Chairman's Letter - 1988

Chairman’s Letter - 1988

BERKSHIRE HATHAWAY INC.

To the Shareholders of Berkshire Hathaway Inc.:

Our gain in net worth during 1988 was $569 million, or

20.0%. Over the last 24 years (that is, since present management

took over), our per-share book value has grown from $19.46 to

$2,974.52, or at a rate of 23.0% compounded annually.

We’ve emphasized in past reports that what counts, however,

is intrinsic business value - the figure, necessarily an

estimate, indicating what all of our constituent businesses are

worth. By our calculations, Berkshire’s intrinsic business value

significantly exceeds its book value. Over the 24 years,

business value has grown somewhat faster than book value; in

1988, however, book value grew the faster, by a bit.

Berkshire’s past rates of gain in both book value and

business value were achieved under circumstances far different

from those that now exist. Anyone ignoring these differences

makes the same mistake that a baseball manager would were he to

judge the future prospects of a 42-year-old center fielder on the

basis of his lifetime batting average.

Important negatives affecting our prospects today are: (1) a

less attractive stock market than generally existed over the past

24 years; (2) higher corporate tax rates on most forms of

investment income; (3) a far more richly-priced market for the

acquisition of businesses; and (4) industry conditions for

Capital Cities/ABC, Inc., GEICO Corporation, and The Washington

Post Company - Berkshire’s three permanent investments,

constituting about one-half of our net worth - that range from

slightly to materially less favorable than those existing five to

ten years ago. All of these companies have superb management and

strong properties. But, at current prices, their upside

potential looks considerably less exciting to us today than it

did some years ago.

The major problem we face, however, is a growing capital

base. You’ve heard that from us before, but this problem, like

age, grows in significance each year. (And also, just as with

age, it’s better to have this problem continue to grow rather

than to have it “solved.”)

Four years ago I told you that we needed profits of $3.9

billion to achieve a 15% annual return over the decade then

ahead. Today, for the next decade, a 15% return demands profits

of $10.3 billion. That seems like a very big number to me and to

Charlie Munger, Berkshire’s Vice Chairman and my partner. (Should

that number indeed prove too big, Charlie will find himself, in

future reports, retrospectively identified as the senior

partner.)

As a partial offset to the drag that our growing capital

base exerts upon returns, we have a very important advantage now

that we lacked 24 years ago. Then, all our capital was tied up

in a textile business with inescapably poor economic

characteristics. Today part of our capital is invested in some

really exceptional businesses.

Last year we dubbed these operations the Sainted Seven:

Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott

Fetzer Manufacturing Group, See’s, and World Book. In 1988 the

Saints came marching in. You can see just how extraordinary

their returns on capital were by examining the historical-cost

financial statements on page 45, which combine the figures of the

Sainted Seven with those of several smaller units. With no

benefit from financial leverage, this group earned about 67% on

average equity capital.

In most cases the remarkable performance of these units

arises partially from an exceptional business franchise; in all

cases an exceptional management is a vital factor. The

contribution Charlie and I make is to leave these managers alone.

In my judgment, these businesses, in aggregate, will

continue to produce superb returns. We’ll need these: Without

this help Berkshire would not have a chance of achieving our 15%

goal. You can be sure that our operating managers will deliver;

the question mark in our future is whether Charlie and I can

effectively employ the funds that they generate.

In that respect, we took a step in the right direction early

in 1989 when we purchased an 80% interest in Borsheim’s, a

jewelry business in Omaha. This purchase, described later in

this letter, delivers exactly what we look for: an outstanding

business run by people we like, admire, and trust. It’s a great

way to start the year.

Accounting Changes

We have made a significant accounting change that was

mandated for 1988, and likely will have another to make in 1990.

When we move figures around from year to year, without any change

in economic reality, one of our always-thrilling discussions of

accounting is necessary.

First, I’ll offer my customary disclaimer: Despite the

shortcomings of generally accepted accounting principles (GAAP),

I would hate to have the job of devising a better set of rules.

The limitations of the existing set, however, need not be

inhibiting: CEOs are free to treat GAAP statements as a beginning

rather than an end to their obligation to inform owners and

creditors - and indeed they should. After all, any manager of a

subsidiary company would find himself in hot water if he reported

barebones GAAP numbers that omitted key information needed by his

boss, the parent corporation’s CEO. Why, then, should the CEO

himself withhold information vitally useful to his bosses - the

shareholder-owners of the corporation?

What needs to be reported is data - whether GAAP, non-GAAP,

or extra-GAAP - that helps financially-literate readers answer

three key questions: (1) Approximately how much is this company

worth? (2) What is the likelihood that it can meet its future

obligations? and (3) How good a job are its managers doing, given

the hand they have been dealt?

In most cases, answers to one or more of these questions are

somewhere between difficult and impossible to glean from the

minimum GAAP presentation. The business world is simply too

complex for a single set of rules to effectively describe

economic reality for all enterprises, particularly those

operating in a wide variety of businesses, such as Berkshire.

Further complicating the problem is the fact that many

managements view GAAP not as a standard to be met, but as an

obstacle to overcome. Too often their accountants willingly

assist them. (“How much,” says the client, “is two plus two?”

Replies the cooperative accountant, “What number did you have in

mind?”) Even honest and well-intentioned managements sometimes

stretch GAAP a bit in order to present figures they think will

more appropriately describe their performance. Both the

smoothing of earnings and the “big bath” quarter are “white lie”

techniques employed by otherwise upright managements.

Then there are managers who actively use GAAP to deceive and

defraud. They know that many investors and creditors accept GAAP

results as gospel. So these charlatans interpret the rules

“imaginatively” and record business transactions in ways that

technically comply with GAAP but actually display an economic

illusion to the world.

As long as investors - including supposedly sophisticated

institutions - place fancy valuations on reported “earnings” that

march steadily upward, you can be sure that some managers and

promoters will exploit GAAP to produce such numbers, no matter

what the truth may be. Over the years, Charlie and I have

observed many accounting-based frauds of staggering size. Few of

the perpetrators have been punished; many have not even been

censured. It has been far safer to steal large sums with a pen

than small sums with a gun.

Under one major change mandated by GAAP for 1988, we have

been required to fully consolidate all our subsidiaries in our

balance sheet and earnings statement. In the past, Mutual

Savings and Loan, and Scott Fetzer Financial (a credit company

that primarily finances installment sales of World Book and Kirby

products) were consolidated on a “one-line” basis. That meant we

(1) showed our equity in their combined net worths as a single-

entry asset on Berkshire’s consolidated balance sheet and (2)

included our equity in their combined annual earnings as a

single-line income entry in our consolidated statement of

earnings. Now the rules require that we consolidate each asset

and liability of these companies in our balance sheet and each

item of their income and expense in our earnings statement.

This change underscores the need for companies also to

report segmented data: The greater the number of economically

diverse business operations lumped together in conventional

financial statements, the less useful those presentations are and

the less able investors are to answer the three questions posed

earlier. Indeed, the only reason we ever prepare consolidated

figures at Berkshire is to meet outside requirements. On the

other hand, Charlie and I constantly study our segment data.

Now that we are required to bundle more numbers in our GAAP

statements, we have decided to publish additional supplementary

information that we think will help you measure both business

value and managerial performance. (Berkshire’s ability to

discharge its obligations to creditors - the third question we

listed - should be obvious, whatever statements you examine.) In

these supplementary presentations, we will not necessarily follow

GAAP procedures, or even corporate structure. Rather, we will

attempt to lump major business activities in ways that aid

analysis but do not swamp you with detail. Our goal is to give

you important information in a form that we would wish to get it

if our roles were reversed.

On pages 41-47 we show separate combined balance sheets and

earnings statements for: (1) our subsidiaries engaged in finance-

type operations, which are Mutual Savings and Scott Fetzer

Financial; (2) our insurance operations, with their major

investment positions itemized; (3) our manufacturing, publishing

and retailing businesses, leaving aside certain non-operating

assets and purchase-price accounting adjustments; and (4) an all-

other category that includes the non-operating assets (primarily

marketable securities) held by the companies in (3) as well as

various assets and debts of the Wesco and Berkshire parent

companies.

If you combine the earnings and the net worths of these four

segments, you will derive totals matching those shown on our GAAP

statements. However, we want to emphasize that our new

presentation does not fall within the purview of our auditors,

who in no way bless it. (In fact, they may be horrified; I don’t

want to ask.)

I referred earlier to a major change in GAAP that is

expected in 1990. This change relates to the calculation of

deferred taxes, and is both complicated and controversial - so

much so that its imposition, originally scheduled for 1989, was

postponed for a year.

When implemented, the new rule will affect us in various

ways. Most important, we will be required to change the way we

calculate our liability for deferred taxes on the unrealized

appreciation of stocks held by our insurance companies.

Right now, our liability is layered. For the unrealized

appreciation that dates back to 1986 and earlier years, $1.2

billion, we have booked a 28% tax liability. For the unrealized

appreciation built up since, $600 million, the tax liability has

been booked at 34%. The difference reflects the increase in tax

rates that went into effect in 1987.

It now appears, however, that the new accounting rule will

require us to establish the entire liability at 34% in 1990,

taking the charge against our earnings. Assuming no change in

tax rates by 1990, this step will reduce our earnings in that

year (and thereby our reported net worth) by $71 million. The

proposed rule will also affect other items on our balance sheet,

but these changes will have only a minor impact on earnings and

net worth.

We have no strong views about the desirability of this

change in calculation of deferred taxes. We should point out,

however, that neither a 28% nor a 34% tax liability precisely

depicts economic reality at Berkshire since we have no plans to

sell the stocks in which we have the great bulk of our gains.

To those of you who are uninterested in accounting, I

apologize for this dissertation. I realize that many of you do

not pore over our figures, but instead hold Berkshire primarily

because you know that: (1) Charlie and I have the bulk of our

money in Berkshire; (2) we intend to run things so that your

gains or losses are in direct proportion to ours; and (3) the

record has so far been satisfactory. There is nothing

necessarily wrong with this kind of “faith” approach to

investing. Other shareholders, however, prefer an “analysis”

approach and we want to supply the information they need. In our

own investing, we search for situations in which both approaches

give us the same answer.

Sources of Reported Earnings

In addition to supplying you with our new four-sector

accounting material, we will continue to list the major sources

of Berkshire’s reported earnings just as we have in the past.

In the following table, amortization of Goodwill and other

major purchase-price accounting adjustments are not charged

against the specific businesses to which they apply but are

instead aggregated and shown separately. This procedure lets you

view the earnings of our businesses as they would have been

reported had we not purchased them. I’ve explained in past

reports why this form of presentation seems to us to be more

useful to investors and managers than the standard GAAP

presentation, which makes purchase-price adjustments on a

business-by-business basis. The total net earnings we show in

the table are, of course, identical to the GAAP total in our

audited financial statements.

Further information about these businesses is given in the

Business Segment section on pages 32-34, and in the Management’s

Discussion section on pages 36-40. In these sections you also

will find our segment earnings reported on a GAAP basis. For

information on Wesco’s businesses, I urge you to read Charlie

Munger’s letter, which starts on page 52. It contains the best

description I have seen of the events that produced the present

savings-and-loan crisis. Also, take special note of Dave

Hillstrom’s performance at Precision Steel Warehouse, a Wesco

subsidiary. Precision operates in an extremely competitive

industry, yet Dave consistently achieves good returns on invested

capital. Though data is lacking to prove the point, I think it

is likely that his performance, both in 1988 and years past,

would rank him number one among his peers.

(000s omitted)


Berkshire’s Share

of Net Earnings

(after taxes and

Pre-Tax Earnings minority interests)


1988 1987 1988 1987


Operating Earnings:

Insurance Group:

Underwriting …………… $(11,081) $(55,429) $ (1,045) $(20,696)

Net Investment Income …… 231,250 152,483 197,779 136,658

Buffalo News …………….. 42,429 39,410 25,462 21,304

Fechheimer ………………. 14,152 13,332 7,720 6,580

Kirby …………………… 26,891 22,408 17,842 12,891

Nebraska Furniture Mart …… 18,439 16,837 9,099 7,554

Scott Fetzer

Manufacturing Group ……. 28,542 30,591 17,640 17,555

See’s Candies ……………. 32,473 31,693 19,671 17,363

Wesco - other than Insurance 16,133 6,209 10,650 4,978

World Book ………………. 27,890 25,745 18,021 15,136

Amortization of Goodwill ….. (2,806) (2,862) (2,806) (2,862)

Other Purchase-Price

Accounting Charges …….. (6,342) (5,546) (7,340) (6,544)

Interest on Debt* ………… (35,613) (11,474) (23,212) (5,905)

Shareholder-Designated

Contributions …………. (4,966) (4,938) (3,217) (2,963)

Other …………………… 41,059 23,217 27,177 13,697


Operating Earnings …………. 418,450 281,676 313,441 214,746

Sales of Securities ………… 131,671 28,838 85,829 19,806


Total Earnings - All Entities .. $550,121 $310,514 $399,270 $234,552

*Excludes interest expense of Scott Fetzer Financial Group.

The earnings achieved by our operating businesses are

superb, whether measured on an absolute basis or against those of

their competitors. For that we thank our operating managers: You

and I are fortunate to be associated with them.

At Berkshire, associations like these last a long time. We

do not remove superstars from our lineup merely because they have

attained a specified age - whether the traditional 65, or the 95

reached by Mrs. B on the eve of Hanukkah in 1988. Superb

managers are too scarce a resource to be discarded simply because

a cake gets crowded with candles. Moreover, our experience with

newly-minted MBAs has not been that great. Their academic

records always look terrific and the candidates always know just

what to say; but too often they are short on personal commitment

to the company and general business savvy. It’s difficult to

teach a new dog old tricks.

Here’s an update on our major non-insurance operations:

o At Nebraska Furniture Mart, Mrs. B (Rose Blumkin) and her

cart roll on and on. She’s been the boss for 51 years, having

started the business at 44 with $500. (Think what she would have

done with $1,000!) With Mrs. B, old age will always be ten years

away.

The Mart, long the largest home furnishings store in the

country, continues to grow. In the fall, the store opened a

detached 20,000 square foot Clearance Center, which expands our

ability to offer bargains in all price ranges.

Recently Dillard’s, one of the most successful department

store operations in the country, entered the Omaha market. In

many of its stores, Dillard’s runs a full furniture department,

undoubtedly doing well in this line. Shortly before opening in

Omaha, however, William Dillard, chairman of the company,

announced that his new store would not sell furniture. Said he,

referring to NFM: “We don’t want to compete with them. We think

they are about the best there is.”

At the Buffalo News we extol the value of advertising, and

our policies at NFM prove that we practice what we preach. Over

the past three years NFM has been the largest ROP advertiser in

the Omaha World-Herald. (ROP advertising is the kind printed in

the paper, as contrasted to the preprinted-insert kind.) In no

other major market, to my knowledge, is a home furnishings

operation the leading customer of the newspaper. At times, we

also run large ads in papers as far away as Des Moines, Sioux

City and Kansas City - always with good results. It truly does

pay to advertise, as long as you have something worthwhile to

offer.

Mrs. B’s son, Louie, and his boys, Ron and Irv, complete the

winning Blumkin team. It’s a joy to work with this family. All

its members have character that matches their extraordinary

abilities.

o Last year I stated unequivocally that pre-tax margins at

The Buffalo News would fall in 1988. That forecast would have

proved correct at almost any other newspaper our size or larger.

But Stan Lipsey - bless him - has managed to make me look

foolish.

Though we increased our prices a bit less than the industry

average last year, and though our newsprint costs and wage rates

rose in line with industry norms, Stan actually improved margins

a tad. No one in the newspaper business has a better managerial

record. He has achieved it, furthermore, while running a paper

that gives readers an extraordinary amount of news. We believe

that our “newshole” percentage - the portion of the paper devoted

to news - is bigger than that of any other dominant paper of our

size or larger. The percentage was 49.5% in 1988 versus 49.8% in

  1. We are committed to keeping it around 50%, whatever the

level or trend of profit margins.

Charlie and I have loved the newspaper business since we

were youngsters, and we have had great fun with the News in the

12 years since we purchased it. We were fortunate to find Murray

Light, a top-flight editor, on the scene when we arrived and he

has made us proud of the paper ever since.

o See’s Candies sold a record 25.1 million pounds in 1988.

Prospects did not look good at the end of October, but excellent

Christmas volume, considerably better than the record set in

1987, turned the tide.

As we’ve told you before, See’s business continues to become

more Christmas-concentrated. In 1988, the Company earned a

record 90% of its full-year profits in December: $29 million out

of $32.5 million before tax. (It’s enough to make you believe in

Santa Claus.) December’s deluge of business produces a modest

seasonal bulge in Berkshire’s corporate earnings. Another small

bulge occurs in the first quarter, when most World Book annuals

are sold.

Charlie and I put Chuck Huggins in charge of See’s about

five minutes after we bought the company. Upon reviewing his

record, you may wonder what took us so long.

o At Fechheimer, the Heldmans - Bob, George, Gary, Roger and

Fred - are the Cincinnati counterparts of the Blumkins. Neither

furniture retailing nor uniform manufacturing has inherently

attractive economics. In these businesses, only exceptional

managements can deliver high returns on invested capital. And

that’s exactly what the five Heldmans do. (As Mets announcer

Ralph Kiner once said when comparing pitcher Steve Trout to his

father, Dizzy Trout, the famous Detroit Tigers pitcher: “There’s

a lot of heredity in that family.”)

Fechheimer made a fairly good-sized acquisition in 1988.

Charlie and I have such confidence in the business savvy of the

Heldman family that we okayed the deal without even looking at

it. There are very few managements anywhere - including those

running the top tier companies of the Fortune 500 - in which we

would exhibit similar confidence.

Because of both this acquisition and some internal growth,

sales at Fechheimer should be up significantly in 1989.

o All of the operations managed by Ralph Schey - World Book,

Kirby, and The Scott Fetzer Manufacturing Group - performed

splendidly in 1988. Returns on the capital entrusted to Ralph

continue to be exceptional.

Within the Scott Fetzer Manufacturing Group, particularly

fine progress was recorded at its largest unit, Campbell

Hausfeld. This company, the country’s leading producer of small

and medium-sized air compressors, has more than doubled earnings

since 1986.

Unit sales at both Kirby and World Book were up

significantly in 1988, with export business particularly strong.

World Book became available in the Soviet Union in September,

when that country’s largest American book store opened in Moscow.

Ours is the only general encyclopedia offered at the store.

Ralph’s personal productivity is amazing: In addition to

running 19 businesses in superb fashion, he is active at The

Cleveland Clinic, Ohio University, Case Western Reserve, and a

venture capital operation that has spawned sixteen Ohio-based

companies and resurrected many others. Both Ohio and Berkshire

are fortunate to have Ralph on their side.

Borsheim’s

It was in 1983 that Berkshire purchased an 80% interest in

The Nebraska Furniture Mart. Your Chairman blundered then by

neglecting to ask Mrs. B a question any schoolboy would have

thought of: “Are there any more at home like you?” Last month I

corrected the error: We are now 80% partners with another branch

of the family.

After Mrs. B came over from Russia in 1917, her parents and

five siblings followed. (Her two other siblings had preceded

her.) Among the sisters was Rebecca Friedman who, with her

husband, Louis, escaped in 1922 to the west through Latvia in a

journey as perilous as Mrs. B’s earlier odyssey to the east

through Manchuria. When the family members reunited in Omaha

they had no tangible assets. However, they came equipped with an

extraordinary combination of brains, integrity, and enthusiasm

for work - and that’s all they needed. They have since proved

themselves invincible.

In 1948 Mr. Friedman purchased Borsheim’s, a small Omaha

jewelry store. He was joined in the business by his son, Ike, in

1950 and, as the years went by, Ike’s son, Alan, and his sons-in-

law, Marvin Cohn and Donald Yale, came in also.

You won’t be surprised to learn that this family brings to

the jewelry business precisely the same approach that the

Blumkins bring to the furniture business. The cornerstone for

both enterprises is Mrs. B’s creed: “Sell cheap and tell the

truth.” Other fundamentals at both businesses are: (1) single

store operations featuring huge inventories that provide

customers with an enormous selection across all price ranges, (2)

daily attention to detail by top management, (3) rapid turnover,

(4) shrewd buying, and (5) incredibly low expenses. The

combination of the last three factors lets both stores offer

everyday prices that no one in the country comes close to

matching.

Most people, no matter how sophisticated they are in other

matters, feel like babes in the woods when purchasing jewelry.

They can judge neither quality nor price. For them only one rule

makes sense: If you don’t know jewelry, know the jeweler.

I can assure you that those who put their trust in Ike

Friedman and his family will never be disappointed. The way in

which we purchased our interest in their business is the ultimate

testimonial. Borsheim’s had no audited financial statements;

nevertheless, we didn’t take inventory, verify receivables or

audit the operation in any way. Ike simply told us what was so -

large check.

Business at Borsheim’s has mushroomed in recent years as the

reputation of the Friedman family has spread. Customers now come

to the store from all over the country. Among them have been

some friends of mine from both coasts who thanked me later for

getting them there.

Borsheim’s new links to Berkshire will change nothing in the

way this business is run. All members of the Friedman family

will continue to operate just as they have before; Charlie and I

will stay on the sidelines where we belong. And when we say “all

members,” the words have real meaning. Mr. and Mrs. Friedman, at

88 and 87, respectively, are in the store daily. The wives of

Ike, Alan, Marvin and Donald all pitch in at busy times, and a

fourth generation is beginning to learn the ropes.

It is great fun to be in business with people you have long

admired. The Friedmans, like the Blumkins, have achieved success

because they have deserved success. Both families focus on

what’s right for the customer and that, inevitably, works out

well for them, also. We couldn’t have better partners.

Insurance Operations

Shown below is an updated version of our usual table

presenting key figures for the insurance industry:

Statutory

Yearly Change Combined Ratio Yearly Change Inflation Rate

in Premiums After Policyholder in Incurred Measured by

Written (%) Dividends Losses (%) GNP Deflator (%)


1981 ….. 3.8 106.0 6.5 9.6

1982 ….. 3.7 109.6 8.4 6.4

1983 ….. 5.0 112.0 6.8 3.8

1984 ….. 8.5 118.0 16.9 3.7

1985 ….. 22.1 116.3 16.1 3.2

1986 ….. 22.2 108.0 13.5 2.7

1987 ….. 9.4 104.6 7.8 3.3

1988 (Est.) 3.9 105.4 4.2 3.6

Source: A.M. Best Co.

The combined ratio represents total insurance costs (losses

incurred plus expenses) compared to revenue from premiums: A

ratio below 100 indicates an underwriting profit, and one above

100 indicates a loss. When the investment income that an insurer

earns from holding on to policyholders’ funds (“the float”) is

taken into account, a combined ratio in the 107-111 range

typically produces an overall break-even result, exclusive of

earnings on the funds provided by shareholders.

For the reasons laid out in previous reports, we expect the

industry’s incurred losses to grow by about 10% annually, even in

years when general inflation runs considerably lower. If premium

growth meanwhile materially lags that 10% rate, underwriting

losses will mount, though the industry’s tendency to underreserve

when business turns bad may obscure their size for a time. As

the table shows, the industry’s underwriting loss grew in 1988.

This trend is almost certain to continue - and probably will

accelerate - for at least two more years.

The property-casualty insurance industry is not only

subnormally profitable, it is subnormally popular. (As Sam

Goldwyn philosophized: “In life, one must learn to take the

bitter with the sour.”) One of the ironies of business is that

many relatively-unprofitable industries that are plagued by

inadequate prices habitually find themselves beat upon by irate

customers even while other, hugely profitable industries are

spared complaints, no matter how high their prices.

Take the breakfast cereal industry, whose return on invested

capital is more than double that of the auto insurance industry

(which is why companies like Kellogg and General Mills sell at

five times book value and most large insurers sell close to

book). The cereal companies regularly impose price increases,

few of them related to a significant jump in their costs. Yet

not a peep is heard from consumers. But when auto insurers raise

prices by amounts that do not even match cost increases,

customers are outraged. If you want to be loved, it’s clearly

better to sell high-priced corn flakes than low-priced auto

insurance.

The antagonism that the public feels toward the industry can

have serious consequences: Proposition 103, a California

initiative passed last fall, threatens to push auto insurance

prices down sharply, even though costs have been soaring. The

price cut has been suspended while the courts review the

initiative, but the resentment that brought on the vote has not

been suspended: Even if the initiative is overturned, insurers

are likely to find it tough to operate profitably in California.

(Thank heavens the citizenry isn’t mad at bonbons: If Proposition

103 applied to candy as well as insurance, See’s would be forced

to sell its product for $5.76 per pound. rather than the $7.60 we

charge - and would be losing money by the bucketful.)

The immediate direct effects on Berkshire from the

initiative are minor, since we saw few opportunities for profit

in the rate structure that existed in California prior to the

vote. However, the forcing down of prices would seriously affect

GEICO, our 44%-owned investee, which gets about 10% of its

premium volume from California. Even more threatening to GEICO

is the possibility that similar pricing actions will be taken in

other states, through either initiatives or legislation.

If voters insist that auto insurance be priced below cost,

it eventually must be sold by government. Stockholders can

subsidize policyholders for a short period, but only taxpayers

can subsidize them over the long term. At most property-casualty

companies, socialized auto insurance would be no disaster for

shareholders. Because of the commodity characteristics of the

industry, most insurers earn mediocre returns and therefore have

little or no economic goodwill to lose if they are forced by

government to leave the auto insurance business. But GEICO,

because it is a low-cost producer able to earn high returns on

equity, has a huge amount of economic goodwill at risk. In turn,

so do we.

At Berkshire, in 1988, our premium volume continued to fall,

and in 1989 we will experience a large decrease for a special

reason: The contract through which we receive 7% of the business

of Fireman’s Fund expires on August 31. At that time, we will

return to Fireman’s Fund the unearned premiums we hold that

relate to the contract. This transfer of funds will show up in

our “premiums written” account as a negative $85 million or so

and will make our third-quarter figures look rather peculiar.

However, the termination of this contract will not have a

significant effect on profits.

Berkshire’s underwriting results continued to be excellent

in 1988. Our combined ratio (on a statutory basis and excluding

structured settlements and financial reinsurance) was 104.

Reserve development was favorable for the second year in a row,

after a string of years in which it was very unsatisfactory.

Details on both underwriting and reserve development appear on

pages 36-38.

Our insurance volume over the next few years is likely to

run very low, since business with a reasonable potential for

profit will almost certainly be scarce. So be it. At Berkshire,

we simply will not write policies at rates that carry the

expectation of economic loss. We encounter enough troubles when

we expect a gain.

Despite - or perhaps because of - low volume, our profit

picture during the next few years is apt to be considerably

brighter than the industry’s. We are sure to have an exceptional

amount of float compared to premium volume, and that augurs well

for profits. In 1989 and 1990 we expect our float/premiums

ratio to be at least three times that of the typical

property/casualty company. Mike Goldberg, with special help from

Ajit Jain, Dinos Iordanou, and the National Indemnity managerial

team, has positioned us well in that respect.

At some point - we don’t know when - we will be deluged with

insurance business. The cause will probably be some major

physical or financial catastrophe. But we could also experience

an explosion in business, as we did in 1985, because large and

increasing underwriting losses at other companies coincide with

their recognition that they are far underreserved. in the

meantime, we will retain our talented professionals, protect our

capital, and try not to make major mistakes.

Marketable Securities

In selecting marketable securities for our insurance

companies, we can choose among five major categories: (1) long-

term common stock investments, (2) medium-term fixed-income

securities, (3) long-term fixed-income securities, (4) short-term

cash equivalents, and (5) short-term arbitrage commitments.

We have no particular bias when it comes to choosing from

these categories. We just continuously search among them for the

highest after-tax returns as measured by “mathematical

expectation,” limiting ourselves always to investment

alternatives we think we understand. Our criteria have nothing

to do with maximizing immediately reportable earnings; our goal,

rather, is to maximize eventual net worth.

o Below we list our common stock holdings having a value over

$100 million, not including arbitrage commitments, which will be

discussed later. A small portion of these investments belongs to

subsidiaries of which Berkshire owns less than 100%.

Shares Company Cost Market


(000s omitted)

3,000,000 Capital Cities/ABC, Inc. ………….. $517,500 $1,086,750

14,172,500 The Coca-Cola Company …………….. 592,540 632,448

2,400,000 Federal Home Loan Mortgage

Corporation Preferred* …………. 71,729 121,200

6,850,000 GEICO Corporation ………………… 45,713 849,400

1,727,765 The Washington Post Company ……….. 9,731 364,126

*Although nominally a preferred stock, this security is

financially equivalent to a common stock.

Our permanent holdings - Capital Cities/ABC, Inc., GEICO

Corporation, and The Washington Post Company - remain unchanged.

Also unchanged is our unqualified admiration of their

managements: Tom Murphy and Dan Burke at Cap Cities, Bill Snyder

and Lou Simpson at GEICO, and Kay Graham and Dick Simmons at The

Washington Post. Charlie and I appreciate enormously the talent

and integrity these managers bring to their businesses.

Their performance, which we have observed at close range,

contrasts vividly with that of many CEOs, which we have

fortunately observed from a safe distance. Sometimes these CEOs

clearly do not belong in their jobs; their positions,

nevertheless, are usually secure. The supreme irony of business

management is that it is far easier for an inadequate CEO to keep

his job than it is for an inadequate subordinate.

If a secretary, say, is hired for a job that requires typing

ability of at least 80 words a minute and turns out to be capable

of only 50 words a minute, she will lose her job in no time.

There is a logical standard for this job; performance is easily

measured; and if you can’t make the grade, you’re out.

Similarly, if new sales people fail to generate sufficient

business quickly enough, they will be let go. Excuses will not

be accepted as a substitute for orders.

However, a CEO who doesn’t perform is frequently carried

indefinitely. One reason is that performance standards for his

job seldom exist. When they do, they are often fuzzy or they may

be waived or explained away, even when the performance shortfalls

are major and repeated. At too many companies, the boss shoots

the arrow of managerial performance and then hastily paints the

bullseye around the spot where it lands.

Another important, but seldom recognized, distinction

between the boss and the foot soldier is that the CEO has no

immediate superior whose performance is itself getting measured.

The sales manager who retains a bunch of lemons in his sales

force will soon be in hot water himself. It is in his immediate

self-interest to promptly weed out his hiring mistakes.

Otherwise, he himself may be weeded out. An office manager who

has hired inept secretaries faces the same imperative.

But the CEO’s boss is a Board of Directors that seldom

measures itself and is infrequently held to account for

substandard corporate performance. If the Board makes a mistake

in hiring, and perpetuates that mistake, so what? Even if the

company is taken over because of the mistake, the deal will

probably bestow substantial benefits on the outgoing Board

members. (The bigger they are, the softer they fall.)

Finally, relations between the Board and the CEO are

expected to be congenial. At board meetings, criticism of the

CEO’s performance is often viewed as the social equivalent of

belching. No such inhibitions restrain the office manager from

critically evaluating the substandard typist.

These points should not be interpreted as a blanket

condemnation of CEOs or Boards of Directors: Most are able and

hard-working, and a number are truly outstanding. But the

management failings that Charlie and I have seen make us thankful

that we are linked with the managers of our three permanent

holdings. They love their businesses, they think like owners,

and they exude integrity and ability.

o In 1988 we made major purchases of Federal Home Loan

Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold

these securities for a long time. In fact, when we own portions

of outstanding businesses with outstanding managements, our

favorite holding period is forever. We are just the opposite of

those who hurry to sell and book profits when companies perform

well but who tenaciously hang on to businesses that disappoint.

Peter Lynch aptly likens such behavior to cutting the flowers and

watering the weeds. Our holdings of Freddie Mac are the maximum

allowed by law, and are extensively described by Charlie in his

letter. In our consolidated balance sheet these shares are

carried at cost rather than market, since they are owned by

Mutual Savings and Loan, a non-insurance subsidiary.

We continue to concentrate our investments in a very few

companies that we try to understand well. There are only a

handful of businesses about which we have strong long-term

convictions. Therefore, when we find such a business, we want to

participate in a meaningful way. We agree with Mae West: “Too

much of a good thing can be wonderful.”

o We reduced our holdings of medium-term tax-exempt bonds by

about $100 million last year. All of the bonds sold were

acquired after August 7, 1986. When such bonds are held by

property-casualty insurance companies, 15% of the “tax-exempt”

interest earned is subject to tax.

The $800 million position we still hold consists almost

entirely of bonds “grandfathered” under the Tax Reform Act of

1986, which means they are entirely tax-exempt. Our sales

produced a small profit and our remaining bonds, which have an

average maturity of about six years, are worth modestly more than

carrying value.

Last year we described our holdings of short-term and

intermediate-term bonds of Texaco, which was then in bankruptcy.

During 1988, we sold practically all of these bonds at a pre-tax

profit of about $22 million. This sale explains close to $100

million of the reduction in fixed-income securities on our

balance sheet.

We also told you last year about our holdings of another

security whose predominant characteristics are those of an

intermediate fixed-income issue: our $700 million position in

Salomon Inc 9% convertible preferred. This preferred has a

sinking fund that will retire it in equal annual installments

from 1995 to 1999. Berkshire carries this holding at cost. For

reasons discussed by Charlie on page 69, the estimated market

value of our holding has improved from moderately under cost at

the end of last year to moderately over cost at 1988 year end.

The close association we have had with John Gutfreund, CEO

of Salomon, during the past year has reinforced our admiration

for him. But we continue to have no great insights about the

near, intermediate or long-term economics of the investment

banking business: This is not an industry in which it is easy to

forecast future levels of profitability. We continue to believe

that our conversion privilege could well have important value

over the life of our preferred. However, the overwhelming

portion of the preferred’s value resides in its fixed-income

characteristics, not its equity characteristics.

o We have not lost our aversion to long-term bonds. We will

become enthused about such securities only when we become

enthused about prospects for long-term stability in the

purchasing power of money. And that kind of stability isn’t in

the cards: Both society and elected officials simply have too

many higher-ranking priorities that conflict with purchasing-

power stability. The only long-term bonds we hold are those of

Washington Public Power Supply Systems (WPPSS). A few of our

WPPSS bonds have short maturities and many others, because of

their high coupons, are likely to be refunded and paid off in a

few years. Overall, our WPPSS holdings are carried on our

balance sheet at $247 million and have a market value of about

$352 million.

We explained the reasons for our WPPSS purchases in the 1983

annual report, and are pleased to tell you that this commitment

has worked out about as expected. At the time of purchase, most

of our bonds were yielding around 17% after taxes and carried no

ratings, which had been suspended. Recently, the bonds were

rated AA- by Standard & Poor’s. They now sell at levels only

slightly below those enjoyed by top-grade credits.

In the 1983 report, we compared the economics of our WPPSS

purchase to those involved in buying a business. As it turned

out, this purchase actually worked out better than did the

general run of business acquisitions made in 1983, assuming both

are measured on the basis of unleveraged, after tax returns

achieved through 1988.

Our WPPSS experience, though pleasant, does nothing to alter

our negative opinion about long-term bonds. It only makes us

hope that we run into some other large stigmatized issue, whose

troubles have caused it to be significantly misappraised by the

market.

Arbitrage

In past reports we have told you that our insurance

subsidiaries sometimes engage in arbitrage as an alternative to

holding short-term cash equivalents. We prefer, of course, to

make major long-term commitments, but we often have more cash

than good ideas. At such times, arbitrage sometimes promises

much greater returns than Treasury Bills and, equally important,

cools any temptation we may have to relax our standards for long-

term investments. (Charlie’s sign off after we’ve talked about

an arbitrage commitment is usually: “Okay, at least it will keep

you out of bars.”)

During 1988 we made unusually large profits from arbitrage,

measured both by absolute dollars and rate of return. Our pre-

tax gain was about $78 million on average invested funds of about

$147 million.

This level of activity makes some detailed discussion of

arbitrage and our approach to it appropriate. Once, the word

applied only to the simultaneous purchase and sale of securities

or foreign exchange in two different markets. The goal was to

exploit tiny price differentials that might exist between, say,

Royal Dutch stock trading in guilders in Amsterdam, pounds in

London, and dollars in New York. Some people might call this

scalping; it won’t surprise you that practitioners opted for the

French term, arbitrage.

Since World War I the definition of arbitrage - or “risk

arbitrage,” as it is now sometimes called - has expanded to

include the pursuit of profits from an announced corporate event

such as sale of the company, merger, recapitalization,

reorganization, liquidation, self-tender, etc. In most cases the

arbitrageur expects to profit regardless of the behavior of the

stock market. The major risk he usually faces instead is that

the announced event won’t happen.

Some offbeat opportunities occasionally arise in the

arbitrage field. I participated in one of these when I was 24

and working in New York for Graham-Newman Corp. Rockwood & Co.,

a Brooklyn based chocolate products company of limited

profitability, had adopted LIFO inventory valuation in 1941

when cocoa was selling for 5¢ per pound. In 1954 a

temporary shortage of cocoa caused the price to soar to over

60¢. Consequently Rockwood wished to unload its valuable

inventory - quickly, before the price dropped. But if the cocoa

had simply been sold off, the company would have owed close to

a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an

arcane provision that eliminated the tax otherwise due on LIFO

profits if inventory was distributed to shareholders as part of a

plan reducing the scope of a corporation’s business. Rockwood

decided to terminate one of its businesses, the sale of cocoa

butter, and said 13 million pounds of its cocoa bean inventory

was attributable to that activity. Accordingly, the company

offered to repurchase its stock in exchange for the cocoa beans

it no longer needed, paying 80 pounds of beans for each share.

For several weeks I busily bought shares, sold beans, and

made periodic stops at Schroeder Trust to exchange stock

certificates for warehouse receipts. The profits were good and

my only expense was subway tokens.

The architect of Rockwood’s restructuring was an unknown,

but brilliant Chicagoan, Jay Pritzker, then 32. If you’re

familiar with Jay’s subsequent record, you won’t be surprised to

hear the action worked out rather well for Rockwood’s continuing

shareholders also. From shortly before the tender until shortly

after it, Rockwood stock appreciated from 15 to 100, even though

the company was experiencing large operating losses. Sometimes

there is more to stock valuation than price-earnings ratios.

In recent years, most arbitrage operations have involved

takeovers, friendly and unfriendly. With acquisition fever

rampant, with anti-trust challenges almost non-existent, and with

bids often ratcheting upward, arbitrageurs have prospered

mightily. They have not needed special talents to do well; the

trick, a la Peter Sellers in the movie, has simply been “Being

There.” In Wall Street the old proverb has been reworded: “Give a

man a fish and you feed him for a day. Teach him how to

arbitrage and you feed him forever.” (If, however, he studied at

the Ivan Boesky School of Arbitrage, it may be a state

institution that supplies his meals.)

To evaluate arbitrage situations you must answer four

questions: (1) How likely is it that the promised event will

indeed occur? (2) How long will your money be tied up? (3) What

chance is there that something still better will transpire - a

competing takeover bid, for example? and (4) What will happen if

the event does not take place because of anti-trust action,

financing glitches, etc.?

Arcata Corp., one of our more serendipitous arbitrage

experiences, illustrates the twists and turns of the business.

On September 28, 1981 the directors of Arcata agreed in principle

to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR),

then and now a major leveraged-buy out firm. Arcata was in the

printing and forest products businesses and had one other thing

going for it: In 1978 the U.S. Government had taken title to

10,700 acres of Arcata timber, primarily old-growth redwood, to

expand Redwood National Park. The government had paid $97.9

million, in several installments, for this acreage, a sum Arcata

was contesting as grossly inadequate. The parties also disputed

the interest rate that should apply to the period between the

taking of the property and final payment for it. The enabling

legislation stipulated 6% simple interest; Arcata argued for a

much higher and compounded rate.

Buying a company with a highly-speculative, large-sized

claim in litigation creates a negotiating problem, whether the

claim is on behalf of or against the company. To solve this

problem, KKR offered $37.00 per Arcata share plus two-thirds of

any additional amounts paid by the government for the redwood

lands.

Appraising this arbitrage opportunity, we had to ask

ourselves whether KKR would consummate the transaction since,

among other things, its offer was contingent upon its obtaining

“satisfactory financing.” A clause of this kind is always

dangerous for the seller: It offers an easy exit for a suitor

whose ardor fades between proposal and marriage. However, we

were not particularly worried about this possibility because

KKR’s past record for closing had been good.

We also had to ask ourselves what would happen if the KKR

deal did fall through, and here we also felt reasonably

comfortable: Arcata’s management and directors had been shopping

the company for some time and were clearly determined to sell.

If KKR went away, Arcata would likely find another buyer, though

of course, the price might be lower.

Finally, we had to ask ourselves what the redwood claim

might be worth. Your Chairman, who can’t tell an elm from an

oak, had no trouble with that one: He coolly evaluated the claim

at somewhere between zero and a whole lot.

We started buying Arcata stock, then around $33.50, on

September 30 and in eight weeks purchased about 400,000 shares,

or 5% of the company. The initial announcement said that the

$37.00 would be paid in January, 1982. Therefore, if everything

had gone perfectly, we would have achieved an annual rate of

return of about 40% - not counting the redwood claim, which would

have been frosting.

All did not go perfectly. In December it was announced that

the closing would be delayed a bit. Nevertheless, a definitive

agreement was signed on January 4. Encouraged, we raised our

stake, buying at around $38.00 per share and increasing our

holdings to 655,000 shares, or over 7% of the company. Our

willingness to pay up - even though the closing had been

postponed - reflected our leaning toward “a whole lot” rather

than “zero” for the redwoods.

Then, on February 25 the lenders said they were taking a

“second look” at financing terms “ in view of the severely

depressed housing industry and its impact on Arcata’s outlook.”

The stockholders’ meeting was postponed again, to April. An

Arcata spokesman said he “did not think the fate of the

acquisition itself was imperiled.” When arbitrageurs hear such

reassurances, their minds flash to the old saying: “He lied like

a finance minister on the eve of devaluation.”

On March 12 KKR said its earlier deal wouldn’t work, first

cutting its offer to $33.50, then two days later raising it to

$35.00. On March 15, however, the directors turned this bid down

and accepted another group’s offer of $37.50 plus one-half of any

redwood recovery. The shareholders okayed the deal, and the

$37.50 was paid on June 4.

We received $24.6 million versus our cost of $22.9 million;

our average holding period was close to six months. Considering

the trouble this transaction encountered, our 15% annual rate of

return excluding any value for the redwood claim - was more than

satisfactory.

But the best was yet to come. The trial judge appointed two

commissions, one to look at the timber’s value, the other to

consider the interest rate questions. In January 1987, the first

commission said the redwoods were worth $275.7 million and the

second commission recommended a compounded, blended rate of

return working out to about 14%.

In August 1987 the judge upheld these conclusions, which

meant a net amount of about $600 million would be due Arcata.

The government then appealed. In 1988, though, before this

appeal was heard, the claim was settled for $519 million.

Consequently, we received an additional $29.48 per share, or

about $19.3 million. We will get another $800,000 or so in 1989.

Berkshire’s arbitrage activities differ from those of many

arbitrageurs. First, we participate in only a few, and usually

very large, transactions each year. Most practitioners buy into

a great many deals perhaps 50 or more per year. With that many

irons in the fire, they must spend most of their time monitoring

both the progress of deals and the market movements of the

related stocks. This is not how Charlie nor I wish to spend our

lives. (What’s the sense in getting rich just to stare at a

ticker tape all day?)

Because we diversify so little, one particularly profitable

or unprofitable transaction will affect our yearly result from

arbitrage far more than it will the typical arbitrage operation.

So far, Berkshire has not had a really bad experience. But we

will - and when it happens we’ll report the gory details to you.

The other way we differ from some arbitrage operations is

that we participate only in transactions that have been publicly

announced. We do not trade on rumors or try to guess takeover

candidates. We just read the newspapers, think about a few of

the big propositions, and go by our own sense of probabilities.

At yearend, our only major arbitrage position was 3,342,000

shares of RJR Nabisco with a cost of $281.8 million and a market

value of $304.5 million. In January we increased our holdings to

roughly four million shares and in February we eliminated our

position. About three million shares were accepted when we

tendered our holdings to KKR, which acquired RJR, and the

returned shares were promptly sold in the market. Our pre-tax

profit was a better-than-expected $64 million.

Earlier, another familiar face turned up in the RJR bidding

contest: Jay Pritzker, who was part of a First Boston group that

made a tax-oriented offer. To quote Yogi Berra; “It was deja vu

all over again.”

During most of the time when we normally would have been

purchasers of RJR, our activities in the stock were restricted

because of Salomon’s participation in a bidding group.

Customarily, Charlie and I, though we are directors of Salomon,

are walled off from information about its merger and acquisition

work. We have asked that it be that way: The information would

do us no good and could, in fact, occasionally inhibit

Berkshire’s arbitrage operations.

However, the unusually large commitment that Salomon

proposed to make in the RJR deal required that all directors be

fully informed and involved. Therefore, Berkshire’s purchases of

RJR were made at only two times: first, in the few days

immediately following management’s announcement of buyout plans,

before Salomon became involved; and considerably later, after the

RJR board made its decision in favor of KKR. Because we could

not buy at other times, our directorships cost Berkshire

significant money.

Considering Berkshire’s good results in 1988, you might

expect us to pile into arbitrage during 1989. Instead, we expect

to be on the sidelines.

One pleasant reason is that our cash holdings are down -

because our position in equities that we expect to hold for a

very long time is substantially up. As regular readers of this

report know, our new commitments are not based on a judgment

about short-term prospects for the stock market. Rather, they

reflect an opinion about long-term business prospects for

specific companies. We do not have, never have had, and never

will have an opinion about where the stock market, interest

rates, or business activity will be a year from now.

Even if we had a lot of cash we probably would do little in

arbitrage in 1989. Some extraordinary excesses have developed in

the takeover field. As Dorothy says: “Toto, I have a feeling

we’re not in Kansas any more.”

We have no idea how long the excesses will last, nor do we

know what will change the attitudes of government, lender and

buyer that fuel them. But we do know that the less the prudence

with which others conduct their affairs, the greater the prudence

with which we should conduct our own affairs. We have no desire

to arbitrage transactions that reflect the unbridled - and, in

our view, often unwarranted - optimism of both buyers and

lenders. In our activities, we will heed the wisdom of Herb

Stein: “If something can’t go on forever, it will end.”

Efficient Market Theory

The preceding discussion about arbitrage makes a small

discussion of “efficient market theory” (EMT) also seem relevant.

This doctrine became highly fashionable - indeed, almost holy

scripture in academic circles during the 1970s. Essentially, it

said that analyzing stocks was useless because all public

information about them was appropriately reflected in their

prices. In other words, the market always knew everything. As a

corollary, the professors who taught EMT said that someone

throwing darts at the stock tables could select a stock portfolio

having prospects just as good as one selected by the brightest,

most hard-working security analyst. Amazingly, EMT was embraced

not only by academics, but by many investment professionals and

corporate managers as well. Observing correctly that the market

was frequently efficient, they went on to conclude incorrectly

that it was always efficient. The difference between these

propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience

of Graham-Newman Corp. Buffett Partnership, and Berkshire

illustrates just how foolish EMT is. (There’s plenty of other

evidence, also.) While at Graham-Newman, I made a study of its

earnings from arbitrage during the entire 1926-1956 lifespan of

the company. Unleveraged returns averaged 20% per year.

Starting in 1956, I applied Ben Graham’s arbitrage principles,

first at Buffett Partnership and then Berkshire. Though I’ve not

made an exact calculation, I have done enough work to know that

the 1956-1988 returns averaged well over 20%. (Of course, I

operated in an environment far more favorable than Ben’s; he had

1929-1932 to contend with.)

All of the conditions are present that are required for a

fair test of portfolio performance: (1) the three organizations

traded hundreds of different securities while building this 63-

year record; (2) the results are not skewed by a few fortunate

experiences; (3) we did not have to dig for obscure facts or

develop keen insights about products or managements - we simply

acted on highly-publicized events; and (4) our arbitrage

positions were a clearly identified universe - they have not been

selected by hindsight.

Over the 63 years, the general market delivered just under a

10% annual return, including dividends. That means $1,000 would

have grown to $405,000 if all income had been reinvested. A 20%

rate of return, however, would have produced $97 million. That

strikes us as a statistically-significant differential that

might, conceivably, arouse one’s curiosity.

Yet proponents of the theory have never seemed interested in

discordant evidence of this type. True, they don’t talk quite as

much about their theory today as they used to. But no one, to my

knowledge, has ever said he was wrong, no matter how many

thousands of students he has sent forth misinstructed. EMT,

moreover, continues to be an integral part of the investment

curriculum at major business schools. Apparently, a reluctance

to recant, and thereby to demystify the priesthood, is not

limited to theologians.

Naturally the disservice done students and gullible

investment professionals who have swallowed EMT has been an

extraordinary service to us and other followers of Graham. In

any sort of a contest - financial, mental, or physical - it’s an

enormous advantage to have opponents who have been taught that

it’s useless to even try. From a selfish point of view,

Grahamites should probably endow chairs to ensure the perpetual

teaching of EMT.

All this said, a warning is appropriate. Arbitrage has

looked easy recently. But this is not a form of investing that

guarantees profits of 20% a year or, for that matter, profits of

any kind. As noted, the market is reasonably efficient much of

the time: For every arbitrage opportunity we seized in that 63-

year period, many more were foregone because they seemed

properly-priced.

An investor cannot obtain superior profits from stocks by

simply committing to a specific investment category or style. He

can earn them only by carefully evaluating facts and continuously

exercising discipline. Investing in arbitrage situations, per

se, is no better a strategy than selecting a portfolio by

throwing darts.

New York Stock Exchange Listing

Berkshire’s shares were listed on the New York Stock

Exchange on November 29, 1988. On pages 50-51 we reproduce the

letter we sent to shareholders concerning the listing.

Let me clarify one point not dealt with in the letter:

Though our round lot for trading on the NYSE is ten shares, any

number of shares from one on up can be bought or sold.

As the letter explains, our primary goal in listing was to

reduce transaction costs, and we believe this goal is being

achieved. Generally, the spread between the bid and asked price

on the NYSE has been well below the spread that prevailed in the

over-the-counter market.

Henderson Brothers, Inc., the specialist in our shares, is

the oldest continuing specialist firm on the Exchange; its

progenitor, William Thomas Henderson, bought his seat for $500 on

September 8, 1861. (Recently, seats were selling for about

$625,000.) Among the 54 firms acting as specialists, HBI ranks

second in number of stocks assigned, with 83. We were pleased

when Berkshire was allocated to HBI, and have been delighted with

the firm’s performance. Jim Maguire, Chairman of HBI, personally

manages the trading in Berkshire, and we could not be in better

hands.

In two respects our goals probably differ somewhat from

those of most listed companies. First, we do not want to

maximize the price at which Berkshire shares trade. We wish

instead for them to trade in a narrow range centered at intrinsic

business value (which we hope increases at a reasonable - or,

better yet, unreasonable - rate). Charlie and I are bothered as

much by significant overvaluation as significant undervaluation.

Both extremes will inevitably produce results for many

shareholders that will differ sharply from Berkshire’s business

results. If our stock price instead consistently mirrors

business value, each of our shareholders will receive an

investment result that roughly parallels the business results of

Berkshire during his holding period.

Second, we wish for very little trading activity. If we ran

a private business with a few passive partners, we would be

disappointed if those partners, and their replacements,

frequently wanted to leave the partnership. Running a public

company, we feel the same way.

Our goal is to attract long-term owners who, at the time of

purchase, have no timetable or price target for sale but plan

instead to stay with us indefinitely. We don’t understand the

CEO who wants lots of stock activity, for that can be achieved

only if many of his owners are constantly exiting. At what other

organization - school, club, church, etc. - do leaders cheer when

members leave? (However, if there were a broker whose livelihood

depended upon the membership turnover in such organizations, you

could be sure that there would be at least one proponent of

activity, as in: “There hasn’t been much going on in Christianity

for a while; maybe we should switch to Buddhism next week.“)

Of course, some Berkshire owners will need or want to sell

from time to time, and we wish for good replacements who will pay

them a fair price. Therefore we try, through our policies,

performance, and communications, to attract new shareholders who

understand our operations, share our time horizons, and measure

us as we measure ourselves. If we can continue to attract this

sort of shareholder - and, just as important, can continue to be

uninteresting to those with short-term or unrealistic

expectations - Berkshire shares should consistently sell at

prices reasonably related to business value.

David L. Dodd

Dave Dodd, my friend and teacher for 38 years, died last

year at age 93. Most of you don’t know of him. Yet any long-

time shareholder of Berkshire is appreciably wealthier because of

the indirect influence he had upon our company.

Dave spent a lifetime teaching at Columbia University, and

he co-authored Security Analysis with Ben Graham. From the

moment I arrived at Columbia, Dave personally encouraged and

educated me; one influence was as important as the other.

Everything he taught me, directly or through his book, made

sense. Later, through dozens of letters, he continued my

education right up until his death.

I have known many professors of finance and investments but

I have never seen any, except for Ben Graham, who was the match

of Dave. The proof of his talent is the record of his students:

No other teacher of investments has sent forth so many who have

achieved unusual success.

When students left Dave’s classroom, they were equipped to

invest intelligently for a lifetime because the principles he

taught were simple, sound, useful, and enduring. Though these

may appear to be unremarkable virtues, the teaching of principles

embodying them has been rare.

It’s particularly impressive that Dave could practice as

well as preach. just as Keynes became wealthy by applying his

academic ideas to a very small purse, so, too, did Dave. Indeed,

his financial performance far outshone that of Keynes, who began

as a market-timer (leaning on business and credit-cycle theory)

and converted, after much thought, to value investing. Dave was

right from the start.

In Berkshire’s investments, Charlie and I have employed the

principles taught by Dave and Ben Graham. Our prosperity is the

fruit of their intellectual tree.

Miscellaneous

We hope to buy more businesses that are similar to the ones

we have, and we can use some help. If you have a business that

fits the following criteria, call me or, preferably, write.

Here’s what we’re looking for:

(1) large purchases (at least $10 million of after-tax

earnings),

(2) demonstrated consistent earning power (future projections

are of little interest to us, nor are “turnaround”

situations),

(3) businesses earning good returns on equity while employing

little or no debt,

(4) management in place (we can’t supply it),

(5) simple businesses (if there’s lots of technology, we won’t

understand it),

(6) an offering price (we don’t want to waste our time or that

of the seller by talking, even preliminarily, about a

transaction when price is unknown).

We will not engage in unfriendly takeovers. We can promise

complete confidentiality and a very fast answer - customarily

within five minutes - as to whether we’re interested. We prefer

to buy for cash, but will consider issuing stock when we receive

as much in intrinsic business value as we give.

Our favorite form of purchase is one fitting the Blumkin-

Friedman-Heldman mold. In cases like these, the company’s owner-

managers wish to generate significant amounts of cash, sometimes

for themselves, but often for their families or inactive

shareholders. However, these managers also wish to remain

significant owners who continue to run their companies just as

they have in the past. We think we offer a particularly good fit

for owners with these objectives and invite potential sellers to

check us out by contacting people with whom we have done business

in the past.

Charlie and I frequently get approached about acquisitions

that don’t come close to meeting our tests: We’ve found that if

you advertise an interest in buying collies, a lot of people will

call hoping to sell you their cocker spaniels. Our interest in

new ventures, turnarounds, or auction-like sales can best be

expressed by another Goldwynism: “Please include me out.”

Besides being interested in the purchase of businesses as

described above, we are also interested in the negotiated

purchase of large, but not controlling, blocks of stock

comparable to those we hold in Cap Cities and Salomon. We have a

special interest in purchasing convertible preferreds as a long-

term investment, as we did at Salomon.


We received some good news a few weeks ago: Standard &

Poor’s raised our credit rating to AAA, which is the highest

rating it bestows. Only 15 other U.S. industrial or property-

casualty companies are rated AAA, down from 28 in 1980.

Corporate bondholders have taken their lumps in the past few

years from “event risk.” This term refers to the overnight

degradation of credit that accompanies a heavily-leveraged

purchase or recapitalization of a business whose financial

policies, up to then, had been conservative. In a world of

takeovers inhabited by few owner-managers, most corporations

present such a risk. Berkshire does not. Charlie and I promise

bondholders the same respect we afford shareholders.


About 97.4% of all eligible shares participated in

Berkshire’s 1988 shareholder-designated contributions program.

Contributions made through the program were $5 million, and 2,319

charities were recipients. If we achieve reasonable business

results, we plan to increase the per-share contributions in 1989.

We urge new shareholders to read the description of our

shareholder-designated contributions program that appears on

pages 48-49. If you wish to participate in future programs, we

strongly urge that you immediately make sure your shares are

registered in the name of the actual owner, not in the nominee

name of a broker, bank or depository. Shares not so registered

on September 30, 1989 will be ineligible for the 1989 program.


Berkshire’s annual meeting will be held in Omaha on Monday,

April 24, 1989, and I hope you will come. The meeting provides

the forum for you to ask any owner-related questions you may

have, and we will keep answering until all (except those dealing

with portfolio activities or other proprietary information) have

been dealt with.

After the meeting we will have several buses available to

take you to visit Mrs. B at The Nebraska Furniture Mart and Ike

Friedman at Borsheim’s. Be prepared for bargains.

Out-of-towners may prefer to arrive early and visit Mrs. B

during the Sunday store hours of noon to five. (These Sunday

hours seem ridiculously short to Mrs. B, who feels they scarcely

allow her time to warm up; she much prefers the days on which the

store remains open from 10 a.m. to 9 p.m.) Borsheims, however, is

not open on Sunday.

Ask Mrs. B the secret of her astonishingly low carpet

prices. She will confide to you - as she does to everyone - how

she does it: “I can sell so cheap ‘cause I work for this dummy

who doesn’t know anything about carpet.”

Warren E. Buffett

February 28, 1989 Chairman of the Board


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