Chairman's Letter - 1978

Chairman’s Letter - 1978

BERKSHIRE HATHAWAY INC.

To the Shareholders of Berkshire Hathaway Inc.:

First, a few words about accounting. The merger with

Diversified Retailing Company, Inc. at yearend adds two new

complications in the presentation of our financial results.

After the merger, our ownership of Blue Chip Stamps increased to

approximately 58% and, therefore, the accounts of that company

must be fully consolidated in the Balance Sheet and Statement of

Earnings presentation of Berkshire. In previous reports, our

share of the net earnings only of Blue Chip had been included as

a single item on Berkshire’s Statement of Earnings, and there had

been a similar one-line inclusion on our Balance Sheet of our

share of their net assets.

This full consolidation of sales, expenses, receivables,

inventories, debt, etc. produces an aggregation of figures from

many diverse businesses - textiles, insurance, candy, newspapers,

trading stamps - with dramatically different economic

characteristics. In some of these your ownership is 100% but, in

those businesses which are owned by Blue Chip but fully

consolidated, your ownership as a Berkshire shareholder is only

58%. (Ownership by others of the balance of these businesses is

accounted for by the large minority interest item on the

liability side of the Balance Sheet.) Such a grouping of Balance

Sheet and Earnings items - some wholly owned, some partly owned -

tends to obscure economic reality more than illuminate it. In

fact, it represents a form of presentation that we never prepare

for internal use during the year and which is of no value to us

in any management activities.

For that reason, throughout the report we provide much

separate financial information and commentary on the various

segments of the business to help you evaluate Berkshire’s

performance and prospects. Much of this segmented information is

mandated by SEC disclosure rules and covered in “Management’s

Discussion” on pages 29 to 34. And in this letter we try to

present to you a view of our various operating entities from the

same perspective that we view them managerially.

A second complication arising from the merger is that the

1977 figures shown in this report are different from the 1977

figures shown in the report we mailed to you last year.

Accounting convention requires that when two entities such as

Diversified and Berkshire are merged, all financial data

subsequently must be presented as if the companies had been

merged at the time they were formed rather than just recently.

So the enclosed financial statements, in effect, pretend that in

1977 (and earlier years) the Diversified-Berkshire merger already

had taken place, even though the actual merger date was December

30, 1978. This shifting base makes comparative commentary

confusing and, from time to time in our narrative report, we will

talk of figures and performance for Berkshire shareholders as

historically reported to you rather than as restated after the

Diversified merger.

With that preamble it can be stated that, with or without

restated figures, 1978 was a good year. Operating earnings,

exclusive of capital gains, at 19.4% of beginning shareholders’

investment were within a fraction of our 1972 record. While we

believe it is improper to include capital gains or losses in

evaluating the performance of a single year, they are an

important component of the longer term record. Because of such

gains, Berkshire’s long-term growth in equity per share has been

greater than would be indicated by compounding the returns from

operating earnings that we have reported annually.

For example, over the last three years - generally a bonanza

period for the insurance industry, our largest profit producer -

Berkshire’s per share net worth virtually has doubled, thereby

compounding at about 25% annually through a combination of good

operating earnings and fairly substantial capital gains. Neither

this 25% equity gain from all sources nor the 19.4% equity gain

from operating earnings in 1978 is sustainable. The insurance

cycle has turned downward in 1979, and it is almost certain that

operating earnings measured by return on equity will fall this

year. However, operating earnings measured in dollars are likely

to increase on the much larger shareholders’ equity now employed

in the business.

In contrast to this cautious view about near term return

from operations, we are optimistic about prospects for long term

return from major equity investments held by our insurance

companies. We make no attempt to predict how security markets

will behave; successfully forecasting short term stock price

movements is something we think neither we nor anyone else can

do. In the longer run, however, we feel that many of our major

equity holdings are going to be worth considerably more money

than we paid, and that investment gains will add significantly to

the operating returns of the insurance group.

Sources of Earnings

To give you a better picture of just where Berkshire’s

earnings are produced, we show below a table which requires a

little explanation. Berkshire owns close to 58% of Blue Chip

which, in addition to 100% ownership of several businesses, owns

80% of Wesco Financial Corporation. Thus, Berkshire’s equity in

Wesco’s earnings is about 46%. In aggregate, businesses that we

control have about 7,000 full-time employees and generate

revenues of over $500 million.

The table shows the overall earnings of each major operating

category on a pre-tax basis (several of the businesses have low

tax rates because of significant amounts of tax-exempt interest

and dividend income), as well as the share of those earnings

belonging to Berkshire both on a pre-tax and after-tax basis.

Significant capital gains or losses attributable to any of the

businesses are not shown in the operating earnings figure, but

are aggregated on the “Realized Securities Gain” line at the

bottom of the table. Because of various accounting and tax

intricacies, the figures in the table should not be treated as

holy writ, but rather viewed as close approximations of the 1977

and 1978 earnings contributions of our constituent businesses.

Net Earnings

Earnings Before Income Taxes After Tax


Total Berkshire Share Berkshire Share


(in thousands of dollars) 1978 1977 1978 1977 1978 1977


Total - all entities ……… $66,180 $57,089 $54,350 $42,234 $39,242 $30,393

======== ======== ======== ======== ======== ========

Earnings from operations:

Insurance Group:

Underwriting …………. $ 3,001 $ 5,802 $ 3,000 $ 5,802 $ 1,560 $ 3,017

Net investment income …. 19,705 12,804 19,691 12,804 16,400 11,360

Berkshire-Waumbec textiles 2,916 (620) 2,916 (620) 1,342 (322)

Associated Retail

Stores, Inc. ………… 2,757 2,775 2,757 2,775 1,176 1,429

See’s Candies ………….. 12,482 12,840 7,013 6,598 3,049 2,974

Buffalo Evening News ……. (2,913) 751 (1,637) 389 (738) 158

Blue Chip Stamps - Parent .. 2,133 1,091 1,198 566 1,382 892

Illinois National Bank

and Trust Company ……. 4,822 3,800 4,710 3,706 4,262 3,288

Wesco Financial

Corporation - Parent …. 1,771 2,006 777 813 665 419

Mutual Savings and

Loan Association …….. 10,556 6,779 4,638 2,747 3,042 1,946

Interest on Debt ……….. (5,566) (5,302) (4,546) (4,255) (2,349) (2,129)

Other …………………. 720 165 438 102 261 48


Total Earnings from

Operations ………… $52,384 $42,891 $40,955 $31,427 $30,052 $23,080

Realized Securities Gain ….. 13,796 14,198 13,395 10,807 9,190 7,313


Total Earnings ……….. $66,180 $57,089 $54,350 $42,234 $39,242 $30,393

======== ======== ======== ======== ======== ========

Blue Chip and Wesco are public companies with reporting

requirements of their own. Later in this report we are

reproducing the narrative reports of the principal executives of

both companies, describing their 1978 operations. Some of the

figures they utilize will not match to the penny the ones we use

in this report, again because of accounting and tax complexities.

But their comments should be helpful to you in understanding the

underlying economic characteristics of these important partly-

owned businesses. A copy of the full annual report of either

company will be mailed to any shareholder of Berkshire upon

request to Mr. Robert H. Bird for Blue Chips Stamps, 5801 South

Eastern Avenue, Los Angeles, California 90040, or to Mrs. Bette

Deckard for Wesco Financial Corporation, 315 East Colorado

Boulevard, Pasadena, California 91109.

Textiles

Earnings of $1.3 million in 1978, while much improved from

1977, still represent a low return on the $17 million of capital

employed in this business. Textile plant and equipment are on

the books for a very small fraction of what it would cost to

replace such equipment today. And, despite the age of the

equipment, much of it is functionally similar to new equipment

being installed by the industry. But despite this “bargain cost”

of fixed assets, capital turnover is relatively low reflecting

required high investment levels in receivables and inventory

compared to sales. Slow capital turnover, coupled with low

profit margins on sales, inevitably produces inadequate returns

on capital. Obvious approaches to improved profit margins

involve differentiation of product, lowered manufacturing costs

through more efficient equipment or better utilization of people,

redirection toward fabrics enjoying stronger market trends, etc.

Our management is diligent in pursuing such objectives. The

problem, of course, is that our competitors are just as

diligently doing the same thing.

The textile industry illustrates in textbook style how

producers of relatively undifferentiated goods in capital

intensive businesses must earn inadequate returns except under

conditions of tight supply or real shortage. As long as excess

productive capacity exists, prices tend to reflect direct

operating costs rather than capital employed. Such a supply-

excess condition appears likely to prevail most of the time in

the textile industry, and our expectations are for profits of

relatively modest amounts in relation to capital.

We hope we don’t get into too many more businesses with such

tough economic characteristics. But, as we have stated before:

(1) our textile businesses are very important employers in their

communities, (2) management has been straightforward in reporting

on problems and energetic in attacking them, (3) labor has been

cooperative and understanding in facing our common problems, and

(4) the business should average modest cash returns relative to

investment. As long as these conditions prevail - and we expect

that they will - we intend to continue to support our textile

business despite more attractive alternative uses for capital.

Insurance Underwriting

The number one contributor to Berkshire’s overall excellent

results in 1978 was the segment of National Indemnity Company’s

insurance operation run by Phil Liesche. On about $90 million of

earned premiums, an underwriting profit of approximately $11

million was realized, a truly extraordinary achievement even

against the background of excellent industry conditions. Under

Phil’s leadership, with outstanding assistance by Roland Miller

in Underwriting and Bill Lyons in Claims, this segment of

National Indemnity (including National Fire and Marine Insurance

Company, which operates as a running mate) had one of its best

years in a long history of performances which, in aggregate, far

outshine those of the industry. Present successes reflect credit

not only upon present managers, but equally upon the business

talents of Jack Ringwalt, founder of National Indemnity, whose

operating philosophy remains etched upon the company.

Home and Automobile Insurance Company had its best year

since John Seward stepped in and straightened things out in 1975.

Its results are combined in this report with those of Phil

Liesche’s operation under the insurance category entitled

“Specialized Auto and General Liability”.

Worker’s Compensation was a mixed bag in 1978. In its first

year as a subsidiary, Cypress Insurance Company, managed by Milt

Thornton, turned in outstanding results. The worker’s

compensation line can cause large underwriting losses when rapid

inflation interacts with changing social concepts, but Milt has a

cautious and highly professional staff to cope with these

problems. His performance in 1978 has reinforced our very good

feelings about this purchase.

Frank DeNardo came with us in the spring of 1978 to

straighten out National Indemnity’s California Worker’s

Compensation business which, up to that point, had been a

disaster. Frank has the experience and intellect needed to

correct the major problems of the Los Angeles office. Our volume

in this department now is running only about 25% of what it was

eighteen months ago, and early indications are that Frank is

making good progress.

George Young’s reinsurance department continues to produce

very large sums for investment relative to premium volume, and

thus gives us reasonably satisfactory overall results. However,

underwriting results still are not what they should be and can

be. It is very easy to fool yourself regarding underwriting

results in reinsurance (particularly in casualty lines involving

long delays in settlement), and we believe this situation

prevails with many of our competitors. Unfortunately, self-

delusion in company reserving almost always leads to inadequate

industry rate levels. If major factors in the market don’t know

their true costs, the competitive “fall-out” hits all - even

those with adequate cost knowledge. George is quite willing to

reduce volume significantly, if needed, to achieve satisfactory

underwriting, and we have a great deal of confidence in the long

term soundness of this business under his direction.

The homestate operation was disappointing in 1978. Our

unsatisfactory underwriting, even though partially explained by

an unusual incidence of Midwestern storms, is particularly

worrisome against the backdrop of very favorable industry results

in the conventional lines written by our homestate group. We

have confidence in John Ringwalt’s ability to correct this

situation. The bright spot in the group was the performance of

Kansas Fire and Casualty in its first full year of business.

Under Floyd Taylor, this subsidiary got off to a truly remarkable

start. Of course, it takes at least several years to evaluate

underwriting results, but the early signs are encouraging and

Floyd’s operation achieved the best loss ratio among the

homestate companies in 1978.

Although some segments were disappointing, overall our

insurance operation had an excellent year. But of course we

should expect a good year when the industry is flying high, as in

  1. It is a virtual certainty that in 1979 the combined ratio

(see definition on page 31) for the industry will move up at

least a few points, perhaps enough to throw the industry as a

whole into an underwriting loss position. For example, in the

auto lines - by far the most important area for the industry and

for us - CPI figures indicate rates overall were only 3% higher

in January 1979 than a year ago. But the items that make up loss

costs - auto repair and medical care costs - were up over 9%.

How different than yearend 1976 when rates had advanced over 22%

in the preceding twelve months, but costs were up 8%.

Margins will remain steady only if rates rise as fast as

costs. This assuredly will not be the case in 1979, and

conditions probably will worsen in 1980. Our present thinking is

that our underwriting performance relative to the industry will

improve somewhat in 1979, but every other insurance management

probably views its relative prospects with similar optimism -

someone is going to be disappointed. Even if we do improve

relative to others, we may well have a higher combined ratio and

lower underwriting profits in 1979 than we achieved last year.

We continue to look for ways to expand our insurance

operation. But your reaction to this intent should not be

unrestrained joy. Some of our expansion efforts - largely

initiated by your Chairman have been lackluster, others have been

expensive failures. We entered the business in 1967 through

purchase of the segment which Phil Liesche now manages, and it

still remains, by a large margin, the best portion of our

insurance business. It is not easy to buy a good insurance

business, but our experience has been that it is easier to buy

one than create one. However, we will continue to try both

approaches, since the rewards for success in this field can be

exceptional.

Insurance Investments

We confess considerable optimism regarding our insurance

equity investments. Of course, our enthusiasm for stocks is not

unconditional. Under some circumstances, common stock

investments by insurers make very little sense.

We get excited enough to commit a big percentage of

insurance company net worth to equities only when we find (1)

businesses we can understand, (2) with favorable long-term

prospects, (3) operated by honest and competent people, and (4)

priced very attractively. We usually can identify a small number

of potential investments meeting requirements (1), (2) and (3),

but (4) often prevents action. For example, in 1971 our total

common stock position at Berkshire’s insurance subsidiaries

amounted to only $10.7 million at cost, and $11.7 million at

market. There were equities of identifiably excellent companies

available - but very few at interesting prices. (An irresistible

footnote: in 1971, pension fund managers invested a record 122%

of net funds available in equities - at full prices they couldn’t

buy enough of them. In 1974, after the bottom had fallen out,

they committed a then record low of 21% to stocks.)

The past few years have been a different story for us. At

the end of 1975 our insurance subsidiaries held common equities

with a market value exactly equal to cost of $39.3 million. At

the end of 1978 this position had been increased to equities

(including a convertible preferred) with a cost of $129.1 million

and a market value of $216.5 million. During the intervening

three years we also had realized pre-tax gains from common

equities of approximately $24.7 million. Therefore, our overall

unrealized and realized pre-tax gains in equities for the three

year period came to approximately $112 million. During this same

interval the Dow-Jones Industrial Average declined from 852 to

  1. It was a marvelous period for the value-oriented equity

buyer.

We continue to find for our insurance portfolios small

portions of really outstanding businesses that are available,

through the auction pricing mechanism of security markets, at

prices dramatically cheaper than the valuations inferior

businesses command on negotiated sales.

This program of acquisition of small fractions of businesses

(common stocks) at bargain prices, for which little enthusiasm

exists, contrasts sharply with general corporate acquisition

activity, for which much enthusiasm exists. It seems quite clear

to us that either corporations are making very significant

mistakes in purchasing entire businesses at prices prevailing in

negotiated transactions and takeover bids, or that we eventually

are going to make considerable sums of money buying small

portions of such businesses at the greatly discounted valuations

prevailing in the stock market. (A second footnote: in 1978

pension managers, a group that logically should maintain the

longest of investment perspectives, put only 9% of net available

funds into equities - breaking the record low figure set in 1974

and tied in 1977.)

We are not concerned with whether the market quickly

revalues upward securities that we believe are selling at bargain

prices. In fact, we prefer just the opposite since, in most

years, we expect to have funds available to be a net buyer of

securities. And consistent attractive purchasing is likely to

prove to be of more eventual benefit to us than any selling

opportunities provided by a short-term run up in stock prices to

levels at which we are unwilling to continue buying.

Our policy is to concentrate holdings. We try to avoid

buying a little of this or that when we are only lukewarm about

the business or its price. When we are convinced as to

attractiveness, we believe in buying worthwhile amounts.

Equity holdings of our insurance companies with a market value of

over $8 million on December 31, 1978 were as follows:

No. of

Shares Company Cost Market


(000s omitted)

246,450 American Broadcasting Companies, Inc. … $ 6,082 $ 8,626

1,294,308 Government Employees Insurance Company

Common Stock ……………………. 4,116 9,060

1,986,953 Government Employees Insurance Company

Convertible Preferred ……………. 19,417 28,314

592,650 Interpublic Group of Companies, Inc. …. 4,531 19,039

1,066,934 Kaiser Aluminum and Chemical Corporation 18,085 18,671

453,800 Knight-Ridder Newspapers, Inc. ………. 7,534 10,267

953,750 SAFECO Corporation …………………. 23,867 26,467

934,300 The Washington Post Company …………. 10,628 43,445


Total …………………………….. $ 94,260 $163,889

All Other Holdings …………………. 39,506 57,040


Total Equities …………………….. $133,766 $220,929

========== ==========

In some cases our indirect interest in earning power is

becoming quite substantial. For example, note our holdings of

953,750 shares of SAFECO Corp. SAFECO probably is the best run

large property and casualty insurance company in the United

States. Their underwriting abilities are simply superb, their

loss reserving is conservative, and their investment policies

make great sense.

SAFECO is a much better insurance operation than our own

(although we believe certain segments of ours are much better

than average), is better than one we could develop and,

similarly, is far better than any in which we might negotiate

purchase of a controlling interest. Yet our purchase of SAFECO

was made at substantially under book value. We paid less than

100 cents on the dollar for the best company in the business,

when far more than 100 cents on the dollar is being paid for

mediocre companies in corporate transactions. And there is no

way to start a new operation - with necessarily uncertain

prospects - at less than 100 cents on the dollar.

Of course, with a minor interest we do not have the right to

direct or even influence management policies of SAFECO. But why

should we wish to do this? The record would indicate that they

do a better job of managing their operations than we could do

ourselves. While there may be less excitement and prestige in

sitting back and letting others do the work, we think that is all

one loses by accepting a passive participation in excellent

management. Because, quite clearly, if one controlled a company

run as well as SAFECO, the proper policy also would be to sit

back and let management do its job.

Earnings attributable to the shares of SAFECO owned by

Berkshire at yearend amounted to $6.1 million during 1978, but

only the dividends received (about 18% of earnings) are reflected

in our operating earnings. We believe the balance, although not

reportable, to be just as real in terms of eventual benefit to us

as the amount distributed. In fact, SAFECO’s retained earnings

(or those of other well-run companies if they have opportunities

to employ additional capital advantageously) may well eventually

have a value to shareholders greater than 100 cents on the

dollar.

We are not at all unhappy when our wholly-owned businesses

retain all of their earnings if they can utilize internally those

funds at attractive rates. Why should we feel differently about

retention of earnings by companies in which we hold small equity

interests, but where the record indicates even better prospects

for profitable employment of capital? (This proposition cuts the

other way, of course, in industries with low capital

requirements, or if management has a record of plowing capital

into projects of low profitability; then earnings should be paid

out or used to repurchase shares - often by far the most

attractive option for capital utilization.)

The aggregate level of such retained earnings attributable

to our equity interests in fine companies is becoming quite

substantial. It does not enter into our reported operating

earnings, but we feel it well may have equal long-term

significance to our shareholders. Our hope is that conditions

continue to prevail in securities markets which allow our

insurance companies to buy large amounts of underlying earning

power for relatively modest outlays. At some point market

conditions undoubtedly will again preclude such bargain buying

but, in the meantime, we will try to make the most of

opportunities.

Banking

Under Gene Abegg and Pete Jeffrey, the Illinois National

Bank and Trust Company in Rockford continues to establish new

records. Last year’s earnings amounted to approximately 2.1% of

average assets, about three times the level averaged by major

banks. In our opinion, this extraordinary level of earnings is

being achieved while maintaining significantly less asset risk

than prevails at most of the larger banks.

We purchased the Illinois National Bank in March 1969. It

was a first-class operation then, just as it had been ever since

Gene Abegg opened the doors in 1931. Since 1968, consumer time

deposits have quadrupled, net income has tripled and trust

department income has more than doubled, while costs have been

closely controlled.

Our experience has been that the manager of an already high-

cost operation frequently is uncommonly resourceful in finding

new ways to add to overhead, while the manager of a tightly-run

operation usually continues to find additional methods to curtail

costs, even when his costs are already well below those of his

competitors. No one has demonstrated this latter ability better

than Gene Abegg.

We are required to divest our bank by December 31, 1980.

The most likely approach is to spin it off to Berkshire

shareholders some time in the second half of 1980.

Retailing

Upon merging with Diversified, we acquired 100% ownership of

Associated Retail Stores, Inc., a chain of about 75 popular

priced women’s apparel stores. Associated was launched in

Chicago on March 7, 1931 with one store, $3200, and two

extraordinary partners, Ben Rosner and Leo Simon. After Mr.

Simon’s death, the business was offered to Diversified for cash

in 1967. Ben was to continue running the business - and run it,

he has.

Associated’s business has not grown, and it consistently has

faced adverse demographic and retailing trends. But Ben’s

combination of merchandising, real estate and cost-containment

skills has produced an outstanding record of profitability, with

returns on capital necessarily employed in the business often in

the 20% after-tax area.

Ben is now 75 and, like Gene Abegg, 81, at Illinois National

and Louie Vincenti, 73, at Wesco, continues daily to bring an

almost passionately proprietary attitude to the business. This

group of top managers must appear to an outsider to be an

overreaction on our part to an OEO bulletin on age

discrimination. While unorthodox, these relationships have been

exceptionally rewarding, both financially and personally. It is

a real pleasure to work with managers who enjoy coming to work

each morning and, once there, instinctively and unerringly think

like owners. We are associated with some of the very best.

Warren E. Buffett, Chairman

March 26, 1979


Source

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