Our insurance business has also made some important non-
financial gains during the last few years. Mike Goldberg, its
manager, has assembled a group of talented professionals to write
larger risks and unusual coverages. His operation is now well
equipped to handle the lines of business that will occasionally
offer us major opportunities.

Our loss reserve development, detailed on pages 41-42, looks
better this year than it has previously. But we write lots of
"long-tail" business - that is, policies generating claims that
often take many years to resolve. Examples would be product
liability, or directors and officers liability coverages. With a
business mix like this, one year of reserve development tells you
very little.

You should be very suspicious of any earnings figures
reported by insurers (including our own, as we have unfortunately
proved to you in the past). The record of the last decade shows
that a great many of our best-known insurers have reported
earnings to shareholders that later proved to be wildly
erroneous. In most cases, these errors were totally innocent:
The unpredictability of our legal system makes it impossible for
even the most conscientious insurer to come close to judging the
eventual cost of long-tail claims.

Nevertheless, auditors annually certify the numbers given
them by management and in their opinions unqualifiedly state that
these figures "present fairly" the financial position of their
clients. The auditors use this reassuring language even though
they know from long and painful experience that the numbers so
certified are likely to differ dramatically from the true
earnings of the period. Despite this history of error, investors
understandably rely upon auditors' opinions. After all, a
declaration saying that "the statements present fairly" hardly
sounds equivocal to the non-accountant.

The wording in the auditor's standard opinion letter is
scheduled to change next year. The new language represents
improvement, but falls far short of describing the limitations of
a casualty-insurer audit. If it is to depict the true state of
affairs, we believe the standard opinion letter to shareholders
of a property-casualty company should read something like: "We
have relied upon representations of management in respect to the
liabilities shown for losses and loss adjustment expenses, the
estimate of which, in turn, very materially affects the earnings
and financial condition herein reported. We can express no
opinion about the accuracy of these figures. Subject to that
important reservation, in our opinion, etc."

If lawsuits develop in respect to wildly inaccurate
financial statements (which they do), auditors will definitely
say something of that sort in court anyway. Why should they not
be forthright about their role and its limitations from the
outset?

We want to emphasize that we are not faulting auditors for
their inability to accurately assess loss reserves (and therefore
earnings). We fault them only for failing to publicly
acknowledge that they can't do this job.

From all appearances, the innocent mistakes that are
constantly made in reserving are accompanied by others that are
deliberate. Various charlatans have enriched themselves at the
expense of the investing public by exploiting, first, the
inability of auditors to evaluate reserve figures and, second,
the auditors' willingness to confidently certify those figures as
if they had the expertise to do so. We will continue to see such
chicanery in the future. Where "earnings" can be created by the
stroke of a pen, the dishonest will gather. For them, long-tail
insurance is heaven. The audit wording we suggest would at least
serve to put investors on guard against these predators.

The taxes that insurance companies pay - which increased
materially, though on a delayed basis, upon enactment of the Tax
Reform Act of 1986 - took a further turn for the worse at the end
of 1987. We detailed the 1986 changes in last year's report. We
also commented on the irony of a statute that substantially
increased 1987 reported earnings for insurers even as it
materially reduced both their long-term earnings potential and
their business value. At Berkshire, the temporarily-helpful
"fresh start" adjustment inflated 1987 earnings by $8.2 million.

In our opinion, the 1986 Act was the most important economic
event affecting the insurance industry over the past decade. The
1987 Bill further reduced the intercorporate dividends-received
credit from 80% to 70%, effective January 1, 1988, except for
cases in which the taxpayer owns at least 20% of an investee.

Investors who have owned stocks or bonds through corporate
intermediaries other than qualified investment companies have
always been disadvantaged in comparison to those owning the same
securities directly. The penalty applying to indirect ownership
was greatly increased by the 1986 Tax Bill and, to a lesser
extent, by the 1987 Bill, particularly in instances where the
intermediary is an insurance company. We have no way of
offsetting this increased level of taxation. It simply means
that a given set of pre-tax investment returns will now translate
into much poorer after-tax results for our shareholders.

All in all, we expect to do well in the insurance business,
though our record is sure to be uneven. The immediate outlook is
for substantially lower volume but reasonable earnings
improvement. The decline in premium volume will accelerate after
our quota-share agreement with Fireman's Fund expires in 1989.
At some point, likely to be at least a few years away, we may see
some major opportunities, for which we are now much better
prepared than we were in 1985.

Marketable Securities - Permanent Holdings

Whenever Charlie and I buy common stocks for Berkshire's
insurance companies (leaving aside arbitrage purchases, discussed
later) we approach the transaction as if we were buying into a
private business. We look at the economic prospects of the
business, the people in charge of running it, and the price we
must pay. We do not have in mind any time or price for sale.
Indeed, we are willing to hold a stock indefinitely so long as we
expect the business to increase in intrinsic value at a
satisfactory rate. When investing, we view ourselves as business
analysts - not as market analysts, not as macroeconomic analysts,
and not even as security analysts.

Our approach makes an active trading market useful, since it
periodically presents us with mouth-watering opportunities. But
by no means is it essential: a prolonged suspension of trading in
the securities we hold would not bother us any more than does the
lack of daily quotations on World Book or Fechheimer.
Eventually, our economic fate will be determined by the economic
fate of the business we own, whether our ownership is partial or
total.

Ben Graham, my friend and teacher, long ago described the
mental attitude toward market fluctuations that I believe to be
most conducive to investment success. He said that you should
imagine market quotations as coming from a remarkably
accommodating fellow named Mr. Market who is your partner in a
private business. Without fail, Mr. Market appears daily and
names a price at which he will either buy your interest or sell
you his.

Even though the business that the two of you own may have
economic characteristics that are stable, Mr. Market's quotations
will be anything but. For, sad to say, the poor fellow has
incurable emotional problems. At times he feels euphoric and can
see only the favorable factors affecting the business. When in
that mood, he names a very high buy-sell price because he fears
that you will snap up his interest and rob him of imminent gains.
At other times he is depressed and can see nothing but trouble
ahead for both the business and the world. On these occasions he
will name a very low price, since he is terrified that you will
unload your interest on him.

Mr. Market has another endearing characteristic: He doesn't
mind being ignored. If his quotation is uninteresting to you
today, he will be back with a new one tomorrow. Transactions are
strictly at your option. Under these conditions, the more manic-
depressive his behavior, the better for you.

But, like Cinderella at the ball, you must heed one warning
or everything will turn into pumpkins and mice: Mr. Market is
there to serve you, not to guide you. It is his pocketbook, not
his wisdom, that you will find useful. If he shows up some day
in a particularly foolish mood, you are free to either ignore him
or to take advantage of him, but it will be disastrous if you
fall under his influence. Indeed, if you aren't certain that you
understand and can value your business far better than Mr.
Market, you don't belong in the game. As they say in poker, "If
you've been in the game 30 minutes and you don't know who the
patsy is, you're the patsy."

Ben's Mr. Market allegory may seem out-of-date in today's
investment world, in which most professionals and academicians
talk of efficient markets, dynamic hedging and betas. Their
interest in such matters is understandable, since techniques
shrouded in mystery clearly have value to the purveyor of
investment advice. After all, what witch doctor has ever
achieved fame and fortune by simply advising "Take two aspirins"?

The value of market esoterica to the consumer of investment
advice is a different story. In my opinion, investment success
will not be produced by arcane formulae, computer programs or
signals flashed by the price behavior of stocks and markets.
Rather an investor will succeed by coupling good business
judgment with an ability to insulate his thoughts and behavior
from the super-contagious emotions that swirl about the
marketplace. In my own efforts to stay insulated, I have found
it highly useful to keep Ben's Mr. Market concept firmly in mind.

Following Ben's teachings, Charlie and I let our marketable
equities tell us by their operating results - not by their daily,
or even yearly, price quotations - whether our investments are
successful. The market may ignore business success for a while,
but eventually will confirm it. As Ben said: "In the short run,
the market is a voting machine but in the long run it is a
weighing machine." The speed at which a business's success is
recognized, furthermore, is not that important as long as the
company's intrinsic value is increasing at a satisfactory rate.
In fact, delayed recognition can be an advantage: It may give us
the chance to buy more of a good thing at a bargain price.

Sometimes, of course, the market may judge a business to be
more valuable than the underlying facts would indicate it is. In
such a case, we will sell our holdings. Sometimes, also, we will
sell a security that is fairly valued or even undervalued because
we require funds for a still more undervalued investment or one
we believe we understand better.

We need to emphasize, however, that we do not sell holdings
just because they have appreciated or because we have held them
for a long time. (Of Wall Street maxims the most foolish may be
"You can't go broke taking a profit.") We are quite content to
hold any security indefinitely, so long as the prospective return
on equity capital of the underlying business is satisfactory,
management is competent and honest, and the market does not
overvalue the business.

However, our insurance companies own three marketable common
stocks that we would not sell even though they became far
overpriced in the market. In effect, we view these investments
exactly like our successful controlled businesses - a permanent
part of Berkshire rather than merchandise to be disposed of once
Mr. Market offers us a sufficiently high price. To that, I will
add one qualifier: These stocks are held by our insurance
companies and we would, if absolutely necessary, sell portions of
our holdings to pay extraordinary insurance losses. We intend,
however, to manage our affairs so that sales are never required.

A determination to have and to hold, which Charlie and I
share, obviously involves a mixture of personal and financial
considerations. To some, our stand may seem highly eccentric.
(Charlie and I have long followed David Oglivy's advice: "Develop
your eccentricities while you are young. That way, when you get
old, people won't think you're going ga-ga.") Certainly, in the
transaction-fixated Wall Street of recent years, our posture must
seem odd: To many in that arena, both companies and stocks are
seen only as raw material for trades.

Our attitude, however, fits our personalities and the way we
want to live our lives. Churchill once said, "You shape your
houses and then they shape you." We know the manner in which we
wish to be shaped. For that reason, we would rather achieve a
return of X while associating with people whom we strongly like
and admire than realize 110% of X by exchanging these
relationships for uninteresting or unpleasant ones. And we will
never find people we like and admire more than some of the main
participants at the three companies - our permanent holdings -
shown below:

No. of Shares Cost Market
------------- ---------- ----------
(000s omitted)
3,000,000 Capital Cities/ABC, Inc. ........... $517,500 $1,035,000
6,850,000 GEICO Corporation .................. 45,713 756,925
1,727,765 The Washington Post Company ........ 9,731 323,092
We really don't see many fundamental differences between the
purchase of a controlled business and the purchase of marketable
holdings such as these. In each case we try to buy into
businesses with favorable long-term economics. Our goal is to
find an outstanding business at a sensible price, not a mediocre
business at a bargain price. Charlie and I have found that
making silk purses out of silk is the best that we can do; with
sow's ears, we fail.

(It must be noted that your Chairman, always a quick study,
required only 20 years to recognize how important it was to buy
good businesses. In the interim, I searched for "bargains" - and
had the misfortune to find some. My punishment was an education
in the economics of short-line farm implement manufacturers,
third-place department stores, and New England textile
manufacturers.)

Of course, Charlie and I may misread the fundamental
economics of a business. When that happens, we will encounter
problems whether that business is a wholly-owned subsidiary or a
marketable security, although it is usually far easier to exit
from the latter. (Indeed, businesses can be misread: Witness the
European reporter who, after being sent to this country to
profile Andrew Carnegie, cabled his editor, "My God, you'll never
believe the sort of money there is in running libraries.")

In making both control purchases and stock purchases, we try
to buy not only good businesses, but ones run by high-grade,
talented and likeable managers. If we make a mistake about the
managers we link up with, the controlled company offers a certain
advantage because we have the power to effect change. In
practice, however, this advantage is somewhat illusory:
Management changes, like marital changes, are painful, time-
consuming and chancy. In any event, at our three marketable-but
permanent holdings, this point is moot: With Tom Murphy and Dan
Burke at Cap Cities, Bill Snyder and Lou Simpson at GEICO, and
Kay Graham and Dick Simmons at The Washington Post, we simply
couldn't be in better hands.

I would say that the controlled company offers two main
advantages. First, when we control a company we get to allocate
capital, whereas we are likely to have little or nothing to say
about this process with marketable holdings. This point can be
important because the heads of many companies are not skilled in
capital allocation. Their inadequacy is not surprising. Most
bosses rise to the top because they have excelled in an area such
as marketing, production, engineering, administration or,
sometimes, institutional politics.

Once they become CEOs, they face new responsibilities. They
now must make capital allocation decisions, a critical job that
they may have never tackled and that is not easily mastered. To
stretch the point, it's as if the final step for a highly-
talented musician was not to perform at Carnegie Hall but,
instead, to be named Chairman of the Federal Reserve.

The lack of skill that many CEOs have at capital allocation
is no small matter: After ten years on the job, a CEO whose
company annually retains earnings equal to 10% of net worth will
have been responsible for the deployment of more than 60% of all
the capital at work in the business.

CEOs who recognize their lack of capital-allocation skills
(which not all do) will often try to compensate by turning to
their staffs, management consultants, or investment bankers.
Charlie and I have frequently observed the consequences of such
"help." On balance, we feel it is more likely to accentuate the
capital-allocation problem than to solve it.

In the end, plenty of unintelligent capital allocation takes
place in corporate America. (That's why you hear so much about
"restructuring.") Berkshire, however, has been fortunate. At the
companies that are our major non-controlled holdings, capital has
generally been well-deployed and, in some cases, brilliantly so.

The second advantage of a controlled company over a
marketable security has to do with taxes. Berkshire, as a
corporate holder, absorbs some significant tax costs through the
ownership of partial positions that we do not when our ownership
is 80%, or greater. Such tax disadvantages have long been with
us, but changes in the tax code caused them to increase
significantly during the past year. As a consequence, a given
business result can now deliver Berkshire financial results that
are as much as 50% better if they come from an 80%-or-greater
holding rather than from a lesser holding.

The disadvantages of owning marketable securities are
sometimes offset by a huge advantage: Occasionally the stock
market offers us the chance to buy non-controlling pieces of
extraordinary businesses at truly ridiculous prices -
dramatically below those commanded in negotiated transactions
that transfer control. For example, we purchased our Washington
Post stock in 1973 at $5.63 per share, and per-share operating
earnings in 1987 after taxes were $10.30. Similarly, Our GEICO
stock was purchased in 1976, 1979 and 1980 at an average of $6.67
per share, and after-tax operating earnings per share last year
were $9.01. In cases such as these, Mr. Market has proven to be a
mighty good friend.

An interesting accounting irony overlays a comparison of the
reported financial results of our controlled companies with those
of the permanent minority holdings listed above. As you can see,
those three stocks have a market value of over $2 billion. Yet
they produced only $11 million in reported after-tax earnings for
Berkshire in 1987.

Accounting rules dictate that we take into income only the
dividends these companies pay us - which are little more than
nominal - rather than our share of their earnings, which in 1987
amounted to well over $100 million. On the other hand,
accounting rules provide that the carrying value of these three
holdings - owned, as they are, by insurance companies - must be
recorded on our balance sheet at current market prices. The
result: GAAP accounting lets us reflect in our net worth the up-
to-date underlying values of the businesses we partially own, but
does not let us reflect their underlying earnings in our income
account.

In the case of our controlled companies, just the opposite
is true. Here, we show full earnings in our income account but
never change asset values on our balance sheet, no matter how
much the value of a business might have increased since we
purchased it.

Our mental approach to this accounting schizophrenia is to
ignore GAAP figures and to focus solely on the future earning
power of both our controlled and non-controlled businesses.
Using this approach, we establish our own ideas of business
value, keeping these independent from both the accounting values
shown on our books for controlled companies and the values placed
by a sometimes foolish market on our partially-owned companies.
It is this business value that we hope to increase at a
reasonable (or, preferably, unreasonable) rate in the years
ahead.

Marketable Securities - Other

In addition to our three permanent common stock holdings, we
hold large quantities of marketable securities in our insurance
companies. In selecting these, we can choose among five major
categories: (1) long-term common stock investments, (2) medium-
term fixed-income securities, (3) long-term fixed income
securities, (4) short-term cash equivalents, and (5) short-term
arbitrage commitments.

We have no particular bias when it comes to choosing from
these categories. We just continuously search among them for the
highest after-tax returns as measured by "mathematical
expectation," limiting ourselves always to investment
alternatives we think we understand. Our criteria have nothing
to do with maximizing immediately reportable earnings; our goal,
rather, is to maximize eventual net worth.

o Let's look first at common stocks. During 1987 the stock
market was an area of much excitement but little net movement:
The Dow advanced 2.3% for the year. You are aware, of course, of
the roller coaster ride that produced this minor change. Mr.
Market was on a manic rampage until October and then experienced
a sudden, massive seizure.

We have "professional" investors, those who manage many
billions, to thank for most of this turmoil. Instead of focusing
on what businesses will do in the years ahead, many prestigious
money managers now focus on what they expect other money managers
to do in the days ahead. For them, stocks are merely tokens in a
game, like the thimble and flatiron in Monopoly.

An extreme example of what their attitude leads to is
"portfolio insurance," a money-management strategy that many
leading investment advisors embraced in 1986-1987. This strategy
- which is simply an exotically-labeled version of the small
speculator's stop-loss order dictates that ever increasing
portions of a stock portfolio, or their index-future equivalents,
be sold as prices decline. The strategy says nothing else
matters: A downtick of a given magnitude automatically produces a
huge sell order. According to the Brady Report, $60 billion to
$90 billion of equities were poised on this hair trigger in mid-
October of 1987.

If you've thought that investment advisors were hired to
invest, you may be bewildered by this technique. After buying a
farm, would a rational owner next order his real estate agent to
start selling off pieces of it whenever a neighboring property
was sold at a lower price? Or would you sell your house to
whatever bidder was available at 9:31 on some morning merely
because at 9:30 a similar house sold for less than it would have
brought on the previous day?

Moves like that, however, are what portfolio insurance tells
a pension fund or university to make when it owns a portion of
enterprises such as Ford or General Electric. The less these
companies are being valued at, says this approach, the more
vigorously they should be sold. As a "logical" corollary, the
approach commands the institutions to repurchase these companies
- I'm not making this up - once their prices have rebounded
significantly. Considering that huge sums are controlled by
managers following such Alice-in-Wonderland practices, is it any
surprise that markets sometimes behave in aberrational fashion?

Many commentators, however, have drawn an incorrect
conclusion upon observing recent events: They are fond of saying
that the small investor has no chance in a market now dominated
by the erratic behavior of the big boys. This conclusion is dead
wrong: Such markets are ideal for any investor - small or large -
so long as he sticks to his investment knitting. Volatility
caused by money managers who speculate irrationally with huge
sums will offer the true investor more chances to make
intelligent investment moves. He can be hurt by such volatility
only if he is forced, by either financial or psychological
pressures, to sell at untoward times.

At Berkshire, we have found little to do in stocks during
the past few years. During the break in October, a few stocks
fell to prices that interested us, but we were unable to make
meaningful purchases before they rebounded. At yearend 1987 we
had no major common stock investments (that is, over $50 million)
other than those we consider permanent or arbitrage holdings.
However, Mr. Market will offer us opportunities - you can be sure
of that - and, when he does, we will be willing and able to
participate.

o In the meantime, our major parking place for money is
medium-term tax-exempt bonds, whose limited virtues I explained
in last year's annual report. Though we both bought and sold
some of these bonds in 1987, our position changed little overall,
holding around $900 million. A large portion of our bonds are
"grandfathered" under the Tax Reform Act of 1986, which means
they are fully tax-exempt. Bonds currently purchased by
insurance companies are not.

As an alternative to short-term cash equivalents, our
medium-term tax-exempts have - so far served us well. They have
produced substantial extra income for us and are currently worth
a bit above our cost. Regardless of their market price, we are
ready to dispose of our bonds whenever something better comes
along.

o We continue to have an aversion to long-term bonds (and may
be making a serious mistake by not disliking medium-term bonds as
well). Bonds are no better than the currency in which they are
denominated, and nothing we have seen in the past year - or past
decade - makes us enthusiastic about the long-term future of U.S.
currency.

Our enormous trade deficit is causing various forms of
"claim checks" - U.S. government and corporate bonds, bank
deposits, etc. - to pile up in the hands of foreigners at a
distressing rate. By default, our government has adopted an
approach to its finances patterned on that of Blanche DuBois, of
A Streetcar Named Desire, who said, "I have always depended on
the kindness of strangers." In this case, of course, the
"strangers" are relying on the integrity of our claim checks
although the plunging dollar has already made that proposition
expensive for them.

The faith that foreigners are placing in us may be
misfounded. When the claim checks outstanding grow sufficiently
numerous and when the issuing party can unilaterally determine
their purchasing power, the pressure on the issuer to dilute
their value by inflating the currency becomes almost
irresistible. For the debtor government, the weapon of inflation
is the economic equivalent of the "H" bomb, and that is why very
few countries have been allowed to swamp the world with debt
denominated in their own currency. Our past, relatively good
record for fiscal integrity has let us break this rule, but the
generosity accorded us is likely to intensify, rather than
relieve, the eventual pressure on us to inflate. If we do
succumb to that pressure, it won't be just the foreign holders of
our claim checks who will suffer. It will be all of us as well.

Of course, the U.S. may take steps to stem our trade deficit
well before our position as a net debtor gets out of hand. (In
that respect, the falling dollar will help, though unfortunately
it will hurt in other ways.) Nevertheless, our government's
behavior in this test of its mettle is apt to be consistent with
its Scarlett O'Hara approach generally: "I'll think about it
tomorrow." And, almost inevitably, procrastination in facing up
to fiscal problems will have inflationary consequences.

Both the timing and the sweep of those consequences are
unpredictable. But our inability to quantify or time the risk
does not mean we should ignore it. While recognizing the
possibility that we may be wrong and that present interest rates
may adequately compensate for the inflationary risk, we retain a
general fear of long-term bonds.

We are, however, willing to invest a moderate portion of our
funds in this category if we think we have a significant edge in
a specific security. That willingness explains our holdings of
the Washington Public Power Supply Systems #1, #2 and #3 issues,
discussed in our 1984 report. We added to our WPPSS position
during 1987. At yearend, we had holdings with an amortized cost
of $240 million and a market value of $316 million, paying us
tax-exempt income of $34 million annually.

o We continued to do well in arbitrage last year, though - or
perhaps because - we operated on a very limited scale. We enter
into only a few arbitrage commitments each year and restrict
ourselves to large transactions that have been publicly
announced. We do not participate in situations in which green-
mailers are attempting to put a target company "in play."

We have practiced arbitrage on an opportunistic basis for
decades and, to date, our results have been quite good. Though
we've never made an exact calculation, I believe that overall we
have averaged annual pre-tax returns of at least 25% from
arbitrage. I'm quite sure we did better than that in 1987. But
it should be emphasized that a really bad experience or two -
such as many arbitrage operations suffered in late 1987 - could
change the figures dramatically.

Our only $50 million-plus arbitrage position at yearend 1987
was 1,096,200 shares of Allegis, with a cost of $76 million and a
market value of $78 million.

o We had two other large holdings at yearend that do not fit
precisely into any of our five categories. One was various
Texaco, Inc. bonds with short maturities, all purchased after
Texaco went into bankruptcy. Were it not for the extraordinarily
strong capital position of our insurance companies, it would be
inappropriate for us to buy defaulted bonds. At prices
prevailing after Texaco's bankruptcy filing, however, we regarded
these issues as by far the most attractive bond investment
available to us.

On a worst-case basis with respect to the Pennzoil
litigation, we felt the bonds were likely to be worth about what
we paid for them. Given a sensible settlement, which seemed
likely, we expected the bonds to be worth considerably more. At
yearend our Texaco bonds were carried on our books at $104
million and had a market value of $119 million.

By far our largest - and most publicized - investment in
1987 was a $700 million purchase of Salomon Inc 9% preferred
stock. This preferred is convertible after three years into
Salomon common stock at $38 per share and, if not converted, will
be redeemed ratably over five years beginning October 31, 1995.
From most standpoints, this commitment fits into the medium-term
fixed-income securities category. In addition, we have an
interesting conversion possibility.

We, of course, have no special insights regarding the
direction or future profitability of investment banking. By
their nature, the economics of this industry are far less
predictable than those of most other industries in which we have
major Commitments. This unpredictability is one of the reasons
why our participation is in the form of a convertible preferred.

What we do have a strong feeling about is the ability and
integrity of John Gutfreund, CEO of Salomon Inc. Charlie and I
like, admire and trust John. We first got to know him in 1976
when he played a key role in GEICO's escape from near-bankruptcy.
Several times since, we have seen John steer clients away from
transactions that would have been unwise, but that the client
clearly wanted to make - even though his advice provided no fee
to Salomon and acquiescence would have delivered a large fee.
Such service-above-self behavior is far from automatic in Wall
Street.

For the reasons Charlie outlines on page 50, at yearend we
valued our Salomon investment at 98% of par, $14 million less
than our cost. However, we believe there is a reasonable
likelihood that a leading, high-quality capital-raising and
market-making operation can average good returns on equity. If
so, our conversion right will eventually prove to be valuable.

Two further comments about our investments in marketable
securities are appropriate. First, we give you our usual
warning: Our holdings have changed since yearend and will
continue to do so without notice.

The second comment is related: During 1987, as in some
earlier years, there was speculation in the press from time to
time about our purchase or sale of various securities. These
stories were sometimes true, sometimes partially true, and other
times completely untrue. Interestingly, there has been no
correlation between the size and prestige of the publication and
the accuracy of the report. One dead-wrong rumor was given
considerable prominence by a major national magazine, and another
leading publication misled its readers by writing about an
arbitrage position as if it were a long-term investment
commitment. (In not naming names, I am observing the old warning
that it's not wise to pick fights with people who buy ink by the
barrel.)

You should understand that we simply don't comment in any
way on rumors, whether they are true or false. If we were to
deny the incorrect reports and refuse comment on the correct
ones, we would in effect be commenting on all.

In a world in which big investment ideas are both limited
and valuable, we have no interest in telling potential
competitors what we are doing except to the extent required by
law. We certainly don't expect others to tell us of their
investment ideas. Nor would we expect a media company to
disclose news of acquisitions it was privately pursuing or a
journalist to tell his competitors about stories on which he is
working or sources he is using.

I find it uncomfortable when friends or acquaintances
mention that they are buying X because it has been reported -
incorrectly - that Berkshire is a buyer. However, I do not set
them straight. If they want to participate in whatever Berkshire
actually is buying, they can always purchase Berkshire stock.
But perhaps that is too simple. Usually, I suspect, they find it
more exciting to buy what is being talked about. Whether that
strategy is more profitable is another question.

Financing

Shortly after yearend, Berkshire sold two issues of
debentures, totaling $250 million. Both issues mature in 2018
and will be retired at an even pace through sinking fund
operations that begin in 1999. Our overall interest cost, after
allowing for expenses of issuance, is slightly over 10%. Salomon
was our investment banker, and its service was excellent.

Despite our pessimistic views about inflation, our taste for
debt is quite limited. To be sure, it is likely that Berkshire
could improve its return on equity by moving to a much higher,
though still conventional, debt-to-business-value ratio. It's
even more likely that we could handle such a ratio, without
problems, under economic conditions far worse than any that have
prevailed since the early 1930s.

But we do not wish it to be only likely that we can meet our
obligations; we wish that to be certain. Thus we adhere to
policies - both in regard to debt and all other matters - that
will allow us to achieve acceptable long-term results under
extraordinarily adverse conditions, rather than optimal results
under a normal range of conditions.

Good business or investment decisions will eventually
produce quite satisfactory economic results, with no aid from
leverage. Therefore, it seems to us to be both foolish and
improper to risk what is important (including, necessarily, the
welfare of innocent bystanders such as policyholders and
employees) for some extra returns that are relatively
unimportant. This view is not the product of either our
advancing age or prosperity: Our opinions about debt have
remained constant.

However, we are not phobic about borrowing. (We're far from
believing that there is no fate worse than debt.) We are willing
to borrow an amount that we believe - on a worst-case basis -
will pose no threat to Berkshire's well-being. Analyzing what
that amount might be, we can look to some important strengths
that would serve us well if major problems should engulf our
economy: Berkshire's earnings come from many diverse and well-
entrenched businesses; these businesses seldom require much
capital investment; what debt we have is structured well; and we
maintain major holdings of liquid assets. Clearly, we could be
comfortable with a higher debt-to-business-value ratio than we
now have.

One further aspect of our debt policy deserves comment:
Unlike many in the business world, we prefer to finance in
anticipation of need rather than in reaction to it. A business
obtains the best financial results possible by managing both
sides of its balance sheet well. This means obtaining the
highest-possible return on assets and the lowest-possible cost on
liabilities. It would be convenient if opportunities for
intelligent action on both fronts coincided. However, reason
tells us that just the opposite is likely to be the case: Tight
money conditions, which translate into high costs for
liabilities, will create the best opportunities for acquisitions,
and cheap money will cause assets to be bid to the sky. Our
conclusion: Action on the liability side should sometimes be
taken independent of any action on the asset side.

Alas, what is "tight" and "cheap" money is far from clear at
any particular time. We have no ability to forecast interest
rates and - maintaining our usual open-minded spirit - believe
that no one else can. Therefore, we simply borrow when
conditions seem non-oppressive and hope that we will later find
intelligent expansion or acquisition opportunities, which - as we
have said - are most likely to pop up when conditions in the debt
market are clearly oppressive. Our basic principle is that if
you want to shoot rare, fast-moving elephants, you should always
carry a loaded gun.

Our fund-first, buy-or-expand-later policy almost always
penalizes near-term earnings. For example, we are now earning
about 6 1/2% on the $250 million we recently raised at 10%, a
disparity that is currently costing us about $160,000 per week.
This negative spread is unimportant to us and will not cause us
to stretch for either acquisitions or higher-yielding short-term
instruments. If we find the right sort of business elephant
within the next five years or so, the wait will have been
worthwhile.

Miscellaneous

We hope to buy more businesses that are similar to the ones
we have, and we can use some help. If you have a business that
fits the following criteria, call me or, preferably, write.

Here's what we're looking for:

(1) large purchases (at least $10 million of after-tax
earnings),

(2) demonstrated consistent earning power (future
projections are of little interest to us, nor are
"turnaround" situations),

(3) businesses earning good returns on equity while
employing little or no debt,

(4) management in place (we can't supply it),

(5) simple businesses (if there's lots of technology,
we won't understand it),

(6) an offering price (we don't want to waste our time
or that of the seller by talking, even preliminarily,
about a transaction when price is unknown).

We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we're interested. We prefer
to buy for cash, but will consider issuing stock when we receive
as much in intrinsic business value as we give. We invite
potential sellers to check us out by contacting people with whom
we have done business in the past. For the right business - and
the right people - we can provide a good home.

On the other hand, we frequently get approached about
acquisitions that don't come close to meeting our tests: new
ventures, turnarounds, auction-like sales, and the ever-popular
(among brokers) "I'm-sure-something-will-work-out-if-you-people-
get-to-know-each-other." None of these attracts us in the least.

Besides being interested in the purchases of entire
businesses as described above, we are also interested in the
negotiated purchase of large, but not controlling, blocks of
stock comparable to those we hold in Cap Cities and Salomon. We
have a special interest in purchasing convertible preferreds as a
long-term investment, as we did at Salomon.

* * *

And now a bit of deja vu. Most of Berkshire's major
stockholders received their shares at yearend 1969 in a
liquidating distribution from Buffett Partnership, Ltd. Some of
these former partners will remember that in 1962 I encountered
severe managerial problems at Dempster Mill Manufacturing Co., a
pump and farm implement manufacturing company that BPL
controlled.

At that time, like now, I went to Charlie with problems that
were too tough for me to solve. Charlie suggested the solution
might lie in a California friend of his, Harry Bottle, whose
special knack was never forgetting the fundamental. I met Harry
in Los Angeles on April 17, 1962, and on April 23 he was in
Beatrice, Nebraska, running Dempster. Our problems disappeared
almost immediately. In my 1962 annual letter to partners, I
named Harry "Man of the Year."

Fade to 24 years later: The scene is K & W Products, a small
Berkshire subsidiary that produces automotive compounds. For
years K & W did well, but in 1985-86 it stumbled badly, as it
pursued the unattainable to the neglect of the achievable.
Charlie, who oversees K & W, knew there was no need to consult
me. Instead, he called Harry, now 68 years old, made him CEO,
and sat back to await the inevitable. He didn't wait long. In
1987 K & W's profits set a record, up more than 300% from 1986.
And, as profits went up, capital employed went down: K & W's
investment in accounts receivable and inventories has decreased
20%.

If we run into another managerial problem ten or twenty
years down the road, you know whose phone will ring.

* * *

About 97.2% of all eligible shares participated in
Berkshire's 1987 shareholder-designated contributions program.
Contributions made through the program were $4.9 million, and
2,050 charities were recipients.

A recent survey reported that about 50% of major American
companies match charitable contributions made by directors
(sometimes by a factor of three to one). In effect, these
representatives of the owners direct funds to their favorite
charities, and never consult the owners as to their charitable
preferences. (I wonder how they would feel if the process were
reversed and shareholders could invade the directors' pockets for
charities favored by the shareholders.) When A takes money from B
to give to C and A is a legislator, the process is called
taxation. But when A is an officer or director of a corporation,
it is called philanthropy. We continue to believe that
contributions, aside from those with quite clear direct benefits
to the company, should reflect the charitable preferences of
owners rather than those of officers and directors.

We urge new shareholders to read the description of our
shareholder-designated contributions program that appears on
pages 54 and 55. If you wish to participate in future programs,
we strongly urge that you immediately make sure your shares are
registered in the name of the actual owner, not in "street" name
or nominee name. Shares not so registered on September 30, l988
will be ineligible for the 1988 program.

* * *

Last year we again had about 450 shareholders at our annual
meeting. The 60 or so questions they asked were, as always,
excellent. At many companies, the annual meeting is a waste of
time because exhibitionists turn it into a sideshow. Ours,
however, is different. It is informative for shareholders and
fun for us. (At Berkshire's meetings, the exhibitionists are on
the dais.)

This year our meeting will be on May 23, 1988 in Omaha, and
we hope that you come. The meeting provides the forum for you to
ask any owner-related questions you may have, and we will keep
answering until all (except those dealing with portfolio
activities or other proprietary information) have been dealt
with.

Last year we rented two buses - for $100 - to take
shareholders interested in the trip to the Furniture Mart. Your
actions demonstrated your good judgment: You snapped up about
$40,000 of bargains. Mrs. B regards this expense/sales ratio as
on the high side and attributes it to my chronic inattention to
costs and generally sloppy managerial practices. But, gracious
as always, she has offered me another chance and we will again
have buses available following the meeting. Mrs. B says you must
beat last year's sales figures, and I have told her she won't be
disappointed.



Warren E. Buffett
February 29, 1988 Chairman of the Board

To the Shareholders of Berkshire Hathaway Inc.:

Our gain in net worth during 1988 was $569 million, or
20.0%. Over the last 24 years (that is, since present management
took over), our per-share book value has grown from $19.46 to
$2,974.52, or at a rate of 23.0% compounded annually.

We’ve emphasized in past reports that what counts, however,
is intrinsic business value - the figure, necessarily an
estimate, indicating what all of our constituent businesses are
worth. By our calculations, Berkshire’s intrinsic business value
significantly exceeds its book value. Over the 24 years,
business value has grown somewhat faster than book value; in
1988, however, book value grew the faster, by a bit.

Berkshire’s past rates of gain in both book value and
business value were achieved under circumstances far different
from those that now exist. Anyone ignoring these differences
makes the same mistake that a baseball manager would were he to
judge the future prospects of a 42-year-old center fielder on the
basis of his lifetime batting average.

Important negatives affecting our prospects today are: (1) a
less attractive stock market than generally existed over the past
24 years; (2) higher corporate tax rates on most forms of
investment income; (3) a far more richly-priced market for the
acquisition of businesses; and (4) industry conditions for
Capital Cities/ABC, Inc., GEICO Corporation, and The Washington
Post Company - Berkshire’s three permanent investments,
constituting about one-half of our net worth - that range from
slightly to materially less favorable than those existing five to
ten years ago. All of these companies have superb management and
strong properties. But, at current prices, their upside
potential looks considerably less exciting to us today than it
did some years ago.

The major problem we face, however, is a growing capital
base. You’ve heard that from us before, but this problem, like
age, grows in significance each year. (And also, just as with
age, it’s better to have this problem continue to grow rather
than to have it “solved.”)

Four years ago I told you that we needed profits of $3.9
billion to achieve a 15% annual return over the decade then
ahead. Today, for the next decade, a 15% return demands profits
of $10.3 billion. That seems like a very big number to me and to
Charlie Munger, Berkshire’s Vice Chairman and my partner. (Should
that number indeed prove too big, Charlie will find himself, in
future reports, retrospectively identified as the senior
partner.)

As a partial offset to the drag that our growing capital
base exerts upon returns, we have a very important advantage now
that we lacked 24 years ago. Then, all our capital was tied up
in a textile business with inescapably poor economic
characteristics. Today part of our capital is invested in some
really exceptional businesses.

Last year we dubbed these operations the Sainted Seven:
Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott
Fetzer Manufacturing Group, See’s, and World Book. In 1988 the
Saints came marching in. You can see just how extraordinary
their returns on capital were by examining the historical-cost
financial statements on page 45, which combine the figures of the
Sainted Seven with those of several smaller units. With no
benefit from financial leverage, this group earned about 67% on
average equity capital.

In most cases the remarkable performance of these units
arises partially from an exceptional business franchise; in all
cases an exceptional management is a vital factor. The
contribution Charlie and I make is to leave these managers alone.

In my judgment, these businesses, in aggregate, will
continue to produce superb returns. We’ll need these: Without
this help Berkshire would not have a chance of achieving our 15%
goal. You can be sure that our operating managers will deliver;
the question mark in our future is whether Charlie and I can
effectively employ the funds that they generate.

In that respect, we took a step in the right direction early
in 1989 when we purchased an 80% interest in Borsheim’s, a
jewelry business in Omaha. This purchase, described later in
this letter, delivers exactly what we look for: an outstanding
business run by people we like, admire, and trust. It’s a great
way to start the year.

Accounting Changes

We have made a significant accounting change that was
mandated for 1988, and likely will have another to make in 1990.
When we move figures around from year to year, without any change
in economic reality, one of our always-thrilling discussions of
accounting is necessary.

First, I’ll offer my customary disclaimer: Despite the
shortcomings of generally accepted accounting principles (GAAP),
I would hate to have the job of devising a better set of rules.
The limitations of the existing set, however, need not be
inhibiting: CEOs are free to treat GAAP statements as a beginning
rather than an end to their obligation to inform owners and
creditors - and indeed they should. After all, any manager of a
subsidiary company would find himself in hot water if he reported
barebones GAAP numbers that omitted key information needed by his
boss, the parent corporation’s CEO. Why, then, should the CEO
himself withhold information vitally useful to his bosses - the
shareholder-owners of the corporation?

What needs to be reported is data - whether GAAP, non-GAAP,
or extra-GAAP - that helps financially-literate readers answer
three key questions: (1) Approximately how much is this company
worth? (2) What is the likelihood that it can meet its future
obligations? and (3) How good a job are its managers doing, given
the hand they have been dealt?

In most cases, answers to one or more of these questions are
somewhere between difficult and impossible to glean from the
minimum GAAP presentation. The business world is simply too
complex for a single set of rules to effectively describe
economic reality for all enterprises, particularly those
operating in a wide variety of businesses, such as Berkshire.

Further complicating the problem is the fact that many
managements view GAAP not as a standard to be met, but as an
obstacle to overcome. Too often their accountants willingly
assist them. (“How much,” says the client, “is two plus two?”
Replies the cooperative accountant, “What number did you have in
mind?”) Even honest and well-intentioned managements sometimes
stretch GAAP a bit in order to present figures they think will
more appropriately describe their performance. Both the
smoothing of earnings and the “big bath” quarter are “white lie”
techniques employed by otherwise upright managements.

Then there are managers who actively use GAAP to deceive and
defraud. They know that many investors and creditors accept GAAP
results as gospel. So these charlatans interpret the rules
“imaginatively” and record business transactions in ways that
technically comply with GAAP but actually display an economic
illusion to the world.

As long as investors - including supposedly sophisticated
institutions - place fancy valuations on reported “earnings” that
march steadily upward, you can be sure that some managers and
promoters will exploit GAAP to produce such numbers, no matter
what the truth may be. Over the years, Charlie and I have
observed many accounting-based frauds of staggering size. Few of
the perpetrators have been punished; many have not even been
censured. It has been far safer to steal large sums with a pen
than small sums with a gun.

Under one major change mandated by GAAP for 1988, we have
been required to fully consolidate all our subsidiaries in our
balance sheet and earnings statement. In the past, Mutual
Savings and Loan, and Scott Fetzer Financial (a credit company
that primarily finances installment sales of World Book and Kirby
products) were consolidated on a “one-line” basis. That meant we
(1) showed our equity in their combined net worths as a single-
entry asset on Berkshire’s consolidated balance sheet and (2)
included our equity in their combined annual earnings as a
single-line income entry in our consolidated statement of
earnings. Now the rules require that we consolidate each asset
and liability of these companies in our balance sheet and each
item of their income and expense in our earnings statement.

This change underscores the need for companies also to
report segmented data: The greater the number of economically
diverse business operations lumped together in conventional
financial statements, the less useful those presentations are and
the less able investors are to answer the three questions posed
earlier. Indeed, the only reason we ever prepare consolidated
figures at Berkshire is to meet outside requirements. On the
other hand, Charlie and I constantly study our segment data.

Now that we are required to bundle more numbers in our GAAP
statements, we have decided to publish additional supplementary
information that we think will help you measure both business
value and managerial performance. (Berkshire’s ability to
discharge its obligations to creditors - the third question we
listed - should be obvious, whatever statements you examine.) In
these supplementary presentations, we will not necessarily follow
GAAP procedures, or even corporate structure. Rather, we will
attempt to lump major business activities in ways that aid
analysis but do not swamp you with detail. Our goal is to give
you important information in a form that we would wish to get it
if our roles were reversed.

On pages 41-47 we show separate combined balance sheets and
earnings statements for: (1) our subsidiaries engaged in finance-
type operations, which are Mutual Savings and Scott Fetzer
Financial; (2) our insurance operations, with their major
investment positions itemized; (3) our manufacturing, publishing
and retailing businesses, leaving aside certain non-operating
assets and purchase-price accounting adjustments; and (4) an all-
other category that includes the non-operating assets (primarily
marketable securities) held by the companies in (3) as well as
various assets and debts of the Wesco and Berkshire parent
companies.

If you combine the earnings and the net worths of these four
segments, you will derive totals matching those shown on our GAAP
statements. However, we want to emphasize that our new
presentation does not fall within the purview of our auditors,
who in no way bless it. (In fact, they may be horrified; I don’t
want to ask.)

I referred earlier to a major change in GAAP that is
expected in 1990. This change relates to the calculation of
deferred taxes, and is both complicated and controversial - so
much so that its imposition, originally scheduled for 1989, was
postponed for a year.

When implemented, the new rule will affect us in various
ways. Most important, we will be required to change the way we
calculate our liability for deferred taxes on the unrealized
appreciation of stocks held by our insurance companies.

Right now, our liability is layered. For the unrealized
appreciation that dates back to 1986 and earlier years, $1.2
billion, we have booked a 28% tax liability. For the unrealized
appreciation built up since, $600 million, the tax liability has
been booked at 34%. The difference reflects the increase in tax
rates that went into effect in 1987.

It now appears, however, that the new accounting rule will
require us to establish the entire liability at 34% in 1990,
taking the charge against our earnings. Assuming no change in
tax rates by 1990, this step will reduce our earnings in that
year (and thereby our reported net worth) by $71 million. The
proposed rule will also affect other items on our balance sheet,
but these changes will have only a minor impact on earnings and
net worth.

We have no strong views about the desirability of this
change in calculation of deferred taxes. We should point out,
however, that neither a 28% nor a 34% tax liability precisely
depicts economic reality at Berkshire since we have no plans to
sell the stocks in which we have the great bulk of our gains.

To those of you who are uninterested in accounting, I
apologize for this dissertation. I realize that many of you do
not pore over our figures, but instead hold Berkshire primarily
because you know that: (1) Charlie and I have the bulk of our
money in Berkshire; (2) we intend to run things so that your
gains or losses are in direct proportion to ours; and (3) the
record has so far been satisfactory. There is nothing
necessarily wrong with this kind of “faith” approach to
investing. Other shareholders, however, prefer an “analysis”
approach and we want to supply the information they need. In our
own investing, we search for situations in which both approaches
give us the same answer.

Sources of Reported Earnings

In addition to supplying you with our new four-sector
accounting material, we will continue to list the major sources
of Berkshire’s reported earnings just as we have in the past.

In the following table, amortization of Goodwill and other
major purchase-price accounting adjustments are not charged
against the specific businesses to which they apply but are
instead aggregated and shown separately. This procedure lets you
view the earnings of our businesses as they would have been
reported had we not purchased them. I’ve explained in past
reports why this form of presentation seems to us to be more
useful to investors and managers than the standard GAAP
presentation, which makes purchase-price adjustments on a
business-by-business basis. The total net earnings we show in
the table are, of course, identical to the GAAP total in our
audited financial statements.

Further information about these businesses is given in the
Business Segment section on pages 32-34, and in the Management’s
Discussion section on pages 36-40. In these sections you also
will find our segment earnings reported on a GAAP basis. For
information on Wesco’s businesses, I urge you to read Charlie
Munger’s letter, which starts on page 52. It contains the best
description I have seen of the events that produced the present
savings-and-loan crisis. Also, take special note of Dave
Hillstrom’s performance at Precision Steel Warehouse, a Wesco
subsidiary. Precision operates in an extremely competitive
industry, yet Dave consistently achieves good returns on invested
capital. Though data is lacking to prove the point, I think it
is likely that his performance, both in 1988 and years past,
would rank him number one among his peers.

(000s omitted)
------------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
------------------- -------------------
1988 1987 1988 1987
-------- -------- -------- --------
Operating Earnings:
Insurance Group:
Underwriting ............... $(11,081) $(55,429) $ (1,045) $(20,696)
Net Investment Income ...... 231,250 152,483 197,779 136,658
Buffalo News ................. 42,429 39,410 25,462 21,304
Fechheimer ................... 14,152 13,332 7,720 6,580
Kirby ........................ 26,891 22,408 17,842 12,891
Nebraska Furniture Mart ...... 18,439 16,837 9,099 7,554
Scott Fetzer
Manufacturing Group ....... 28,542 30,591 17,640 17,555
See’s Candies ................ 32,473 31,693 19,671 17,363
Wesco - other than Insurance 16,133 6,209 10,650 4,978
World Book ................... 27,890 25,745 18,021 15,136
Amortization of Goodwill ..... (2,806) (2,862) (2,806) (2,862)
Other Purchase-Price
Accounting Charges ........ (6,342) (5,546) (7,340) (6,544)
Interest on Debt* ............ (35,613) (11,474) (23,212) (5,905)
Shareholder-Designated
Contributions ............. (4,966) (4,938) (3,217) (2,963)
Other ........................ 41,059 23,217 27,177 13,697
-------- -------- -------- --------
Operating Earnings ............. 418,450 281,676 313,441 214,746
Sales of Securities ............ 131,671 28,838 85,829 19,806
-------- -------- -------- --------
Total Earnings - All Entities .. $550,121 $310,514 $399,270 $234,552

*Excludes interest expense of Scott Fetzer Financial Group.

The earnings achieved by our operating businesses are
superb, whether measured on an absolute basis or against those of
their competitors. For that we thank our operating managers: You
and I are fortunate to be associated with them.

At Berkshire, associations like these last a long time. We
do not remove superstars from our lineup merely because they have
attained a specified age - whether the traditional 65, or the 95
reached by Mrs. B on the eve of Hanukkah in 1988. Superb
managers are too scarce a resource to be discarded simply because
a cake gets crowded with candles. Moreover, our experience with
newly-minted MBAs has not been that great. Their academic
records always look terrific and the candidates always know just
what to say; but too often they are short on personal commitment
to the company and general business savvy. It’s difficult to
teach a new dog old tricks.

Here’s an update on our major non-insurance operations:

o At Nebraska Furniture Mart, Mrs. B (Rose Blumkin) and her
cart roll on and on. She’s been the boss for 51 years, having
started the business at 44 with $500. (Think what she would have
done with $1,000!) With Mrs. B, old age will always be ten years
away.
The Mart, long the largest home furnishings store in the
country, continues to grow. In the fall, the store opened a
detached 20,000 square foot Clearance Center, which expands our
ability to offer bargains in all price ranges.

Recently Dillard’s, one of the most successful department
store operations in the country, entered the Omaha market. In
many of its stores, Dillard’s runs a full furniture department,
undoubtedly doing well in this line. Shortly before opening in
Omaha, however, William Dillard, chairman of the company,
announced that his new store would not sell furniture. Said he,
referring to NFM: “We don’t want to compete with them. We think
they are about the best there is.”

At the Buffalo News we extol the value of advertising, and
our policies at NFM prove that we practice what we preach. Over
the past three years NFM has been the largest ROP advertiser in
the Omaha World-Herald. (ROP advertising is the kind printed in
the paper, as contrasted to the preprinted-insert kind.) In no
other major market, to my knowledge, is a home furnishings
operation the leading customer of the newspaper. At times, we
also run large ads in papers as far away as Des Moines, Sioux
City and Kansas City - always with good results. It truly does
pay to advertise, as long as you have something worthwhile to
offer.

Mrs. B’s son, Louie, and his boys, Ron and Irv, complete the
winning Blumkin team. It’s a joy to work with this family. All
its members have character that matches their extraordinary
abilities.

o Last year I stated unequivocally that pre-tax margins at
The Buffalo News would fall in 1988. That forecast would have
proved correct at almost any other newspaper our size or larger.
But Stan Lipsey - bless him - has managed to make me look
foolish.

Though we increased our prices a bit less than the industry
average last year, and though our newsprint costs and wage rates
rose in line with industry norms, Stan actually improved margins
a tad. No one in the newspaper business has a better managerial
record. He has achieved it, furthermore, while running a paper
that gives readers an extraordinary amount of news. We believe
that our “newshole” percentage - the portion of the paper devoted
to news - is bigger than that of any other dominant paper of our
size or larger. The percentage was 49.5% in 1988 versus 49.8% in
1987. We are committed to keeping it around 50%, whatever the
level or trend of profit margins.

Charlie and I have loved the newspaper business since we
were youngsters, and we have had great fun with the News in the
12 years since we purchased it. We were fortunate to find Murray
Light, a top-flight editor, on the scene when we arrived and he
has made us proud of the paper ever since.

o See’s Candies sold a record 25.1 million pounds in 1988.
Prospects did not look good at the end of October, but excellent
Christmas volume, considerably better than the record set in
1987, turned the tide.

As we’ve told you before, See’s business continues to become
more Christmas-concentrated. In 1988, the Company earned a
record 90% of its full-year profits in December: $29 million out
of $32.5 million before tax. (It’s enough to make you believe in
Santa Claus.) December’s deluge of business produces a modest
seasonal bulge in Berkshire’s corporate earnings. Another small
bulge occurs in the first quarter, when most World Book annuals
are sold.

Charlie and I put Chuck Huggins in charge of See’s about
five minutes after we bought the company. Upon reviewing his
record, you may wonder what took us so long.

o At Fechheimer, the Heldmans - Bob, George, Gary, Roger and
Fred - are the Cincinnati counterparts of the Blumkins. Neither
furniture retailing nor uniform manufacturing has inherently
attractive economics. In these businesses, only exceptional
managements can deliver high returns on invested capital. And
that’s exactly what the five Heldmans do. (As Mets announcer
Ralph Kiner once said when comparing pitcher Steve Trout to his
father, Dizzy Trout, the famous Detroit Tigers pitcher: “There’s
a lot of heredity in that family.”)

Fechheimer made a fairly good-sized acquisition in 1988.
Charlie and I have such confidence in the business savvy of the
Heldman family that we okayed the deal without even looking at
it. There are very few managements anywhere - including those
running the top tier companies of the Fortune 500 - in which we
would exhibit similar confidence.

Because of both this acquisition and some internal growth,
sales at Fechheimer should be up significantly in 1989.

o All of the operations managed by Ralph Schey - World Book,
Kirby, and The Scott Fetzer Manufacturing Group - performed
splendidly in 1988. Returns on the capital entrusted to Ralph
continue to be exceptional.

Within the Scott Fetzer Manufacturing Group, particularly
fine progress was recorded at its largest unit, Campbell
Hausfeld. This company, the country’s leading producer of small
and medium-sized air compressors, has more than doubled earnings
since 1986.

Unit sales at both Kirby and World Book were up
significantly in 1988, with export business particularly strong.
World Book became available in the Soviet Union in September,
when that country’s largest American book store opened in Moscow.
Ours is the only general encyclopedia offered at the store.

Ralph’s personal productivity is amazing: In addition to
running 19 businesses in superb fashion, he is active at The
Cleveland Clinic, Ohio University, Case Western Reserve, and a
venture capital operation that has spawned sixteen Ohio-based
companies and resurrected many others. Both Ohio and Berkshire
are fortunate to have Ralph on their side.

Borsheim’s

It was in 1983 that Berkshire purchased an 80% interest in
The Nebraska Furniture Mart. Your Chairman blundered then by
neglecting to ask Mrs. B a question any schoolboy would have
thought of: “Are there any more at home like you?” Last month I
corrected the error: We are now 80% partners with another branch
of the family.

After Mrs. B came over from Russia in 1917, her parents and
five siblings followed. (Her two other siblings had preceded
her.) Among the sisters was Rebecca Friedman who, with her
husband, Louis, escaped in 1922 to the west through Latvia in a
journey as perilous as Mrs. B’s earlier odyssey to the east
through Manchuria. When the family members reunited in Omaha
they had no tangible assets. However, they came equipped with an
extraordinary combination of brains, integrity, and enthusiasm
for work - and that’s all they needed. They have since proved
themselves invincible.

In 1948 Mr. Friedman purchased Borsheim’s, a small Omaha
jewelry store. He was joined in the business by his son, Ike, in
1950 and, as the years went by, Ike’s son, Alan, and his sons-in-
law, Marvin Cohn and Donald Yale, came in also.

You won’t be surprised to learn that this family brings to
the jewelry business precisely the same approach that the
Blumkins bring to the furniture business. The cornerstone for
both enterprises is Mrs. B’s creed: “Sell cheap and tell the
truth.” Other fundamentals at both businesses are: (1) single
store operations featuring huge inventories that provide
customers with an enormous selection across all price ranges, (2)
daily attention to detail by top management, (3) rapid turnover,
(4) shrewd buying, and (5) incredibly low expenses. The
combination of the last three factors lets both stores offer
everyday prices that no one in the country comes close to
matching.

Most people, no matter how sophisticated they are in other
matters, feel like babes in the woods when purchasing jewelry.
They can judge neither quality nor price. For them only one rule
makes sense: If you don’t know jewelry, know the jeweler.

I can assure you that those who put their trust in Ike
Friedman and his family will never be disappointed. The way in
which we purchased our interest in their business is the ultimate
testimonial. Borsheim’s had no audited financial statements;
nevertheless, we didn’t take inventory, verify receivables or
audit the operation in any way. Ike simply told us what was so -
- and on that basis we drew up a one-page contract and wrote a
large check.

Business at Borsheim’s has mushroomed in recent years as the
reputation of the Friedman family has spread. Customers now come
to the store from all over the country. Among them have been
some friends of mine from both coasts who thanked me later for
getting them there.

Borsheim’s new links to Berkshire will change nothing in the
way this business is run. All members of the Friedman family
will continue to operate just as they have before; Charlie and I
will stay on the sidelines where we belong. And when we say “all
members,” the words have real meaning. Mr. and Mrs. Friedman, at
88 and 87, respectively, are in the store daily. The wives of
Ike, Alan, Marvin and Donald all pitch in at busy times, and a
fourth generation is beginning to learn the ropes.

It is great fun to be in business with people you have long
admired. The Friedmans, like the Blumkins, have achieved success
because they have deserved success. Both families focus on
what’s right for the customer and that, inevitably, works out
well for them, also. We couldn’t have better partners.

Insurance Operations

Shown below is an updated version of our usual table
presenting key figures for the insurance industry:

Statutory
Yearly Change Combined Ratio Yearly Change Inflation Rate
in Premiums After Policyholder in Incurred Measured by
Written (%) Dividends Losses (%) GNP Deflator (%)
------------- ------------------ ------------- ----------------
1981 ..... 3.8 106.0 6.5 9.6
1982 ..... 3.7 109.6 8.4 6.4
1983 ..... 5.0 112.0 6.8 3.8
1984 ..... 8.5 118.0 16.9 3.7
1985 ..... 22.1 116.3 16.1 3.2
1986 ..... 22.2 108.0 13.5 2.7
1987 ..... 9.4 104.6 7.8 3.3
1988 (Est.) 3.9 105.4 4.2 3.6

Source: A.M. Best Co.

The combined ratio represents total insurance costs (losses
incurred plus expenses) compared to revenue from premiums: A
ratio below 100 indicates an underwriting profit, and one above
100 indicates a loss. When the investment income that an insurer
earns from holding on to policyholders’ funds (“the float”) is
taken into account, a combined ratio in the 107-111 range
typically produces an overall break-even result, exclusive of
earnings on the funds provided by shareholders.

For the reasons laid out in previous reports, we expect the
industry’s incurred losses to grow by about 10% annually, even in
years when general inflation runs considerably lower. If premium
growth meanwhile materially lags that 10% rate, underwriting
losses will mount, though the industry’s tendency to underreserve
when business turns bad may obscure their size for a time. As
the table shows, the industry’s underwriting loss grew in 1988.
This trend is almost certain to continue - and probably will
accelerate - for at least two more years.

The property-casualty insurance industry is not only
subnormally profitable, it is subnormally popular. (As Sam
Goldwyn philosophized: “In life, one must learn to take the
bitter with the sour.”) One of the ironies of business is that
many relatively-unprofitable industries that are plagued by
inadequate prices habitually find themselves beat upon by irate
customers even while other, hugely profitable industries are
spared complaints, no matter how high their prices.

Take the breakfast cereal industry, whose return on invested
capital is more than double that of the auto insurance industry
(which is why companies like Kellogg and General Mills sell at
five times book value and most large insurers sell close to
book). The cereal companies regularly impose price increases,
few of them related to a significant jump in their costs. Yet
not a peep is heard from consumers. But when auto insurers raise
prices by amounts that do not even match cost increases,
customers are outraged. If you want to be loved, it’s clearly
better to sell high-priced corn flakes than low-priced auto
insurance.

The antagonism that the public feels toward the industry can
have serious consequences: Proposition 103, a California
initiative passed last fall, threatens to push auto insurance
prices down sharply, even though costs have been soaring. The
price cut has been suspended while the courts review the
initiative, but the resentment that brought on the vote has not
been suspended: Even if the initiative is overturned, insurers
are likely to find it tough to operate profitably in California.
(Thank heavens the citizenry isn’t mad at bonbons: If Proposition
103 applied to candy as well as insurance, See’s would be forced
to sell its product for $5.76 per pound. rather than the $7.60 we
charge - and would be losing money by the bucketful.)

The immediate direct effects on Berkshire from the
initiative are minor, since we saw few opportunities for profit
in the rate structure that existed in California prior to the
vote. However, the forcing down of prices would seriously affect
GEICO, our 44%-owned investee, which gets about 10% of its
premium volume from California. Even more threatening to GEICO
is the possibility that similar pricing actions will be taken in
other states, through either initiatives or legislation.

If voters insist that auto insurance be priced below cost,
it eventually must be sold by government. Stockholders can
subsidize policyholders for a short period, but only taxpayers
can subsidize them over the long term. At most property-casualty
companies, socialized auto insurance would be no disaster for
shareholders. Because of the commodity characteristics of the
industry, most insurers earn mediocre returns and therefore have
little or no economic goodwill to lose if they are forced by
government to leave the auto insurance business. But GEICO,
because it is a low-cost producer able to earn high returns on
equity, has a huge amount of economic goodwill at risk. In turn,
so do we.

At Berkshire, in 1988, our premium volume continued to fall,
and in 1989 we will experience a large decrease for a special
reason: The contract through which we receive 7% of the business
of Fireman’s Fund expires on August 31. At that time, we will
return to Fireman’s Fund the unearned premiums we hold that
relate to the contract. This transfer of funds will show up in
our “premiums written” account as a negative $85 million or so
and will make our third-quarter figures look rather peculiar.
However, the termination of this contract will not have a
significant effect on profits.

Berkshire’s underwriting results continued to be excellent
in 1988. Our combined ratio (on a statutory basis and excluding
structured settlements and financial reinsurance) was 104.
Reserve development was favorable for the second year in a row,
after a string of years in which it was very unsatisfactory.
Details on both underwriting and reserve development appear on
pages 36-38.

Our insurance volume over the next few years is likely to
run very low, since business with a reasonable potential for
profit will almost certainly be scarce. So be it. At Berkshire,
we simply will not write policies at rates that carry the
expectation of economic loss. We encounter enough troubles when
we expect a gain.

Despite - or perhaps because of - low volume, our profit
picture during the next few years is apt to be considerably
brighter than the industry’s. We are sure to have an exceptional
amount of float compared to premium volume, and that augurs well
for profits. In 1989 and 1990 we expect our float/premiums
ratio to be at least three times that of the typical
property/casualty company. Mike Goldberg, with special help from
Ajit Jain, Dinos Iordanou, and the National Indemnity managerial
team, has positioned us well in that respect.

At some point - we don’t know when - we will be deluged with
insurance business. The cause will probably be some major
physical or financial catastrophe. But we could also experience
an explosion in business, as we did in 1985, because large and
increasing underwriting losses at other companies coincide with
their recognition that they are far underreserved. in the
meantime, we will retain our talented professionals, protect our
capital, and try not to make major mistakes.

Marketable Securities

In selecting marketable securities for our insurance
companies, we can choose among five major categories: (1) long-
term common stock investments, (2) medium-term fixed-income
securities, (3) long-term fixed-income securities, (4) short-term
cash equivalents, and (5) short-term arbitrage commitments.

We have no particular bias when it comes to choosing from
these categories. We just continuously search among them for the
highest after-tax returns as measured by “mathematical
expectation,” limiting ourselves always to investment
alternatives we think we understand. Our criteria have nothing
to do with maximizing immediately reportable earnings; our goal,
rather, is to maximize eventual net worth.

o Below we list our common stock holdings having a value over
$100 million, not including arbitrage commitments, which will be
discussed later. A small portion of these investments belongs to
subsidiaries of which Berkshire owns less than 100%.

Shares Company Cost Market
------ ------- ---------- ----------
(000s omitted)
3,000,000 Capital Cities/ABC, Inc. .............. $517,500 $1,086,750
14,172,500 The Coca-Cola Company ................. 592,540 632,448
2,400,000 Federal Home Loan Mortgage
Corporation Preferred* ............. 71,729 121,200
6,850,000 GEICO Corporation ..................... 45,713 849,400
1,727,765 The Washington Post Company ........... 9,731 364,126

*Although nominally a preferred stock, this security is
financially equivalent to a common stock.
Our permanent holdings - Capital Cities/ABC, Inc., GEICO
Corporation, and The Washington Post Company - remain unchanged.
Also unchanged is our unqualified admiration of their
managements: Tom Murphy and Dan Burke at Cap Cities, Bill Snyder
and Lou Simpson at GEICO, and Kay Graham and Dick Simmons at The
Washington Post. Charlie and I appreciate enormously the talent
and integrity these managers bring to their businesses.

Their performance, which we have observed at close range,
contrasts vividly with that of many CEOs, which we have
fortunately observed from a safe distance. Sometimes these CEOs
clearly do not belong in their jobs; their positions,
nevertheless, are usually secure. The supreme irony of business
management is that it is far easier for an inadequate CEO to keep
his job than it is for an inadequate subordinate.

If a secretary, say, is hired for a job that requires typing
ability of at least 80 words a minute and turns out to be capable
of only 50 words a minute, she will lose her job in no time.
There is a logical standard for this job; performance is easily
measured; and if you can’t make the grade, you’re out.
Similarly, if new sales people fail to generate sufficient
business quickly enough, they will be let go. Excuses will not
be accepted as a substitute for orders.

However, a CEO who doesn’t perform is frequently carried
indefinitely. One reason is that performance standards for his
job seldom exist. When they do, they are often fuzzy or they may
be waived or explained away, even when the performance shortfalls
are major and repeated. At too many companies, the boss shoots
the arrow of managerial performance and then hastily paints the
bullseye around the spot where it lands.

Another important, but seldom recognized, distinction
between the boss and the foot soldier is that the CEO has no
immediate superior whose performance is itself getting measured.
The sales manager who retains a bunch of lemons in his sales
force will soon be in hot water himself. It is in his immediate
self-interest to promptly weed out his hiring mistakes.
Otherwise, he himself may be weeded out. An office manager who
has hired inept secretaries faces the same imperative.

But the CEO’s boss is a Board of Directors that seldom
measures itself and is infrequently held to account for
substandard corporate performance. If the Board makes a mistake
in hiring, and perpetuates that mistake, so what? Even if the
company is taken over because of the mistake, the deal will
probably bestow substantial benefits on the outgoing Board
members. (The bigger they are, the softer they fall.)

Finally, relations between the Board and the CEO are
expected to be congenial. At board meetings, criticism of the
CEO’s performance is often viewed as the social equivalent of
belching. No such inhibitions restrain the office manager from
critically evaluating the substandard typist.

These points should not be interpreted as a blanket
condemnation of CEOs or Boards of Directors: Most are able and
hard-working, and a number are truly outstanding. But the
management failings that Charlie and I have seen make us thankful
that we are linked with the managers of our three permanent
holdings. They love their businesses, they think like owners,
and they exude integrity and ability.

o In 1988 we made major purchases of Federal Home Loan
Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold
these securities for a long time. In fact, when we own portions
of outstanding businesses with outstanding managements, our
favorite holding period is forever. We are just the opposite of
those who hurry to sell and book profits when companies perform
well but who tenaciously hang on to businesses that disappoint.
Peter Lynch aptly likens such behavior to cutting the flowers and
watering the weeds. Our holdings of Freddie Mac are the maximum
allowed by law, and are extensively described by Charlie in his
letter. In our consolidated balance sheet these shares are
carried at cost rather than market, since they are owned by
Mutual Savings and Loan, a non-insurance subsidiary.

We continue to concentrate our investments in a very few
companies that we try to understand well. There are only a
handful of businesses about which we have strong long-term
convictions. Therefore, when we find such a business, we want to
participate in a meaningful way. We agree with Mae West: “Too
much of a good thing can be wonderful.”

o We reduced our holdings of medium-term tax-exempt bonds by
about $100 million last year. All of the bonds sold were
acquired after August 7, 1986. When such bonds are held by
property-casualty insurance companies, 15% of the “tax-exempt”
interest earned is subject to tax.

The $800 million position we still hold consists almost
entirely of bonds “grandfathered” under the Tax Reform Act of
1986, which means they are entirely tax-exempt. Our sales
produced a small profit and our remaining bonds, which have an
average maturity of about six years, are worth modestly more than
carrying value.

Last year we described our holdings of short-term and
intermediate-term bonds of Texaco, which was then in bankruptcy.
During 1988, we sold practically all of these bonds at a pre-tax
profit of about $22 million. This sale explains close to $100
million of the reduction in fixed-income securities on our
balance sheet.

We also told you last year about our holdings of another
security whose predominant characteristics are those of an
intermediate fixed-income issue: our $700 million position in
Salomon Inc 9% convertible preferred. This preferred has a
sinking fund that will retire it in equal annual installments
from 1995 to 1999. Berkshire carries this holding at cost. For
reasons discussed by Charlie on page 69, the estimated market
value of our holding has improved from moderately under cost at
the end of last year to moderately over cost at 1988 year end.

The close association we have had with John Gutfreund, CEO
of Salomon, during the past year has reinforced our admiration
for him. But we continue to have no great insights about the
near, intermediate or long-term economics of the investment
banking business: This is not an industry in which it is easy to
forecast future levels of profitability. We continue to believe
that our conversion privilege could well have important value
over the life of our preferred. However, the overwhelming
portion of the preferred’s value resides in its fixed-income
characteristics, not its equity characteristics.

o We have not lost our aversion to long-term bonds. We will
become enthused about such securities only when we become
enthused about prospects for long-term stability in the
purchasing power of money. And that kind of stability isn’t in
the cards: Both society and elected officials simply have too
many higher-ranking priorities that conflict with purchasing-
power stability. The only long-term bonds we hold are those of
Washington Public Power Supply Systems (WPPSS). A few of our
WPPSS bonds have short maturities and many others, because of
their high coupons, are likely to be refunded and paid off in a
few years. Overall, our WPPSS holdings are carried on our
balance sheet at $247 million and have a market value of about
$352 million.

We explained the reasons for our WPPSS purchases in the 1983
annual report, and are pleased to tell you that this commitment
has worked out about as expected. At the time of purchase, most
of our bonds were yielding around 17% after taxes and carried no
ratings, which had been suspended. Recently, the bonds were
rated AA- by Standard & Poor’s. They now sell at levels only
slightly below those enjoyed by top-grade credits.

In the 1983 report, we compared the economics of our WPPSS
purchase to those involved in buying a business. As it turned
out, this purchase actually worked out better than did the
general run of business acquisitions made in 1983, assuming both
are measured on the basis of unleveraged, after tax returns
achieved through 1988.

Our WPPSS experience, though pleasant, does nothing to alter
our negative opinion about long-term bonds. It only makes us
hope that we run into some other large stigmatized issue, whose
troubles have caused it to be significantly misappraised by the
market.

Arbitrage

In past reports we have told you that our insurance
subsidiaries sometimes engage in arbitrage as an alternative to
holding short-term cash equivalents. We prefer, of course, to
make major long-term commitments, but we often have more cash
than good ideas. At such times, arbitrage sometimes promises
much greater returns than Treasury Bills and, equally important,
cools any temptation we may have to relax our standards for long-
term investments. (Charlie’s sign off after we’ve talked about
an arbitrage commitment is usually: “Okay, at least it will keep
you out of bars.”)

During 1988 we made unusually large profits from arbitrage,
measured both by absolute dollars and rate of return. Our pre-
tax gain was about $78 million on average invested funds of about
$147 million.

This level of activity makes some detailed discussion of
arbitrage and our approach to it appropriate. Once, the word
applied only to the simultaneous purchase and sale of securities
or foreign exchange in two different markets. The goal was to
exploit tiny price differentials that might exist between, say,
Royal Dutch stock trading in guilders in Amsterdam, pounds in
London, and dollars in New York. Some people might call this
scalping; it won’t surprise you that practitioners opted for the
French term, arbitrage.

Since World War I the definition of arbitrage - or “risk
arbitrage,” as it is now sometimes called - has expanded to
include the pursuit of profits from an announced corporate event
such as sale of the company, merger, recapitalization,
reorganization, liquidation, self-tender, etc. In most cases the
arbitrageur expects to profit regardless of the behavior of the
stock market. The major risk he usually faces instead is that
the announced event won’t happen.

Some offbeat opportunities occasionally arise in the
arbitrage field. I participated in one of these when I was 24
and working in New York for Graham-Newman Corp. Rockwood & Co.,
a Brooklyn based chocolate products company of limited
profitability, had adopted LIFO inventory valuation in 1941
when cocoa was selling for 50 cents per pound. In 1954 a
temporary shortage of cocoa caused the price to soar to over
60 cents. Consequently Rockwood wished to unload its valuable
inventory - quickly, before the price dropped. But if the cocoa
had simply been sold off, the company would have owed close to
a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an
arcane provision that eliminated the tax otherwise due on LIFO
profits if inventory was distributed to shareholders as part of a
plan reducing the scope of a corporation’s business. Rockwood
decided to terminate one of its businesses, the sale of cocoa
butter, and said 13 million pounds of its cocoa bean inventory
was attributable to that activity. Accordingly, the company
offered to repurchase its stock in exchange for the cocoa beans
it no longer needed, paying 80 pounds of beans for each share.

For several weeks I busily bought shares, sold beans, and
made periodic stops at Schroeder Trust to exchange stock
certificates for warehouse receipts. The profits were good and
my only expense was subway tokens.

The architect of Rockwood’s restructuring was an unknown,
but brilliant Chicagoan, Jay Pritzker, then 32. If you’re
familiar with Jay’s subsequent record, you won’t be surprised to
hear the action worked out rather well for Rockwood’s continuing
shareholders also. From shortly before the tender until shortly
after it, Rockwood stock appreciated from 15 to 100, even though
the company was experiencing large operating losses. Sometimes
there is more to stock valuation than price-earnings ratios.

In recent years, most arbitrage operations have involved
takeovers, friendly and unfriendly. With acquisition fever
rampant, with anti-trust challenges almost non-existent, and with
bids often ratcheting upward, arbitrageurs have prospered
mightily. They have not needed special talents to do well; the
trick, a la Peter Sellers in the movie, has simply been “Being
There.” In Wall Street the old proverb has been reworded: “Give a
man a fish and you feed him for a day. Teach him how to
arbitrage and you feed him forever.” (If, however, he studied at
the Ivan Boesky School of Arbitrage, it may be a state
institution that supplies his meals.)

To evaluate arbitrage situations you must answer four
questions: (1) How likely is it that the promised event will
indeed occur? (2) How long will your money be tied up? (3) What
chance is there that something still better will transpire - a
competing takeover bid, for example? and (4) What will happen if
the event does not take place because of anti-trust action,
financing glitches, etc.?

Arcata Corp., one of our more serendipitous arbitrage
experiences, illustrates the twists and turns of the business.
On September 28, 1981 the directors of Arcata agreed in principle
to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR),
then and now a major leveraged-buy out firm. Arcata was in the
printing and forest products businesses and had one other thing
going for it: In 1978 the U.S. Government had taken title to
10,700 acres of Arcata timber, primarily old-growth redwood, to
expand Redwood National Park. The government had paid $97.9
million, in several installments, for this acreage, a sum Arcata
was contesting as grossly inadequate. The parties also disputed
the interest rate that should apply to the period between the
taking of the property and final payment for it. The enabling
legislation stipulated 6% simple interest; Arcata argued for a
much higher and compounded rate.

Buying a company with a highly-speculative, large-sized
claim in litigation creates a negotiating problem, whether the
claim is on behalf of or against the company. To solve this
problem, KKR offered $37.00 per Arcata share plus two-thirds of
any additional amounts paid by the government for the redwood
lands.

Appraising this arbitrage opportunity, we had to ask
ourselves whether KKR would consummate the transaction since,
among other things, its offer was contingent upon its obtaining
“satisfactory financing.” A clause of this kind is always
dangerous for the seller: It offers an easy exit for a suitor
whose ardor fades between proposal and marriage. However, we
were not particularly worried about this possibility because
KKR’s past record for closing had been good.

We also had to ask ourselves what would happen if the KKR
deal did fall through, and here we also felt reasonably
comfortable: Arcata’s management and directors had been shopping
the company for some time and were clearly determined to sell.
If KKR went away, Arcata would likely find another buyer, though
of course, the price might be lower.

Finally, we had to ask ourselves what the redwood claim
might be worth. Your Chairman, who can’t tell an elm from an
oak, had no trouble with that one: He coolly evaluated the claim
at somewhere between zero and a whole lot.

We started buying Arcata stock, then around $33.50, on
September 30 and in eight weeks purchased about 400,000 shares,
or 5% of the company. The initial announcement said that the
$37.00 would be paid in January, 1982. Therefore, if everything
had gone perfectly, we would have achieved an annual rate of
return of about 40% - not counting the redwood claim, which would
have been frosting.

All did not go perfectly. In December it was announced that
the closing would be delayed a bit. Nevertheless, a definitive
agreement was signed on January 4. Encouraged, we raised our
stake, buying at around $38.00 per share and increasing our
holdings to 655,000 shares, or over 7% of the company. Our
willingness to pay up - even though the closing had been
postponed - reflected our leaning toward “a whole lot” rather
than “zero” for the redwoods.

Then, on February 25 the lenders said they were taking a
“second look” at financing terms “ in view of the severely
depressed housing industry and its impact on Arcata’s outlook.”
The stockholders’ meeting was postponed again, to April. An
Arcata spokesman said he “did not think the fate of the
acquisition itself was imperiled.” When arbitrageurs hear such
reassurances, their minds flash to the old saying: “He lied like
a finance minister on the eve of devaluation.”

On March 12 KKR said its earlier deal wouldn’t work, first
cutting its offer to $33.50, then two days later raising it to
$35.00. On March 15, however, the directors turned this bid down
and accepted another group’s offer of $37.50 plus one-half of any
redwood recovery. The shareholders okayed the deal, and the
$37.50 was paid on June 4.

We received $24.6 million versus our cost of $22.9 million;
our average holding period was close to six months. Considering
the trouble this transaction encountered, our 15% annual rate of
return excluding any value for the redwood claim - was more than
satisfactory.

But the best was yet to come. The trial judge appointed two
commissions, one to look at the timber’s value, the other to
consider the interest rate questions. In January 1987, the first
commission said the redwoods were worth $275.7 million and the
second commission recommended a compounded, blended rate of
return working out to about 14%.

In August 1987 the judge upheld these conclusions, which
meant a net amount of about $600 million would be due Arcata.
The government then appealed. In 1988, though, before this
appeal was heard, the claim was settled for $519 million.
Consequently, we received an additional $29.48 per share, or
about $19.3 million. We will get another $800,000 or so in 1989.

Berkshire’s arbitrage activities differ from those of many
arbitrageurs. First, we participate in only a few, and usually
very large, transactions each year. Most practitioners buy into
a great many deals perhaps 50 or more per year. With that many
irons in the fire, they must spend most of their time monitoring
both the progress of deals and the market movements of the
related stocks. This is not how Charlie nor I wish to spend our
lives. (What’s the sense in getting rich just to stare at a
ticker tape all day?)

Because we diversify so little, one particularly profitable
or unprofitable transaction will affect our yearly result from
arbitrage far more than it will the typical arbitrage operation.
So far, Berkshire has not had a really bad experience. But we
will - and when it happens we’ll report the gory details to you.

The other way we differ from some arbitrage operations is
that we participate only in transactions that have been publicly
announced. We do not trade on rumors or try to guess takeover
candidates. We just read the newspapers, think about a few of
the big propositions, and go by our own sense of probabilities.

At yearend, our only major arbitrage position was 3,342,000
shares of RJR Nabisco with a cost of $281.8 million and a market
value of $304.5 million. In January we increased our holdings to
roughly four million shares and in February we eliminated our
position. About three million shares were accepted when we
tendered our holdings to KKR, which acquired RJR, and the
returned shares were promptly sold in the market. Our pre-tax
profit was a better-than-expected $64 million.

Earlier, another familiar face turned up in the RJR bidding
contest: Jay Pritzker, who was part of a First Boston group that
made a tax-oriented offer. To quote Yogi Berra; “It was deja vu
all over again.”

During most of the time when we normally would have been
purchasers of RJR, our activities in the stock were restricted
because of Salomon’s participation in a bidding group.
Customarily, Charlie and I, though we are directors of Salomon,
are walled off from information about its merger and acquisition
work. We have asked that it be that way: The information would
do us no good and could, in fact, occasionally inhibit
Berkshire’s arbitrage operations.

However, the unusually large commitment that Salomon
proposed to make in the RJR deal required that all directors be
fully informed and involved. Therefore, Berkshire’s purchases of
RJR were made at only two times: first, in the few days
immediately following management’s announcement of buyout plans,
before Salomon became involved; and considerably later, after the
RJR board made its decision in favor of KKR. Because we could
not buy at other times, our directorships cost Berkshire
significant money.

Considering Berkshire’s good results in 1988, you might
expect us to pile into arbitrage during 1989. Instead, we expect
to be on the sidelines.

One pleasant reason is that our cash holdings are down -
because our position in equities that we expect to hold for a
very long time is substantially up. As regular readers of this
report know, our new commitments are not based on a judgment
about short-term prospects for the stock market. Rather, they
reflect an opinion about long-term business prospects for
specific companies. We do not have, never have had, and never
will have an opinion about where the stock market, interest
rates, or business activity will be a year from now.

Even if we had a lot of cash we probably would do little in
arbitrage in 1989. Some extraordinary excesses have developed in
the takeover field. As Dorothy says: “Toto, I have a feeling
we’re not in Kansas any more.”

We have no idea how long the excesses will last, nor do we
know what will change the attitudes of government, lender and
buyer that fuel them. But we do know that the less the prudence
with which others conduct their affairs, the greater the prudence
with which we should conduct our own affairs. We have no desire
to arbitrage transactions that reflect the unbridled - and, in
our view, often unwarranted - optimism of both buyers and
lenders. In our activities, we will heed the wisdom of Herb
Stein: “If something can’t go on forever, it will end.”

Efficient Market Theory

The preceding discussion about arbitrage makes a small
discussion of “efficient market theory” (EMT) also seem relevant.
This doctrine became highly fashionable - indeed, almost holy
scripture in academic circles during the 1970s. Essentially, it
said that analyzing stocks was useless because all public
information about them was appropriately reflected in their
prices. In other words, the market always knew everything. As a
corollary, the professors who taught EMT said that someone
throwing darts at the stock tables could select a stock portfolio
having prospects just as good as one selected by the brightest,
most hard-working security analyst. Amazingly, EMT was embraced
not only by academics, but by many investment professionals and
corporate managers as well. Observing correctly that the market
was frequently efficient, they went on to conclude incorrectly
that it was always efficient. The difference between these
propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience
of Graham-Newman Corp. Buffett Partnership, and Berkshire
illustrates just how foolish EMT is. (There’s plenty of other
evidence, also.) While at Graham-Newman, I made a study of its
earnings from arbitrage during the entire 1926-1956 lifespan of
the company. Unleveraged returns averaged 20% per year.
Starting in 1956, I applied Ben Graham’s arbitrage principles,
first at Buffett Partnership and then Berkshire. Though I’ve not
made an exact calculation, I have done enough work to know that
the 1956-1988 returns averaged well over 20%. (Of course, I
operated in an environment far more favorable than Ben’s; he had
1929-1932 to contend with.)

All of the conditions are present that are required for a
fair test of portfolio performance: (1) the three organizations
traded hundreds of different securities while building this 63-
year record; (2) the results are not skewed by a few fortunate
experiences; (3) we did not have to dig for obscure facts or
develop keen insights about products or managements - we simply
acted on highly-publicized events; and (4) our arbitrage
positions were a clearly identified universe - they have not been
selected by hindsight.

Over the 63 years, the general market delivered just under a
10% annual return, including dividends. That means $1,000 would
have grown to $405,000 if all income had been reinvested. A 20%
rate of return, however, would have produced $97 million. That
strikes us as a statistically-significant differential that
might, conceivably, arouse one’s curiosity.

Yet proponents of the theory have never seemed interested in
discordant evidence of this type. True, they don’t talk quite as
much about their theory today as they used to. But no one, to my
knowledge, has ever said he was wrong, no matter how many
thousands of students he has sent forth misinstructed. EMT,
moreover, continues to be an integral part of the investment
curriculum at major business schools. Apparently, a reluctance
to recant, and thereby to demystify the priesthood, is not
limited to theologians.

Naturally the disservice done students and gullible
investment professionals who have swallowed EMT has been an
extraordinary service to us and other followers of Graham. In
any sort of a contest - financial, mental, or physical - it’s an
enormous advantage to have opponents who have been taught that
it’s useless to even try. From a selfish point of view,
Grahamites should probably endow chairs to ensure the perpetual
teaching of EMT.

All this said, a warning is appropriate. Arbitrage has
looked easy recently. But this is not a form of investing that
guarantees profits of 20% a year or, for that matter, profits of
any kind. As noted, the market is reasonably efficient much of
the time: For every arbitrage opportunity we seized in that 63-
year period, many more were foregone because they seemed
properly-priced.

An investor cannot obtain superior profits from stocks by
simply committing to a specific investment category or style. He
can earn them only by carefully evaluating facts and continuously
exercising discipline. Investing in arbitrage situations, per
se, is no better a strategy than selecting a portfolio by
throwing darts.

New York Stock Exchange Listing

Berkshire’s shares were listed on the New York Stock
Exchange on November 29, 1988. On pages 50-51 we reproduce the
letter we sent to shareholders concerning the listing.

Let me clarify one point not dealt with in the letter:
Though our round lot for trading on the NYSE is ten shares, any
number of shares from one on up can be bought or sold.

As the letter explains, our primary goal in listing was to
reduce transaction costs, and we believe this goal is being
achieved. Generally, the spread between the bid and asked price
on the NYSE has been well below the spread that prevailed in the
over-the-counter market.

Henderson Brothers, Inc., the specialist in our shares, is
the oldest continuing specialist firm on the Exchange; its
progenitor, William Thomas Henderson, bought his seat for $500 on
September 8, 1861. (Recently, seats were selling for about
$625,000.) Among the 54 firms acting as specialists, HBI ranks
second in number of stocks assigned, with 83. We were pleased
when Berkshire was allocated to HBI, and have been delighted with
the firm’s performance. Jim Maguire, Chairman of HBI, personally
manages the trading in Berkshire, and we could not be in better
hands.

In two respects our goals probably differ somewhat from
those of most listed companies. First, we do not want to
maximize the price at which Berkshire shares trade. We wish
instead for them to trade in a narrow range centered at intrinsic
business value (which we hope increases at a reasonable - or,
better yet, unreasonable - rate). Charlie and I are bothered as
much by significant overvaluation as significant undervaluation.
Both extremes will inevitably produce results for many
shareholders that will differ sharply from Berkshire’s business
results. If our stock price instead consistently mirrors
business value, each of our shareholders will receive an
investment result that roughly parallels the business results of
Berkshire during his holding period.

Second, we wish for very little trading activity. If we ran
a private business with a few passive partners, we would be
disappointed if those partners, and their replacements,
frequently wanted to leave the partnership. Running a public
company, we feel the same way.

Our goal is to attract long-term owners who, at the time of
purchase, have no timetable or price target for sale but plan
instead to stay with us indefinitely. We don’t understand the
CEO who wants lots of stock activity, for that can be achieved
only if many of his owners are constantly exiting. At what other
organization - school, club, church, etc. - do leaders cheer when
members leave? (However, if there were a broker whose livelihood
depended upon the membership turnover in such organizations, you
could be sure that there would be at least one proponent of
activity, as in: “There hasn’t been much going on in Christianity
for a while; maybe we should switch to Buddhism next week.“)

Of course, some Berkshire owners will need or want to sell
from time to time, and we wish for good replacements who will pay
them a fair price. Therefore we try, through our policies,
performance, and communications, to attract new shareholders who
understand our operations, share our time horizons, and measure
us as we measure ourselves. If we can continue to attract this
sort of shareholder - and, just as important, can continue to be
uninteresting to those with short-term or unrealistic
expectations - Berkshire shares should consistently sell at
prices reasonably related to business value.

David L. Dodd

Dave Dodd, my friend and teacher for 38 years, died last
year at age 93. Most of you don’t know of him. Yet any long-
time shareholder of Berkshire is appreciably wealthier because of
the indirect influence he had upon our company.

Dave spent a lifetime teaching at Columbia University, and
he co-authored Security Analysis with Ben Graham. From the
moment I arrived at Columbia, Dave personally encouraged and
educated me; one influence was as important as the other.
Everything he taught me, directly or through his book, made
sense. Later, through dozens of letters, he continued my
education right up until his death.

I have known many professors of finance and investments but
I have never seen any, except for Ben Graham, who was the match
of Dave. The proof of his talent is the record of his students:
No other teacher of investments has sent forth so many who have
achieved unusual success.

When students left Dave’s classroom, they were equipped to
invest intelligently for a lifetime because the principles he
taught were simple, sound, useful, and enduring. Though these
may appear to be unremarkable virtues, the teaching of principles
embodying them has been rare.

It’s particularly impressive that Dave could practice as
well as preach. just as Keynes became wealthy by applying his
academic ideas to a very small purse, so, too, did Dave. Indeed,
his financial performance far outshone that of Keynes, who began
as a market-timer (leaning on business and credit-cycle theory)
and converted, after much thought, to value investing. Dave was
right from the start.

In Berkshire’s investments, Charlie and I have employed the
principles taught by Dave and Ben Graham. Our prosperity is the
fruit of their intellectual tree.

Miscellaneous

We hope to buy more businesses that are similar to the ones
we have, and we can use some help. If you have a business that
fits the following criteria, call me or, preferably, write.

Here’s what we’re looking for:

(1) large purchases (at least $10 million of after-tax
earnings),

(2) demonstrated consistent earning power (future projections
are of little interest to us, nor are “turnaround”
situations),

(3) businesses earning good returns on equity while employing
little or no debt,

(4) management in place (we can’t supply it),

(5) simple businesses (if there’s lots of technology, we won’t
understand it),

(6) an offering price (we don’t want to waste our time or that
of the seller by talking, even preliminarily, about a
transaction when price is unknown).

We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we’re interested. We prefer
to buy for cash, but will consider issuing stock when we receive
as much in intrinsic business value as we give.

Our favorite form of purchase is one fitting the Blumkin-
Friedman-Heldman mold. In cases like these, the company’s owner-
managers wish to generate significant amounts of cash, sometimes
for themselves, but often for their families or inactive
shareholders. However, these managers also wish to remain
significant owners who continue to run their companies just as
they have in the past. We think we offer a particularly good fit
for owners with these objectives and invite potential sellers to
check us out by contacting people with whom we have done business
in the past.

Charlie and I frequently get approached about acquisitions
that don’t come close to meeting our tests: We’ve found that if
you advertise an interest in buying collies, a lot of people will
call hoping to sell you their cocker spaniels. Our interest in
new ventures, turnarounds, or auction-like sales can best be
expressed by another Goldwynism: “Please include me out.”

Besides being interested in the purchase of businesses as
described above, we are also interested in the negotiated
purchase of large, but not controlling, blocks of stock
comparable to those we hold in Cap Cities and Salomon. We have a
special interest in purchasing convertible preferreds as a long-
term investment, as we did at Salomon.

* * *

We received some good news a few weeks ago: Standard &
Poor’s raised our credit rating to AAA, which is the highest
rating it bestows. Only 15 other U.S. industrial or property-
casualty companies are rated AAA, down from 28 in 1980.

Corporate bondholders have taken their lumps in the past few
years from “event risk.” This term refers to the overnight
degradation of credit that accompanies a heavily-leveraged
purchase or recapitalization of a business whose financial
policies, up to then, had been conservative. In a world of
takeovers inhabited by few owner-managers, most corporations
present such a risk. Berkshire does not. Charlie and I promise
bondholders the same respect we afford shareholders.

* * *

About 97.4% of all eligible shares participated in
Berkshire’s 1988 shareholder-designated contributions program.
Contributions made through the program were $5 million, and 2,319
charities were recipients. If we achieve reasonable business
results, we plan to increase the per-share contributions in 1989.

We urge new shareholders to read the description of our
shareholder-designated contributions program that appears on
pages 48-49. If you wish to participate in future programs, we
strongly urge that you immediately make sure your shares are
registered in the name of the actual owner, not in the nominee
name of a broker, bank or depository. Shares not so registered
on September 30, 1989 will be ineligible for the 1989 program.

* * *

Berkshire’s annual meeting will be held in Omaha on Monday,
April 24, 1989, and I hope you will come. The meeting provides
the forum for you to ask any owner-related questions you may
have, and we will keep answering until all (except those dealing
with portfolio activities or other proprietary information) have
been dealt with.

After the meeting we will have several buses available to
take you to visit Mrs. B at The Nebraska Furniture Mart and Ike
Friedman at Borsheim’s. Be prepared for bargains.

Out-of-towners may prefer to arrive early and visit Mrs. B
during the Sunday store hours of noon to five. (These Sunday
hours seem ridiculously short to Mrs. B, who feels they scarcely
allow her time to warm up; she much prefers the days on which the
store remains open from 10 a.m. to 9 p.m.) Borsheims, however, is
not open on Sunday.

Ask Mrs. B the secret of her astonishingly low carpet
prices. She will confide to you - as she does to everyone - how
she does it: “I can sell so cheap ‘cause I work for this dummy
who doesn’t know anything about carpet.”


Warren E. Buffett
February 28, 1989 Chairman of the Board

To the Shareholders of Berkshire Hathaway Inc.:

Our gain in net worth during 1989 was $1.515 billion, or
44.4%. Over the last 25 years (that is, since present management
took over) our per-share book value has grown from $19.46 to
$4,296.01, or at a rate of 23.8% compounded annually.

What counts, however, is intrinsic value - the figure
indicating what all of our constituent businesses are rationally
worth. With perfect foresight, this number can be calculated by
taking all future cash flows of a business - in and out - and
discounting them at prevailing interest rates. So valued, all
businesses, from manufacturers of buggy whips to operators of
cellular phones, become economic equals.

Back when Berkshire's book value was $19.46, intrinsic
value was somewhat less because the book value was entirely tied
up in a textile business not worth the figure at which it was
carried. Now most of our businesses are worth far more than their
carrying values. This agreeable evolution from a discount to a
premium means that Berkshire's intrinsic business value has
compounded at a rate that somewhat exceeds our 23.8% annual
growth in book value.

The rear-view mirror is one thing; the windshield is
another. A large portion of our book value is represented by
equity securities that, with minor exceptions, are carried on our
balance sheet at current market values. At yearend these
securities were valued at higher prices, relative to their own
intrinsic business values, than has been the case in the past.
One reason is the buoyant 1989 stock market. More important, the
virtues of these businesses have been widely recognized. Whereas
once their stock prices were inappropriately low, they are not
now.

We will keep most of our major holdings, regardless of how
they are priced relative to intrinsic business value. This 'til-
death-do-us-part attitude, combined with the full prices these
holdings command, means that they cannot be expected to push up
Berkshire's value in the future as sharply as in the past. In
other words, our performance to date has benefited from a double-
dip: (1) the exceptional gains in intrinsic value that our
portfolio companies have achieved; (2) the additional bonus we
realized as the market appropriately "corrected" the prices of
these companies, raising their valuations in relation to those of
the average business. We will continue to benefit from good gains
in business value that we feel confident our portfolio companies
will make. But our "catch-up" rewards have been realized, which
means we'll have to settle for a single-dip in the future.

We face another obstacle: In a finite world, high growth
rates must self-destruct. If the base from which the growth is
taking place is tiny, this law may not operate for a time. But
when the base balloons, the party ends: A high growth rate
eventually forges its own anchor.

Carl Sagan has entertainingly described this phenomenon,
musing about the destiny of bacteria that reproduce by dividing
into two every 15 minutes. Says Sagan: "That means four doublings
an hour, and 96 doublings a day. Although a bacterium weighs only
about a trillionth of a gram, its descendants, after a day of
wild asexual abandon, will collectively weigh as much as a
mountain...in two days, more than the sun - and before very long,
everything in the universe will be made of bacteria." Not to
worry, says Sagan: Some obstacle always impedes this kind of
exponential growth. "The bugs run out of food, or they poison
each other, or they are shy about reproducing in public."

Even on bad days, Charlie Munger (Berkshire's Vice Chairman
and my partner) and I do not think of Berkshire as a bacterium.
Nor, to our unending sorrow, have we found a way to double its
net worth every 15 minutes. Furthermore, we are not the least bit
shy about reproducing - financially - in public. Nevertheless,
Sagan's observations apply. From Berkshire's present base of $4.9
billion in net worth, we will find it much more difficult to
average 15% annual growth in book value than we did to average
23.8% from the $22 million we began with.

Taxes

Our 1989 gain of $1.5 billion was achieved after we took a
charge of about $712 million for income taxes. In addition,
Berkshire's share of the income taxes paid by its five major
investees totaled about $175 million.

Of this year's tax charge, about $172 million will be paid
currently; the remainder, $540 million, is deferred. Almost all
of the deferred portion relates to the 1989 increase in
unrealized profits in our common stock holdings. Against this
increase, we have reserved a 34% tax.

We also carry reserves at that rate against all unrealized
profits generated in 1987 and 1988. But, as we explained last
year, the unrealized gains we amassed before 1987 - about $1.2
billion - carry reserves booked at the 28% tax rate that then
prevailed.

A new accounting rule is likely to be adopted that will
require companies to reserve against all gains at the current tax
rate, whatever it may be. With the rate at 34%, such a rule would
increase our deferred tax liability, and decrease our net worth,
by about $71 million - the result of raising the reserve on our
pre-1987 gain by six percentage points. Because the proposed rule
has sparked widespread controversy and its final form is unclear,
we have not yet made this change.

As you can see from our balance sheet on page 27, we would
owe taxes of more than $1.1 billion were we to sell all of our
securities at year-end market values. Is this $1.1 billion
liability equal, or even similar, to a $1.1 billion liability
payable to a trade creditor 15 days after the end of the year?
Obviously not - despite the fact that both items have exactly the
same effect on audited net worth, reducing it by $1.1 billion.

On the other hand, is this liability for deferred taxes a
meaningless accounting fiction because its payment can be
triggered only by the sale of stocks that, in very large part, we
have no intention of selling? Again, the answer is no.

In economic terms, the liability resembles an interest-free
loan from the U.S. Treasury that comes due only at our election
(unless, of course, Congress moves to tax gains before they are
realized). This "loan" is peculiar in other respects as well: It
can be used only to finance the ownership of the particular,
appreciated stocks and it fluctuates in size - daily as market
prices change and periodically if tax rates change. In effect,
this deferred tax liability is equivalent to a very large
transfer tax that is payable only if we elect to move from one
asset to another. Indeed, we sold some relatively small holdings
in 1989, incurring about $76 million of "transfer" tax on $224
million of gains.

Because of the way the tax law works, the Rip Van Winkle
style of investing that we favor - if successful - has an
important mathematical edge over a more frenzied approach. Let's
look at an extreme comparison.

Imagine that Berkshire had only $1, which we put in a
security that doubled by yearend and was then sold. Imagine
further that we used the after-tax proceeds to repeat this
process in each of the next 19 years, scoring a double each time.
At the end of the 20 years, the 34% capital gains tax that we
would have paid on the profits from each sale would have
delivered about $13,000 to the government and we would be left
with about $25,250. Not bad. If, however, we made a single
fantastic investment that itself doubled 20 times during the 20
years, our dollar would grow to $1,048,576. Were we then to cash
out, we would pay a 34% tax of roughly $356,500 and be left with
about $692,000.

The sole reason for this staggering difference in results
would be the timing of tax payments. Interestingly, the
government would gain from Scenario 2 in exactly the same 27:1
ratio as we - taking in taxes of $356,500 vs. $13,000 - though,
admittedly, it would have to wait for its money.

We have not, we should stress, adopted our strategy
favoring long-term investment commitments because of these
mathematics. Indeed, it is possible we could earn greater after-
tax returns by moving rather frequently from one investment to
another. Many years ago, that's exactly what Charlie and I did.

Now we would rather stay put, even if that means slightly
lower returns. Our reason is simple: We have found splendid
business relationships to be so rare and so enjoyable that we
want to retain all we develop. This decision is particularly
easy for us because we feel that these relationships will produce
good - though perhaps not optimal - financial results.
Considering that, we think it makes little sense for us to give
up time with people we know to be interesting and admirable for
time with others we do not know and who are likely to have human
qualities far closer to average. That would be akin to marrying
for money - a mistake under most circumstances, insanity if one
is already rich.

Sources of Reported Earnings

The table below shows the major sources of Berkshire's
reported earnings. In this presentation, amortization of Goodwill
and other major purchase-price accounting adjustments are not
charged against the specific businesses to which they apply, but
are instead aggregated and shown separately. This procedure lets
you view the earnings of our businesses as they would have been
reported had we not purchased them. I've explained in past
reports why this form of presentation seems to us to be more
useful to investors and managers than one utilizing generally
accepted accounting principles (GAAP), which require purchase-
price adjustments to be made on a business-by-business basis. The
total net earnings we show in the table are, of course, identical
to the GAAP total in our audited financial statements.

Further information about these businesses is given in the
Business Segment section on pages 37-39, and in the Management's
Discussion section on pages 40-44. In these sections you also
will find our segment earnings reported on a GAAP basis. For
information on Wesco's businesses, I urge you to read Charlie
Munger's letter, which starts on page 54. In addition, we have
reprinted on page 71 Charlie's May 30, 1989 letter to the U. S.
League of Savings Institutions, which conveyed our disgust with
its policies and our consequent decision to resign.

(000s omitted)
----------------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
---------------------- ----------------------
1989 1988 1989 1988
---------- ---------- ---------- ----------
Operating Earnings:
Insurance Group:
Underwriting ............ $(24,400) $(11,081) $(12,259) $ (1,045)
Net Investment Income ... 243,599 231,250 213,642 197,779
Buffalo News .............. 46,047 42,429 27,771 25,462
Fechheimer ................ 12,621 14,152 6,789 7,720
Kirby ..................... 26,114 26,891 16,803 17,842
Nebraska Furniture Mart ... 17,070 18,439 8,441 9,099
Scott Fetzer
Manufacturing Group .... 33,165 28,542 19,996 17,640
See's Candies ............. 34,235 32,473 20,626 19,671
Wesco - other than Insurance 13,008 16,133 9,810 10,650
World Book ................ 25,583 27,890 16,372 18,021
Amortization of Goodwill .. (3,387) (2,806) (3,372) (2,806)
Other Purchase-Price
Accounting Charges ........ (5,740) (6,342) (6,668) (7,340)
Interest Expense* ......... (42,389) (35,613) (27,098) (23,212)
Shareholder-Designated
Contributions .......... (5,867) (4,966) (3,814) (3,217)
Other ..................... 23,755 41,059 12,863 27,177
---------- ---------- ---------- ----------
Operating Earnings .......... 393,414 418,450 299,902 313,441
Sales of Securities ......... 223,810 131,671 147,575 85,829
---------- ---------- ---------- ----------
Total Earnings - All Entities $617,224 $550,121 $447,477 $399,270

*Excludes interest expense of Scott Fetzer Financial Group and
Mutual Savings & Loan.


We refer you also to pages 45-51, where we have rearranged
Berkshire's financial data into four segments. These correspond
to the way Charlie and I think about the business and should help
you calculate Berkshire's intrinsic value. Shown on these pages
are balance sheets and earnings statements for: (1) our
insurance operations, with their major investment positions
itemized; (2) our manufacturing, publishing and retailing
businesses, leaving aside certain non-operating assets and
purchase-price accounting adjustments; (3) our subsidiaries
engaged in finance-type operations, which are Mutual Savings and
Scott Fetzer Financial; and (4) an all-other category that
includes the non-operating assets (primarily marketable
securities) held by the companies in segment (2), all purchase
price accounting adjustments, and various assets and debts of the
Wesco and Berkshire parent companies.

If you combine the earnings and net worths of these four
segments, you will derive totals matching those shown on our GAAP
statements. However, I want to emphasize that this four-category
presentation does not fall within the purview of our auditors,
who in no way bless it.

In addition to our reported earnings, we also benefit from
significant earnings of investees that standard accounting rules
do not permit us to report. On page 15, we list five major
investees from which we received dividends in 1989 of about $45
million, after taxes. However, our share of the retained earnings
of these investees totaled about $212 million last year, not
counting large capital gains realized by GEICO and Coca-Cola. If
this $212 million had been distributed to us, our own operating
earnings, after the payment of additional taxes, would have been
close to $500 million rather than the $300 million shown in the
table.

The question you must decide is whether these undistributed
earnings are as valuable to us as those we report. We believe
they are - and even think they may be more valuable. The reason
for this a-bird-in-the-bush-may-be-worth-two-in-the-hand
conclusion is that earnings retained by these investees will
be deployed by talented, owner-oriented managers who
sometimes have better uses for these funds in their own
businesses than we would have in ours. I would not make such a
generous assessment of most managements, but it is appropriate in
these cases.

In our view, Berkshire's fundamental earning power is best
measured by a "look-through" approach, in which we append our
share of the operating earnings retained by our investees to our
own reported operating earnings, excluding capital gains in both
instances. For our intrinsic business value to grow at an average
of 15% per year, our "look-through" earnings must grow at about
the same pace. We'll need plenty of help from our present
investees, and also need to add a new one from time to time, in
order to reach this 15% goal.
Non-Insurance Operations
In the past, we have labeled our major manufacturing,
publishing and retail operations "The Sainted Seven." With our
acquisition of Borsheim's early in 1989, the challenge was to
find a new title both alliterative and appropriate. We failed:
Let's call the group "The Sainted Seven Plus One."

This divine assemblage - Borsheim's, The Buffalo News,
Fechheimer Bros., Kirby, Nebraska Furniture Mart, Scott Fetzer
Manufacturing Group, See's Candies, World Book - is a collection
of businesses with economic characteristics that range from good
to superb. Its managers range from superb to superb.

Most of these managers have no need to work for a living;
they show up at the ballpark because they like to hit home runs.
And that's exactly what they do. Their combined financial
statements (including those of some smaller operations), shown on
page 49, illustrate just how outstanding their performance is. On
an historical accounting basis, after-tax earnings of these
operations were 57% on average equity capital. Moreover, this
return was achieved with no net leverage: Cash equivalents have
matched funded debt. When I call off the names of our managers -
the Blumkin, Friedman and Heldman families, Chuck Huggins, Stan
Lipsey, and Ralph Schey - I feel the same glow that Miller
Huggins must have experienced when he announced the lineup of his
1927 New York Yankees.

Let's take a look, business by business:

o In its first year with Berkshire, Borsheim's met all
expectations. Sales rose significantly and are now considerably
better than twice what they were four years ago when the company
moved to its present location. In the six years prior to the
move, sales had also doubled. Ike Friedman, Borsheim's managing
genius - and I mean that - has only one speed: fast-forward.

If you haven't been there, you've never seen a jewelry store
like Borsheim's. Because of the huge volume it does at one
location, the store can maintain an enormous selection across all
price ranges. For the same reason, it can hold its expense ratio
to about one-third that prevailing at jewelry stores offering
comparable merchandise. The store's tight control of expenses,
accompanied by its unusual buying power, enable it to offer
prices far lower than those of other jewelers. These prices, in
turn, generate even more volume, and so the circle goes 'round
and 'round. The end result is store traffic as high as 4,000
people on seasonally-busy days.

Ike Friedman is not only a superb businessman and a great
showman but also a man of integrity. We bought the business
without an audit, and all of our surprises have been on the plus
side. "If you don't know jewelry, know your jeweler" makes sense
whether you are buying the whole business or a tiny diamond.

A story will illustrate why I enjoy Ike so much: Every two
years I'm part of an informal group that gathers to have fun and
explore a few subjects. Last September, meeting at Bishop's Lodge
in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come
by and educate us on jewels and the jewelry business.

Ike decided to dazzle the group, so he brought from Omaha
about $20 million of particularly fancy merchandise. I was
somewhat apprehensive - Bishop's Lodge is no Fort Knox - and I
mentioned my concern to Ike at our opening party the evening
before his presentation. Ike took me aside. "See that safe?" he
said. "This afternoon we changed the combination and now even the
hotel management doesn't know what it is." I breathed easier. Ike
went on: "See those two big fellows with guns on their hips?
They'll be guarding the safe all night." I now was ready to
rejoin the party. But Ike leaned closer: "And besides, Warren,"
he confided, "the jewels aren't in the safe."

How can we miss with a fellow like that - particularly when
he comes equipped with a talented and energetic family, Alan,
Marvin Cohn, and Don Yale.

o At See's Candies we had an 8% increase in pounds sold, even
though 1988 was itself a record year. Included in the 1989
performance were excellent same-store poundage gains, our first
in many years.
Advertising played an important role in this outstanding
performance. We increased total advertising expenditures from $4
million to $5 million and also got copy from our agency, Hal
Riney & Partners, Inc., that was 100% on the money in conveying
the qualities that make See's special.

In our media businesses, such as the Buffalo News, we sell
advertising. In other businesses, such as See's, we are buyers.
When we buy, we practice exactly what we preach when we sell. At
See's, we more than tripled our expenditures on newspaper
advertising last year, to the highest percentage of sales that I
can remember. The payoff was terrific, and we thank both Hal
Riney and the power of well-directed newspaper advertising for
this result.

See's splendid performances have become routine. But there
is nothing routine about the management of Chuck Huggins: His
daily involvement with all aspects of production and sales
imparts a quality-and-service message to the thousands of
employees we need to produce and distribute over 27 million
pounds of candy annually. In a company with 225 shops and a
massive mail order and phone business, it is no small trick to
run things so that virtually every customer leaves happy. Chuck
makes it look easy.
o The Nebraska Furniture Mart had record sales and excellent
earnings in 1989, but there was one sad note. Mrs. B - Rose
Blumkin, who started the company 52 years ago with $500 - quit in
May, after disagreeing with other members of the Blumkin
family/management about the remodeling and operation of the
carpet department.

Mrs. B probably has made more smart business decisions than
any living American, but in this particular case I believe the
other members of the family were entirely correct: Over the past
three years, while the store's other departments increased sales
by 24%, carpet sales declined by 17% (but not because of any lack
of sales ability by Mrs. B, who has always personally sold far
more merchandise than any other salesperson in the store).

You will be pleased to know that Mrs. B continues to make
Horatio Alger's heroes look like victims of tired blood. At age
96 she has started a new business selling - what else? - carpet
and furniture. And as always, she works seven days a week.

At the Mart Louie, Ron, and Irv Blumkin continue to propel
what is by far the largest and most successful home furnishings
store in the country. They are outstanding merchants, outstanding
managers, and a joy to be associated with. One reading on their
acumen: In the fourth quarter of 1989, the carpet department
registered a 75.3% consumer share in the Omaha market, up from
67.7% a year earlier and over six times that of its nearest
competitor.

NFM and Borsheim's follow precisely the same formula for
success: (1) unparalleled depth and breadth of merchandise at one
location; (2) the lowest operating costs in the business; (3) the
shrewdest of buying, made possible in part by the huge volumes
purchased; (4) gross margins, and therefore prices, far below
competitors'; and (5) friendly personalized service with family
members on hand at all times.

Another plug for newspapers: NFM increased its linage in the
local paper by over 20% in 1989 - off a record 1988 - and remains
the paper's largest ROP advertiser by far. (ROP advertising is
the kind printed in the paper, as opposed to that in preprinted
inserts.) To my knowledge, Omaha is the only city in which a home
furnishings store is the advertising leader. Many retailers cut
space purchases in 1989; our experience at See's and NFM would
indicate they made a major mistake.

o The Buffalo News continued to star in 1989 in three
important ways: First, among major metropolitan papers, both
daily and Sunday, the News is number one in household penetration
- the percentage of local households that purchase it each day.
Second, in "news hole" - the portion of the paper devoted to news
- the paper stood at 50.1% in 1989 vs. 49.5% in 1988, a level
again making it more news-rich than any comparable American
paper. Third, in a year that saw profits slip at many major
papers, the News set its seventh consecutive profit record.
To some extent, these three factors are related, though
obviously a high-percentage news hole, by itself, reduces profits
significantly. A large and intelligently-utilized news hole,
however, attracts a wide spectrum of readers and thereby boosts
penetration. High penetration, in turn, makes a newspaper
particularly valuable to retailers since it allows them to talk
to the entire community through a single "megaphone." A low-
penetration paper is a far less compelling purchase for many
advertisers and will eventually suffer in both ad rates and
profits.
It should be emphasized that our excellent penetration is
neither an accident nor automatic. The population of Erie County,
home territory of the News, has been falling - from 1,113,000 in
1970 to 1,015,000 in 1980 to an estimated 966,000 in 1988.
Circulation figures tell a different story. In 1975, shortly
before we started our Sunday edition, the Courier-Express, a
long-established Buffalo paper, was selling 207,500 Sunday copies
in Erie County. Last year - with population at least 5% lower -
the News sold an average of 292,700 copies. I believe that in no
other major Sunday market has there been anything close to that
increase in penetration.

When this kind of gain is made - and when a paper attains an
unequaled degree of acceptance in its home town - someone is
doing something right. In this case major credit clearly belongs
to Murray Light, our long-time editor who daily creates an
informative, useful, and interesting product. Credit should go
also to the Circulation and Production Departments: A paper that
is frequently late, because of production problems or
distribution weaknesses, will lose customers, no matter how
strong its editorial content.

Stan Lipsey, publisher of the News, has produced profits
fully up to the strength of our product. I believe Stan's
managerial skills deliver at least five extra percentage points
in profit margin compared to the earnings that would be achieved
by an average manager given the same circumstances. That is an
amazing performance, and one that could only be produced by a
talented manager who knows - and cares - about every nut and bolt
of the business.
Stan's knowledge and talents, it should be emphasized,
extend to the editorial product. His early years in the business
were spent on the news side and he played a key role in
developing and editing a series of stories that in 1972 won a
Pulitzer Prize for the Sun Newspaper of Omaha. Stan and I have
worked together for over 20 years, through some bad times as well
as good, and I could not ask for a better partner.

o At Fechheimer, the Heldman clan - Bob, George, Gary,
Roger and Fred - continue their extraordinary performance. Profits
in 1989 were down somewhat because of problems the business
experienced in integrating a major 1988 acquisition. These
problems will be ironed out in time. Meanwhile, return on invested
capital at Fechheimer remains splendid.
Like all of our managers, the Heldmans have an exceptional
command of the details of their business. At last year's annual
meeting I mentioned that when a prisoner enters San Quentin, Bob
and George probably know his shirt size. That's only a slight
exaggeration: No matter what area of the country is being
discussed, they know exactly what is going on with major
customers and with the competition.

Though we purchased Fechheimer four years ago, Charlie and I
have never visited any of its plants or the home office in
Cincinnati. We're much like the lonesome Maytag repairman: The
Heldman managerial product is so good that a service call is
never needed.

o Ralph Schey continues to do a superb job in managing
our largest group - World Book, Kirby, and the Scott Fetzer
Manufacturing Companies. Aggregate earnings of these businesses
have increased every year since our purchase and returns on
invested capital continue to be exceptional. Ralph is running an
enterprise large enough, were it standing alone, to be on the
Fortune 500. And he's running it in a fashion that would put him
high in the top decile, measured by return on equity.

For some years, World Book has operated out of a single
location in Chicago's Merchandise Mart. Anticipating the imminent
expiration of its lease, the business is now decentralizing into
four locations. The expenses of this transition are significant;
nevertheless profits in 1989 held up well. It will be another
year before costs of the move are fully behind us.

Kirby's business was particularly strong last year,
featuring large gains in export sales. International business has
more than doubled in the last two years and quintupled in the
past four; its share of unit sales has risen from 5% to 20%. Our
largest capital expenditures in 1989 were at Kirby, in
preparation for a major model change in 1990.

Ralph's operations contribute about 40% of the total
earnings of the non-insurance group whose results are shown on
page 49. When we bought Scott Fetzer at the start of 1986, our
acquisition of Ralph as a manager was fully as important as our
acquisition of the businesses. In addition to generating
extraordinary earnings, Ralph also manages capital extremely
well. These abilities have produced funds for Berkshire that, in
turn, have allowed us to make many other profitable commitments.

And that completes our answer to the 1927 Yankees.


Insurance Operations

Shown below is an updated version of our usual table
presenting key figures for the property-casualty insurance
industry:

Statutory
Yearly Change Combined Ratio Yearly Change Inflation Rate
in Premiums After Policyholder in Incurred Measured by
Written (%) Dividends Losses (%) GNP Deflator (%)
------------- ------------------ ------------- ----------------

1981 3.8 106.0 6.5 9.6
1982 3.7 109.6 8.4 6.5
1983 5.0 112.0 6.8 3.8
1984 8.5 118.0 16.9 3.8
1985 22.1 116.3 16.1 3.0
1986 22.2 108.0 13.5 2.6
1987 9.4 104.6 7.8 3.1
1988 4.4 105.4 5.5 3.3
1989 (Est.) 2.1 110.4 8.7 4.2

Source: A.M. Best Co.


The combined ratio represents total insurance costs (losses
incurred plus expenses) compared to revenue from premiums: A
ratio below 100 indicates an underwriting profit, and one above
100 indicates a loss. When the investment income that an insurer
earns from holding policyholders' funds ("the float") is taken
into account, a combined ratio in the 107-111 range typically
produces an overall breakeven result, exclusive of earnings on
the funds provided by shareholders.

For the reasons laid out in previous reports, we expect the
industry's incurred losses to grow by about 10% annually, even in
years when general inflation runs considerably lower. (Actually,
over the last 25 years, incurred losses have grown at a still
faster rate, 11%.) If premium growth meanwhile materially lags
that 10% rate, underwriting losses will mount, though the
industry's tendency to underreserve when business turns bad may
obscure their size for a time.

Last year we said the climb in the combined ratio was
"almost certain to continue - and probably will accelerate - for
at least two more years." This year we will not predict
acceleration, but otherwise must repeat last year's forecast.
Premium growth is running far below the 10% required annually.
Remember also that a 10% rate would only stabilize the combined
ratio, not bring it down.

The increase in the combined ratio in 1989 was a little more
than we had expected because catastrophes (led by Hurricane Hugo)
were unusually severe. These abnormalities probably accounted for
about two points of the increase. If 1990 is more of a "normal"
year, the combined ratio should rise only minimally from the
catastrophe-swollen base of 1989. In 1991, though, the ratio is
apt to climb by a greater degree.

Commentators frequently discuss the "underwriting cycle" and
speculate about its next turn. If that term is used to connote
rhythmic qualities, it is in our view a misnomer that leads to
faulty thinking about the industry's fundamental economics.

The term was appropriate some decades ago when the industry
and regulators cooperated to conduct the business in cartel
fashion. At that time, the combined ratio fluctuated
rhythmically for two reasons, both related to lags. First, data
from the past were analyzed and then used to set new "corrected"
rates, which were subsequently put into effect by virtually all
insurers. Second, the fact that almost all policies were then
issued for a one-to three-year term - which meant that it took a
considerable time for mispriced policies to expire - delayed the
impact of new rates on revenues. These two lagged responses made
combined ratios behave much like alternating current. Meanwhile,
the absence of significant price competition guaranteed that
industry profits, averaged out over the cycle, would be
satisfactory.

The cartel period is long gone. Now the industry has
hundreds of participants selling a commodity-like product at
independently-established prices. Such a configuration - whether
the product being sold is steel or insurance policies - is
certain to cause subnormal profitability in all circumstances but
one: a shortage of usable capacity. Just how often these periods
occur and how long they last determines the average profitability
of the industry in question.

In most industries, capacity is described in physical terms.
In the insurance world, however, capacity is customarily
described in financial terms; that is, it's considered
appropriate for a company to write no more than X dollars of
business if it has Y dollars of net worth. In practice, however,
constraints of this sort have proven ineffective. Regulators,
insurance brokers, and customers are all slow to discipline
companies that strain their resources. They also acquiesce when
companies grossly overstate their true capital. Hence, a company
can write a great deal of business with very little capital if it
is so inclined. At bottom, therefore, the amount of industry
capacity at any particular moment primarily depends on the mental
state of insurance managers.

All this understood, it is not very difficult to
prognosticate the industry's profits. Good profits will be
realized only when there is a shortage of capacity. Shortages
will occur only when insurers are frightened. That happens rarely
- and most assuredly is not happening now.

Some analysts have argued that the more onerous taxes
recently imposed on the insurance industry and 1989's
catastrophes - Hurricane Hugo and the California earthquake -
will cause prices to strengthen significantly. We disagree. These
adversities have not destroyed the eagerness of insurers to write
business at present prices. Therefore, premium volume won't grow
by 10% in 1990, which means the negative underwriting trend will
not reverse.

The industry will meantime say it needs higher prices to
achieve profitability matching that of the average American
business. Of course it does. So does the steel business. But
needs and desires have nothing to do with the long-term
profitability of industries. Instead, economic fundamentals
determine the outcome. Insurance profitability will improve only
when virtually all insurers are turning away business despite
higher prices. And we're a long way from that point.

Berkshire's premium volume may drop to $150 million or so in
1990 (from a high of $1 billion in 1986), partly because our
traditional business continues to shrink and partly because the
contract under which we received 7% of the business of Fireman's
Fund expired last August. Whatever the size of the drop, it will
not disturb us. We have no interest in writing insurance that
carries a mathematical expectation of loss; we experience enough
disappointments doing transactions we believe to carry an
expectation of profit.

However, our appetite for appropriately-priced business is
ample, as one tale from 1989 will tell. It concerns "CAT covers,"
which are reinsurance contracts that primary insurance companies
(and also reinsurers themselves) buy to protect themselves
against a single catastrophe, such as a tornado or hurricane,
that produces losses from a large number of policies. In these
contracts, the primary insurer might retain the loss from a
single event up to a maximum of, say, $10 million, buying various
layers of reinsurance above that level. When losses exceed the
retained amount, the reinsurer typically pays 95% of the excess
up to its contractual limit, with the primary insurer paying the
remainder. (By requiring the primary insurer to keep 5% of each
layer, the reinsurer leaves him with a financial stake in each
loss settlement and guards against his throwing away the
reinsurer's money.)

CAT covers are usually one-year policies that also provide
for one automatic reinstatement, which requires a primary insurer
whose coverage has been exhausted by a catastrophe to buy a
second cover for the balance of the year in question by paying
another premium. This provision protects the primary company from
being "bare" for even a brief period after a first catastrophic
event. The duration of "an event" is usually limited by contract
to any span of 72 hours designated by the primary company. Under
this definition, a wide-spread storm, causing damage for three
days, will be classified as a single event if it arises from a
single climatic cause. If the storm lasts four days, however, the
primary company will file a claim carving out the 72 consecutive
hours during which it suffered the greatest damage. Losses that
occurred outside that period will be treated as arising from a
separate event.

In 1989, two unusual things happened. First, Hurricane Hugo
generated $4 billion or more of insured loss, at a pace, however,
that caused the vast damage in the Carolinas to occur slightly
more than 72 hours after the equally severe damage in the
Caribbean. Second, the California earthquake hit within weeks,
causing insured damage that was difficult to estimate, even well
after the event. Slammed by these two - or possibly three - major
catastrophes, some primary insurers, and also many reinsurers
that had themselves bought CAT protection, either used up their
automatic second cover or became uncertain as to whether they had
done so.

At that point sellers of CAT policies had lost a huge amount
of money - perhaps twice because of the reinstatements - and not
taken in much in premiums. Depending upon many variables, a CAT
premium might generally have run 3% to 15% of the amount of
protection purchased. For some years, we've thought premiums of
that kind inadequate and have stayed away from the business.

But because the 1989 disasters left many insurers either
actually or possibly bare, and also left most CAT writers licking
their wounds, there was an immediate shortage after the
earthquake of much-needed catastrophe coverage. Prices instantly
became attractive, particularly for the reinsurance that CAT
writers themselves buy. Just as instantly, Berkshire Hathaway
offered to write up to $250 million of catastrophe coverage,
advertising that proposition in trade publications. Though we did
not write all the business we sought, we did in a busy ten days
book a substantial amount.

Our willingness to put such a huge sum on the line for a
loss that could occur tomorrow sets us apart from any reinsurer
in the world. There are, of course, companies that sometimes
write $250 million or even far more of catastrophe coverage. But
they do so only when they can, in turn, reinsure a large
percentage of the business with other companies. When they can't
"lay off" in size, they disappear from the market.

Berkshire's policy, conversely, is to retain the business we
write rather than lay it off. When rates carry an expectation of
profit, we want to assume as much risk as is prudent. And in our
case, that's a lot.

We will accept more reinsurance risk for our own account
than any other company because of two factors: (1) by the
standards of regulatory accounting, we have a net worth in our
insurance companies of about $6 billion - the second highest
amount in the United States; and (2) we simply don't care what
earnings we report quarterly, or even annually, just as long as
the decisions leading to those earnings (or losses) were reached
intelligently.

Obviously, if we write $250 million of catastrophe coverage
and retain it all ourselves, there is some probability that we
will lose the full $250 million in a single quarter. That
probability is low, but it is not zero. If we had a loss of that
magnitude, our after-tax cost would be about $165 million. Though
that is far more than Berkshire normally earns in a quarter, the
damage would be a blow only to our pride, not to our well-being.

This posture is one few insurance managements will assume.
Typically, they are willing to write scads of business on terms
that almost guarantee them mediocre returns on equity. But they
do not want to expose themselves to an embarrassing single-
quarter loss, even if the managerial strategy that causes the
loss promises, over time, to produce superior results. I can
understand their thinking: What is best for their owners is not
necessarily best for the managers. Fortunately Charlie and I have
both total job security and financial interests that are
identical with those of our shareholders. We are willing to look
foolish as long as we don't feel we have acted foolishly.

Our method of operation, incidentally, makes us a
stabilizing force in the industry. We add huge capacity when
capacity is short and we become less competitive only when
capacity is abundant. Of course, we don't follow this policy in
the interest of stabilization - we follow it because we believe
it to be the most sensible and profitable course of action.
Nevertheless, our behavior steadies the market. In this case,
Adam Smith's invisible hand works as advertised.

Currently, we hold an exceptional amount of float compared
to premium volume. This circumstance should produce quite
favorable insurance results for us during the next few years as
it did in 1989. Our underwriting losses should be tolerable and
our investment income from policyholder funds large. This
pleasant situation, however, will gradually deteriorate as our
float runs off.

At some point, however, there will be an opportunity for us
to write large amounts of profitable business. Mike Goldberg and
his management team of Rod Eldred, Dinos Iordanou, Ajit Jain,
Phil Urban, and Don Wurster continue to position us well for this
eventuality.


Marketable Securities

In selecting marketable securities for our insurance
companies, we generally choose among five major categories: (1)
long-term common stock investments, (2) medium-term fixed income
securities, (3) long-term fixed income securities, (4) short-term
cash equivalents, and (5) short-term arbitrage commitments.

We have no particular bias when it comes to choosing from
these categories; we just continuously search among them for the
highest after-tax returns as measured by "mathematical
expectation," limiting ourselves always to investment
alternatives we think we understand. Our criteria have nothing to
do with maximizing immediately reportable earnings; our goal,
rather, is to maximize eventual net worth.

o Below we list our common stock holdings having a value
of over $100 million. A small portion of these investments belongs
to subsidiaries of which Berkshire owns less than 100%.

12/31/89
Shares Company Cost Market
------ ------- ---------- ----------
(000s omitted)
3,000,000 Capital Cities/ABC, Inc. ................ $ 517,500 $1,692,375
23,350,000 The Coca-Cola Co. ....................... 1,023,920 1,803,787
2,400,000 Federal Home Loan Mortgage Corp. ........ 71,729 161,100
6,850,000 GEICO Corp. ............................. 45,713 1,044,625
1,727,765 The Washington Post Company ............. 9,731 486,366

This list of companies is the same as last year's and in
only one case has the number of shares changed: Our holdings of
Coca-Cola increased from 14,172,500 shares at the end of 1988 to
23,350,000.

This Coca-Cola investment provides yet another example of
the incredible speed with which your Chairman responds to
investment opportunities, no matter how obscure or well-disguised
they may be. I believe I had my first Coca-Cola in either 1935 or
1936. Of a certainty, it was in 1936 that I started buying Cokes
at the rate of six for 25 cents from Buffett & Son, the family
grocery store, to sell around the neighborhood for 5 cents each.
In this excursion into high-margin retailing, I duly observed
the extraordinary consumer attractiveness and commercial
possibilities of the product.

I continued to note these qualities for the next 52 years as
Coke blanketed the world. During this period, however, I
carefully avoided buying even a single share, instead allocating
major portions of my net worth to street railway companies,
windmill manufacturers, anthracite producers, textile businesses,
trading-stamp issuers, and the like. (If you think I'm making
this up, I can supply the names.) Only in the summer of 1988 did
my brain finally establish contact with my eyes.

What I then perceived was both clear and fascinating. After
drifting somewhat in the 1970's, Coca-Cola had in 1981 become a
new company with the move of Roberto Goizueta to CEO. Roberto,
along with Don Keough, once my across-the-street neighbor in
Omaha, first rethought and focused the company's policies and
then energetically carried them out. What was already the world's
most ubiquitous product gained new momentum, with sales overseas
virtually exploding.

Through a truly rare blend of marketing and financial
skills, Roberto has maximized both the growth of his product and
the rewards that this growth brings to shareholders. Normally,
the CEO of a consumer products company, drawing on his natural
inclinations or experience, will cause either marketing or
finance to dominate the business at the expense of the other
discipline. With Roberto, the mesh of marketing and finance is
perfect and the result is a shareholder's dream.

Of course, we should have started buying Coke much earlier,
soon after Roberto and Don began running things. In fact, if I
had been thinking straight I would have persuaded my grandfather
to sell the grocery store back in 1936 and put all of the
proceeds into Coca-Cola stock. I've learned my lesson: My
response time to the next glaringly attractive idea will be
slashed to well under 50 years.

As I mentioned earlier, the yearend prices of our major
investees were much higher relative to their intrinsic values
than theretofore. While those prices may not yet cause
nosebleeds, they are clearly vulnerable to a general market
decline. A drop in their prices would not disturb us at all - it
might in fact work to our eventual benefit - but it would cause
at least a one-year reduction in Berkshire's net worth. We think
such a reduction is almost certain in at least one of the next
three years. Indeed, it would take only about a 10% year-to-year
decline in the aggregate value of our portfolio investments to
send Berkshire's net worth down.

We continue to be blessed with extraordinary managers at our
portfolio companies. They are high-grade, talented, and
shareholder-oriented. The exceptional results we have achieved
while investing with them accurately reflect their exceptional
personal qualities.

o We told you last year that we expected to do little in
arbitrage during 1989, and that's the way it turned out.
Arbitrage positions are a substitute for short-term cash
equivalents, and during part of the year we held relatively low
levels of cash. In the rest of the year we had a fairly good-
sized cash position and even so chose not to engage in arbitrage.
The main reason was corporate transactions that made no economic
sense to us; arbitraging such deals comes too close to playing
the greater-fool game. (As Wall Streeter Ray DeVoe says: "Fools
rush in where angels fear to trade.") We will engage in arbitrage
from time to time - sometimes on a large scale - but only when we
like the odds.

o Leaving aside the three convertible preferreds discussed in
the next section, we substantially reduced our holdings in both
medium- and long-term fixed-income securities. In the long-terms,
just about our only holdings have been Washington Public Power
Supply Systems (WPPSS) bonds carrying coupons ranging from low to
high. During the year we sold a number of the low-coupon issues,
which we originally bought at very large discounts. Many of these
issues had approximately doubled in price since we purchased them
and in addition had paid us 15%-17% annually, tax-free. Our
prices upon sale were only slightly cheaper than typical high-
grade tax-exempts then commanded. We have kept all of our high-
coupon WPPSS issues. Some have been called for redemption in 1991
and 1992, and we expect the rest to be called in the early to
mid-1990s.

We also sold many of our medium-term tax-exempt bonds during
the year. When we bought these bonds we said we would be happy to
sell them - regardless of whether they were higher or lower than
at our time of purchase - if something we liked better came
along. Something did - and concurrently we unloaded most of these
issues at modest gains. Overall, our 1989 profit from the sale of
tax-exempt bonds was about $51 million pre-tax.

o The proceeds from our bond sales, along with our excess cash
at the beginning of the year and that generated later through
earnings, went into the purchase of three convertible preferred
stocks. In the first transaction, which took place in July, we
purchased $600 million of The Gillette Co. preferred with an 8
3/4% dividend, a mandatory redemption in ten years, and the right
to convert into common at $50 per share. We next purchased $358
million of USAir Group, Inc. preferred stock with mandatory
redemption in ten years, a dividend of 9 1/4%, and the right to
convert into common at $60 per share. Finally, late in the year
we purchased $300 million of Champion International Corp.
preferred with mandatory redemption in ten years, a 9 1/4%
dividend, and the right to convert into common at $38 per share.

Unlike standard convertible preferred stocks, the issues we
own are either non-salable or non-convertible for considerable
periods of time and there is consequently no way we can gain from
short-term price blips in the common stock. I have gone on the
board of Gillette, but I am not on the board of USAir or
Champion. (I thoroughly enjoy the boards I am on, but can't
handle any more.)

Gillette's business is very much the kind we like. Charlie
and I think we understand the company's economics and therefore
believe we can make a reasonably intelligent guess about its
future. (If you haven't tried Gillette's new Sensor razor, go
right out and get one.) However, we have no ability to forecast
the economics of the investment banking business (in which we
have a position through our 1987 purchase of Salomon convertible
preferred), the airline industry, or the paper industry. This
does not mean that we predict a negative future for these
industries: we're agnostics, not atheists. Our lack of strong
convictions about these businesses, however, means that we must
structure our investments in them differently from what we do
when we invest in a business appearing to have splendid economic
characteristics.

In one major respect, however, these purchases are not
different: We only want to link up with people whom we like,
admire, and trust. John Gutfreund at Salomon, Colman Mockler, Jr.
at Gillette, Ed Colodny at USAir, and Andy Sigler at Champion
meet this test in spades.

They in turn have demonstrated some confidence in us,
insisting in each case that our preferreds have unrestricted
voting rights on a fully-converted basis, an arrangement that is
far from standard in corporate finance. In effect they are
trusting us to be intelligent owners, thinking about tomorrow
instead of today, just as we are trusting them to be intelligent
managers, thinking about tomorrow as well as today.

The preferred-stock structures we have negotiated will
provide a mediocre return for us if industry economics hinder the
performance of our investees, but will produce reasonably
attractive results for us if they can earn a return comparable to
that of American industry in general. We believe that Gillette,
under Colman's management, will far exceed that return and
believe that John, Ed, and Andy will reach it unless industry
conditions are harsh.

Under almost any conditions, we expect these preferreds to
return us our money plus dividends. If that is all we get,
though, the result will be disappointing, because we will have
given up flexibility and consequently will have missed some
significant opportunities that are bound to present themselves
during the decade. Under that scenario, we will have obtained
only a preferred-stock yield during a period when the typical
preferred stock will have held no appeal for us whatsoever. The
only way Berkshire can achieve satisfactory results from its four
preferred issues is to have the common stocks of the investee
companies do well.

Good management and at least tolerable industry conditions
will be needed if that is to happen. But we believe Berkshire's
investment will also help and that the other shareholders of each
investee will profit over the years ahead from our preferred-
stock purchase. The help will come from the fact that each
company now has a major, stable, and interested shareholder whose
Chairman and Vice Chairman have, through Berkshire's investments,
indirectly committed a very large amount of their own money to
these undertakings. In dealing with our investees, Charlie and I
will be supportive, analytical, and objective. We recognize that
we are working with experienced CEOs who are very much in command
of their own businesses but who nevertheless, at certain moments,
appreciate the chance to test their thinking on someone without
ties to their industry or to decisions of the past.

As a group, these convertible preferreds will not produce
the returns we can achieve when we find a business with wonderful
economic prospects that is unappreciated by the market. Nor will
the returns be as attractive as those produced when we make our
favorite form of capital deployment, the acquisition of 80% or
more of a fine business with a fine management. But both
opportunities are rare, particularly in a size befitting our
present and anticipated resources.

In summation, Charlie and I feel that our preferred stock
investments should produce returns moderately above those
achieved by most fixed-income portfolios and that we can play a
minor but enjoyable and constructive role in the investee
companies.


Zero-Coupon Securities

In September, Berkshire issued $902.6 million principal
amount of Zero-Coupon Convertible Subordinated Debentures, which
are now listed on the New York Stock Exchange. Salomon Brothers
handled the underwriting in superb fashion, providing us helpful
advice and a flawless execution.

Most bonds, of course, require regular payments of interest,
usually semi-annually. A zero-coupon bond, conversely, requires
no current interest payments; instead, the investor receives his
yield by purchasing the security at a significant discount from
maturity value. The effective interest rate is determined by the
original issue price, the maturity value, and the amount of time
between issuance and maturity.

In our case, the bonds were issued at 44.314% of maturity
value and are due in 15 years. For investors purchasing the
bonds, that is the mathematical equivalent of a 5.5% current
payment compounded semi-annually. Because we received only
44.31 cents on the dollar, our proceeds from this offering were
$400 million (less about $9.5 million of offering expenses).

The bonds were issued in denominations of $10,000 and each
bond is convertible into .4515 shares of Berkshire Hathaway.
Because a $10,000 bond cost $4,431, this means that the
conversion price was $9,815 per Berkshire share, a 15% premium to
the market price then existing. Berkshire can call the bonds at
any time after September 28, 1992 at their accreted value (the
original issue price plus 5.5% compounded semi-annually) and on
two specified days, September 28 of 1994 and 1999, the
bondholders can require Berkshire to buy the securities at their
accreted value.

For tax purposes, Berkshire is entitled to deduct the 5.5%
interest accrual each year, even though we make no payments to
the bondholders. Thus the net effect to us, resulting from the
reduced taxes, is positive cash flow. That is a very significant
benefit. Some unknowable variables prevent us from calculating
our exact effective rate of interest, but under all circumstances
it will be well below 5.5%. There is meanwhile a symmetry to the
tax law: Any taxable holder of the bonds must pay tax each year
on the 5.5% interest, even though he receives no cash.

Neither our bonds nor those of certain other companies that
issued similar bonds last year (notably Loews and Motorola)
resemble the great bulk of zero-coupon bonds that have been
issued in recent years. Of these, Charlie and I have been, and
will continue to be, outspoken critics. As I will later explain,
such bonds have often been used in the most deceptive of ways and
with deadly consequences to investors. But before we tackle that
subject, let's travel back to Eden, to a time when the apple had
not yet been bitten.

If you're my age you bought your first zero-coupon bonds
during World War II, by purchasing the famous Series E U. S.
Savings Bond, the most widely-sold bond issue in history. (After
the war, these bonds were held by one out of two U. S.
households.) Nobody, of course, called the Series E a zero-coupon
bond, a term in fact that I doubt had been invented. But that's
precisely what the Series E was.

These bonds came in denominations as small as $18.75. That
amount purchased a $25 obligation of the United States government
due in 10 years, terms that gave the buyer a compounded annual
return of 2.9%. At the time, this was an attractive offer: the
2.9% rate was higher than that generally available on Government
bonds and the holder faced no market-fluctuation risk, since he
could at any time cash in his bonds with only a minor reduction
in interest.

A second form of zero-coupon U. S. Treasury issue, also
benign and useful, surfaced in the last decade. One problem with
a normal bond is that even though it pays a given interest rate -
say 10% - the holder cannot be assured that a compounded 10%
return will be realized. For that rate to materialize, each semi-
annual coupon must be reinvested at 10% as it is received. If
current interest rates are, say, only 6% or 7% when these coupons
come due, the holder will be unable to compound his money over
the life of the bond at the advertised rate. For pension funds or
other investors with long-term liabilities, "reinvestment risk"
of this type can be a serious problem. Savings Bonds might have
solved it, except that they are issued only to individuals and
are unavailable in large denominations. What big buyers needed
was huge quantities of "Savings Bond Equivalents."

Enter some ingenious and, in this case, highly useful
investment bankers (led, I'm happy to say, by Salomon Brothers).
They created the instrument desired by "stripping" the semi-
annual coupons from standard Government issues. Each coupon, once
detached, takes on the essential character of a Savings Bond
since it represents a single sum due sometime in the future. For
example, if you strip the 40 semi-annual coupons from a U. S.
Government Bond due in the year 2010, you will have 40 zero-
coupon bonds, with maturities from six months to 20 years, each
of which can then be bundled with other coupons of like maturity
and marketed. If current interest rates are, say, 10% for all
maturities, the six-month issue will sell for 95.24% of maturity
value and the 20-year issue will sell for 14.20%. The purchaser
of any given maturity is thus guaranteed a compounded rate of 10%
for his entire holding period. Stripping of government bonds has
occurred on a large scale in recent years, as long-term
investors, ranging from pension funds to individual IRA accounts,
recognized these high-grade, zero-coupon issues to be well suited
to their needs.

But as happens in Wall Street all too often, what the wise
do in the beginning, fools do in the end. In the last few years
zero-coupon bonds (and their functional equivalent, pay-in-kind
bonds, which distribute additional PIK bonds semi-annually as
interest instead of paying cash) have been issued in enormous
quantities by ever-junkier credits. To these issuers, zero (or
PIK) bonds offer one overwhelming advantage: It is impossible to
default on a promise to pay nothing. Indeed, if LDC governments
had issued no debt in the 1970's other than long-term zero-coupon
obligations, they would now have a spotless record as debtors.

This principle at work - that you need not default for a
long time if you solemnly promise to pay nothing for a long time
- has not been lost on promoters and investment bankers seeking
to finance ever-shakier deals. But its acceptance by lenders took
a while: When the leveraged buy-out craze began some years back,
purchasers could borrow only on a reasonably sound basis, in
which conservatively-estimated free cash flow - that is,
operating earnings plus depreciation and amortization less
normalized capital expenditures - was adequate to cover both
interest and modest reductions in debt.

Later, as the adrenalin of deal-makers surged, businesses
began to be purchased at prices so high that all free cash flow
necessarily had to be allocated to the payment of interest. That
left nothing for the paydown of debt. In effect, a Scarlett
O'Hara "I'll think about it tomorrow" position in respect to
principal payments was taken by borrowers and accepted by a new
breed of lender, the buyer of original-issue junk bonds. Debt now
became something to be refinanced rather than repaid. The change
brings to mind a New Yorker cartoon in which the grateful
borrower rises to shake the hand of the bank's lending officer
and gushes: "I don't know how I'll ever repay you."

Soon borrowers found even the new, lax standards intolerably
binding. To induce lenders to finance even sillier transactions,
they introduced an abomination, EBDIT - Earnings Before
Depreciation, Interest and Taxes - as the test of a company's
ability to pay interest. Using this sawed-off yardstick, the
borrower ignored depreciation as an expense on the theory that it
did not require a current cash outlay.

Such an attitude is clearly delusional. At 95% of American
businesses, capital expenditures that over time roughly
approximate depreciation are a necessity and are every bit as
real an expense as labor or utility costs. Even a high school
dropout knows that to finance a car he must have income that
covers not only interest and operating expenses, but also
realistically-calculated depreciation. He would be laughed out of
the bank if he started talking about EBDIT.

Capital outlays at a business can be skipped, of course, in
any given month, just as a human can skip a day or even a week of
eating. But if the skipping becomes routine and is not made up,
the body weakens and eventually dies. Furthermore, a start-and-
stop feeding policy will over time produce a less healthy
organism, human or corporate, than that produced by a steady
diet. As businessmen, Charlie and I relish having competitors who
are unable to fund capital expenditures.

You might think that waving away a major expense such as
depreciation in an attempt to make a terrible deal look like a
good one hits the limits of Wall Street's ingenuity. If so, you
haven't been paying attention during the past few years.
Promoters needed to find a way to justify even pricier
acquisitions. Otherwise, they risked - heaven forbid! - losing
deals to other promoters with more "imagination."

So, stepping through the Looking Glass, promoters and their
investment bankers proclaimed that EBDIT should now be measured
against cash interest only, which meant that interest accruing on
zero-coupon or PIK bonds could be ignored when the financial
feasibility of a transaction was being assessed. This approach
not only relegated depreciation expense to the let's-ignore-it
corner, but gave similar treatment to what was usually a
significant portion of interest expense. To their shame, many
professional investment managers went along with this nonsense,
though they usually were careful to do so only with clients'
money, not their own. (Calling these managers "professionals" is
actually too kind; they should be designated "promotees.")

Under this new standard, a business earning, say, $100
million pre-tax and having debt on which $90 million of interest
must be paid currently, might use a zero-coupon or PIK issue to
incur another $60 million of annual interest that would accrue
and compound but not come due for some years. The rate on these
issues would typically be very high, which means that the
situation in year 2 might be $90 million cash interest plus $69
million accrued interest, and so on as the compounding proceeds.
Such high-rate reborrowing schemes, which a few years ago were
appropriately confined to the waterfront, soon became models of
modern finance at virtually all major investment banking houses.

When they make these offerings, investment bankers display
their humorous side: They dispense income and balance sheet
projections extending five or more years into the future for
companies they barely had heard of a few months earlier. If you
are shown such schedules, I suggest that you join in the fun:
Ask the investment banker for the one-year budgets that his own
firm prepared as the last few years began and then compare these
with what actually happened.

Some time ago Ken Galbraith, in his witty and insightful
The Great Crash, coined a new economic term: "the bezzle,"
defined as the current amount of undiscovered embezzlement. This
financial creature has a magical quality: The embezzlers are richer
by the amount of the bezzle, while the embezzlees do not yet feel
poorer.

Professor Galbraith astutely pointed out that this sum
should be added to the National Wealth so that we might know the
Psychic National Wealth. Logically, a society that wanted to feel
enormously prosperous would both encourage its citizens to
embezzle and try not to detect the crime. By this means, "wealth"
would balloon though not an erg of productive work had been done.

The satirical nonsense of the bezzle is dwarfed by the real-
world nonsense of the zero-coupon bond. With zeros, one party to
a contract can experience "income" without his opposite
experiencing the pain of expenditure. In our illustration, a
company capable of earning only $100 million dollars annually -
and therefore capable of paying only that much in interest -
magically creates "earnings" for bondholders of $150 million. As
long as major investors willingly don their Peter Pan wings and
repeatedly say "I believe," there is no limit to how much
"income" can be created by the zero-coupon bond.

Wall Street welcomed this invention with the enthusiasm
less-enlightened folk might reserve for the wheel or the plow.
Here, finally, was an instrument that would let the Street make
deals at prices no longer limited by actual earning power. The
result, obviously, would be more transactions: Silly prices will
always attract sellers. And, as Jesse Unruh might have put it,
transactions are the mother's milk of finance.

The zero-coupon or PIK bond possesses one additional
attraction for the promoter and investment banker, which is that
the time elapsing between folly and failure can be stretched out.
This is no small benefit. If the period before all costs must be
faced is long, promoters can create a string of foolish deals -
and take in lots of fees - before any chickens come home to roost
from their earlier ventures.

But in the end, alchemy, whether it is metallurgical or
financial, fails. A base business can not be transformed into a
golden business by tricks of accounting or capital structure. The
man claiming to be a financial alchemist may become rich. But
gullible investors rather than business achievements will usually
be the source of his wealth.

Whatever their weaknesses, we should add, many zero-coupon
and PIK bonds will not default. We have in fact owned some and
may buy more if their market becomes sufficiently distressed.
(We've not, however, even considered buying a new issue from a
weak credit.) No financial instrument is evil per se; it's just
that some variations have far more potential for mischief than
others.

The blue ribbon for mischief-making should go to the zero-
coupon issuer unable to make its interest payments on a current
basis. Our advice: Whenever an investment banker starts talking
about EBDIT - or whenever someone creates a capital structure
that does not allow all interest, both payable and accrued, to be
comfortably met out of current cash flow net of ample capital
expenditures - zip up your wallet. Turn the tables by suggesting
that the promoter and his high-priced entourage accept zero-
coupon fees, deferring their take until the zero-coupon bonds
have been paid in full. See then how much enthusiasm for the deal
endures.

Our comments about investment bankers may seem harsh. But
Charlie and I - in our hopelessly old-fashioned way - believe
that they should perform a gatekeeping role, guarding investors
against the promoter's propensity to indulge in excess.
Promoters, after all, have throughout time exercised the same
judgment and restraint in accepting money that alcoholics have
exercised in accepting liquor. At a minimum, therefore, the
banker's conduct should rise to that of a responsible bartender
who, when necessary, refuses the profit from the next drink to
avoid sending a drunk out on the highway. In recent years,
unfortunately, many leading investment firms have found bartender
morality to be an intolerably restrictive standard. Lately, those
who have traveled the high road in Wall Street have not
encountered heavy traffic.

One distressing footnote: The cost of the zero-coupon folly
will not be borne solely by the direct participants. Certain
savings and loan associations were heavy buyers of such bonds,
using cash that came from FSLIC-insured deposits. Straining to
show splendid earnings, these buyers recorded - but did not
receive - ultra-high interest income on these issues. Many of
these associations are now in major trouble. Had their loans to
shaky credits worked, the owners of the associations would have
pocketed the profits. In the many cases in which the loans will
fail, the taxpayer will pick up the bill. To paraphrase Jackie
Mason, at these associations it was the managers who should have
been wearing the ski masks.


Mistakes of the First Twenty-five Years (A Condensed Version)

To quote Robert Benchley, "Having a dog teaches a boy
fidelity, perseverance, and to turn around three times before
lying down." Such are the shortcomings of experience.
Nevertheless, it's a good idea to review past mistakes before
committing new ones. So let's take a quick look at the last 25
years.

o My first mistake, of course, was in buying control of
Berkshire. Though I knew its business - textile manufacturing -
to be unpromising, I was enticed to buy because the price looked
cheap. Stock purchases of that kind had proved reasonably
rewarding in my early years, though by the time Berkshire came
along in 1965 I was becoming aware that the strategy was not
ideal.

If you buy a stock at a sufficiently low price, there will
usually be some hiccup in the fortunes of the business that gives
you a chance to unload at a decent profit, even though the long-
term performance of the business may be terrible. I call this the
"cigar butt" approach to investing. A cigar butt found on the
street that has only one puff left in it may not offer much of a
smoke, but the "bargain purchase" will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying
businesses is foolish. First, the original "bargain" price
probably will not turn out to be such a steal after all. In a
difficult business, no sooner is one problem solved than another
surfaces - never is there just one cockroach in the kitchen.
Second, any initial advantage you secure will be quickly eroded
by the low return that the business earns. For example, if you
buy a business for $8 million that can be sold or liquidated for
$10 million and promptly take either course, you can realize a
high return. But the investment will disappoint if the business
is sold for $10 million in ten years and in the interim has
annually earned and distributed only a few percent on cost. Time
is the friend of the wonderful business, the enemy of the
mediocre.

You might think this principle is obvious, but I had to
learn it the hard way - in fact, I had to learn it several times
over. Shortly after purchasing Berkshire, I acquired a Baltimore
department store, Hochschild Kohn, buying through a company
called Diversified Retailing that later merged with Berkshire. I
bought at a substantial discount from book value, the people were
first-class, and the deal included some extras - unrecorded real
estate values and a significant LIFO inventory cushion. How could
I miss? So-o-o - three years later I was lucky to sell the
business for about what I had paid. After ending our corporate
marriage to Hochschild Kohn, I had memories like those of the
husband in the country song, "My Wife Ran Away With My Best
Friend and I Still Miss Him a Lot."

I could give you other personal examples of "bargain-
purchase" folly but I'm sure you get the picture: It's far
better to buy a wonderful company at a fair price than a fair
company at a wonderful price. Charlie understood this early; I
was a slow learner. But now, when buying companies or common
stocks, we look for first-class businesses accompanied by first-
class managements.

o That leads right into a related lesson: Good jockeys will
do well on good horses, but not on broken-down nags. Both
Berkshire's textile business and Hochschild, Kohn had able and
honest people running them. The same managers employed in a
business with good economic characteristics would have achieved
fine records. But they were never going to make any progress
while running in quicksand.

I've said many times that when a management with a
reputation for brilliance tackles a business with a reputation
for bad economics, it is the reputation of the business that
remains intact. I just wish I hadn't been so energetic in
creating examples. My behavior has matched that admitted by Mae
West: "I was Snow White, but I drifted."

o A further related lesson: Easy does it. After 25 years of
buying and supervising a great variety of businesses, Charlie and
I have not learned how to solve difficult business problems. What
we have learned is to avoid them. To the extent we have been
successful, it is because we concentrated on identifying one-foot
hurdles that we could step over rather than because we acquired
any ability to clear seven-footers.

The finding may seem unfair, but in both business and
investments it is usually far more profitable to simply stick
with the easy and obvious than it is to resolve the difficult. On
occasion, tough problems must be tackled as was the case when we
started our Sunday paper in Buffalo. In other instances, a great
investment opportunity occurs when a marvelous business
encounters a one-time huge, but solvable, problem as was the case
many years back at both American Express and GEICO. Overall,
however, we've done better by avoiding dragons than by slaying
them.

o My most surprising discovery: the overwhelming importance in
business of an unseen force that we might call "the institutional
imperative." In business school, I was given no hint of the
imperative's existence and I did not intuitively understand it
when I entered the business world. I thought then that decent,
intelligent, and experienced managers would automatically make
rational business decisions. But I learned over time that isn't
so. Instead, rationality frequently wilts when the institutional
imperative comes into play.

For example: (1) As if governed by Newton's First Law of
Motion, an institution will resist any change in its current
direction; (2) Just as work expands to fill available time,
corporate projects or acquisitions will materialize to soak up
available funds; (3) Any business craving of the leader, however
foolish, will be quickly supported by detailed rate-of-return and
strategic studies prepared by his troops; and (4) The behavior of
peer companies, whether they are expanding, acquiring, setting
executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set
businesses on these courses, which are too often misguided. After
making some expensive mistakes because I ignored the power of the
imperative, I have tried to organize and manage Berkshire in ways
that minimize its influence. Furthermore, Charlie and I have
attempted to concentrate our investments in companies that appear
alert to the problem.

o After some other mistakes, I learned to go into business
only with people whom I like, trust, and admire. As I noted
before, this policy of itself will not ensure success: A second-
class textile or department-store company won't prosper simply
because its managers are men that you would be pleased to see
your daughter marry. However, an owner - or investor - can
accomplish wonders if he manages to associate himself with such
people in businesses that possess decent economic
characteristics. Conversely, we do not wish to join with managers
who lack admirable qualities, no matter how attractive the
prospects of their business. We've never succeeded in making a
good deal with a bad person.

o Some of my worst mistakes were not publicly visible. These
were stock and business purchases whose virtues I understood and
yet didn't make. It's no sin to miss a great opportunity outside
one's area of competence. But I have passed on a couple of really
big purchases that were served up to me on a platter and that I
was fully capable of understanding. For Berkshire's shareholders,
myself included, the cost of this thumb-sucking has been huge.

o Our consistently-conservative financial policies may appear
to have been a mistake, but in my view were not. In retrospect,
it is clear that significantly higher, though still conventional,
leverage ratios at Berkshire would have produced considerably
better returns on equity than the 23.8% we have actually
averaged. Even in 1965, perhaps we could have judged there to be
a 99% probability that higher leverage would lead to nothing but
good. Correspondingly, we might have seen only a 1% chance that
some shock factor, external or internal, would cause a
conventional debt ratio to produce a result falling somewhere
between temporary anguish and default.

We wouldn't have liked those 99:1 odds - and never will. A
small chance of distress or disgrace cannot, in our view, be
offset by a large chance of extra returns. If your actions are
sensible, you are certain to get good results; in most such
cases, leverage just moves things along faster. Charlie and I
have never been in a big hurry: We enjoy the process far more
than the proceeds - though we have learned to live with those
also.

* * * * * * * * * * * *

We hope in another 25 years to report on the mistakes of the
first 50. If we are around in 2015 to do that, you can count on
this section occupying many more pages than it does here.


Miscellaneous

We hope to buy more businesses that are similar to the ones
we have, and we can use some help. If you have a business that
fits the following criteria, call me or, preferably, write.

Here's what we're looking for:

(1) Large purchases (at least $10 million of after-tax
earnings),

(2) demonstrated consistent earning power (future
projections are of little interest to us, nor are
"turnaround" situations),

(3) businesses earning good returns on equity while
employing little or no debt,

(4) management in place (we can't supply it),

(5) simple businesses (if there's lots of technology, we
won't understand it),

(6) an offering price (we don't want to waste our time or
that of the seller by talking, even preliminarily,
about a transaction when price is unknown).

We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we're interested. We prefer
to buy for cash, but will consider issuing stock when we receive
as much in intrinsic business value as we give.

Our favorite form of purchase is one fitting the Blumkin-
Friedman-Heldman mold. In cases like these, the company's owner-
managers wish to generate significant amounts of cash, sometimes
for themselves, but often for their families or inactive
shareholders. At the same time, these managers wish to remain
significant owners who continue to run their companies just as
they have in the past. We think we offer a particularly good fit
for owners with such objectives. We invite potential sellers to
check us out by contacting people with whom we have done business
in the past.

Charlie and I frequently get approached about acquisitions
that don't come close to meeting our tests: We've found that if
you advertise an interest in buying collies, a lot of people will
call hoping to sell you their cocker spaniels. Our interest in
new ventures, turnarounds, or auction-like sales can best be
expressed by a Goldwynism: "Please include me out."

Besides being interested in the purchase of businesses as
described above, we are also interested in the negotiated
purchase of large, but not controlling, blocks of stock
comparable to those we hold in Capital Cities, Salomon, Gillette,
USAir and Champion. Last year we said we had a special interest
in large purchases of convertible preferreds. We still have an
appetite of that kind, but it is limited since we now are close
to the maximum position we feel appropriate for this category of
investment.

* * * * * * * * * * * *

Two years ago, I told you about Harry Bottle, who in 1962
quickly cured a major business mess at the first industrial
company I controlled, Dempster Mill Manufacturing (one of my
"bargain" purchases) and who 24 years later had reappeared to
again rescue me, this time from problems at K&W Products, a small
Berkshire subsidiary that produces automotive compounds. As I
reported, in short order Harry reduced capital employed at K&W,
rationalized production, cut costs, and quadrupled profits. You
might think he would then have paused for breath. But last year
Harry, now 70, attended a bankruptcy auction and, for a pittance,
acquired a product line that is a natural for K&W. That company's
profitability may well be increased 50% by this coup. Watch this
space for future bulletins on Harry's triumphs.

* * * * * * * * * * * *

With more than a year behind him of trading Berkshire's
stock on the New York Stock Exchange, our specialist, Jim Maguire
of Henderson Brothers, Inc. ("HBI"), continues his outstanding
performance. Before we listed, dealer spreads often were 3% or
more of market price. Jim has maintained the spread at 50 points
or less, which at current prices is well under 1%. Shareholders
who buy or sell benefit significantly from this reduction in
transaction costs.

Because we are delighted by our experience with Jim, HBI and
the NYSE, I said as much in ads that have been run in a series
placed by the NYSE. Normally I shun testimonials, but I was
pleased in this instance to publicly compliment the Exchange.

* * * * * * * * * * * *

Last summer we sold the corporate jet that we purchased for
$850,000 three years ago and bought another used jet for $6.7
million. Those of you who recall the mathematics of the
multiplying bacteria on page 5 will understandably panic: If our
net worth continues to increase at current rates, and the cost of
replacing planes also continues to rise at the now-established
rate of 100% compounded annually, it will not be long before
Berkshire's entire net worth is consumed by its jet.

Charlie doesn't like it when I equate the jet with bacteria;
he feels it's degrading to the bacteria. His idea of traveling in
style is an air-conditioned bus, a luxury he steps up to only
when bargain fares are in effect. My own attitude toward the jet
can be summarized by the prayer attributed, apocryphally I'm
sure, to St. Augustine as he contemplated leaving a life of
secular pleasures to become a priest. Battling the conflict
between intellect and glands, he pled: "Help me, Oh Lord, to
become chaste - but not yet."

Naming the plane has not been easy. I initially suggested
"The Charles T. Munger." Charlie countered with "The Aberration."
We finally settled on "The Indefensible."

* * * * * * * * * * * *

About 96.9% of all eligible shares participated in
Berkshire's 1989 shareholder-designated contributions program.
Contributions made through the program were $5.9 million, and
2,550 charities were recipients.

We urge new shareholders to read the description of our
shareholder-designated contributions program that appears on
pages 52-53. If you wish to participate in future programs, we
strongly urge that you immediately make sure your shares are
registered in the name of the actual owner, not in the nominee
name of a broker, bank or depository. Shares not so registered on
August 31, 1990 will be ineligible for the 1990 program.

* * * * * * * * * * * *

The annual meeting this year will take place at 9:30 a.m. on
Monday, April 30, 1990. Attendance grew last year to about 1,000,
very close to the seating capacity of the Witherspoon Hall at
Joslyn Museum. So this year's meeting will be moved to the
Orpheum Theatre, which is in downtown Omaha, about one-quarter of
a mile from the Red Lion Hotel. The Radisson-Redick Tower, a much
smaller but nice hotel, is located across the street from the
Orpheum. Or you may wish to stay at the Marriott, which is in
west Omaha, about 100 yards from Borsheim's. We will have buses
at the Marriott that will leave at 8:30 and 8:45 for the meeting
and return after it ends.

Charlie and I always enjoy the meeting, and we hope you can
make it. The quality of our shareholders is reflected in the
quality of the questions we get: We have never attended an annual
meeting anywhere that features such a consistently high level of
intelligent, owner-related questions.

An attachment to our proxy material explains how you can
obtain the card you will need for admission to the meeting.
Because weekday parking can be tight around the Orpheum, we have
lined up a number of nearby lots for our shareholders to use. The
attachment also contains information about them.

As usual, we will have buses to take you to Nebraska
Furniture Mart and Borsheim's after the meeting and to take you
to downtown hotels or to the airport later. I hope that you will
allow plenty of time to fully explore the attractions of both
stores. Those of you arriving early can visit the Furniture Mart
any day of the week; it is open from 10 a.m. to 5:30 p.m. on
Saturdays, and from noon to 5:30 p.m. on Sundays.

Borsheim's normally is closed on Sunday, but we will open
for shareholders and their guests from noon to 6 p.m. on Sunday,
April 29th. Ike likes to put on a show, and you can rely on him
to produce something very special for our shareholders.

In this letter we've had a lot to say about rates of
compounding. If you can bear having your own rate turn negative
for a day - not a pretty thought, I admit - visit Ike on the
29th.




Warren E. Buffett
March 2, 1990 Chairman of the Board

BERKSHIRE HATHAWAY INC.

To the Shareholders of Berkshire Hathaway Inc.:

Last year we made a prediction: "A reduction [in Berkshire's net worth] is almost certain in at least one of the next three years." During much of 1990's second half, we were on the road to quickly proving that forecast accurate. But some strengthening in stock prices late in the year enabled us to close 1990 with net worth up by $362 million, or 7.3%. Over the last 26 years (that is, since present management took over) our per-share book value has grown from $19.46 to $4,612.06, or at a rate of 23.2% compounded annually.

Our growth rate was lackluster in 1990 because our four major common stock holdings, in aggregate, showed little change in market value. Last year I told you that though these companies - Capital Cities/ABC, Coca-Cola, GEICO, and Washington Post - had fine businesses and superb managements, widespread recognition of these attributes had pushed the stock prices of the four to lofty levels. The market prices of the two media companies have since fallen significantly - for good reasons relating to evolutionary industry developments that I will discuss later - and the price of Coca-Cola stock has increased significantly for what I also believe are good reasons. Overall, yearend 1990 prices of our "permanent four," though far from enticing, were a bit more appealing than they were a year earlier.

Berkshire's 26-year record is meaningless in forecasting future results; so also, we hope, is the one-year record. We continue to aim for a 15% average annual gain in intrinsic value. But, as we never tire of telling you, this goal becomes ever more difficult to reach as our equity base, now $5.3 billion, increases.

If we do attain that 15% average, our shareholders should fare well. However, Berkshire's corporate gains will produce an identical gain for a specific shareholder only if he eventually sells his shares at the same relationship to intrinsic value that existed when he bought them. For example, if you buy at a 10% premium to intrinsic value; if intrinsic value subsequently grows at 15% a year; and if you then sell at a 10% premium, your own return will correspondingly be 15% compounded. (The calculation assumes that no dividends are paid.) If, however, you buy at a premium and sell at a smaller premium, your results will be somewhat inferior to those achieved by the company.

Ideally, the results of every Berkshire shareholder would closely mirror those of the company during his period of ownership. That is why Charlie Munger, Berkshire's Vice Chairman and my partner, and I hope for Berkshire to sell consistently at about intrinsic value. We prefer such steadiness to the value-ignoring volatility of the past two years: In 1989 intrinsic value grew less than did book value, which was up 44%, while the market price rose 85%; in 1990 book value and intrinsic value increased by a small amount, while the market price fell 23%.

Berkshire's intrinsic value continues to exceed book value by a substantial margin. We can't tell you the exact differential because intrinsic value is necessarily an estimate; Charlie and I might, in fact, differ by 10% in our appraisals. We do know, however, that we own some exceptional businesses that are worth considerably more than the values at which they are carried on our books.

Much of the extra value that exists in our businesses has been created by the managers now running them. Charlie and I feel free to brag about this group because we had nothing to do with developing the skills they possess: These superstars just came that way. Our job is merely to identify talented managers and provide an environment in which they can do their stuff. Having done it, they send their cash to headquarters and we face our only other task: the intelligent deployment of these funds.

My own role in operations may best be illustrated by a small tale concerning my granddaughter, Emily, and her fourth birthday party last fall. Attending were other children, adoring relatives, and Beemer the Clown, a local entertainer who includes magic tricks in his act.

Beginning these, Beemer asked Emily to help him by waving a "magic wand" over "the box of wonders." Green handkerchiefs went into the box, Emily waved the wand, and Beemer removed blue ones. Loose handkerchiefs went in and, upon a magisterial wave by Emily, emerged knotted. After four such transformations, each more amazing than its predecessor, Emily was unable to contain herself. Her face aglow, she exulted: "Gee, I'm really good at this."

And that sums up my contribution to the performance of Berkshire's business magicians - the Blumkins, the Friedman family, Mike Goldberg, the Heldmans, Chuck Huggins, Stan Lipsey and Ralph Schey. They deserve your applause.

Sources of Reported Earnings

The table below shows the major sources of Berkshire's reported earnings. In this presentation, amortization of Goodwill and other major purchase-price accounting adjustments are not charged against the specific businesses to which they apply, but are instead aggregated and shown separately. This procedure lets you view the earnings of our businesses as they would have been reported had we not purchased them. I've explained in past reports why this form of presentation seems to us to be more useful to investors and managers than one utilizing generally accepted accounting principles (GAAP), which require purchase-price adjustments to be made on a business-by-business basis. The total net earnings we show in the table are, of course, identical to the GAAP total in our audited financial statements.

Much additional information about these businesses is given on pages 39-46, where you also will find our segment earnings reported on a GAAP basis. For information on Wesco's businesses, I urge you to read Charlie Munger's letter, which starts on page 56. His letter also contains the clearest and most insightful discussion of the banking industry that I have seen.


(000s omitted)
-----------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
------------------- -------------------
1990 1989 1990 1989
-------- -------- -------- --------
Operating Earnings:
Insurance Group:
Underwriting ................ $(26,647) $(24,400) $(14,936) $(12,259)
Net Investment Income ....... 327,048 243,599 282,613 213,642
Buffalo News .................. 43,954 46,047 25,981 27,771
Fechheimer .................... 12,450 12,621 6,605 6,789
Kirby ......................... 27,445 26,114 17,613 16,803
Nebraska Furniture Mart ....... 17,248 17,070 8,485 8,441
Scott Fetzer Manufacturing Group 30,378 33,165 18,458 19,996
See's Candies ................. 39,580 34,235 23,892 20,626
Wesco - other than Insurance .. 12,441 13,008 9,676 9,810
World Book .................... 31,896 25,583 20,420 16,372
Amortization of Goodwill ...... (3,476) (3,387) (3,461) (3,372)
Other Purchase-Price
Accounting Charges ......... (5,951) (5,740) (6,856) (6,668)
Interest Expense* ............. (76,374) (42,389) (49,726) (27,098)
Shareholder-Designated
Contributions .............. (5,824) (5,867) (3,801) (3,814)
Other ......................... 58,309 23,755 35,782 12,863
-------- -------- -------- --------
Operating Earnings .............. 482,477 393,414 370,745 299,902
Sales of Securities ............. 33,989 223,810 23,348 147,575
-------- -------- -------- --------
Total Earnings - All Entities $516,466 $617,224 $394,093 $447,477
======== ======== ======== ========

*Excludes interest expense of Scott Fetzer Financial Group and Mutual Savings & Loan.

We refer you also to pages 47-53, where we have rearranged Berkshire's financial data into four segments. These correspond to the way Charlie and I think about the business and should help you more in estimating Berkshire's intrinsic value than consolidated figures would do. Shown on these pages are balance sheets and earnings statements for: (1) our insurance operations, with their major investment positions itemized; (2) our manufacturing, publishing and retailing businesses, leaving aside certain non- operating assets and purchase-price accounting adjustments; (3) our subsidiaries engaged in finance-type operations, which are Mutual Savings and Scott Fetzer Financial; and (4) an all-other category that includes the non-operating assets (primarily marketable securities) held by the companies in segment (2), all purchase- price accounting adjustments, and various assets and debts of the Wesco and Berkshire parent companies.

If you combine the earnings and net worths of these four segments, you will derive totals matching those shown on our GAAP statements. However, I want to emphasize that this four-category presentation does not fall within the purview of our auditors, who in no way bless it.

"Look-Through" Earnings

The term "earnings" has a precise ring to it. And when an earnings figure is accompanied by an unqualified auditor's certificate, a naive reader might think it comparable in certitude to pi, calculated to dozens of decimal places.

In reality, however, earnings can be as pliable as putty when a charlatan heads the company reporting them. Eventually truth will surface, but in the meantime a lot of money can change hands. Indeed, some important American fortunes have been created by the monetization of accounting mirages.

Funny business in accounting is not new. For connoisseurs of chicanery, I have attached as Appendix A on page 22 a previously unpublished satire on accounting practices written by Ben Graham in 1936. Alas, excesses similar to those he then lampooned have many times since found their way into the financial statements of major American corporations and been duly certified by big-name auditors. Clearly, investors must always keep their guard up and use accounting numbers as a beginning, not an end, in their attempts to calculate true "economic earnings" accruing to them.

Berkshire's own reported earnings are misleading in a different, but important, way: We have huge investments in companies ("investees") whose earnings far exceed their dividends and in which we record our share of earnings only to the extent of the dividends we receive. The extreme case is Capital Cities/ABC, Inc. Our 17% share of the company's earnings amounted to more than $83 million last year. Yet only about $530,000 ($600,000 of dividends it paid us less some $70,000 of tax) is counted in Berkshire's GAAP earnings. The residual $82 million-plus stayed with Cap Cities as retained earnings, which work for our benefit but go unrecorded on our books.

Our perspective on such "forgotten-but-not-gone" earnings is simple: The way they are accounted for is of no importance, but their ownership and subsequent utilization is all-important. We care not whether the auditors hear a tree fall in the forest; we do care who owns the tree and what's next done with it.

When Coca-Cola uses retained earnings to repurchase its shares, the company increases our percentage ownership in what I regard to be the most valuable franchise in the world. (Coke also, of course, uses retained earnings in many other value-enhancing ways.) Instead of repurchasing stock, Coca-Cola could pay those funds to us in dividends, which we could then use to purchase more Coke shares. That would be a less efficient scenario: Because of taxes we would pay on dividend income, we would not be able to increase our proportionate ownership to the degree that Coke can, acting for us. If this less efficient procedure were followed, however, Berkshire would report far greater "earnings."

I believe the best way to think about our earnings is in terms of "look-through" results, calculated as follows: Take $250 million, which is roughly our share of the 1990 operating earnings retained by our investees; subtract $30 million, for the incremental taxes we would have owed had that $250 million been paid to us in dividends; and add the remainder, $220 million, to our reported operating earnings of $371 million. Thus our 1990 "look-through earnings" were about $590 million.

As I mentioned last year, we hope to have look-through earnings grow about 15% annually. In 1990 we substantially exceeded that rate but in 1991 we will fall far short of it. Our Gillette preferred has been called and we will convert it into common stock on April 1. This will reduce reported earnings by about $35 million annually and look-through earnings by a much smaller, but still significant, amount. Additionally, our media earnings - both direct and look-through - appear sure to decline. Whatever the results, we will post you annually on how we are doing on a look-through basis.

Non-Insurance Operations

Take another look at the figures on page 51, which aggregate the earnings and balance sheets of our non-insurance operations. After-tax earnings on average equity in 1990 were 51%, a result that would have placed the group about 20th on the 1989 Fortune 500.

Two factors make this return even more remarkable. First, leverage did not produce it: Almost all our major facilities are owned, not leased, and such small debt as these operations have is basically offset by cash they hold. In fact, if the measurement was return on assets - a calculation that eliminates the effect of debt upon returns - our group would rank in Fortune's top ten.

Equally important, our return was not earned from industries, such as cigarettes or network television stations, possessing spectacular economics for all participating in them. Instead it came from a group of businesses operating in such prosaic fields as furniture retailing, candy, vacuum cleaners, and even steel warehousing. The explanation is clear: Our extraordinary returns flow from outstanding operating managers, not fortuitous industry economics.

Let's look at the larger operations:

o It was a poor year for retailing - particularly for big-ticket items - but someone forgot to tell Ike Friedman at Borsheim's. Sales were up 18%. That's both a same-stores and all-stores percentage, since Borsheim's operates but one establishment.

But, oh, what an establishment! We can't be sure about the fact (because most fine-jewelry retailers are privately owned) but we believe that this jewelry store does more volume than any other in the U.S., except for Tiffany's New York store.

Borsheim's could not do nearly that well if our customers came only from the Omaha metropolitan area, whose population is about 600,000. We have long had a huge percentage of greater Omaha's jewelry business, so growth in that market is necessarily limited. But every year business from non-Midwest customers grows dramatically. Many visit the store in person. A large number of others, however, buy through the mail in a manner you will find interesting.

These customers request a jewelry selection of a certain type and value - say, emeralds in the $10,000 -$20,000 range - and we then send them five to ten items meeting their specifications and from which they can pick. Last year we mailed about 1,500 assortments of all kinds, carrying values ranging from under $1,000 to hundreds of thousands of dollars.

The selections are sent all over the country, some to people no one at Borsheim's has ever met. (They must always have been well recommended, however.) While the number of mailings in 1990 was a record, Ike has been sending merchandise far and wide for decades. Misanthropes will be crushed to learn how well our "honor-system" works: We have yet to experience a loss from customer dishonesty.

We attract business nationwide because we have several advantages that competitors can't match. The most important item in the equation is our operating costs, which run about 18% of sales compared to 40% or so at the typical competitor. (Included in the 18% are occupancy and buying costs, which some public companies include in "cost of goods sold.") Just as Wal-Mart, with its 15% operating costs, sells at prices that high-cost competitors can't touch and thereby constantly increases its market share, so does Borsheim's. What works with diapers works with diamonds.

Our low prices create huge volume that in turn allows us to carry an extraordinarily broad inventory of goods, running ten or more times the size of that at the typical fine-jewelry store. Couple our breadth of selection and low prices with superb service and you can understand how Ike and his family have built a national jewelry phenomenon from an Omaha location.

And family it is. Ike's crew always includes son Alan and sons-in-law Marvin Cohn and Donald Yale. And when things are busy - that's often - they are joined by Ike's wife, Roz, and his daughters, Janis and Susie. In addition, Fran Blumkin, wife of Louie (Chairman of Nebraska Furniture Mart and Ike's cousin), regularly pitches in. Finally, you'll find Ike's 89-year-old mother, Rebecca, in the store most afternoons, Wall Street Journal in hand. Given a family commitment like this, is it any surprise that Borsheim's runs rings around competitors whose managers are thinking about how soon 5 o'clock will arrive?

o While Fran Blumkin was helping the Friedman family set records at Borsheim's, her sons, Irv and Ron, along with husband Louie, were setting records at The Nebraska Furniture Mart. Sales at our one-and-only location were $159 million, up 4% from 1989. Though again the fact can't be conclusively proved, we believe NFM does close to double the volume of any other home furnishings store in the country.

The NFM formula for success parallels that of Borsheim's. First, operating costs are rock-bottom - 15% in 1990 against about 40% for Levitz, the country's largest furniture retailer, and 25% for Circuit City Stores, the leading discount retailer of electronics and appliances. Second, NFM's low costs allow the business to price well below all competitors. Indeed, major chains, knowing what they will face, steer clear of Omaha. Third, the huge volume generated by our bargain prices allows us to carry the broadest selection of merchandise available anywhere.

Some idea of NFM's merchandising power can be gleaned from a recent report of consumer behavior in Des Moines, which showed that NFM was Number 3 in popularity among 20 furniture retailers serving that city. That may sound like no big deal until you consider that 19 of those retailers are located in Des Moines, whereas our store is 130 miles away. This leaves customers driving a distance equal to that between Washington and Philadelphia in order to shop with us, even though they have a multitude of alternatives next door. In effect, NFM, like Borsheim's, has dramatically expanded the territory it serves - not by the traditional method of opening new stores but rather by creating an irresistible magnet that employs price and selection to pull in the crowds.

Last year at the Mart there occurred an historic event: I experienced a counterrevelation. Regular readers of this report know that I have long scorned the boasts of corporate executives about synergy, deriding such claims as the last refuge of scoundrels defending foolish acquisitions. But now I know better: In Berkshire's first synergistic explosion, NFM put a See's candy cart in the store late last year and sold more candy than that moved by some of the full-fledged stores See's operates in California. This success contradicts all tenets of retailing. With the Blumkins, though, the impossible is routine.

o At See's, physical volume set a record in 1990 - but only barely and only because of good sales early in the year. After the invasion of Kuwait, mall traffic in the West fell. Our poundage volume at Christmas dropped slightly, though our dollar sales were up because of a 5% price increase.

That increase, and better control of expenses, improved profit margins. Against the backdrop of a weak retailing environment, Chuck Huggins delivered outstanding results, as he has in each of the nineteen years we have owned See's. Chuck's imprint on the business - a virtual fanaticism about quality and service - is visible at all of our 225 stores.

One happening in 1990 illustrates the close bond between See's and its customers. After 15 years of operation, our store in Albuquerque was endangered: The landlord would not renew our lease, wanting us instead to move to an inferior location in the mall and even so to pay a much higher rent. These changes would have wiped out the store's profit. After extended negotiations got us nowhere, we set a date for closing the store.

On her own, the store's manager, Ann Filkins, then took action, urging customers to protest the closing. Some 263 responded by sending letters and making phone calls to See's headquarters in San Francisco, in some cases threatening to boycott the mall. An alert reporter at the Albuquerque paper picked up the story. Supplied with this evidence of a consumer uprising, our landlord offered us a satisfactory deal. (He, too, proved susceptible to a counterrevelation.)

Chuck subsequently wrote personal letters of thanks to every loyalist and sent each a gift certificate. He repeated his thanks in a newspaper ad that listed the names of all 263. The sequel: Christmas sales in Albuquerque were up substantially.

o Charlie and I were surprised at developments this past year in the media industry, including newspapers such as our Buffalo News. The business showed far more vulnerability to the early stages of a recession than has been the case in the past. The question is whether this erosion is just part of an aberrational cycle - to be fully made up in the next upturn - or whether the business has slipped in a way that permanently reduces intrinsic business values.

Since I didn't predict what has happened, you may question the value of my prediction about what will happen. Nevertheless, I'll proffer a judgment: While many media businesses will remain economic marvels in comparison with American industry generally, they will prove considerably less marvelous than I, the industry, or lenders thought would be the case only a few years ago.

The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. In addition, retailers that do little or no media advertising (though they sometimes use the Postal Service) have gradually taken market share in certain merchandise categories. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished. These circumstances materially reduce the intrinsic value of our major media investments and also the value of our operating unit, Buffalo News - though all remain fine businesses.

Notwithstanding the problems, Stan Lipsey's management of the News continues to be superb. During 1990, our earnings held up much better than those of most metropolitan papers, falling only 5%. In the last few months of the year, however, the rate of decrease was far greater.

I can safely make two promises about the News in 1991: (1) Stan will again rank at the top among newspaper publishers; and (2) earnings will fall substantially. Despite a slowdown in the demand for newsprint, the price per ton will average significantly more in 1991 and the paper's labor costs will also be considerably higher. Since revenues may meanwhile be down, we face a real squeeze.

Profits may be off but our pride in the product remains. We continue to have a larger "news hole" - the portion of the paper devoted to news - than any comparable paper. In 1990, the proportion rose to 52.3% against 50.1% in 1989. Alas, the increase resulted from a decline in advertising pages rather than from a gain in news pages. Regardless of earnings pressures, we will maintain at least a 50% news hole. Cutting product quality is not a proper response to adversity.

o The news at Fechheimer, our manufacturer and retailer of uniforms, is all good with one exception: George Heldman, at 69, has decided to retire. I tried to talk him out of it but he had one irrefutable argument: With four other Heldmans - Bob, Fred, Gary and Roger - to carry on, he was leaving us with an abundance of managerial talent.

Fechheimer's operating performance improved considerably in 1990, as many of the problems we encountered in integrating the large acquisition we made in 1988 were moderated or solved. However, several unusual items caused the earnings reported in the "Sources" table to be flat. In the retail operation, we continue to add stores and now have 42 in 22 states. Overall, prospects appear excellent for Fechheimer.

o At Scott Fetzer, Ralph Schey runs 19 businesses with a mastery few bring to running one. In addition to overseeing three entities listed on page 6 - World Book, Kirby, and Scott Fetzer Manufacturing - Ralph directs a finance operation that earned a record $12.2 million pre-tax in 1990.

Were Scott Fetzer an independent company, it would rank close to the top of the Fortune 500 in terms of return on equity, although it is not in businesses that one would expect to be economic champs. The superior results are directly attributable to Ralph.

At World Book, earnings improved on a small decrease in unit volume. The costs of our decentralization move were considerably less in 1990 than 1989 and the benefits of decentralization are being realized. World Book remains far and away the leader in United States encyclopedia sales and we are growing internationally, though from a small base.

Kirby unit volume grew substantially in 1990 with the help of our new vacuum cleaner, The Generation 3, which was an unqualified success. Earnings did not grow as fast as sales because of both start-up expenditures and "learning-curve" problems we encountered in manufacturing the new product. International business, whose dramatic growth I described last year, had a further 20% sales gain in 1990. With the aid of a recent price increase, we expect excellent earnings at Kirby in 1991.

Within the Scott Fetzer Manufacturing Group, Campbell Hausfeld, its largest unit, had a particularly fine year. This company, the country's leading producer of small and medium-sized air compressors, achieved record sales of $109 million, more than 30% of which came from products introduced during the last five years.

* * * * * * * * * * * *

In looking at the figures for our non-insurance operations, you will see that net worth increased by only $47 million in 1990 although earnings were $133 million. This does not mean that our managers are in any way skimping on investments that strengthen their business franchises or that promote growth. Indeed, they diligently pursue both goals.

But they also never deploy capital without good reason. The result: In the past five years they have funneled well over 80% of their earnings to Charlie and me for use in new business and investment opportunities.

Insurance Operations

Shown below is an updated version of our usual table presenting key figures for the property-casualty insurance industry:

Yearly Change Combined Ratio Yearly Change Inflation Rate
in Premiums After Policyholder in Incurred Measured by
Written (%) Dividends Losses (%) GNP Deflator (%)
------------- ------------------ ------------- ----------------
1981 ..... 3.8 106.0 6.5 9.6
1982 ..... 3.7 109.6 8.4 6.5
1983 ..... 5.0 112.0 6.8 3.8
1984 ..... 8.5 118.0 16.9 3.8
1985 ..... 22.1 116.3 16.1 3.0
1986 ..... 22.2 108.0 13.5 2.6
1987 ..... 9.4 104.6 7.8 3.1
1988 ..... 4.4 105.4 5.5 3.3
1989 (Revised) 3.2 109.2 7.7 4.1
1990(Est.) 4.5 109.8 5.0 4.1

Source: A.M. Best Co.
The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: A ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss. The higher the ratio, the worse the year. When the investment income that an insurer earns from holding policyholders' funds ("the float") is taken into account, a combined ratio in the 107 - 111 range typically produces an overall breakeven result, exclusive of earnings on the funds provided by shareholders.

For the reasons laid out in previous reports, we expect the industry's incurred losses to grow at an average of 10% annually, even in periods when general inflation runs considerably lower. (Over the last 25 years, incurred losses have in reality grown at a still faster rate, 11%.) If premium growth meanwhile materially lags that 10% rate, underwriting losses will mount, though the industry's tendency to under-reserve when business turns bad may obscure their size for a time.

Last year premium growth fell far short of the required 10% and underwriting results therefore worsened. (In our table, however, the severity of the deterioration in 1990 is masked because the industry's 1989 losses from Hurricane Hugo caused the ratio for that year to be somewhat above trendline.) The combined ratio will again increase in 1991, probably by about two points.

Results will improve only when most insurance managements become so fearful that they run from business, even though it can be done at much higher prices than now exist. At some point these managements will indeed get the message: The most important thing to do when you find yourself in a hole is to stop digging. But so far that point hasn't gotten across: Insurance managers continue to dig - sullenly but vigorously.

The picture would change quickly if a major physical or financial catastrophe were to occur. Absent such a shock, one to two years will likely pass before underwriting losses become large enough to raise management fear to a level that would spur major price increases. When that moment arrives, Berkshire will be ready - both financially and psychologically - to write huge amounts of business.

In the meantime, our insurance volume continues to be small but satisfactory. In the next section of this report we will give you a framework for evaluating insurance results. From that discussion, you will gain an understanding of why I am so enthusiastic about the performance of our insurance manager, Mike Goldberg, and his cadre of stars, Rod Eldred, Dinos Iordanou, Ajit Jain, and Don Wurster.

In assessing our insurance results over the next few years, you should be aware of one type of business we are pursuing that could cause them to be unusually volatile. If this line of business expands, as it may, our underwriting experience will deviate from the trendline you might expect: In most years we will somewhat exceed expectations and in an occasional year we will fall far below them.

The volatility I predict reflects the fact that we have become a large seller of insurance against truly major catastrophes ("super-cats"), which could for example be hurricanes, windstorms or earthquakes. The buyers of these policies are reinsurance companies that themselves are in the business of writing catastrophe coverage for primary insurers and that wish to "lay off," or rid themselves, of part of their exposure to catastrophes of special severity. Because the need for these buyers to collect on such a policy will only arise at times of extreme stress - perhaps even chaos - in the insurance business, they seek financially strong sellers. And here we have a major competitive advantage: In the industry, our strength is unmatched.

A typical super-cat contract is complicated. But in a plain- vanilla instance we might write a one-year, $10 million policy providing that the buyer, a reinsurer, would be paid that sum only if a catastrophe caused two results: (1) specific losses for the reinsurer above a threshold amount; and (2) aggregate losses for the insurance industry of, say, more than $5 billion. Under virtually all circumstances, loss levels that satisfy the second condition will also have caused the first to be met.

For this $10 million policy, we might receive a premium of, say, $3 million. Say, also, that we take in annual premiums of $100 million from super-cat policies of all kinds. In that case we are very likely in any given year to report either a profit of close to $100 million or a loss of well over $200 million. Note that we are not spreading risk as insurers typically do; we are concentrating it. Therefore, our yearly combined ratio on this business will almost never fall in the industry range of 100 - 120, but will instead be close to either zero or 300%.

Most insurers are financially unable to tolerate such swings. And if they have the ability to do so, they often lack the desire. They may back away, for example, because they write gobs of primary property insurance that would deliver them dismal results at the very time they would be experiencing major losses on super- cat reinsurance. In addition, most corporate managements believe that their shareholders dislike volatility in results.

We can take a different tack: Our business in primary property insurance is small and we believe that Berkshire shareholders, if properly informed, can handle unusual volatility in profits so long as the swings carry with them the prospect of superior long-term results. (Charlie and I always have preferred a lumpy 15% return to a smooth 12%.)

We want to emphasize three points: (1) While we expect our super-cat business to produce satisfactory results over, say, a decade, we're sure it will produce absolutely terrible results in at least an occasional year; (2) Our expectations can be based on little more than subjective judgments - for this kind of insurance, historical loss data are of very limited value to us as we decide what rates to charge today; and (3) Though we expect to write significant quantities of super-cat business, we will do so only at prices we believe to be commensurate with risk. If competitors become optimistic, our volume will fall. This insurance has, in fact, tended in recent years to be woefully underpriced; most sellers have left the field on stretchers.

At the moment, we believe Berkshire to be the largest U.S. writer of super-cat business. So when a major quake occurs in an urban area or a winter storm rages across Europe, light a candle for us.

Measuring Insurance Performance

In the previous section I mentioned "float," the funds of others that insurers, in the conduct of their business, temporarily hold. Because these funds are available to be invested, the typical property-casualty insurer can absorb losses and expenses that exceed premiums by 7% to 11% and still be able to break even on its business. Again, this calculation excludes the earnings the insurer realizes on net worth - that is, on the funds provided by shareholders.

However, many exceptions to this 7% to 11% range exist. For example, insurance covering losses to crops from hail damage produces virtually no float at all. Premiums on this kind of business are paid to the insurer just prior to the time hailstorms are a threat, and if a farmer sustains a loss he will be paid almost immediately. Thus, a combined ratio of 100 for crop hail insurance produces no profit for the insurer.

At the other extreme, malpractice insurance covering the potential liabilities of doctors, lawyers and accountants produces a very high amount of float compared to annual premium volume. The float materializes because claims are often brought long after the alleged wrongdoing takes place and because their payment may be still further delayed by lengthy litigation. The industry calls malpractice and certain other kinds of liability insurance "long- tail" business, in recognition of the extended period during which insurers get to hold large sums that in the end will go to claimants and their lawyers (and to the insurer's lawyers as well).

In long-tail situations a combined ratio of 115 (or even more) can prove profitable, since earnings produced by the float will exceed the 15% by which claims and expenses overrun premiums. The catch, though, is that "long-tail" means exactly that: Liability business written in a given year and presumed at first to have produced a combined ratio of 115 may eventually smack the insurer with 200, 300 or worse when the years have rolled by and all claims have finally been settled.

The pitfalls of this business mandate an operating principle that too often is ignored: Though certain long-tail lines may prove profitable at combined ratios of 110 or 115, insurers will invariably find it unprofitable to price using those ratios as targets. Instead, prices must provide a healthy margin of safety against the societal trends that are forever springing expensive surprises on the insurance industry. Setting a target of 100 can itself result in heavy losses; aiming for 110 - 115 is business suicide.

All of that said, what should the measure of an insurer's profitability be? Analysts and managers customarily look to the combined ratio - and it's true that this yardstick usually is a good indicator of where a company ranks in profitability. We believe a better measure, however, to be a comparison of underwriting loss to float developed.
This loss/float ratio, like any statistic used in evaluating insurance results, is meaningless over short time periods: Quarterly underwriting figures and even annual ones are too heavily based on estimates to be much good. But when the ratio takes in a period of years, it gives a rough indication of the cost of funds generated by insurance operations. A low cost of funds signifies a good business; a high cost translates into a poor business.

On the next page we show the underwriting loss, if any, of our insurance group in each year since we entered the business and relate that bottom line to the average float we have held during the year. From this data we have computed a "cost of funds developed from insurance."

(1) (2) Yearend Yield
Underwriting Approximate on Long-Term
Loss Average Float Cost of Funds Govt. Bonds
------------ ------------- --------------- -------------
(In $ Millions) (Ratio of 1 to 2)

1967 ......... profit $17.3 less than zero 5.50%
1968 ......... profit 19.9 less than zero 5.90%
1969 ......... profit 23.4 less than zero 6.79%
1970 ......... $0.37 32.4 1.14% 6.25%
1971 ......... profit 52.5 less than zero 5.81%
1972 ......... profit 69.5 less than zero 5.82%
1973 ......... profit 73.3 less than zero 7.27%
1974 ......... 7.36 79.1 9.30% 8.13%
1975 ......... 11.35 87.6 12.96% 8.03%
1976 ......... profit 102.6 less than zero 7.30%
1977 ......... profit 139.0 less than zero 7.97%
1978 ......... profit 190.4 less than zero 8.93%
1979 ......... profit 227.3 less than zero 10.08%
1980 ......... profit 237.0 less than zero 11.94%
1981 ......... profit 228.4 less than zero 13.61%
1982 ......... 21.56 220.6 9.77% 10.64%
1983 ......... 33.87 231.3 14.64% 11.84%
1984 ......... 48.06 253.2 18.98% 11.58%
1985 ......... 44.23 390.2 11.34% 9.34%
1986 ......... 55.84 797.5 7.00% 7.60%
1987 ......... 55.43 1,266.7 4.38% 8.95%
1988 ......... 11.08 1,497.7 0.74% 9.00%
1989 ......... 24.40 1,541.3 1.58% 7.97%
1990 ......... 26.65 1,637.3 1.63% 8.24%

The float figures are derived from the total of loss reserves, loss adjustment expense reserves and unearned premium reserves minus agents' balances, prepaid acquisition costs and deferred charges applicable to assumed reinsurance. At some insurers other items should enter into the calculation, but in our case these are unimportant and have been ignored.

During 1990 we held about $1.6 billion of float slated eventually to find its way into the hands of others. The underwriting loss we sustained during the year was $27 million and thus our insurance operation produced funds for us at a cost of about 1.6%. As the table shows, we managed in some years to underwrite at a profit and in those instances our cost of funds was less than zero. In other years, such as 1984, we paid a very high price for float. In 19 years out of the 24 we have been in insurance, though, we have developed funds at a cost below that paid by the government.
There are two important qualifications to this calculation. First, the fat lady has yet to gargle, let alone sing, and we won't know our true 1967 - 1990 cost of funds until all losses from this period have been settled many decades from now. Second, the value of the float to shareholders is somewhat undercut by the fact that they must put up their own funds to support the insurance operation and are subject to double taxation on the investment income these funds earn. Direct investments would be more tax-efficient.

The tax penalty that indirect investments impose on shareholders is in fact substantial. Though the calculation is necessarily imprecise, I would estimate that the owners of the average insurance company would find the tax penalty adds about one percentage point to their cost of float. I also think that approximates the correct figure for Berkshire.

Figuring a cost of funds for an insurance business allows anyone analyzing it to determine whether the operation has a positive or negative value for shareholders. If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, the value is negative. If the cost is lower, the value is positive - and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.

So far Berkshire has fallen into the significantly-lower camp. Even more dramatic are the numbers at GEICO, in which our ownership interest is now 48% and which customarily operates at an underwriting profit. GEICO's growth has generated an ever-larger amount of funds for investment that have an effective cost of considerably less than zero. Essentially, GEICO's policyholders, in aggregate, pay the company interest on the float rather than the other way around. (But handsome is as handsome does: GEICO's unusual profitability results from its extraordinary operating efficiency and its careful classification of risks, a package that in turn allows rock-bottom prices for policyholders.)

Many well-known insurance companies, on the other hand, incur an underwriting loss/float cost that, combined with the tax penalty, produces negative results for owners. In addition, these companies, like all others in the industry, are vulnerable to catastrophe losses that could exceed their reinsurance protection and take their cost of float right off the chart. Unless these companies can materially improve their underwriting performance - and history indicates that is an almost impossible task - their shareholders will experience results similar to those borne by the owners of a bank that pays a higher rate of interest on deposits than it receives on loans.

All in all, the insurance business has treated us very well. We have expanded our float at a cost that on the average is reasonable, and we have further prospered because we have earned good returns on these low-cost funds. Our shareholders, true, have incurred extra taxes, but they have been more than compensated for this cost (so far) by the benefits produced by the float.

A particularly encouraging point about our record is that it was achieved despite some colossal mistakes made by your Chairman prior to Mike Goldberg's arrival. Insurance offers a host of opportunities for error, and when opportunity knocked, too often I answered. Many years later, the bills keep arriving for these mistakes: In the insurance business, there is no statute of limitations on stupidity.

The intrinsic value of our insurance business will always be far more difficult to calculate than the value of, say, our candy or newspaper companies. By any measure, however, the business is worth far more than its carrying value. Furthermore, despite the problems this operation periodically hands us, it is the one - among all the fine businesses we own - that has the greatest potential.

Marketable Securities

Below we list our common stock holdings having a value of over $100 million. A small portion of these investments belongs to subsidiaries of which Berkshire owns less than 100%.


12/31/90
Shares Company Cost Market
------ ------- ---------- ----------
(000s omitted)
3,000,000 Capital Cities/ABC, Inc. ............ $ 517,500 $1,377,375
46,700,000 The Coca-Cola Co. ................... 1,023,920 2,171,550
2,400,000 Federal Home Loan Mortgage Corp. .... 71,729 117,000
6,850,000 GEICO Corp. ......................... 45,713 1,110,556
1,727,765 The Washington Post Company ......... 9,731 342,097
5,000,000 Wells Fargo & Company ............... 289,431 289,375

Lethargy bordering on sloth remains the cornerstone of our investment style: This year we neither bought nor sold a share of five of our six major holdings. The exception was Wells Fargo, a superbly-managed, high-return banking operation in which we increased our ownership to just under 10%, the most we can own without the approval of the Federal Reserve Board. About one-sixth of our position was bought in 1989, the rest in 1990.

The banking business is no favorite of ours. When assets are twenty times equity - a common ratio in this industry - mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly-managed bank at a "cheap" price. Instead, our only interest is in buying into well-managed banks at fair prices.

With Wells Fargo, we think we have obtained the best managers in the business, Carl Reichardt and Paul Hazen. In many ways the combination of Carl and Paul reminds me of another - Tom Murphy and Dan Burke at Capital Cities/ABC. First, each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other. Second, both managerial teams pay able people well, but abhor having a bigger head count than is needed. Third, both attack costs as vigorously when profits are at record levels as when they are under pressure. Finally, both stick with what they understand and let their abilities, not their egos, determine what they attempt. (Thomas J. Watson Sr. of IBM followed the same rule: "I'm no genius," he said. "I'm smart in spots - but I stay around those spots.")

Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of once well-regarded banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings.

Wells Fargo is big - it has $56 billion in assets - and has been earning more than 20% on equity and 1.25% on assets. Our purchase of one-tenth of the bank may be thought of as roughly equivalent to our buying 100% of a $5 billion bank with identical financial characteristics. But were we to make such a purchase, we would have to pay about twice the $290 million we paid for Wells Fargo. Moreover, that $5 billion bank, commanding a premium price, would present us with another problem: We would not be able to find a Carl Reichardt to run it. In recent years, Wells Fargo executives have been more avidly recruited than any others in the banking business; no one, however, has been able to hire the dean.

Of course, ownership of a bank - or about any other business - is far from riskless. California banks face the specific risk of a major earthquake, which might wreak enough havoc on borrowers to in turn destroy the banks lending to them. A second risk is systemic - the possibility of a business contraction or financial panic so severe that it would endanger almost every highly-leveraged institution, no matter how intelligently run. Finally, the market's major fear of the moment is that West Coast real estate values will tumble because of overbuilding and deliver huge losses to banks that have financed the expansion. Because it is a leading real estate lender, Wells Fargo is thought to be particularly vulnerable.

None of these eventualities can be ruled out. The probability of the first two occurring, however, is low and even a meaningful drop in real estate values is unlikely to cause major problems for well-managed institutions. Consider some mathematics: Wells Fargo currently earns well over $1 billion pre-tax annually after expensing more than $300 million for loan losses. If 10% of all $48 billion of the bank's loans - not just its real estate loans - were hit by problems in 1991, and these produced losses (including foregone interest) averaging 30% of principal, the company would roughly break even.

A year like that - which we consider only a low-level possibility, not a likelihood - would not distress us. In fact, at Berkshire we would love to acquire businesses or invest in capital projects that produced no return for a year, but that could then be expected to earn 20% on growing equity. Nevertheless, fears of a California real estate disaster similar to that experienced in New England caused the price of Wells Fargo stock to fall almost 50% within a few months during 1990. Even though we had bought some shares at the prices prevailing before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic prices.

Investors who expect to be ongoing buyers of investments throughout their lifetimes should adopt a similar attitude toward market fluctuations; instead many illogically become euphoric when stock prices rise and unhappy when they fall. They show no such confusion in their reaction to food prices: Knowing they are forever going to be buyers of food, they welcome falling prices and deplore price increases. (It's the seller of food who doesn't like declining prices.) Similarly, at the Buffalo News we would cheer lower prices for newsprint - even though it would mean marking down the value of the large inventory of newsprint we always keep on hand - because we know we are going to be perpetually buying the product.

Identical reasoning guides our thinking about Berkshire's investments. We will be buying businesses - or small parts of businesses, called stocks - year in, year out as long as I live (and longer, if Berkshire's directors attend the seances I have scheduled). Given these intentions, declining prices for businesses benefit us, and rising prices hurt us.

The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: "Most men would rather die than think. Many do."

* * * * * * * * * * * *

Our other major portfolio change last year was large additions to our holdings of RJR Nabisco bonds, securities that we first bought in late 1989. At yearend 1990 we had $440 million invested in these securities, an amount that approximated market value. (As I write this, however, their market value has risen by more than $150 million.)

Just as buying into the banking business is unusual for us, so is the purchase of below-investment-grade bonds. But opportunities that interest us and that are also large enough to have a worthwhile impact on Berkshire's results are rare. Therefore, we will look at any category of investment, so long as we understand the business we're buying into and believe that price and value may differ significantly. (Woody Allen, in another context, pointed out the advantage of open-mindedness: "I can't understand why more people aren't bi-sexual because it doubles your chances for a date on Saturday night.")

In the past we have bought a few below-investment-grade bonds with success, though these were all old-fashioned "fallen angels" - bonds that were initially of investment grade but that were downgraded when the issuers fell on bad times. In the 1984 annual report we described our rationale for buying one fallen angel, the Washington Public Power Supply System.

A kind of bastardized fallen angel burst onto the investment scene in the 1980s - "junk bonds" that were far below investment- grade when issued. As the decade progressed, new offerings of manufactured junk became ever junkier and ultimately the predictable outcome occurred: Junk bonds lived up to their name. In 1990 - even before the recession dealt its blows - the financial sky became dark with the bodies of failing corporations.

The disciples of debt assured us that this collapse wouldn't happen: Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care. We'll acknowledge that such an attention-getter would produce a very alert driver. But another certain consequence would be a deadly - and unnecessary - accident if the car hit even the tiniest pothole or sliver of ice. The roads of business are riddled with potholes; a plan that requires dodging them all is a plan for disaster.

In the final chapter of The Intelligent Investor Ben Graham forcefully rejected the dagger thesis: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Forty-two years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses as the 1990s began.

At the height of the debt mania, capital structures were concocted that guaranteed failure: In some cases, so much debt was issued that even highly favorable business results could not produce the funds to service it. One particularly egregious "kill- 'em-at-birth" case a few years back involved the purchase of a mature television station in Tampa, bought with so much debt that the interest on it exceeded the station's gross revenues. Even if you assume that all labor, programs and services were donated rather than purchased, this capital structure required revenues to explode - or else the station was doomed to go broke. (Many of the bonds that financed the purchase were sold to now-failed savings and loan associations; as a taxpayer, you are picking up the tab for this folly.)

All of this seems impossible now. When these misdeeds were done, however, dagger-selling investment bankers pointed to the "scholarly" research of academics, which reported that over the years the higher interest rates received from low-grade bonds had more than compensated for their higher rate of default. Thus, said the friendly salesmen, a diversified portfolio of junk bonds would produce greater net returns than would a portfolio of high-grade bonds. (Beware of past-performance "proofs" in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.)

There was a flaw in the salesmen's logic - one that a first- year student in statistics is taught to recognize. An assumption was being made that the universe of newly-minted junk bonds was identical to the universe of low-grade fallen angels and that, therefore, the default experience of the latter group was meaningful in predicting the default experience of the new issues. (That was an error similar to checking the historical death rate from Kool-Aid before drinking the version served at Jonestown.)

The universes were of course dissimilar in several vital respects. For openers, the manager of a fallen angel almost invariably yearned to regain investment-grade status and worked toward that goal. The junk-bond operator was usually an entirely different breed. Behaving much as a heroin user might, he devoted his energies not to finding a cure for his debt-ridden condition, but rather to finding another fix. Additionally, the fiduciary sensitivities of the executives managing the typical fallen angel were often, though not always, more finely developed than were those of the junk-bond-issuing financiopath.

Wall Street cared little for such distinctions. As usual, the Street's enthusiasm for an idea was proportional not to its merit, but rather to the revenue it would produce. Mountains of junk bonds were sold by those who didn't care to those who didn't think - and there was no shortage of either.

Junk bonds remain a mine field, even at prices that today are often a small fraction of issue price. As we said last year, we have never bought a new issue of a junk bond. (The only time to buy these is on a day with no "y" in it.) We are, however, willing to look at the field, now that it is in disarray.

In the case of RJR Nabisco, we feel the Company's credit is considerably better than was generally perceived for a while and that the yield we receive, as well as the potential for capital gain, more than compensates for the risk we incur (though that is far from nil). RJR has made asset sales at favorable prices, has added major amounts of equity, and in general is being run well.

However, as we survey the field, most low-grade bonds still look unattractive. The handiwork of the Wall Street of the 1980s is even worse than we had thought: Many important businesses have been mortally wounded. We will, though, keep looking for opportunities as the junk market continues to unravel.

Convertible Preferred Stocks

We continue to hold the convertible preferred stocks described in earlier reports: $700 million of Salomon Inc, $600 million of The Gillette Company, $358 million of USAir Group, Inc. and $300 million of Champion International Corp. Our Gillette holdings will be converted into 12 million shares of common stock on April 1. Weighing interest rates, credit quality and prices of the related common stocks, we can assess our holdings in Salomon and Champion at yearend 1990 as worth about what we paid, Gillette as worth somewhat more, and USAir as worth substantially less.

In making the USAir purchase, your Chairman displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems. (No one pushed me; in tennis parlance, I committed an "unforced error.") The company's troubles were brought on both by industry conditions and by the post-merger difficulties it encountered in integrating Piedmont, an affliction I should have expected since almost all airline mergers have been followed by operational turmoil.

In short order, Ed Colodny and Seth Schofield resolved the second problem: The airline now gets excellent marks for service. Industry-wide problems have proved to be far more serious. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor.

However, unless the industry is decimated during the next few years, our USAir investment should work out all right. Ed and Seth have decisively addressed the current turbulence by making major changes in operations. Even so, our investment is now less secure than at the time I made it.

Our convertible preferred stocks are relatively simple securities, yet I should warn you that, if the past is any guide, you may from time to time read inaccurate or misleading statements about them. Last year, for example, several members of the press calculated the value of all our preferreds as equal to that of the common stock into which they are convertible. By their logic, that is, our Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80. But there is a small problem with this line of reasoning: Using it, one must conclude that all of the value of a convertible preferred resides in the conversion privilege and that the value of a non-convertible preferred of Salomon would be zero, no matter what its coupon or terms for redemption.

The point you should keep in mind is that most of the value of our convertible preferreds is derived from their fixed-income characteristics. That means the securities cannot be worth less than the value they would possess as non-convertible preferreds and may be worth more because of their conversion options.

* * * * * * * * * * * *

I deeply regret having to end this section of the report with a note about my friend, Colman Mockler, Jr., CEO of Gillette, who died in January. No description better fitted Colman than "gentleman" - a word signifying integrity, courage and modesty. Couple these qualities with the humor and exceptional business ability that Colman possessed and you can understand why I thought it an undiluted pleasure to work with him and why I, and all others who knew him, will miss Colman so much.

A few days before Colman died, Gillette was richly praised in a Forbes cover story. Its theme was simple: The company's success in shaving products has come not from marketing savvy (though it exhibits that talent repeatedly) but has instead resulted from its devotion to quality. This mind-set has caused it to consistently focus its energies on coming up with something better, even though its existing products already ranked as the class of the field. In so depicting Gillette, Forbes in fact painted a portrait of Colman.

Help! Help!

Regular readers know that I shamelessly utilize the annual letter in an attempt to acquire businesses for Berkshire. And, as we constantly preach at the Buffalo News, advertising does work: Several businesses have knocked on our door because someone has read in these pages of our interest in making acquisitions. (Any good ad salesman will tell you that trying to sell something without advertising is like winking at a girl in the dark.)

In Appendix B (on pages 26-27) I've reproduced the essence of a letter I wrote a few years back to the owner/manager of a desirable business. If you have no personal connection with a business that might be of interest to us but have a friend who does, perhaps you can pass this report along to him.

Here's the sort of business we are looking for:

(1) Large purchases (at least $10 million of after-tax earnings),

(2) Demonstrated consistent earning power (future projections are of little interest to us, nor are "turnaround" situations),

(3) Businesses earning good returns on equity while employing little or no debt,

(4) Management in place (we can't supply it),

(5) Simple businesses (if there's lots of technology, we won't understand it),

(6) An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown).

We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give.

Our favorite form of purchase is one fitting the Blumkin- Friedman-Heldman mold. In cases like these, the company's owner- managers wish to generate significant amounts of cash, sometimes for themselves, but often for their families or inactive shareholders. At the same time, these managers wish to remain significant owners who continue to run their companies just as they have in the past. We think we offer a particularly good fit for owners with such objectives. We invite potential sellers to check us out by contacting people with whom we have done business in the past.

Charlie and I frequently get approached about acquisitions that don't come close to meeting our tests: We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: "When the phone don't ring, you'll know it's me."

Besides being interested in the purchase of businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Capital Cities, Salomon, Gillette, USAir, and Champion. We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.
Miscellaneous

Ken Chace has decided not to stand for reelection as a director at our upcoming annual meeting. We have no mandatory retirement age for directors at Berkshire (and won't!), but Ken, at 75 and living in Maine, simply decided to cut back his activities.

Ken was my immediate choice to run the textile operation after Buffett Partnership, Ltd. assumed control of Berkshire early in 1965. Although I made an economic mistake in sticking with the textile business, I made no mistake in choosing Ken: He ran the operation well, he was always 100% straight with me about its problems, and he generated the funds that allowed us to diversify into insurance.

My wife, Susan, will be nominated to succeed Ken. She is now the second largest shareholder of Berkshire and if she outlives me will inherit all of my stock and effectively control the company. She knows, and agrees, with my thoughts on successor management and also shares my view that neither Berkshire nor its subsidiary businesses and important investments should be sold simply because some very high bid is received for one or all.

I feel strongly that the fate of our businesses and their managers should not depend on my health - which, it should be added, is excellent - and I have planned accordingly. Neither my estate plan nor that of my wife is designed to preserve the family fortune; instead, both are aimed at preserving the character of Berkshire and returning the fortune to society.

Were I to die tomorrow, you could be sure of three things: (1) None of my stock would have to be sold; (2) Both a controlling shareholder and a manager with philosophies similar to mine would follow me; and (3) Berkshire's earnings would increase by $1 million annually, since Charlie would immediately sell our corporate jet, The Indefensible (ignoring my wish that it be buried with me).

* * * * * * * * * * * *

About 97.3% of all eligible shares participated in Berkshire's 1990 shareholder-designated contributions program. Contributions made through the program were $5.8 million, and 2,600 charities were recipients.

We suggest that new shareholders read the description of our shareholder-designated contributions program that appears on pages 54-55. To participate in future programs, you must make sure your shares are registered in the name of the actual owner, not in the nominee name of a broker, bank or depository. Shares not so registered on August 31, 1991 will be ineligible for the 1991 program.

In addition to the shareholder-designated contributions that Berkshire distributes, managers of our operating businesses make contributions, including merchandise, averaging about $1.5 million annually. These contributions support local charities, such as The United Way, and produce roughly commensurate benefits for our businesses.

However, neither our operating managers nor officers of the parent company use Berkshire funds to make contributions to broad national programs or charitable activities of special personal interest to them, except to the extent they do so as shareholders. If your employees, including your CEO, wish to give to their alma maters or other institutions to which they feel a personal attachment, we believe they should use their own money, not yours.

* * * * * * * * * * * *

The annual meeting this year will be held at the Orpheum Theater in downtown Omaha at 9:30 a.m. on Monday, April 29, 1991. Attendance last year grew to a record 1,300, about a 100-fold increase from ten years ago.

We recommend getting your hotel reservations early at one of these hotels: (1) The Radisson-Redick Tower, a small (88 rooms) but nice hotel across the street from the Orpheum; (2) the much larger Red Lion Hotel, located about a five-minute walk from the Orpheum; or (3) the Marriott, located in West Omaha about 100 yards from Borsheim's and a twenty minute drive from downtown. We will have buses at the Marriott that will leave at 8:30 and 8:45 for the meeting, and return after it ends.

Charlie and I always enjoy the meeting, and we hope you can make it. The quality of our shareholders is reflected in the quality of the questions we get: We have never attended an annual meeting anywhere that features such a consistently high level of intelligent, owner-related questions.

An attachment to our proxy material explains how you can obtain the card you will need for admission to the meeting. Because weekday parking can be tight around the Orpheum, we have lined up a number of nearby lots for our shareholders to use. The attachment also contains information about them.

As usual, we will have buses to take you to Nebraska Furniture Mart and Borsheim's after the meeting and to take you to downtown hotels or to the airport later. I hope that you will allow plenty of time to fully explore the attractions of both stores. Those of you arriving early can visit the Furniture Mart any day of the week; it is open from 10 a.m. to 5:30 p.m. on Saturdays, and from noon to 5:30 p.m. on Sundays. While there, stop at the See's Candy cart and see for yourself the dawn of synergism at Berkshire.

Borsheim's normally is closed on Sunday, but we will open for shareholders and their guests from noon to 6 p.m. on Sunday, April 28. At our Sunday opening last year you made Ike very happy: After totaling the day's volume, he suggested to me that we start holding annual meetings quarterly. Join us at Borsheim's even if you just come to watch; it's a show you shouldn't miss.

Last year the first question at the annual meeting was asked by 11-year-old Nicholas Kenner, a third-generation shareholder from New York City. Nicholas plays rough: "How come the stock is down?" he fired at me. My answer was not memorable.

We hope that other business engagements won't keep Nicholas away from this year's meeting. If he attends, he will be offered the chance to again ask the first question; Charlie and I want to tackle him while we're fresh. This year, however, it's Charlie's turn to answer.

March 1, 1991


Warren E. Buffett
Chairman of the Board

APPENDIX A

U. S. STEEL ANNOUNCES SWEEPING MODERNIZATION SCHEME*



* An unpublished satire by Ben Graham, written in 1936 and given by the author to Warren Buffett in 1954.


Myron C. Taylor, Chairman of U. S. Steel Corporation, today announced the long awaited plan for completely modernizing the world's largest industrial enterprise. Contrary to expectations, no changes will be made in the company's manufacturing or selling policies. Instead, the bookkeeping system is to be entirely revamped. By adopting and further improving a number of modern accounting and financial devices the corporation's earning power will be amazingly transformed. Even under the subnormal conditions of 1935, it is estimated that the new bookkeeping methods would have yielded a reported profit of close to $50 per share on the common stock. The scheme of improvement is the result of a comprehensive survey made by Messrs. Price, Bacon, Guthrie & Colpitts; it includes the following six points:

1. Writing down of Plant Account to Minus $1,000,000,000.

2. Par value of common stock to be reduced to 1¢.

3. Payment of all wages and salaries in option warrants.

4. Inventories to be carried at $1.

5. Preferred Stock to be replaced by non-interest bearing bonds redeemable at 50% discount.

6. A $1,000,000,000 Contingency Reserve to be established.

The official statement of this extraordinary Modernization Plan follows in full:

The Board of Directors of U. S. Steel Corporation is pleased to announce that after intensive study of the problems arising from changed conditions in the industry, it has approved a comprehensive plan for remodeling the Corporation's accounting methods. A survey by a Special Committee, aided and abetted by Messrs. Price, Bacon, Guthrie & Colpitts, revealed that our company has lagged somewhat behind other American business enterprises in utilizing certain advanced bookkeeping methods, by means of which the earning power may be phenomenally enhanced without requiring any cash outlay or any changes in operating or sales conditions. It has been decided not only to adopt these newer methods, but to develop them to a still higher stage of perfection. The changes adopted by the Board may be summarized under six heads, as follows:

1. Fixed Assets to be written down to Minus $1,000,000,000.

Many representative companies have relieved their income accounts of all charges for depreciation by writing down their plant account to $1. The Special Committee points out that if their plants are worth only $1, the fixed assets of U. S. Steel Corporation are worth a good deal less than that sum. It is now a well-recognized fact that many plants are in reality a liability rather than an asset, entailing not only depreciation charges, but taxes, maintenance, and other expenditures. Accordingly, the Board has decided to extend the write-down policy initiated in the 1935 report, and to mark down the Fixed Assets from $1,338,522,858.96 to a round Minus $1,000,000,000.

The advantages of this move should be evident. As the plant wears out, the liability becomes correspondingly reduced. Hence, instead of the present depreciation charge of some $47,000,000 yearly there will be an annual appreciation credit of 5%, or $50,000,000. This will increase earnings by no less than $97,000,000 per annum.

2. Reduction of Par Value of Common Stock to 1¢, and

3. Payment of Salaries and Wages in Option Warrants.

Many corporations have been able to reduce their overhead expenses substantially by paying a large part of their executive salaries in the form of options to buy stock, which carry no charge against earnings. The full possibilities of this modern device have apparently not been adequately realized. The Board of Directors has adopted the following advanced form of this idea:

The entire personnel of the Corporation are to receive their compensation in the form of rights to buy common stock at $50 per share, at the rate of one purchase right for each $50 of salary and/or wages in their present amounts. The par value of the common stock is to be reduced to 1¢.

The almost incredible advantages of this new plan are evident from the following:

A. The payroll of the Corporation will be entirely eliminated, a saving of $250,000,000 per annum, based on 1935 operations.

B. At the same time, the effective compensation of all our employees will be increased severalfold. Because of the large earnings per share to be shown on our common stock under the new methods, it is certain that the shares will command a price in the market far above the option level of $50 per share, making the readily realizable value of these option warrants greatly in excess of the present cash wages that they will replace.

C. The Corporation will realize an additional large annual profit through the exercise of these warrants. Since the par value of the common stock will be fixed at 1¢, there will be a gain of $49.99 on each share subscribed for. In the interest of conservative accounting, however, this profit will not be included in the income account, but will be shown separately as a credit to Capital Surplus.

D. The Corporation's cash position will be enormously strengthened. In place of the present annual cash outgo of $250,000,000 for wages (1935 basis), there will be annual cash inflow of $250,000,000 through exercise of the subscription warrants for 5,000,000 shares of common stock. The Company's large earnings and strong cash position will permit the payment of a liberal dividend which, in turn, will result in the exercise of these option warrants immediately after issuance which, in turn, will further improve the cash position which, in turn, will permit a higher dividend rate -- and so on, indefinitely.

4. Inventories to be carried at $1.

Serious losses have been taken during the depression due to the necessity of adjusting inventory value to market. Various enterprises -- notably in the metal and cotton-textile fields -- have successfully dealt with this problem by carrying all or part of their inventories at extremely low unit prices. The U. S. Steel Corporation has decided to adopt a still more progressive policy, and to carry its entire inventory at $1. This will be effected by an appropriate write-down at the end of each year, the amount of said write-down to be charged to the Contingency Reserve hereinafter referred to.

The benefits to be derived from this new method are very great. Not only will it obviate all possibility of inventory depreciation, but it will substantially enhance the annual earnings of the Corporation. The inventory on hand at the beginning of the year, valued at $1, will be sold during the year at an excellent profit. It is estimated that our income will be increased by means of this method to the extent of at least $150,000,000 per annum which, by a coincidence, will about equal the amount of the write-down to be made each year against Contingency Reserve.

A minority report of the Special Committee recommends that Accounts Receivable and Cash also be written down to $1, in the interest of consistency and to gain additional advantages similar to those just discussed. This proposal has been rejected for the time being because our auditors still require that any recoveries of receivables and cash so charged off be credited to surplus instead of to the year's income. It is expected, however, that this auditing rule -- which is rather reminiscent of the horse-and-buggy days -- will soon be changed in line with modern tendencies. Should this occur, the minority report will be given further and favorable consideration.

5. Replacement of Preferred Stock by Non-Interest-Bearing Bonds Redeemable at 50% Discount.

During the recent depression many companies have been able to offset their operating losses by including in income profits arising from repurchases of their own bonds at a substantial discount from par. Unfortunately the credit of U. S. Steel Corporation has always stood so high that this lucrative source of revenue has not hitherto been available to it. The Modernization Scheme will remedy this condition.

It is proposed that each share of preferred stock be exchanged for $300 face value of non-interest-bearing sinking-fund notes, redeemable by lot at 50% of face value in 10 equal annual installments. This will require the issuance of $1,080,000,000 of new notes, of which $108,000,000 will be retired each year at a cost to the Corporation of only $54,000,000, thus creating an annual profit of the same amount.

Like the wage-and/or-salary plan described under 3. above, this arrangement will benefit both the Corporation and its preferred stockholders. The latter are assured payment for their present shares at 150% of par value over an average period of five years. Since short-term securities yield practically no return at present, the non-interest-bearing feature is of no real importance. The Corporation will convert its present annual charge of $25,000,000 for preferred dividends into an annual bond-retirement profit of $54,000,000 -- an aggregate yearly gain of $79,000,000.

6. Establishment of a Contingency Reserve of $1,000,000,000.

The Directors are confident that the improvements hereinbefore described will assure the Corporation of a satisfactory earning power under all conditions in the future. Under modern accounting methods, however, it is unnecessary to incur the slightest risk of loss through adverse business developments of any sort, since all these may be provided for in advance by means of a Contingency Reserve.

The Special Committee has recommended that the Corporation create such a Contingency Reserve in the fairly substantial amount of $1,000,000,000. As previously set forth, the annual write-down of inventory to $1 will be absorbed by this reserve. To prevent eventual exhaustion of the Contingency Reserve, it has been further decided that it be replenished each year by transfer of an appropriate sum from Capital Surplus. Since the latter is expected to increase each year by not less than $250,000,000 through the exercise of the Stock Option Warrants (see 3. above), it will readily make good any drains on the Contingency Reserve.

In setting up this arrangement, the Board of Directors must confess regretfully that they have been unable to improve upon the devices already employed by important corporations in transferring large sums between Capital, Capital Surplus, Contingency Reserves and other Balance Sheet Accounts. In fact, it must be admitted that our entries will be somewhat too simple, and will lack that element of extreme mystification that characterizes the most advanced procedure in this field. The Board of Directors, however, have insisted upon clarity and simplicity in framing their Modernization Plan, even at the sacrifice of possible advantage to the Corporation's earning power.

In order to show the combined effect of the new proposals upon the Corporation's earning power, we submit herewith a condensed Income Account for 1935 on two bases, viz:


B. Pro-Forma
Giving Effect to
Changes Proposed
Herewith









A. As Reported

Gross Receipts from all Sources (Including Inter-Company)


$765,000,000


$765,000,000

Salaries and Wages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


251,000,000


--

Other Operating Expenses and Taxes . . . . . . . . . . . . . . . . . .


461,000,000


311,000,000

Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


47,000,000


(50,000,000)

Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


5,000,000


5,000,000

Discount on Bonds Retired . . . . . . . . . . . . . . . . . . . . . . . . .


--


(54,000,000)

Preferred Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


25,000,000


--

Balance for Common . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


(24,000,000)


553,000,000

Average Shares Outstanding . . . . . . . . . . . . . . . . . . . . . . . .


8,703,252


11,203,252

Earned Per Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


($2.76)


$49.80

In accordance with a somewhat antiquated custom there is appended herewith a condensed pro-forma Balance Sheet of the U. S. Steel Corporation as of December 31, 1935, after giving effect to proposed changes in asset and liability accounts.

ASSETS

Fixed Assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .


($1,000,000,000)

Cash Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


142,000,000

Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


56,000,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


1

Miscellaneous Assets . . . . . . . . . . . . . . . . . . . . . . . . .


27,000,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


($774,999,999)

LIABILITIES

Common Stock Par 1¢ (Par Value $87,032.52) Stated Value*


($3,500,000,000)

Subsidiaries' Bonds and Stocks . . . . . . . . . . . . . . . . . .


113,000,000

New Sinking Fund Notes . . . . . . . . . . . . . . . . . . . . . .


1,080,000,000

Current Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . .


69,000,000

Contingency Reserve . . . . . . . . . . . . . . . . . . . . . . . . .


1,000,000,000

Other Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


74,000,000

Initial Surplus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


389,000,001

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


($774,999,999)

*Given a Stated Value differing from Par Value, in accordance with the laws of the State of Virginia, where the company will be re-incorporated.

It is perhaps unnecessary to point out to our stockholders that modern accounting methods give rise to balance sheets differing somewhat in appearance from those of a less advanced period. In view of the very large earning power that will result from these changes in the Corporation's Balance Sheet, it is not expected that undue attention will be paid to the details of assets and liabilities.

In conclusion, the Board desires to point out that the combined procedure, whereby plant will be carried at a minus figure, our wage bill will be eliminated, and inventory will stand on our books at virtually nothing, will give U. S. Steel Corporation an enormous competitive advantage in the industry. We shall be able to sell our products at exceedingly low prices and still show a handsome margin of profit. It is the considered view of the Board of Directors that under the Modernization Scheme we shall be able to undersell all competitors to such a point that the anti-trust laws will constitute the only barrier to 100% domination of the industry.

In making this statement, the Board is not unmindful of the possibility that some of our competitors may seek to offset our new advantages by adopting similar accounting improvements. We are confident, however, that U. S. Steel will be able to retain the loyalty of its customers, old and new, through the unique prestige that will accrue to it as the originator and pioneer in these new fields of service to the user of steel. Should necessity arise, moreover, we believe we shall be able to maintain our deserved superiority by introducing still more advanced bookkeeping methods, which are even now under development in our Experimental Accounting Laboratory.



APPENDIX B

Some Thoughts on Selling Your Business*



*This is an edited version of a letter I sent some years ago to a man who had indicated that he might want to sell his family business. I present it here because it is a message I would like to convey to other prospective sellers. -- W.E.B.


Dear _____________:

Here are a few thoughts pursuant to our conversation of the other day.

Most business owners spend the better part of their lifetimes building their businesses. By experience built upon endless repetition, they sharpen their skills in merchandising, purchasing, personnel selection, etc. It's a learning process, and mistakes made in one year often contribute to competence and success in succeeding years.

In contrast, owner-managers sell their business only once -- frequently in an emotionally-charged atmosphere with a multitude of pressures coming from different directions. Often, much of the pressure comes from brokers whose compensation is contingent upon consummation of a sale, regardless of its consequences for both buyer and seller. The fact that the decision is so important, both financially and personally, to the owner can make the process more, rather than less, prone to error. And, mistakes made in the once-in-a-lifetime sale of a business are not reversible.

Price is very important, but often is not the most critical aspect of the sale. You and your family have an extraordinary business -- one of a kind in your field -- and any buyer is going to recognize that. It's also a business that is going to get more valuable as the years go by. So if you decide not to sell now, you are very likely to realize more money later on. With that knowledge you can deal from strength and take the time required to select the buyer you want.

If you should decide to sell, I think Berkshire Hathaway offers some advantages that most other buyers do not. Practically all of these buyers will fall into one of two categories:

(1) A company located elsewhere but operating in your business or in a business somewhat akin to yours. Such a buyer -- no matter what promises are made -- will usually have managers who feel they know how to run your business operations and, sooner or later, will want to apply some hands-on "help." If the acquiring company is much larger, it often will have squads of managers, recruited over the years in part by promises that they will get to run future acquisitions. They will have their own way of doing things and, even though your business record undoubtedly will be far better than theirs, human nature will at some point cause them to believe that their methods of operating are superior. You and your family probably have friends who have sold their businesses to larger companies, and I suspect that their experiences will confirm the tendency of parent companies to take over the running of their subsidiaries, particularly when the parent knows the industry, or thinks it does.

(2) A financial maneuverer, invariably operating with large amounts of borrowed money, who plans to resell either to the public or to another corporation as soon as the time is favorable. Frequently, this buyer's major contribution will be to change accounting methods so that earnings can be presented in the most favorable light just prior to his bailing out. I'm enclosing a recent article that describes this sort of transaction, which is becoming much more frequent because of a rising stock market and the great supply of funds available for such transactions.

If the sole motive of the present owners is to cash their chips and put the business behind them -- and plenty of sellers fall in this category -- either type of buyer that I've just described is satisfactory. But if the sellers' business represents the creative work of a lifetime and forms an integral part of their personality and sense of being, buyers of either type have serious flaws.

Berkshire is another kind of buyer -- a rather unusual one. We buy to keep, but we don't have, and don't expect to have, operating people in our parent organization. All of the businesses we own are run autonomously to an extraordinary degree. In most cases, the managers of important businesses we have owned for many years have not been to Omaha or even met each other. When we buy a business, the sellers go on running it just as they did before the sale; we adapt to their methods rather than vice versa.

We have no one -- family, recently recruited MBAs, etc. -- to whom we have promised a chance to run businesses we have bought from owner-managers. And we won't have.

You know of some of our past purchases. I'm enclosing a list of everyone from whom we have ever bought a business, and I invite you to check with them as to our performance versus our promises. You should be particularly interested in checking with the few whose businesses did not do well in order to ascertain how we behaved under difficult conditions.

Any buyer will tell you that he needs you personally -- and if he has any brains, he most certainly does need you. But a great many buyers, for the reasons mentioned above, don't match their subsequent actions to their earlier words. We will behave exactly as promised, both because we have so promised, and because we need to in order to achieve the best business results.

This need explains why we would want the operating members of your family to retain a 20% interest in the business. We need 80% to consolidate earnings for tax purposes, which is a step important to us. It is equally important to us that the family members who run the business remain as owners. Very simply, we would not want to buy unless we felt key members of present management would stay on as our partners. Contracts cannot guarantee your continued interest; we would simply rely on your word.

The areas I get involved in are capital allocation and selection and compensation of the top man. Other personnel decisions, operating strategies, etc. are his bailiwick. Some Berkshire managers talk over some of their decisions with me; some don't. It depends upon their personalities and, to an extent, upon their own personal relationship with me.

If you should decide to do business with Berkshire, we would pay in cash. Your business would not be used as collateral for any loan by Berkshire. There would be no brokers involved.

Furthermore, there would be no chance that a deal would be announced and that the buyer would then back off or start suggesting adjustments (with apologies, of course, and with an explanation that banks, lawyers, boards of directors, etc. were to be blamed). And finally, you would know exactly with whom you are dealing. You would not have one executive negotiate the deal only to have someone else in charge a few years later, or have the president regretfully tell you that his board of directors required this change or that (or possibly required sale of your business to finance some new interest of the parent's).

It's only fair to tell you that you would be no richer after the sale than now. The ownership of your business already makes you wealthy and soundly invested. A sale would change the form of your wealth, but it wouldn't change its amount. If you sell, you will have exchanged a 100%-owned valuable asset that you understand for another valuable asset -- cash -- that will probably be invested in small pieces (stocks) of other businesses that you understand less well. There is often a sound reason to sell but, if the transaction is a fair one, the reason is not so that the seller can become wealthier.

I will not pester you; if you have any possible interest in selling, I would appreciate your call. I would be extraordinarily proud to have Berkshire, along with the key members of your family, own _______; I believe we would do very well financially; and I believe you would have just as much fun running the business over the next 20 years as you have had during the past 20.




Sincerely,




/s/ Warren E. Buffett

To the Shareholders of Berkshire Hathaway Inc.:

Our gain in net worth during 1991 was $2.1 billion, or
39.6%. Over the last 27 years (that is, since present management
took over) our per-share book value has grown from $19 to $6,437,
or at a rate of 23.7% compounded annually.

The size of our equity capital - which now totals $7.4
billion - makes it certain that we cannot maintain our past rate
of gain or, for that matter, come close to doing so. As Berkshire
grows, the universe of opportunities that can significantly
influence the company's performance constantly shrinks. When we
were working with capital of $20 million, an idea or business
producing $1 million of profit added five percentage points to
our return for the year. Now we need a $370 million idea (i.e.,
one contributing over $550 million of pre-tax profit) to achieve
the same result. And there are many more ways to make $1 million
than to make $370 million.

Charlie Munger, Berkshire's Vice Chairman, and I have set a
goal of attaining a 15% average annual increase in Berkshire's
intrinsic value. If our growth in book value is to keep up with a
15% pace, we must earn $22 billion during the next decade. Wish
us luck - we'll need it.

Our outsized gain in book value in 1991 resulted from a
phenomenon not apt to be repeated: a dramatic rise in the price-
earnings ratios of Coca-Cola and Gillette. These two stocks
accounted for nearly $1.6 billion of our $2.1 billion growth in
net worth last year. When we loaded up on Coke three years ago,
Berkshire's net worth was $3.4 billion; now our Coke stock alone
is worth more than that.

Coca-Cola and Gillette are two of the best companies in the
world and we expect their earnings to grow at hefty rates in the
years ahead. Over time, also, the value of our holdings in these
stocks should grow in rough proportion. Last year, however, the
valuations of these two companies rose far faster than their
earnings. In effect, we got a double-dip benefit, delivered
partly by the excellent earnings growth and even more so by the
market's reappraisal of these stocks. We believe this reappraisal
was warranted. But it can't recur annually: We'll have to settle
for a single dip in the future.

A Second Job

In 1989 when I - a happy consumer of five cans of Cherry
Coke daily - announced our purchase of $1 billion worth of Coca-
Cola stock, I described the move as a rather extreme example of
putting our money where my mouth was. On August 18 of last year,
when I was elected Interim Chairman of Salomon Inc, it was a
different story: I put my mouth where our money was.

You've all read of the events that led to my appointment. My
decision to take the job carried with it an implicit but
important message: Berkshire's operating managers are so
outstanding that I knew I could materially reduce the time I was
spending at the company and yet remain confident that its
economic progress would not skip a beat. The Blumkins, the
Friedman family, Mike Goldberg, the Heldmans, Chuck Huggins, Stan
Lipsey, Ralph Schey and Frank Rooney (CEO of H.H. Brown, our
latest acquisition, which I will describe later) are all masters
of their operations and need no help from me. My job is merely to
treat them right and to allocate the capital they generate.
Neither function is impeded by my work at Salomon.

The role that Charlie and I play in the success of our
operating units can be illustrated by a story about George Mira,
the one-time quarterback of the University of Miami, and his
coach, Andy Gustafson. Playing Florida and near its goal line,
Mira dropped back to pass. He spotted an open receiver but found
his right shoulder in the unshakable grasp of a Florida
linebacker. The right-handed Mira thereupon switched the ball to
his other hand and threw the only left-handed pass of his life -
for a touchdown. As the crowd erupted, Gustafson calmly turned to
a reporter and declared: "Now that's what I call coaching."

Given the managerial stars we have at our operating units,
Berkshire's performance is not affected if Charlie or I slip away
from time to time. You should note, however, the "interim" in my
Salomon title. Berkshire is my first love and one that will never
fade: At the Harvard Business School last year, a student asked
me when I planned to retire and I replied, "About five to ten
years after I die."

Sources of Reported Earnings

The table below shows the major sources of Berkshire's
reported earnings. In this presentation, amortization of Goodwill
and other major purchase-price accounting adjustments are not
charged against the specific businesses to which they apply, but
are instead aggregated and shown separately. This procedure lets
you view the earnings of our businesses as they would have been
reported had we not purchased them. I've explained in past
reports why this form of presentation seems to us to be more
useful to investors and managers than one utilizing generally
accepted accounting principles (GAAP), which require purchase-
price adjustments to be made on a business-by-business basis. The
total net earnings we show in the table are, of course, identical
to the GAAP total in our audited financial statements.

A large amount of additional information about these
businesses is given on pages 33-47, where you also will find
our segment earnings reported on a GAAP basis. However, we will
not in this letter discuss each of our non-insurance operations,
as we have in the past. Our businesses have grown in number - and
will continue to grow - so it now makes sense to rotate coverage,
discussing one or two in detail each year.

(000s omitted)
----------------------------------------------
Berkshire's Share
of Net Earnings
(after taxes and
Pre-Tax Earnings minority interests)
---------------------- ----------------------
1991 1990 1991 1990
---------- ---------- ---------- ----------
Operating Earnings:
Insurance Group:
Underwriting ............ $(119,593) $ (26,647) $ (77,229) $ (14,936)
Net Investment Income ... 331,846 327,047 285,173 282,613
H. H. Brown (acquired 7/1/91) 13,616 --- 8,611 ---
Buffalo News .............. 37,113 43,954 21,841 25,981
Fechheimer ................ 12,947 12,450 6,843 6,605
Kirby ..................... 35,726 27,445 22,555 17,613
Nebraska Furniture Mart ... 14,384 17,248 6,993 8,485
Scott Fetzer
Manufacturing Group .... 26,123 30,378 15,901 18,458
See's Candies ............. 42,390 39,580 25,575 23,892
Wesco - other than Insurance 12,230 12,441 8,777 9,676
World Book ................ 22,483 31,896 15,487 20,420
Amortization of Goodwill .. (4,113) (3,476) (4,098) (3,461)
Other Purchase-Price
Accounting Charges ..... (6,021) (5,951) (7,019) (6,856)
Interest Expense* ......... (89,250) (76,374) (57,165) (49,726)
Shareholder-Designated
Contributions .......... (6,772) (5,824) (4,388) (3,801)
Other ..................... 77,399 58,310 47,896 35,782
---------- ---------- ---------- ----------
Operating Earnings 400,508 482,477 315,753 370,745
Sales of Securities 192,478 33,989 124,155 23,348
Total Earnings - All Entities $ 592,986 $ 516,466 $ 439,908 $ 394,093

*Excludes interest expense of Scott Fetzer Financial Group and
Mutual Savings & Loan.


"Look-Through" Earnings

We've previously discussed look-through earnings, which
consist of: (1) the operating earnings reported in the previous
section, plus; (2) the retained operating earnings of major
investees that, under GAAP accounting, are not reflected in our
profits, less; (3) an allowance for the tax that would be paid by
Berkshire if these retained earnings of investees had instead been
distributed to us.

I've told you that over time look-through earnings must
increase at about 15% annually if our intrinsic business value is
to grow at that rate. Indeed, since present management took over in
1965, our look-through earnings have grown at almost the identical
23% rate of gain recorded for book value.

Last year, however, our look-through earnings did not grow at
all but rather declined by 14%. To an extent, the decline was
precipitated by two forces that I discussed in last year's report
and that I warned you would have a negative effect on look-through
earnings.

First, I told you that our media earnings - both direct and
look-through - were "sure to decline" and they in fact did. The
second force came into play on April 1, when the call of our
Gillette preferred stock required us to convert it into common. The
after-tax earnings in 1990 from our preferred had been about $45
million, an amount somewhat higher than the combination in 1991 of
three months of dividends on our preferred plus nine months of
look-through earnings on the common.

Two other outcomes that I did not foresee also hurt look-
through earnings in 1991. First, we had a break-even result from
our interest in Wells Fargo (dividends we received from the company
were offset by negative retained earnings). Last year I said that
such a result at Wells was "a low-level possibility - not a
likelihood." Second, we recorded significantly lower - though still
excellent - insurance profits.

The following table shows you how we calculate look-through
earnings, although I warn you that the figures are necessarily very
rough. (The dividends paid to us by these investees have been
included in the operating earnings itemized on page 6, mostly
under "Insurance Group: Net Investment Income.")

Berkshire's Share
of Undistributed
Berkshire's Approximate Operating Earnings
Berkshire's Major Investees Ownership at Yearend (in millions)
--------------------------- ----------------------- ------------------

1991 1990 1991 1990
------ ------ -------- --------
Capital Cities/ABC Inc. ........ 18.1% 17.9% $ 61 $ 85
The Coca-Cola Company .......... 7.0% 7.0% 69 58
Federal Home Loan Mortgage Corp. 3.4%(1) 3.2%(1) 15 10
The Gillette Company ........... 11.0% --- 23(2) ---
GEICO Corp. .................... 48.2% 46.1% 69 76
The Washington Post Company .... 14.6% 14.6% 10 18
Wells Fargo & Company .......... 9.6% 9.7% (17) 19(3)
-------- --------
Berkshire's share of
undistributed earnings of major investees $230 $266
Hypothetical tax on these undistributed investee earnings (30) (35)
Reported operating earnings of Berkshire 316 371
-------- --------
Total look-through earnings of Berkshire $516 $602
======== ========

(1) Net of minority interest at Wesco
(2) For the nine months after Berkshire converted its
preferred on April 1
(3) Calculated on average ownership for the year

* * * * * * * * * * * *

We also believe that investors can benefit by focusing on
their own look-through earnings. To calculate these, they should
determine the underlying earnings attributable to the shares they
hold in their portfolio and total these. The goal of each investor
should be to create a portfolio (in effect, a "company") that will
deliver him or her the highest possible look-through earnings a
decade or so from now.

An approach of this kind will force the investor to think
about long-term business prospects rather than short-term stock
market prospects, a perspective likely to improve results. It's
true, of course, that, in the long run, the scoreboard for
investment decisions is market price. But prices will be determined
by future earnings. In investing, just as in baseball, to put runs
on the scoreboard one must watch the playing field, not the
scoreboard.

A Change in Media Economics and Some Valuation Math

In last year's report, I stated my opinion that the decline in
the profitability of media companies reflected secular as well as
cyclical factors. The events of 1991 have fortified that case: The
economic strength of once-mighty media enterprises continues to
erode as retailing patterns change and advertising and
entertainment choices proliferate. In the business world,
unfortunately, the rear-view mirror is always clearer than the
windshield: A few years back no one linked to the media business -
neither lenders, owners nor financial analysts - saw the economic
deterioration that was in store for the industry. (But give me a
few years and I'll probably convince myself that I did.)

The fact is that newspaper, television, and magazine
properties have begun to resemble businesses more than franchises
in their economic behavior. Let's take a quick look at the
characteristics separating these two classes of enterprise, keeping
in mind, however, that many operations fall in some middle ground
and can best be described as weak franchises or strong businesses.

An economic franchise arises from a product or service that:
(1) is needed or desired; (2) is thought by its customers to have
no close substitute and; (3) is not subject to price regulation.
The existence of all three conditions will be demonstrated by a
company's ability to regularly price its product or service
aggressively and thereby to earn high rates of return on capital.
Moreover, franchises can tolerate mis-management. Inept managers
may diminish a franchise's profitability, but they cannot inflict
mortal damage.

In contrast, "a business" earns exceptional profits only if it
is the low-cost operator or if supply of its product or service is
tight. Tightness in supply usually does not last long. With
superior management, a company may maintain its status as a low-
cost operator for a much longer time, but even then unceasingly
faces the possibility of competitive attack. And a business, unlike
a franchise, can be killed by poor management.

Until recently, media properties possessed the three
characteristics of a franchise and consequently could both price
aggressively and be managed loosely. Now, however, consumers
looking for information and entertainment (their primary interest
being the latter) enjoy greatly broadened choices as to where to
find them. Unfortunately, demand can't expand in response to this
new supply: 500 million American eyeballs and a 24-hour day are all
that's available. The result is that competition has intensified,
markets have fragmented, and the media industry has lost some -
though far from all - of its franchise strength.

* * * * * * * * * * * *

The industry's weakened franchise has an impact on its value
that goes far beyond the immediate effect on earnings. For an
understanding of this phenomenon, let's look at some much over-
simplified, but relevant, math.

A few years ago the conventional wisdom held that a newspaper,
television or magazine property would forever increase its earnings
at 6% or so annually and would do so without the employment of
additional capital, for the reason that depreciation charges would
roughly match capital expenditures and working capital requirements
would be minor. Therefore, reported earnings (before amortization
of intangibles) were also freely-distributable earnings, which
meant that ownership of a media property could be construed as akin
to owning a perpetual annuity set to grow at 6% a year. Say, next,
that a discount rate of 10% was used to determine the present value
of that earnings stream. One could then calculate that it was
appropriate to pay a whopping $25 million for a property with
current after-tax earnings of $1 million. (This after-tax multiplier
of 25 translates to a multiplier on pre-tax earnings of about 16.)

Now change the assumption and posit that the $1 million
represents "normal earning power" and that earnings will bob around
this figure cyclically. A "bob-around" pattern is indeed the lot of
most businesses, whose income stream grows only if their owners are
willing to commit more capital (usually in the form of retained
earnings). Under our revised assumption, $1 million of earnings,
discounted by the same 10%, translates to a $10 million valuation.
Thus a seemingly modest shift in assumptions reduces the property's
valuation to 10 times after-tax earnings (or about 6 1/2 times
pre-tax earnings).

Dollars are dollars whether they are derived from the
operation of media properties or of steel mills. What in the past
caused buyers to value a dollar of earnings from media far higher
than a dollar from steel was that the earnings of a media property
were expected to constantly grow (without the business requiring
much additional capital), whereas steel earnings clearly fell in
the bob-around category. Now, however, expectations for media have
moved toward the bob-around model. And, as our simplified example
illustrates, valuations must change dramatically when expectations
are revised.

We have a significant investment in media - both through our
direct ownership of Buffalo News and our shareholdings in The
Washington Post Company and Capital Cities/ABC - and the intrinsic
value of this investment has declined materially because of the
secular transformation that the industry is experiencing. (Cyclical
factors have also hurt our current look-through earnings, but these
factors do not reduce intrinsic value.) However, as our Business
Principles on page 2-3 note, one of the rules by which we run
Berkshire is that we do not sell businesses - or investee holdings
that we have classified as permanent - simply because we see ways
to use the money more advantageously elsewhere. (We did sell
certain other media holdings sometime back, but these were
relatively small.)

The intrinsic value losses that we have suffered have been
moderated because the Buffalo News, under Stan Lipsey's leadership,
has done far better than most newspapers and because both Cap
Cities and Washington Post are exceptionally well-managed. In
particular, these companies stayed on the sidelines during the late
1980's period in which purchasers of media properties regularly
paid irrational prices. Also, the debt of both Cap Cities and
Washington Post is small and roughly offset by cash that they hold.
As a result, the shrinkage in the value of their assets has not
been accentuated by the effects of leverage. Among publicly-owned
media companies, our two investees are about the only ones
essentially free of debt. Most of the other companies, through a
combination of the aggressive acquisition policies they pursued and
shrinking earnings, find themselves with debt equal to five or more
times their current net income.

The strong balance sheets and strong managements of Cap Cities
and Washington Post leave us more comfortable with these
investments than we would be with holdings in any other media
companies. Moreover, most media properties continue to have far
better economic characteristics than those possessed by the average
American business. But gone are the days of bullet-proof franchises
and cornucopian economics.

Twenty Years in a Candy Store

We've just passed a milestone: Twenty years ago, on January 3,
1972, Blue Chip Stamps (then an affiliate of Berkshire and later
merged into it) bought control of See's Candy Shops, a West Coast
manufacturer and retailer of boxed-chocolates. The nominal price
that the sellers were asking - calculated on the 100% ownership we
ultimately attained - was $40 million. But the company had $10
million of excess cash, and therefore the true offering price was
$30 million. Charlie and I, not yet fully appreciative of the value
of an economic franchise, looked at the company's mere $7 million
of tangible net worth and said $25 million was as high as we would
go (and we meant it). Fortunately, the sellers accepted our offer.

The sales of trading stamps by Blue Chip thereafter declined
from $102.5 million in 1972 to $1.2 million in 1991. But See's
candy sales in the same period increased from $29 million to $196
million. Moreover, profits at See's grew even faster than sales,
from $4.2 million pre-tax in 1972 to $42.4 million last year.

For an increase in profits to be evaluated properly, it must
be compared with the incremental capital investment required to
produce it. On this score, See's has been astounding: The company
now operates comfortably with only $25 million of net worth, which
means that our beginning base of $7 million has had to be
supplemented by only $18 million of reinvested earnings. Meanwhile,
See's remaining pre-tax profits of $410 million were distributed to
Blue Chip/Berkshire during the 20 years for these companies to
deploy (after payment of taxes) in whatever way made most sense.

In our See's purchase, Charlie and I had one important
insight: We saw that the business had untapped pricing power.
Otherwise, we were lucky twice over. First, the transaction was not
derailed by our dumb insistence on a $25 million price. Second, we
found Chuck Huggins, then See's executive vice-president, whom we
instantly put in charge. Both our business and personal experiences
with Chuck have been outstanding. One example: When the purchase
was made, we shook hands with Chuck on a compensation arrangement -
conceived in about five minutes and never reduced to a written
contract - that remains unchanged to this day.

In 1991, See's sales volume, measured in dollars, matched that
of 1990. In pounds, however, volume was down 4%. All of that
slippage took place in the last two months of the year, a period
that normally produces more than 80% of annual profits. Despite the
weakness in sales, profits last year grew 7%, and our pre-tax
profit margin was a record 21.6%.

Almost 80% of See's sales come from California and our
business clearly was hurt by the recession, which hit the state
with particular force late in the year. Another negative, however,
was the mid-year initiation in California of a sales tax of 7%-8«%
(depending on the county involved) on "snack food" that was deemed
applicable to our candy.

Shareholders who are students of epistemological shadings will
enjoy California's classifications of "snack" and "non-snack"
foods:

Taxable "Snack" Foods Non-Taxable "Non-Snack" Foods
--------------------- -----------------------------
Ritz Crackers Soda Crackers
Popped Popcorn Unpopped Popcorn
Granola Bars Granola Cereal
Slice of Pie (Wrapped) Whole Pie
Milky Way Candy Bar Milky Way Ice Cream Bar

What - you are sure to ask - is the tax status of a melted
Milky Way ice cream bar? In that androgynous form, does it more
resemble an ice cream bar or a candy bar that has been left in the
sun? It's no wonder that Brad Sherman, Chairman of California's
State Board of Equalization, who opposed the snack food bill but
must now administer it, has said: "I came to this job as a
specialist in tax law. Now I find my constituents should have
elected Julia Child."

Charlie and I have many reasons to be thankful for our
association with Chuck and See's. The obvious ones are that we've
earned exceptional returns and had a good time in the process.
Equally important, ownership of See's has taught us much about the
evaluation of franchises. We've made significant money in certain
common stocks because of the lessons we learned at See's.

H. H. Brown

We made a sizable acquisition in 1991 - the H. H. Brown
Company - and behind this business is an interesting history. In
1927 a 29-year-old businessman named Ray Heffernan purchased the
company, then located in North Brookfield, Massachusetts, for
$10,000 and began a 62-year career of running it. (He also found
time for other pursuits: At age 90 he was still joining new golf
clubs.) By Mr. Heffernan's retirement in early 1990 H. H. Brown had
three plants in the United States and one in Canada; employed close
to 2,000 people; and earned about $25 million annually before
taxes.

Along the way, Frances Heffernan, one of Ray's daughters,
married Frank Rooney, who was sternly advised by Mr. Heffernan
before the wedding that he had better forget any ideas he might
have about working for his father-in-law. That was one of Mr.
Heffernan's few mistakes: Frank went on to become CEO of Melville
Shoe (now Melville Corp.). During his 23 years as boss, from 1964
through 1986, Melville's earnings averaged more than 20% on equity
and its stock (adjusted for splits) rose from $16 to $960. And a
few years after Frank retired, Mr. Heffernan, who had fallen ill,
asked him to run Brown.

After Mr. Heffernan died late in 1990, his family decided to
sell the company - and here we got lucky. I had known Frank for a
few years but not well enough for him to think of Berkshire as a
possible buyer. He instead gave the assignment of selling Brown to
a major investment banker, which failed also to think of us. But
last spring Frank was playing golf in Florida with John Loomis, a
long-time friend of mine as well as a Berkshire shareholder, who is
always on the alert for something that might fit us. Hearing about
the impending sale of Brown, John told Frank that the company
should be right up Berkshire's alley, and Frank promptly gave me a
call. I thought right away that we would make a deal and before
long it was done.

Much of my enthusiasm for this purchase came from Frank's
willingness to continue as CEO. Like most of our managers, he has
no financial need to work but does so because he loves the game and
likes to excel. Managers of this stripe cannot be "hired" in the
normal sense of the word. What we must do is provide a concert hall
in which business artists of this class will wish to perform.

Brown (which, by the way, has no connection to Brown Shoe of
St. Louis) is the leading North American manufacturer of work shoes
and boots, and it has a history of earning unusually fine margins
on sales and assets. Shoes are a tough business - of the billion
pairs purchased in the United States each year, about 85% are
imported - and most manufacturers in the industry do poorly. The
wide range of styles and sizes that producers offer causes
inventories to be heavy; substantial capital is also tied up in
receivables. In this kind of environment, only outstanding managers
like Frank and the group developed by Mr. Heffernan can prosper.

A distinguishing characteristic of H. H. Brown is one of the
most unusual compensation systems I've encountered - but one that
warms my heart: A number of key managers are paid an annual salary
of $7,800, to which is added a designated percentage of the profits
of the company after these are reduced by a charge for capital
employed. These managers therefore truly stand in the shoes of
owners. In contrast, most managers talk the talk but don't walk the
walk, choosing instead to employ compensation systems that are long
on carrots but short on sticks (and that almost invariably treat
equity capital as if it were cost-free). The arrangement at Brown,
in any case, has served both the company and its managers
exceptionally well, which should be no surprise: Managers eager to
bet heavily on their abilities usually have plenty of ability to
bet on.

* * * * * * * * * * * *

It's discouraging to note that though we have on four
occasions made major purchases of companies whose sellers were
represented by prominent investment banks, we were in only one of
these instances contacted by the investment bank. In the other
three cases, I myself or a friend initiated the transaction at some
point after the investment bank had solicited its own list of
prospects. We would love to see an intermediary earn its fee by
thinking of us - and therefore repeat here what we're looking for:

(1) Large purchases (at least $10 million of after-tax
earnings),
(2) Demonstrated consistent earning power (future projections
are of little interest to us, nor are "turnaround"
situations),
(3) Businesses earning good returns on equity while employing
little or no debt,
(4) Management in place (we can't supply it),
(5) Simple businesses (if there's lots of technology, we
won't understand it),
(6) An offering price (we don't want to waste our time or
that of the seller by talking, even preliminarily,
about a transaction when price is unknown).

We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we're interested. (With Brown,
we didn't even need to take five.) We prefer to buy for cash, but
will consider issuing stock when we receive as much in intrinsic
business value as we give.

Our favorite form of purchase is one fitting the pattern
through which we acquired Nebraska Furniture Mart, Fechheimer's and
Borsheim's. In cases like these, the company's owner-managers wish
to generate significant amounts of cash, sometimes for themselves,
but often for their families or inactive shareholders. At the same
time, these managers wish to remain significant owners who continue
to run their companies just as they have in the past. We think we
offer a particularly good fit for owners with such objectives and
we invite potential sellers to check us out by contacting people
with whom we have done business in the past.

Charlie and I frequently get approached about acquisitions
that don't come close to meeting our tests: We've found that if
you advertise an interest in buying collies, a lot of people will
call hoping to sell you their cocker spaniels. A line from a
country song expresses our feeling about new ventures, turnarounds,
or auction-like sales: "When the phone don't ring, you'll know it's
me."

Besides being interested in the purchase of businesses as
described above, we are also interested in the negotiated purchase
of large, but not controlling, blocks of stock comparable to those
we hold in Capital Cities, Salomon, Gillette, USAir, Champion, and
American Express. We are not interested, however, in receiving
suggestions about purchases we might make in the general stock
market.

Insurance Operations

Shown below is an updated version of our usual table
presenting key figures for the property-casualty insurance
industry:

Yearly Change Combined Ratio Yearly Change Inflation Rate
in Premiums After Policyholder in Incurred Measured by
Written (%) Dividends Losses (%) GDP Deflator (%)
------------- ------------------ ------------- ----------------
1981 ..... 3.8 106.0 6.5 10.0
1982 ..... 3.7 109.6 8.4 6.2
1983 ..... 5.0 112.0 6.8 4.0
1984 ..... 8.5 118.0 16.9 4.5
1985 ..... 22.1 116.3 16.1 3.7
1986 ..... 22.2 108.0 13.5 2.7
1987 ..... 9.4 104.6 7.8 3.1
1988 ..... 4.4 105.4 5.5 3.9
1989 ..... 3.2 109.2 7.7 4.4
1990 (Revised) 4.4 109.6 4.8 4.1
1991 (Est.) 3.1 109.1 2.9 3.7

The combined ratio represents total insurance costs (losses
incurred plus expenses) compared to revenue from premiums: A
ratio below 100 indicates an underwriting profit, and one above
100 indicates a loss. The higher the ratio, the worse the year.
When the investment income that an insurer earns from holding
policyholders' funds ("the float") is taken into account, a
combined ratio in the 107 - 111 range typically produces an
overall break-even result, exclusive of earnings on the funds
provided by shareholders.