1979 Letter to Berkshire Shareholders
BERKSHIRE HATHAWAY INC.
To the Shareholders of Berkshire Hathaway Inc.:
Again, we must lead off with a few words about accounting. Since our last annual report, accounting rules have been adopted requiring insurance companies to consolidate the financial statements of all insurance subsidiaries in which they have a majority voting interest. This requirement contrasts with the previous practice which permitted such subsidiaries to be carried on an “equity” basis. In equity accounting, only the net profit or loss of the subsidiary was reflected on the parent’s books. Berkshire Hathaway has, since 1967, carried National Indemnity Company and its subsidiaries on an equity basis. The new accounting rules require that, instead of the single profit or loss entry on Berkshire’s books, we now must bring to the parent’s books all of the assets and liabilities of the insurance subsidiaries.
As indicated in our 1978 annual report, we believe that the new rules result in presentation of the economic realities of an insurance operation more accurately and more promptly than did equity accounting. We strongly endorse the adoption of the new rules. In particular, we believe that equity accounting has allowed managements of insurance companies to obscure operating losses for long periods while presenting to shareholders an altogether misleading picture of underlying economics. In the case of Berkshire Hathaway, the switch to the new accounting rules does not significantly change reported aggregate profits, but does result in significantly different presentation of both profit and loss elements. Our profit figures now will reflect in full the underwriting loss of our insurance subsidiaries, even though such loss may be offset by large investment gains attributable to the operations that produced the underwriting loss. Most of such investment gains (interest and dividends, but not realized capital gains) are, under the old rules, reflected in our consolidated figures.
During 1978 our insurance subsidiaries produced an underwriting loss of 17 million. Thus, our insurance operations, in aggregate, produced a profit of approximately 15 million aggregate profit as a single entry in our consolidated figures. Under the new rules we will show, in the insurance section of our business, a 17 million of investment income. The result, net, is the same - $15 million of profit. But the presentation is quite different. Under equity accounting, shareholders were denied the opportunity to see the relationship between underwriting loss and investment income. They could not judge the economics of the insurance business because loss data were suppressed. Thus, they could not judge whether the insurance operation was truly profitable or was surviving only because of large investment gains. The new accounting rules eliminate this problem.
The impact on Berkshire’s net worth of the adoption of the new accounting rules was minimal. Our consolidated net worth was affected only to the extent that we reduced the carrying value of National Indemnity’s investment in our affiliate, Blue Chip Stamps, to conform to the new rules. (Blue Chip Stamps is a publicly-traded company in which Berkshire Hathaway and its subsidiaries hold approximately 54% of the stock. The remaining 46% is held by about 2,000 other shareholders.) As explained in Note 1 to our financial statements, this reduction in net worth had the effect of increasing the net worth attributable to Berkshire’s shareholders by approximately $1.3 million. We believe this adjustment results in a more meaningful presentation of net worth in our consolidated balance sheet.
Operating Results
We continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity is the most appropriate measure of single-year managerial performance. Inflation and some other items that can significantly affect net worth make the use of absolute dollar figures of earnings, or earnings per share, of questionable utility in measuring operating performance. For example, while a 20% return on equity will produce the same absolute dollar result in a year when net worth is 20 million, we believe the latter result to be much more impressive. Even a completely dormant savings account will produce steadily increasing annual interest earnings because of compounding, even though the interest rate remains unchanged. Similarly, a dormant business with a constant return on equity will produce steadily increasing earnings simply by retaining all earnings and reinvesting them in the business. Thus, measurement of managerial economic performance must recognize the facts of both the return on equity achieved and the retention of earnings.
Our operating earnings in 1979 approximated 18.6% of beginning net worth. This compares with 19.4% in 1978. We believe that 1979 was a reasonably good year, but not outstanding, in terms of operating results. Our textile operation had a poor year and our banking operation had a very good year. Our insurance operation, in aggregate, produced reasonable results but, as explained below, we expect a substantial deterioration in insurance underwriting results in 1980. For reasons set forth in last year’s report, we believe the measurement of operating earnings as a percentage of beginning net worth to be a meaningful one. However, it must be recognized that any such measurement is based upon a single year’s results and, therefore, is subject to the distortions attendant upon any short-term measurement. For example, insurance underwriting results are highly volatile and should be measured over a period of several years.
It should be noted that the calculation of return on equity, as we utilize it, excludes capital gains or losses, both realized and unrealized. We feel that inclusion of such items, particularly on a single-year basis, would produce a distorted picture of operating results. While capital gains are as much a part of overall investment results as are dividends and interest, we feel they should not be counted in measuring the results of a single year’s operation. After all, a capital gain is realized only when the underlying security is sold and, up until that time, is subject to significant fluctuation. Capital gains, in effect, often are realized in years following the period in which the value increase actually occurred.
In any year, the amount of realized capital gains or losses is largely a function of stock market movements in earlier years, and also reflects decisions made in earlier years regarding which securities to purchase. For example, we realized substantial capital gains in 1977 reflecting stock market increases that occurred primarily in 1975 and 1976. We made most of the purchases giving rise to those gains in 1974 and early 1975. Thus, inclusion of realized capital gains in a single-year operating earnings figure would reflect, to a significant extent, events and decisions of earlier years.
Our insurance subsidiaries, in aggregate, realized net capital gains of 6.9 million in 1978. We expect the pace of capital gain realizations to diminish in future years as the market value of our equity portfolio increases, and as we find fewer attractive opportunities for reinvestment of realized gains.
We have suggested in past reports that measurement of operating earnings on a percentage-of-net-worth basis can be distorted by unusual debt-equity ratios. Such distortion is especially applicable to financial institutions, including insurance companies. Most banks and insurance companies operate with very high debt-equity ratios, often 20:1 or more. Thus, even a very small positive spread between the rate earned on assets and the cost of liabilities can produce a very high return on equity. However, a very small negative spread can wipe out equity. Thus, institutions operating with high debt-equity ratios should not be given credit for very high returns on equity when the spread is positive. Conversely, they should not be penalized heavily for low returns on equity when the spread is negative. Recognition should be given to the fact that the institution is operating on a very high leverage base that exaggerates both positive and negative results.
We believe that meaningful measurement of operating performance of a financial institution must reflect both the level of return on equity and the level of risk inherent in the business operation. The risk factor largely reflects the degree of leverage in the operation. We have attempted to reflect both return and risk in the measurement of our insurance operations. We have reduced net worth by excluding unrealized appreciation in equity securities (and by including unrealized depreciation). The effect of this adjustment is to produce a net worth figure that better reflects the true equity underlying our insurance operations, and to produce a return on equity figure that more accurately reflects the level of risk inherent in our operations.
We have reported in the past that we believe the better measurement of insurance underwriting profitability to be the “combined ratio”. This ratio compares total operating costs and losses incurred to premiums earned. A ratio below 100 indicates an underwriting profit; a ratio above 100 indicates an underwriting loss. We believe that, over time, the combined ratio is the most important single determinant of insurance company profitability. The ratio reflects the pure profitability of the insurance underwriting function, without distortion from investment results. However, it should be noted that the combined ratio is an imperfect measure because it does not reflect the important fact that insurance operations generate investment income. An insurance company can operate at a combined ratio above 100 and still produce an overall profit if the investment income exceeds the underwriting loss. But, over time, combined ratio results will dominate.
Our insurance subsidiaries, in aggregate, had a combined ratio of approximately 100.7 in 1979. This compares with 98.2 in 1978. We believe the 1978 figure was unusually good and that the 1979 figure is closer to the level we can reasonably expect over a longer period. However, as explained below, we expect a significant deterioration in combined ratio results in 1980.
Insurance Operations
Our insurance subsidiaries had premium volume of 151 million in 1977. We believe this growth rate to be somewhat above that of the industry generally and to be relatively healthy, given our underwriting standards and pricing philosophy. However, we expect the rate of growth to diminish significantly in 1980 and 1981.
The insurance industry is experiencing significant adverse trends in both pricing and cost. Rates increased sharply during 1976 and 1977, but the pace of increase slowed materially during 1978 and 1979. We estimate that industry rates increased by less than 5% during 1979. However, claims costs, driven by both monetary and social inflation, are increasing at a rate approximating 1% per month. Thus, unless rates increase at a comparable rate, underwriting profit margins must shrink. During 1979 the industry rate increases lagged significantly behind cost increases, and we believe the lag will widen in 1980. Thus, we expect industry underwriting results to deteriorate significantly.
Our own combined ratio of approximately 100.7 in 1979 reflects the fact that we maintained our rates at levels somewhat above industry averages. However, even our rates did not fully reflect cost increases, and we expect our combined ratio to deteriorate in 1980 to a level approximating 105 or higher.
Phil Liesche’s operation at National Indemnity Company again produced outstanding results in 1979, with a combined ratio of approximately 94. This operation is unique in its ability to produce excellent underwriting results while also generating large premium volume. Phil’s operation produced premium volume of 76 million in 1978. We believe this growth rate to be healthy, but we expect the rate of growth to slow in 1980 as we maintain our pricing standards in an increasingly competitive market.
The homestate insurance operation, managed by John Ringwalt, had a combined ratio of approximately 104 in 1979. This compares with approximately 99 in 1978. We believe the deterioration primarily reflects adverse trends in the general insurance market, although some of it reflects problems specific to our operation. We expect the homestate operation to have a combined ratio of approximately 108 to 110 in 1980.
John Seward’s operation at Home and Automobile Insurance Company produced satisfactory results in 1979, with a combined ratio of approximately 101. This operation has made significant progress since 1975 when it had a combined ratio of approximately 115. However, we expect Home and Auto to have a combined ratio of approximately 105 to 107 in 1980.
Our reinsurance operation, managed by George Young, had a combined ratio of approximately 107 in 1979. This compares with approximately 107 in 1978. The reinsurance market has been highly competitive during recent years, and we expect continued difficult conditions in 1980. We believe George Young has managed this operation well under difficult conditions.
We continue to believe that the insurance business offers significant opportunities for profit over the long term. However, we also believe that the industry currently is experiencing significant adverse trends that will produce difficult conditions for most operators during the next few years. Our goal is to maintain our underwriting standards and pricing discipline, even if it means accepting a significant reduction in premium volume. We believe that such discipline will produce satisfactory results over the long term, even though it may produce unsatisfactory combined ratios during the next few years.
Insurance Investments
Our insurance subsidiaries had investments at cost (excluding the investment in Blue Chip Stamps) of approximately 253 million at yearend 1978. The increase reflects growth in insurance reserves produced by premium volume growth, plus retained earnings. Net investment income of the insurance subsidiaries approximated 12.3 million in 1978.
Our equity holdings at yearend 1979 with a market value of over $5 million were as follows:
| No. of Shares | Company | Cost ($000) | Market ($000) |
|---|---|---|---|
| 1,871,692 | American Broadcasting Companies, Inc. | 8,533 | 26,871 |
| 1,294,308 | Government Employees Insurance Co. Common Stock | 4,116 | 9,600 |
| 592,650 | The Interpublic Group of Companies, Inc. | 4,531 | 15,165 |
| 226,900 | Knight-Ridder Newspapers, Inc. | 7,534 | 12,190 |
| 170,800 | Ogilvy & Mather International, Inc. | 2,762 | 4,930 |
| 451,720 | SAFECO Corporation | 7,929 | 13,015 |
| 268,400 | The Washington Post Company Class B | 2,896 | 14,045 |
| Total | 37,061 | 95,616 | |
| All Other Holdings | 51,833 | 72,907 | |
| Total Equities | 88,894 | 168,523 |
We have discussed in past reports our philosophy regarding equity investments. We select equity investments in much the same manner as we would select a business for acquisition. We want the business to be one that we can understand, with favorable long-term prospects, operated by honest and competent people, and available at a very attractive price. We ordinarily make no attempt to buy equities for anticipated favorable short-term price behavior. Instead, we welcome lower market prices for stocks we own if their business experience continues to satisfy us, since such lower prices give us the opportunity to increase our ownership of good businesses at better prices.
Our equity investments are concentrated in a relatively few companies. This concentration reflects our belief that truly outstanding businesses are very difficult to find and, when found, should be purchased in meaningful quantities. We do not believe that meaningful diversification is required for intelligent investment, and we believe that diversification often is practiced simply to protect against the consequences of ignorance. We would much prefer to have a meaningful position in a few outstanding businesses than to have small positions in many mediocre businesses.
The current market values of our equity holdings are significantly above our cost. However, we have no intention of selling these holdings merely because the prices have risen. We believe that these businesses have excellent long-term prospects and that the current market prices, while above our cost, are reasonable in relation to underlying business value. We intend to hold these positions for many years and expect that business results over that period will produce satisfactory investment results.
Banking
The Illinois National Bank continued its outstanding record in 1979. Under the leadership of Peter Jeffrey, the bank achieved earnings of approximately $4.1 million, a record. The bank continues to pay maximum rates to savers and maintains an asset position combining low risk and exceptional liquidity. We believe the bank to be one of the best-managed and most profitable banks of its size in the United States.
Gene Abegg continues as Chairman, and his wisdom and experience remain invaluable. We are fortunate to have both Gene Abegg and Peter Jeffrey managing our banking operation.
Retail Operations
Associated Retail Stores, Inc., which operates a chain of women’s apparel stores in Nebraska and Iowa, had an excellent year in 1979. Earnings were up significantly from 1978, and the operation continues to produce very good results with minimal capital requirements. Ben Rosner, who manages this operation, continues to do an outstanding job.
Blue Chip Stamps
We owned approximately 58% of Blue Chip Stamps at yearend 1979, compared to approximately 54% at yearend 1978. Blue Chip had an excellent year in 1979, with operating earnings of approximately 2.6 million.
See’s Candies, a wholly-owned subsidiary of Blue Chip Stamps, had an excellent year. Earnings before tax were approximately 12.6 million in 1978. Chuck Huggins continues to manage See’s with great skill. Since we purchased See’s in 1972, its earnings have grown from 13 million with minimal additional capital investment.
Wesco Financial Corporation, an 80%-owned subsidiary of Blue Chip Stamps, also had a good year. Louis Vincenti continues to manage Wesco effectively.
Shareholders of Berkshire Hathaway may obtain the annual report of Blue Chip Stamps by writing to Mr. Robert H. Bird, Blue Chip Stamps, 5801 South Eastern Avenue, Los Angeles, California 90040.
Warren E. Buffett, Chairman March 3, 1980
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