Warren Buffett Letters

Key Points and Extracts from Warren Buffett’s Letters 1957 – 1984

Warren Buffett’s 55 (and counting) annual letters collectively constitute arguably “The Best Investment Book [N]ever Written”

Warren Buffett started his Investment Partnerships in Omaha on May 5, 1956. Buffett was age 25 and freshly back from a stint of several years working with Benjamin Graham in New York, after having earlier studied under Graham at Columbia University in New York, completing a Masters in Economics.

The initial partnership was for $105,100, (from four family members and three close friends) with Buffett himself contributing just $100. Two additional and separate partnerships were formed by year end.

The following uses extensive quotes from Warren Buffett’s annual letters issued to his partners and later to shareholders of Berkshire Hathaway. 


There was a year end letter for 1956 year but we don’t have a copy of it. But parts of it were quoted in the 1957 letter. Buffett said ” My view of the general market level is that it is priced above intrinsic value”. In 1956 Buffett therefore favored investments in “workouts”  (defined below, see 1957 and 1961) as opposed to undervalued “generals” (also defined below). If the market were to fall substantially he said he might employ the capital exclusively in general issues, perhaps even adding some borrowed money. If the market were to instead move higher he would reduce the general issues and increase the investments in workouts.


The investments were concentrated 85% in undervalued securities and only 15% in “work-outs” (defined below). This was driven by a decline in the general market by the end of 1957, that provided more undervalued securities. There was no mention of the specific companies owned in the 1957 letter.

One investment accounted for 10 to 20% of the assets and was expected to take 3 to 5 years of work.

Buffett indicated he would be quite satisfied to beat the Dow by 10% on average over the years. Buffett expected to beat the Dow in poor market years, but was satisfied to just keep pace in bull market years.

“A work-out is an investment which is dependent on a specific corporate action for its profit rather than a general advance in the price of the stock as in the case of undervalued securities. Work-outs come about through sales, mergers, liquidations, (takeover) tenders, etc. In each case, the risk is that something will upset the applecart and cause the abandonment of the planned action, not that the economic picture will deteriorate and stocks decline generally.”

“Obviously, during any acquisition period (when accumulating stock in a company), our primary interest is to have the stock do nothing or decline rather than advance.”


Buffett quoted a friend who had written him that “The mercurial temperament, characteristic of the American people, produced a major transformation in 1958 and “exuberant” would be the proper word for the stock market. at least”.

Buffett said “I make no attempt to forecast the general market – my efforts are devoted to finding undervalued securities. However, I do believe that widespread public belief in the inevitability of profits from investment in stocks will lead to eventual trouble. Should this occur, price, but not intrinsic values in my opinion, of even undervalued securities can be expected to be substantially affected”.

Regarding CommonWealth Trust Co., Buffett  had invested, over a period of a year or so,  a large portion of the partnership’s money at 5 times earnings ($51). Buffett estimated its intrinsic value at, conservatively, $125. It paid no dividend. Buffett said there was evidence that this value would eventually be realized but it might take one year or ten years. Buffett believed that risk of any ultimate loss in this investment was minimal.

A larger bank owned 25.5% of CommonWealth and wanted to merge but it was prevented. It was expected this merger would eventually happen and be a catalyst for a higher share price. Meanwhile the investment had a margin of safety. With only 300 shareholders CommonWealth Trust Co. was extremely illiquid. Buffett acquired 12%.  Buffett later sold the shares, to free up funds for a more attractive investment, in a block at $80 while the quoted price was 20% lower.

Buffett put 25% of the partnerships’ assets into an unnamed company (later identified as Sanborn Map ) becoming the largest shareholder and hoping to effect a workout.

Buffett said: “The higher the level of the market, the fewer the undervalued securities and I am finding some difficulty in securing an adequate number of attractive investments” (including work-outs).

“To the extent possible, I am attempting to create my own work-outs by acquiring large positions in several undervalued securities.


35% of assets now in the unnamed company (later identified as Sanborn Map) mentioned in 1958.

The remaining 65% of investments are in undervalued securities and in other workout situations.


The “workout” of Sanborn Map Company was completed. Sanborn Map had been engaged in the publication and continuous revision of extremely detailed maps of all cities in the United States. The information was primarily of use to fire insurance companies. The bulk of its business was done with about 30 insurance companies although public utilities, mortgage companies and the cities themselves were sometimes customers.

Sanborn had been able for 75 years to to operate in a monopolistic manner, recession proof, no effort at sales needed. Sanborn’s insurance company customers joined Sanborn’s Board of directors to keep its profits down! Competition emerged in the early 1950’s and profits fell dramatically. The map business could have been more profitable but had been allowed to wither.

The company had a large investment portfolio and the Sanborn shares had traded at 70% of the value of its investment portfolio with the map business thrown in for nothing. Under Buffett’s influence shareholders were allowed to receive the portfolio shares in exchange for their Sanborn stock (Sounds like Buffett took the investment shares? We are not sure. He said he did not care for these blue chip shares). Sanborn is still in operation today but it does not appear that Buffett owned it after 1960.

Refer to the full 1960 letter at the link above for a detailed description of the “workout” of Sanborn Map.


Buffett’s partnership portfolio was in three categories (in order of size from largest to smallest portion of the fund):

  1. Generals (undervalued and unglamorous) often only 5 or 6 main companies with say 5% to 10% of  the fund’s assets in each. Another 10-15 companies with smaller positions. These provide a margin of safety through cheap prices and diversification. May rise strongly in a strong market. Tend to move with the market but out-perform long-term. Willing to sell at less than their full value to a private buyer, not looking for the last nickel of value.
  2. Work-outs, these are take over candidates, includes announced acquisitions.  It appears these had roughly predictable take-out dates 10 to 15 positions. Buffett was  willing to borrow to fund these (maximum leverage of the fund is 25% – a Buffett self-imposed limit).
  3. Control situations

Acquired 70% of and control of Dempster Mills Manufacturing (farm implements and water systems) having started acquiring as a general under-valued security five years ago and gone on the Board 1957. Nominal profits due to poor management. Such a company is insulated from movements in the stock price. Buffett sees more danger than opportunity in the general market.

“You are right, over many transitions, if your hypothesis, facts and reasoning are correct.”

Realized gains to realized losses in Buffett’s funds over the years has been something like 100 to 1.

Says Conservative Investing means doing well in down markets.

Says bigger size at this stage was probably a net advantage, bigger size helped in control situations but hurt in certain small companies.

Says he can’t predict pattern of high and low market return years and anyway the sequence is not important.

Says the Dow total return over the future years will probably be 5 to 7%. (not as good as recent years had been). (Interestingly, he would essentially repeat the 5 to 7% figure some 39 years later in a famous Fortune magazine article written at the tail end of the 1990’s stock boom).

Says his job is to pile up yearly advantages over the Dow not important that his return be positive, just better than the Dow.

$1,025,000 is the amount he and wife Suzie have invested. Other relatives have $782,600. Buffett inserted a new rule that requires him to own no other marketable securities.

Moved into Kiewit plaza. There are 90 partners and 40 securities.

Employees are secretary Beth Henley and Bill Scott who was to help in security analysis.


Buffett describes his investment fund portfolio as conservative and would like it to decline at (only) half the Dow decline in the bad years (also wants to beat or keep pace with the Dow in good years).

Described a 7.5% loss year as one of his best periods because the Dow was down 21.7% even after adding back dividends.

Raised the minimum investment to $100,000 for 1963. Lawyers only allowing him to admit 9 new partners

Introduced Ground Rules. The most interesting and relevant of these were:

Performance is not to be measured on an absolute basis of whether he was positive or negative for the year. It is to be measured relative to the DOW. Would prefer a 5-year measurement period but considers three years the absolute minimum period over which to judge performance.

He is not in the business of predicting where the stock market or the economy will go.

Investments are chosen on the basis of value, not popularity.

Will limit risk of permanent (as opposed to short-term market fluctuations) loss of capital by obtaining a wide margin of safety in each security and by maintaining a diversity of securities.

He (and his wife and children) will have virtually their entire net worth invested in the partnership.

Says that his unscientific opinion is that beating the Dow by 10% is the very maximum that can be achieved with invested funds over any longer period of years. (Apparently he was trying to tone down expectations as the Buffett funds had beaten by over 17% over the six years of the funds and the limited partners after Buffett’s fees had earned 12.8% more than the Dow.)

Buffett reiterated the three types of his investments:

  1. Generals (undervalued and unglamorous) often 5 or 6 main companies only, with say 5% to 10% of funds’ assets in each. Another 10-15 companies with smaller positions. These provide a margin of safety through cheap prices and diversification. A lack of glamour or immediate prospects for a price rise result in a lot of value being available for the price paid. Individual margins of safety combined with diversity creates a most attractive package of safety and appreciation potential.  Willing to sell at less than their full value to a private buyer, not looking for the last nickel of value. Sometimes they are riding the coattails of a controlling investor who Buffett thinks will convert under-utilized assets to a better use. These stocks move up and down with the market but will outperform long term.
  2. Work-outs, take over candidates, includes announced acquisitions re-orgs, spin-offs, appears these had roughly predictable take-out dates 10 to 15 positions. Willing to borrow to fund these (maximum leverage of the fund is 25%, a Buffett self-imposed limit). Results tend to be independent of the Dow. Had a good portion of funds in work-outs in 1962.
  3. Control situations. Where Buffett can take control or influence the company. These take several years to work out. Results are relatively independent of the Dow.

Continued to control Dempster Mills Manufacturing (farm implements and water systems). For a decade it had been characterized by flat sales, low inventory turnover and almost no profits on invested capital. Bought most of the shares at about $30. Book value per share was about $76 but Buffett valued it conservatively at $35 for purposes of valuing the funds.

Brought in Mr. Harry Bottle to run it. By year end Buffett valued it at $51 for the partnership, while book value was actually slightly reduced by writing down inventory. Mr. Bottle freed up cash by selling inventory and some assets and collecting accounts receivable and Buffett had the company invest in (guess what?) marketable securities. In early 1963 it borrowed money to invest in even more stocks.

Buffett noted that in Bottle he now has a relationship with an “operating man” who is mobile and could be of great value in future control situations. (see 1987 and 1989). Buffett noted that Bottle likes to get paid well for doing well.

Buffett sold two “non-marketable securities” that he owned personally and would retain the one remaining one indefinitely. (This meant that essentially all of Buffett’s investments were in the partnerships, so that his interest and that of his partners were extremely well aligned).

Buffett has $1,377,400 invested in the partnerships and relatives of his have a total $893,600 invested. Employee Bill Scott has $167,400 invested.


Buffett noted that he makes no attempt to time the market by being 100% in generals during times the DOW is going up and 100% in work-outs when the DOW is falling. Buffett considers attempting to gauge stock market fluctuations to be a very poor business. 

Again this year he showed figures that indicated that highly paid and respected investments advisors have difficulty in matching the performance of the unmanaged DOW index of blue chip stocks. These fund managers provide the useful service of convenience and diversification but not of beating the market.

Buffett’s “partnership’s fundamental reason for existence is to compound funds at a better-than-average rate with less exposure to long-term loss of capital than” (popular fund managers). Can’t promise to do it but if not achieved over a reasonable period (outside of a market boom) he will shut down.

Harry Bottle continued his work at Dempster Mills Manufacturing (farm implements and water systems) reducing inventory to generate cash and also making the company more profitable. Inventories had been reduced dramatically by Bottle. Initially about two-thirds of Dempster’s assets were in inventory, now they were under 20%.

Buffett discussed how he trusted the value of Dempster’s investment portfolio a lot more than any prayerful reliance that someone would pay him 35 times next year’s earnings.

Note that Dempster, now named Dempster Industries was still in business as of 2010.

“Investment decisions should be made on the basis of the most probable compounding of after-tax net worth with minimum risk.” Does not consider holding the DOW to be the optimum after-tax compounder of wealth.

Buffett notes his strong results in the first seven years of the partnerships (beating the Dow by a compound 17.7%!) and warns the partners to expect some yeas where they barely beat the DOW and some where they under-perform the Dow and perhaps substantially so.

Observes that the big investment funds tend to move with the DOW and slightly under-perform it but believes that this is necessarily the case. For these funds to behave unconventionally would be difficult.

Noted that Francis I of France had purchased the Mona Lisa in 1540 for the equivalent of $20,000. Buffett noted that if $20,000 had been compounded since then at even 6.0% it would today amount to one billion trillion dollars (which InvestorsFriend suspects is more than all the wealth in the world today, let alone 1963). InvestorsFriend thinks Buffett’s point here is that even compounding wealth at 6.0% may be a very daunting task. His other point was apparently that art was historically a bad investment.

Buffett also demonstrated how a few extra percentage points in compounded return creates a HUGE difference in wealth over twenty and thirty years.

Buffett described again the three categories of his investments. We note here some interesting new nuggets not mentioned under 1962 above.

Generals – main qualification is a bargain price substantially below a carefully calculated value to a private owner. There are also qualitative factors. “We like good management – we like a decent industry – we like a certain amount of “ferment” in a previously dormant management or stockholder group. But we demand value”.

Workouts – These are securities with a timetable. They arise from sell-outs, mergers, re-organizations, spin-offs etc. Not rumors or insider information about such events but publicly announced plans. The risk is that the announced event does not happen due to anti-trust, votes against it, unfavorable tax rulings or other factors. These give small returns but in a short time period.

Controls – Some generals turn into control situations as stock is bought cheaply as the market price stays low. Will only become active in the management when it is warranted. In control situations there should be a built in profit. Value will determined by the value of the business not by the often times irrational stock market. Because results can take years,  “in controls we look for wide margins of profit– if it looks at all close, we pass.” Expects the trend as his asset grow to be toward controls.

Buffett’s investment is now worth $2,392,900. His relatives had $1,247,900. Employee Bill Scott had $237,400.  Buffett had to withdraw some money – above his salary – for the first time – to pay income taxes.

InvestorsFriend speculates that this in part may explain why he later went to a corporate structure, where he would not pay personal income tax as long as Berkshire did not pay dividends. Another explanation for preferring a corporate structure rather than a partnership is that with the partnership, Buffett had to keep a certain amount of money in cash in case partners withdrew their money, which was allowed each year-end. With a corporation, an investor can sell his shares but that would not affect Buffett.

Buffett described one of his workouts in some detail in an Appendix:

A small oil producer, Texas National Petroleum was sold out to Union Oil. Buffett heard about it at the rumor stage but did not invest until it became public knowledge.

His analysis revealed that the controlling shareholders wanted to sell and so there was no chance the shareholders would vote against it. No anti trust concerns. The prospectus indicated the approximate amount that would be received for each share and for some debt that was trading. Buffett bought shares, debt and warrants on the shares. A tax ruling was needed and was thought to be forthcoming but could cause a delay. There was in fact some delay and Buffett owned the investments for six months and made about 10.5% or 21% annualized.

Regarding Dempster Mills Manufacturing (farm implements and water systems):

In InvestorsFriend’s 1962 summary just above we summarized that: Harry Bottle continued his work at Dempster Mills Manufacturing (farm implements and water systems) reducing inventory to generate cash and also making the company more profitable. Inventories had been reduced dramatically by Bottle.

In the 1963 letter Buffett summarized Bottle’s achievements which included cutting administrative and selling expenses in half. Closing five of eight branches and replacing them with more productive distributors. Eliminated some zero profit product lines. Increased the prices for repair parts. The company assets and the name were sold for book value of $80 per share leaving behind the investment portfolio.

Buffett said that the Dempster saga illustrated that it can take years for things to come to fruition (he started buying in 1956 and sold in 1963). Buffett said “it is to our advantage that stocks do nothing price-wise for months or perhaps years while we are buying them”. Buffett also said it illustrates that he has to keep these things secret while accumulating stock.


In the July letter Buffett said that in the General category there were 3 companies where the partnership was the largest shareholder. He indicated that he continued to buy these shares at a price significantly below the value to a private owner, had been buying quietly for up to 18 months, and might continue buying for another 18 months.

Buffett indicated that the realization of gains by the partnership was not a measure of performance. He judged performance by market value gains not by when gains were realized. He would play no games in realizing gains just to make things look good on a taxable profits basis. He would make decisions based on what was most profitable. If that involved paying taxes, then fine.

Buffett indicated that most analysts would describe his investments as more risky than the DOW but he would disagree. He argued that his investments might not be conventional but they were conservative.

He said “Truly conservative actions arise from intelligent hypothesis, correct facts and sound reasoning”. ” A public opinion is no substitute for thought”. 

“Over a span of 20 or 30 years, I would expect something more like 6 to 7% annual gain from the DOW instead of the 11.1% during our brief history” (1957-1964). “If a 20% to 30% drop in the market value of your equity holdings is going to produce emotional or financial distress, you should simply avoid common stock type investments.”

Buffett had  Four Categories of Investment:

  1. Generals –  Private Owner Basis – See description of generals from 1962 and 1963 above. Hope to benefit by a substantial appreciation in market price or (less often) by taking a control position.
  2. Generals – Relatively Undervalued – Here the company is undervalued, but due to the large size of the firm, value to a private owner is not a meaningful concept. In this category Buffett looks at many companies and passes on most, often because he does not know enough about the company or industry to conclude it is substantially undervalued. An example here is to buy companies at 12 times earnings when similar companies are selling at 20 times earnings. (It was not described in detail but it sounded like he started shorting the group at 20 to lower risk and focus on the P/E differential).
  3. Workouts (see 1962 above)
  4. Controls (see 1962 above)

Due to Buffett’s need to “own the most attractive securities available at current prices” there was a need to change positions and this did result in tax payable. He is trying to maximize after-tax return, not minimize tax. The amount of tax payable on selling will usually be minor compared to the difference in performance expected by switching to a different security.

The fact that a stock has performed great or poorly last year has no bearing on whether it should  continue to be held.


In his July letter, Buffett noted that the partnership had gained a control position in one its investments. Later it was revealed this was Berkshire Hathaway. He said “When a controlling interest is held, we own a business rather than a stock, and a business valuation is appropriate.” He “carried” this business on his books at a conservatively calculated value and not simply at the value indicated by its share price.

Discussing a report that mutual funds could not do better than random results he said “the beauty of the American economic scene has been that random results have been pretty darn good results”.

This year with assets at $43 million, Buffett closed the funds to new partners. He felt that increased size was more likely than not at this point to hurt investors (although he said bigger size would be to his own personal advantage).

Buffett described how one of the companies the partnership held shares in was sold at a good profit when a private buyer took the company private through a tender offer. “A private owner was quite willing (and in our opinion quite wise) to pay a price for control of the business which isolated stock buyers were unwilling to pay for very small fractions of the business.”

Buffett described how the partnership had been accumulating shares in Berkshire Hathaway since 1962 on the basis that it was trading significantly below the value to a private owner. The first buys were at a price of $7.60 and the average cost was $14.86 reflecting heavy purchases in 1965 as Buffett took control of the company in the Spring of 1965. At the end of 1965 it had a net working capital (without placing any value on plant and equipment) of about $19 per share. The discounted price reflected large losses incurred in closing mills.

The 1979 letter reveals that: “The book value per share of Berkshire Hathaway on September 30, 1964 (the fiscal year-end prior to the time that your present management assumed responsibility) was $19.46 per share.”

Buffett noted that in 1948 Berkshire had had 11 mills and 11,000 workers but by the time Buffett took control it had only 2 mills and 2,300 employees.

Some existing employees were found to be excellent management personnel. Ken Chace, he said, was now running the business in a first-class manner and it also had several of the best sales people in the business.

Buffett mentioned that while the category of “Generals-Relatively Undervalued” was growing and profitable, he felt this category was not as solid as the others (Work-outs, controls and generals – private owner basis).

Buffett said he did not have a great flood of ideas going into 1966.

He described five reasons why the overwhelming majority of fund managers can’t beat the index. 1. Group Decisions would not be outstanding, 2. conforming to how other fund managers do things, 3. an institutional framework where average is safe and independent action is risky, 4. certain irrational diversification policies, and 5. inertia.

He described a new ground rule whereby the fund diversifies much less than other fund managers and might invest up to 40% of the money in a single security if there was both a high probability that our facts and reasoning are correct and a very low probability that anything could drastically change the underlying value of the investment.

Ideally he would put 2% each into 50 un-correlated investments that all had an expectation of beating the Dow by 15%. Then he could have a high certainty of getting near that 15% advantage. But, “it doesn’t work that way”. He works extremely hard to find just a very few attractive investment situations. Where the expectation by definition is at least 10% higher per year than the Dow. “Our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations.” It is imprecise and emotionally influenced.

A portfolio that expects to beat the market and yet contains 100 securities is not being operated logically. This is the Noah school of investing – two of everything.

“The optimum portfolio depends on the various expectations of choices available and the degree of variance in performance which is tolerable”. More securities leads to less variation but lower returns (as you invest less in the securities with the highest expected returns). Buffett was willing to accept quite a bit of variability for higher returns. Therefore he concentrated in the best investments and accepted that there would occasionally be a very sour year.

Buffett noted that the range of his results versus the Dow (beating the Dow by 2.4% to 33.0%) was greater than for most most funds versus Dow. But the results were worth it. He had gone above a 25% allocation to a security only five or six times in nine years. Anytime he does it he thinks that the security will beat the Dow by a wide margin. And the chance of serious permanent loss (as opposed to temporary market value loss) must be minimal.

Results for 1965 were overwhelmingly the results from five investment situations.

Textbooks counsel adequate diversification but don’t usually say how they arrive at their conclusion.

Buffett noted that he had set up his operations such that he could devote a higher percentage of his time to thinking about the investment process than virtually anyone else in the money management business.

Buffett and his wife at the end of 1965 had $6,849,936. His employees had $600,000 combined. His relatives had a total of $2,708,233.


Buffett (the investment partnerships) purchased private Baltimore department store Hochschild, Kohn & Co. Owned 80% as there were two 10% partners. This was the first time (of what would prove to be many via Berkshire) that the partnership had purchased an entire business by negotiation from private owners. Buffett described management as topnotch people from both a personal and business standpoint ( a sentiment that Buffett would repeat in many or all future such purchases). Apparently the business had several thousand employees.

In a 1967 letter it was indicated that Hochschild, Kohn & Co. was owned indirectly through Diversified Retailing Company. In the November 1968 letter it was noted that Diversified had been purchased for $4.8 million.

Buffett mentioned that he prefers an iceberg approach to investment disclosure. Does not want to show people what his ideas are.

Buffett said ” all of our investments usually appear undervalued to me – otherwise we wouldn’t own them”.

“We don’t buy and sell stocks based upon what other people think the stock market is going to do (I never have an opinion) but rather upon what we think the company is going to do” Market can determine when we will be right but not whether we are right. We tend to concentrate on what should happen, not when it should happen.”

Buffett noted that the future has never been clear to him. Basically he is not about to let anyone’s prediction of the stock market direction influence what he buys and sells. Silly market prices in either direction are to be taken advantage of but not used to formulate judgments of the value of businesses.

Despite his best year ever in 1966, Buffett was finding substantially fewer investment opportunities that were understandable to him and that could be expected to beat the Dow by 10%. He attributed this to a changed market environment, large size of the fund and substantially more competition.

“We will not go into businesses where technology which is away over my head is crucial to the investment decision” (Buffett would famously continue to shun high tech investments throughout his career).

He indicated he would not pick stocks based on an attempt to anticipate market action (fashion or momentum investing). He indicated it was a technique whose soundness he could neither affirm nor deny. But it would not satisfy his intellect or his temperament.

He would avoid investments, even very promising ones, where there was a substantial chance that major human problems could develop.

Buffett described a business that he was buying at share prices far below its value to a private owner. “The various businesses that the company operated were understandable and we could check out competitive strengths and weaknesses thoroughly with competitors, distributors, customers, suppliers, ex-employees etc.” (This shows that Buffett was not doing analysis strictly from financial statements and annual reports). Buffett noted that this stock had risen in 1965 for a gain, but he wished it had stayed low as he wanted to buy many more shares. These shares were ultimately sold and another party made a tender offer to buy out the company, but Buffett wished he had been able to keep buying at low prices – he felt that the tender offer turned a potential mountain for him into a molehill.

Describing an investment which had already made money and in which Buffett was prepared to invest up to 40% of the partnership’s money, Buffett said “We spend considerable effort evaluating every facet of the company and constantly testing our hypothesis that this security is superior to alternative investment choices. Such constant evaluation and comparison at shifting prices is absolutely essential to our investment operation.” This was not a controlled company but rather a stock market investment. The 1994 letter appears to confirm that this was American Express.

Buffett indicated that the strong results in 1966 were essentially due to a small number of home runs, and that many of his investments had not done nearly as well as his overall return for 1966.

“I am willing to trade the pains of substantial short term variance in exchange for maximization of long term performance. However, I am not willing to incur risk of substantial permanent capital loss in seeking to better long term performance.”

Buffett together with his employees had $10 million in the fund at the end of 1966 but he did not give his own precise share of that. His investment was well over 90% of his (and his wife’s) net worth.


Buffett indicated that Berkshire Hathaway faces real difficulties in the portion of its assets employed in the textile business and he saw no prospect of a good return on these textile assets.

In October 1967 Buffett wrote to inform his partners of a major change which involved Buffett substantially lowering the goals of the Partnership in regards to its future returns.

Buffet listed and explained four reasons for the change which InvestorsFriend summarizes / paraphrases as follows:

  1. The number of obvious quantitatively based investment bargains had sharply reduced over the past decade (his Partnership had now operated for 11 years). “Interestingly enough, although I consider myself to be primarily in the quantitative school…the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a high-probability insight” but these are infrequent. “no insight is required on the quantitative side – the figures should hit you over the head with a baseball bat”. “The really big money tends to be made… on qualitative decisions but… the more sure money tends to be made on the obvious quantitative decisions.”  “Such statistical bargains have tended to disappear over the years”.
  2. “Mushrooming interest in investment performance… has created a hyper-reactive pattern of market behavior against which my analytical techniques have limited value”. “I make no attempt to guess the action of the stock market and haven’t the foggiest notion of whether the Dow will (be down 33%, flat, or up 33%) a year from now. With all the focus on short-term results and momentum trading Buffett said “Essentially I am out of step with present conditions”. But, “I will not abandon a previous approach whose logic I understand (although I find it difficult to apply) even though it may mean foregoing large, and apparently easy, profits to embrace an approach which I don’t fully understand, have not practiced successfully and which, possibly, could lead to substantial permanent loss of capital.
  3. A higher invested amount has presented problems given his diminishing trickle of investment ideas, “increased funds are presently a moderately negative factor”.
  4. “My own personal interests dictate a less compulsive approach to superior investment results than when I was younger and leaner.” Buffett explained that a goal of “ten points better than the Dow” set when he was younger, poorer, and probably more competitive was now too high a speed for his treadmill. He now wanted to slow down from the former all-out effort. “it may mean pursuing lines within the investment field that do not promise the greatest economic reward. An example… might be the continued investment in a satisfactory (but far from spectacular) controlled business where I liked the people and the nature of the business even though alternative investments offered an expectable higher rate of return”. “Thus I am likely to limit myself to things which are reasonably easy, safe, profitable and pleasant”… the upside potential will be less.

“Specifically, our longer term goal will be to achieve the lesser of 9% per annum or a five percentage point advantage over the Dow.” “(and it is only a goal not a promise)”.

“I wanted to pick a time when past goals had been achieved to set a forth reduction in future goals. I would not want to reduce the speed of the treadmill unless I had fulfilled my objectives to this point”.

“Partners with attractive alternative investment opportunities may logically decide that their funds would can be better employed elsewhere, and you can be sure I will be wholly in sympathy with such decision.”

At year end Buffett had a large amount invested in controlled companies that don’t move with the market and a large amount in cash. “This does not reflect any market judgment on my part; it simply means I can’t find any obviously profitable and safe (from a long-term value standpoint, not a short-term quotation one)” investments.

Diversified Retailing and Berkshire Hathaway were two companies that Buffett controlled at that time.

In 1967 Buffett realized large capital gains due to the sale of some long-standing large positions in marketable securities.

“Many investment organizations performed substantially better than (Buffett Partnerships), with gains ranging to over 100%. …converging in a maximum effort for the achievement of large and quick stock market profits.  It looks to me like greatly intensified speculation with concomitant risks – but many of the advocates insist otherwise.”

Controlled company Diversified Retailing Company purchased Associated Cotton Shops (Based on the 1978 letter it appears this was renamed Associated Retail Stores) and Berkshire Hathaway purchased  National Indemnity (an insurance company that specialized in non-standard higher risk insured auto and general liability) (along with National Fire and Marine, an affiliated company). Buffett praised the sellers of these businesses who stayed on as managers.

(In the 1977 letter it was indicated that the price paid for the two insurance companies was $8.6 million.) An interesting question arises. How did Berkshire Hathaway come up with $8.6 million? How much cash was on the books when Buffett bought it and how much did he raise by selling inventory and collecting accounts payable? Was any land and equipment sold off at that point? How quickly was he able to have Berkshire invest in stocks and make gains that way?

Buffett described how he would not be looking to Trade these type of controlled companies just to gain a bit more return. He indicated he would keep a portion of the money “(but not over 40% because of the possible liquidity requirements arising from the nature of our partnership agreement”) invested in controlled businesses at an expected rate of return below that inherent in an aggressive stock market operation.

The return on general stock market investments for Buffett in 1967 was 72%. Largely driven by one stock investment that represented 40% of the partnerships money and which had done well for several years and which position was substantially reduced in 1967. In the 1994  letter, Buffett revealed that this was American Express.

“We begin the new year with net assets of $68.1 million. We had partners with capital of about $1.6 million withdraw at yearend, primarily because of the reduced objectives announced…”

The Office group, spouses and children had over $15 million invested at the end of 1967.


“Our marketable securities are concentrated in a few situations, making relative performance potentially more volatile than in widely diversified investment vehicles.”

In his mid-year letter Buffett praised the managers of his four controlled businesses. This form of public written praise was a practice that Buffett would continue every year.

Buffett cautioned that permanent ownership of controlled businesses would not earn as much return as would buying and re-selling such businesses or from skilled investment in marketable securities. “nevertheless, they offer a pleasant long-term form of activity (when conducted in conjunction with high grade, able people) at satisfactory rates of return.”

“I make no effort to predict the course of general business or the stock market. Period.” Buffett noted he was bothered by what was occurring in the markets on a mushrooming scale. Spectacular amounts of money are being made by originators, top employees, advisors, investment bankers stock speculators etc. in the chain-letter stock-promotion area. This frequently requires accounting distortions.

This had allowed Buffett to profit when the market decided that some of the small companies he owned were worth a lot more but it was drying up the supply of cheap companies. Buffett believed that activity would eventually be recognized to be a “mania”.

Buffett reaffirmed that at this time he was not taking on any new partners – no exceptions. He felt new money would dampen performance.

In 1968 Buffett had a banner year in the category he called Generals – Private Owner. The definition of this category was (from our 1963 summary above): The main qualification is a bargain price substantially below a carefully calculated value to a private owner. There are also qualitative factors. “We like good management – we like a decent industry – we like a certain amount of “ferment” in a previously dormant management or stockholder group. But we demand value”.

“The cash register really rang on one simple industry idea (implemented in several ways) in this area in 1968”. He even earned a substantial fee (for the partnership) for some work in this field.

Buffett indicated that this category (generals – private owner) represented the way he had been taught he business. “Our total individual profits in this category during (our) twelve year history are probably fifty times or more our total losses.  However at the end of 1968 Buffett had largely cashed out of all of these and that he had no ideas in the hopper.

1968 was also a strong year for his “workouts” (arbitrage)  category with “a relatively heavy concentration in just a few situations per year”.

“The quality and quantity of ideas is presently at an all time low”.


In May 1969, Buffett announced that he was retiring. He noted his frustration with the markets because: 1. opportunities for investments based on quantitative (value) analysis had virtually disappeared. 2. The partnerships’ $100 million in assets eliminated the ability to invest meaningfully in small size opportunities. 3. The market was increasingly short-term oriented and speculative.

Buffett had not been able to slow-down his efforts as he had hoped and move into non- Buffett Partnership activities.  He noted he was unable to do that given the the responsibility for managing what amounts to virtually 100% of the net worth of many partners.

“I don’t want to be totally occupied with out-pacing an investment rabbit all my life. The only way to slow down is to stop.”

He indicated he had selected an investment manager that all partners could switch to.

He wanted all partners to be able to maintain their proportionate interests in the two controlled companies, Diversified Retailing Company Inc. and Berkshire Hathaway. Because he would be setting a unilateral fair value on these two it was fair that people had the choice to keep them. Due to the large control bloc partners might be unable to sell these shares for quite some time. Partners were able to take the cash value that Buffett would set for these two rather than shares if they desired. Buffett indicated he liked the people running these companies and wanted the relationship to be life-long.

Buffett noted that Berkshire had purchased earlier in 1969, The Illinois National Bank and Trust Company of Rockford Illinois, a $100 million (deposits) extremely well-run bank.

Buffett noted that he expected a poor year in 1969 and that it was 100% his fault.

He alluded to some government action which although it was socially desirable and he said he had been in favor of it (though not necessarily the means utilized) but he had not thought it would happen so fast and it had cost the partnership millions.

Buffett noted he would have preferred to end the partnership on a good year instead of a bad one but had no good ideas in the hopper and was not going to grope around hoping to get lucky with other people’s money.

“I am not attuned to this market environment, and I don’t want to spoil a decent record by trying to play a game I don’t understand just so I can go out a hero.”

We don’t have a letter with the final Partnership results for 1969

1969 Berkshire Hathaway only

This first Berkshire letter was signed by Ken Chace but one suspects there was considerable Buffett influence.

Ken noted that Berkshire’s portfolio of marketable securities had largely been sold over the last two years (at a profit) in order to make corporate acquisitions.

Textile earnings on capital employed remain unsatisfactory despite strenuous efforts toward improvement.

Subsidiary National Indemnity achieved significant adjusted operating profits despite a bad year for the industry. Founder and manager Jack Ringwalt has held to the principal of underwriting profit since found the company in 1941.

Entered the surety business including workers compensation through a new Los Angeles office.

Created a reinsurance division, apparently as part of National Indemnity.

Noted plans for a new “home state” insurance operation.

Acquired The Illinois National Bank and Trust Co. of Rockford Illinois.  Eugene Abegg (who continued as Chairman) had built it from $250,000 net worth, $400,000 deposits in 1931 to $16 million net worth and $100 million deposits in 1969 – without addition of outside capital. Earnings on assets in 1969 were 2.0%, close to the top among larger commercial banks in the country.

From the 1973 letter we learn that tiny Sun Newspapers Inc. was purchased by Berkshire in 1969.


No letter available.

The 1971 letter indicates that they inaugurated their home state insurance operations with the formation of Cornhusker Casualty Company. It would operate strictly in one state (Nebraska).


A good year in insurance but it is becoming more competitive. “We set no volume goals in our insurance business generally – and certainly not in reinsurance – as virtually any volume can be achieved if profitability standards are ignored.”.

Additional home state insurance companies were formed: Lakeland Fire and Casualty Company – Minnesota

Acquired Home & Automobile Insurance Company of Chicago. Built by Victor Raab into a major auto insurer in Cook County. $7.5 million premium volume in 1971. Vic has “a talent for operating profitably accompanied by enthusiasm for his business”. Buffett would supply additional capital to expand into branch offices. It had a highly concentrated and on-the-spot marketing and claims approach that could be expanded to other densely populated areas.

The founders of the two insurance companies Buffett had acquired plus the Illinois bank had sold their ownership for cash but “retain every bit of proprietary interest and pride that they have always had”.

The Illinois National Bank had earned well over 2% after-tax on deposits while not using long-term debt, maintaining high liquidity far above average, loan losses far below average, using over 50% higher interest time deposits. This bank had moved away from demand deposits into higher cost time deposits (InvestorsFriend speculates that this probably reduced risk in a rising interest rate scenario).  Marketing efforts were intensified during the year, with excellent results. This bank would seek additional time deposits even though they provided marginal net income at present.

“Our insurance and banking subsidiaries possess a fiduciary relationship with the public. We retain a fundamental belief in operating from a very strongly financed position so as to be in a position to unquestionably fulfill our obligations. Thus, we will continue to map our financial future for maximum financial strength in our subsidiaries as well as at the parent company level.”


Texas United Insurance was founded as another “home state” company.

Large amounts of investable funds from the insurance operations had been invested in tax-exempt bonds, taking advantage of high interest rates.

Volume in insurance would slow as they refused to accept unprofitable business as competitors drove down rates.

The net-charge off rate at Illinois National Bank and Trust was just 5% of the average for commercial banks. Buffett praised the managers. Grew the loans and ceased investing in short-term commercial paper.

Berkshire borrowed money at 8% on an interest-only basis for 6 years and then principal repayable over 15 years.

Berkshire would continue to maintain unusually high capital strength but hoped to continue to earn a good level of profitability on such capital.

The 1977 letter mentioned that it was at the beginning of 1972 that Blue Chip Stamps purchased See’s Candies. We understand that Buffett controlled Blue Chip though a combination of shares owned by Diversified Retailing and Berkshire Hathaway, both of which Buffett controlled. Blue Chip stamps would eventually be merged into Berkshire Hathaway.


“Management’s objective is to achieve a return on capital over the long term which averages somewhat higher than that of American industry generally – while utilizing sound accounting and debt policies.”

In the textile business due to large raw material price increases, adopted LIFO accounting which minimizes inventory profits.

Founded a home state operation The Insurance Company of Iowa.

“In (Texas home state insurance) we virtually had to start over during 1973 as the initial management we selected proved incapable of underwriting successfully.”

Home and Auto proved to be pricing too low in its Chicago base.

The insurance subsidiaries made substantial additional commitments to common stocks in 1973 but lost considerable market value in 1973. But “we believe that our common stock portfolio at cost represents good value in terms of intrinsic business worth…. we expect satisfactory results from this portfolio over the longer term.”

Diversified Retailing Company Inc. was to be merged into Berkshire (This was pending regulatory approvals and the merger did not happen as planned in 1974).

Diversified Retailing now operated a chain of popular priced women’s cloths stores (Associated Cotton Shops) . It also conducts a reinsurance operation. The most important asset was 16% of Blue Chip Stamps. Berkshire owned a further 19% of Blue Chip and would raise that to 22.5% early in 1974.

Blue Chip’s stamp business was declining but it had important sources of earning power in its See’s Candy Shops subsidiary as well as 54% owned Wesco Financial Corporation.

Berkshire’s tiny Sun Newspapers, Inc. subsidiary won a Pulitzer Prize for investigative journalism.


A poor year due to poor results from insurance due to inadequate pricing in the industry. Unusually high recent profit levels in the industry had attracted unintelligent competitors. Costs of auto repair and medical care were rising while industry pricing was staying flat leading to negative industry profits.

Loss reserves for many giant insurance companies appeared to be inadequate, meaning they were underestimating the cost of their product.

“During this period we plan to continue to build financial strength and liquidity, preparing for the time when insurance rates become adequate and we can once again aggressively pursue opportunities for growth in this area.”

The textile business which specialized in curtains suffered as curtains were deferrable purchases in times of consumer uncertainty and also due to very low levels of housing starts.

Berkshire had started a home state operation in Florida but suffered losses and pulled out.

“Blue Chip stamp sales continued at a greatly reduced level, but the Blue Chip management has done an excellent job of adjusting operating costs.” The See’s Candy Shops. Inc. subsidiary had an outstanding year, and has excellent prospects for the future.

There was no comment this year on the state of the stock markets.


Berkshire Hathaway profits were poor in 1975.

Textile profits were low with losses and steep job cuts early in the year but with a strong recovery in Q4.

Acquired Waumbec Mills Incorporated and Waumbec Dyeing and Finishing Co. These companies were operating at half capacity and at losses but moved into a significant profit position by early 1976.

Insurance had really disastrous results in autos and long-tail contracts. Costs were rising and also social inflation was causing law suits and extensions of coverages to things not originally contemplated. These long-tail contracts produce unusually high levels of investment income which is what attracted Buffett to them.

Home and Automobile Insurance Company retreated to write only in its original Cook County (Chicago) area. A management change was made.

Equities which had been in a large unrealized loss position at the end of 1975 had moved to a large unrealized gain position by early 1976 (when the 1975 letter was written).

“Our equity investments are heavily concentrated in a few companies which are selected based on favorable economic characteristics, competent and honest management, and a purchase price attractive when measured against the yardstick of value to a private owner.”

Investments included $10.6 million invested in Washington Post Company, “which we expect to hold permanently”.

“With this approach, stock market fluctuations are of little importance to us – except as they may provide buying opportunities – but business performance is of major importance.” Market fluctuations in bond investments held (due to interest rate movements) were also of little importance since the bonds would unlikely be sold other than at times of Buffett’s choice.

At Illinois National, there were $65 million in loans and yet loan losses were only $24,000 or 0.04%. 75% of the deposits were invested in very short-term government and government agency bonds rather than loaned out. This meant the bank had unusually high liquidity.

Berkshire’s book value per share had grown from $19.46 per share in September 1964 to $94.92 per share at year end 1975. Six businesses had been acquired, and four started (the home state companies). There  was a 31.5% interest in a large affiliated enterprise. Equity per share had compounded at just over 15% per year.

“…efforts will continue to develop growing and diversified sources of earnings. Our objective is a conservatively financed and highly liquid business – possessing extra margins of balance sheet strength consistent with the fiduciary obligations inherent in the banking and insurance industries – which will produce a long term rate of return on equity capital exceeding that of American industry as a whole.”


Buffett noted that textiles had had a bad year and stated “the textile business does not offer the expectation of high returns on investment. Nevertheless, we maintain a commitment to this division – a very important source of employment in (the two towns his mills were located in) – and believe reasonable returns on average are possible.”

In insurance, Berkshire had a much improved and a good year for National Indemnity which was an  auto and general liability insurer (InvestorsFriend understands it was higher risk people and companies that this company focused on). Insurance industry rates had finally risen. Buffett’s reinsurance business was not doing well and had been hard hit by inflation.

Regarding bonds: Higher interest rates tended to push the bond portfolio value below its cost but Buffet preferred that since it gave the opportunity to invest new money at higher rates.

Buffett had a large unrealized gain in stocks at the end of 1976 compared to a loss a few years earlier. But he considered such fluctuations to be unimportant. “However, we consider the yearly business progress of the companies in which we own stocks to be very important. … If business results continue excellent over a period of years, we are certain eventually to achieve good financial results from our stock holdings, regardless of wide year-to-year fluctuations in market values.”

Buffett detailed Berkshire’s equity holdings with a market value over $3 million at the end of 1976.

Shares Company Cost
141,987 California Water Service Company $3,608,711
1,986,953 Government Employees Insurance Company Convertible Preferred (GEICO preferred) 19,416,635
1,294,308 Government Employees Insurance Company Common Stock (GEICO common) 4,115,670
395,100 Interpublic Group of Companies 4,530,615
562,900 Kaiser Industries, Inc. 8,270,871
188,900 Munsingwear, Inc. 3,398,404
83,400 National Presto Industries, Inc. 1,689,896
170,800 Ogilvy & Mather International 2,762,433
934,300 The Washington Post Company Class B 10,627,604
  Total $58,420,839
  All other Holdings 16,974,375
  Total Equities $75,395,214

Note that GEICO and Washington Post Company would become permanent holdings. Also note that the largest position by far was in preferred shares (GEICO).

Buffett noted that this was a concentrated portfolio.

“We select such investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business: (1) favorable long-term economic characteristics; (2) competent and honest management; (3) purchase price attractive when measured against the yardstick of value to a private owner; and (4) an industry with which we are familiar and whose long-term business characteristics we feel competent to judge. It is difficult to find investments meeting such a test, and that is one reason for our concentration of holdings.”

“Our intention usually is to maintain equity positions for a long time, but sometimes we will make a purchase with a shorter expected time horizon.”

Buffett noted the exceptional performance of his National Bank and Trust Company, noting its exceptional 2% return on assets, it’s ultra low 0.02% loan losses, and its excellent cost management whereby staff levels were relatively unchanged even as customer time deposits grew from $30 million to $90 million.

Mentioned K&W Products which apparently was acquired in late 1975 or early 1976.

Kirkling Reinsurance Corporation (renamed Central Fire and Casualty) was purchased. (per 1977 letter)


“Most companies define “record” earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”

“Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.”

Kansas Fire and Casualty Company  was started.

Cypress Insurance Company (California Workers Compensation business) was purchased.

“One of the lessons your management has learned – and, unfortunately, sometimes re-learned – is the importance of being in businesses where tailwinds prevail (his insurance operations) rather than headwinds (textiles).”

Buffett described the success of his National Indemnity company, how its “underwriting profitability had increased dramatically, and, in addition, large sums have been made available for investment”

Buffett described how high quality management was important in insurance operations since there was no proprietary product or rates.  “There are no important advantages from trademarks, patents, location, corporate longevity, raw material sources etc. , and very little consumer differentiation to produce insulation from competition.

“Most of our large stock positions are going to be held for many years and the scorecard on our investment decisions will be provided by business results over that period, and not by prices on any given day. Just as it would be foolish to focus unduly on short-term prospects when acquiring an entire company, we think it equally unsound to become mesmerized by prospective near term earnings or recent trends in earnings when purchasing small pieces of a company; i.e., marketable common stocks.”

“We select our marketable equity securities in much the same way we would evaluate a business for acquisition in its entirety. We want the business to be (1) one that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term. In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”

“Our experience has been that pro-rata portions of truly outstanding businesses sometimes sell in the securities markets at very large discounts from the prices they would command in negotiated transactions involving entire companies.”

By the end of 1977 Berkshire owned 36% of Blue Chip Stamps. And Diversified Retailing, another company controlled by Buffett also owned shares in Blue Chip Stamps providing total ownership of Blue Chip Stamps of about 58% (see 1978 letter).

“Since See’s (Candies) was purchased by Blue Chip Stamps at the beginning of 1972, pre-tax operating earnings have grown from $4.2 million to $12.6 million with little additional capital investment. See’s achieved this record while operating in an industry experiencing practically no unit growth.”


At the end of 1977 Berkshire Hathaway merged with Diversified Retailing Inc. This raised Berkshire’s ownership of Blue Chip Stamps to 58% and meant that Berkshire would now consolidate the diverse operations of Blue Chip into its consolidated results.

Buffalo Evening News was owned by 1978 and may have been part of Blue Chip Stamps. Also Mutual Savings and Loan Association.

Buffett commented on the limitations of Berkshire’s consolidated financial statements in regards to understanding the company.

“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.”

Buffett commented on how operating earnings (which excludes capital gains and losses on sales of stocks) is the most accurate performance indicator for a given year, but that he had achieved and expected to continue to achieve capital gains over the years. Therefore, for Berkshire operating earnings understate the long-term earnings.

“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.”

Buffett also repeated his inability to forecast the stock market.

“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.”

Regarding textiles, Buffett mentioned that it (unfortunately) required high investments in receivables and inventory.

Buffett made an important comment on the undesirable aspects of commodity type businesses:

“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.”

There were many comments on his insurance company results and on the characteristics of the industry.

“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.”

Buffett noted that he was having trouble finding businesses to buy at “interesting prices” but he appears to have been speaking of prices for the acquisition of whole companies, as he did indicate some bargains were available in stocks.

Buffett noted:

“…in 1971, pension fund managers invested a record 122% of net new 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.” Buffett also noted that in 1978, Pension Funds put only 9% of new funds in equities, this despite their long-term time horizons.

“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.

“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.”

Regarding commons stocks, Buffett’s letter revealed that he had a huge unrealized gain of 320% in Interpublic Group of companies. It was not clear what year these shares were purchased.

Buffett made the following somewhat surprising statements:

“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.”

Buffett also noted that when Berkshire owned shares in companies, only the dividends received came into Berkshire’s income, not its full share of earnings. This was under-stating Berkshire’s earnings. These earnings would eventually show up in Capital Gains if and when the shares were sold. InvestorsFriend believes that this would still be the case today regarding Berkshire’s investments in Coke and any other company where it owns less than 20%. (Above 20% ownership of another company, companies book their proportional share of earnings minus any dividend s received).

Buffett commented on whether he wanted companies he owned to pay out dividends. It depended.

“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.”

Buffett complimented the performance of a chain of retail stores that Berkshire owned:

Associated’s (Retail Stores) business has not grown, and it consistently has faced adverse demographic and retailing trends. “But Ben’s (the founding manager) 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.”


“We continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with all securities valued at cost is the most appropriate way to measure any single year’s operating performance.”

“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.”

“In measuring long term economic performance – in contrast to yearly performance – we believe it is appropriate to recognize fully any realized capital gains or losses as well as extraordinary items, and also to utilize financial statements presenting equity securities at market value. Such capital gains or losses, either realized or unrealized, are fully as important to shareholders over a period of years as earnings realized in a more routine manner through operations; it is just that their impact is often extremely capricious in the short run, a characteristic that makes them inappropriate as an indicator of single year managerial performance.”

Berkshire’s book value per share had grown from $19.46 per share in September 1964 to $335.85 per share at year end 1979. Equity per share had therefore compounded at 20.5% per year, on average, for 15.25 years.

“We have achieved this result while utilizing a low amount of leverage (both financial leverage measured by debt to equity, and operating leverage measured by premium volume to capital funds of our insurance business), and also without significant issuance or repurchase of shares. Basically, we have worked with the capital with which we started. From our textile base we, or our Blue Chip and Wesco subsidiaries, have acquired total ownership of thirteen businesses through negotiated purchases from private owners for cash, and have started six others.”

But, “a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail.”

“…the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) – can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.

“One friendly but sharp-eyed commentator on Berkshire has pointed out that our book value at the end of 1964 would have bought about one-half ounce of gold and, fifteen years later, after we have plowed back all earnings along with much blood, sweat and tears, the book value produced will buy about the same half ounce. A similar comparison could be drawn with Middle Eastern oil. The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.”

Precision Steel was acquired (albeit less than 100%) in 1979.

“Our textile business also continues to produce some cash, but at a low rate compared to capital employed. This is not a reflection on the managers, but rather on the industry in which they operate. In some businesses – a network TV station, for example – it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. And assets in such businesses sell at equally extraordinary prices, one thousand cents or more on the dollar, a valuation reflecting the splendid, almost unavoidable, economic results obtainable. Despite a fancy price tag, the “easy” business may be the better route to go.”

“We can speak from experience, having tried the other route. Your Chairman made the decision a few years ago to purchase Waumbec Mills in Manchester, New Hampshire, thereby expanding our textile commitment. By any statistical test, the purchase price was an extraordinary bargain; we bought well below the working capital of the business and, in effect, got very substantial amounts of machinery and real estate for less than nothing. But the purchase was a mistake. While we labored mightily, new problems arose as fast as old problems were tamed.”

“Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.”

Buffett commented on the property insurance business.

“We hear a great many insurance managers talk about being willing to reduce volume in order to underwrite profitably, but we find that very few actually do so.” But Buffett’s insurance managers reduced volume when prices were too low. “We believe such strong-mindedness is as rare as it is sound – and absolutely essential to the running of a first-class casualty insurance operation.”

“At yearend we entered the specialized area of surety reinsurance” InvestorsFriend notes that this was likely the purchase or formation of Kansas Surety. Surety is insurance that pays out if a third party fails to perform its contractual obligations. An example is deposit insurance which pays out if the bank fails.

“Present (high) interest rates encourage the obtaining of (insurance) business at underwriting loss levels formerly regarded as totally unacceptable. Managers decry the folly of underwriting at a loss to obtain investment income, but we believe that many will.”

“You can get a lot of surprises in insurance. Nevertheless, we believe that insurance can be a very good business. It tends to magnify, to an unusual degree, human managerial talent – or the lack of it.”

Buffett listed the stock investments held by Berkshire. Interestingly, he said the following:

“We currently believe that equity markets in 1980 are likely to evolve in a manner that will result in an underperformance by our portfolio for the first time in recent years. We very much like the companies in which we have major investments, and plan no changes to try to attune ourselves to the markets of a specific year.”

Buffett discussed the nature of long-term bonds, on which many investors (he spoke of other insurance companies) had lost a lot of money recently as interest rates rose due to inflation.

“Ironically, many insurance companies have decided that a one-year auto policy is inappropriate during a time of inflation, and six-month policies have been brought in as replacements. “How,” say many of the insurance managers, “can we be expected to look forward twelve months and estimate such imponderables as hospital costs, auto parts prices, etc.?” But, having decided that one year is too long a period for which to set a fixed price for insurance in an inflationary world, they then have turned around, taken the proceeds from the sale of that six-month policy, and sold the money at a fixed price for thirty or forty years.”

“The very long-term bond contract has been the last major fixed price contract of extended duration still regularly initiated in an inflation-ridden world. The buyer of money to be used between 1980 and 2020 has been able to obtain a firm price now for each year of its use while the buyer of auto insurance, medical services, newsprint, office space – or just about any other product or service – would be greeted with laughter if he were to request a firm price now to apply through 1985. For in virtually all other areas of commerce, parties to long-term contracts now either index prices in some manner, or insist on the right to review the situation every year or so.”

“A cultural lag has prevailed in the bond area. The buyers (borrowers) and middlemen (underwriters) of money hardly could be expected to raise the question of whether it all made sense, and the sellers (lenders) slept through an economic and contractual revolution.”

“Even prior to this period, we never would buy thirty or forty-year bonds; instead we tried to concentrate in the straight bond area on shorter issues with sinking funds and on issues that seemed relatively undervalued because of bond market inefficiencies. However, the mild degree of caution that we exercised was an improper response to the world unfolding about us. You do not adequately protect yourself by being half awake while others are sleeping. It was a mistake to buy fifteen-year bonds, and yet we did; we made an even more serious mistake in not selling them (at losses, if necessary) when our present views began to crystallize. (Naturally, those views are much clearer and definite in retrospect; it would be fair for you to ask why we weren’t writing about this subject last year.)”

“We have severe doubts as to whether a very long-term fixed-interest bond, denominated in dollars, remains an appropriate business contract in a world where the value of dollars seems almost certain to shrink by the day. Those dollars, as well as paper creations of other governments, simply may have too many structural weaknesses to appropriately serve as a unit of long term commercial reference. If so, really long bonds may turn out to be obsolete instruments and insurers who have bought those maturities of 2010 or 2020 could have major and continuing problems on their hands. We, likewise, will be unhappy with our fifteen-year bonds and will annually pay a price in terms of earning power that reflects that mistake.”

“And, of course, there is the possibility that our present analysis is much too negative. The chances for very low rates of inflation are not nil. Inflation is man-made; perhaps it can be man-mastered. The threat which alarms us may also alarm legislators and other powerful groups, prompting some appropriate response. Furthermore, present interest rates incorporate much higher inflation projections than those of a year or two ago. Such rates may prove adequate or more than adequate to protect bond buyers. We even may miss large profits from a major rebound in bond prices. However, our unwillingness to fix a price now for a pound of See’s candy or a yard of Berkshire cloth to be delivered in 2010 or 2020 makes us equally unwilling to buy bonds which set a price on money now for use in those years. Overall, we opt for Polonius (slightly restated): “Neither a short-term borrower nor a long-term lender be.””

Buffett spoke about the shareholders of Berkshire, which was a very thinly traded stock at this time but had just been listed on NASDAQ. And he spoke about how he communicated with shareholders.  “…at the end of each year about 98% of the shares outstanding are held by people who also were shareholders at the beginning of the year. … Furthermore, perhaps 90% of our shares are owned by investors for whom Berkshire is their largest security holding, very often far and away the largest. Many of these owners are willing to spend a significant amount of time with the annual report, and we attempt to provide them with the same information we would find useful if the roles were reversed.”

“When you do receive a communication from us, it will come from the fellow you are paying to run the business. Your Chairman has a firm belief that owners are entitled to hear directly from the CEO as to what is going on and how he evaluates the business, currently and prospectively. You would demand that in a private company; you should expect no less in a public company. A once-a-year report of stewardship should not be turned over to a staff specialist or public relations consultant who is unlikely to be in a position to talk frankly on a manager-to-owner basis.”

“We feel that you, as owners, are entitled to the same sort of reporting by your manager as we feel is owed to us at Berkshire Hathaway by managers of our business units. Obviously, the degree of detail must be different, particularly where information would be useful to a business competitor or the like. But the general scope, balance, and level of candor should be similar. We don’t expect a public relations document when our operating managers tell us what is going on, and we don’t feel you should receive such a document.”

“The reasoning of managements that seek large trading activity in their shares puzzles us. In effect, such managements are saying that they want a good many of the existing clientele continually to desert them in favor of new ones – because you can’t add lots of new owners (with new expectations) without losing lots of former owners.”

“…we hope to continue to have a very low turnover among our owners, reflecting a constituency that understands our operation, approves of our policies, and shares our expectations. And we hope to deliver on those expectations.”

“We continue to feel very good about our insurance equity investments. Over a period of years, we expect to develop very large and growing amounts of underlying earning power attributable to our fractional ownership of these companies. In most cases they are splendid businesses, splendidly managed, purchased at highly attractive prices.”


Buffett gave a detailed explanation of how Berkshire’s earnings were effectively understated due to the fact that for many of its equity (stock) investments it could only report as earnings the dividends received rather than its full proportionate share of earnings. If Berkshire owned 20% or more of the shares of a given company then it was able to, and required to, recognize its full proportionate share of earnings. If it owned less than 20% it could only report the dividends received. This was important because at this time such investments made up a very significant portion of Berkshire’s assets to the point where the “missing” earnings were actually larger than the reported earnings.

“…while our reported operating earnings reflect only the dividends received from such companies, our economic well-being is determined by their earnings, not their dividends.”

Buffett talked about how some reported earnings were worth more than others. (All earnings are NOT created equal).

The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage. This is true whether we determine the usage, or whether managers we did not hire – but did elect to join – determine that usage. (It’s the act that counts, not the actors.) And the value is in no way affected by the inclusion or non-inclusion of those retained earnings in our own reported operating earnings. If a tree grows in a forest partially owned by us, but we don’t record the growth in our financial statements, we still own part of the tree.”

“Our view, we warn you, is non-conventional. But we would rather have earnings for which we did not get accounting credit put to good use in a 10%-owned company by a management we did not personally hire, than have earnings for which we did get credit put into projects of more dubious potential by another management – even if we are that management.”

Buffett talked about his enthusiasm for share buy backs – but only when a company’s shares are far undervalued.

“One usage of retained earnings we often greet with special enthusiasm when practiced by companies in which we have an investment interest is repurchase of their own shares. The reasoning is simple: if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price? The competitive nature of corporate acquisition activity almost guarantees the payment of a full – frequently more than full price when a company buys the entire ownership of another enterprise. But the auction nature of security markets often allows finely-run companies the opportunity to purchase portions of their own businesses at a price under 50% of that needed to acquire the same earning power through the negotiated acquisition of another enterprise.”

Buffett talked about how he measured Corporate performance of Berkshire.

“As we have noted, we evaluate single-year corporate performance by comparing operating earnings to shareholders’ equity with securities valued at cost. Our long-term yardstick of performance, however, includes all capital gains or losses, realized or unrealized. We continue to achieve a long-term return on equity that considerably exceeds the average of our yearly returns. The major factor causing this pleasant result is a simple one: the retained earnings of those non-controlled holdings we discussed earlier have been translated into gains in market value.”

“…when purchase prices (at which stocks are bought) are sensible, some long-term market recognition of the accumulation of retained earnings almost certainly will occur. Periodically you even will receive some frosting on the cake, with market appreciation far exceeding post-purchase retained earnings.”

Buffett spoke at length about how inflation (and income taxes on earnings that represented inflation gains and not real returns) was sharply reducing the real returns that investors were making. InvestorsFriend has copied in here the entire section.

“Unfortunately, earnings reported in corporate financial statements are no longer the dominant variable that determines whether there are any real earnings for you, the owner. For only gains in purchasing power represent real earnings on investment. If you (a) forego ten hamburgers to purchase an investment; (b) receive dividends which, after tax, buy two hamburgers; and (c) receive, upon sale of your holdings, after-tax proceeds that will buy eight hamburgers, then (d) you have had no real income from your investment, no matter how much it appreciated in dollars. You may feel richer, but you won’t eat richer.”

High rates of inflation create a tax on capital that makes much corporate investment unwise – at least if measured by the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be achieved by a corporation in order to produce any real return for its individual owners – has increased dramatically in recent years. The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.”

“For example, in a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do) and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it. (Half of the 20% will go for income tax; the remaining 10% leaves the owners of the business with only 98% of the purchasing power they possessed at the start of the year – even though they have not spent a penny of their “earnings”). The investors in this bracket would actually be better off with a combination of stable prices and corporate earnings on equity capital of only a few per cent.”

“Explicit income taxes alone, unaccompanied by any implicit inflation tax, never can turn a positive corporate return into a negative owner return. (Even if there were 90% personal income tax rates on both dividends and capital gains, some real income would be left for the owner at a zero inflation rate.) But the inflation tax is not limited by reported income. Inflation rates not far from those recently experienced can turn the level of positive returns achieved by a majority of corporations into negative returns for all owners, including those not required to pay explicit taxes. (For example, if inflation reached 16%, owners of the 60% plus of corporate America earning less than this rate of return would be realizing a negative real return – even if income taxes on dividends and capital gains were eliminated.)”

“Of course, the two forms of taxation co-exist and interact since explicit taxes are levied on nominal, not real, income. Thus you pay income taxes on what would be deficits if returns to stockholders were measured in constant dollars.”

At present inflation rates, we believe individual owners in medium or high tax brackets (as distinguished from tax-free entities such as pension funds, eleemosynary institutions, etc.) should expect no real long-term return from the average American corporation, even though these individuals reinvest the entire after-tax proceeds from all dividends they receive. The average return on equity of corporations is fully offset by the combination of the implicit tax on capital levied by inflation and the explicit taxes levied both on dividends and gains in value produced by retained earnings.”

“As we said last year, Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity.”

“Indexing is the insulation that all seek against inflation. But the great bulk (although there are important exceptions) of corporate capital is not even partially indexed. Of course, earnings and dividends per share usually will rise if significant earnings are “saved” by a corporation; i.e., reinvested instead of paid as dividends. But that would be true without inflation. A thrifty wage earner, likewise, could achieve regular annual increases in his total income without ever getting a pay increase – if he were willing to take only half of his paycheck in cash (his wage “dividend”) and consistently add the other half (his “retained earnings”) to a savings account. Neither this high-saving wage earner nor the stockholder in a high-saving corporation whose annual dividend rate increases while its rate of return on equity remains flat is truly indexed.”

“For capital to be truly indexed, return on equity must rise, i.e., business earnings consistently must increase in proportion to the increase in the price level without any need for the business to add to capital – including working capital – employed. (Increased earnings produced by increased investment don’t count.) Only a few businesses come close to exhibiting this ability. And Berkshire Hathaway isn’t one of them.”

“We, of course, have a corporate policy of reinvesting earnings for growth, diversity and strength, which has the incidental effect of minimizing the current imposition of explicit taxes on our owners. However, on a day-by-day basis, you will be subjected to the implicit inflation tax, and when you wish to transfer your investment in Berkshire into another form of investment, or into consumption, you also will face explicit taxes.”

Buffett listed the companies controlled by Berkshire and its major stock investments. Buffett noted that through its stock investments Berkshire then had a larger interest in the Aluminum business than it had in any of its controlled businesses.

Buffett noted that Berkshire’s largest non-controlled company was GEICO of which it owned 33% of the shares.

“GEICO represents the best of all investment worlds – the coupling of a very important and very hard to duplicate business advantage with an extraordinary management whose skills in operations are matched by skills in capital allocation.”

“…our holdings cost us $47 million, with about half of this amount invested in 1976 and most of the remainder invested in 1980. At the present dividend rate, our reported earnings from GEICO amount to a little over $3 million annually. But we estimate our share of its earning power is on the order of $20 million annually.”

“We should emphasize that we feel as comfortable with GEICO management retaining an estimated $17 million of earnings applicable to our ownership as we would if that sum were in our own hands. In just the last two years GEICO, through repurchases of its own stock, has reduced the share equivalents it has outstanding from 34.2 million to 21.6 million, dramatically enhancing the interests of shareholders in a business that simply can’t be replicated. The owners could not have been better served.”

“We have written in past reports about the disappointments that usually result from purchase and operation of “turnaround” businesses. Literally hundreds of turnaround possibilities in dozens of industries have been described to us over the years and, either as participants or as observers, we have tracked performance against expectations. Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

“GEICO may appear to be an exception, having been turned around from the very edge of bankruptcy in 1976. It certainly is true that managerial brilliance was needed for its resuscitation, and that Jack Byrne, upon arrival in that year, supplied that ingredient in abundance.”

“But it also is true that the fundamental business advantage that GEICO had enjoyed – an advantage that previously had produced staggering success – was still intact within the company, although submerged in a sea of financial and operating troubles.”

GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) populated largely by companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its customers while earning unusual returns for itself. For decades it had been run in just this manner. Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage. GEICO’s problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true “turnaround” situation in which the managers expect – and need – to pull off a corporate Pygmalion.”

“Whatever the appellation, we are delighted with our GEICO holding which, as noted, cost us $47 million. To buy a similar $20 million of earning power in a business with first-class economic characteristics and bright prospects would cost a minimum of $200 million (much more in some industries) if it had to be accomplished through negotiated purchase of an entire company. A 100% interest of that kind gives the owner the options of leveraging the purchase, changing managements, directing cash flow, and selling the business. It may also provide some excitement around corporate headquarters (less frequently mentioned).”

“We find it perfectly satisfying that the nature of our insurance business dictates we buy many minority portions of already well-run businesses (at prices far below our share of the total value of the entire business) that do not need management change, re-direction of cash flow, or sale. There aren’t many Jack Byrnes in the managerial world, or GEICOs in the business world. What could be better than buying into a partnership with both of them?”

Buffett gave a long discussion on insurance industry conditions. Anyone working in the insurance industry should click the link above to his full 1980 letter and study this section, at page 9 of his letter.

One of Buffett’s insurance companies, Insurance Company of Iowa founded in 1973 was folded into Cornhusker Casualty his Nebraska home state insurance company and they stopped doing business in Iowa.

In Textiles,  Waumbec Mills , or at least its textile mill assets, was liquidated. The remaining textile operations were split into a manufacturing operation and a sales operation – each free to do business independent of the other.

As required by law, Illinois National Bank and Trust of Rockford was spun off, and it was done in an interesting fashion.  Effectively Berkshire shareholders were allowed to choose between keeping their existing proportional interest in the Bank, in return for losing some Berkshire shares or just keeping all Berkshire shares. Most wisely chose to forego the Bank shares and just keep the all their Berkshire shares. A few opted for more Bank shares and gave up additional Berkshire shares to get Bank shares. One wonders what ever became of these people. Are they still kicking themselves?

Buffett described how Berkshire had borrowed some money, that it did not really need yet, and talked about the type of companies he was looking to buy with the money.

“In August we sold $60 million of 12 3/4% notes due August 1, 2005, with a sinking fund to begin in 1991.”

“Unlike most businesses, Berkshire did not finance because of any specific immediate needs. Rather, we borrowed because we think that, over a period far shorter than the life of the loan, we will have many opportunities to put the money to good use. The most attractive opportunities may present themselves at a time when credit is extremely expensive – or even unavailable. At such a time we want to have plenty of financial firepower.”

“Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business. There is a certain mirage-like quality to such operations. However attractive the earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no-strings-attached cash.”

“Businesses meeting our standards are not easy to find. (Each year we read of hundreds of corporate acquisitions; only a handful would have been of interest to us.) And logical expansion of our present operations is not easy to implement. But we’ll continue to utilize both avenues in our attempts to further Berkshire’s growth.”

“Under all circumstances we plan to operate with plenty of liquidity, with debt that is moderate in size and properly structured, and with an abundance of capital strength. Our return on equity is penalized somewhat by this conservative approach, but it is the only one with which we feel comfortable.”


As he had in the 1980 letter, Buffett discussed how Berkshire owned shares in companies which were earning money for Berkshire but where, under accounting rules, only the dividend received by Berkshire was reported in Berkshire’s income.

“We know that this translation of non-controlled ownership earnings into corresponding realized and unrealized capital gains for Berkshire will be extremely irregular as to time of occurrence. While market values track business values quite well over long periods, in any given year the relationship can gyrate capriciously. Market recognition of retained earnings also will be unevenly realized among companies. It will be disappointingly low or negative in cases where earnings are employed non- productively, and far greater than dollar-for-dollar of retained earnings in cases of companies that achieve high returns with their augmented capital.”

“The accounting rules that entirely ignore these undistributed earnings diminish the utility of our annual return on equity calculation, or any other single year measure of economic performance.”

“In aggregate, our non-controlled business interests have more favorable underlying economic characteristics than our controlled businesses. That’s understandable; the area of choice has been far wider. Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety only rarely, and then almost always at high prices.”

“Our acquisition decisions will be aimed at maximizing real economic benefits, not at maximizing either managerial domain or reported numbers for accounting purposes. (In the long run, managements stressing accounting appearance over economic substance usually achieve little of either.)”

“Regardless of the impact upon immediately reportable earnings, we would rather buy 10% of Wonderful Business T at X per share than 100% of T at 2X per share. Most corporate managers prefer just the reverse, and have no shortage of stated rationales for their behavior.”

Buffett said that the real reasons that businesses pay huge premiums to buy other businesses are (paraphrased:

  1. i) Animal Spirits (the excitement of it all) ii) Company presidents make more money when their company grows iii) They believe that they can kiss “toad” companies and turn them into princes

Buffett said that one category of acquisitions that had worked in the past was when the acquisitions had pricing power and could increase prices easily and where an increased volume of business did not require much capital investment in the company. “However, very few enterprises possess both characteristics, and competition to buy those that do has now become fierce to the point of being self-defeating.”

The second category of acquisitions that had worked was when it was carried out by managerial superstars. Leaders able to recognize rare princes disguised (and priced) as toads.

“On a GAAP basis, during the present management’s term of seventeen years, book value has increased from $19.46 per share to $526.02 per share, or 21.1% compounded annually. This rate of return number is highly likely to drift downward in future years. We hope, however, that it can be maintained significantly above the rate of return achieved by the average large American corporation.”

“In past reports we have explained how inflation has caused our apparently satisfactory long-term corporate performance to be illusory as a measure of true investment results for our owners.”

“[B]ecause of the unrelenting destruction of currency values, our corporate efforts will continue to do a much better job of filling your wallet than of filling your stomach.”

Buffett wrote a length section about the problems that were created for equity investors by the environment in 1981 that included high inflation and interest rates on long-term government bonds of over 16%. Although lengthy, InvestorsFriend has copied it here in its entirety.

Equity Value-Added 

“An additional factor should further subdue any residual enthusiasm you may retain regarding our long-term rate of return. The economic case justifying equity investment is that, in aggregate, additional earnings above passive investment returns – interest on fixed-income securities – will be derived through the employment of managerial and entrepreneurial skills in conjunction with that equity capital. Furthermore, the case says that since the equity capital position is associated with greater risk than passive forms of investment, it is “entitled” to higher returns. A “value-added” bonus from equity capital seems natural and certain.

“But is it? Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a “good” business – i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than one hundred cents. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10% earned by the corporation to perhaps 6%-8% in the hands of the individual investor.

“Investment markets recognized this truth. During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were “good” businesses because they earned far more than their keep (the return on long-term passive money). The value-added produced by equity investment, in aggregate, was substantial.

“That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday’s assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.

“During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor.

“Thus, with interest rates on passive investments at late 1981 levels, a typical American business is no longer worth one hundred cents on the dollar to owners who are individuals. (If the business is owned by pension funds or other tax-exempt investors, the arithmetic, although still unenticing, changes substantially for the better.) Assume an investor in a 50% tax bracket; if our typical company pays out all earnings, the income return to the investor will be equivalent to that from a 7% tax- exempt bond. And, if conditions persist – if all earnings are paid out and return on equity stays at 14% – the 7% tax-exempt equivalent to the higher-bracket individual investor is just as frozen as is the coupon on a tax-exempt bond. Such a perpetual 7% tax-exempt bond might be worth fifty cents on the dollar as this is written.

“If, on the other hand, all earnings of our typical American business are retained and return on equity again remains constant, earnings will grow at 14% per year. If the p/e ratio remains constant, the price of our typical stock will also grow at 14% per year. But that 14% is not yet in the pocket of the shareholder. Putting it there will require the payment of a capital gains tax, presently assessed at a maximum rate of 20%. This net return, of course, works out to a poorer rate of return than the currently available passive after-tax rate.

“Unless passive rates fall, companies achieving 14% per year gains in earnings per share while paying no cash dividend are an economic failure for their individual shareholders. The returns from passive capital outstrip the returns from active capital. This is an unpleasant fact for both investors and corporate managers and, therefore, one they may wish to ignore. But facts do not cease to exist, either because they are unpleasant or because they are ignored.

“Most American businesses pay out a significant portion of their earnings and thus fall between the two examples. And most American businesses are currently “bad” businesses economically – producing less for their individual investors after-tax than the tax-exempt passive rate of return on money. Of course, some high-return businesses still remain attractive, even under present conditions. But American equity capital, in aggregate, produces no value-added for individual investors.

“It should be stressed that this depressing situation does not occur because corporations are jumping, economically, less high than previously. In fact, they are jumping somewhat higher: return on equity has improved a few points in the past decade. But the crossbar of passive return has been elevated much faster. Unhappily, most companies can do little but hope that the bar will be lowered significantly; there are few industries in which the prospects seem bright for substantial gains in return on equity.

“Inflationary experience and expectations will be major (but not the only) factors affecting the height of the crossbar in future years. If the causes of long-term inflation can be tempered, passive returns are likely to fall and the intrinsic position of American equity capital should significantly improve. Many businesses that now must be classified as economically “bad” would be restored to the “good” category under such circumstances.

“A further, particularly ironic, punishment is inflicted by an inflationary environment upon the owners of the “bad” business. To continue operating in its present mode, such a low- return business usually must retain much of its earnings – no matter what penalty such a policy produces for shareholders.

“Reason, of course, would prescribe just the opposite policy. An individual, stuck with a 5% bond with many years to run before maturity, does not take the coupons from that bond and pay one hundred cents on the dollar for more 5% bonds while similar bonds are available at, say, forty cents on the dollar. Instead, he takes those coupons from his low-return bond and – if inclined to reinvest – looks for the highest return with safety currently available. Good money is not thrown after bad.

“What makes sense for the bondholder makes sense for the shareholder. Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas. (The Scriptures concur. In the parable of the talents, the two high-earning servants are rewarded with 100% retention of earnings and encouraged to expand their operations. However, the non-earning third servant is not only chastised – “wicked and slothful” – but also is required to redirect all of his capital to the top performer. Matthew 25: 14-30)

“But inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the “bad” business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past – and most entities, including businesses, do – it simply has no choice.

“For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

“Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or “real” dividends. The tapeworm of inflation simply cleans the plate. (The low-return company’s inability to pay dividends, understandably, is often disguised. Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of “dividends” that can be paid out only if someone promises to replace the capital distributed.)

“Berkshire continues to retain its earnings for offensive, not defensive or obligatory, reasons. But in no way are we immune from the pressures that escalating passive returns exert on equity capital. We continue to clear the crossbar of after- tax passive return – but barely. Our historic 21% return – not at all assured for the future – still provides, after the current capital gain tax rate (which we expect to rise considerably in future years), a modest margin over current after-tax rates on passive money. It would be a bit humiliating to have our corporate value-added turn negative. But it can happen here as it has elsewhere, either from events outside anyone’s control or from poor relative adaptation on our part.”

Buffett included a lengthy discussion on the business conditions of property insurance. InvestorsFriend has not copied it in here but anyone in the insurance business should click the link above to the full 1981 letter (see page 10) and study Buffett’s thinking on insurance pricing.

Buffett closed with a comment on how he worked with his partner, vice Chairman Charlie Munger.

“Irrespective of titles, Charlie and I work as partners in managing all controlled companies. To almost a sinful degree, we enjoy our work as managing partners. And we enjoy having you as our financial partners.”


“It was only a few years ago that we told you that the operating earnings/equity capital percentage, with proper allowance for a few other variables, was the most important yardstick of single-year managerial performance. While we still believe this to be the case with the vast majority of companies, we believe its utility in our own case has greatly diminished.”

This was because of all the unreported earnings in the companies Berkshire owned shares of.

“We prefer a concept of “economic” earnings that includes all undistributed earnings, regardless of ownership percentage.”

“[i]f you have owned 100% of a great many capital-intensive businesses during the decade, retained earnings that were credited fully and with painstaking precision to you under standard accounting methods have resulted in minor or zero economic value. This is not a criticism of accounting procedures. We would not like to have the job of designing a better system. It’s simply to say that managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.”

“The(ir) magnitude, (of our share of unreported earnings of companies we own shares in) we believe, is what makes our reported operating earnings figure of limited significance.”

“[W]hile retained earnings over the years, and in the aggregate, have translated into at least equal market value for shareholders, the translation has been both extraordinarily uneven among companies and irregular and unpredictable in timing. However, this very unevenness and irregularity offers advantages to the value-oriented purchaser of fractional portions of businesses. This investor may select from almost the entire array of major American corporations, including many far superior to virtually any of the businesses that could be bought in their entirety in a negotiated deal. And fractional-interest purchases can be made in an auction market where prices are set by participants with behavior patterns that sometimes resemble those of an army of manic-depressive lemmings.”

“Within this gigantic auction arena, it is our job to select businesses with economic characteristics allowing each dollar of retained earnings to be translated eventually into at least a dollar of market value.”

“Satisfactory as our partial-ownership approach has been, what really makes us dance is the purchase of 100% of good businesses at reasonable prices. We’ve accomplished this feat a few times (and expect to do so again), but it is an extraordinarily difficult job – far more difficult than the purchase at attractive prices of fractional interests.”

“As we look at the major acquisitions that others made during 1982, our reaction is not envy, but relief that we were non- participants. For in many of these acquisitions, managerial intellect wilted in competition with managerial adrenaline The thrill of the chase blinded the pursuers to the consequences of the catch.”

“Our partial-ownership approach can be continued soundly only as long as portions of attractive businesses can be acquired at attractive prices. We need a moderately-priced stock market to assist us in this endeavor. The market, like the Lord, helps those who help themselves. But, unlike the Lord, the market does not forgive those who know not what they do. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.”

“Should the stock market advance to considerably higher levels, our ability to utilize capital effectively in partial- ownership positions will be reduced or eliminated. This will happen periodically: just ten years ago, at the height of the two-tier market mania (with high-return-on-equity businesses bid to the sky by institutional investors), Berkshire’s insurance subsidiaries owned only $18 million in market value of equities, excluding their interest in Blue Chip Stamps. At that time, such equity holdings amounted to about 15% of our insurance company investments versus the present 80%. There were as many good businesses around in 1972 as in 1982, but the prices the stock market placed upon those businesses in 1972 looked absurd. While high stock prices in the future would make our performance look good temporarily, they would hurt our long-term business prospects rather than help them. We currently are seeing early traces of this problem.”

Buffett’s Long Term Performance as of the end of 1982:

“During the 18-year tenure of present management, book value (per share of Berkshire Hathaway) has grown from $19.46 per share to $737.43 per share, or 22.0% compounded annually. You can be certain that this percentage will diminish in the future. Geometric progressions eventually forge their own anchors.”

“Berkshire’s economic goal remains to produce a long-term rate of return well above the return achieved by the average large American corporation. Our willingness to purchase either partial or total ownership positions in favorably-situated businesses, coupled with reasonable discipline about the prices we are willing to pay, should give us a good chance of achieving our goal.”

“Even if our partially-owned businesses (i.e. shares Berkshire owns in other companies) continue to perform well in an economic sense, there will be years when they perform poorly in the market. At such times our net worth could shrink significantly. We will not be distressed by such a shrinkage; if the businesses continue to look attractive and we have cash available, we simply will add to our holdings at even more favorable prices.”

“[O]ur largest area of business activity has been, and almost certainly will continue to be, the property-casualty insurance area. So commentary on developments in that industry is appropriate.”

Buffett described in some detail the business characteristics of the property insurance business during 1982 and his outlook. This is must-read material for anyone in the insurance business, click the link to 1982 above to access the full letter.

Within the insurance discussion, Buffett wrote that business conditions in general had recently become much more competitive for all those businesses that suffer from both over-capacity and a commodity type product..

“The conventional wisdom is that 1983 or 1984 will see the worst of underwriting experience and then, as in the past, the “cycle” will move, significantly and steadily, toward better results. We disagree because of a pronounced change in the competitive environment, hard to see for many years but now quite visible.”

“To understand the change, we need to look at some major factors that affect levels of corporate profitability generally. Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. These may be escaped, true, if prices or costs are administered in some manner and thereby insulated at least partially from normal market forces. This administration can be carried out (a) legally through government intervention (until recently, this category included pricing for truckers and deposit costs for financial institutions), (b) illegally through collusion, or (c) “extra- legally” through OPEC-style foreign cartelization (with tag-along benefits for domestic non-cartel operators).”

“If, however, costs and prices are determined by full-bore competition, there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. They may well be disastrous.”

“Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a “two-ounce candy bar”) but doesn’t work with sugar (how often do you hear, “I’ll have a cup of coffee with cream and C & H sugar, please”).”

“In many industries, differentiation simply can’t be made meaningful. A few producers in such industries may consistently do well if they have a cost advantage that is both wide and sustainable. By definition such exceptions are few, and, in many industries, are non-existent. For the great majority of companies selling “commodity”products, a depressing equation of business economics prevails: persistent over-capacity without administered prices (or costs) equals poor profitability.”

“Of course, over-capacity may eventually self-correct, either as capacity shrinks or demand expands. Unfortunately for the participants, such corrections often are long delayed. When they finally occur, the rebound to prosperity frequently produces a pervasive enthusiasm for expansion that, within a few years, again creates over-capacity and a new profitless environment. In other words, nothing fails like success.”

“What finally determines levels of long-term profitability in such industries is the ratio of supply-tight to supply-ample years. Frequently that ratio is dismal. (It seems as if the most recent supply-tight period in our textile business – it occurred some years back – lasted the better part of a morning.)”

“In some industries, however, capacity-tight conditions can last a long time. Sometimes actual growth in demand will outrun forecasted growth for an extended period. In other cases, adding capacity requires very long lead times because complicated manufacturing facilities must be planned and built.”

“But in the insurance business, to return to that subject, capacity can be instantly created by capital plus an underwriter’s willingness to sign his name. (Even capital is less important in a world in which state-sponsored guaranty funds protect many policyholders against insurer insolvency.) Under almost all conditions except that of fear for survival – produced, perhaps, by a stock market debacle or a truly major natural disaster – the insurance industry operates under the competitive sword of substantial overcapacity. Generally, also, despite heroic attempts to do otherwise, the industry sells a relatively undifferentiated commodity-type product. (Many insureds, including the managers of large businesses, do not even know the names of their insurers.) Insurance, therefore, would seem to be a textbook case of an industry usually faced with the deadly combination of excess capacity and a “commodity” product.”

“GEICO continues to be managed with a zeal for efficiency and value to the customer that virtually guarantees unusual success. Jack Byrne and Bill Snyder are achieving the most elusive of human goals – keeping things simple and remembering what you set out to do. In Lou Simpson, additionally, GEICO has the best investment manager in the property-casualty business. We are happy with every aspect of this operation. GEICO is a magnificent illustration of the high-profit exception we described earlier in discussing commodity industries with over- capacity – a company with a wide and sustainable cost advantage. Our 35% interest in GEICO represents about $250 million of premium volume, an amount considerably greater than all of the direct volume we produce.”

Buffett wrote about his views on when companies should issue new equity shares.

“Berkshire and Blue Chip are considering merger in 1983. If it takes place, it will involve an exchange of stock based upon an identical valuation method applied to both companies. The one other significant issuance of shares by Berkshire or its affiliated companies that occurred during present management’s tenure was in the 1978 merger of Berkshire with Diversified Retailing Company.”

“Our share issuances follow a simple basic rule: we will not issue shares unless we receive as much intrinsic business value as we give. Such a policy might seem axiomatic. Why, you might ask, would anyone issue dollar bills in exchange for fifty-cent pieces? Unfortunately, many corporate managers have been willing to do just that.”

“The first choice of these managers in making acquisitions may be to use cash or debt. But frequently the CEO’s cravings outpace cash and credit resources (certainly mine always have). Frequently, also, these cravings occur when his own stock is selling far below intrinsic business value. This state of affairs produces a moment of truth. At that point, as Yogi Berra has said, “You can observe a lot just by watching.” For shareholders then will find which objective the management truly prefers – expansion of domain or maintenance of owners’ wealth.”

“The need to choose between these objectives occurs for some simple reasons. Companies often sell in the stock market below their intrinsic business value. But when a company wishes to sell out completely, in a negotiated transaction, it inevitably wants to – and usually can – receive full business value in whatever kind of currency the value is to be delivered. If cash is to be used in payment, the seller’s calculation of value received couldn’t be easier. If stock of the buyer is to be the currency, the seller’s calculation is still relatively easy: just figure the market value in cash of what is to be received in stock.

“Meanwhile, the buyer wishing to use his own stock as currency for the purchase has no problems if the stock is selling in the market at full intrinsic value.

“But suppose it is selling at only half intrinsic value. In that case, the buyer is faced with the unhappy prospect of using a substantially undervalued currency to make its purchase.

“Ironically, were the buyer to instead be a seller of its entire business, it too could negotiate for, and probably get, full intrinsic business value. But when the buyer makes a partial sale of itself – and that is what the issuance of shares to make an acquisition amounts to – it can customarily get no higher value set on its shares than the market chooses to grant it.

“The acquirer who nevertheless barges ahead ends up using an undervalued (market value) currency to pay for a fully valued (negotiated value) property. In effect, the acquirer must give up $2 of value to receive $1 of value. Under such circumstances, a marvelous business purchased at a fair sales price becomes a terrible buy. For gold valued as gold cannot be purchased intelligently through the utilization of gold – or even silver – valued as lead.

“If, however, the thirst for size and action is strong enough, the acquirer’s manager will find ample rationalizations for such a value-destroying issuance of stock. Friendly investment bankers will reassure him as to the soundness of his actions. (Don’t ask the barber whether you need a haircut.)

“A few favorite rationalizations employed by stock-issuing managements follow:

(a) “The company we’re buying is going to be worth a lot more in the future.” (Presumably so is the interest in the old business that is being traded away; future prospects are implicit in the business valuation process. If 2X is issued for X, the imbalance still exists when both parts double in business value.)

(b) “We have to grow.” (Who, it might be asked, is the “we”? For present shareholders, the reality is that all existing businesses shrink when shares are issued. Were Berkshire to issue shares tomorrow for an acquisition, Berkshire would own everything that it now owns plus the new business, but your interest in such hard-to-match businesses as See’s Candy Shops, National Indemnity, etc. would automatically be reduced. If (1) your family owns a 120-acre farm and (2) you invite a neighbor with 60 acres of comparable land to merge his farm into an equal partnership – with you to be managing partner, then (3) your managerial domain will have grown to 180 acres but you will have permanently shrunk by 25% your family’s ownership interest in both acreage and crops. Managers who want to expand their domain at the expense of owners might better consider a career in government.)

(c) “Our stock is undervalued and we’ve minimized its use in this deal – but we need to give the selling shareholders 51% in stock and 49% in cash so that certain of those shareholders can get the tax-free exchange they want.” (This argument acknowledges that it is beneficial to the acquirer to hold down the issuance of shares, and we like that. But if it hurts the old owners to utilize shares on a 100% basis, it very likely hurts on a 51% basis. After all, a man is not charmed if a spaniel defaces his lawn, just because it’s a spaniel and not a St. Bernard. And the wishes of sellers can’t be the determinant of the best interests of the buyer – what would happen if, heaven forbid, the seller insisted that as a condition of merger the CEO of the acquirer be replaced?)

“There are three ways to avoid destruction of value for old owners when shares are issued for acquisitions. One is to have a true business-value-for-business-value merger, such as the Berkshire-Blue Chip combination is intended to be. Such a merger attempts to be fair to shareholders of both parties, with each receiving just as much as it gives in terms of intrinsic business value. The Dart Industries-Kraft and Nabisco Standard Brands mergers appeared to be of this type, but they are the exceptions. It’s not that acquirers wish to avoid such deals; it’s just that they are very hard to do.

“The second route presents itself when the acquirer’s stock sells at or above its intrinsic business value. In that situation, the use of stock as currency actually may enhance the wealth of the acquiring company’s owners. Many mergers were accomplished on this basis in the 1965-69 period. The results were the converse of most of the activity since 1970: the shareholders of the acquired company received very inflated currency (frequently pumped up by dubious accounting and promotional techniques) and were the losers of wealth through such transactions.

During recent years the second solution has been available to very few large companies. The exceptions have primarily been those companies in glamorous or promotional businesses to which the market temporarily attaches valuations at or above intrinsic business valuation.

The third solution is for the acquirer to go ahead with the acquisition, but then subsequently repurchase a quantity of shares equal to the number issued in the merger. In this manner, what originally was a stock-for-stock merger can be converted, effectively, into a cash-for-stock acquisition. Repurchases of this kind are damage-repair moves. Regular readers will correctly guess that we much prefer repurchases that directly enhance the wealth of owners instead of repurchases that merely repair previous damage. Scoring touchdowns is more exhilarating than recovering one’s fumbles. But, when a fumble has occurred, recovery is important and we heartily recommend damage-repair repurchases that turn a bad stock deal into a fair cash deal.

The language utilized in mergers tends to confuse the issues and encourage irrational actions by managers. For example, “dilution” is usually carefully calculated on a pro forma basis for both book value and current earnings per share. Particular emphasis is given to the latter item. When that calculation is negative (dilutive) from the acquiring company’s standpoint, a justifying explanation will be made (internally, if not elsewhere) that the lines will cross favorably at some point in the future. (While deals often fail in practice, they never fail in projections – if the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.) Should the calculation produce numbers that are immediately positive – that is, anti-dilutive – for the acquirer, no comment is thought to be necessary.

The attention given this form of dilution is overdone: current earnings per share (or even earnings per share of the next few years) are an important variable in most business valuations, but far from all powerful.

There have been plenty of mergers, non-dilutive in this limited sense, that were instantly value destroying for the acquirer. And some mergers that have diluted current and near- term earnings per share have in fact been value-enhancing. What really counts is whether a merger is dilutive or anti-dilutive in terms of intrinsic business value (a judgment involving consideration of many variables). We believe calculation of dilution from this viewpoint to be all-important (and too seldom made).

A second language problem relates to the equation of exchange. If Company A announces that it will issue shares to merge with Company B, the process is customarily described as “Company A to Acquire Company B”, or “B Sells to A”. Clearer thinking about the matter would result if a more awkward but more accurate description were used: “Part of A sold to acquire B”, or “Owners of B to receive part of A in exchange for their properties”. In a trade, what you are giving is just as important as what you are getting. This remains true even when the final tally on what is being given is delayed. Subsequent sales of common stock or convertible issues, either to complete the financing for a deal or to restore balance sheet strength, must be fully counted in evaluating the fundamental mathematics of the original acquisition. (If corporate pregnancy is going to be the consequence of corporate mating, the time to face that fact is before the moment of ecstasy.)

Managers and directors might sharpen their thinking by asking themselves if they would sell 100% of their business on the same basis they are being asked to sell part of it. And if it isn’t smart to sell all on such a basis, they should ask themselves why it is smart to sell a portion. A cumulation of small managerial stupidities will produce a major stupidity – not a major triumph. (Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.)

The “giving versus getting” factor can most easily be calculated in the case of registered investment companies. Assume Investment Company X, selling at 50% of asset value, wishes to merge with Investment Company Y. Assume, also, that Company X therefore decides to issue shares equal in market value to 100% of Y’s asset value.

Such a share exchange would leave X trading $2 of its previous intrinsic value for $1 of Y’s intrinsic value. Protests would promptly come forth from both X’s shareholders and the SEC, which rules on the fairness of registered investment company mergers. Such a transaction simply would not be allowed.

In the case of manufacturing, service, financial companies, etc., values are not normally as precisely calculable as in the case of investment companies. But we have seen mergers in these industries that just as dramatically destroyed value for the owners of the acquiring company as was the case in the hypothetical illustration above. This destruction could not happen if management and directors would assess the fairness of any transaction by using the same yardstick in the measurement of both businesses.

Finally, a word should be said about the “double whammy” effect upon owners of the acquiring company when value-diluting stock issuances occur. Under such circumstances, the first blow is the loss of intrinsic business value that occurs through the merger itself. The second is the downward revision in market valuation that, quite rationally, is given to that now-diluted business value. For current and prospective owners understandably will not pay as much for assets lodged in the hands of a management that has a record of wealth-destruction through unintelligent share issuances as they will pay for assets entrusted to a management with precisely equal operating talents, but a known distaste for anti-owner actions. Once management shows itself insensitive to the interests of owners, shareholders will suffer a long time from the price/value ratio afforded their stock (relative to other stocks), no matter what assurances management gives that the value-diluting action taken was a one- of-a-kind event.

Those assurances are treated by the market much as one-bug- in-the-salad explanations are treated at restaurants. Such explanations, even when accompanied by a new waiter, do not eliminate a drop in the demand (and hence market value) for salads, both on the part of the offended customer and his neighbors pondering what to order. Other things being equal, the highest stock market prices relative to intrinsic business value are given to companies whose managers have demonstrated their unwillingness to issue shares at any time on terms unfavorable to the owners of the business.

At Berkshire, or any company whose policies we determine (including Blue Chip and Wesco), we will issue shares only if our owners receive in business value as much as we give. We will not equate activity with progress or corporate size with owner- wealth.”

In closing the letter, Buffett acknowledged two of his retiring managers. Part of Buffett’s success was definitely due to buying companies with great managers in place.

“Two of our managerial stars retired this year: Phil Liesche at 65 from National Indemnity Company, and Ben Rosner at 79 from Associated Retail Stores. Both of these men made you, as shareholders of Berkshire, a good bit wealthier than you otherwise would have been. National Indemnity has been the most important operation in Berkshire’s growth. Phil and Jack Ringwalt, his predecessor, were the two prime movers in National Indemnity’s success. Ben Rosner sold Associated Retail Stores to Diversified Retailing Company for cash in 1967, promised to stay on only until the end of the year, and then hit business home runs for us for the next fifteen years.”

“Both Ben and Phil ran their businesses for Berkshire with every bit of the care and drive that they would have exhibited had they personally owned 100% of these businesses. No rules were necessary to enforce or even encourage this attitude; it was embedded in the character of these men long before we came on the scene. Their good character became our good fortune. If we can continue to attract managers with the qualities of Ben and Phil, you need not worry about Berkshire’s future.”


“[I]t’s appropriate to summarize the major business principles we follow that pertain to the manager-owner relationship:”

o Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we also are, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but, instead, view the company as a conduit through which our shareholders own the assets.

o In line with this owner-orientation, our directors are all major shareholders of Berkshire Hathaway. In the case of at least four of the five, over 50% of family net worth is represented by holdings of Berkshire. We eat our own cooking.

o Our long-term economic goal (subject to some qualifications mentioned later) is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future – a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.

o Our preference would be to reach this goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.

o Because of this two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.

o Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.

o We rarely use much debt and, when we do, we attempt to structure it on a long-term fixed rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, depositors, lenders and the many equity holders who have committed unusually large portions of their net worth to our care.

o A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.

o We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

o We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance – not only mergers or public stock offerings, but stock for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company – and that is what the issuance of shares amounts to – on a basis inconsistent with the value of the entire enterprise.

o You should be fully aware of one attitude Charlie and I share that hurts our financial performance: regardless of price, we have no interest at all in selling any good businesses that Berkshire owns, and are very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling – the advocates will be sincere – but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in it.

o We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: the CEO who misleads others in public may eventually mislead himself in private.

o Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore, we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say “no comment” on other occasions, the no-comments become confirmation.

Buffett discussed the acquisition of Nebraska Furniture Mart from 90 year old Rose Blumkin – with the Blumkin family retaining 10% (and a further 10% in options) and remaining as management. The story of how Mrs. Blumkin started the company and built it from scratch is interesting – see the full 1983 letter at the link just above.

“Today Nebraska Furniture Mart generates over $100 million of sales annually out of one 200,000 square-foot store. No other home furnishings store in the country comes close to that volume. That single store also sells more furniture, carpets, and appliances than do all Omaha competitors combined.”

“One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.”

“Louie Blumkin, Mrs. B’s son, has been President of Nebraska Furniture Mart for many years and is widely regarded as the shrewdest buyer of furniture and appliances in the country. Louie says he had the best teacher, and Mrs. B says she had the best student. They’re both right. Louie and his three sons all have the Blumkin business ability, work ethic, and, most important, character.”

Buffett commented on Berkshire’s corporate performance in terms of growth in book value which was a stellar 32%.

“We never take the one-year figure very seriously. After all, why should the time required for a planet to circle the sun synchronize precisely with the time required for business actions to pay off? Instead, we recommend not less than a five-year test as a rough yardstick of economic performance.”

“During the 19-year tenure of present management, book value has grown from $19.46 per share to $975.83, or 22.6% compounded annually. Considering our present size, nothing close to this rate of return can be sustained. Those who believe otherwise should pursue a career in sales, but avoid one in mathematics.”

“We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value – the measurement that really counts. Book value’s virtue as a score-keeping measure is that it is easy to calculate and doesn’t involve the subjective (but important) judgments employed in calculation of intrinsic business value. It is important to understand, however, that the two terms – book value and intrinsic business value – have very different meanings.”

“Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.”

“An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child’s education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously – from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.”

“At Berkshire, at the beginning of fiscal 1965 when the present management took over, the $19.46 per share book value considerably overstated intrinsic business value. All of that book value consisted of textile assets that could not earn, on average, anything close to an appropriate rate of return. In the terms of our analogy, the investment in textile assets resembled investment in a largely-wasted education.”

“Now, however, our intrinsic business value considerably exceeds book value. There are two major reasons:

(1) Standard accounting principles require that common stocks held by our insurance subsidiaries be stated on our books at market value, but that other stocks we own be carried at the lower of aggregate cost or market. At the end of 1983, the market value of this latter group exceeded carrying value by $70 million pre-tax, or about $50 million after tax. This excess belongs in our intrinsic business value, but is not included in the calculation of book value;

[InvestorsFriend understands that accounting rules have since changed and would now count all of the market value of investments in common stocks in book value]

(2) More important, we own several businesses that possess economic Goodwill (which is properly includable in intrinsic business value) far larger than the accounting Goodwill that is carried on our balance sheet and reflected in book value.”

“Goodwill, both economic and accounting, is an arcane subject and requires more explanation than is appropriate here. The appendix that follows this letter – “Goodwill and its Amortization: The Rules and The Realities” – explains why economic and accounting Goodwill can, and usually do, differ enormously.”

“You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.”

“Keynes identified my problem: “The difficulty lies not in the new ideas but in escaping from the old ones.” My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets.”

Buffett discussed the components or sources of Berkshire’s earnings and included the following comments:

“We regard any annual figure for realized capital gains or losses as meaningless, but we regard the aggregate realized and unrealized capital gains over a period of years as very important.”

“The table showing you our sources of earnings includes dividends from those non-controlled companies whose marketable equity securities we own. But the table does not include earnings those companies have retained that are applicable to our ownership. In aggregate and over time we expect those undistributed earnings to be reflected in market prices and to increase our intrinsic business value on a dollar-for-dollar basis, just as if those earnings had been under our control and reported as part of our profits. That does not mean we expect all of our holdings to behave uniformly; some will disappoint us, others will deliver pleasant surprises. To date our experience has been better than we originally anticipated, In aggregate, we have received far more than a dollar of market value gain for every dollar of earnings retained.”

Buffett discussed the Buffalo Newspaper business that Berkshire owned. We note the following comments:

“[T]he News has one exceptional strength: its acceptance by the public, a matter measured by the paper’s “penetration ratio” – the percentage of households within the community purchasing the paper each day. Our ratio is superb: for the six months ended September 30, 1983 the News stood number one in weekday penetration among the 100 largest papers in the United States.”

“We believe a paper’s penetration ratio to be the best measure of the strength of its franchise. Papers with unusually high penetration in the geographical area that is of prime interest to major local retailers, and with relatively little circulation elsewhere, are exceptionally efficient buys for those retailers. Low-penetration papers have a far less compelling message to present to advertisers.”

Buffett discussed the results at See’s Candy Shops. We note the following comments:

“In effect, raw material costs are largely beyond our control since we will, as a matter of course, buy the finest ingredients that we can, regardless of changes in their price levels. We regard product quality as sacred.”

“But other kinds of costs are more controllable, and it is in this area that we have had problems. On a per-pound basis, our costs (not including those for raw materials) have increased in the last few years at a rate significantly greater than the increase in the general price level. It is vital to our competitive position and profit potential that we reverse this trend.”

Buffett provided figures showing the vast increase in profits that had occurred at See’s in the 11 years that Buffett owned it. From those figures InvestorsFriend calculated the following:

Profits had grown 558% or almost 19% compounded per year.

Growth in pounds sold per store was relatively small at 17% or 1.5% per year. (Rather calling into question the obsession that retail analysts have with volume growth per store, these days).

Store-count growth was relatively small at 24% or 2.0% per year

Costs went up at 9.9% per year, which was lower than the price increases of 10.3% per year.

Price increases of 193% per pound sold, 10.3% per year compounded. (Not that much higher than the increase in costs per pound)

The result of the price increase of just 0.4% per year higher than the cost increase increased the markup over costs by 61% from 7.1% to 11.4%. Up 4.3%, or, not coincidently about 11 times the 0.4% average annual improvement. The lesson here is that in a low margin business, a tiny increase in margin each year adds up to a very big deal over the years.

Profit per pound sold rose 352% or 14.7% per year.

The increase in profit of 558% is explained by the increase in costs of 182%, the increase in the pounds per store of 17%, the increase in the store count of 24% and the increase in the margin of 61%. The key was not a massive increase in the margin but rather was the ability to increase prices fully (and a little more) with cost increases. That combined with a small volume increase and a modest increase in the store count.

Buffett stated:

“[W]e regard the most important measure of retail trends to be units sold per store rather than dollar volume.”

“See’s strengths are many and important. In our primary marketing area, the West, our candy is preferred by an enormous margin to that of any competitor. In fact, we believe most lovers of chocolate prefer it to candy costing two or three times as much. (In candy, as in stocks, price and value can differ; price is what you give, value is what you get.) The quality of customer service in our shops – operated throughout the country by us and not by franchisees is every bit as good as the product. Cheerful, helpful personnel are as much a trademark of See’s as is the logo on the box.”

Buffett discussed the insurance business:

(Anyone in the insurance business should click to the original complete letter and study this section)

“I made some serious mistakes a few years ago that came home to roost.”

“The industry had its worst underwriting year in a long time…”

“Though business policies may be changed and personnel improved, a significant period must pass before the effects are seen. (This characteristic of the business enabled us to make a great deal of money in GEICO; we could picture what was likely to happen well before it actually occurred.)”

“We have become active recently – and hope to become much more active – in reinsurance transactions where the buyer’s overriding concern should be the seller’s long-term creditworthiness. In such transactions our premier financial strength should make us the number one choice of both claimants and insurers who must rely on the reinsurer’s promises for a great many years to come.”

“A major source of such business is structured settlements – a procedure for settling losses under which claimants receive periodic payments (almost always monthly, for life) rather than a single lump sum settlement. This form of settlement has important tax advantages for the claimant and also prevents his squandering a large lump-sum payment. Frequently, some inflation protection is built into the settlement. Usually the claimant has been seriously injured, and thus the periodic payments must be unquestionably secure for decades to come. We believe we offer unparalleled security. No other insurer we know of – even those with much larger gross assets – has our financial strength.”

“We also think our financial strength should recommend us to companies wishing to transfer loss reserves. In such transactions, other insurance companies pay us lump sums to assume all (or a specified portion of) future loss payments applicable to large blocks of expired business. Here also, the company transferring such claims needs to be certain of the transferee’s financial strength for many years to come. Again, most of our competitors soliciting such business appear to us to have a financial condition that is materially inferior to ours.”

“Potentially, structured settlements and the assumption of loss reserves could become very significant to us.”

“Geico’s performance during 1983 was as good as our own insurance performance was poor. Compared to the industry’s combined ratio of 111, GEICO wrote at 96 after a large voluntary accrual for policyholder dividends. A few years ago I would not have thought GEICO could so greatly outperform the industry. Its superiority reflects the combination of a truly exceptional business idea and an exceptional management.”

Buffett discussed Stock Splits and Stock Trading Activity:

“Were we to split the stock or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the exiting class of sellers. At $1300, there are very few investors who can’t afford a Berkshire share. Would a potential one-share purchaser be better off if we split 100 for 1 so he could buy 100 shares? Those who think so and who would buy the stock because of the split or in anticipation of one would definitely downgrade the quality of our present shareholder group. (Could we really improve our shareholder group by trading some of our present clear-thinking members for impressionable new ones who, preferring paper to value, feel wealthier with nine $10 bills than with one $100 bill?) People who buy for non-value reasons are likely to sell for non-value reasons. Their presence in the picture will accentuate erratic price swings unrelated to underlying business developments.”

“One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as “marketability” and “liquidity”, sing the praises of companies with high share turnover (those who cannot fill your pocket will confidently fill your ear). But investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pickpocket of enterprise.”

“For example, consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on low-priced stocks) and if the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company’s net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the “frictional” cost of transfer. (And this calculation does not count option trading, which would increase frictional costs still further.)”

“All that makes for a rather expensive game of musical chairs. Can you imagine the agonized cry that would arise if a governmental unit were to impose a new 16 2/3% tax on earnings of corporations or investors? By market activity, investors can impose upon themselves the equivalent of such a tax.”

“(We are aware of the pie-expanding argument that says that such activities improve the rationality of the capital allocation process. We think that this argument is specious and that, on balance, hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy.)”

“Berkshire now has 1,146,909 shares outstanding compared to 1,137,778 shares at the beginning of fiscal 1965, the year present management assumed responsibility. For every 1% of the company you owned at that time, you now would own .99%. Thus, all of today’s assets – the (Buffalo) News, See’s, Nebraska Furniture Mart, the Insurance Group, $1.3 billion in marketable stocks, etc. – have been added to the original textile assets with virtually no net dilution to the original owners.”

From Appendix on Goodwill

“When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of the identifiable assets that are acquired. Frequently the sum of the fair values put on the assets (after the deduction of liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account entitled “excess of cost over equity in net assets acquired”. To avoid constant repetition of this mouthful, we will substitute “Goodwill”.

“Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed conservatively representative of future earning power in constant 1972 dollars.”

“Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic Goodwill.”

“In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return. Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based upon countless pleasant experiences they have had with both product and personnel.”

“Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and an enduring position as the low cost producer in an industry.”

Buffett noted that Berkshire had been required to amortize or charge to expenses one fortieth of the Goodwill each year. Below Buffett argues that this was not a “real ” expense. Later the accounting rules were changed so that goodwill no longer has to be amortized. This accounting change agrees with what Buffett was saying. However certain items that are very much like goodwill such as the value of customer contracts purchased in an acquisition still must be amortized. InvestorsFriend’s view is that most amortization of intangibles are not a real expense (an exception would be amortization of software investments which is a very real expense because software programs tend to become obsolete and have to be replaced).

“But what are the economic realities? One reality is that the amortization charges that have been deducted as costs in the earnings statement each year since acquisition of See’s were not true economic costs. We know that because See’s last year earned $13 million after taxes on about $20 million of net tangible assets – a performance indicating the existence of economic Goodwill far larger than the total original cost of our accounting Goodwill. In other words, while accounting Goodwill regularly decreased from the moment of purchase, economic Goodwill increased in irregular but very substantial fashion.”

“Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation.”

“That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no economic Goodwill.”

“A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast, we paid $25 million for See’s, even though it had no more in earnings and less than half as much in “honest-to-God” assets. Could less really have been more, as our purchase price implied? The answer is “yes” – even if both businesses were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.”

“To understand why, imagine the effect that a doubling of the price level would subsequently have on the two businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins remain unchanged, profits also must double.”

“But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And all of this inflation-required investment will produce no improvement in rate of return. The motivation for this investment is the survival of the business, not the prosperity of the owner.”

“Remember, however, that See’s had net tangible assets of only $8 million. So it would only have had to commit an additional $8 million to finance the capital needs imposed by inflation. The mundane business, meanwhile, had a burden over twice as large – a need for $18 million of additional capital.”

“After the dust had settled, the mundane business, now earning $4 million annually, might still be worth the value of its tangible assets, or $36 million. That means its owners would have gained only a dollar of nominal value for every new dollar invested. (This is the same dollar-for-dollar result they would have achieved if they had added money to a savings account.)”

“See’s, however, also earning $4 million, might be worth $50 million if valued (as it logically would be) on the same basis as it was at the time of our purchase. So it would have gained $25 million in nominal value while the owners were putting up only $8 million in additional capital – over $3 of nominal value gained for each $1 invested.”

“Remember, even so, that the owners of the See’s kind of business were forced by inflation to ante up $8 million in additional capital just to stay even in real profits. Any unleveraged business that requires some net tangible assets to operate (and almost all do) is hurt by inflation. Businesses needing little in the way of tangible assets simply are hurt the least.”

“And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom – long on tradition, short on wisdom – held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets (“In Goods We Trust”). It doesn’t work that way. Asset-heavy businesses generally earn low rates of return – rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.”

“In contrast, a disproportionate number of the great business fortunes built up during the inflationary years arose from ownership of operations that combined intangibles of lasting value with relatively minor requirements for tangible assets. In such cases earnings have bounded upward in nominal dollars, and these dollars have been largely available for the acquisition of additional businesses. This phenomenon has been particularly evident in the communications business. That business has required little in the way of tangible investment – yet its franchises have endured. During inflation, Goodwill is the gift that keeps giving.”

“But that statement applies, naturally, only to true economic Goodwill. Spurious accounting Goodwill – and there is plenty of it around – is another matter. When an overexcited management purchases a business at a silly price, the same accounting niceties described earlier are observed. Because it can’t go anywhere else, the silliness ends up in the Goodwill account. Considering the lack of managerial discipline that created the account, under such circumstances it might better be labeled “No-Will”. Whatever the term, the 40-year ritual typically is observed and the adrenalin so capitalized remains on the books as an “asset” just as if the acquisition had been a sensible one.”

“In analysis of operating results – that is, in evaluating the underlying economics of a business unit – amortization charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets, excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic attractiveness of the operation. It is also the best guide to the current value of the operation’s economic Goodwill.”

“A good business is not always a good purchase – although it’s a good place to look for one.”


“Our gain in net worth during 1984 was $152.6 million, or $133 per share. This sounds pretty good but actually it’s mediocre. Economic gains must be evaluated by comparison with the capital that produces them. Our twenty-year compounded annual gain in book value has been 22.1% (from $19.46 in 1964 to $1108.77 in 1984), but our gain in 1984 was only 13.6%.”

“Using my academic voice, I have told you in the past of the drag that a mushrooming capital base exerts upon rates of return. Unfortunately, my academic voice is now giving way to a reportorial voice. Our historical 22% rate is just that – history. To earn even 15% annually over the next decade (assuming we continue to follow our present dividend policy, about which more will be said later in this letter) we would need profits aggregating about $3.9 billion. Accomplishing this will require a few big ideas – small ones just won’t do. Charlie Munger, my partner in general management, and I do not have any such ideas at present, but our experience has been that they pop up occasionally. (How’s that for a strategic plan?)”

Buffett commented on share buy-backs by companies. He said, in part:

“When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.”

“The companies in which we have our largest investments have all engaged in significant stock repurhases (sic) at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons – one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.”

“The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.”

“The key word is “demonstrated”. A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth – and, after a while, neither will the market.”

“We have prospered in a very major way – as have other shareholders – by the large share repurchases of GEICO, Washington Post, and General Foods, our three largest holdings. (Exxon, in which we have our fourth largest holding, has also wisely and aggressively repurchased shares but, in this case, we have only recently established our position.) In each of these companies, shareholders have had their interests in outstanding businesses materially enhanced by repurchases made at bargain prices. We feel very comfortable owning interests in businesses such as these that offer excellent economics combined with shareholder-conscious managements.”

Buffett commented on his Nebraska Furniture Mart (NFM) and its economics and management (the then 91 years old Rose Blumkin and her offspring). He said, in part:

“In its fiscal 1984 10-K, the largest independent specialty retailer of home furnishings in the country, Levitz Furniture, described its prices as “generally lower than the prices charged by conventional furniture stores in its trading area”. Levitz, in that year, operated at a gross margin of 44.4% (that is, on average, customers paid it $100 for merchandise that had cost it $55.60 to buy). The gross margin at NFM is not much more than half of that. NFM’s low mark-ups are possible because of its exceptional efficiency: operating expenses (payroll, occupancy, advertising, etc.) are about 16.5% of sales versus 35.6% at Levitz.”

“None of this is in criticism of Levitz, which has a well- managed operation. But the NFM operation is simply extraordinary (and, remember, it all comes from a $500 investment by Mrs. B in 1937). By unparalleled efficiency and astute volume purchasing, NFM is able to earn excellent returns on capital while saving its customers at least $30 million annually from what, on average, it would cost them to buy the same merchandise at stores maintaining typical mark-ups. Such savings enable NFM to constantly widen its geographical reach and thus to enjoy growth well beyond the natural growth of the Omaha market.”

“I have been asked by a number of people just what secrets the Blumkins bring to their business. These are not very esoteric. All members of the family: (1) apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts; (2) define with extraordinary realism their area of special competence and act decisively on all matters within it; (3) ignore even the most enticing propositions failing outside of that area of special competence; and, (4) unfailingly behave in a high-grade manner with everyone they deal with. (Mrs. B boils it down to “sell cheap and tell the truth”.)”

“Our evaluation of the integrity of Mrs. B and her family was demonstrated when we purchased 90% of the business: NFM had never had an audit and we did not request one; we did not take an inventory nor verify the receivables; we did not check property titles. We gave Mrs. B a check for $55 million and she gave us her word. That made for an even exchange.”

Buffett made detailed comments on his highly profitable See’s Candies and it economics and management. We note in particular the following comment:

“This performance has not been produced by a generally rising tide. To the contrary, many well-known participants in the boxed-chocolate industry either have lost money in this same period or have been marginally profitable. To our knowledge, only one good-sized competitor has achieved high profitability. The success of See’s reflects the combination of an exceptional product and an exceptional manager, Chuck Huggins.”

Buffett made detailed comments on his Buffalo Evening News and its economics and management. He said, in part:

“Working in our favor at the News are two factors of major economic importance:”

“(1) Our circulation is concentrated to an unusual degree in the area of maximum utility to our advertisers. “Regional” newspapers with wide-ranging circulation, on the other hand, have a significant portion of their circulation in areas that are of negligible utility to most advertisers. A subscriber several hundred miles away is not much of a prospect for the puppy you are offering to sell via a classified ad – nor for the grocer with stores only in the metropolitan area. “Wasted” circulation – as the advertisers call it – hurts profitability: expenses of a newspaper are determined largely by gross circulation while advertising revenues (usually 70% – 80% of total revenues) are responsive only to useful circulation;”

“(2) Our penetration of the Buffalo retail market is exceptional; advertisers can reach almost all of their potential customers using only the News.”

“Last year I told you about this unusual reader acceptance: among the 100 largest newspapers in the country, we were then number one, daily, and number three, Sunday, in penetration. The most recent figures show us number one in penetration on weekdays and number two on Sunday. (Even so, the number of households in Buffalo has declined, so our current weekday circulation is down slightly; on Sundays it is unchanged.)”

“The economics of a dominant newspaper are excellent, among the very best in the business world. Owners, naturally, would like to believe that their wonderful profitability is achieved only because they unfailingly turn out a wonderful product. That comfortable theory wilts before an uncomfortable fact. While first-class newspapers make excellent profits, the profits of third-rate papers are as good or better – as long as either class of paper is dominant within its community. Of course, product quality may have been crucial to the paper in achieving dominance. We believe this was the case at the News, in very large part because of people such as Alfred Kirchhofer who preceded us.”

“Once dominant, the newspaper itself, not the marketplace, determines just how good or how bad the paper will be. Good or bad, it will prosper. That is not true of most businesses: inferior quality generally produces inferior economics. But even a poor newspaper is a bargain to most citizens simply because of its “bulletin board” value. Other things being equal, a poor product will not achieve quite the level of readership achieved by a first-class product. A poor product, however, will still remain essential to most citizens, and what commands their attention will command the attention of advertisers.”

Buffett made detailed comments on his insurance businesses and their economics and management. He said, in part: (any one in the insurance business should be sure to read his entire comments)

Buffett showed figures indicating that the combined ratio (insurance payouts plus all administrative and operating expenses divided by insurance revenue) was a horrible 118% for the industry as a whole.

“Our own combined ratio in 1984 was a humbling 134. (Here, as throughout this report, we exclude structured settlements and the assumption of loss reserves in reporting this ratio. Much additional detail, including the effect of discontinued operations on the ratio, appears on pages 42-43). This is the third year in a row that our underwriting performance has been far poorer than that of the industry. We expect an improvement in the combined ratio in 1985, and also expect our improvement to be substantially greater than that of the industry. Mike Goldberg has corrected many of the mistakes I made before he took over insurance operations. Moreover, our business is concentrated in lines that have experienced poorer-than-average results during the past several years, and that circumstance has begun to subdue many of our competitors and even eliminate some. With the competition shaken, we were able during the last half of 1984 to raise prices significantly in certain important lines with little loss of business.”

“For some years I have told you that there could be a day coming when our premier financial strength would make a real difference in the competitive position of our insurance operation. That day may have arrived. We are almost without question the strongest property/casualty insurance operation in the country, with a capital position far superior to that of well-known companies of much greater size.”

“Equally important, our corporate policy is to retain that superiority. The buyer of insurance receives only a promise in exchange for his cash. The value of that promise should be appraised against the possibility of adversity, not prosperity. At a minimum, the promise should appear able to withstand a prolonged combination of depressed financial markets and exceptionally unfavorable underwriting results. Our insurance subsidiaries are both willing and able to keep their promises in any such environment – and not too many other companies clearly are.”

“We have grown in these new lines of business: funds that we hold to offset assumed liabilities grew from $16.2 million to $30.6 million during the year. We expect growth to continue and perhaps to greatly accelerate. To support this projected growth we have added substantially to the capital of Columbia Insurance Company, our reinsurance unit specializing in structured settlements and loss reserve assumptions. While these businesses are very competitive, returns should be satisfactory.”

“At GEICO the news, as usual, is mostly good. That company achieved excellent unit growth in its primary insurance business during 1984, and the performance of its investment portfolio continued to be extraordinary. Though underwriting results deteriorated late in the year, they still remain far better than those of the industry. Our ownership in GEICO at yearend amounted to 36% and thus our interest in their direct property/casualty volume of $885 million amounted to $320 million, or well over double our own premium volume.”

“I have reported to you in the past few years that the performance of GEICO’s stock has considerably exceeded that company’s business performance, brilliant as the latter has been. In those years, the carrying value of our GEICO investment on our balance sheet grew at a rate greater than the growth in GEICO’s intrinsic business value. I warned you that over performance by the stock relative to the performance of the business obviously could not occur every year, and that in some years the stock must under perform the business. In 1984 that occurred and the carrying value of our interest in GEICO changed hardly at all, while the intrinsic business value of that interest increased substantially. Since 27% of Berkshire’s net worth at the beginning of 1984 was represented by GEICO, its static market value had a significant impact upon our rate of gain for the year. We are not at all unhappy with such a result: we would far rather have the business value of GEICO increase by X during the year, while market value decreases, than have the intrinsic value increase by only 1/2 X with market value soaring. In GEICO’s case, as in all of our investments, we look to business performance, not market performance. If we are correct in expectations regarding the business, the market eventually will follow along.”

“You, as shareholders of Berkshire, have benefited in enormous measure from the talents of GEICO’s Jack Byrne, Bill Snyder, and Lou Simpson. In its core business – low-cost auto and homeowners insurance – GEICO has a major, sustainable competitive advantage. That is a rare asset in business generally, and it’s almost non-existent in the field of financial services. (GEICO, itself, illustrates this point: despite the company’s excellent management, superior profitability has eluded GEICO in all endeavors other than its core business.) In a large industry, a competitive advantage such as GEICO’s provides the potential for unusual economic rewards, and Jack and Bill continue to exhibit great skill in realizing that potential.”

“Most of the funds generated by GEICO’s core insurance operation are made available to Lou for investment. Lou has the rare combination of temperamental and intellectual characteristics that produce outstanding long-term investment performance. Operating with below-average risk, he has generated returns that have been by far the best in the insurance industry. I applaud and appreciate the efforts and talents of these three outstanding managers.”

Buffett commented extensively on the topic of errors in loss reserving (estimates of future insurance payouts). We note, in particular, the following:

“Unfortunately, the financial statements of a property/casualty insurer provide, at best, only a first rough draft of earnings and financial condition.”

“The determination of costs is the main problem. Most of an insurer’s costs result from losses on claims, and many of the losses that should be charged against the current year’s revenue are exceptionally difficult to estimate. Sometimes the extent of these losses, or even their existence, is not known for decades.”

“The necessarily-extensive use of estimates in assembling the figures that appear in such deceptively precise form in the income statement of property/casualty companies means that some error must seep in, no matter how proper the intentions of management. In an attempt to minimize error, most insurers use various statistical techniques to adjust the thousands of individual loss evaluations (called case reserves) that comprise the raw data for estimation of aggregate liabilities. The extra reserves created by these adjustments are variously labeled “bulk”, “development”, or “supplemental” reserves. The goal of the adjustments should be a loss-reserve total that has a 50-50 chance of being proved either slightly too high or slightly too low when all losses that occurred prior to the date of the financial statement are ultimately paid.”

“Because our business is weighted toward casualty and reinsurance lines, we have more problems in estimating loss costs than companies that specialize in property insurance. (When a building that you have insured burns down, you get a much faster fix on your costs than you do when an employer you have insured finds out that one of his retirees has contracted a disease attributable to work he did decades earlier.) But I still find our errors embarrassing. In our direct business, we have far underestimated the mushrooming tendency of juries and courts to make the “deep pocket” pay, regardless of the factual situation and the past precedents for establishment of liability. We also have underestimated the contagious effect that publicity regarding giant awards has on juries. In the reinsurance area, where we have had our worst experience in under reserving, our customer insurance companies have made the same mistakes. Since we set reserves based on information they supply us, their mistakes have become our mistakes.”

“Not all reserving errors in the industry have been of the innocent-but-dumb variety. With underwriting results as bad as they have been in recent years – and with managements having as much discretion as they do in the presentation of financial statements – some unattractive aspects of human nature have manifested themselves. Companies that would be out of business if they realistically appraised their loss costs have, in some cases, simply preferred to take an extraordinarily optimistic view about these yet-to-be-paid sums. Others have engaged in various transactions to hide true current loss costs.”

“Both of these approaches can “work” for a considerable time: external auditors cannot effectively police the financial statements of property/casualty insurers. If liabilities of an insurer, correctly stated, would exceed assets, it falls to the insurer to volunteer this morbid information. In other words, the corpse is supposed to file the death certificate. Under this “honor system” of mortality, the corpse sometimes gives itself the benefit of the doubt.”

“In most businesses, of course, insolvent companies run out of cash. Insurance is different: you can be broke but flush. Since cash comes in at the inception of an insurance policy and losses are paid much later, insolvent insurers don’t run out of cash until long after they have run out of net worth. In fact, these “walking dead” often redouble their efforts to write business, accepting almost any price or risk, simply to keep the cash flowing in. With an attitude like that of an embezzler who has gambled away his purloined funds, these companies hope that somehow they can get lucky on the next batch of business and thereby cover up earlier shortfalls. Even if they don’t get lucky, the penalty to managers is usually no greater for a $100 million shortfall than one of $10 million; in the meantime, while the losses mount, the managers keep their jobs and perquisites.”

“The loss-reserving errors of other property/casualty companies are of more than academic interest to Berkshire. Not only does Berkshire suffer from sell-at-any-price competition by the “walking dead”, but we also suffer when their insolvency is finally acknowledged. Through various state guarantee funds that levy assessments, Berkshire ends up paying a portion of the insolvent insurers’ asset deficiencies, swollen as they usually are by the delayed detection that results from wrong reporting. There is even some potential for cascading trouble. The insolvency of a few large insurers and the assessments by state guarantee funds that would follow could imperil weak-but- previously-solvent insurers. Such dangers can be mitigated if state regulators become better at prompt identification and termination of insolvent insurers, but progress on that front has been slow.”

Buffett commented extensively on his purchase of discounted bonds of a troubled power utility. His comments compared the purchase of bonds to the purchase of a business. He also addressed here portfolio concentration versus diversification. We have copied here his entire comments:

“From October, 1983 through June, 1984 Berkshire’s insurance subsidiaries continuously purchased large quantities of bonds of Projects 1, 2, and 3 of Washington Public Power Supply System (“WPPSS”). This is the same entity that, on July 1, 1983, defaulted on $2.2 billion of bonds issued to finance partial construction of the now-abandoned Projects 4 and 5. While there are material differences in the obligors, promises, and properties underlying the two categories of bonds, the problems of Projects 4 and 5 have cast a major cloud over Projects 1, 2, and 3, and might possibly cause serious problems for the latter issues. In addition, there have been a multitude of problems related directly to Projects 1, 2, and 3 that could weaken or destroy an otherwise strong credit position arising from guarantees by Bonneville Power Administration.”

“Despite these important negatives, Charlie and I judged the risks at the time we purchased the bonds and at the prices Berkshire paid (much lower than present prices) to be considerably more than compensated for by prospects of profit.”

“As you know, we buy marketable stocks for our insurance companies based upon the criteria we would apply in the purchase of an entire business. This business-valuation approach is not widespread among professional money managers and is scorned by many academics. Nevertheless, it has served its followers well (to which the academics seem to say, “Well, it may be all right in practice, but it will never work in theory.”) Simply put, we feel that if we can buy small pieces of businesses with satisfactory underlying economics at a fraction of the per-share value of the entire business, something good is likely to happen to us – particularly if we own a group of such securities.”

“We extend this business-valuation approach even to bond purchases such as WPPSS. We compare the $139 million cost of our yearend investment in WPPSS to a similar $139 million investment in an operating business. In the case of WPPSS, the “business” contractually earns $22.7 million after tax (via the interest paid on the bonds), and those earnings are available to us currently in cash. We are unable to buy operating businesses with economics close to these. Only a relatively few businesses earn the 16.3% after tax on unleveraged capital that our WPPSS investment does and those businesses, when available for purchase, sell at large premiums to that capital. In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre- tax) might command a price of $250 – $300 million (or sometimes far more). For a business we understand well and strongly like, we will gladly pay that much. But it is double the price we paid to realize the same earnings from WPPSS bonds.”

“However, in the case of WPPSS, there is what we view to be a very slight risk that the “business” could be worth nothing within a year or two. There also is the risk that interest payments might be interrupted for a considerable period of time. Furthermore, the most that the “business” could be worth is about the $205 million face value of the bonds that we own, an amount only 48% higher than the price we paid.”

“This ceiling on upside potential is an important minus. It should be realized, however, that the great majority of operating businesses have a limited upside potential also unless more capital is continuously invested in them. That is so because most businesses are unable to significantly improve their average returns on equity – even under inflationary conditions, though these were once thought to automatically raise returns.”

“(Let’s push our bond-as-a-business example one notch further: if you elect to “retain” the annual earnings of a 12% bond by using the proceeds from coupons to buy more bonds, earnings of that bond “business” will grow at a rate comparable to that of most operating businesses that similarly reinvest all earnings. In the first instance, a 30-year, zero-coupon, 12% bond purchased today for $10 million will be worth $300 million in 2015. In the second, a $10 million business that regularly earns 12% on equity and retains all earnings to grow, will also end up with $300 million of capital in 2015. Both the business and the bond will earn over $32 million in the final year.)”

“Our approach to bond investment – treating it as an unusual sort of “business” with special advantages and disadvantages – may strike you as a bit quirky. However, we believe that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. For example, in 1946, 20-year AAA tax-exempt bonds traded at slightly below a 1% yield. In effect, the buyer of those bonds at that time bought a “business” that earned about 1% on “book value” (and that, moreover, could never earn a dime more than 1% on book), and paid 100 cents on the dollar for that abominable business.”

“If an investor had been business-minded enough to think in those terms – and that was the precise reality of the bargain struck – he would have laughed at the proposition and walked away. For, at the same time, businesses with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, or 15% after tax on book. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar, although less extreme, conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards. (In what I think is by far the best book on investing ever written – “The Intelligent Investor”, by Ben Graham – the last section of the last chapter begins with, “Investment is most intelligent when it is most businesslike.” This section is called “A Final Word”, and it is appropriately titled.)”

“We will emphasize again that there is unquestionably some risk in the WPPSS commitment. It is also the sort of risk that is difficult to evaluate. Were Charlie and I to deal with 50 similar evaluations over a lifetime, we would expect our judgment to prove reasonably satisfactory. But we do not get the chance to make 50 or even 5 such decisions in a single year. Even though our long-term results may turn out fine, in any given year we run a risk that we will look extraordinarily foolish. (That’s why all of these sentences say “Charlie and I”, or “we”.)”

“Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)”

“Our equation is different. With 47% of Berkshire’s stock, Charlie and I don’t worry about being fired, and we receive our rewards as owners, not managers. Thus we behave with Berkshire’s money as we would with our own. That frequently leads us to unconventional behavior both in investments and general business management.”

“We remain unconventional in the degree to which we concentrate the investments of our insurance companies, including those in WPPSS bonds. This concentration makes sense only because our insurance business is conducted from a position of exceptional financial strength. For almost all other insurers, a comparable degree of concentration (or anything close to it) would be totally inappropriate. Their capital positions are not strong enough to withstand a big error, no matter how attractive an investment opportunity might appear when analyzed on the basis of probabilities.”

“With our financial strength we can own large blocks of a few securities that we have thought hard about and bought at attractive prices. (Billy Rose described the problem of over- diversification: “If you have a harem of forty women, you never get to know any of them very well.”) Over time our policy of concentration should produce superior results, though these will be tempered by our large size. When this policy produces a really bad year, as it must, at least you will know that our money was committed on the same basis as yours.”

“We made the major part of our WPPSS investment at different prices and under somewhat different factual circumstances than exist at present. If we decide to change our position, we will not inform shareholders until long after the change has been completed. (We may be buying or selling as you read this.) The buying and selling of securities is a competitive business, and even a modest amount of added competition on either side can cost us a great deal of money. Our WPPSS purchases illustrate this principle. From October, 1983 through June, 1984, we attempted to buy almost all the bonds that we could of Projects 1, 2, and 3. Yet we purchased less than 3% of the bonds outstanding. Had we faced even a few additional well-heeled investors, stimulated to buy because they knew we were, we could have ended up with a materially smaller amount of bonds, purchased at a materially higher price. (A couple of coat-tail riders easily could have cost us $5 million.) For this reason, we will not comment about our activities in securities – neither to the press, nor shareholders, nor to anyone else – unless legally required to do so.”

“One final observation regarding our WPPSS purchases: we dislike the purchase of most long-term bonds under most circumstances and have bought very few in recent years. That’s because bonds are as sound as a dollar – and we view the long- term outlook for dollars as dismal. We believe substantial inflation lies ahead, although we have no idea what the average rate will turn out to be. Furthermore, we think there is a small, but not insignificant, chance of runaway inflation.”

“Such a possibility may seem absurd, considering the rate to which inflation has dropped. But we believe that present fiscal policy – featuring a huge deficit – is both extremely dangerous and difficult to reverse. (So far, most politicians in both parties have followed Charlie Brown’s advice: “No problem is so big that it can’t be run away from.”) Without a reversal, high rates of inflation may be delayed (perhaps for a long time), but will not be avoided. If high rates materialize, they bring with them the potential for a runaway upward spiral.”

“While there is not much to choose between bonds and stocks (as a class) when annual inflation is in the 5%-10% range, runaway inflation is a different story. In that circumstance, a diversified stock portfolio would almost surely suffer an enormous loss in real value. But bonds already outstanding would suffer far more. Thus, we think an all-bond portfolio carries a small but unacceptable “wipe out” risk, and we require any purchase of long-term bonds to clear a special hurdle. Only when bond purchases appear decidedly superior to other business opportunities will we engage in them. Those occasions are likely to be few and far between.”

Buffett commented extensively on the topic of Dividend Policy – when a company should pay a dividend and when it should not. His entire comments were:

“Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI”. And that’s it – no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.”

“The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion – let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.”

“Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Meanwhile, at construction and maintenance sites throughout New York, signs proudly proclaimed the corporate slogan, “Dig We Must”.)”

“Restricted earnings need not concern us further in this dividend discussion. Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.”

“This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

“To illustrate, let’s assume that an investor owns a risk- free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or- reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.”

“If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course – reinvestment of the coupon – would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.”

“An analysis similar to that made by our hypothetical bondholder is appropriate for owners in thinking about whether a company’s unrestricted earnings should be retained or paid out. Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.”

“Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.”

“With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO’s business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% – and market rates are 10% – he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.”

“In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return (as was discussed in last year’s section on Goodwill). But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.”

“Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)”

“In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners’ interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.”

“Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.”

“Let’s now turn to Berkshire Hathaway and examine how these dividend principles apply to it. Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.”

“In fact, significant distributions in the early years might have been disastrous, as a review of our starting position will show you. Charlie and I then controlled and managed three companies, Berkshire Hathaway Inc., Diversified Retailing Company, Inc., and Blue Chip Stamps (all now merged into our present operation). Blue Chip paid only a small dividend, Berkshire and DRC paid nothing. If, instead, the companies had paid out their entire earnings, we almost certainly would have no earnings at all now – and perhaps no capital as well. The three companies each originally made their money from a single business: (1) textiles at Berkshire; (2) department stores at Diversified; and (3) trading stamps at Blue Chip. These cornerstone businesses (carefully chosen, it should be noted, by your Chairman and Vice Chairman) have, respectively, (1) survived but earned almost nothing, (2) shriveled in size while incurring large losses, and (3) shrunk in sales volume to about 5% its size at the time of our entry. (Who says “you can’t lose ‘em all”?) Only by committing available funds to much better businesses were we able to overcome these origins. (It’s been like overcoming a misspent youth.) Clearly, diversification has served us well.”

“We expect to continue to diversify while also supporting the growth of current operations though, as we’ve pointed out, our returns from these efforts will surely be below our historical returns. But as long as prospective returns are above the rate required to produce a dollar of market value per dollar retained, we will continue to retain all earnings. Should our estimate of future returns fall below that point, we will distribute all unrestricted earnings that we believe can not be effectively used. In making that judgment, we will look at both our historical record and our prospects. Because our year-to-year results are inherently volatile, we believe a five-year rolling average to be appropriate for judging the historical record.”

“Our present plan is to use our retained earnings to further build the capital of our insurance companies. Most of our competitors are in weakened financial condition and reluctant to expand substantially. Yet large premium-volume gains for the industry are imminent, amounting probably to well over $15 billion in 1985 versus less than $5 billion in 1983. These circumstances could produce major amounts of profitable business for us. Of course, this result is no sure thing, but prospects for it are far better than they have been for many years.”

1985 – ????

Note, All other years are available at this link. These annual letters constitute “The Best Investment Book [N]ever Written”.