cost auto
and homeowners insurance - GEICO has a major, sustainable
competitive advantage. That is a rare asset in business
generally, and it’s almost non-existent in the field of financial
services. (GEICO, itself, illustrates this point: despite the
company’s excellent management, superior profitability has eluded
GEICO in all endeavors other than its core business.) In a large
industry, a competitive advantage such as GEICO’s provides the
potential for unusual economic rewards, and Jack and Bill
continue to exhibit great skill in realizing that potential.
Most of the funds generated by GEICO’s core insurance
operation are made available to Lou for investment. Lou has the
rare combination of temperamental and intellectual
characteristics that produce outstanding long-term investment
performance. Operating with below-average risk, he has generated
returns that have been by far the best in the insurance industry.
I applaud and appreciate the efforts and talents of these three
outstanding managers.
Errors in Loss Reserving
Any shareholder in a company with important interests in the
property/casualty insurance business should have some
understanding of the weaknesses inherent in the reporting of
current earnings in that industry. Phil Graham, when publisher
of the Washington Post, described the daily newspaper as “a first
rough draft of history”. Unfortunately, the financial statements
of a property/casualty insurer provide, at best, only a first
rough draft of earnings and financial condition.
The determination of costs is the main problem. Most of an
insurer’s costs result from losses on claims, and many of the
losses that should be charged against the current year’s revenue
are exceptionally difficult to estimate. Sometimes the extent of
these losses, or even their existence, is not known for decades.
The loss expense charged in a property/casualty company’s
current income statement represents: (1) losses that occurred and
were paid during the year; (2) estimates for losses that occurred
and were reported to the insurer during the year, but which have
yet to be settled; (3) estimates of ultimate dollar costs for
losses that occurred during the year but of which the insurer is
unaware (termed “IBNR”: incurred but not reported); and (4) the
net effect of revisions this year of similar estimates for (2)
and (3) made in past years.
Such revisions may be long delayed, but eventually any
estimate of losses that causes the income for year X to be
misstated must be corrected, whether it is in year X + 1, or
X + 10. This, perforce, means that earnings in the year of
correction also are misstated. For example, assume a claimant
was injured by one of our insureds in 1979 and we thought a
settlement was likely to be made for $10,000. That year we would
have charged $10,000 to our earnings statement for the estimated
cost of the loss and, correspondingly, set up a liability reserve
on the balance sheet for that amount. If we settled the claim in
1984 for $100,000, we would charge earnings with a loss cost of
$90,000 in 1984, although that cost was truly an expense of 1979.
And if that piece of business was our only activity in 1979, we
would have badly misled ourselves as to costs, and you as to
earnings.
The necessarily-extensive use of estimates in assembling the
figures that appear in such deceptively precise form in the
income statement of property/casualty companies means that some
error must seep in, no matter how proper the intentions of
management. In an attempt to minimize error, most insurers use
various statistical techniques to adjust the thousands of
individual loss evaluations (called case reserves) that comprise
the raw data for estimation of aggregate liabilities. The extra
reserves created by these adjustments are variously labeled
“bulk”, “development”, or “supplemental” reserves. The goal of
the adjustments should be a loss-reserve total that has a 50-50
chance of being proved either slightly too high or slightly too
low when all losses that occurred prior to the date of the
financial statement are ultimately paid.
At Berkshire, we have added what we thought were appropriate
supplemental reserves but in recent years they have not been
adequate. It is important that you understand the magnitude of
the errors that have been involved in our reserving. You can
thus see for yourselves just how imprecise the process is, and
also judge whether we may have some systemic bias that should
make you wary of our current and future figures.
The following table shows the results from insurance
underwriting as we have reported them to you in recent years, and
also gives you calculations a year later on an “if-we-knew-then-
what-we think-we-know-now” basis. I say “what we think we know
now” because the adjusted figures still include a great many
estimates for losses that occurred in the earlier years.
However, many claims from the earlier years have been settled so
that our one-year-later estimate contains less guess work than
our earlier estimate:
Underwriting Results Corrected Figures
as Reported After One Year’s
Year to You Experience
---- -------------------- -----------------
1980 $ 6,738,000 $ 14,887,000
1981 1,478,000 (1,118,000)
1982 (21,462,000) (25,066,000)
1983 (33,192,000) (50,974,000)
1984 (45,413,000) ?
Our structured settlement and loss-reserve assumption
businesses are not included in this table. Important
additional information on loss reserve experience appears
on pages 43-45.
To help you understand this table, here is an explanation of
the most recent figures: 1984’s reported pre-tax underwriting
loss of $45.4 million consists of $27.6 million we estimate that
we lost on 1984’s business, plus the increased loss of $17.8
million reflected in the corrected figure for 1983.
As you can see from reviewing the table, my errors in
reporting to you have been substantial and recently have always
presented a better underwriting picture than was truly the case.
This is a source of particular chagrin to me because: (1) I like
for you to be able to count on what I say; (2) our insurance
managers and I undoubtedly acted with less urgency than we would
have had we understood the full extent of our losses; and (3) we
paid income taxes calculated on overstated earnings and thereby
gave the government money that we didn’t need to. (These
overpayments eventually correct themselves, but the delay is long
and we don’t receive interest on the amounts we overpaid.)
Because our business is weighted toward casualty and
reinsurance lines, we have more problems in estimating loss costs
than companies that specialize in property insurance. (When a
building that you have insured burns down, you get a much faster
fix on your costs than you do when an employer you have insured
finds out that one of his retirees has contracted a disease
attributable to work he did decades earlier.) But I still find
our errors embarrassing. In our direct business, we have far
underestimated the mushrooming tendency of juries and courts to
make the “deep pocket” pay, regardless of the factual situation
and the past precedents for establishment of liability. We also
have underestimated the contagious effect that publicity
regarding giant awards has on juries. In the reinsurance area,
where we have had our worst experience in under reserving, our
customer insurance companies have made the same mistakes. Since
we set reserves based on information they supply us, their
mistakes have become our mistakes.
I heard a story recently that is applicable to our insurance
accounting problems: a man was traveling abroad when he received
a call from his sister informing him that their father had died
unexpectedly. It was physically impossible for the brother to
get back home for the funeral, but he told his sister to take
care of the funeral arrangements and to send the bill to him.
After returning home he received a bill for several thousand
dollars, which he promptly paid. The following month another
bill came along for $15, and he paid that too. Another month
followed, with a similar bill. When, in the next month, a third
bill for $15 was presented, he called his sister to ask what was
going on. “Oh”, she said. “I forgot to tell you. We buried Dad
in a rented suit.”
If you’ve been in the insurance business in recent years -
particularly the reinsurance business - this story hurts. We
have tried to include all of our “rented suit” liabilities in our
current financial statement, but our record of past error should
make us humble, and you suspicious. I will continue to report to
you the errors, plus or minus, that surface each year.
Not all reserving errors in the industry have been of the
innocent-but-dumb variety. With underwriting results as bad as
they have been in recent years - and with managements having as
much discretion as they do in the presentation of financial
statements - some unattractive aspects of human nature have
manifested themselves. Companies that would be out of business
if they realistically appraised their loss costs have, in some
cases, simply preferred to take an extraordinarily optimistic
view about these yet-to-be-paid sums. Others have engaged in
various transactions to hide true current loss costs.
Both of these approaches can “work” for a considerable time:
external auditors cannot effectively police the financial
statements of property/casualty insurers. If liabilities of an
insurer, correctly stated, would exceed assets, it falls to the
insurer to volunteer this morbid information. In other words,
the corpse is supposed to file the death certificate. Under this
“honor system” of mortality, the corpse sometimes gives itself
the benefit of the doubt.
In most businesses, of course, insolvent companies run out
of cash. Insurance is different: you can be broke but flush.
Since cash comes in at the inception of an insurance policy and
losses are paid much later, insolvent insurers don’t run out of
cash until long after they have run out of net worth. In fact,
these “walking dead” often redouble their efforts to write
business, accepting almost any price or risk, simply to keep the
cash flowing in. With an attitude like that of an embezzler who
has gambled away his purloined funds, these companies hope that
somehow they can get lucky on the next batch of business and
thereby cover up earlier shortfalls. Even if they don’t get
lucky, the penalty to managers is usually no greater for a $100
million shortfall than one of $10 million; in the meantime, while
the losses mount, the managers keep their jobs and perquisites.
The loss-reserving errors of other property/casualty
companies are of more than academic interest to Berkshire. Not
only does Berkshire suffer from sell-at-any-price competition by
the “walking dead”, but we also suffer when their insolvency is
finally acknowledged. Through various state guarantee funds that
levy assessments, Berkshire ends up paying a portion of the
insolvent insurers’ asset deficiencies, swollen as they usually
are by the delayed detection that results from wrong reporting.
There is even some potential for cascading trouble. The
insolvency of a few large insurers and the assessments by state
guarantee funds that would follow could imperil weak-but-
previously-solvent insurers. Such dangers can be mitigated if
state regulators become better at prompt identification and
termination of insolvent insurers, but progress on that front has
been slow.
Washington Public Power Supply System
From October, 1983 through June, 1984 Berkshire’s insurance
subsidiaries continuously purchased large quantities of bonds of
Projects 1, 2, and 3 of Washington Public Power Supply System
(“WPPSS”). This is the same entity that, on July 1, 1983,
defaulted on $2.2 billion of bonds issued to finance partial
construction of the now-abandoned Projects 4 and 5. While there
are material differences in the obligors, promises, and
properties underlying the two categories of bonds, the problems
of Projects 4 and 5 have cast a major cloud over Projects 1, 2,
and 3, and might possibly cause serious problems for the latter
issues. In addition, there have been a multitude of problems
related directly to Projects 1, 2, and 3 that could weaken or
destroy an otherwise strong credit position arising from
guarantees by Bonneville Power Administration.
Despite these important negatives, Charlie and I judged the
risks at the time we purchased the bonds and at the prices
Berkshire paid (much lower than present prices) to be
considerably more than compensated for by prospects of profit.
As you know, we buy marketable stocks for our insurance
companies based upon the criteria we would apply in the purchase
of an entire business. This business-valuation approach is not
widespread among professional money managers and is scorned by
many academics. Nevertheless, it has served its followers well
(to which the academics seem to say, “Well, it may be all right
in practice, but it will never work in theory.”) Simply put, we
feel that if we can buy small pieces of businesses with
satisfactory underlying economics at a fraction of the per-share
value of the entire business, something good is likely to happen
to us - particularly if we own a group of such securities.
We extend this business-valuation approach even to bond
purchases such as WPPSS. We compare the $139 million cost of our
yearend investment in WPPSS to a similar $139 million investment
in an operating business. In the case of WPPSS, the “business”
contractually earns $22.7 million after tax (via the interest
paid on the bonds), and those earnings are available to us
currently in cash. We are unable to buy operating businesses
with economics close to these. Only a relatively few businesses
earn the 16.3% after tax on unleveraged capital that our WPPSS
investment does and those businesses, when available for
purchase, sell at large premiums to that capital. In the average
negotiated business transaction, unleveraged corporate earnings
of $22.7 million after-tax (equivalent to about $45 million pre-
tax) might command a price of $250 - $300 million (or sometimes
far more). For a business we understand well and strongly like,
we will gladly pay that much. But it is double the price we paid
to realize the same earnings from WPPSS bonds.
However, in the case of WPPSS, there is what we view to be a
very slight risk that the “business” could be worth nothing
within a year or two. There also is the risk that interest
payments might be interrupted for a considerable period of time.
Furthermore, the most that the “business” could be worth is about
the $205 million face value of the bonds that we own, an amount
only 48% higher than the price we paid.
This ceiling on upside potential is an important minus. It
should be realized, however, that the great majority of operating
businesses have a limited upside potential also unless more
capital is continuously invested in them. That is so because
most businesses are unable to significantly improve their average
returns on equity - even under inflationary conditions, though
these were once thought to automatically raise returns.
(Let’s push our bond-as-a-business example one notch
further: if you elect to “retain” the annual earnings of a 12%
bond by using the proceeds from coupons to buy more bonds,
earnings of that bond “business” will grow at a rate comparable
to that of most operating businesses that similarly reinvest all
earnings. In the first instance, a 30-year, zero-coupon, 12%
bond purchased today for $10 million will be worth $300 million
in 2015. In the second, a $10 million business that regularly
earns 12% on equity and retains all earnings to grow, will also
end up with $300 million of capital in 2015. Both the business
and the bond will earn over $32 million in the final year.)
Our approach to bond investment - treating it as an unusual
sort of “business” with special advantages and disadvantages -
may strike you as a bit quirky. However, we believe that many
staggering errors by investors could have been avoided if they
had viewed bond investment with a businessman’s perspective. For
example, in 1946, 20-year AAA tax-exempt bonds traded at slightly
below a 1% yield. In effect, the buyer of those bonds at that
time bought a “business” that earned about 1% on “book value”
(and that, moreover, could never earn a dime more than 1% on
book), and paid 100 cents on the dollar for that abominable
business.
If an investor had been business-minded enough to think in
those terms - and that was the precise reality of the bargain
struck - he would have laughed at the proposition and walked
away. For, at the same time, businesses with excellent future
prospects could have been bought at, or close to, book value
while earning 10%, 12%, or 15% after tax on book. Probably no
business in America changed hands in 1946 at book value that the
buyer believed lacked the ability to earn more than 1% on book.
But investors with bond-buying habits eagerly made economic
commitments throughout the year on just that basis. Similar,
although less extreme, conditions prevailed for the next two
decades as bond investors happily signed up for twenty or thirty
years on terms outrageously inadequate by business standards.
(In what I think is by far the best book on investing ever
written - “The Intelligent Investor”, by Ben Graham - the last
section of the last chapter begins with, “Investment is most
intelligent when it is most businesslike.” This section is called
“A Final Word”, and it is appropriately titled.)
We will emphasize again that there is unquestionably some
risk in the WPPSS commitment. It is also the sort of risk that
is difficult to evaluate. Were Charlie and I to deal with 50
similar evaluations over a lifetime, we would expect our judgment
to prove reasonably satisfactory. But we do not get the chance
to make 50 or even 5 such decisions in a single year. Even
though our long-term results may turn out fine, in any given year
we run a risk that we will look extraordinarily foolish. (That’s
why all of these sentences say “Charlie and I”, or “we”.)
Most managers have very little incentive to make the
intelligent-but-with-some-chance-of-looking-like-an-idiot
decision. Their personal gain/loss ratio is all too obvious: if
an unconventional decision works out well, they get a pat on the
back and, if it works out poorly, they get a pink slip. (Failing
conventionally is the route to go; as a group, lemmings may have
a rotten image, but no individual lemming has ever received bad
press.)
Our equation is different. With 47% of Berkshire’s stock,
Charlie and I don’t worry about being fired, and we receive our
rewards as owners, not managers. Thus we behave with Berkshire’s
money as we would with our own. That frequently leads us to
unconventional behavior both in investments and general business
management.
We remain unconventional in the degree to which we
concentrate the investments of our insurance companies, including
those in WPPSS bonds. This concentration makes sense only
because our insurance business is conducted from a position of
exceptional financial strength. For almost all other insurers, a
comparable degree of concentration (or anything close to it)
would be totally inappropriate. Their capital positions are not
strong enough to withstand a big error, no matter how attractive
an investment opportunity might appear when analyzed on the basis
of probabilities.
With our financial strength we can own large blocks of a few
securities that we have thought hard about and bought at
attractive prices. (Billy Rose described the problem of over-
diversification: “If you have a harem of forty women, you never
get to know any of them very well.”) Over time our policy of
concentration should produce superior results, though these will
be tempered by our large size. When this policy produces a
really bad year, as it must, at least you will know that our
money was committed on the same basis as yours.
We made the major part of our WPPSS investment at different
prices and under somewhat different factual circumstances than
exist at present. If we decide to change our position, we will
not inform shareholders until long after the change has been
completed. (We may be buying or selling as you read this.) The
buying and selling of securities is a competitive business, and
even a modest amount of added competition on either side can cost
us a great deal of money. Our WPPSS purchases illustrate this
principle. From October, 1983 through June, 1984, we attempted
to buy almost all the bonds that we could of Projects 1, 2, and
3. Yet we purchased less than 3% of the bonds outstanding. Had
we faced even a few additional well-heeled investors, stimulated
to buy because they knew we were, we could have ended up with a
materially smaller amount of bonds, purchased at a materially
higher price. (A couple of coat-tail riders easily could have
cost us $5 million.) For this reason, we will not comment about
our activities in securities - neither to the press, nor
shareholders, nor to anyone else - unless legally required to do
so.
One final observation regarding our WPPSS purchases: we
dislike the purchase of most long-term bonds under most
circumstances and have bought very few in recent years. That’s
because bonds are as sound as a dollar - and we view the long-
term outlook for dollars as dismal. We believe substantial
inflation lies ahead, although we have no idea what the average
rate will turn out to be. Furthermore, we think there is a
small, but not insignificant, chance of runaway inflation.
Such a possibility may seem absurd, considering the rate to
which inflation has dropped. But we believe that present fiscal
policy - featuring a huge deficit - is both extremely dangerous
and difficult to reverse. (So far, most politicians in both
parties have followed Charlie Brown’s advice: “No problem is so
big that it can’t be run away from.”) Without a reversal, high
rates of inflation may be delayed (perhaps for a long time), but
will not be avoided. If high rates materialize, they bring with
them the potential for a runaway upward spiral.
While there is not much to choose between bonds and stocks
(as a class) when annual inflation is in the 5%-10% range,
runaway inflation is a different story. In that circumstance, a
diversified stock portfolio would almost surely suffer an
enormous loss in real value. But bonds already outstanding would
suffer far more. Thus, we think an all-bond portfolio carries a
small but unacceptable “wipe out” risk, and we require any
purchase of long-term bonds to clear a special hurdle. Only when
bond purchases appear decidedly superior to other business
opportunities will we engage in them. Those occasions are likely
to be few and far between.
Dividend Policy
Dividend policy is often reported to shareholders, but
seldom explained. A company will say something like, “Our goal
is to pay out 40% to 50% of earnings and to increase dividends at
a rate at least equal to the rise in the CPI”. And that’s it -
no analysis will be supplied as to why that particular policy is
best for the owners of the business. Yet, allocation of capital
is crucial to business and investment management. Because it is,
we believe managers and owners should think hard about the
circumstances under which earnings should be retained and under
which they should be distributed.
The first point to understand is that all earnings are not
created equal. In many businesses particularly those that have
high asset/profit ratios - inflation causes some or all of the
reported earnings to become ersatz. The ersatz portion - let’s
call these earnings “restricted” - cannot, if the business is to
retain its economic position, be distributed as dividends. Were
these earnings to be paid out, the business would lose ground in
one or more of the following areas: its ability to maintain its
unit volume of sales, its long-term competitive position, its
financial strength. No matter how conservative its payout ratio,
a company that consistently distributes restricted earnings is
destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they
often must be discounted heavily. In effect, they are
conscripted by the business, no matter how poor its economic
potential. (This retention-no-matter-how-unattractive-the-return
situation was communicated unwittingly in a marvelously ironic
way by Consolidated Edison a decade ago. At the time, a punitive
regulatory policy was a major factor causing the company’s stock
to sell as low as one-fourth of book value; i.e., every time a
dollar of earnings was retained for reinvestment in the business,
that dollar was transformed into only 25 cents of market value.
But, despite this gold-into-lead process, most earnings were
reinvested in the business rather than paid to owners.
Meanwhile, at construction and maintenance sites throughout New
York, signs proudly proclaimed the corporate slogan, “Dig We
Must”.)
Restricted earnings need not concern us further in this
dividend discussion. Let’s turn to the much-more-valued
unrestricted variety. These earnings may, with equal
feasibility, be retained or distributed. In our opinion,
management should choose whichever course makes greater sense for
the owners of the business.
This principle is not universally accepted. For a number of
reasons managers like to withhold unrestricted, readily
distributable earnings from shareholders - to expand the
corporate empire over which the managers rule, to operate from a
position of exceptional financial comfort, etc. But we believe
there is only one valid reason for retention. Unrestricted
earnings should be retained only when there is a reasonable
prospect - backed preferably by historical evidence or, when
appropriate, by a thoughtful analysis of the future - that for
every dollar retained by the corporation, at least one dollar of
market value will be created for owners. This will happen only
if the capital retained produces incremental earnings equal to,
or above, those generally available to investors.
To illustrate, let’s assume that an investor owns a risk-
free 10% perpetual bond with one very unusual feature. Each year
the investor can elect either to take his 10% coupon in cash, or
to reinvest the coupon in more 10% bonds with identical terms;
i.e., a perpetual life and coupons offering the same cash-or-
reinvest option. If, in any given year, the prevailing interest
rate on long-term, risk-free bonds is 5%, it would be foolish for
the investor to take his coupon in cash since the 10% bonds he
could instead choose would be worth considerably more than 100
cents on the dollar. Under these circumstances, the investor
wanting to get his hands on cash should take his coupon in
additional bonds and then immediately sell them. By doing that,
he would realize more cash than if he had taken his coupon
directly in cash. Assuming all bonds were held by rational
investors, no one would opt for cash in an era of 5% interest
rates, not even those bondholders needing cash for living
purposes.
If, however, interest rates were 15%, no rational investor
would want his money invested for him at 10%. Instead, the
investor would choose to take his coupon in cash, even if his
personal cash needs were nil. The opposite course - reinvestment
of the coupon - would give an investor additional bonds with
market value far less than the cash he could have elected. If he
should want 10% bonds, he can simply take the cash received
and buy them in the market, where they will be available at a
large discount.
An analysis similar to that made by our hypothetical
bondholder is appropriate for owners in thinking about whether a
company’s unrestricted earnings should be retained or paid out.
Of course, the analysis is much more difficult and subject to
error because the rate earned on reinvested earnings is not a
contractual figure, as in our bond case, but rather a fluctuating
figure. Owners must guess as to what the rate will average over
the intermediate future. However, once an informed guess is
made, the rest of the analysis is simple: you should wish your
earnings to be reinvested if they can be expected to earn high
returns, and you should wish them paid to you if low returns are
the likely outcome of reinvestment.
Many corporate managers reason very much along these lines
in determining whether subsidiaries should distribute earnings to
their parent company. At that level,. the managers have no
trouble thinking like intelligent owners. But payout decisions
at the parent company level often are a different story. Here
managers frequently have trouble putting themselves in the shoes
of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional
company will instruct Subsidiary A, whose earnings on incremental
capital may be expected to average 5%, to distribute all
available earnings in order that they may be invested in
Subsidiary B, whose earnings on incremental capital are expected
to be 15%. The CEO’s business school oath will allow no lesser
behavior. But if his own long-term record with incremental
capital is 5% - and market rates are 10% - he is likely to impose
a dividend policy on shareholders of the parent company that
merely follows some historical or industry-wide payout pattern.
Furthermore, he will expect managers of subsidiaries to give him
a full account as to why it makes sense for earnings to be
retained in their operations rather than distributed to the
parent-owner. But seldom will he supply his owners with a
similar analysis pertaining to the whole company.
In judging whether managers should retain earnings,
shareholders should not simply compare total incremental earnings
in recent years to total incremental capital because that
relationship may be distorted by what is going on in a core
business. During an inflationary period, companies with a core
business characterized by extraordinary economics can use small
amounts of incremental capital in that business at very high
rates of return (as was discussed in last year’s section on
Goodwill). But, unless they are experiencing tremendous unit
growth, outstanding businesses by definition generate large
amounts of excess cash. If a company sinks most of this money in
other businesses that earn low returns, the company’s overall
return on retained capital may nevertheless appear excellent
because of the extraordinary returns being earned by the portion
of earnings incrementally invested in the core business. The
situation is analogous to a Pro-Am golf event: even if all of the
amateurs are hopeless duffers, the team’s best-ball score will be
respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both
on equity and on overall incremental capital have, indeed,
employed a large portion of their retained earnings on an
economically unattractive, even disastrous, basis. Their
marvelous core businesses, however, whose earnings grow year
after year, camouflage repeated failures in capital allocation
elsewhere (usually involving high-priced acquisitions of
businesses that have inherently mediocre economics). The
managers at fault periodically report on the lessons they have
learned from the latest disappointment. They then usually seek
out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if
earnings were retained only to expand the high-return business,
with the balance paid in dividends or used to repurchase stock
(an action that increases the owners’ interest in the exceptional
business while sparing them participation in subpar businesses).
Managers of high-return businesses who consistently employ much
of the cash thrown off by those businesses in other ventures with
low returns should be held to account for those allocation
decisions, regardless of how profitable the overall enterprise
is.
Nothing in this discussion is intended to argue for
dividends that bounce around from quarter to quarter with each
wiggle in earnings or in investment opportunities. Shareholders
of public corporations understandably prefer that dividends be
consistent and predictable. Payments, therefore, should reflect
long-term expectations for both earnings and returns on
incremental capital. Since the long-term corporate outlook
changes only infrequently, dividend patterns should change no
more often. But over time distributable earnings that have been
withheld by managers should earn their keep. If earnings have
been unwisely retained, it is likely that managers, too, have
been unwisely retained.
Let’s now turn to Berkshire Hathaway and examine how these
dividend principles apply to it. Historically, Berkshire has
earned well over market rates on retained earnings, thereby
creating over one dollar of market value for every dollar
retained. Under such circumstances, any distribution would have
been contrary to the financial interest of shareholders, large or
small.
In fact, significant distributions in the early years might
have been disastrous, as a review of our starting position will
show you. Charlie and I then controlled and managed three
companies, Berkshire Hathaway Inc., Diversified Retailing
Company, Inc., and Blue Chip Stamps (all now merged into our
present operation). Blue Chip paid only a small dividend,
Berkshire and DRC paid nothing. If, instead, the companies had
paid out their entire earnings, we almost certainly would have no
earnings at all now - and perhaps no capital as well. The three
companies each originally made their money from a single
business: (1) textiles at Berkshire; (2) department stores at
Diversified; and (3) trading stamps at Blue Chip. These
cornerstone businesses (carefully chosen, it should be noted, by
your Chairman and Vice Chairman) have, respectively, (1) survived
but earned almost nothing, (2) shriveled in size while incurring
large losses, and (3) shrunk in sales volume to about 5% its size
at the time of our entry. (Who says “you can’t lose ‘em all”?)
Only by committing available funds to much better businesses were
we able to overcome these origins. (It’s been like overcoming a
misspent youth.) Clearly, diversification has served us well.
We expect to continue to diversify while also supporting the
growth of current operations though, as we’ve pointed out, our
returns from these efforts will surely be below our historical
returns. But as long as prospective returns are above the rate
required to produce a dollar of market value per dollar retained,
we will continue to retain all earnings. Should our estimate of
future returns fall below that point, we will distribute all
unrestricted earnings that we believe can not be effectively
used. In making that judgment, we will look at both our
historical record and our prospects. Because our year-to-year
results are inherently volatile, we believe a five-year rolling
average to be appropriate for judging the historical record.
Our present plan is to use our retained earnings to further
build the capital of our insurance companies. Most of our
competitors are in weakened financial condition and reluctant to
expand substantially. Yet large premium-volume gains for the
industry are imminent, amounting probably to well over $15
billion in 1985 versus less than $5 billion in 1983. These
circumstances could produce major amounts of profitable business
for us. Of course, this result is no sure thing, but prospects
for it are far better than they have been for many years.
Miscellaneous
This is the spot where each year I run my small “business
wanted” ad. In 1984 John Loomis, one of our particularly
knowledgeable and alert shareholders, came up with a company that
met all of our tests. We immediately pursued this idea, and only
a chance complication prevented a deal. Since our ad is pulling,
we will repeat it in precisely last year’s form:
We prefer:
(1) large purchases (at least $5 million of after-tax
earnings),
(2) demonstrated consistent earning power (future
projections are of little interest to us, nor are
“turn-around” situations),
(3) businesses earning good returns on equity while
employing little or no debt,
(4) management in place (we can’t supply it),
(5) simple businesses (if there’s lots of technology, we
won’t understand it),
(6) an offering price (we don’t want to waste our time or
that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we’re interested. We prefer
to buy for cash, but will consider issuance of stock when we
receive as much in intrinsic business value as we give. We
invite potential sellers to check us out by contacting people
with whom we have done business in the past. For the right
business - and the right people - we can provide a good home.
* * *
A record 97.2% of all eligible shares participated in
Berkshire’s 1984 shareholder-designated contributions program.
Total contributions made through this program were $3,179,000,
and 1,519 charities were recipients. Our proxy material for the
annual meeting will allow you to cast an advisory vote expressing
your views about this program - whether you think we should
continue it and, if so, at what per-share level. (You may be
interested to learn that we were unable to find a precedent for
an advisory vote in which management seeks the opinions of
shareholders about owner-related corporate policies. Managers
who put their trust in capitalism seem in no hurry to put their
trust in capitalists.)
We urge new shareholders to read the description of our
shareholder-designated contributions program that appears on
pages 60 and 61. If you wish to participate in future programs,
we strongly urge that you immediately make sure that your shares
are registered in the name of the actual owner, not in “street”
name or nominee name. Shares not so registered on September 30,
1985 will be ineligible for the 1985 program.
* * *
Our annual meeting will be on May 21, 1985 in Omaha, and I
hope that you attend. Many annual meetings are a waste of time,
both for shareholders and for management. Sometimes that is true
because management is reluctant to open up on matters of business
substance. More often a nonproductive session is the fault of
shareholder participants who are more concerned about their own
moment on stage than they are about the affairs of the
corporation. What should be a forum for business discussion
becomes a forum for theatrics, spleen-venting and advocacy of
issues. (The deal is irresistible: for the price of one share you
get to tell a captive audience your ideas as to how the world
should be run.) Under such circumstances, the quality of the
meeting often deteriorates from year to year as the antics of
those interested in themselves discourage attendance by those
interested in the business.
Berkshire’s meetings are a different story. The number of
shareholders attending grows a bit each year and we have yet to
experience a silly question or an ego-inspired commentary.
Instead, we get a wide variety of thoughtful questions about the
business. Because the annual meeting is the time and place for
these, Charlie and I are happy to answer them all, no matter how
long it takes. (We cannot, however, respond to written or phoned
questions at other times of the year; one-person-at-a time
reporting is a poor use of management time in a company with 3000
shareholders.) The only business matters that are off limits at
the annual meeting are those about which candor might cost our
company real money. Our activities in securities would be the
main example.
We always have bragged a bit on these pages about the
quality of our shareholder-partners. Come to the annual meeting
and you will see why. Out-of-towners should schedule a stop at
Nebraska Furniture Mart. If you make some purchases, you’ll save
far more than enough to pay for your trip, and you’ll enjoy the
experience.
Warren E. Buffett
February 25, 1985 Chairman of the Board
Subsequent Event: On March 18, a week after copy for this
report went to the typographer but shortly before production, we
agreed to purchase three million shares of Capital Cities
Communications, Inc. at $172.50 per share. Our purchase is
contingent upon the acquisition of American Broadcasting
Companies, Inc. by Capital Cities, and will close when that
transaction closes. At the earliest, that will be very late in
1985. Our admiration for the management of Capital Cities, led
by Tom Murphy and Dan Burke, has been expressed several times in
previous annual reports. Quite simply, they are tops in both
ability and integrity. We will have more to say about this
investment in next year’s report.