Warren Buffett, Berkshire Hathaway — 1985
Chairman's Letter - 1985 BERKSHIRE HATHAWAY INC. To the Shareholders of Berkshire Hathaway Inc.: You may remember the wildly upbeat message of last year�s report: nothing much was in the works but our experience had been that something big popped up occasionally. This carefully- crafted corporate strategy paid off in 1985. Later sections of this report discuss (a) our purchase of a major position in Capital Cities/ABC, (b) our acquisition of Scott & Fetzer, (c) our entry into a large, extended term participation in the insurance business of Fireman�s Fund, and (d) our sale of our stock in General Foods. Our gain in net worth during the year was $613.6 million, or 48.2%. It is fitting that the visit of Halley�s Comet coincided with this percentage gain: neither will be seen again in my lifetime. Our gain in per-share book value over the last twenty- one years (that is, since present management took over) has been from $19.46 to $1643.71, or 23.2% compounded annually, another percentage that will not be repeated. Two factors make anything approaching this rate of gain unachievable in the future. One factor probably transitory - is a stock market that offers very little opportunity compared to the markets that prevailed throughout much of the 1964-1984 period. Today we cannot find significantly-undervalued equities to purchase for our insurance company portfolios. The current situation is 180 degrees removed from that existing about a decade ago, when the only question was which bargain to choose. This change in the market also has negative implications for our present portfolio. In our 1974 annual report I could say: �We consider several of our major holdings to have great potential for significantly increased values in future years.� I can�t say that now. It�s true that our insurance companies currently hold major positions in companies with exceptional underlying economics and outstanding managements, just as they did in 1974. But current market prices generously appraise these attributes, whereas they were ignored in 1974. Today�s valuations mean that our insurance companies have no chance for future portfolio gains on the scale of those achieved in the past. The second negative factor, far more telling, is our size. Our equity capital is more than twenty times what it was only ten years ago. And an iron law of business is that growth eventually dampens exceptional economics. just look at the records of high- return companies once they have amassed even $1 billion of equity capital. None that I know of has managed subsequently, over a ten-year period, to keep on earning 20% or more on equity while reinvesting all or substantially all of its earnings. Instead, to sustain their high returns, such companies have needed to shed a lot of capital by way of either dividends or repurchases of stock. Their shareholders would have been far better off if all earnings could have been reinvested at the fat returns earned by these exceptional businesses. But the companies simply couldn�t turn up enough high-return opportunities to make that possible. Their problem is our problem. Last year I told you that we needed profits of $3.9 billion over the ten years then coming up to earn 15% annually. The comparable figure for the ten years now ahead is $5.7 billion, a 48% increase that corresponds - as it must mathematically - to the growth in our capital base during 1985. (Here�s a little perspective: leaving aside oil companies, only about 15 U.S. businesses have managed to earn over $5.7 billion during the past ten years.) Charlie Munger, my partner in managing Berkshire, and I are reasonably optimistic about Berkshire�s ability to earn returns superior to those earned by corporate America generally, and you will benefit from the company�s retention of all earnings as long as those returns are forthcoming. We have several things going for us: (1) we don�t have to worry about quarterly or annual figures but, instead, can focus on whatever actions will maximize long-term value; (2) we can expand the business into any areas that make sense - our scope is not circumscribed by history, structure, or concept; and (3) we love our work. All of these help. Even so, we will also need a full measure of good fortune to average our hoped-for 15% - far more good fortune than was required for our past 23.2%. We need to mention one further item in the investment equation that could affect recent purchasers of our stock. Historically, Berkshire shares have sold modestly below intrinsic business value. With the price there, purchasers could be certain (as long as they did not experience a widening of this discount) that their personal investment experience would at least equal the financial experience of the business. But recently the discount has disappeared, and occasionally a modest premium has prevailed. The elimination of the discount means that Berkshire�s market value increased even faster than business value (which, itself, grew at a pleasing pace). That was good news for any owner holding while that move took place, but it is bad news for the new or prospective owner. If the financial experience of new owners of Berkshire is merely to match the future financial experience of the company, any premium of market value over intrinsic business value that they pay must be maintained. Management cannot determine market prices, although it can, by its disclosures and policies, encourage rational behavior by market participants. My own preference, as perhaps you�d guess, is for a market price that consistently approximates business value. Given that relationship, all owners prosper precisely as the business prospers during their period of ownership. Wild swings in market prices far above and below business value do not change the final gains for owners in aggregate; in the end, investor gains must equal business gains. But long periods of substantial undervaluation and/or overvaluation will cause the gains of the business to be inequitably distributed among various owners, with the investment result of any given owner largely depending upon how lucky, shrewd, or foolish he happens to be. Over the long term there has been a more consistent relationship between Berkshire�s market value and business value than has existed for any other publicly-traded equity with which I am familiar. This is a tribute to you. Because you have been rational, interested, and investment-oriented, the market price for Berkshire stock has almost always been sensible. This unusual result has been achieved by a shareholder group with unusual demographics: virtually all of our shareholders are individuals, not institutions. No other public company our size can claim the same. You might think that institutions, with their large staffs of highly-paid and experienced investment professionals, would be a force for stability and reason in financial markets. They are not: stocks heavily owned and constantly monitored by institutions have often been among the most inappropriately valued. Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. �You�re qualified for residence�, said St. Peter, �but, as you can see, the compound reserved for oil men is packed. There�s no way to squeeze you in.� After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, �Oil discovered in hell.� Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. �No,� he said, �I think I�ll go along with the rest of the boys. There might be some truth to that rumor after all.� Sources of Reported Earnings The table on the next page shows the major sources of Berkshire�s reported earnings. These numbers, along with far more detailed sub-segment numbers, are the ones that Charlie and I focus upon. We do not find consolidated figures an aid in either managing or evaluating Berkshire and, in fact, never prepare them for internal use. Segment information is equally essential for investors wanting to know what is going on in a multi-line business. Corporate managers always have insisted upon such information before making acquisition decisions but, until a few years ago, seldom made it available to investors faced with acquisition and disposition decisions of their own. Instead, when owners wishing to understand the economic realities of their business asked for data, managers usually gave them a we-can�t-tell-you-what-is- going-on-because-it-would-hurt-the-company answer. Ultimately the SEC ordered disclosure of segment data and management began supplying real answers. The change in their behavior recalls an insight of Al Capone: �You can get much further with a kind word and a gun than you can with a kind word alone.� 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 the 1977-1984 letters is available upon request.) In the Business Segment Data and Management�s Discussion sections on pages 39-41 and 49-55, much additional information regarding our businesses is provided, including Goodwill and Goodwill Amortization figures for each of the segments. I urge you to read those sections as well as Charlie Munger�s letter to Wesco shareholders, which starts on page 56.
Berkshire's Share of Net Earnings (after taxes and Pre-Tax Earnings minority interests)
1985 1984 1985 1984
Operating Earnings: Insurance Group: Underwriting ................ $(44,230) $(48,060) $(23,569) $(25,955) Net Investment Income ....... 95,217 68,903 79,716 62,059 Associated Retail Stores ...... 270 (1,072) 134 (579) Blue Chip Stamps .............. 5,763 (1,843) 2,813 (899) Buffalo News .................. 29,921 27,328 14,580 13,317 Mutual Savings and Loan ....... 2,622 1,456 4,016 3,151 Nebraska Furniture Mart ....... 12,686 14,511 5,181 5,917 Precision Steel ............... 3,896 4,092 1,477 1,696 See�s Candies ................. 28,989 26,644 14,558 13,380 Textiles ...................... (2,395) 418 (1,324) 226 Wesco Financial ............... 9,500 9,777 4,191 4,828 Amortization of Goodwill ...... (1,475) (1,434) (1,475) (1,434) Interest on Debt .............. (14,415) (14,734) (7,288) (7,452) Shareholder-Designated Contributions .............. (4,006) (3,179) (2,164) (1,716) Other ......................... 3,106 4,932 2,102 3,475
Operating Earnings .............. 125,449 87,739 92,948 70,014 Special General Foods Distribution 4,127 8,111 3,779 7,294 Special Washington Post Distribution ................. 14,877 --- 13,851 --- Sales of Securities ............. 468,903 104,699 325,237 71,587
Total Earnings - all entities ... $613,356 $200,549 $435,815 $148,895 ======== ======== ======== ======== Our 1985 results include unusually large earnings from the sale of securities. This fact, in itself, does not mean that we had a particularly good year (though, of course, we did). Security profits in a given year bear similarities to a college graduation ceremony in which the knowledge gained over four years is recognized on a day when nothing further is learned. We may hold a stock for a decade or more, and during that period it may grow quite consistently in both business and market value. In the year in which we finally sell it there may be no increase in value, or there may even be a decrease. But all growth in value since purchase will be reflected in the accounting earnings of the year of sale. (If the stock owned is in our insurance subsidiaries, however, any gain or loss in market value will be reflected in net worth annually.) Thus, reported capital gains or losses in any given year are meaningless as a measure of how well we have done in the current year. A large portion of the realized gain in 1985 ($338 million pre-tax out of a total of $488 million) came about through the sale of our General Foods shares. We held most of these shares since 1980, when we had purchased them at a price far below what we felt was their per/share business value. Year by year, the managerial efforts of Jim Ferguson and Phil Smith substantially increased General Foods� business value and, last fall, Philip Morris made an offer for the company that reflected the increase. We thus benefited from four factors: a bargain purchase price, a business with fine underlying economics, an able management concentrating on the interests of shareholders, and a buyer willing to pay full business value. While that last factor is the only one that produces reported earnings, we consider identification of the first three to be the key to building value for Berkshire shareholders. In selecting common stocks, we devote our attention to attractive purchases, not to the possibility of attractive sales. We have again reported substantial income from special distributions, this year from Washington Post and General Foods. (The General Foods transactions obviously took place well before the Philip Morris offer.) Distributions of this kind occur when we sell a portion of our shares in a company back to it simultaneously with its purchase of shares from other shareholders. The number of shares we sell is contractually set so as to leave our percentage ownership in the company precisely the same after the sale as before. Such a transaction is quite properly regarded by the IRS as substantially equivalent to a dividend since we, as a shareholder, receive cash while maintaining an unchanged ownership interest. This tax treatment benefits us because corporate taxpayers, unlike individual taxpayers, incur much lower taxes on dividend income than on income from long-term capital gains. (This difference will be widened further if the House-passed tax bill becomes law: under its provisions, capital gains realized by corporations will be taxed at the same rate as ordinary income.) However, accounting rules are unclear as to pro