BERKSHIRE HATHAWAY INC.
To the Shareholders of Berkshire Hathaway Inc.:
First, a few words about accounting. The merger with
Diversified Retailing Company, Inc. at yearend adds two new
complications in the presentation of our financial results.
After the merger, our ownership of Blue Chip Stamps increased to
approximately 58% and, therefore, the accounts of that company
must be fully consolidated in the Balance Sheet and Statement of
Earnings presentation of Berkshire. In previous reports, our
share of the net earnings only of Blue Chip had been included as
a single item on Berkshire’s Statement of Earnings, and there had
been a similar one-line inclusion on our Balance Sheet of our
share of their net assets.
This full consolidation of sales, expenses, receivables,
inventories, debt, etc. produces an aggregation of figures from
many diverse businesses - textiles, insurance, candy, newspapers,
trading stamps - with dramatically different economic
characteristics. In some of these your ownership is 100% but, in
those businesses which are owned by Blue Chip but fully
consolidated, your ownership as a Berkshire shareholder is only
58%. (Ownership by others of the balance of these businesses is
accounted for by the large minority interest item on the
liability side of the Balance Sheet.) Such a grouping of Balance
Sheet and Earnings items - some wholly owned, some partly owned -
tends to obscure economic reality more than illuminate it. In
fact, it represents a form of presentation that we never prepare
for internal use during the year and which is of no value to us
in any management activities.
For that reason, throughout the report we provide much
separate financial information and commentary on the various
segments of the business to help you evaluate Berkshire’s
performance and prospects. Much of this segmented information is
mandated by SEC disclosure rules and covered in “Management’s
Discussion” on pages 29 to 34. And in this letter we try to
present to you a view of our various operating entities from the
same perspective that we view them managerially.
A second complication arising from the merger is that the
1977 figures shown in this report are different from the 1977
figures shown in the report we mailed to you last year.
Accounting convention requires that when two entities such as
Diversified and Berkshire are merged, all financial data
subsequently must be presented as if the companies had been
merged at the time they were formed rather than just recently.
So the enclosed financial statements, in effect, pretend that in
1977 (and earlier years) the Diversified-Berkshire merger already
had taken place, even though the actual merger date was December
30, 1978. This shifting base makes comparative commentary
confusing and, from time to time in our narrative report, we will
talk of figures and performance for Berkshire shareholders as
historically reported to you rather than as restated after the
Diversified merger.
With that preamble it can be stated that, with or without
restated figures, 1978 was a good year. Operating earnings,
exclusive of capital gains, at 19.4% of beginning shareholders’
investment were within a fraction of our 1972 record. While we
believe it is improper to include capital gains or losses in
evaluating the performance of a single year, they are an
important component of the longer term record. Because of such
gains, Berkshire’s long-term growth in equity per share has been
greater than would be indicated by compounding the returns from
operating earnings that we have reported annually.
For example, over the last three years - generally a bonanza
period for the insurance industry, our largest profit producer -
Berkshire’s per share net worth virtually has doubled, thereby
compounding at about 25% annually through a combination of good
operating earnings and fairly substantial capital gains. Neither
this 25% equity gain from all sources nor the 19.4% equity gain
from operating earnings in 1978 is sustainable. The insurance
cycle has turned downward in 1979, and it is almost certain that
operating earnings measured by return on equity will fall this
year. However, operating earnings measured in dollars are likely
to increase on the much larger shareholders’ equity now employed
in the business.
In contrast to this cautious view about near term return
from operations, we are optimistic about prospects for long term
return from major equity investments held by our insurance
companies. We make no attempt to predict how security markets
will behave; successfully forecasting short term stock price
movements is something we think neither we nor anyone else can
do. In the longer run, however, we feel that many of our major
equity holdings are going to be worth considerably more money
than we paid, and that investment gains will add significantly to
the operating returns of the insurance group.
Sources of Earnings
To give you a better picture of just where Berkshire’s
earnings are produced, we show below a table which requires a
little explanation. Berkshire owns close to 58% of Blue Chip
which, in addition to 100% ownership of several businesses, owns
80% of Wesco Financial Corporation. Thus, Berkshire’s equity in
Wesco’s earnings is about 46%. In aggregate, businesses that we
control have about 7,000 full-time employees and generate
revenues of over $500 million.
The table shows the overall earnings of each major operating
category on a pre-tax basis (several of the businesses have low
tax rates because of significant amounts of tax-exempt interest
and dividend income), as well as the share of those earnings
belonging to Berkshire both on a pre-tax and after-tax basis.
Significant capital gains or losses attributable to any of the
businesses are not shown in the operating earnings figure, but
are aggregated on the “Realized Securities Gain” line at the
bottom of the table. Because of various accounting and tax
intricacies, the figures in the table should not be treated as
holy writ, but rather viewed as close approximations of the 1977
and 1978 earnings contributions of our constituent businesses.
Net Earnings
Earnings Before Income Taxes After Tax
-------------------------------------- ------------------
Total Berkshire Share Berkshire Share
------------------ ------------------ ------------------
(in thousands of dollars) 1978 1977 1978 1977 1978 1977
-------- -------- -------- -------- -------- --------
Total - all entities ......... $66,180 $57,089 $54,350 $42,234 $39,242 $30,393
======== ======== ======== ======== ======== ========
Earnings from operations:
Insurance Group:
Underwriting ............. $ 3,001 $ 5,802 $ 3,000 $ 5,802 $ 1,560 $ 3,017
Net investment income .... 19,705 12,804 19,691 12,804 16,400 11,360
Berkshire-Waumbec textiles 2,916 (620) 2,916 (620) 1,342 (322)
Associated Retail
Stores, Inc. ............ 2,757 2,775 2,757 2,775 1,176 1,429
See’s Candies .............. 12,482 12,840 7,013 6,598 3,049 2,974
Buffalo Evening News ....... (2,913) 751 (1,637) 389 (738) 158
Blue Chip Stamps - Parent .. 2,133 1,091 1,198 566 1,382 892
Illinois National Bank
and Trust Company ....... 4,822 3,800 4,710 3,706 4,262 3,288
Wesco Financial
Corporation - Parent .... 1,771 2,006 777 813 665 419
Mutual Savings and
Loan Association ........ 10,556 6,779 4,638 2,747 3,042 1,946
Interest on Debt ........... (5,566) (5,302) (4,546) (4,255) (2,349) (2,129)
Other ...................... 720 165 438 102 261 48
-------- -------- -------- -------- -------- --------
Total Earnings from
Operations ............ $52,384 $42,891 $40,955 $31,427 $30,052 $23,080
Realized Securities Gain ..... 13,796 14,198 13,395 10,807 9,190 7,313
-------- -------- -------- -------- -------- --------
Total Earnings ........... $66,180 $57,089 $54,350 $42,234 $39,242 $30,393
======== ======== ======== ======== ======== ========
Blue Chip and Wesco are public companies with reporting
requirements of their own. Later in this report we are
reproducing the narrative reports of the principal executives of
both companies, describing their 1978 operations. Some of the
figures they utilize will not match to the penny the ones we use
in this report, again because of accounting and tax complexities.
But their comments should be helpful to you in understanding the
underlying economic characteristics of these important partly-
owned businesses. A copy of the full annual report of either
company will be mailed to any shareholder of Berkshire upon
request to Mr. Robert H. Bird for Blue Chips Stamps, 5801 South
Eastern Avenue, Los Angeles, California 90040, or to Mrs. Bette
Deckard for Wesco Financial Corporation, 315 East Colorado
Boulevard, Pasadena, California 91109.
Textiles
Earnings of $1.3 million in 1978, while much improved from
1977, still represent a low return on the $17 million of capital
employed in this business. Textile plant and equipment are on
the books for a very small fraction of what it would cost to
replace such equipment today. And, despite the age of the
equipment, much of it is functionally similar to new equipment
being installed by the industry. But despite this “bargain cost”
of fixed assets, capital turnover is relatively low reflecting
required high investment levels in receivables and inventory
compared to sales. Slow capital turnover, coupled with low
profit margins on sales, inevitably produces inadequate returns
on capital. Obvious approaches to improved profit margins
involve differentiation of product, lowered manufacturing costs
through more efficient equipment or better utilization of people,
redirection toward fabrics enjoying stronger market trends, etc.
Our management is diligent in pursuing such objectives. The
problem, of course, is that our competitors are just as
diligently doing the same thing.
The textile industry illustrates in textbook style how
producers of relatively undifferentiated goods in capital
intensive businesses must earn inadequate returns except under
conditions of tight supply or real shortage. As long as excess
productive capacity exists, prices tend to reflect direct
operating costs rather than capital employed. Such a supply-
excess condition appears likely to prevail most of the time in
the textile industry, and our expectations are for profits of
relatively modest amounts in relation to capital.
We hope we don’t get into too many more businesses with such
tough economic characteristics. But, as we have stated before:
(1) our textile businesses are very important employers in their
communities, (2) management has been straightforward in reporting
on problems and energetic in attacking them, (3) labor has been
cooperative and understanding in facing our common problems, and
(4) the business should average modest cash returns relative to
investment. As long as these conditions prevail - and we expect
that they will - we intend to continue to support our textile
business despite more attractive alternative uses for capital.
Insurance Underwriting
The number one contributor to Berkshire’s overall excellent
results in 1978 was the segment of National Indemnity Company’s
insurance operation run by Phil Liesche. On about $90 million of
earned premiums, an underwriting profit of approximately $11
million was realized, a truly extraordinary achievement even
against the background of excellent industry conditions. Under
Phil’s leadership, with outstanding assistance by Roland Miller
in Underwriting and Bill Lyons in Claims, this segment of
National Indemnity (including National Fire and Marine Insurance
Company, which operates as a running mate) had one of its best
years in a long history of performances which, in aggregate, far
outshine those of the industry. Present successes reflect credit
not only upon present managers, but equally upon the business
talents of Jack Ringwalt, founder of National Indemnity, whose
operating philosophy remains etched upon the company.
Home and Automobile Insurance Company had its best year
since John Seward stepped in and straightened things out in 1975.
Its results are combined in this report with those of Phil
Liesche’s operation under the insurance category entitled
“Specialized Auto and General Liability”.
Worker’s Compensation was a mixed bag in 1978. In its first
year as a subsidiary, Cypress Insurance Company, managed by Milt
Thornton, turned in outstanding results. The worker’s
compensation line can cause large underwriting losses when rapid
inflation interacts with changing social concepts, but Milt has a
cautious and highly professional staff to cope with these
problems. His performance in 1978 has reinforced our very good
feelings about this purchase.
Frank DeNardo came with us in the spring of 1978 to
straighten out National Indemnity’s California Worker’s
Compensation business which, up to that point, had been a
disaster. Frank has the experience and intellect needed to
correct the major problems of the Los Angeles office. Our volume
in this department now is running only about 25% of what it was
eighteen months ago, and early indications are that Frank is
making good progress.
George Young’s reinsurance department continues to produce
very large sums for investment relative to premium volume, and
thus gives us reasonably satisfactory overall results. However,
underwriting results still are not what they should be and can
be. It is very easy to fool yourself regarding underwriting
results in reinsurance (particularly in casualty lines involving
long delays in settlement), and we believe this situation
prevails with many of our competitors. Unfortunately, self-
delusion in company reserving almost always leads to inadequate
industry rate levels. If major factors in the market don’t know
their true costs, the competitive “fall-out” hits all - even
those with adequate cost knowledge. George is quite willing to
reduce volume significantly, if needed, to achieve satisfactory
underwriting, and we have a great deal of confidence in the long
term soundness of this business under his direction.
The homestate operation was disappointing in 1978. Our
unsatisfactory underwriting, even though partially explained by
an unusual incidence of Midwestern storms, is particularly
worrisome against the backdrop of very favorable industry results
in the conventional lines written by our homestate group. We
have confidence in John Ringwalt’s ability to correct this
situation. The bright spot in the group was the performance of
Kansas Fire and Casualty in its first full year of business.
Under Floyd Taylor, this subsidiary got off to a truly remarkable
start. Of course, it takes at least several years to evaluate
underwriting results, but the early signs are encouraging and
Floyd’s operation achieved the best loss ratio among the
homestate companies in 1978.
Although some segments were disappointing, overall our
insurance operation had an excellent year. But of course we
should expect a good year when the industry is flying high, as in
1978. It is a virtual certainty that in 1979 the combined ratio
(see definition on page 31) for the industry will move up at
least a few points, perhaps enough to throw the industry as a
whole into an underwriting loss position. For example, in the
auto lines - by far the most important area for the industry and
for us - CPI figures indicate rates overall were only 3% higher
in January 1979 than a year ago. But the items that make up loss
costs - auto repair and medical care costs - were up over 9%.
How different than yearend 1976 when rates had advanced over 22%
in the preceding twelve months, but costs were up 8%.
Margins will remain steady only if rates rise as fast as
costs. This assuredly will not be the case in 1979, and
conditions probably will worsen in 1980. Our present thinking is
that our underwriting performance relative to the industry will
improve somewhat in 1979, but every other insurance management
probably views its relative prospects with similar optimism -
someone is going to be disappointed. Even if we do improve
relative to others, we may well have a higher combined ratio and
lower underwriting profits in 1979 than we achieved last year.
We continue to look for ways to expand our insurance
operation. But your reaction to this intent should not be
unrestrained joy. Some of our expansion efforts - largely
initiated by your Chairman have been lackluster, others have been
expensive failures. We entered the business in 1967 through
purchase of the segment which Phil Liesche now manages, and it
still remains, by a large margin, the best portion of our
insurance business. It is not easy to buy a good insurance
business, but our experience has been that it is easier to buy
one than create one. However, we will continue to try both
approaches, since the rewards for success in this field can be
exceptional.
Insurance Investments
We confess considerable optimism regarding our insurance
equity investments. Of course, our enthusiasm for stocks is not
unconditional. Under some circumstances, common stock
investments by insurers make very little sense.
We get excited enough to commit a big percentage of
insurance company net worth to equities only when we find (1)
businesses we can understand, (2) with favorable long-term
prospects, (3) operated by honest and competent people, and (4)
priced very attractively. We usually can identify a small number
of potential investments meeting requirements (1), (2) and (3),
but (4) often prevents action. For example, in 1971 our total
common stock position at Berkshire’s insurance subsidiaries
amounted to only $10.7 million at cost, and $11.7 million at
market. There were equities of identifiably excellent companies
available - but very few at interesting prices. (An irresistible
footnote: in 1971, pension fund managers invested a record 122%
of net funds available in equities - at full prices they couldn’t
buy enough of them. In 1974, after the bottom had fallen out,
they committed a then record low of 21% to stocks.)
The past few years have been a different story for us. At
the end of 1975 our insurance subsidiaries held common equities
with a market value exactly equal to cost of $39.3 million. At
the end of 1978 this position had been increased to equities
(including a convertible preferred) with a cost of $129.1 million
and a market value of $216.5 million. During the intervening
three years we also had realized pre-tax gains from common
equities of approximately $24.7 million. Therefore, our overall
unrealized and realized pre-tax gains in equities for the three
year period came to approximately $112 million. During this same
interval the Dow-Jones Industrial Average declined from 852 to
805. It was a marvelous period for the value-oriented equity
buyer.
We continue to find for our insurance portfolios small
portions of really outstanding businesses that are available,
through the auction pricing mechanism of security markets, at
prices dramatically cheaper than the valuations inferior
businesses command on negotiated sales.
This program of acquisition of small fractions of businesses
(common stocks) at bargain prices, for which little enthusiasm
exists, contrasts sharply with general corporate acquisition
activity, for which much enthusiasm exists. It seems quite clear
to us that either corporations are making very significant
mistakes in purchasing entire businesses at prices prevailing in
negotiated transactions and takeover bids, or that we eventually
are going to make considerable sums of money buying small
portions of such businesses at the greatly discounted valuations
prevailing in the stock market. (A second footnote: in 1978
pension managers, a group that logically should maintain the
longest of investment perspectives, put only 9% of net available
funds into equities - breaking the record low figure set in 1974
and tied in 1977.)
We are not concerned with whether the market quickly
revalues upward securities that we believe are selling at bargain
prices. In fact, we prefer just the opposite since, in most
years, we expect to have funds available to be a net buyer of
securities. And consistent attractive purchasing is likely to
prove to be of more eventual benefit to us than any selling
opportunities provided by a short-term run up in stock prices to
levels at which we are unwilling to continue buying.
Our policy is to concentrate holdings. We try to avoid
buying a little of this or that when we are only lukewarm about
the business or its price. When we are convinced as to
attractiveness, we believe in buying worthwhile amounts.
Equity holdings of our insurance companies with a market value of
over $8 million on December 31, 1978 were as follows:
No. of
Shares Company Cost Market
---------- ------- ---------- ----------
(000s omitted)
246,450 American Broadcasting Companies, Inc. ... $ 6,082 $ 8,626
1,294,308 Government Employees Insurance Company
Common Stock ......................... 4,116 9,060
1,986,953 Government Employees Insurance Company
Convertible Preferred ................ 19,417 28,314
592,650 Interpublic Group of Companies, Inc. .... 4,531 19,039
1,066,934 Kaiser Aluminum and Chemical Corporation 18,085 18,671
453,800 Knight-Ridder Newspapers, Inc. .......... 7,534 10,267
953,750 SAFECO Corporation ...................... 23,867 26,467
934,300 The Washington Post Company ............. 10,628 43,445
---------- ----------
Total ................................... $ 94,260 $163,889
All Other Holdings ...................... 39,506 57,040
---------- ----------
Total Equities .......................... $133,766 $220,929
========== ==========
In some cases our indirect interest in earning power is
becoming quite substantial. For example, note our holdings of
953,750 shares of SAFECO Corp. SAFECO probably is the best run
large property and casualty insurance company in the United
States. Their underwriting abilities are simply superb, their
loss reserving is conservative, and their investment policies
make great sense.
SAFECO is a much better insurance operation than our own
(although we believe certain segments of ours are much better
than average), is better than one we could develop and,
similarly, is far better than any in which we might negotiate
purchase of a controlling interest. Yet our purchase of SAFECO
was made at substantially under book value. We paid less than
100 cents on the dollar for the best company in the business,
when far more than 100 cents on the dollar is being paid for
mediocre companies in corporate transactions. And there is no
way to start a new operation - with necessarily uncertain
prospects - at less than 100 cents on the dollar.
Of course, with a minor interest we do not have the right to
direct or even influence management policies of SAFECO. But why
should we wish to do this? The record would indicate that they
do a better job of managing their operations than we could do
ourselves. While there may be less excitement and prestige in
sitting back and letting others do the work, we think that is all
one loses by accepting a passive participation in excellent
management. Because, quite clearly, if one controlled a company
run as well as SAFECO, the proper policy also would be to sit
back and let management do its job.
Earnings attributable to the shares of SAFECO owned by
Berkshire at yearend amounted to $6.1 million during 1978, but
only the dividends received (about 18% of earnings) are reflected
in our operating earnings. We believe the balance, although not
reportable, to be just as real in terms of eventual benefit to us
as the amount distributed. In fact, SAFECO’s retained earnings
(or those of other well-run companies if they have opportunities
to employ additional capital advantageously) may well eventually
have a value to shareholders greater than 100 cents on the
dollar.
We are not at all unhappy when our wholly-owned businesses
retain all of their earnings if they can utilize internally those
funds at attractive rates. Why should we feel differently about
retention of earnings by companies in which we hold small equity
interests, but where the record indicates even better prospects
for profitable employment of capital? (This proposition cuts the
other way, of course, in industries with low capital
requirements, or if management has a record of plowing capital
into projects of low profitability; then earnings should be paid
out or used to repurchase shares - often by far the most
attractive option for capital utilization.)
The aggregate level of such retained earnings attributable
to our equity interests in fine companies is becoming quite
substantial. It does not enter into our reported operating
earnings, but we feel it well may have equal long-term
significance to our shareholders. Our hope is that conditions
continue to prevail in securities markets which allow our
insurance companies to buy large amounts of underlying earning
power for relatively modest outlays. At some point market
conditions undoubtedly will again preclude such bargain buying
but, in the meantime, we will try to make the most of
opportunities.
Banking
Under Gene Abegg and Pete Jeffrey, the Illinois National
Bank and Trust Company in Rockford continues to establish new
records. Last year’s earnings amounted to approximately 2.1% of
average assets, about three times the level averaged by major
banks. In our opinion, this extraordinary level of earnings is
being achieved while maintaining significantly less asset risk
than prevails at most of the larger banks.
We purchased the Illinois National Bank in March 1969. It
was a first-class operation then, just as it had been ever since
Gene Abegg opened the doors in 1931. Since 1968, consumer time
deposits have quadrupled, net income has tripled and trust
department income has more than doubled, while costs have been
closely controlled.
Our experience has been that the manager of an already high-
cost operation frequently is uncommonly resourceful in finding
new ways to add to overhead, while the manager of a tightly-run
operation usually continues to find additional methods to curtail
costs, even when his costs are already well below those of his
competitors. No one has demonstrated this latter ability better
than Gene Abegg.
We are required to divest our bank by December 31, 1980.
The most likely approach is to spin it off to Berkshire
shareholders some time in the second half of 1980.
Retailing
Upon merging with Diversified, we acquired 100% ownership of
Associated Retail Stores, Inc., a chain of about 75 popular
priced women’s apparel stores. Associated was launched in
Chicago on March 7, 1931 with one store, $3200, and two
extraordinary partners, Ben Rosner and Leo Simon. After Mr.
Simon’s death, the business was offered to Diversified for cash
in 1967. Ben was to continue running the business - and run it,
he has.
Associated’s business has not grown, and it consistently has
faced adverse demographic and retailing trends. But Ben’s
combination of merchandising, real estate and cost-containment
skills has produced an outstanding record of profitability, with
returns on capital necessarily employed in the business often in
the 20% after-tax area.
Ben is now 75 and, like Gene Abegg, 81, at Illinois National
and Louie Vincenti, 73, at Wesco, continues daily to bring an
almost passionately proprietary attitude to the business. This
group of top managers must appear to an outsider to be an
overreaction on our part to an OEO bulletin on age
discrimination. While unorthodox, these relationships have been
exceptionally rewarding, both financially and personally. It is
a real pleasure to work with managers who enjoy coming to work
each morning and, once there, instinctively and unerringly think
like owners. We are associated with some of the very best.
Warren E. Buffett, Chairman
March 26, 1979