Chairman's Letter - 1989

Chairman’s Letter - 1989

BERKSHIRE HATHAWAY INC.

To the Shareholders of Berkshire Hathaway Inc.:

Our gain in net worth during 1989 was $1.515 billion, or

44.4%. Over the last 25 years (that is, since present management

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

$4,296.01, or at a rate of 23.8% compounded annually.

What counts, however, is intrinsic value - the figure

indicating what all of our constituent businesses are rationally

worth. With perfect foresight, this number can be calculated by

taking all future cash flows of a business - in and out - and

discounting them at prevailing interest rates. So valued, all

businesses, from manufacturers of buggy whips to operators of

cellular phones, become economic equals.

Back when Berkshire’s book value was $19.46, intrinsic

value was somewhat less because the book value was entirely tied

up in a textile business not worth the figure at which it was

carried. Now most of our businesses are worth far more than their

carrying values. This agreeable evolution from a discount to a

premium means that Berkshire’s intrinsic business value has

compounded at a rate that somewhat exceeds our 23.8% annual

growth in book value.

The rear-view mirror is one thing; the windshield is

another. A large portion of our book value is represented by

equity securities that, with minor exceptions, are carried on our

balance sheet at current market values. At yearend these

securities were valued at higher prices, relative to their own

intrinsic business values, than has been the case in the past.

One reason is the buoyant 1989 stock market. More important, the

virtues of these businesses have been widely recognized. Whereas

once their stock prices were inappropriately low, they are not

now.

We will keep most of our major holdings, regardless of how

they are priced relative to intrinsic business value. This 'til-

death-do-us-part attitude, combined with the full prices these

holdings command, means that they cannot be expected to push up

Berkshire’s value in the future as sharply as in the past. In

other words, our performance to date has benefited from a double-

dip: (1) the exceptional gains in intrinsic value that our

portfolio companies have achieved; (2) the additional bonus we

realized as the market appropriately “corrected” the prices of

these companies, raising their valuations in relation to those of

the average business. We will continue to benefit from good gains

in business value that we feel confident our portfolio companies

will make. But our “catch-up” rewards have been realized, which

means we’ll have to settle for a single-dip in the future.

We face another obstacle: In a finite world, high growth

rates must self-destruct. If the base from which the growth is

taking place is tiny, this law may not operate for a time. But

when the base balloons, the party ends: A high growth rate

eventually forges its own anchor.

Carl Sagan has entertainingly described this phenomenon,

musing about the destiny of bacteria that reproduce by dividing

into two every 15 minutes. Says Sagan: "That means four doublings

an hour, and 96 doublings a day. Although a bacterium weighs only

about a trillionth of a gram, its descendants, after a day of

wild asexual abandon, will collectively weigh as much as a

mountain…in two days, more than the sun - and before very long,

everything in the universe will be made of bacteria." Not to

worry, says Sagan: Some obstacle always impedes this kind of

exponential growth. "The bugs run out of food, or they poison

each other, or they are shy about reproducing in public."

Even on bad days, Charlie Munger (Berkshire’s Vice Chairman

and my partner) and I do not think of Berkshire as a bacterium.

Nor, to our unending sorrow, have we found a way to double its

net worth every 15 minutes. Furthermore, we are not the least bit

shy about reproducing - financially - in public. Nevertheless,

Sagan’s observations apply. From Berkshire’s present base of $4.9

billion in net worth, we will find it much more difficult to

average 15% annual growth in book value than we did to average

23.8% from the $22 million we began with.

Taxes

Our 1989 gain of $1.5 billion was achieved after we took a

charge of about $712 million for income taxes. In addition,

Berkshire’s share of the income taxes paid by its five major

investees totaled about $175 million.

Of this year’s tax charge, about $172 million will be paid

currently; the remainder, $540 million, is deferred. Almost all

of the deferred portion relates to the 1989 increase in

unrealized profits in our common stock holdings. Against this

increase, we have reserved a 34% tax.

We also carry reserves at that rate against all unrealized

profits generated in 1987 and 1988. But, as we explained last

year, the unrealized gains we amassed before 1987 - about $1.2

billion - carry reserves booked at the 28% tax rate that then

prevailed.

A new accounting rule is likely to be adopted that will

require companies to reserve against all gains at the current tax

rate, whatever it may be. With the rate at 34%, such a rule would

increase our deferred tax liability, and decrease our net worth,

by about $71 million - the result of raising the reserve on our

pre-1987 gain by six percentage points. Because the proposed rule

has sparked widespread controversy and its final form is unclear,

we have not yet made this change.

As you can see from our balance sheet on page 27, we would

owe taxes of more than $1.1 billion were we to sell all of our

securities at year-end market values. Is this $1.1 billion

liability equal, or even similar, to a $1.1 billion liability

payable to a trade creditor 15 days after the end of the year?

Obviously not - despite the fact that both items have exactly the

same effect on audited net worth, reducing it by $1.1 billion.

On the other hand, is this liability for deferred taxes a

meaningless accounting fiction because its payment can be

triggered only by the sale of stocks that, in very large part, we

have no intention of selling? Again, the answer is no.

In economic terms, the liability resembles an interest-free

loan from the U.S. Treasury that comes due only at our election

(unless, of course, Congress moves to tax gains before they are

realized). This “loan” is peculiar in other respects as well: It

can be used only to finance the ownership of the particular,

appreciated stocks and it fluctuates in size - daily as market

prices change and periodically if tax rates change. In effect,

this deferred tax liability is equivalent to a very large

transfer tax that is payable only if we elect to move from one

asset to another. Indeed, we sold some relatively small holdings

in 1989, incurring about $76 million of “transfer” tax on $224

million of gains.

Because of the way the tax law works, the Rip Van Winkle

style of investing that we favor - if successful - has an

important mathematical edge over a more frenzied approach. Let’s

look at an extreme comparison.

Imagine that Berkshire had only $1, which we put in a

security that doubled by yearend and was then sold. Imagine

further that we used the after-tax proceeds to repeat this

process in each of the next 19 years, scoring a double each time.

At the end of the 20 years, the 34% capital gains tax that we

would have paid on the profits from each sale would have

delivered about $13,000 to the government and we would be left

with about $25,250. Not bad. If, however, we made a single

fantastic investment that itself doubled 20 times during the 20

years, our dollar would grow to $1,048,576. Were we then to cash

out, we would pay a 34% tax of roughly $356,500 and be left with

about $692,000.

The sole reason for this staggering difference in results

would be the timing of tax payments. Interestingly, the

government would gain from Scenario 2 in exactly the same 27:1

ratio as we - taking in taxes of $356,500 vs. $13,000 - though,

admittedly, it would have to wait for its money.

We have not, we should stress, adopted our strategy

favoring long-term investment commitments because of these

mathematics. Indeed, it is possible we could earn greater after-

tax returns by moving rather frequently from one investment to

another. Many years ago, that’s exactly what Charlie and I did.

Now we would rather stay put, even if that means slightly

lower returns. Our reason is simple: We have found splendid

business relationships to be so rare and so enjoyable that we

want to retain all we develop. This decision is particularly

easy for us because we feel that these relationships will produce

good - though perhaps not optimal - financial results.

Considering that, we think it makes little sense for us to give

up time with people we know to be interesting and admirable for

time with others we do not know and who are likely to have human

qualities far closer to average. That would be akin to marrying

for money - a mistake under most circumstances, insanity if one

is already rich.

Sources of Reported Earnings

The table below shows the major sources of Berkshire’s

reported earnings. In this presentation, amortization of Goodwill

and other major purchase-price accounting adjustments are not

charged against the specific businesses to which they apply, but

are instead aggregated and shown separately. This procedure lets

you view the earnings of our businesses as they would have been

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

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

useful to investors and managers than one utilizing generally

accepted accounting principles (GAAP), which require purchase-

price adjustments to be made on a business-by-business basis. The

total net earnings we show in the table are, of course, identical

to the GAAP total in our audited financial statements.

Further information about these businesses is given in the

Business Segment section on pages 37-39, and in the Management’s

Discussion section on pages 40-44. In these sections you also

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

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

Munger’s letter, which starts on page 54. In addition, we have

reprinted on page 71 Charlie’s May 30, 1989 letter to the U. S.

League of Savings Institutions, which conveyed our disgust with

its policies and our consequent decision to resign.

(000s omitted)


Berkshire’s Share

of Net Earnings

(after taxes and

Pre-Tax Earnings minority interests)


1989 1988 1989 1988


Operating Earnings:

Insurance Group:

Underwriting ………… $(24,400) $(11,081) $(12,259) $ (1,045)

Net Investment Income … 243,599 231,250 213,642 197,779

Buffalo News ………….. 46,047 42,429 27,771 25,462

Fechheimer ……………. 12,621 14,152 6,789 7,720

Kirby ………………… 26,114 26,891 16,803 17,842

Nebraska Furniture Mart … 17,070 18,439 8,441 9,099

Scott Fetzer

Manufacturing Group …. 33,165 28,542 19,996 17,640

See’s Candies …………. 34,235 32,473 20,626 19,671

Wesco - other than Insurance 13,008 16,133 9,810 10,650

World Book ……………. 25,583 27,890 16,372 18,021

Amortization of Goodwill .. (3,387) (2,806) (3,372) (2,806)

Other Purchase-Price

Accounting Charges …….. (5,740) (6,342) (6,668) (7,340)

Interest Expense* ……… (42,389) (35,613) (27,098) (23,212)

Shareholder-Designated

Contributions ………. (5,867) (4,966) (3,814) (3,217)

Other ………………… 23,755 41,059 12,863 27,177


Operating Earnings ………. 393,414 418,450 299,902 313,441

Sales of Securities ……… 223,810 131,671 147,575 85,829


Total Earnings - All Entities $617,224 $550,121 $447,477 $399,270

*Excludes interest expense of Scott Fetzer Financial Group and

Mutual Savings & Loan.

We refer you also to pages 45-51, where we have rearranged

Berkshire’s financial data into four segments. These correspond

to the way Charlie and I think about the business and should help

you calculate Berkshire’s intrinsic value. Shown on these pages

are balance sheets and earnings statements for: (1) our

insurance operations, with their major investment positions

itemized; (2) our manufacturing, publishing and retailing

businesses, leaving aside certain non-operating assets and

purchase-price accounting adjustments; (3) our subsidiaries

engaged in finance-type operations, which are Mutual Savings and

Scott Fetzer Financial; and (4) an all-other category that

includes the non-operating assets (primarily marketable

securities) held by the companies in segment (2), all purchase

price accounting adjustments, and various assets and debts of the

Wesco and Berkshire parent companies.

If you combine the earnings and net worths of these four

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

statements. However, I want to emphasize that this four-category

presentation does not fall within the purview of our auditors,

who in no way bless it.

In addition to our reported earnings, we also benefit from

significant earnings of investees that standard accounting rules

do not permit us to report. On page 15, we list five major

investees from which we received dividends in 1989 of about $45

million, after taxes. However, our share of the retained earnings

of these investees totaled about $212 million last year, not

counting large capital gains realized by GEICO and Coca-Cola. If

this $212 million had been distributed to us, our own operating

earnings, after the payment of additional taxes, would have been

close to $500 million rather than the $300 million shown in the

table.

The question you must decide is whether these undistributed

earnings are as valuable to us as those we report. We believe

they are - and even think they may be more valuable. The reason

for this a-bird-in-the-bush-may-be-worth-two-in-the-hand

conclusion is that earnings retained by these investees will

be deployed by talented, owner-oriented managers who

sometimes have better uses for these funds in their own

businesses than we would have in ours. I would not make such a

generous assessment of most managements, but it is appropriate in

these cases.

In our view, Berkshire’s fundamental earning power is best

measured by a “look-through” approach, in which we append our

share of the operating earnings retained by our investees to our

own reported operating earnings, excluding capital gains in both

instances. For our intrinsic business value to grow at an average

of 15% per year, our “look-through” earnings must grow at about

the same pace. We’ll need plenty of help from our present

investees, and also need to add a new one from time to time, in

order to reach this 15% goal.

Non-Insurance Operations

In the past, we have labeled our major manufacturing,

publishing and retail operations “The Sainted Seven.” With our

acquisition of Borsheim’s early in 1989, the challenge was to

find a new title both alliterative and appropriate. We failed:

Let’s call the group “The Sainted Seven Plus One.”

This divine assemblage - Borsheim’s, The Buffalo News,

Fechheimer Bros., Kirby, Nebraska Furniture Mart, Scott Fetzer

Manufacturing Group, See’s Candies, World Book - is a collection

of businesses with economic characteristics that range from good

to superb. Its managers range from superb to superb.

Most of these managers have no need to work for a living;

they show up at the ballpark because they like to hit home runs.

And that’s exactly what they do. Their combined financial

statements (including those of some smaller operations), shown on

page 49, illustrate just how outstanding their performance is. On

an historical accounting basis, after-tax earnings of these

operations were 57% on average equity capital. Moreover, this

return was achieved with no net leverage: Cash equivalents have

matched funded debt. When I call off the names of our managers -

the Blumkin, Friedman and Heldman families, Chuck Huggins, Stan

Lipsey, and Ralph Schey - I feel the same glow that Miller

Huggins must have experienced when he announced the lineup of his

1927 New York Yankees.

Let’s take a look, business by business:

o In its first year with Berkshire, Borsheim’s met all

expectations. Sales rose significantly and are now considerably

better than twice what they were four years ago when the company

moved to its present location. In the six years prior to the

move, sales had also doubled. Ike Friedman, Borsheim’s managing

genius - and I mean that - has only one speed: fast-forward.

If you haven’t been there, you’ve never seen a jewelry store

like Borsheim’s. Because of the huge volume it does at one

location, the store can maintain an enormous selection across all

price ranges. For the same reason, it can hold its expense ratio

to about one-third that prevailing at jewelry stores offering

comparable merchandise. The store’s tight control of expenses,

accompanied by its unusual buying power, enable it to offer

prices far lower than those of other jewelers. These prices, in

turn, generate even more volume, and so the circle goes 'round

and 'round. The end result is store traffic as high as 4,000

people on seasonally-busy days.

Ike Friedman is not only a superb businessman and a great

showman but also a man of integrity. We bought the business

without an audit, and all of our surprises have been on the plus

side. “If you don’t know jewelry, know your jeweler” makes sense

whether you are buying the whole business or a tiny diamond.

A story will illustrate why I enjoy Ike so much: Every two

years I’m part of an informal group that gathers to have fun and

explore a few subjects. Last September, meeting at Bishop’s Lodge

in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come

by and educate us on jewels and the jewelry business.

Ike decided to dazzle the group, so he brought from Omaha

about $20 million of particularly fancy merchandise. I was

somewhat apprehensive - Bishop’s Lodge is no Fort Knox - and I

mentioned my concern to Ike at our opening party the evening

before his presentation. Ike took me aside. “See that safe?” he

said. "This afternoon we changed the combination and now even the

hotel management doesn’t know what it is." I breathed easier. Ike

went on: "See those two big fellows with guns on their hips?

They’ll be guarding the safe all night." I now was ready to

rejoin the party. But Ike leaned closer: “And besides, Warren,”

he confided, “the jewels aren’t in the safe.”

How can we miss with a fellow like that - particularly when

he comes equipped with a talented and energetic family, Alan,

Marvin Cohn, and Don Yale.

o At See’s Candies we had an 8% increase in pounds sold, even

though 1988 was itself a record year. Included in the 1989

performance were excellent same-store poundage gains, our first

in many years.

Advertising played an important role in this outstanding

performance. We increased total advertising expenditures from $4

million to $5 million and also got copy from our agency, Hal

Riney & Partners, Inc., that was 100% on the money in conveying

the qualities that make See’s special.

In our media businesses, such as the Buffalo News, we sell

advertising. In other businesses, such as See’s, we are buyers.

When we buy, we practice exactly what we preach when we sell. At

See’s, we more than tripled our expenditures on newspaper

advertising last year, to the highest percentage of sales that I

can remember. The payoff was terrific, and we thank both Hal

Riney and the power of well-directed newspaper advertising for

this result.

See’s splendid performances have become routine. But there

is nothing routine about the management of Chuck Huggins: His

daily involvement with all aspects of production and sales

imparts a quality-and-service message to the thousands of

employees we need to produce and distribute over 27 million

pounds of candy annually. In a company with 225 shops and a

massive mail order and phone business, it is no small trick to

run things so that virtually every customer leaves happy. Chuck

makes it look easy.

o The Nebraska Furniture Mart had record sales and excellent

earnings in 1989, but there was one sad note. Mrs. B - Rose

Blumkin, who started the company 52 years ago with $500 - quit in

May, after disagreeing with other members of the Blumkin

family/management about the remodeling and operation of the

carpet department.

Mrs. B probably has made more smart business decisions than

any living American, but in this particular case I believe the

other members of the family were entirely correct: Over the past

three years, while the store’s other departments increased sales

by 24%, carpet sales declined by 17% (but not because of any lack

of sales ability by Mrs. B, who has always personally sold far

more merchandise than any other salesperson in the store).

You will be pleased to know that Mrs. B continues to make

Horatio Alger’s heroes look like victims of tired blood. At age

96 she has started a new business selling - what else? - carpet

and furniture. And as always, she works seven days a week.

At the Mart Louie, Ron, and Irv Blumkin continue to propel

what is by far the largest and most successful home furnishings

store in the country. They are outstanding merchants, outstanding

managers, and a joy to be associated with. One reading on their

acumen: In the fourth quarter of 1989, the carpet department

registered a 75.3% consumer share in the Omaha market, up from

67.7% a year earlier and over six times that of its nearest

competitor.

NFM and Borsheim’s follow precisely the same formula for

success: (1) unparalleled depth and breadth of merchandise at one

location; (2) the lowest operating costs in the business; (3) the

shrewdest of buying, made possible in part by the huge volumes

purchased; (4) gross margins, and therefore prices, far below

competitors’; and (5) friendly personalized service with family

members on hand at all times.

Another plug for newspapers: NFM increased its linage in the

local paper by over 20% in 1989 - off a record 1988 - and remains

the paper’s largest ROP advertiser by far. (ROP advertising is

the kind printed in the paper, as opposed to that in preprinted

inserts.) To my knowledge, Omaha is the only city in which a home

furnishings store is the advertising leader. Many retailers cut

space purchases in 1989; our experience at See’s and NFM would

indicate they made a major mistake.

o The Buffalo News continued to star in 1989 in three

important ways: First, among major metropolitan papers, both

daily and Sunday, the News is number one in household penetration

Second, in “news hole” - the portion of the paper devoted to news

again making it more news-rich than any comparable American

paper. Third, in a year that saw profits slip at many major

papers, the News set its seventh consecutive profit record.

To some extent, these three factors are related, though

obviously a high-percentage news hole, by itself, reduces profits

significantly. A large and intelligently-utilized news hole,

however, attracts a wide spectrum of readers and thereby boosts

penetration. High penetration, in turn, makes a newspaper

particularly valuable to retailers since it allows them to talk

to the entire community through a single “megaphone.” A low-

penetration paper is a far less compelling purchase for many

advertisers and will eventually suffer in both ad rates and

profits.

It should be emphasized that our excellent penetration is

neither an accident nor automatic. The population of Erie County,

home territory of the News, has been falling - from 1,113,000 in

1970 to 1,015,000 in 1980 to an estimated 966,000 in 1988.

Circulation figures tell a different story. In 1975, shortly

before we started our Sunday edition, the Courier-Express, a

long-established Buffalo paper, was selling 207,500 Sunday copies

in Erie County. Last year - with population at least 5% lower -

the News sold an average of 292,700 copies. I believe that in no

other major Sunday market has there been anything close to that

increase in penetration.

When this kind of gain is made - and when a paper attains an

unequaled degree of acceptance in its home town - someone is

doing something right. In this case major credit clearly belongs

to Murray Light, our long-time editor who daily creates an

informative, useful, and interesting product. Credit should go

also to the Circulation and Production Departments: A paper that

is frequently late, because of production problems or

distribution weaknesses, will lose customers, no matter how

strong its editorial content.

Stan Lipsey, publisher of the News, has produced profits

fully up to the strength of our product. I believe Stan’s

managerial skills deliver at least five extra percentage points

in profit margin compared to the earnings that would be achieved

by an average manager given the same circumstances. That is an

amazing performance, and one that could only be produced by a

talented manager who knows - and cares - about every nut and bolt

of the business.

Stan’s knowledge and talents, it should be emphasized,

extend to the editorial product. His early years in the business

were spent on the news side and he played a key role in

developing and editing a series of stories that in 1972 won a

Pulitzer Prize for the Sun Newspaper of Omaha. Stan and I have

worked together for over 20 years, through some bad times as well

as good, and I could not ask for a better partner.

o At Fechheimer, the Heldman clan - Bob, George, Gary,

Roger and Fred - continue their extraordinary performance. Profits

in 1989 were down somewhat because of problems the business

experienced in integrating a major 1988 acquisition. These

problems will be ironed out in time. Meanwhile, return on invested

capital at Fechheimer remains splendid.

Like all of our managers, the Heldmans have an exceptional

command of the details of their business. At last year’s annual

meeting I mentioned that when a prisoner enters San Quentin, Bob

and George probably know his shirt size. That’s only a slight

exaggeration: No matter what area of the country is being

discussed, they know exactly what is going on with major

customers and with the competition.

Though we purchased Fechheimer four years ago, Charlie and I

have never visited any of its plants or the home office in

Cincinnati. We’re much like the lonesome Maytag repairman: The

Heldman managerial product is so good that a service call is

never needed.

o Ralph Schey continues to do a superb job in managing

our largest group - World Book, Kirby, and the Scott Fetzer

Manufacturing Companies. Aggregate earnings of these businesses

have increased every year since our purchase and returns on

invested capital continue to be exceptional. Ralph is running an

enterprise large enough, were it standing alone, to be on the

Fortune 500. And he’s running it in a fashion that would put him

high in the top decile, measured by return on equity.

For some years, World Book has operated out of a single

location in Chicago’s Merchandise Mart. Anticipating the imminent

expiration of its lease, the business is now decentralizing into

four locations. The expenses of this transition are significant;

nevertheless profits in 1989 held up well. It will be another

year before costs of the move are fully behind us.

Kirby’s business was particularly strong last year,

featuring large gains in export sales. International business has

more than doubled in the last two years and quintupled in the

past four; its share of unit sales has risen from 5% to 20%. Our

largest capital expenditures in 1989 were at Kirby, in

preparation for a major model change in 1990.

Ralph’s operations contribute about 40% of the total

earnings of the non-insurance group whose results are shown on

page 49. When we bought Scott Fetzer at the start of 1986, our

acquisition of Ralph as a manager was fully as important as our

acquisition of the businesses. In addition to generating

extraordinary earnings, Ralph also manages capital extremely

well. These abilities have produced funds for Berkshire that, in

turn, have allowed us to make many other profitable commitments.

And that completes our answer to the 1927 Yankees.

Insurance Operations

Shown below is an updated version of our usual table

presenting key figures for the property-casualty insurance

industry:

Statutory

Yearly Change Combined Ratio Yearly Change Inflation Rate

in Premiums After Policyholder in Incurred Measured by

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


1981 3.8 106.0 6.5 9.6

1982 3.7 109.6 8.4 6.5

1983 5.0 112.0 6.8 3.8

1984 8.5 118.0 16.9 3.8

1985 22.1 116.3 16.1 3.0

1986 22.2 108.0 13.5 2.6

1987 9.4 104.6 7.8 3.1

1988 4.4 105.4 5.5 3.3

1989 (Est.) 2.1 110.4 8.7 4.2

Source: A.M. Best Co.

The combined ratio represents total insurance costs (losses

incurred plus expenses) compared to revenue from premiums: A

ratio below 100 indicates an underwriting profit, and one above

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

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

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

produces an overall breakeven result, exclusive of earnings on

the funds provided by shareholders.

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

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

years when general inflation runs considerably lower. (Actually,

over the last 25 years, incurred losses have grown at a still

faster rate, 11%.) If premium growth meanwhile materially lags

that 10% rate, underwriting losses will mount, though the

industry’s tendency to underreserve when business turns bad may

obscure their size for a time.

Last year we said the climb in the combined ratio was

"almost certain to continue - and probably will accelerate - for

at least two more years." This year we will not predict

acceleration, but otherwise must repeat last year’s forecast.

Premium growth is running far below the 10% required annually.

Remember also that a 10% rate would only stabilize the combined

ratio, not bring it down.

The increase in the combined ratio in 1989 was a little more

than we had expected because catastrophes (led by Hurricane Hugo)

were unusually severe. These abnormalities probably accounted for

about two points of the increase. If 1990 is more of a “normal”

year, the combined ratio should rise only minimally from the

catastrophe-swollen base of 1989. In 1991, though, the ratio is

apt to climb by a greater degree.

Commentators frequently discuss the “underwriting cycle” and

speculate about its next turn. If that term is used to connote

rhythmic qualities, it is in our view a misnomer that leads to

faulty thinking about the industry’s fundamental economics.

The term was appropriate some decades ago when the industry

and regulators cooperated to conduct the business in cartel

fashion. At that time, the combined ratio fluctuated

rhythmically for two reasons, both related to lags. First, data

from the past were analyzed and then used to set new “corrected”

rates, which were subsequently put into effect by virtually all

insurers. Second, the fact that almost all policies were then

issued for a one-to three-year term - which meant that it took a

considerable time for mispriced policies to expire - delayed the

impact of new rates on revenues. These two lagged responses made

combined ratios behave much like alternating current. Meanwhile,

the absence of significant price competition guaranteed that

industry profits, averaged out over the cycle, would be

satisfactory.

The cartel period is long gone. Now the industry has

hundreds of participants selling a commodity-like product at

independently-established prices. Such a configuration - whether

the product being sold is steel or insurance policies - is

certain to cause subnormal profitability in all circumstances but

one: a shortage of usable capacity. Just how often these periods

occur and how long they last determines the average profitability

of the industry in question.

In most industries, capacity is described in physical terms.

In the insurance world, however, capacity is customarily

described in financial terms; that is, it’s considered

appropriate for a company to write no more than X dollars of

business if it has Y dollars of net worth. In practice, however,

constraints of this sort have proven ineffective. Regulators,

insurance brokers, and customers are all slow to discipline

companies that strain their resources. They also acquiesce when

companies grossly overstate their true capital. Hence, a company

can write a great deal of business with very little capital if it

is so inclined. At bottom, therefore, the amount of industry

capacity at any particular moment primarily depends on the mental

state of insurance managers.

All this understood, it is not very difficult to

prognosticate the industry’s profits. Good profits will be

realized only when there is a shortage of capacity. Shortages

will occur only when insurers are frightened. That happens rarely

Some analysts have argued that the more onerous taxes

recently imposed on the insurance industry and 1989's

catastrophes - Hurricane Hugo and the California earthquake -

will cause prices to strengthen significantly. We disagree. These

adversities have not destroyed the eagerness of insurers to write

business at present prices. Therefore, premium volume won’t grow

by 10% in 1990, which means the negative underwriting trend will

not reverse.

The industry will meantime say it needs higher prices to

achieve profitability matching that of the average American

business. Of course it does. So does the steel business. But

needs and desires have nothing to do with the long-term

profitability of industries. Instead, economic fundamentals

determine the outcome. Insurance profitability will improve only

when virtually all insurers are turning away business despite

higher prices. And we’re a long way from that point.

Berkshire’s premium volume may drop to $150 million or so in

1990 (from a high of $1 billion in 1986), partly because our

traditional business continues to shrink and partly because the

contract under which we received 7% of the business of Fireman’s

Fund expired last August. Whatever the size of the drop, it will

not disturb us. We have no interest in writing insurance that

carries a mathematical expectation of loss; we experience enough

disappointments doing transactions we believe to carry an

expectation of profit.

However, our appetite for appropriately-priced business is

ample, as one tale from 1989 will tell. It concerns “CAT covers,”

which are reinsurance contracts that primary insurance companies

(and also reinsurers themselves) buy to protect themselves

against a single catastrophe, such as a tornado or hurricane,

that produces losses from a large number of policies. In these

contracts, the primary insurer might retain the loss from a

single event up to a maximum of, say, $10 million, buying various

layers of reinsurance above that level. When losses exceed the

retained amount, the reinsurer typically pays 95% of the excess

up to its contractual limit, with the primary insurer paying the

remainder. (By requiring the primary insurer to keep 5% of each

layer, the reinsurer leaves him with a financial stake in each

loss settlement and guards against his throwing away the

reinsurer’s money.)

CAT covers are usually one-year policies that also provide

for one automatic reinstatement, which requires a primary insurer

whose coverage has been exhausted by a catastrophe to buy a

second cover for the balance of the year in question by paying

another premium. This provision protects the primary company from

being “bare” for even a brief period after a first catastrophic

event. The duration of “an event” is usually limited by contract

to any span of 72 hours designated by the primary company. Under

this definition, a wide-spread storm, causing damage for three

days, will be classified as a single event if it arises from a

single climatic cause. If the storm lasts four days, however, the

primary company will file a claim carving out the 72 consecutive

hours during which it suffered the greatest damage. Losses that

occurred outside that period will be treated as arising from a

separate event.

In 1989, two unusual things happened. First, Hurricane Hugo

generated $4 billion or more of insured loss, at a pace, however,

that caused the vast damage in the Carolinas to occur slightly

more than 72 hours after the equally severe damage in the

Caribbean. Second, the California earthquake hit within weeks,

causing insured damage that was difficult to estimate, even well

after the event. Slammed by these two - or possibly three - major

catastrophes, some primary insurers, and also many reinsurers

that had themselves bought CAT protection, either used up their

automatic second cover or became uncertain as to whether they had

done so.

At that point sellers of CAT policies had lost a huge amount

of money - perhaps twice because of the reinstatements - and not

taken in much in premiums. Depending upon many variables, a CAT

premium might generally have run 3% to 15% of the amount of

protection purchased. For some years, we’ve thought premiums of

that kind inadequate and have stayed away from the business.

But because the 1989 disasters left many insurers either

actually or possibly bare, and also left most CAT writers licking

their wounds, there was an immediate shortage after the

earthquake of much-needed catastrophe coverage. Prices instantly

became attractive, particularly for the reinsurance that CAT

writers themselves buy. Just as instantly, Berkshire Hathaway

offered to write up to $250 million of catastrophe coverage,

advertising that proposition in trade publications. Though we did

not write all the business we sought, we did in a busy ten days

book a substantial amount.

Our willingness to put such a huge sum on the line for a

loss that could occur tomorrow sets us apart from any reinsurer

in the world. There are, of course, companies that sometimes

write $250 million or even far more of catastrophe coverage. But

they do so only when they can, in turn, reinsure a large

percentage of the business with other companies. When they can’t

“lay off” in size, they disappear from the market.

Berkshire’s policy, conversely, is to retain the business we

write rather than lay it off. When rates carry an expectation of

profit, we want to assume as much risk as is prudent. And in our

case, that’s a lot.

We will accept more reinsurance risk for our own account

than any other company because of two factors: (1) by the

standards of regulatory accounting, we have a net worth in our

insurance companies of about $6 billion - the second highest

amount in the United States; and (2) we simply don’t care what

earnings we report quarterly, or even annually, just as long as

the decisions leading to those earnings (or losses) were reached

intelligently.

Obviously, if we write $250 million of catastrophe coverage

and retain it all ourselves, there is some probability that we

will lose the full $250 million in a single quarter. That

probability is low, but it is not zero. If we had a loss of that

magnitude, our after-tax cost would be about $165 million. Though

that is far more than Berkshire normally earns in a quarter, the

damage would be a blow only to our pride, not to our well-being.

This posture is one few insurance managements will assume.

Typically, they are willing to write scads of business on terms

that almost guarantee them mediocre returns on equity. But they

do not want to expose themselves to an embarrassing single-

quarter loss, even if the managerial strategy that causes the

loss promises, over time, to produce superior results. I can

understand their thinking: What is best for their owners is not

necessarily best for the managers. Fortunately Charlie and I have

both total job security and financial interests that are

identical with those of our shareholders. We are willing to look

foolish as long as we don’t feel we have acted foolishly.

Our method of operation, incidentally, makes us a

stabilizing force in the industry. We add huge capacity when

capacity is short and we become less competitive only when

capacity is abundant. Of course, we don’t follow this policy in

the interest of stabilization - we follow it because we believe

it to be the most sensible and profitable course of action.

Nevertheless, our behavior steadies the market. In this case,

Adam Smith’s invisible hand works as advertised.

Currently, we hold an exceptional amount of float compared

to premium volume. This circumstance should produce quite

favorable insurance results for us during the next few years as

it did in 1989. Our underwriting losses should be tolerable and

our investment income from policyholder funds large. This

pleasant situation, however, will gradually deteriorate as our

float runs off.

At some point, however, there will be an opportunity for us

to write large amounts of profitable business. Mike Goldberg and

his management team of Rod Eldred, Dinos Iordanou, Ajit Jain,

Phil Urban, and Don Wurster continue to position us well for this

eventuality.

Marketable Securities

In selecting marketable securities for our insurance

companies, we generally choose among five major categories: (1)

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

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

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

We have no particular bias when it comes to choosing from

these categories; we just continuously search among them for the

highest after-tax returns as measured by "mathematical

expectation," limiting ourselves always to investment

alternatives we think we understand. Our criteria have nothing to

do with maximizing immediately reportable earnings; our goal,

rather, is to maximize eventual net worth.

o Below we list our common stock holdings having a value

of over $100 million. A small portion of these investments belongs

to subsidiaries of which Berkshire owns less than 100%.

12/31/89

Shares Company Cost Market


(000s omitted)

3,000,000 Capital Cities/ABC, Inc. ……………. $ 517,500 $1,692,375

23,350,000 The Coca-Cola Co. ………………….. 1,023,920 1,803,787

2,400,000 Federal Home Loan Mortgage Corp. …….. 71,729 161,100

6,850,000 GEICO Corp. ……………………….. 45,713 1,044,625

1,727,765 The Washington Post Company …………. 9,731 486,366

This list of companies is the same as last year’s and in

only one case has the number of shares changed: Our holdings of

Coca-Cola increased from 14,172,500 shares at the end of 1988 to

23,350,000.

This Coca-Cola investment provides yet another example of

the incredible speed with which your Chairman responds to

investment opportunities, no matter how obscure or well-disguised

they may be. I believe I had my first Coca-Cola in either 1935 or

  1. Of a certainty, it was in 1936 that I started buying Cokes

at the rate of six for 25 cents from Buffett & Son, the family

grocery store, to sell around the neighborhood for 5 cents each.

In this excursion into high-margin retailing, I duly observed

the extraordinary consumer attractiveness and commercial

possibilities of the product.

I continued to note these qualities for the next 52 years as

Coke blanketed the world. During this period, however, I

carefully avoided buying even a single share, instead allocating

major portions of my net worth to street railway companies,

windmill manufacturers, anthracite producers, textile businesses,

trading-stamp issuers, and the like. (If you think I’m making

this up, I can supply the names.) Only in the summer of 1988 did

my brain finally establish contact with my eyes.

What I then perceived was both clear and fascinating. After

drifting somewhat in the 1970's, Coca-Cola had in 1981 become a

new company with the move of Roberto Goizueta to CEO. Roberto,

along with Don Keough, once my across-the-street neighbor in

Omaha, first rethought and focused the company’s policies and

then energetically carried them out. What was already the world’s

most ubiquitous product gained new momentum, with sales overseas

virtually exploding.

Through a truly rare blend of marketing and financial

skills, Roberto has maximized both the growth of his product and

the rewards that this growth brings to shareholders. Normally,

the CEO of a consumer products company, drawing on his natural

inclinations or experience, will cause either marketing or

finance to dominate the business at the expense of the other

discipline. With Roberto, the mesh of marketing and finance is

perfect and the result is a shareholder’s dream.

Of course, we should have started buying Coke much earlier,

soon after Roberto and Don began running things. In fact, if I

had been thinking straight I would have persuaded my grandfather

to sell the grocery store back in 1936 and put all of the

proceeds into Coca-Cola stock. I’ve learned my lesson: My

response time to the next glaringly attractive idea will be

slashed to well under 50 years.

As I mentioned earlier, the yearend prices of our major

investees were much higher relative to their intrinsic values

than theretofore. While those prices may not yet cause

nosebleeds, they are clearly vulnerable to a general market

decline. A drop in their prices would not disturb us at all - it

might in fact work to our eventual benefit - but it would cause

at least a one-year reduction in Berkshire’s net worth. We think

such a reduction is almost certain in at least one of the next

three years. Indeed, it would take only about a 10% year-to-year

decline in the aggregate value of our portfolio investments to

send Berkshire’s net worth down.

We continue to be blessed with extraordinary managers at our

portfolio companies. They are high-grade, talented, and

shareholder-oriented. The exceptional results we have achieved

while investing with them accurately reflect their exceptional

personal qualities.

o We told you last year that we expected to do little in

arbitrage during 1989, and that’s the way it turned out.

Arbitrage positions are a substitute for short-term cash

equivalents, and during part of the year we held relatively low

levels of cash. In the rest of the year we had a fairly good-

sized cash position and even so chose not to engage in arbitrage.

The main reason was corporate transactions that made no economic

sense to us; arbitraging such deals comes too close to playing

the greater-fool game. (As Wall Streeter Ray DeVoe says: "Fools

rush in where angels fear to trade.") We will engage in arbitrage

from time to time - sometimes on a large scale - but only when we

like the odds.

o Leaving aside the three convertible preferreds discussed in

the next section, we substantially reduced our holdings in both

medium- and long-term fixed-income securities. In the long-terms,

just about our only holdings have been Washington Public Power

Supply Systems (WPPSS) bonds carrying coupons ranging from low to

high. During the year we sold a number of the low-coupon issues,

which we originally bought at very large discounts. Many of these

issues had approximately doubled in price since we purchased them

and in addition had paid us 15%-17% annually, tax-free. Our

prices upon sale were only slightly cheaper than typical high-

grade tax-exempts then commanded. We have kept all of our high-

coupon WPPSS issues. Some have been called for redemption in 1991

and 1992, and we expect the rest to be called in the early to

mid-1990s.

We also sold many of our medium-term tax-exempt bonds during

the year. When we bought these bonds we said we would be happy to

sell them - regardless of whether they were higher or lower than

at our time of purchase - if something we liked better came

along. Something did - and concurrently we unloaded most of these

issues at modest gains. Overall, our 1989 profit from the sale of

tax-exempt bonds was about $51 million pre-tax.

o The proceeds from our bond sales, along with our excess cash

at the beginning of the year and that generated later through

earnings, went into the purchase of three convertible preferred

stocks. In the first transaction, which took place in July, we

purchased $600 million of The Gillette Co. preferred with an 8

3/4% dividend, a mandatory redemption in ten years, and the right

to convert into common at $50 per share. We next purchased $358

million of USAir Group, Inc. preferred stock with mandatory

redemption in ten years, a dividend of 9 1/4%, and the right to

convert into common at $60 per share. Finally, late in the year

we purchased $300 million of Champion International Corp.

preferred with mandatory redemption in ten years, a 9 1/4%

dividend, and the right to convert into common at $38 per share.

Unlike standard convertible preferred stocks, the issues we

own are either non-salable or non-convertible for considerable

periods of time and there is consequently no way we can gain from

short-term price blips in the common stock. I have gone on the

board of Gillette, but I am not on the board of USAir or

Champion. (I thoroughly enjoy the boards I am on, but can’t

handle any more.)

Gillette’s business is very much the kind we like. Charlie

and I think we understand the company’s economics and therefore

believe we can make a reasonably intelligent guess about its

future. (If you haven’t tried Gillette’s new Sensor razor, go

right out and get one.) However, we have no ability to forecast

the economics of the investment banking business (in which we

have a position through our 1987 purchase of Salomon convertible

preferred), the airline industry, or the paper industry. This

does not mean that we predict a negative future for these

industries: we’re agnostics, not atheists. Our lack of strong

convictions about these businesses, however, means that we must

structure our investments in them differently from what we do

when we invest in a business appearing to have splendid economic

characteristics.

In one major respect, however, these purchases are not

different: We only want to link up with people whom we like,

admire, and trust. John Gutfreund at Salomon, Colman Mockler, Jr.

at Gillette, Ed Colodny at USAir, and Andy Sigler at Champion

meet this test in spades.

They in turn have demonstrated some confidence in us,

insisting in each case that our preferreds have unrestricted

voting rights on a fully-converted basis, an arrangement that is

far from standard in corporate finance. In effect they are

trusting us to be intelligent owners, thinking about tomorrow

instead of today, just as we are trusting them to be intelligent

managers, thinking about tomorrow as well as today.

The preferred-stock structures we have negotiated will

provide a mediocre return for us if industry economics hinder the

performance of our investees, but will produce reasonably

attractive results for us if they can earn a return comparable to

that of American industry in general. We believe that Gillette,

under Colman’s management, will far exceed that return and

believe that John, Ed, and Andy will reach it unless industry

conditions are harsh.

Under almost any conditions, we expect these preferreds to

return us our money plus dividends. If that is all we get,

though, the result will be disappointing, because we will have

given up flexibility and consequently will have missed some

significant opportunities that are bound to present themselves

during the decade. Under that scenario, we will have obtained

only a preferred-stock yield during a period when the typical

preferred stock will have held no appeal for us whatsoever. The

only way Berkshire can achieve satisfactory results from its four

preferred issues is to have the common stocks of the investee

companies do well.

Good management and at least tolerable industry conditions

will be needed if that is to happen. But we believe Berkshire’s

investment will also help and that the other shareholders of each

investee will profit over the years ahead from our preferred-

stock purchase. The help will come from the fact that each

company now has a major, stable, and interested shareholder whose

Chairman and Vice Chairman have, through Berkshire’s investments,

indirectly committed a very large amount of their own money to

these undertakings. In dealing with our investees, Charlie and I

will be supportive, analytical, and objective. We recognize that

we are working with experienced CEOs who are very much in command

of their own businesses but who nevertheless, at certain moments,

appreciate the chance to test their thinking on someone without

ties to their industry or to decisions of the past.

As a group, these convertible preferreds will not produce

the returns we can achieve when we find a business with wonderful

economic prospects that is unappreciated by the market. Nor will

the returns be as attractive as those produced when we make our

favorite form of capital deployment, the acquisition of 80% or

more of a fine business with a fine management. But both

opportunities are rare, particularly in a size befitting our

present and anticipated resources.

In summation, Charlie and I feel that our preferred stock

investments should produce returns moderately above those

achieved by most fixed-income portfolios and that we can play a

minor but enjoyable and constructive role in the investee

companies.

Zero-Coupon Securities

In September, Berkshire issued $902.6 million principal

amount of Zero-Coupon Convertible Subordinated Debentures, which

are now listed on the New York Stock Exchange. Salomon Brothers

handled the underwriting in superb fashion, providing us helpful

advice and a flawless execution.

Most bonds, of course, require regular payments of interest,

usually semi-annually. A zero-coupon bond, conversely, requires

no current interest payments; instead, the investor receives his

yield by purchasing the security at a significant discount from

maturity value. The effective interest rate is determined by the

original issue price, the maturity value, and the amount of time

between issuance and maturity.

In our case, the bonds were issued at 44.314% of maturity

value and are due in 15 years. For investors purchasing the

bonds, that is the mathematical equivalent of a 5.5% current

payment compounded semi-annually. Because we received only

44.31 cents on the dollar, our proceeds from this offering were

$400 million (less about $9.5 million of offering expenses).

The bonds were issued in denominations of $10,000 and each

bond is convertible into .4515 shares of Berkshire Hathaway.

Because a $10,000 bond cost $4,431, this means that the

conversion price was $9,815 per Berkshire share, a 15% premium to

the market price then existing. Berkshire can call the bonds at

any time after September 28, 1992 at their accreted value (the

original issue price plus 5.5% compounded semi-annually) and on

two specified days, September 28 of 1994 and 1999, the

bondholders can require Berkshire to buy the securities at their

accreted value.

For tax purposes, Berkshire is entitled to deduct the 5.5%

interest accrual each year, even though we make no payments to

the bondholders. Thus the net effect to us, resulting from the

reduced taxes, is positive cash flow. That is a very significant

benefit. Some unknowable variables prevent us from calculating

our exact effective rate of interest, but under all circumstances

it will be well below 5.5%. There is meanwhile a symmetry to the

tax law: Any taxable holder of the bonds must pay tax each year

on the 5.5% interest, even though he receives no cash.

Neither our bonds nor those of certain other companies that

issued similar bonds last year (notably Loews and Motorola)

resemble the great bulk of zero-coupon bonds that have been

issued in recent years. Of these, Charlie and I have been, and

will continue to be, outspoken critics. As I will later explain,

such bonds have often been used in the most deceptive of ways and

with deadly consequences to investors. But before we tackle that

subject, let’s travel back to Eden, to a time when the apple had

not yet been bitten.

If you’re my age you bought your first zero-coupon bonds

during World War II, by purchasing the famous Series E U. S.

Savings Bond, the most widely-sold bond issue in history. (After

the war, these bonds were held by one out of two U. S.

households.) Nobody, of course, called the Series E a zero-coupon

bond, a term in fact that I doubt had been invented. But that’s

precisely what the Series E was.

These bonds came in denominations as small as $18.75. That

amount purchased a $25 obligation of the United States government

due in 10 years, terms that gave the buyer a compounded annual

return of 2.9%. At the time, this was an attractive offer: the

2.9% rate was higher than that generally available on Government

bonds and the holder faced no market-fluctuation risk, since he

could at any time cash in his bonds with only a minor reduction

in interest.

A second form of zero-coupon U. S. Treasury issue, also

benign and useful, surfaced in the last decade. One problem with

a normal bond is that even though it pays a given interest rate -

say 10% - the holder cannot be assured that a compounded 10%

return will be realized. For that rate to materialize, each semi-

annual coupon must be reinvested at 10% as it is received. If

current interest rates are, say, only 6% or 7% when these coupons

come due, the holder will be unable to compound his money over

the life of the bond at the advertised rate. For pension funds or

other investors with long-term liabilities, “reinvestment risk”

of this type can be a serious problem. Savings Bonds might have

solved it, except that they are issued only to individuals and

are unavailable in large denominations. What big buyers needed

was huge quantities of “Savings Bond Equivalents.”

Enter some ingenious and, in this case, highly useful

investment bankers (led, I’m happy to say, by Salomon Brothers).

They created the instrument desired by “stripping” the semi-

annual coupons from standard Government issues. Each coupon, once

detached, takes on the essential character of a Savings Bond

since it represents a single sum due sometime in the future. For

example, if you strip the 40 semi-annual coupons from a U. S.

Government Bond due in the year 2010, you will have 40 zero-

coupon bonds, with maturities from six months to 20 years, each

of which can then be bundled with other coupons of like maturity

and marketed. If current interest rates are, say, 10% for all

maturities, the six-month issue will sell for 95.24% of maturity

value and the 20-year issue will sell for 14.20%. The purchaser

of any given maturity is thus guaranteed a compounded rate of 10%

for his entire holding period. Stripping of government bonds has

occurred on a large scale in recent years, as long-term

investors, ranging from pension funds to individual IRA accounts,

recognized these high-grade, zero-coupon issues to be well suited

to their needs.

But as happens in Wall Street all too often, what the wise

do in the beginning, fools do in the end. In the last few years

zero-coupon bonds (and their functional equivalent, pay-in-kind

bonds, which distribute additional PIK bonds semi-annually as

interest instead of paying cash) have been issued in enormous

quantities by ever-junkier credits. To these issuers, zero (or

PIK) bonds offer one overwhelming advantage: It is impossible to

default on a promise to pay nothing. Indeed, if LDC governments

had issued no debt in the 1970's other than long-term zero-coupon

obligations, they would now have a spotless record as debtors.

This principle at work - that you need not default for a

long time if you solemnly promise to pay nothing for a long time

to finance ever-shakier deals. But its acceptance by lenders took

a while: When the leveraged buy-out craze began some years back,

purchasers could borrow only on a reasonably sound basis, in

which conservatively-estimated free cash flow - that is,

operating earnings plus depreciation and amortization less

normalized capital expenditures - was adequate to cover both

interest and modest reductions in debt.

Later, as the adrenalin of deal-makers surged, businesses

began to be purchased at prices so high that all free cash flow

necessarily had to be allocated to the payment of interest. That

left nothing for the paydown of debt. In effect, a Scarlett

O’Hara “I’ll think about it tomorrow” position in respect to

principal payments was taken by borrowers and accepted by a new

breed of lender, the buyer of original-issue junk bonds. Debt now

became something to be refinanced rather than repaid. The change

brings to mind a New Yorker cartoon in which the grateful

borrower rises to shake the hand of the bank’s lending officer

and gushes: “I don’t know how I’ll ever repay you.”

Soon borrowers found even the new, lax standards intolerably

binding. To induce lenders to finance even sillier transactions,

they introduced an abomination, EBDIT - Earnings Before

Depreciation, Interest and Taxes - as the test of a company’s

ability to pay interest. Using this sawed-off yardstick, the

borrower ignored depreciation as an expense on the theory that it

did not require a current cash outlay.

Such an attitude is clearly delusional. At 95% of American

businesses, capital expenditures that over time roughly

approximate depreciation are a necessity and are every bit as

real an expense as labor or utility costs. Even a high school

dropout knows that to finance a car he must have income that

covers not only interest and operating expenses, but also

realistically-calculated depreciation. He would be laughed out of

the bank if he started talking about EBDIT.

Capital outlays at a business can be skipped, of course, in

any given month, just as a human can skip a day or even a week of

eating. But if the skipping becomes routine and is not made up,

the body weakens and eventually dies. Furthermore, a start-and-

stop feeding policy will over time produce a less healthy

organism, human or corporate, than that produced by a steady

diet. As businessmen, Charlie and I relish having competitors who

are unable to fund capital expenditures.

You might think that waving away a major expense such as

depreciation in an attempt to make a terrible deal look like a

good one hits the limits of Wall Street’s ingenuity. If so, you

haven’t been paying attention during the past few years.

Promoters needed to find a way to justify even pricier

acquisitions. Otherwise, they risked - heaven forbid! - losing

deals to other promoters with more “imagination.”

So, stepping through the Looking Glass, promoters and their

investment bankers proclaimed that EBDIT should now be measured

against cash interest only, which meant that interest accruing on

zero-coupon or PIK bonds could be ignored when the financial

feasibility of a transaction was being assessed. This approach

not only relegated depreciation expense to the let’s-ignore-it

corner, but gave similar treatment to what was usually a

significant portion of interest expense. To their shame, many

professional investment managers went along with this nonsense,

though they usually were careful to do so only with clients’

money, not their own. (Calling these managers “professionals” is

actually too kind; they should be designated “promotees.”)

Under this new standard, a business earning, say, $100

million pre-tax and having debt on which $90 million of interest

must be paid currently, might use a zero-coupon or PIK issue to

incur another $60 million of annual interest that would accrue

and compound but not come due for some years. The rate on these

issues would typically be very high, which means that the

situation in year 2 might be $90 million cash interest plus $69

million accrued interest, and so on as the compounding proceeds.

Such high-rate reborrowing schemes, which a few years ago were

appropriately confined to the waterfront, soon became models of

modern finance at virtually all major investment banking houses.

When they make these offerings, investment bankers display

their humorous side: They dispense income and balance sheet

projections extending five or more years into the future for

companies they barely had heard of a few months earlier. If you

are shown such schedules, I suggest that you join in the fun:

Ask the investment banker for the one-year budgets that his own

firm prepared as the last few years began and then compare these

with what actually happened.

Some time ago Ken Galbraith, in his witty and insightful

The Great Crash , coined a new economic term: “the bezzle,”

defined as the current amount of undiscovered embezzlement. This

financial creature has a magical quality: The embezzlers are richer

by the amount of the bezzle, while the embezzlees do not yet feel

poorer.

Professor Galbraith astutely pointed out that this sum

should be added to the National Wealth so that we might know the

Psychic National Wealth. Logically, a society that wanted to feel

enormously prosperous would both encourage its citizens to

embezzle and try not to detect the crime. By this means, “wealth”

would balloon though not an erg of productive work had been done.

The satirical nonsense of the bezzle is dwarfed by the real-

world nonsense of the zero-coupon bond. With zeros, one party to

a contract can experience “income” without his opposite

experiencing the pain of expenditure. In our illustration, a

company capable of earning only $100 million dollars annually -

and therefore capable of paying only that much in interest -

magically creates “earnings” for bondholders of $150 million. As

long as major investors willingly don their Peter Pan wings and

repeatedly say “I believe,” there is no limit to how much

“income” can be created by the zero-coupon bond.

Wall Street welcomed this invention with the enthusiasm

less-enlightened folk might reserve for the wheel or the plow.

Here, finally, was an instrument that would let the Street make

deals at prices no longer limited by actual earning power. The

result, obviously, would be more transactions: Silly prices will

always attract sellers. And, as Jesse Unruh might have put it,

transactions are the mother’s milk of finance.

The zero-coupon or PIK bond possesses one additional

attraction for the promoter and investment banker, which is that

the time elapsing between folly and failure can be stretched out.

This is no small benefit. If the period before all costs must be

faced is long, promoters can create a string of foolish deals -

and take in lots of fees - before any chickens come home to roost

from their earlier ventures.

But in the end, alchemy, whether it is metallurgical or

financial, fails. A base business can not be transformed into a

golden business by tricks of accounting or capital structure. The

man claiming to be a financial alchemist may become rich. But

gullible investors rather than business achievements will usually

be the source of his wealth.

Whatever their weaknesses, we should add, many zero-coupon

and PIK bonds will not default. We have in fact owned some and

may buy more if their market becomes sufficiently distressed.

(We’ve not, however, even considered buying a new issue from a

weak credit.) No financial instrument is evil per se; it’s just

that some variations have far more potential for mischief than

others.

The blue ribbon for mischief-making should go to the zero-

coupon issuer unable to make its interest payments on a current

basis. Our advice: Whenever an investment banker starts talking

about EBDIT - or whenever someone creates a capital structure

that does not allow all interest, both payable and accrued, to be

comfortably met out of current cash flow net of ample capital

expenditures - zip up your wallet. Turn the tables by suggesting

that the promoter and his high-priced entourage accept zero-

coupon fees, deferring their take until the zero-coupon bonds

have been paid in full. See then how much enthusiasm for the deal

endures.

Our comments about investment bankers may seem harsh. But

Charlie and I - in our hopelessly old-fashioned way - believe

that they should perform a gatekeeping role, guarding investors

against the promoter’s propensity to indulge in excess.

Promoters, after all, have throughout time exercised the same

judgment and restraint in accepting money that alcoholics have

exercised in accepting liquor. At a minimum, therefore, the

banker’s conduct should rise to that of a responsible bartender

who, when necessary, refuses the profit from the next drink to

avoid sending a drunk out on the highway. In recent years,

unfortunately, many leading investment firms have found bartender

morality to be an intolerably restrictive standard. Lately, those

who have traveled the high road in Wall Street have not

encountered heavy traffic.

One distressing footnote: The cost of the zero-coupon folly

will not be borne solely by the direct participants. Certain

savings and loan associations were heavy buyers of such bonds,

using cash that came from FSLIC-insured deposits. Straining to

show splendid earnings, these buyers recorded - but did not

receive - ultra-high interest income on these issues. Many of

these associations are now in major trouble. Had their loans to

shaky credits worked, the owners of the associations would have

pocketed the profits. In the many cases in which the loans will

fail, the taxpayer will pick up the bill. To paraphrase Jackie

Mason, at these associations it was the managers who should have

been wearing the ski masks.

Mistakes of the First Twenty-five Years (A Condensed Version)

To quote Robert Benchley, "Having a dog teaches a boy

fidelity, perseverance, and to turn around three times before

lying down." Such are the shortcomings of experience.

Nevertheless, it’s a good idea to review past mistakes before

committing new ones. So let’s take a quick look at the last 25

years.

o My first mistake, of course, was in buying control of

Berkshire. Though I knew its business - textile manufacturing -

to be unpromising, I was enticed to buy because the price looked

cheap. Stock purchases of that kind had proved reasonably

rewarding in my early years, though by the time Berkshire came

along in 1965 I was becoming aware that the strategy was not

ideal.

If you buy a stock at a sufficiently low price, there will

usually be some hiccup in the fortunes of the business that gives

you a chance to unload at a decent profit, even though the long-

term performance of the business may be terrible. I call this the

“cigar butt” approach to investing. A cigar butt found on the

street that has only one puff left in it may not offer much of a

smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying

businesses is foolish. First, the original “bargain” price

probably will not turn out to be such a steal after all. In a

difficult business, no sooner is one problem solved than another

surfaces - never is there just one cockroach in the kitchen.

Second, any initial advantage you secure will be quickly eroded

by the low return that the business earns. For example, if you

buy a business for $8 million that can be sold or liquidated for

$10 million and promptly take either course, you can realize a

high return. But the investment will disappoint if the business

is sold for $10 million in ten years and in the interim has

annually earned and distributed only a few percent on cost. Time

is the friend of the wonderful business, the enemy of the

mediocre.

You might think this principle is obvious, but I had to

learn it the hard way - in fact, I had to learn it several times

over. Shortly after purchasing Berkshire, I acquired a Baltimore

department store, Hochschild Kohn, buying through a company

called Diversified Retailing that later merged with Berkshire. I

bought at a substantial discount from book value, the people were

first-class, and the deal included some extras - unrecorded real

estate values and a significant LIFO inventory cushion. How could

I miss? So-o-o - three years later I was lucky to sell the

business for about what I had paid. After ending our corporate

marriage to Hochschild Kohn, I had memories like those of the

husband in the country song, "My Wife Ran Away With My Best

Friend and I Still Miss Him a Lot."

I could give you other personal examples of "bargain-

purchase’ folly but I’m sure you get the picture: It’s far

better to buy a wonderful company at a fair price than a fair

company at a wonderful price. Charlie understood this early; I

was a slow learner. But now, when buying companies or common

stocks, we look for first-class businesses accompanied by first-

class managements.

o That leads right into a related lesson: Good jockeys will

do well on good horses, but not on broken-down nags. Both

Berkshire’s textile business and Hochschild, Kohn had able and

honest people running them. The same managers employed in a

business with good economic characteristics would have achieved

fine records. But they were never going to make any progress

while running in quicksand.

I’ve said many times that when a management with a

reputation for brilliance tackles a business with a reputation

for bad economics, it is the reputation of the business that

remains intact. I just wish I hadn’t been so energetic in

creating examples. My behavior has matched that admitted by Mae

West: “I was Snow White, but I drifted.”

o A further related lesson: Easy does it. After 25 years of

buying and supervising a great variety of businesses, Charlie and

I have not learned how to solve difficult business problems. What

we have learned is to avoid them. To the extent we have been

successful, it is because we concentrated on identifying one-foot

hurdles that we could step over rather than because we acquired

any ability to clear seven-footers.

The finding may seem unfair, but in both business and

investments it is usually far more profitable to simply stick

with the easy and obvious than it is to resolve the difficult. On

occasion, tough problems must be tackled as was the case when we

started our Sunday paper in Buffalo. In other instances, a great

investment opportunity occurs when a marvelous business

encounters a one-time huge, but solvable, problem as was the case

many years back at both American Express and GEICO. Overall,

however, we’ve done better by avoiding dragons than by slaying

them.

o My most surprising discovery: the overwhelming importance in

business of an unseen force that we might call "the institutional

imperative." In business school, I was given no hint of the

imperative’s existence and I did not intuitively understand it

when I entered the business world. I thought then that decent,

intelligent, and experienced managers would automatically make

rational business decisions. But I learned over time that isn’t

so. Instead, rationality frequently wilts when the institutional

imperative comes into play.

For example: (1) As if governed by Newton’s First Law of

Motion, an institution will resist any change in its current

direction; (2) Just as work expands to fill available time,

corporate projects or acquisitions will materialize to soak up

available funds; (3) Any business craving of the leader, however

foolish, will be quickly supported by detailed rate-of-return and

strategic studies prepared by his troops; and (4) The behavior of

peer companies, whether they are expanding, acquiring, setting

executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set

businesses on these courses, which are too often misguided. After

making some expensive mistakes because I ignored the power of the

imperative, I have tried to organize and manage Berkshire in ways

that minimize its influence. Furthermore, Charlie and I have

attempted to concentrate our investments in companies that appear

alert to the problem.

o After some other mistakes, I learned to go into business

only with people whom I like, trust, and admire. As I noted

before, this policy of itself will not ensure success: A second-

class textile or department-store company won’t prosper simply

because its managers are men that you would be pleased to see

your daughter marry. However, an owner - or investor - can

accomplish wonders if he manages to associate himself with such

people in businesses that possess decent economic

characteristics. Conversely, we do not wish to join with managers

who lack admirable qualities, no matter how attractive the

prospects of their business. We’ve never succeeded in making a

good deal with a bad person.

o Some of my worst mistakes were not publicly visible. These

were stock and business purchases whose virtues I understood and

yet didn’t make. It’s no sin to miss a great opportunity outside

one’s area of competence. But I have passed on a couple of really

big purchases that were served up to me on a platter and that I

was fully capable of understanding. For Berkshire’s shareholders,

myself included, the cost of this thumb-sucking has been huge.

o Our consistently-conservative financial policies may appear

to have been a mistake, but in my view were not. In retrospect,

it is clear that significantly higher, though still conventional,

leverage ratios at Berkshire would have produced considerably

better returns on equity than the 23.8% we have actually

averaged. Even in 1965, perhaps we could have judged there to be

a 99% probability that higher leverage would lead to nothing but

good. Correspondingly, we might have seen only a 1% chance that

some shock factor, external or internal, would cause a

conventional debt ratio to produce a result falling somewhere

between temporary anguish and default.

We wouldn’t have liked those 99:1 odds - and never will. A

small chance of distress or disgrace cannot, in our view, be

offset by a large chance of extra returns. If your actions are

sensible, you are certain to get good results; in most such

cases, leverage just moves things along faster. Charlie and I

have never been in a big hurry: We enjoy the process far more

than the proceeds - though we have learned to live with those

also.


We hope in another 25 years to report on the mistakes of the

first 50. If we are around in 2015 to do that, you can count on

this section occupying many more pages than it does here.

Miscellaneous

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

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

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

Here’s what we’re looking for:

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

earnings),

(2) demonstrated consistent earning power (future

projections are of little interest to us, nor are

“turnaround” situations),

(3) businesses earning good returns on equity while

employing little or no debt,

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

(5) simple businesses (if there’s lots of technology, we

won’t understand it),

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

that of the seller by talking, even preliminarily,

about a transaction when price is unknown).

We will not engage in unfriendly takeovers. We can promise

complete confidentiality and a very fast answer - customarily

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

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

as much in intrinsic business value as we give.

Our favorite form of purchase is one fitting the Blumkin-

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

managers wish to generate significant amounts of cash, sometimes

for themselves, but often for their families or inactive

shareholders. At the same time, these managers wish to remain

significant owners who continue to run their companies just as

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

for owners with such objectives. We invite potential sellers to

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

in the past.

Charlie and I frequently get approached about acquisitions

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

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

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

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

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

Besides being interested in the purchase of businesses as

described above, we are also interested in the negotiated

purchase of large, but not controlling, blocks of stock

comparable to those we hold in Capital Cities, Salomon, Gillette,

USAir and Champion. Last year we said we had a special interest

in large purchases of convertible preferreds. We still have an

appetite of that kind, but it is limited since we now are close

to the maximum position we feel appropriate for this category of

investment.


Two years ago, I told you about Harry Bottle, who in 1962

quickly cured a major business mess at the first industrial

company I controlled, Dempster Mill Manufacturing (one of my

“bargain” purchases) and who 24 years later had reappeared to

again rescue me, this time from problems at K&W Products, a small

Berkshire subsidiary that produces automotive compounds. As I

reported, in short order Harry reduced capital employed at K&W,

rationalized production, cut costs, and quadrupled profits. You

might think he would then have paused for breath. But last year

Harry, now 70, attended a bankruptcy auction and, for a pittance,

acquired a product line that is a natural for K&W. That company’s

profitability may well be increased 50% by this coup. Watch this

space for future bulletins on Harry’s triumphs.


With more than a year behind him of trading Berkshire’s

stock on the New York Stock Exchange, our specialist, Jim Maguire

of Henderson Brothers, Inc. (“HBI”), continues his outstanding

performance. Before we listed, dealer spreads often were 3% or

more of market price. Jim has maintained the spread at 50 points

or less, which at current prices is well under 1%. Shareholders

who buy or sell benefit significantly from this reduction in

transaction costs.

Because we are delighted by our experience with Jim, HBI and

the NYSE, I said as much in ads that have been run in a series

placed by the NYSE. Normally I shun testimonials, but I was

pleased in this instance to publicly compliment the Exchange.


Last summer we sold the corporate jet that we purchased for

$850,000 three years ago and bought another used jet for $6.7

million. Those of you who recall the mathematics of the

multiplying bacteria on page 5 will understandably panic: If our

net worth continues to increase at current rates, and the cost of

replacing planes also continues to rise at the now-established

rate of 100% compounded annually, it will not be long before

Berkshire’s entire net worth is consumed by its jet.

Charlie doesn’t like it when I equate the jet with bacteria;

he feels it’s degrading to the bacteria. His idea of traveling in

style is an air-conditioned bus, a luxury he steps up to only

when bargain fares are in effect. My own attitude toward the jet

can be summarized by the prayer attributed, apocryphally I’m

sure, to St. Augustine as he contemplated leaving a life of

secular pleasures to become a priest. Battling the conflict

between intellect and glands, he pled: "Help me, Oh Lord, to

become chaste - but not yet."

Naming the plane has not been easy. I initially suggested

“The Charles T. Munger.” Charlie countered with “The Aberration.”

We finally settled on “The Indefensible.”


About 96.9% of all eligible shares participated in

Berkshire’s 1989 shareholder-designated contributions program.

Contributions made through the program were $5.9 million, and

2,550 charities were recipients.

We urge new shareholders to read the description of our

shareholder-designated contributions program that appears on

pages 52-53. If you wish to participate in future programs, we

strongly urge that you immediately make sure your shares are

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

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

August 31, 1990 will be ineligible for the 1990 program.


The annual meeting this year will take place at 9:30 a.m. on

Monday, April 30, 1990. Attendance grew last year to about 1,000,

very close to the seating capacity of the Witherspoon Hall at

Joslyn Museum. So this year’s meeting will be moved to the

Orpheum Theatre, which is in downtown Omaha, about one-quarter of

a mile from the Red Lion Hotel. The Radisson-Redick Tower, a much

smaller but nice hotel, is located across the street from the

Orpheum. Or you may wish to stay at the Marriott, which is in

west Omaha, about 100 yards from Borsheim’s. We will have buses

at the Marriott that will leave at 8:30 and 8:45 for the meeting

and return after it ends.

Charlie and I always enjoy the meeting, and we hope you can

make it. The quality of our shareholders is reflected in the

quality of the questions we get: We have never attended an annual

meeting anywhere that features such a consistently high level of

intelligent, owner-related questions.

An attachment to our proxy material explains how you can

obtain the card you will need for admission to the meeting.

Because weekday parking can be tight around the Orpheum, we have

lined up a number of nearby lots for our shareholders to use. The

attachment also contains information about them.

As usual, we will have buses to take you to Nebraska

Furniture Mart and Borsheim’s after the meeting and to take you

to downtown hotels or to the airport later. I hope that you will

allow plenty of time to fully explore the attractions of both

stores. Those of you arriving early can visit the Furniture Mart

any day of the week; it is open from 10 a.m. to 5:30 p.m. on

Saturdays, and from noon to 5:30 p.m. on Sundays.

Borsheim’s normally is closed on Sunday, but we will open

for shareholders and their guests from noon to 6 p.m. on Sunday,

April 29th. Ike likes to put on a show, and you can rely on him

to produce something very special for our shareholders.

In this letter we’ve had a lot to say about rates of

compounding. If you can bear having your own rate turn negative

for a day - not a pretty thought, I admit - visit Ike on the

29th.

Warren E. Buffett

March 2, 1990 Chairman of the Board


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