Date Published: 27 February, 1987
Written By: Warren E. Buffett
Our gain in net worth during 1986 was $492.5 million, or 26.1%. Over the last 22 years (that is, since present management took over), our per-share book value has grown from $19.46 to $2,073.06, or 23.3% compounded annually. Both the numerator and denominator are important in the per-share book value calculation: during the 22-year period our corporate net worth has increased 10,600% while shares outstanding have increased less than 1%.
In past reports I have noted that book value at most companies differs widely from intrinsic business value – the number that really counts for owners. In our own case, however, book value has served for more than a decade as a reasonable if somewhat conservative proxy for business value. That is, our business value has moderately exceeded our book value, with the ratio between the two remaining fairly steady.
The good news is that in 1986 our percentage gain in business value probably exceeded the book value gain. I say “probably” because business value is a soft number: in our own case, two equally well-informed observers might make judgments more than 10% apart.
A large measure of our improvement in business value relative to book value reflects the outstanding performance of key managers at our major operating businesses. These managers – the Blumkins, Mike Goldberg, the Heldmans, Chuck Huggins, Stan Lipsey, and Ralph Schey – have over the years improved the earnings of their businesses dramatically while, except in the case of insurance, utilizing little additional capital. This accomplishment builds economic value, or “Goodwill,” that does not show up in the net worth figure on our balance sheet, nor in our per-share book value. In 1986 this unrecorded gain was substantial.
So much for the good news. The bad news is that my performance did not match that of our managers. While they were doing a superb job in running our businesses, I was unable to skillfully deploy much of the capital they generated. Charlie Munger, our Vice Chairman, and I really have only two jobs. One is to attract and keep outstanding managers to run our various operations. This hasn’t been all that difficult. Usually the managers came with the companies we bought, having demonstrated their talents throughout careers that spanned a wide variety of business circumstances. They were managerial stars long before they knew us, and our main contribution has been to not get in their way. This approach seems elementary: if my job were to manage a golf team – and if Jack Nicklaus or Arnold Palmer were willing to play for me – neither would get a lot of directives from me about how to swing.
Some of our key managers are independently wealthy (we hope they all become so), but that poses no threat to their continued interest: they work because they love what they do and relish the thrill of outstanding performance. They unfailingly think like owners (the highest compliment we can pay a manager) and find all aspects of their business absorbing.
(Our prototype for occupational fervor is the Catholic tailor who used his small savings of many years to finance a pilgrimage to the Vatican. When he returned, his parish held a special meeting to get his first-hand account of the Pope. “Tell us,” said the eager faithful, “just what sort of fellow is he?” Our hero wasted no words: “He’s a forty-four, medium.”)
Charlie and I know that the right players will make almost any team manager look good. We subscribe to the philosophy of Ogilvy & Mather’s founding genius, David Ogilvy: “If each of us hires people who are smaller than we are, we shall become a company of dwarfs. But, if each of us hires people who are bigger than we are, we shall become a company of giants.”
A by-product of our managerial style is the ability it gives us to easily expand Berkshire’s activities. We’ve read management treatises that specify exactly how many people should report to any one executive, but they make little sense to us. When you have able managers of high character running businesses about which they are passionate, you can have a dozen or more reporting to you and still have time for an afternoon nap. Conversely, if you have even one person reporting to you who is deceitful, inept or uninterested, you will find yourself with more than you can handle. Charlie and I could work with double the number of managers we now have, so long as they had the rare qualities of the present ones.
We intend to continue our practice of working only with people whom we like and admire. This policy not only maximizes our chances for good results, it also ensures us an extraordinarily good time. On the other hand, working with people who cause your stomach to churn seems much like marrying for money – probably a bad idea under any circumstances, but absolute madness if you are already rich.
The second job Charlie and I must handle is the allocation of capital, which at Berkshire is a considerably more important challenge than at most companies. Three factors make that so: we earn more money than average; we retain all that we earn; and, we are fortunate to have operations that, for the most part, require little incremental capital to remain competitive and to grow. Obviously, the future results of a business earning 23% annually and retaining it all are far more affected by today’s capital allocations than are the results of a business earning 10% and distributing half of that to shareholders. If our retained earnings – and those of our major investees, GEICO and Capital Cities/ABC, Inc. – are employed in an unproductive manner, the economics of Berkshire will deteriorate very quickly. In a company adding only, say, 5% to net worth annually, capital- allocation decisions, though still important, will change the company’s economics far more slowly.
Capital allocation at Berkshire was tough work in 1986. We did make one business acquisition – The Fechheimer Bros. Company, which we will discuss in a later section. Fechheimer is a company with excellent economics, run by exactly the kind of people with whom we enjoy being associated. But it is relatively small, utilizing only about 2% of Berkshire’s net worth.
Meanwhile, we had no new ideas in the marketable equities field, an area in which once, only a few years ago, we could readily employ large sums in outstanding businesses at very reasonable prices. So our main capital allocation moves in 1986 were to pay off debt and stockpile funds. Neither is a fate worse than death, but they do not inspire us to do handsprings either. If Charlie and I were to draw blanks for a few years in our capital-allocation endeavors, Berkshire’s rate of growth would slow significantly.
We will continue to look for operating businesses that meet our tests and, with luck, will acquire such a business every couple of years. But an acquisition will have to be large if it is to help our performance materially. Under current stock market conditions, we have little hope of finding equities to buy for our insurance companies. Markets will change significantly – you can be sure of that and some day we will again get our turn at bat. However, we haven’t the faintest idea when that might happen.
It can’t be said too often (although I’m sure you feel I’ve tried) that, even under favorable conditions, our returns are certain to drop substantially because of our enlarged size. We have told you that we hope to average a return of 15% on equity and we maintain that hope, despite some negative tax law changes described in a later section of this report. If we are to achieve this rate of return, our net worth must increase $7.2 billion in the next ten years. A gain of that magnitude will be possible only if, before too long, we come up with a few very big (and good) ideas. Charlie and I can’t promise results, but we do promise you that we will keep our efforts focused on our goals.
Sources of Reported Earnings
The table on the next page shows the major sources of Berkshire’s reported earnings. This table differs in several ways from the one presented last year. We have added four new lines of business because of the Scott Fetzer and Fechheimer acquisitions. In the case of Scott Fetzer, the two major units acquired were World Book and Kirby, and each is presented separately. Fourteen other businesses of Scott Fetzer are aggregated in Scott Fetzer – Diversified Manufacturing. SF Financial Group, a credit company holding both World Book and Kirby receivables, is included in “Other.” This year, because Berkshire is so much larger, we also have eliminated separate reporting for several of our smaller businesses.
In the table, amortization of Goodwill is not charged against the specific businesses but, for reasons outlined in the Appendix to my letter in the 1983 Annual Report, is aggregated as a separate item. (A Compendium of earlier letters, including the Goodwill discussion, is available upon request.) Both the Scott Fetzer and Fechheimer acquisitions created accounting Goodwill, which is why the amortization charge for Goodwill increased in 1986.
Additionally, the Scott Fetzer acquisition required other major purchase-price accounting adjustments, as prescribed by generally accepted accounting principles (GAAP). The GAAP figures, of course, are the ones used in our consolidated financial statements. But, in our view, the GAAP figures are not necessarily the most useful ones for investors or managers. Therefore, the figures shown for specific operating units are earnings before purchase-price adjustments are taken into account. In effect, these are the earnings that would have been reported by the businesses if we had not purchased them.
A discussion of our reasons for preferring this form of presentation is in the Appendix to this letter. This Appendix will never substitute for a steamy novel and definitely is not required reading. However, I know that among our 6,000 shareholders there are those who are thrilled by my essays on accounting – and I hope that both of you enjoy the Appendix.
In the Business Segment Data on pages 41-43 and in the Management’s Discussion section on pages 45-49, you will find much additional information about our businesses. I urge you to read those sections, as well as Charlie Munger’s letter to Wesco shareholders, describing the various businesses of that subsidiary, which starts on page 50.
(000s omitted)
------------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
------------------- -------------------
1986 1985 1986 1985
-------- -------- -------- --------
Operating Earnings:
Insurance Group:
Underwriting ............... $(55,844) $(44,230) $(29,864) $(23,569)
Net Investment Income ...... 107,143 95,217 96,440 79,716
Buffalo News ................. 34,736 29,921 16,918 14,580
Fechheimer (Acquired 6/3/86) 8,400 --- 3,792 ---
Kirby ........................ 20,218 --- 10,508 ---
Nebraska Furniture Mart ...... 17,685 12,686 7,192 5,181
Scott Fetzer - Diversified Mfg. 25,358 --- 13,354 ---
See’s Candies ................ 30,347 28,989 15,176 14,558
Wesco - other than insurance 5,542 16,018 5,550 9,684
World Book ................... 21,978 --- 11,670 ---
Amortization of Goodwill (2,555) (1,475) (2,555) (1,475)
Other purchase-price
accounting charges ........ (10,033) --- (11,031) ---
Interest on Debt and
Pre-Payment penalty ....... (23,891) (14,415) (12,213) (7,288)
Shareholder-Designated
Contributions ............. (3,997) (4,006) (2,158) (2,164)
Other ........................ 20,770 6,744 8,685 3,725
-------- -------- -------- --------
Operating Earnings ............. 195,857 125,449 131,464 92,948
Special General Foods
Distribution ................ --- 4,127 --- 3,779
Special Washington Post
Distribution ................ --- 14,877 --- 13,851
Sales of securities ............ 216,242 468,903 150,897 325,237
-------- -------- -------- --------
Total Earnings - all entities .. $412,099 $613,356 $282,361 $435,815
======== ======== ======== ========
As you can see, operating earnings substantially improved during 1986. Some of the improvement came from the insurance operation, whose results I will discuss in a later section. Fechheimer also will be discussed separately. Our other major businesses performed as follows:
Operating results at The Buffalo News continue to reflect a truly superb managerial job by Stan Lipsey. For the third year in a row, man-hours worked fell significantly and other costs were closely controlled. Consequently, our operating margins improved materially in 1986, even though our advertising rate increases were well below those of most major newspapers.
Our cost-control efforts have in no way reduced our commitment to news. We continue to deliver a 50% “news hole” (the portion of the total space in the paper devoted to news), a higher percentage, we believe, than exists at any dominant newspaper in this country of our size or larger.
The average news hole at papers comparable to the News is about 40%. The difference between 40% and 50% is more important than it might first seem: a paper with 30 pages of ads and a 40% news hole delivers 20 pages of news a day, whereas our paper matches 30 pages of ads with 30 pages of news. Therefore, given ad pages equal in number, we end up delivering our readers no less than 50% more news.
We believe this heavy commitment to news is one of the reasons The Buffalo News has the highest weekday penetration rate (the percentage of households in the paper’s primary marketing area purchasing it each day) among any of the top 50 papers in the country. Our Sunday penetration, where we are also number one, is even more impressive. Ten years ago, the only Sunday paper serving Buffalo (the Courier-Express) had circulation of 271,000 and a penetration ratio of about 63%. The Courier- Express had served the area for many decades and its penetration ratio – which was similar to those existing in many metropolitan markets – was thought to be a “natural” one, accurately reflecting the local citizenry’s appetite for a Sunday product.
Our Sunday paper was started in late 1977. It now has a penetration ratio of 83% and sells about 100,000 copies more each Sunday than did the Courier-Express ten years ago – even though population in our market area has declined during the decade. In recent history, no other city that has long had a local Sunday paper has experienced a penetration gain anywhere close to Buffalo’s.
Despite our exceptional market acceptance, our operating margins almost certainly have peaked. A major newsprint price increase took effect at the end of 1986, and our advertising rate increases in 1987 will again be moderate compared to those of the industry. However, even if margins should materially shrink, we would not reduce our news-hole ratio.
As I write this, it has been exactly ten years since we purchased The News. The financial rewards it has brought us have far exceeded our expectations and so, too, have the non-financial rewards. Our respect for the News – high when we bought it – has grown consistently ever since the purchase, as has our respect and admiration for Murray Light, the editor who turns out the product that receives such extraordinary community acceptance. The efforts of Murray and Stan, which were crucial to the News during its dark days of financial reversals and litigation, have not in the least been lessened by prosperity. Charlie and I are grateful to them.
The amazing Blumkins continue to perform business miracles at Nebraska Furniture Mart. Competitors come and go (mostly go), but Mrs. B. and her progeny roll on. In 1986 net sales increased 10.2% to $132 million. Ten years ago sales were $44 million and, even then, NFM appeared to be doing just about all of the business available in the Greater Omaha Area. Given NFM’s remarkable dominance, Omaha’s slow growth in population and the modest inflation rates that have applied to the goods NFM sells, how can this operation continue to rack up such large sales gains? The only logical explanation is that the marketing territory of NFM’s one-and-only store continues to widen because of its ever-growing reputation for rock-bottom everyday prices and the broadest of selections. In preparation for further gains, NFM is expanding the capacity of its warehouse, located a few hundred yards from the store, by about one-third.
Mrs. B, Chairman of Nebraska Furniture Mart, continues at age 93 to outsell and out-hustle any manager I’ve ever seen. She’s at the store seven days a week, from opening to close. Competing with her represents a triumph of courage over judgment.
It’s easy to overlook what I consider to be the critical lesson of the Mrs. B saga: at 93, Omaha based Board Chairmen have yet to reach their peak. Please file this fact away to consult before you mark your ballot at the 2024 annual meeting of Berkshire.
At See’s, sales trends improved somewhat from those of recent years. Total pounds sold rose about 2%. (For you chocaholics who like to fantasize, one statistic: we sell over 12,000 tons annually.) Same-store sales, measured in pounds, were virtually unchanged. In the previous six years, same store poundage fell, and we gained or maintained poundage volume only by adding stores. But a particularly strong Christmas season in 1986 stemmed the decline. By stabilizing same-store volume and making a major effort to control costs, See’s was able to maintain its excellent profit margin in 1986 though it put through only minimal price increases. We have Chuck Huggins, our long-time manager at See’s, to thank for this significant achievement.
See’s has a one-of-a-kind product “personality” produced by a combination of its candy’s delicious taste and moderate price, the company’s total control of the distribution process, and the exceptional service provided by store employees. Chuck rightfully measures his success by the satisfaction of our customers, and his attitude permeates the organization. Few major retailing companies have been able to sustain such a customer-oriented spirit, and we owe Chuck a great deal for keeping it alive and well at See’s.
See’s profits should stay at about their present level. We will continue to increase prices very modestly, merely matching prospective cost increases.
World Book is the largest of 17 Scott Fetzer operations that joined Berkshire at the beginning of 1986. Last year I reported to you enthusiastically about the businesses of Scott Fetzer and about Ralph Schey, its manager. A year’s experience has added to my enthusiasm for both. Ralph is a superb businessman and a straight shooter. He also brings exceptional versatility and energy to his job: despite the wide array of businesses that he manages, he is on top of the operations, opportunities and problems of each. And, like our other managers, Ralph is a real pleasure to work with. Our good fortune continues.
World Book’s unit volume increased for the fourth consecutive year, with encyclopedia sales up 7% over 1985 and 45% over 1982. Childcraft’s unit sales also grew significantly.
World Book continues to dominate the U.S. direct-sales encyclopedia market – and for good reasons. Extraordinarily well-edited and priced at under 5 cents per page, these books are a bargain for youngster and adult alike. You may find one editing technique interesting: World Book ranks over 44,000 words by difficulty. Longer entries in the encyclopedia include only the most easily comprehended words in the opening sections, with the difficulty of the material gradually escalating as the exposition proceeds. As a result, youngsters can easily and profitably read to the point at which subject matter gets too difficult, instead of immediately having to deal with a discussion that mixes up words requiring college-level comprehension with others of fourth-grade level.
Selling World Book is a calling. Over one-half of our active salespeople are teachers or former teachers, and another 5% have had experience as librarians. They correctly think of themselves as educators, and they do a terrific job. If you don’t have a World Book set in your house, I recommend one.
Kirby likewise recorded its fourth straight year of unit volume gains. Worldwide, unit sales grew 4% from 1985 and 33% from 1982. While the Kirby product is more expensive than most cleaners, it performs in a manner that leaves cheaper units far behind (“in the dust,” so to speak). Many 30- and 40-year-old Kirby cleaners are still in active duty. If you want the best, you buy a Kirby.
Some companies that historically have had great success in direct sales have stumbled in recent years. Certainly the era of the working woman has created new challenges for direct sales organizations. So far, the record shows that both Kirby and World Book have responded most successfully.
The businesses described above, along with the insurance operation and Fechheimer, constitute our major business units. The brevity of our descriptions is in no way meant to diminish the importance of these businesses to us. All have been discussed in past annual reports and, because of the tendency of Berkshire owners to stay in the fold (about 98% of the stock at the end of each year is owned by people who were owners at the start of the year), we want to avoid undue repetition of basic facts. You can be sure that we will immediately report to you in detail if the underlying economics or competitive position of any of these businesses should materially change. In general, the businesses described in this section can be characterized as having very strong market positions, very high returns on capital employed, and the best of operating managements.
The Fechheimer Bros. Co.
Every year in Berkshire’s annual report I include a description of the kind of business that we would like to buy. This “ad” paid off in 1986.
On January 15th of last year I received a letter from Bob Heldman of Cincinnati, a shareholder for many years and also Chairman of Fechheimer Bros. Until I read the letter, however, I did not know of either Bob or Fechheimer. Bob wrote that he ran a company that met our tests and suggested that we get together, which we did in Omaha after their results for 1985 were compiled.
He filled me in on a little history: Fechheimer, a uniform manufacturing and distribution business, began operations in 1842. Warren Heldman, Bob’s father, became involved in the business in 1941 and his sons, Bob and George (now President), along with their sons, subsequently joined the company. Under the Heldmans’ management, the business was highly successful.
In 1981 Fechheimer was sold to a group of venture capitalists in a leveraged buy out (an LBO), with management retaining an equity interest. The new company, as is the case with all LBOS, started with an exceptionally high debt/equity ratio. After the buy out, however, operations continued to be very successful. So by the start of last year debt had been paid down substantially and the value of the equity had increased dramatically. For a variety of reasons, the venture capitalists wished to sell and Bob, having dutifully read Berkshire’s annual reports, thought of us.
Fechheimer is exactly the sort of business we like to buy. Its economic record is superb; its managers are talented, high- grade, and love what they do; and the Heldman family wanted to continue its financial interest in partnership with us. Therefore, we quickly purchased about 84% of the stock for a price that was based upon a $55 million valuation for the entire business.
The circumstances of this acquisition were similar to those prevailing in our purchase of Nebraska Furniture Mart: most of the shares were held by people who wished to employ funds elsewhere; family members who enjoyed running their business wanted to continue both as owners and managers; several generations of the family were active in the business, providing management for as far as the eye can see; and the managing family wanted a purchaser who would not re-sell, regardless of price, and who would let the business be run in the future as it had been in the past. Both Fechheimer and NFM were right for us, and we were right for them.
You may be amused to know that neither Charlie nor I have been to Cincinnati, headquarters for Fechheimer, to see their operation. (And, incidentally, it works both ways: Chuck Huggins, who has been running See’s for 15 years, has never been to Omaha.) If our success were to depend upon insights we developed through plant inspections, Berkshire would be in big trouble. Rather, in considering an acquisition, we attempt to evaluate the economic characteristics of the business – its competitive strengths and weaknesses – and the quality of the people we will be joining. Fechheimer was a standout in both respects. In addition to Bob and George Heldman, who are in their mid-60s – spring chickens by our standards – there are three members of the next generation, Gary, Roger and Fred, to insure continuity.
As a prototype for acquisitions, Fechheimer has only one drawback: size. We hope our next acquisition is at least several times as large but a carbon copy in all other respects. Our threshold for minimum annual after-tax earnings of potential acquisitions has been moved up to $10 million from the $5 million level that prevailed when Bob wrote to me.
Flushed with success, we repeat our ad. If you have a business that fits, 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 “turn-around” situations),
(3) businesses earning good returns on equity while employing little or no debt.
(4) management in place (we can’t supply it),
(5) simple businesses (if there’s lots of technology, we won’t understand it),
(6) an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer – customarily within five minutes – as to whether we’re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. Indeed, following recent advances in the price of Berkshire stock, transactions involving stock issuance may be quite feasible. We invite potential sellers to check us out by contacting people with whom we have done business in the past. For the right business – and the right people – we can provide a good home.
On the other hand, we frequently get approached about acquisitions that don’t come close to meeting our tests: new ventures, turnarounds, auction-like sales, and the ever-popular (among brokers) “I’m-sure-something-will-work-out-if-you-people- get-to-know-each-other.” None of these attracts us in the least.
* * *
Besides being interested in the purchases of entire businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock, as in our Cap Cities purchase. Such purchases appeal to us only when we are very comfortable with both the economics of the business and the ability and integrity of the people running the operation. We prefer large transactions: in the unusual case we might do something as small as $50 million (or even smaller), but our preference is for commitments many times that size.
Insurance Operations
We present our usual table of industry figures, expanded this year to include data about incurred losses and the GNP inflation index. The contrast in 1986 between the growth in premiums and growth in incurred losses will show you why underwriting results for the year improved materially:
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 9.7
1982 ..... 4.4 109.8 8.4 6.4
1983 ..... 4.6 112.0 6.8 3.9
1984 ..... 9.2 117.9 16.9 3.8
1985 ..... 22.1 116.5 16.1 3.3
1986 (Est.) 22.6 108.5 15.5 2.6
Source: Best’s Insurance Management Reports
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 107-112 range typically produces an overall break-even result, exclusive of earnings on the funds provided by shareholders.
The math of the insurance business, encapsulated by the table, is not very complicated. In years when the industry’s annual gain in revenues (premiums) pokes along at 4% or 5%, underwriting losses are sure to mount. This is not because auto accidents, fires, windstorms and the like are occurring more frequently, nor has it lately been the fault of general inflation. Today, social and judicial inflation are the major culprits; the cost of entering a courtroom has simply ballooned. Part of the jump in cost arises from skyrocketing verdicts, and part from the tendency of judges and juries to expand the coverage of insurance policies beyond that contemplated by the insurer when the policies were written. Seeing no let-up in either trend, we continue to believe that the industry’s revenues must grow at close to 10% annually for it to just hold its own in terms of profitability, even though general inflation may be running only 2% – 4%.
In 1986, as noted, the industry’s premium volume soared even faster than loss costs. Consequently, the underwriting loss of the industry fell dramatically. In last year’s report we predicted this sharp improvement but also predicted that prosperity would be fleeting. Alas, this second prediction is already proving accurate. The rate of gain in the industry’s premium volume has slowed significantly (from an estimated 27.1% in 1986’s first quarter, to 23.5% in the second, to 21.8% in the third, to 18.7% in the fourth), and we expect further slowing in 1987. Indeed, the rate of gain may well fall below my 10% “equilibrium” figure by the third quarter.
Nevertheless, underwriting results in 1987, assuming they are not dragged down by a major natural catastrophe, will again improve materially because price increases are recognized in revenues on a lagged basis. In effect, the good news in earnings follows the good news in prices by six to twelve months. But the improving trend in earnings will probably end by late 1988 or early 1989. Thereafter the industry is likely to head south in a hurry.
Pricing behavior in the insurance industry continues to be exactly what can be expected in a commodity-type business. Only under shortage conditions are high profits achieved, and such conditions don’t last long. When the profit sun begins to shine, long-established insurers shower investors with new shares in order to build capital. In addition, newly-formed insurers rush to sell shares at the advantageous prices available in the new- issue market (prices advantageous, that is, to the insiders promoting the company but rarely to the new shareholders). These moves guarantee future trouble: capacity soars, competitive juices flow, and prices fade.
It’s interesting to observe insurance leaders beseech their colleagues to behave in a more “statesmanlike” manner when pricing policies. “Why,” they ask, “can’t we learn from history, even out the peaks and valleys, and consistently price to make reasonable profits?” What they wish, of course, is pricing that resembles, say, that of The Wall Street journal, whose prices are ample to start with and rise consistently each year.
Such calls for improved behavior have all of the efficacy of those made by a Nebraska corn grower asking his fellow growers, worldwide, to market their corn with more statesmanship. What’s needed is not more statesmen, but less corn. By raising large amounts of capital in the last two years, the insurance industry has, to continue our metaphor, vastly expanded its plantings of corn. The resulting increase in “crop” – i.e., the proliferation of insurance capacity – will have the same effect on prices and profits that surplus crops have had since time immemorial.
Our own insurance operation did well in 1986 and is also likely to do well in 1987. We have benefited significantly from industry conditions. But much of our prosperity arises from the efforts and ability of Mike Goldberg, manager of all insurance operations.
Our combined ratio (on a statutory basis and excluding structured settlements and financial reinsurance) fell from 111 in 1985 to 103 in 1986. In addition, our premium growth has been exceptional: although final figures aren’t available, I believe that over the past two years we were the fastest growing company among the country’s top 100 insurers. Some of our growth, it is true, came from our large quota-share contract with Fireman’s Fund, described in last year’s report and updated in Charlie’s letter on page 54. But even if the premiums from that contract are excluded from the calculation, we probably still ranked first in growth.
Interestingly, we were the slowest-growing large insurer in the years immediately preceding 1985. In fact, we shrank – and we will do so again from time to time in the future. Our large swings in volume do not mean that we come and go from the insurance marketplace. Indeed, we are its most steadfast participant, always standing ready, at prices we believe adequate, to write a wide variety of high-limit coverages. The swings in our volume arise instead from the here-today, gone- tomorrow behavior of other insurers. When most insurers are “gone,” because their capital is inadequate or they have been frightened by losses, insureds rush to us and find us ready to do business. But when hordes of insurers are “here,” and are slashing prices far below expectable costs, many customers naturally leave us in order to take advantage of the bargains temporarily being offered by our competition.
Our firmness on prices works no hardship on the consumer: he is being bombarded by attractively priced insurance offers at those times when we are doing little business. And it works no hardship on our employees: we don’t engage in layoffs when we experience a cyclical slowdown at one of our generally-profitable insurance operations. This no-layoff practice is in our self- interest. Employees who fear that large layoffs will accompany sizable reductions in premium volume will understandably produce scads of business through thick and thin (mostly thin).
The trends in National Indemnity’s traditional business – the writing of commercial auto and general liability policies through general agents – suggest how gun-shy other insurers became for a while and how brave they are now getting. In the last quarter of 1984, NICO’s monthly volume averaged $5 million, about what it had been running for several years. By the first quarter of 1986, monthly volume had climbed to about $35 million. In recent months, a sharp decline has set in. Monthly volume is currently about $20 million and will continue to fall as new competitors surface and prices are cut. Ironically, the managers of certain major new competitors are the very same managers that just a few years ago bankrupted insurers that were our old competitors. Through state-mandated guaranty funds, we must pay some of the losses these managers left unpaid, and now we find them writing the same sort of business under a new name. C’est la guerre.
The business we call “large risks” expanded significantly during 1986, and will be important to us in the future. In this operation, we regularly write policies with annual premiums of $1 – $3 million, or even higher. This business will necessarily be highly volatile – both in volume and profitability – but our premier capital position and willingness to write large net lines make us a very strong force in the market when prices are right. On the other hand, our structured settlement business has become near-dormant because present prices make no sense to us.
The 1986 loss reserve development of our insurance group is chronicled on page 46. The figures show the amount of error in our yearend 1985 liabilities that a year of settlements and further evaluation has revealed. As you can see, what I told you last year about our loss liabilities was far from true – and that makes three years in a row of error. If the physiological rules that applied to Pinocchio were to apply to me, my nose would now draw crowds.
When insurance executives belatedly establish proper reserves, they often speak of “reserve strengthening,” a term that has a rather noble ring to it. They almost make it sound as if they are adding extra layers of strength to an already-solid balance sheet. That’s not the case: instead the term is a euphemism for what should more properly be called “correction of previous untruths” (albeit non-intentional ones).
We made a special effort at the end of 1986 to reserve accurately. However, we tried just as hard at the end of 1985. Only time will tell whether we have finally succeeded in correctly estimating our insurance liabilities.
Despite the difficulties we have had in reserving and the commodity economics of the industry, we expect our insurance business to both grow and make significant amounts of money – but progress will be distinctly irregular and there will be major unpleasant surprises from time to time. It’s a treacherous business and a wary attitude is essential. We must heed Woody Allen: “While the lamb may lie down with the lion, the lamb shouldn’t count on getting a whole lot of sleep.”
In our insurance operations we have an advantage in attitude, we have an advantage in capital, and we are developing an advantage in personnel. Additionally, I like to think we have some long-term edge in investing the float developed from policyholder funds. The nature of the business suggests that we will need all of these advantages in order to prosper.
* * *
GEICO Corporation, 41% owned by Berkshire, had an outstanding year in 1986. Industrywide, underwriting experience in personal lines did not improve nearly as much as it did in commercial lines. But GEICO, writing personal lines almost exclusively, improved its combined ratio to 96.9 and recorded a 16% gain in premium volume. GEICO also continued to repurchase its own shares and ended the year with 5.5% fewer shares outstanding than it had at the start of the year. Our share of GEICO’s premium volume is over $500 million, close to double that of only three years ago. GEICO’s book of business is one of the best in the world of insurance, far better indeed than Berkshire’s own book.
The most important ingredient in GEICO’s success is rock- bottom operating costs, which set the company apart from literally hundreds of competitors that offer auto insurance. The total of GEICO’s underwriting expense and loss adjustment expense in 1986 was only 23.5% of premiums. Many major companies show percentages 15 points higher than that. Even such huge direct writers as Allstate and State Farm incur appreciably higher costs than does GEICO.
The difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much- sought-after business castle. No one understands this moat- around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise. Between 1985 and 1986, GEICO’s total expense ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s leadership, the ratio is almost certain to drop further. If it does – and if GEICO maintains its service and underwriting standards – the company’s future will be brilliant indeed.
The second stage of the GEICO rocket is fueled by Lou Simpson, Vice Chairman, who has run the company’s investments since late 1979. Indeed, it’s a little embarrassing for me, the fellow responsible for investments at Berkshire, to chronicle Lou’s performance at GEICO. Only my ownership of a controlling block of Berkshire stock makes me secure enough to give you the following figures, comparing the overall return of the equity portfolio at GEICO to that of the Standard & Poor’s 500:
Year GEICO’s Equities S&P 500
---- ---------------- -------
1980 .................. 23.7% 32.3%
1981 .................. 5.4 (5.0)
1982 .................. 45.8 21.4
1983 .................. 36.0 22.4
1984 .................. 21.8 6.2
1985 .................. 45.8 31.6
1986 .................. 38.7 18.6
These are not only terrific figures but, fully as important, they have been achieved in the right way. Lou has consistently invested in undervalued common stocks that, individually, were unlikely to present him with a permanent loss and that, collectively, were close to risk-free.
In sum, GEICO is an exceptional business run by exceptional managers. We are fortunate to be associated with them.
Marketable Securities
During 1986, our insurance companies purchased about $700 million of tax-exempt bonds, most having a maturity of 8 to 12 years. You might think that this commitment indicates a considerable enthusiasm for such bonds. Unfortunately, that’s not so: at best, the bonds are mediocre investments. They simply seemed the least objectionable alternative at the time we bought them, and still seem so. (Currently liking neither stocks nor bonds, I find myself the polar opposite of Mae West as she declared: “I like only two kinds of men – foreign and domestic.”)
We must, of necessity, hold marketable securities in our insurance companies and, as money comes in, we have only five directions to go: (1) long-term common stock investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments.
Common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value – stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests. This statement in no way translates into a stock market prediction: we have no idea – and never have had – whether the market is going to go up, down, or sideways in the near- or intermediate term future.
What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
As this is written, little fear is visible in Wall Street. Instead, euphoria prevails – and why not? What could be more exhilarating than to participate in a bull market in which the rewards to owners of businesses become gloriously uncoupled from the plodding performances of the businesses themselves. Unfortunately, however, stocks can’t outperform businesses indefinitely.
Indeed, because of the heavy transaction and investment management costs they bear, stockholders as a whole and over the long term must inevitably underperform the companies they own. If American business, in aggregate, earns about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.
The second category of investments open to our insurance companies is long-term bonds. These are unlikely to be of interest to us except in very special situations, such as the Washington Public Power Supply System #1, #2 and #3 issues, discussed in our 1984 report. (At yearend, we owned WPPSS issues having an amortized cost of $218 million and a market value of $310 million, paying us $31.7 million in annual tax-exempt income.) Our aversion to long-term bonds relates to our fear that we will see much higher rates of inflation within the next decade. Over time, the behavior of our currency will be determined by the behavior of our legislators. This relationship poses a continuing threat to currency stability – and a corresponding threat to the owners of long-term bonds.
We continue to periodically employ money in the arbitrage field. However, unlike most arbitrageurs, who purchase dozens of securities each year, we purchase only a few. We restrict ourselves to large deals that have been announced publicly and do not bet on the come. Therefore, our potential profits are apt to be small; but, with luck, our disappointments will also be few.
Our yearend portfolio shown below includes one arbitrage commitment, Lear-Siegler. Our balance sheet also includes a receivable for $145 million, representing the money owed us (and paid a few days later) by Unilever, then in the process of purchasing Chesebrough-Ponds, another of our arbitrage holdings. Arbitrage is an alternative to Treasury Bills as a short-term parking place for money – a choice that combines potentially higher returns with higher risks. To date, our returns from the funds committed to arbitrage have been many times higher than they would have been had we left those funds in Treasury Bills. Nonetheless, one bad experience could change the scorecard markedly.
We also, though it takes some straining, currently view medium-term tax-exempt bonds as an alternative to short-term Treasury holdings. Buying these bonds, we run a risk of significant loss if, as seems probable, we sell many of them well before maturity. However, we believe this risk is more than counter-balanced first, by the much higher after-tax returns currently realizable from these securities as compared to Treasury Bills and second, by the possibility that sales will produce an overall profit rather than a loss. Our expectation of a higher total return, after allowing for the possibility of loss and after taking into account all tax effects, is a relatively close call and could well be wrong. Even if we sell our bonds at a fairly large loss, however, we may end up reaping a higher after-tax return than we would have realized by repeatedly rolling over Treasury Bills.
In any event, you should know that our expectations for both the stocks and bonds we now hold are exceptionally modest, given current market levels. Probably the best thing that could happen to us is a market in which we would choose to sell many of our bond holdings at a significant loss in order to re-allocate funds to the far-better equity values then very likely to exist. The bond losses I am talking about would occur if high interest rates came along; the same rates would probably depress common stocks considerably more than medium-term bonds.
We show below our 1986 yearend net holdings in marketable equities. All positions with a market value of over $25 million are listed, and the interests attributable to minority shareholdings of Wesco Financial Corp. and Nebraska Furniture Mart are excluded.
No. of Shares Cost Market
------------- ---------- ----------
(000s omitted)
2,990,000 Capital Cities/ABC, Inc. ....... $515,775 $ 801,694
6,850,000 GEICO Corporation .............. 45,713 674,725
2,379,200 Handy & Harman ................. 27,318 46,989
489,300 Lear Siegler, Inc. ............. 44,064 44,587
1,727,765 The Washington Post Company .... 9,731 269,531
---------- ----------
642,601 1,837,526
All Other Common Stockholdings 12,763 36,507
---------- ----------
Total Common Stocks ............ $655,364 $1,874,033
We should note that we expect to keep permanently our three primary holdings, Capital Cities/ABC, Inc., GEICO Corporation, and The Washington Post. Even if these securities were to appear significantly overpriced, we would not anticipate selling them, just as we would not sell See’s or Buffalo Evening News if someone were to offer us a price far above what we believe those businesses are worth.
This attitude may seem old-fashioned in a corporate world in which activity has become the order of the day. The modern manager refers to his “portfolio” of businesses – meaning that all of them are candidates for “restructuring” whenever such a move is dictated by Wall Street preferences, operating conditions or a new corporate “concept.” (Restructuring is defined narrowly, however: it extends only to dumping offending businesses, not to dumping the officers and directors who bought the businesses in the first place. “Hate the sin but love the sinner” is a theology as popular with the Fortune 500 as it is with the Salvation Army.)
Investment managers are even more hyperkinetic: their behavior during trading hours makes whirling dervishes appear sedated by comparison. Indeed, the term “institutional investor” is becoming one of those self-contradictions called an oxymoron, comparable to “jumbo shrimp,” “lady mudwrestler” and “inexpensive lawyer.”
Despite the enthusiasm for activity that has swept business and financial America, we will stick with our ‘til-death-do-us- part policy. It’s the only one with which Charlie and I are comfortable, it produces decent results, and it lets our managers and those of our investees run their businesses free of distractions.
NHP, Inc.
Last year we paid $23.7 million for about 50% of NHP, Inc., a developer, syndicator, owner and manager of multi-family rental housing. Should all executive stock options that have been authorized be granted and exercised, our equity interest will decline to slightly over 45%.
NHP, Inc. has a most unusual genealogy. In 1967, President Johnson appointed a commission of business and civic leaders, led by Edgar Kaiser, to study ways to increase the supply of multifamily housing for low- and moderate-income tenants. Certain members of the commission subsequently formed and promoted two business entities to foster this goal. Both are now owned by NHP, Inc. and one operates under unusual ground rules: three of its directors must be appointed by the President, with the advice and consent of the Senate, and it is also required by law to submit an annual report to the President.
Over 260 major corporations, motivated more by the idea of public service than profit, invested $42 million in the two original entities, which promptly began, through partnerships, to develop government-subsidized rental property. The typical partnership owned a single property and was largely financed by a non-recourse mortgage. Most of the equity money for each partnership was supplied by a group of limited partners who were primarily attracted by the large tax deductions that went with the investment. NHP acted as general partner and also purchased a small portion of each partnership’s equity.
The Government’s housing policy has, of course, shifted and NHP has necessarily broadened its activities to include non- subsidized apartments commanding market-rate rents. In addition, a subsidiary of NHP builds single-family homes in the Washington, D.C. area, realizing revenues of about $50 million annually.
NHP now oversees about 500 partnership properties that are located in 40 states, the District of Columbia and Puerto Rico, and that include about 80,000 housing units. The cost of these properties was more than $2.5 billion and they have been well maintained. NHP directly manages about 55,000 of the housing units and supervises the management of the rest. The company’s revenues from management are about $16 million annually, and growing.
In addition to the equity interests it purchased upon the formation of each partnership, NHP owns varying residual interests that come into play when properties are disposed of and distributions are made to the limited partners. The residuals on many of NHP’s “deep subsidy” properties are unlikely to be of much value. But residuals on certain other properties could prove quite valuable, particularly if inflation should heat up.
The tax-oriented syndication of properties to individuals has been halted by the Tax Reform Act of 1986. In the main, NHP is currently trying to develop equity positions or significant residual interests in non-subsidized rental properties of quality and size (typically 200 to 500 units). In projects of this kind, NHP usually works with one or more large institutional investors or lenders. NHP will continue to seek ways to develop low- and moderate-income apartment housing, but will not likely meet success unless government policy changes.
Besides ourselves, the large shareholders in NHP are Weyerhauser (whose interest is about 25%) and a management group led by Rod Heller, chief executive of NHP. About 60 major corporations also continue to hold small interests, none larger than 2%.
Taxation
The Tax Reform Act of 1986 affects our various businesses in important and divergent ways. Although we find much to praise in the Act, the net financial effect for Berkshire is negative: our rate of increase in business value is likely to be at least moderately slower under the new law than under the old. The net effect for our shareholders is even more negative: every dollar of increase in per-share business value, assuming the increase is accompanied by an equivalent dollar gain in the market value of Berkshire stock, will produce 72 cents of after-tax gain for our shareholders rather than the 80 cents produced under the old law. This result, of course, reflects the rise in the maximum tax rate on personal capital gains from 20% to 28%.
Here are the main tax changes that affect Berkshire:
The tax rate on corporate ordinary income is scheduled to decrease from 46% in 1986 to 34% in 1988. This change obviously affects us positively – and it also has a significant positive effect on two of our three major investees, Capital Cities/ABC and The Washington Post Company.
I say this knowing that over the years there has been a lot of fuzzy and often partisan commentary about who really pays corporate taxes – businesses or their customers. The argument, of course, has usually turned around tax increases, not decreases. Those people resisting increases in corporate rates frequently argue that corporations in reality pay none of the taxes levied on them but, instead, act as a sort of economic pipeline, passing all taxes through to consumers. According to these advocates, any corporate-tax increase will simply lead to higher prices that, for the corporation, offset the increase. Having taken this position, proponents of the “pipeline” theory must also conclude that a tax decrease for corporations will not help profits but will instead flow through, leading to correspondingly lower prices for consumers.
Conversely, others argue that corporations not only pay the taxes levied upon them, but absorb them also. Consumers, this school says, will be unaffected by changes in corporate rates.
What really happens? When the corporate rate is cut, do Berkshire, The Washington Post, Cap Cities, etc., themselves soak up the benefits, or do these companies pass the benefits along to their customers in the form of lower prices? This is an important question for investors and managers, as well as for policymakers.
Our conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its shareholders, and that in other cases the benefits are entirely, or almost entirely, passed through to the customer. What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of that franchise is regulated.
For example, when the franchise is strong and after-tax profits are regulated in a relatively precise manner, as is the case with electric utilities, changes in corporate tax rates are largely reflected in prices, not in profits. When taxes are cut, prices will usually be reduced in short order. When taxes are increased, prices will rise, though often not as promptly.
A similar result occurs in a second arena – in the price- competitive industry, whose companies typically operate with very weak business franchises. In such industries, the free market “regulates” after-tax profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the same function in dealing with the price- competitive industry as the Public Utilities Commission does in dealing with electric utilities. In these industries, therefore, tax changes eventually affect prices more than profits.
In the case of unregulated businesses blessed with strong franchises, however, it’s a different story: the corporation and its shareholders are then the major beneficiaries of tax cuts. These companies benefit from a tax cut much as the electric company would if it lacked a regulator to force down prices.
Many of our businesses, both those we own in whole and in part, possess such franchises. Consequently, reductions in their taxes largely end up in our pockets rather than the pockets of our customers. While this may be impolitic to state, it is impossible to deny. If you are tempted to believe otherwise, think for a moment of the most able brain surgeon or lawyer in your area. Do you really expect the fees of this expert (the local “franchise-holder” in his or her specialty) to be reduced now that the top personal tax rate is being cut from 50% to 28%?
Your joy at our conclusion that lower rates benefit a number of our operating businesses and investees should be severely tempered, however, by another of our convictions: scheduled 1988 tax rates, both individual and corporate, seem totally unrealistic to us. These rates will very likely bestow a fiscal problem on Washington that will prove incompatible with price stability. We believe, therefore, that ultimately – within, say, five years – either higher tax rates or higher inflation rates are almost certain to materialize. And it would not surprise us to see both.
Corporate capital gains tax rates have been increased from 28% to 34%, effective in 1987. This change will have an important adverse effect on Berkshire because we expect much of our gain in business value in the future, as in the past, to arise from capital gains. For example, our three major investment holdings – Cap Cities, GEICO, and Washington Post – at yearend had a market value of over $1.7 billion, close to 75% of the total net worth of Berkshire, and yet they deliver us only about $9 million in annual income. Instead, all three retain a very high percentage of their earnings, which we expect to eventually deliver us capital gains.
The new law increases the rate for all gains realized in the future, including the unrealized gains that existed before the law was enacted. At yearend, we had $1.2 billion of such unrealized gains in our equity investments. The effect of the new law on our balance sheet will be delayed because a GAAP rule stipulates that the deferred tax liability applicable to unrealized gains should be stated at last year’s 28% tax rate rather than the current 34% rate. This rule is expected to change soon. The moment it does, about $73 million will disappear from our GAAP net worth and be added to the deferred tax account.
Dividend and interest income received by our insurance companies will be taxed far more heavily under the new law. First, all corporations will be taxed on 20% of the dividends they receive from other domestic corporations, up from 15% under the old law. Second, there is a change concerning the residual 80% that applies only to property/casualty companies: 15% of that residual will be taxed if the stocks paying the dividends were purchased after August 7, 1986. A third change, again applying only to property/casualty companies, concerns tax-exempt bonds: interest on bonds purchased by insurers after August 7, 1986 will only be 85% tax-exempt.
The last two changes are very important. They mean that our income from the investments we make in future years will be significantly lower than would have been the case under the old law. My best guess is that these changes alone will eventually reduce the earning power of our insurance operation by at least 10% from what we could previously have expected.
The new tax law also materially changes the timing of tax payments by property/casualty insurance companies. One new rule requires us to discount our loss reserves in our tax returns, a change that will decrease deductions and increase taxable income. Another rule, to be phased in over six years, requires us to include 20% of our unearned premium reserve in taxable income.
Neither rule changes the amount of the annual tax accrual in our reports to you, but each materially accelerates the schedule of payments. That is, taxes formerly deferred will now be front- ended, a change that will significantly cut the profitability of our business. An analogy will suggest the toll: if, upon turning 21, you were required to immediately pay tax on all income you were due to receive throughout your life, both your lifetime wealth and your estate would be a small fraction of what they would be if all taxes on your income were payable only when you died.
Attentive readers may spot an inconsistency in what we say. Earlier, discussing companies in price-competitive industries, we suggested that tax increases or reductions affect these companies relatively little, but instead are largely passed along to their customers. But now we are saying that tax increases will affect profits of Berkshire’s property/casualty companies even though they operate in an intensely price-competitive industry.
The reason this industry is likely to be an exception to our general rule is that not all major insurers will be working with identical tax equations. Important differences will exist for several reasons: a new alternative minimum tax will materially affect some companies but not others; certain major insurers have huge loss carry-forwards that will largely shield their income from significant taxes for at least a few years; and the results of some large insurers will be folded into the consolidated returns of companies with non-insurance businesses. These disparate conditions will produce widely varying marginal tax rates in the property/casualty industry. That will not be the case, however, in most other price-competitive industries, such as aluminum, autos and department stores, in which the major players will generally contend with similar tax equations.
The absence of a common tax calculus for property/casualty companies means that the increased taxes falling on the industry will probably not be passed along to customers to the degree that they would in a typical price-competitive industry. Insurers, in other words, will themselves bear much of the new tax burdens.
A partial offset to these burdens is a “fresh start” adjustment that occurred on January 1, 1987 when our December 31, 1986 loss reserve figures were converted for tax purposes to the newly-required discounted basis. (In our reports to you, however, reserves will remain on exactly the same basis as in the past – undiscounted except in special cases such as structured settlements.) The net effect of the “fresh start” is to give us a double deduction: we will get a tax deduction in 1987 and future years for a portion of our-incurred-but-unpaid insurance losses that have already been fully deducted as costs in 1986 and earlier years.
The increase in net worth that is produced by this change is not yet reflected in our financial statements. Rather, under present GAAP rules (which may be changed), the benefit will flow into the earnings statement and, consequently, into net worth over the next few years by way of reduced tax charges. We expect the total benefit from the fresh-start adjustment to be in the $30 – $40 million range. It should be noted, however, that this is a one-time benefit, whereas the negative impact of the other insurance-related tax changes is not only ongoing but, in important respects, will become more severe as time passes.
The General Utilities Doctrine was repealed by the new tax law. This means that in 1987 and thereafter there will be a double tax on corporate liquidations, one at the corporate level and another at the shareholder level. In the past, the tax at the corporate level could be avoided, If Berkshire, for example, were to be liquidated – which it most certainly won’t be – shareholders would, under the new law, receive far less from the sales of our properties than they would have if the properties had been sold in the past, assuming identical prices in each sale. Though this outcome is theoretical in our case, the change in the law will very materially affect many companies. Therefore, it also affects our evaluations of prospective investments. Take, for example, producing oil and gas businesses, selected media companies, real estate companies, etc. that might wish to sell out. The values that their shareholders can realize are likely to be significantly reduced simply because the General Utilities Doctrine has been repealed – though the companies’ operating economics will not have changed adversely at all. My impression is that this important change in the law has not yet been fully comprehended by either investors or managers.
This section of our report has been longer and more complicated than I would have liked. But the changes in the law are many and important, particularly for property/casualty insurers. As I have noted, the new law will hurt Berkshire’s results, but the negative impact is impossible to quantify with any precision.
Miscellaneous
We bought a corporate jet last year. What you have heard about such planes is true: they are very expensive and a luxury in situations like ours where little travel to out-of-the-way places is required. And planes not only cost a lot to operate, they cost a lot just to look at. Pre-tax, cost of capital plus depreciation on a new $15 million plane probably runs $3 million annually. On our own plane, bought for $850,000 used, such costs run close to $200,000 annually.
Cognizant of such figures, your Chairman, unfortunately, has in the past made a number of rather intemperate remarks about corporate jets. Accordingly, prior to our purchase, I was forced into my Galileo mode. I promptly experienced the necessary “counter-revelation” and travel is now considerably easier – and considerably costlier – than in the past. Whether Berkshire will get its money’s worth from the plane is an open question, but I will work at achieving some business triumph that I can (no matter how dubiously) attribute to it. I’m afraid Ben Franklin had my number. Said he: “So convenient a thing it is to be a reasonable creature, since it enables one to find or make a reason for everything one has a mind to do.”
About 97% of all eligible shares participated in Berkshire’s 1986 shareholder-designated contributions program. Contributions made through the program were $4 million, and 1,934 charities were recipients.
We urge new shareholders to read the description of our shareholder-designated contributions program that appears on pages 58 and 59. 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 “street” name or nominee name. Shares not so registered on September 30, 1987 will be ineligible for the 1987 program.
* * *
Last year almost 450 people attended our shareholders’ meeting, up from about 250 the year before (and from about a dozen ten years ago). I hope you can join us on May 19th in Omaha. Charlie and I like to answer owner-related questions and I can promise you that our shareholders will pose many good ones. Finishing up the questions may take quite a while – we had about 65 last year so you should feel free to leave once your own have been answered.
Last year, after the meeting, one shareholder from New Jersey and another from New York went to the Furniture Mart, where each purchased a $5,000 Oriental rug from Mrs. B. (To be precise, they purchased rugs that might cost $10,000 elsewhere for which they were charged about $5,000.) Mrs. B was pleased – but not satisfied – and she will be looking for you at the store after this year’s meeting. Unless our shareholders top last year’s record, I’ll be in trouble. So do me (and yourself) a favor, and go see her.
Warren E. Buffett, Chairman
February 27, 1987
* * *
Appendix
Purchase-Price Accounting Adjustments and the “Cash Flow” Fallacy
First a short quiz: below are abbreviated 1986 statements of earnings for two companies. Which business is the more valuable?
|
Company O |
Company N |
|||||||||||
|
(000s Omitted) |
||||||||||||
| Revenues………………………. |
$677,240 |
$677,240 |
||||||||||
| Costs of Goods Sold: | ||||||||||||
| Historical costs, excluding depreciation……………………. |
$341,170 |
$341,170 |
||||||||||
| Special non-cash inventory costs……………………………. |
4,979 |
(1) | ||||||||||
| Depreciation of plant and equipment ……………………… |
8,301 |
13,355 |
(2) | |||||||||
|
349,471 |
359,504 |
|||||||||||
|
$327,769 |
$317,736 |
|||||||||||
| Gross Profit ……………………. | ||||||||||||
| Selling & Admin. Expense…….. |
$260,286 |
$260,286 |
||||||||||
| Amortization of Goodwill ……… |
______ |
____595 |
(3) | |||||||||
|
260,286 |
260,881 |
|||||||||||
| Operating Profit …………………… |
$ 67,483 |
$ 56,855 |
||||||||||
| Other Income, Net ……………..… |
4,135 |
4,135 |
||||||||||
| Pre-Tax Income ………………….… |
$ 71,618 |
$ 60,990 |
||||||||||
| Applicable Income Tax: | ||||||||||||
| Historical deferred and current tax ………………………………. |
$ 31,387 |
$ 31,387 |
||||||||||
| Non-Cash Inter-period Allocation Adjustment …………. |
______ |
_____998 |
(4) | |||||||||
|
31,387 |
32,385 |
|||||||||||
Net Income ............ $40,231 $28,605
======= =======
(Numbers (1) through (4) designate items discussed later in this section.)
As you’ve probably guessed, Companies O and N are the same business – Scott Fetzer. In the “O” (for “old”) column we have shown what the company’s 1986 GAAP earnings would have been if we had not purchased it; in the “N” (for “new”) column we have shown Scott Fetzer’s GAAP earnings as actually reported by Berkshire.
It should be emphasized that the two columns depict identical economics – i.e., the same sales, wages, taxes, etc. And both “companies” generate the same amount of cash for owners. Only the accounting is different.
So, fellow philosophers, which column presents truth? Upon which set of numbers should managers and investors focus?
Before we tackle those questions, let’s look at what produces the disparity between O and N. We will simplify our discussion in some respects, but the simplification should not produce any inaccuracies in analysis or conclusions.
The contrast between O and N comes about because we paid an amount for Scott Fetzer that was different from its stated net worth. Under GAAP, such differences – such premiums or discounts – must be accounted for by “purchase-price adjustments.” In Scott Fetzer’s case, we paid $315 million for net assets that were carried on its books at $172.4 million. So we paid a premium of $142.6 million.
The first step in accounting for any premium paid is to adjust the carrying value of current assets to current values. In practice, this requirement usually does not affect receivables, which are routinely carried at current value, but often affects inventories. Because of a $22.9 million LIFO reserve and other accounting intricacies, Scott Fetzer’s inventory account was carried at a $37.3 million discount from current value. So, making our first accounting move, we used $37.3 million of our $142.6 million premium to increase the carrying value of the inventory.
Assuming any premium is left after current assets are adjusted, the next step is to adjust fixed assets to current value. In our case, this adjustment also required a few accounting acrobatics relating to deferred taxes. Since this has been billed as a simplified discussion, I will skip the details and give you the bottom line: $68.0 million was added to fixed assets and $13.0 million was eliminated from deferred tax liabilities. After making this $81.0 million adjustment, we were left with $24.3 million of premium to allocate.
Had our situation called for them two steps would next have been required: the adjustment of intangible assets other than Goodwill to current fair values, and the restatement of liabilities to current fair values, a requirement that typically affects only long-term debt and unfunded pension liabilities. In Scott Fetzer’s case, however, neither of these steps was necessary.
The final accounting adjustment we needed to make, after recording fair market values for all assets and liabilities, was the assignment of the residual premium to Goodwill (technically known as “excess of cost over the fair value of net assets acquired”). This residual amounted to $24.3 million. Thus, the balance sheet of Scott Fetzer immediately before the acquisition, which is summarized below in column O, was transformed by the purchase into the balance sheet shown in column N. In real terms, both balance sheets depict the same assets and liabilities – but, as you can see, certain figures differ significantly.
|
Company O |
Company N |
|
|
(000s Omitted) |
||
|
Assets |
||
|
Cash and Cash Equivalents …………………………… |
$ 3,593 |
$ 3,593 |
|
Receivables, net ……………………………………….. |
90,919 |
90,919 |
|
Inventories …………………………………………… |
77,489 |
114,764 |
|
Other ……………………………………………………. |
5,954 |
5,954 |
|
Total Current Assets ………………………………….. |
177,955 |
215,230 |
|
Property, Plant, and Equipment, net …………………. |
80,967 |
148,960 |
| Investments in and Advances to Unconsolidated Subsidiaries and Joint Ventures ……………………… |
93,589 |
93,589 |
|
Other Assets, including Goodwill ……………………. |
9,836 |
34,210 |
|
$362,347 |
$491,989 |
|
|
Liabilities |
||
| Notes Payable and Current Portion of Long-term Debt ……………………………………………………… |
$ 4,650 |
$ 4,650 |
|
Accounts Payable ……………………………………… |
39,003 |
39,003 |
|
Accrued Liabilities …………………………………….. |
84,939 |
84,939 |
|
Total Current Liabilities ……………………………….. |
128,592 |
128,592 |
|
Long-term Debt and Capitalized Leases ……………. |
34,669 |
34,669 |
|
Deferred Income Taxes ……………………………….. |
17,052 |
4,075 |
|
Other Deferred Credits ………………………………… |
9,657 |
9,657 |
|
Total Liabilities ………………………………………… |
189,970 |
176,993 |
|
Shareholders’ Equity …………………………………… |
172,377 |
314,996 |
$362,347 $491,989
======== ========
The higher balance sheet figures shown in column N produce the lower income figures shown in column N of the earnings statement presented earlier. This is the result of the asset write-ups and of the fact that some of the written-up assets must be depreciated or amortized. The higher the asset figure, the higher the annual depreciation or amortization charge to earnings must be. The charges that flowed to the earnings statement because of the balance sheet write-ups were numbered in the statement of earnings shown earlier:
$4,979,000 for non-cash inventory costs resulting, primarily, from reductions that Scott Fetzer made in its inventories during 1986; charges of this kind are apt to be small or non-existent in future years. $5,054,000 for extra depreciation attributable to the write-up of fixed assets; a charge approximating this amount will probably be made annually for 12 more years. $595,000 for amortization of Goodwill; this charge will be made annually for 39 more years in a slightly larger amount because our purchase was made on January 6 and, therefore, the 1986 figure applies to only 98% of the year. $998,000 for deferred-tax acrobatics that are beyond my ability to explain briefly (or perhaps even non-briefly); a charge approximating this amount will probably be made annually for 12 more years. It is important to understand that none of these newly-created accounting costs, totaling $11.6 million, are deductible for income tax purposes. The “new” Scott Fetzer pays exactly the same tax as the “old” Scott Fetzer would have, even though the GAAP earnings of the two entities differ greatly. And, in respect to operating earnings, that would be true in the future also. However, in the unlikely event that Scott Fetzer sells one of its businesses, the tax consequences to the “old” and “new” company might differ widely.
By the end of 1986 the difference between the net worth of the “old” and “new” Scott Fetzer had been reduced from $142.6 million to $131.0 million by means of the extra $11.6 million that was charged to earnings of the new entity. As the years go by, similar charges to earnings will cause most of the premium to disappear, and the two balance sheets will converge. However, the higher land values and most of the higher inventory values that were established on the new balance sheet will remain unless land is disposed of or inventory levels are further reduced.
* * *
What does all this mean for owners? Did the shareholders of Berkshire buy a business that earned $40.2 million in 1986 or did they buy one earning $28.6 million? Were those $11.6 million of new charges a real economic cost to us? Should investors pay more for the stock of Company O than of Company N? And, if a business is worth some given multiple of earnings, was Scott Fetzer worth considerably more the day before we bought it than it was worth the following day?
If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since( c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”
The approach we have outlined produces “owner earnings” for Company O and Company N that are identical, which means valuations are also identical, just as common sense would tell you should be the case. This result is reached because the sum of (a) and (b) is the same in both columns O and N, and because( c) is necessarily the same in both cases.
And what do Charlie and I, as owners and managers, believe is the correct figure for the owner earnings of Scott Fetzer? Under current circumstances, we believe ( c) is very close to the “old” company’s (b) number of $8.3 million and much below the “new” company’s (b) number of $19.9 million. Therefore, we believe that owner earnings are far better depicted by the reported earnings in the O column than by those in the N column. In other words, we feel owner earnings of Scott Fetzer are considerably larger than the GAAP figures that we report.
That is obviously a happy state of affairs. But calculations of this sort usually do not provide such pleasant news. Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists – that is, when ( c) exceeds (b) – GAAP earnings overstate owner earnings. Frequently this overstatement is substantial. The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only (b) each year, they would have guaranteed their shrinkage in real terms.
All of this points up the absurdity of the “cash flow” numbers that are often set forth in Wall Street reports. These numbers routinely include (a) plus (b) – but do not subtract ( c) . Most sales brochures of investment bankers also feature deceptive presentations of this kind. These imply that the business being offered is the commercial counterpart of the Pyramids – forever state-of-the-art, never needing to be replaced, improved or refurbished. Indeed, if all U.S. corporations were to be offered simultaneously for sale through our leading investment bankers – and if the sales brochures describing them were to be believed – governmental projections of national plant and equipment spending would have to be slashed by 90%.
“Cash Flow”, true, may serve as a shorthand of some utility in descriptions of certain real estate businesses or other enterprises that make huge initial outlays and only tiny outlays thereafter. A company whose only holding is a bridge or an extremely long-lived gas field would be an example. But “cash flow” is meaningless in such businesses as manufacturing, retailing, extractive companies, and utilities because, for them, ( c) is always significant. To be sure, businesses of this kind may in a given year be able to defer capital spending. But over a five- or ten-year period, they must make the investment – or the business decays.
Why, then, are “cash flow” numbers so popular today? In answer, we confess our cynicism: we believe these numbers are frequently used by marketers of businesses and securities in attempts to justify the unjustifiable (and thereby to sell what should be the unsalable). When (a) – that is, GAAP earnings – looks by itself inadequate to service debt of a junk bond or justify a foolish stock price, how convenient it becomes for salesmen to focus on (a) + (b). But you shouldn’t add (b) without subtracting ( c) : though dentists correctly claim that if you ignore your teeth they’ll go away, the same is not true for ( c) . The company or investor believing that the debt-servicing ability or the equity valuation of an enterprise can be measured by totaling (a) and (b) while ignoring ( c) is headed for certain trouble.
* * *
To sum up: in the case of both Scott Fetzer and our other businesses, we feel that (b) on an historical-cost basis – i.e., with both amortization of intangibles and other purchase-price adjustments excluded – is quite close in amount to ( c) . (The two items are not identical, of course. For example, at See’s we annually make capitalized expenditures that exceed depreciation by $500,000 to $1 million, simply to hold our ground competitively.) Our conviction about this point is the reason we show our amortization and other purchase-price adjustment items separately in the table on page 8 and is also our reason for viewing the earnings of the individual businesses as reported there as much more closely approximating owner earnings than the GAAP figures.
Questioning GAAP figures may seem impious to some. After all, what are we paying the accountants for if it is not to deliver us the “truth” about our business. But the accountants’ job is to record, not to evaluate. The evaluation job falls to investors and managers.
Accounting numbers, of course, are the language of business and as such are of enormous help to anyone evaluating the worth of a business and tracking its progress. Charlie and I would be lost without these numbers: they invariably are the starting point for us in evaluating our own businesses and those of others. Managers and owners need to remember, however, that accounting is but an aid to business thinking, never a substitute for it.