THEESSAYSOFWARRENBUFFETT:LESSONSFORCORPORATEAMERICA

THEESSAYSOFWARRENBUFFETT:LESSONSFORCORPORATEAMERICA

ESSAYSBYWARRENE.BUFFETT

SELECTED,ARRANGED,ANDINTRODUCEDBY

LAWRENCEA.CUNNINGHAM

THIRDEDITION

Library of Congress Cataloging-in-Publication Data eISBN: 978-1-61163-447-1

Cunningham,LawrenceA.,1962-Buffett,WarrenE.,1930-TheEssaysofWarrenBuffett:Lessons forCorporateAmerica/selected,arranged,andintroducedbyLawrenceA.Cunningham—3ded.

308p.26cm.Includes previously copyrighted material. Reprinted with permission.

Includesbibliographicalreferencesandindex.

1. Corporations—United States—Finance. 2. Corporate governance—United States. 3. Investments—United States. 4. Stocks—United States. 5.Consolidation and merger of corporations—United States. 6. Accounting—UnitedStates.I.Buffett,WarrenE.II.Cunningham,LawrenceA.III.Title.

HG4061.B83722001(OCoLC)38497313

Originallypublishedaspartof theCardozoLawReview’sspecial issueonTheEssaysofWarrenBuffett Symposium. Copyright©LawrenceA.Cunningham,1997, 2001, 2008, and 2013. Includes previously copyrighted materials, ©WarrenE.Buffett,reprintedwithpermission.Allrightsreserved.PrintedintheUnitedStatesofAmerica.

ISBN:978-1-61163-409-9

Copiesofthiscollectionareavailableinlargerquantitiesatspecialdiscountstouse for teaching, training, promotions, premiums or other purposes. Formoreinformation,pleasecontactCarolinaAcademicPress,700KentStreet,Durham,NC27701,http://www.cap-press.com.

“ThespeechIloveisasimple,naturalspeech,thesameonpaperasinthemouth;aspeechsucculentandsinewy,briefandcompressed,notsomuchdainty

andwell-combedasvehementandbrusque.”MicheldeMontaigneTheEssaysofMontaigne(1580)

“Thesincerityandmarrowofthemanreachestohissentences.Iknownotanywhereabookthatseemslesswritten.

Cutthesewordsandtheywouldbleed;theyarevascularandalive.”RalphWaldoEmersonRepresentativeMan(1850)(ReferringtoMontaigneandhisEssays)

TABLEOFCONTENTS

PREFACEINTRODUCTIONPROLOGUE:OWNER-RELATEDBUSINESSPRINCIPLES

I.CORPORATEGOVERNANCEA.FullandFairDisclosureB.BoardsandManagersC.TheAnxietiesofBusinessChangeD.SocialCompactsE.AnOwner-BasedApproachtoCorporateCharityF.APrincipledApproachtoExecutivePayG.Risk,ReputationandOversight

II.FINANCEANDINVESTINGA.Mr.MarketB.ArbitrageC.DebunkingStandardDogmaD.“Value”Investing:ARedundancyE.IntelligentInvestingF.CigarButtsandtheInstitutionalImperativeG.LifeandDebt

III.INVESTMENTALTERNATIVESA.SurveyingtheFieldB.JunkBondsC.Zero-CouponBondsD.PreferredStockE.DerivativesF.ForeignCurrenciesandEquitiesG.HomeOwnership:PracticeandPolicy

IV.COMMONSTOCKA.TheBaneofTrading:TransactionCostsB.AttractingtheRightSortofInvestor

C.DividendPolicyandShareRepurchasesD.StockSplitsandTradingActivityE.ShareholderStrategiesF.Berkshire’sRecapitalization

V.MERGERSANDACQUISITIONSA.BadMotivesandHighPricesB.SensibleShareRepurchasesVersusGreenmailC.LeveragedBuyoutsD.SoundAcquisitionPoliciesE.OnSellingOne’sBusinessF.TheBuyerofChoice

VI.VALUATIONANDACCOUNTINGA.AesopandInefficientBushTheoryB.IntrinsicValue,BookValue,andMarketPriceC.Look-ThroughEarningsD.EconomicversusAccountingGoodwillE.OwnerEarningsandtheCashFlowFallacyF.OptionValuation

VII.ACCOUNTINGSHENANIGANSA.ASatireonAccountingShenanigansB.StandardSettingC.StockOptionsD.“Restructuring”ChargesE.PensionEstimatesF.RealizationEvents

VIII.ACCOUNTINGPOLICYA.MergersB.SegmentDataandConsolidationC.DeferredTaxesD.RetireeBenefits

IX.TAXMATTERSA.DistributionoftheCorporateTaxBurdenB.TaxationandInvestmentPhilosophy

EPILOGUE

INDEXCONCEPTGLOSSARYDISPOSITIONSUMMARY

PREFACE

TheoriginaleditionofTheEssaysofWarrenBuffett:LessonsforCorporateAmerica was the centerpiece of a symposium held two decades ago at theBenjamin N. Cardozo School of Law under the auspices of its Samuel andRonnie Heyman Center on Corporate Governance. This gathering broughthundredsofCardozostudentstogetherforatwo-daydissectionofalltheideasinthecollection,featuringaseriesofvibrantdebatesamongsome30distinguishedprofessors,investors,managers,andotherstudents,withWarrenE.BuffettandCharlesT.Mungerparticipatingthroughoutfromtheirseatsinthefrontrow.

TheEssayswas the standard textbook for a specializedcourse I taught atCardozo inproperbusinesspracticesand is adoptedby scoresofprofessorsatother law and business schools for classes such as investment, finance andaccounting.Someinvestmentfirmshavedistributedcopiestotheirprofessionalemployeesandclientsaspartoftrainingprograms.Iamgratefulforthepositivefeedback from these students, teachers, andother users anddelighted toknowthat the lessonsarebeing taughtand learned.Special thanks toProfessorTomJohansen(Ft.HaysStateUniversity,Kansas)andProfessorLeoChan(DelawareStateCollege).

Continuing thanks also to Mr. Buffett’s good friend and advisor, RobertDenham,whomIhavehadthepleasureofgettingtoknowintheyearsfollowingthesymposium.Mr.Denham,apartnerinthelawfirmMunger,Tolles&Olsen,introducedMr.BuffetttoCardozoandmethroughanothermutualfriend,formerMunger,TollescolleagueandnowCardozoprofessorMonroePrice,andIthankbothofthemforopeningthatdoor.ThanksalsotoCarolLoomis,aclosefriendofMr.Buffett’sand thepersonwhoannuallyeditseachshareholder letter.Forinstitutional support in countless ways, thanks as always to Sam and RonnieHeyman.

AsinpreviouseditionsofTheEssays,thisoneretainsthearchitectureandphilosophy of the original edition but adds selections fromMr.Buffett’smostrecentannualshareholderletters.Allthelettersarewoventogetherintoafabricthat reads as a complete and coherent narrative of a sound business andinvestment philosophy. As an aid to all readers, and to enable readers of thepreviouseditionstoseewhatisnewinthisone,adispositiontableattheendofthebookshowsthevariousplacesinthiscollectionwhereselectionsfromeachyear’sletterappear.Footnotesthroughoutindicatetheyearoftheannualreport

from which essays are taken. To avoid interrupting the narrative flow in thiscollection,omissionsoftextwithinexcerptsarenotindicatedbyellipsesorotherpunctuation.

Thenewedition iscalledfornotbecauseanythinghaschangedabout thefundamentals of sound business and investment philosophy but because Mr.Buffett’s articulation of that philosophy is always done in the context ofcontemporaryeventsandbusinessconditions.Soperiodicupdatingiswarrantedtomaintainitscurrency.

In preparing the previous editions, I was aided by numerous people, towhomIexpressedgratitude in thoseeditions, and Iwant to thank themagain.Amongthose,Iespecially thankMr.Buffett.Hisgenerositynotonlymadethesymposiumpossiblebuthisparticipationenricheditmanifold;hiswillingnesstoentrusttherearrangementandrepublicationofhisletterstomeisagreathonor.Hispartner,CharlieMunger,deserves repeated thanks too, fornotonlydidheparticipateinthesymposiumfromthefrontrowhealsograciouslychaired,onamoment’snotice,oneofthepanels.

LawrenceA.Cunningham

NewYorkCityFebruary2,2013

INTRODUCTION

LawrenceA.Cunningham

Experienced readers of Warren Buffett’s letters to the shareholders ofBerkshire Hathaway Inc. have gained an enormously valuable informaleducation. The letters distill in plain words all the basic principles of soundbusinesspractices.Onselectingmanagersandinvestments,valuingbusinesses,andusingfinancial informationprofitably, thewritingsarebroadinscope,andlongonwisdom.Byarrangingthesewritingsasthematicessays,thiscollectionpresentsasynthesisoftheoverallbusinessandinvestmentphilosophyintendedfordisseminationtoawidegeneralaudience.

The central theme uniting Buffett’s lucid essays is that the principles offundamentalbusinessanalysis,firstformulatedbyhisteachersBenGrahamandDavid Dodd, should guide investment practice. Linked to that theme aremanagementprinciplesthatdefinetheproperroleofcorporatemanagersasthestewardsofinvestedcapital,andtheproperroleofshareholdersasthesuppliersand owners of capital. Radiating from these main themes are practical andsensible lessons on the entire range of important business issues, fromaccountingtomergerstovaluation.

BuffetthasappliedthesetraditionalprinciplesaschiefexecutiveofficerofBerkshireHathaway,acompanywithrootsinagroupoftextileoperationsbegunin the early1800s.Buffett took thehelmofBerkshire in1964,when its bookvaluepersharewas$19.46anditsintrinsicvaluepersharefarlower.Today,itsbookvaluepershare isaround$100,000andits intrinsicvaluefarhigher.Thegrowthrateinbookvaluepershareduringthatperiodisabout20%compoundedannually.

Berkshireisnowaholdingcompanyengagedin80distinctbusinesslines.Berkshire’s most important business is insurance, carried on through variouscompanies including its 100% owned subsidiary, GEICO Corporation, amongthelargestautoinsurersintheUnitedStates,andGeneralReCorporation,oneofthe largest reinsurers in the world. In 2010, Berkshire acquired BurlingtonNorthernSantaFeCorporation, among the largest railroads inNorthAmerica,and has long owned and operated large energy companies. Some Berkshiresubsidiariesaremassive:eightwouldbeincludedintheFortune500iftheywere

stand-alone companies. Its other interests are so vast that, as Buffett writes:“whenyouarelookingatBerkshire,youarelookingacrosscorporateAmerica.”Examples: food, clothing, building materials, tools, equipment, newspapers,books,transportationservicesandfinancialproducts.Berkshirealsoownslargeequityinterestsinmajorcorporations,includingAmericanExpress,Coca-Cola,InternationalBusinessMachines(IBM),Procter&Gamble(throughmergerwithlongtimeholdingsinGillette),TheWashingtonPost,andWellsFargo.

Buffett and Berkshire Vice Chairman Charlie Munger have built thissprawling enterprise by investing in businesses with excellent economiccharacteristics and run by outstandingmanagers.While they prefer negotiatedacquisitions of 100% of such a business at a fair price, they take a “double-barreled approach” of buying on the open market less than 100% of somebusinesseswhentheycandosoatapro-ratapricewellbelowwhatitwouldtaketobuy100%.

The double-barreled approach pays off handsomely. The value ofmarketable securities in Berkshire’s portfolio, on a per share basis, increasedfrom$4in1965to$95,000in2010,a20%compoundannualincrease.Pershareoperating earnings increased in the same period from just over $4 to nearly$6,000,acompoundannualincreaseofabout21%.AccordingtoBuffett,theseresultsfollownotfromanymasterplanbutfromfocusedinvesting—allocatingcapitalbyconcentratingonbusinesseswithoutstandingeconomiccharacteristicsandrunbyfirstratemanagers.

Buffett views Berkshire as a partnership among him, Munger and othershareholders,andvirtuallyallhisnetworthisinBerkshirestock.Hiseconomicgoalislong-term—tomaximizeBerkshire’spershareintrinsicvaluebyowningall or part of a diversified group of businesses that generate cash and above-averagereturns.Inachievingthisgoal,Buffettforegoesexpansionfor thesakeof expansion and foregoes divestment of businesses so long as they generatesomecashandhavegoodmanagement.

Berkshire retains and reinvests earnings when doing so delivers at leastproportionalincreasesinpersharemarketvalueovertime.Itusesdebtsparinglyand sells equity only when it receives as much in value as it gives. Buffettpenetratesaccountingconventions,especially those thatobscure realeconomicearnings.

These owner-related business principles, as Buffett calls them, are theorganizing themes of the accompanying essays. As organized, the essaysconstitute an elegant and instructive manual on management, investment,

finance,andaccounting.Buffett’sbasicprinciplesformtheframeworkforarichrange of positions on the wide variety of issues that exist in all aspects ofbusiness.Theygo far beyondmere abstract platitudes. It is true that investorsshouldfocusonfundamentals,bepatient,andexercisegoodjudgmentbasedoncommon sense. In Buffett’s essays, these advisory tidbits are anchored in themoreconcreteprinciplesbywhichBuffettlivesandthrives.

CORPORATEGOVERNANCE

For Buffett, managers are stewards of shareholder capital. The bestmanagers think like owners in making business decisions. They haveshareholder interestsatheart.Buteven firstratemanagerswill sometimeshaveintereststhatconflictwiththoseofshareholders.Howtoeasethoseconflictsandto nurture managerial stewardship have been constant objectives of Buffett’slongcareerandaprominentthemeofhisessays.Theessaysaddresssomeofthemostimportantgovernanceproblems.

Thefirstistheimportanceofforthrightnessandcandorincommunicationsbymanagerstoshareholders.Buffetttellsitlikeitis,oratleastasheseesit,andlamentsthatheisintheminority.Berkshire’sannualreportisnotglossy;Buffettprepares its contents usingwords and numbers people of average intelligencecan understand; and all investors get the same information at the same time.BuffettandBerkshireavoidmakingpredictions,abadmanagerialhabitthattoooftenleadsothermanagerstomakeuptheirfinancialreports.

Besidestheowner-orientationreflectedinBuffett’sdisclosurepracticeandtheowner-relatedbusinessprinciplessummarizedabove, thenextmanagementlessonistodispensewithformulasofmanagerialstructure.Contrarytotextbookrulesonorganizationalbehavior,mappinganabstractchainofcommandontoaparticularbusinesssituation,accordingtoBuffett,doeslittlegood.Whatmattersis selecting people who are able, honest, and hard-working. Having firstratepeopleontheteamismoreimportantthandesigninghierarchiesandclarifyingwhoreportstowhomaboutwhatandatwhattimes.

Specialattentionmustbepaidtoselectingachiefexecutiveofficer(CEO)because of threemajor differencesBuffett identifies betweenCEOs and otheremployees.First,standardsformeasuringaCEO’sperformanceareinadequateoreasytomanipulate,soaCEO’sperformanceishardertomeasurethanthatofmost workers. Second, no one is senior to the CEO, so no senior person’sperformancecanbemeasuredeither.Third,aboardofdirectorscannotservethatsenior role since relations between CEOs and boards are conventionallycongenial.

Major reforms are often directed toward aligning management andshareholder interestsorenhancingboardoversightofCEOperformance.Stockoptionsformanagementweretoutedasonemethod;greateremphasisonboardprocesseswasanother.SeparatingtheidentitiesandfunctionsoftheChairmanofthe Board and the CEO or appointment of standing audit, nominating andcompensationcommitteeswerealsoheraldedaspromisingreforms.Perhapsthemost pervasive prescription is to populate boards with independent directors.Noneoftheseinnovationshassolvedgovernanceproblems,however,andsomehaveexacerbatedthem.

Thebestsolution,Buffettinstructs,istotakegreatcareinidentifyingCEOswho will perform capably regardless of weak structural restraints. Largeinstitutional shareholdersmust exercise their power to oust CEOs that do notmeasureuptothedemandsofcorporatestewardship.OutstandingCEOsdonotneed a lot of coaching from owners, although they can benefit from having asimilarly outstanding board. Directors therefore must be chosen for theirbusinesssavvy,theirinterest,andtheirowner-orientation.AccordingtoBuffett,one of the greatest problems among boards in corporate America is thatmembersareselectedforotherreasons,suchasaddingdiversityorprominencetoaboard—or,famously,independence.

Most reforms are painted with a broad brush, without noting the majordifferencesamongtypesofboardsituationsthatBuffettidentifies.Forexample,director power isweakest in the casewhere there is a controlling shareholderwho is also themanager.Whendisagreements arise between the directors andmanagement,thereislittleadirectorcandootherthantoobjectand,inseriouscircumstances, resign.Director power is strongest at the other extreme,wherethereisacontrollingshareholderwhodoesnotparticipateinmanagement.Thedirectors can take matters directly to the controlling shareholder whendisagreementarises.

Themostcommonsituation,however,isacorporationwithoutacontrollingshareholder.Thisiswheremanagementproblemsaremostacute,Buffettsays.Itwould be helpful if directors could supply necessary discipline, but boardcongeniality usually prevents that. To maximize board effectiveness in thissituation, Buffett believes the board should be small in size and composedmostlyofoutsidedirectors.Thestrongestweaponadirectorcanwieldinthesesituationsremainshisorherthreattoresign.

Allthesesituationsdoshareacommoncharacteristic:theterriblemanagerisaloteasiertoconfrontorremovethanthemediocremanager.Achiefproblemin all governance structures, Buffett emphasizes, is that in corporate Americaevaluationofchiefexecutiveofficersisneverconductedinregularmeetingsin

theabsenceofthatchiefexecutive.Holdingregularmeetingswithoutthechiefexecutivetoreviewhisorherperformancewouldbeamarkedimprovementincorporategovernance.

The CEOs at Berkshire’s various operating companies enjoy a uniquepositionincorporateAmerica.Theyaregivenasimplesetofcommands:toruntheirbusinessasif(1)theyareitssoleowner,(2)itistheonlyassettheyhold,and (3) they can never sell or merge it for a hundred years. This enablesBerkshireCEOstomanagewithalong-termhorizonaheadofthem,somethingalien to theCEOsofpubliccompanieswhoseshort-termorientedshareholdersobsess with meeting the latest quarterly earnings estimate. Short-term resultsmatter, of course, but the Berkshire approach avoids any pressure to achievethemattheexpenseofstrengtheninglong-termcompetitiveadvantages.

If only short-term resultsmattered,manymanagerial decisions would bemuch easier, particularly those relating to businesses whose economiccharacteristicshaveeroded.Considerthetimehorizontrade-offBuffettfacedinmanaging what he considers the worst investment he ever made, buyingBerkshire in the first place. The economic characteristics of Berkshire’s oldtextile business had begun to erode by the late 1970s. Buffett had hoped todevise a reversal of its misfortunes, noting how important Berkshire’s textilebusinesswastoitsemployeesandlocalcommunitiesinNewEngland,andhowable and understanding management and labor had been in addressing theeconomic difficulties. Buffett kept the ailing plant alive through 1985, but afinancial reversal could not be achieved andBuffett eventually closed it. Thisbalancing of short-term results with long-term prospects based on communitytrustisnoteasy,butitisintelligent.KindredlessonscarryovertoothersectorsinwhichBerkshire invests,suchas thenewspaperbusiness in theinternetage,andhighly regulated industries, suchas energyand railroads, inwhichBuffettsees an implicit social compact between private enterprise and regulatoryoverseers.

Sometimes management interests conflict with shareholder interests insubtle or easily disguisedways. Take corporate philanthropy, for example.Atmostmajorcorporations,managementallocatesaportionofcorporateprofit tocharitableconcerns.Thecharitiesarechosenbymanagement,forreasonsoftenunrelated either to corporate interests or shareholder interests.Most state lawspermit management to make these decisions, so long as aggregate annualdonationsarereasonableinamount,usuallynotgreaterthan10%ofannualnetprofits.

Berkshire does things differently. Itmakes no contributions at the parentcompany levelandallows its subsidiaries to followphilanthropicpolicies they

had in effect before Berkshire acquired them. For two decades, moreover,Berkshire used an imaginative program through which its shareholdersdesignatedthecharitiestowhichBerkshirewoulddonateandinwhatamounts.Nearlyallshareholdersparticipated,donatingtensofmillionsofdollarsannuallytothousandsofdifferentcharities.Politicalcontroversyovertheabortionissue,however, interferedwith this program.Political activists organizedboycotts ofBerkshire’s products to protest particular charitable donations thatweremade,destroyingthisfeatureofBerkshire’s“partnership”approach.

The plan to align management and shareholder interests by awardingexecutives stock options not only was oversold, but also subtly disguised adeeper division between those interests that the options created. Manycorporationspaytheirmanagersstockoptionswhosevalueincreasessimplybyretentionofearnings,rather thanbysuperiordeploymentofcapital.AsBuffettexplains,however, simplyby retainingand reinvestingearnings,managerscanreportannualearningsincreaseswithoutsomuchasliftingafingertoimproverealreturnsoncapital.Stockoptionsthusoftenrobshareholdersofwealthandallocatethebootytoexecutives.Moreover,oncegranted,stockoptionsareoftenirrevocable, unconditional, and benefit managers without regard to individualperformance.

It is possible to use stock options to instill a managerial culture thatencourages owner-like thinking, Buffett agrees. But the alignmentwill not beperfect. Shareholders are exposed to the downside risks of suboptimal capitaldeployment in a way that an option holder is not. Buffett therefore cautionsshareholderswhoarereadingproxystatementsaboutapprovingoptionplanstobe aware of the asymmetry in this kind of alignment. Many shareholdersrationallyignoreproxystatements,buttheabuseofstockoptionsshouldbeonthe front-burner of shareholders, particularly institutional investors thatperiodicallyengageinpromotingcorporategovernanceimprovements.

Buffettemphasizesthatperformanceshouldbethebasisforexecutivepaydecisions. Executive performance should be measured by profitability, afterprofitsarereducedbyachargeforthecapitalemployedintherelevantbusinessor earnings retained by it. If stock options are used, they should be related toindividualperformance,ratherthancorporateperformance,andpricedbasedonbusinessvalue.Betteryet, as atBerkshire, stockoptions should simplynotbepartofanexecutive’scompensation.Afterall, exceptionalmanagerswhoearncash bonuses based on the performance of their ownbusiness can simply buystockiftheywantto;iftheydo,they“trulywalkintheshoesofowners,”Buffettsays. And owners’ interests are paramount on executive pay as with othercorporate governance topics Buffett addresses, such as risk management,

corporatecomplianceandfinancialreporting.

FINANCEANDINVESTINGThemost revolutionary investing ideas of the past thirty-five years were

those calledmodern finance theory. This is an elaborate set of ideas that boildowntoonesimpleandmisleadingpracticalimplication:itisawasteoftimetostudyindividualinvestmentopportunitiesinpublicsecurities.Accordingtothisview,youwilldobetterbyrandomlyselectingagroupofstocksforaportfoliobythrowingdartsatthestocktablesthanbythinkingaboutwhetherindividualinvestmentopportunitiesmakesense.

Oneofmodernfinance theory’smain tenets ismodernportfolio theory. Itsays that you can eliminate the peculiar risk of any security by holding adiversified portfolio—that is, it formalizes the folk slogan “don’t put all youreggsinonebasket.”Theriskthatisleftoveristheonlyriskforwhichinvestorswillbecompensated,thestorygoes.

Thisleftoverriskcanbemeasuredbyasimplemathematicalterm—calledbeta—that shows how volatile the security is compared to the market. Betameasures this volatility riskwell for securities that trade on efficientmarkets,where information about publicly traded securities is swiftly and accuratelyincorporatedintoprices.Inthemodernfinancestory,efficientmarketsrule.

Reverence for these ideas was not limited to ivory tower academics, incolleges, universities, business schools, and law schools, but became standarddogma throughout financial America in the past thirty-five years, from WallStreet toMainStreet.Manyprofessionalsstillbelieve that stockmarketpricesalways accurately reflect fundamental values, that the only risk thatmatters isthevolatilityofprices,andthatthebestwaytomanagethatriskistoinvestinadiversifiedgroupofstocks.

Beingpart of a distinguished line of investors stretchingback toGrahamand Dodd which debunks standard dogma by logic and experience, Buffettthinksmostmarketsarenotpurelyefficientandthatequatingvolatilitywithriskis a gross distortion. Accordingly, Buffett worried that a whole generation ofMBAs and JDs, under the influence ofmodern finance theory,was at risk oflearningthewronglessonsandmissingtheimportantones.

A particularly costly lesson of modern finance theory came from theproliferationofportfolioinsurance—acomputerizedtechniqueforreadjustingaportfolio in declining markets. The promiscuous use of portfolio insurancehelpedprecipitatethestockmarketcrashofOctober1987,aswellasthemarketbreakofOctober1989.Itneverthelesshadasilverlining:itshatteredthemodern

finance story being told in business and law schools and faithfully beingfollowedbymanyonWallStreet.

Ensuingmarketvolatilitycouldnotbeexplainedbymodernfinancetheory,nor could mountainous other phenomena relating to the behavior of smallcapitalization stocks, high dividend-yield stocks, and stocks with low price-earnings ratios. The piece de resistance of market inefficiency was thetechnology and Internet stock bubble that blewup in the late 1990s and early2000s, marked by stock price gyrations that spasmodically bounced betweeneuphoria and gloom without the remotest nexus to business value. Growingnumbers of skeptics emerged to say that beta does not really measure theinvestment risk that matters, and that capital markets are really not efficientenoughtomakebetameaningfulanyway.

In stirring up the discussion, people started noticing Buffett’s record ofsuccessful investing and calling for a return to theGraham-Dodd approach toinvestingandbusiness.Afterall,formorethanfortyyearsBuffetthasgeneratedaverageannualreturnsof20%orbetter,whichdoublethemarketaverage.Formorethantwentyyearsbeforethat,BenGraham’sGraham-NewmanCorp.haddone the same thing. As Buffett emphasizes, the stunning performances atGraham-Newman and at Berkshire deserve respect: the sample sizes weresignificant; theywere conducted over an extensive time period, andwere notskewedby a few fortunate experiences; nodata-miningwas involved; and theperformanceswerelongitudinal,notselectedbyhindsight.

ThreatenedbyBuffett’sperformance,stubborndevoteesofmodernfinancetheoryresortedtostrangeexplanationsforhissuccess.Maybeheisjustlucky—the monkey who typed out Hamlet—or maybe he has inside access toinformation that other investors do not. In dismissingBuffett,modern financeenthusiasts still insist that an investor’s best strategy is to diversify based onbetasordartthrowing,andconstantlyreconfigureone’sportfolioofinvestments.

Buffettrespondswithaquipandsomeadvice:thequipisthatdevoteesofhis investment philosophy should probably endow chaired professorships atcolleges and universities to ensure the perpetual teaching of efficient marketdogma; the advice is to ignore modern finance theory and other quasi-sophisticatedviewsofthemarketandsticktoinvestmentknitting.Thatcanbestbedoneformanypeople throughlong-terminvestment inanindexfund.Oritcan be done by conducting hard-headed analyses of businesses within aninvestor’scompetencetoevaluate.Inthatkindofthinking,theriskthatmattersisnotbetaorvolatility,butthepossibilityoflossorinjuryfromaninvestment.

Assessingthatkindofinvestmentriskrequiresthinkingaboutacompany’smanagement, products, competitors, and debt levels. The inquiry is whether

after-taxreturnsonaninvestmentareatleastequaltothepurchasingpoweroftheinitialinvestmentplusafairrateofreturn.Theprimaryrelevantfactorsarethelong-termeconomiccharacteristicsofabusiness,thequalityandintegrityofitsmanagement,andfuturelevelsoftaxationandinflation.Maybethesefactorsare vague, particularly comparedwith the seductive precision of beta, but thepoint is that judgments about such matters cannot be avoided, except to aninvestor’sdisadvantage.

Buffettpointsouttheabsurdityofbetabyobservingthat“astockthathasdroppedverysharplycomparedtothemarket...becomes‘riskier’atthelowerprice than itwasat thehigherprice”—that ishowbetameasures risk.Equallyunhelpful, beta cannot distinguish the risk inherent in “a single-product toycompanysellingpetrocksorhulahoopsfromanothertoycompanywhosesoleproduct is Monopoly or Barbie.” But ordinary investors can make thosedistinctions by thinking about consumer behavior and the way consumerproductscompaniescompete, andcanalso figureoutwhenahuge stock-pricedropsignalsabuyingopportunity.

Contrary tomodern finance theory,Buffett’s investmentknittingdoesnotprescribe diversification. It may even call for concentration, if not of one’sportfolio,thenatleastofitsowner’smind.Astoconcentrationoftheportfolio,BuffettremindsusthatKeynes,whowasnotonlyabrillianteconomistbutalsoanastuteinvestor,believedthataninvestorshouldputfairlylargesumsintotwoor three businesses he knows something about and whose management istrustworthy.Onthatview,riskriseswheninvestmentsandinvestment thinkingarespreadtoothin.Astrategyoffinancialandmentalconcentrationmayreduceriskbyraisingboththeintensityofaninvestor’sthinkingaboutabusinessandthe comfort level he must have with its fundamental characteristics beforebuyingit.

The fashion of beta, according to Buffett, suffers from inattention to “afundamental principle: It is better to be approximately right than preciselywrong.” Long-term investment success depends not on studying betas andmaintainingadiversifiedportfolio,butonrecognizingthatasaninvestor,oneistheownerofabusiness.Reconfiguringaportfoliobybuyingandsellingstocksto accommodate the desired beta-risk profile defeats long-term investmentsuccess.Such“flittingfromflowertoflower”imposeshugetransactioncostsintheformsofspreads,feesandcommissions,nottomentiontaxes.Buffettjokesthat calling someone who trades actively in the market an investor “is likecalling someone who repeatedly engages in one-night stands a romantic.”Investment knitting turns modern finance theory’s folk wisdom on its head:insteadof“don’tputallyoureggsinonebasket,”wegetMarkTwain’sadvice

from Pudd’nhead Wilson: “Put all your eggs in one basket—and watch thatbasket.”

BuffettlearnedtheartofinvestingfromBenGrahamasagraduatestudentat Columbia Business School in the 1950s and later working at Graham-Newman. In a number of classic works, including The Intelligent Investor,Grahamintroducedsomeofthemostprofoundinvestmentwisdominhistory.Itrejectsaprevalentbutmistakenmind-set thatequatespricewithvalue.On thecontrary, Graham held that price is what you pay and value is what you get.These two things are rarely identical, but most people rarely notice anydifference.

OneofGraham’smostprofoundcontributions isacharacterwho livesonWallStreet,Mr.Market.He isyourhypotheticalbusinesspartnerwho isdailywilling to buy your interest in a business or sell you his at prevailingmarketprices. Mr. Market is moody, prone to manic swings from joy to despair.Sometimesheoffers priceswayhigher thanvalue; sometimesheoffers priceswaylowerthanvalue.Themoremanic-depressiveheis, thegreater thespreadbetweenpriceandvalue,andthereforethegreatertheinvestmentopportunitiesheoffers.BuffettreintroducesMr.Market,emphasizinghowvaluableGraham’sallegory of the overall market is for disciplined investment knitting—eventhoughMr.Marketwouldbeunrecognizabletomodernfinancetheorists.

Another leading prudential legacy from Graham is his margin-of-safetyprinciple. This principle holds that one should not make an investment in asecurityunlessthereisasufficientbasisforbelievingthatthepricebeingpaidissubstantiallylowerthanthevaluebeingdelivered.Buffettfollowstheprincipledevotedly,notingthatGrahamhadsaidthatifforcedtodistillthesecretofsoundinvestment into threewords, theywouldbe:marginofsafety.Overfortyyearsafter first reading that, Buffett still thinks those are the right words. Whilemodern finance theory enthusiasts cite market efficiency to deny there is adifferencebetweenprice(whatyoupay)andvalue(whatyouget),BuffettandGrahamregarditasallthedifferenceintheworld.

Thatdifferencealsoshowsthattheterm“valueinvesting”isaredundancy.All true investingmustbebasedonanassessmentof the relationshipbetweenpriceandvalue.Strategiesthatdonotemploythiscomparisonofpriceandvaluedo not amount to investing at all, but to speculation—the hope that pricewillrise,ratherthantheconvictionthatthepricebeingpaidislowerthanthevaluebeing obtained. Many professionals make another common mistake, Buffettnotes, by distinguishing between “growth investing” and “value investing.”

Growthandvalue,Buffettsays,arenotdistinct.Theyareintegrallylinkedsincegrowthmustbetreatedasacomponentofvalue.

Nordoesthephrase“relational investing”resonatewithBuffett.Thetermbecamepopularinthemid-1990s,describingastyleofinvestingthatisdesignedtoreducethecostsoftheseparationofshareholderownershipfrommanagerialcontrol by emphasizing shareholder involvement and monitoring ofmanagement. Many people incorrectly identified Buffett and Berkshire asexemplarsofthisdescriptivelabel.ItistruethatBuffettbuysbigblocksinafewcompaniesandsticksaroundalongtime.Healsoonlyinvestsinbusinessesrunbypeoplehetrusts.Butthatisaboutasfarasthesimilaritygoes.IfBuffettwerepressed to use an adjective to describe his investment style, it would besomething like “focused” or “intelligent” investing.Yet even thesewords ringredundant;theunadornedterminvestorbestdescribesBuffett.

Othermisusesoftermsincludeblurringthedifferencebetweenspeculationand arbitrage as methods of sound cash management; the latter being veryimportant for companies like Berkshire that generate substantial excess cash.Bothspeculationandarbitragearewaystouseexcesscashratherthanholditinshort-termcashequivalentssuchascommercialpaper.Speculationdescribestheuseofcashtobetonlotsofcorporateeventsbasedonrumorsofunannouncedcoming transactions. Arbitrage, traditionally understood to mean exploitingdifferentpricesforthesamethingontwodifferentmarkets,forBuffettdescribestheuseofcashtotakeshort-termpositionsinafewopportunitiesthathavebeenpublicly announced. It exploits different prices for the same thing at differenttimes. Deciding whether to employ cash this way requires evaluating fourcommonsensequestionsbasedoninformationratherthanrumor:theprobabilityoftheeventoccurring, thetimethefundswillbetiedup, theopportunitycost,andthedownsideiftheeventdoesnotoccur.

The circle of competence principle is the third leg of theGraham/Buffettstool of intelligent investing, alongwithMr.Market and themargin of safety.This commonsense rule instructs investors to consider investments onlyconcerning businesses they are capable of understanding with a modicum ofeffort.ItisthiscommitmenttostickwithwhatheknowsthatenablesBuffetttoavoid themistakesothers repeatedlymake,particularly thosewho feaston thefantasiesoffastrichespromisedbytechnologicalfadsandnewerarhetoricthathaverecurrentlyinfestedspeculativemarketsoverthecenturies.

In all investment thinking, onemust guard againstwhatBuffett calls the“institutionalimperative.”Itisapervasiveforceinwhichinstitutionaldynamicsproduce resistance to change, absorption of available corporate funds, andreflexive approval of suboptimal CEO strategies by subordinates. Contrary to

what is often taught in business and law schools, this powerful force ofteninterferes with rational business decision-making. The ultimate result of theinstitutional imperative is a follow-the-pack mentality producing industryimitators, rather than industry leaders—what Buffett calls a lemming-likeapproachtobusiness.

Everyreaderofthiscollectionwillsavor,andwanttosharewithfamilyandfriends,Buffett’scompellingessaysontheuseofdebt.Aptlydubbed“LifeandDebt,” these exquisitely explain both the temptation and perils of leverage inpersonalandcorporatefinance.

INVESTMENTALTERNATIVES

All these investment principles are animated in Buffett’s lively essaysconcerning investment opportunities. After explaining his preference forinvestinginproductiveassets,anddefiningwhat thismeans,aseriesofessaysaddressesawiderangeofalternatives,startingwithjunkandzero-couponbondsandpreferredstock.ChallengingbothWallStreetandtheacademy,BuffettagaindrawsonGraham’sideastorejectthe“daggerthesis”advancedtodefendjunkbonds. The dagger thesis, using the metaphor of the intensified care anautomobile driverwould take facing a daggermounted on the steeringwheel,overemphasizes the disciplining effect that enormous amounts of debt in acapitalstructureexertsonmanagement.

Buffettpoints to the largenumbersofcorporations that failed in theearly1990s recession under crushing debt burdens to dispute academic researchshowingthathigherinterestratesonjunkbondsmorethancompensatedfortheirhigherdefaultrates.Heattributesthiserrortoaflawedassumptionrecognizabletoanyfirst-yearstatisticsstudent:thathistoricalconditionsprevalentduringthestudy period would be identical in the future. They would not. Furtherilluminating the folly of junk bonds is an essay in this collection by CharlieMungerthatdiscussesMichaelMilken’sapproachtofinance.

Wall Street tends to embrace ideas based on revenue-generating power,ratherthanonfinancialsense,a tendencythatoftenpervertsgoodideastobadones. In a history of zero-couponbonds, for example,Buffett shows that theycanenableapurchaser to lockinacompoundrateofreturnequal toacouponratethatanormalbondpayingperiodicinterestwouldnotprovide.Usingzero-coupons thus for a time enabled a borrower to borrowmore without need ofadditionalfreecashflowtopaytheinterestexpense.Problemsarose,however,when zero-coupon bonds started to be issued by weaker and weaker creditswhose free cash flow could not sustain increasing debt obligations. Buffett

laments, “as happens in Wall Street all too often, what the wise do in thebeginning,foolsdointheend.”

Manyculpritscontributed to the financialcrisisof2008,among them theproliferationofderivative financial instruments,whichBuffett’s essayswrittenseveralyearsearlierhadwarnedabout.Contemporaryfinancialengineeringhasproduced an explosion of complex instruments known as derivatives, becausetheirfluctuatingvalueisderivedfrommovementsinacontractuallydesignatedbenchmark. Proponents believe that these devices are useful tomanage risk—andBerkshirefromtimetotimetakesmodestpositionsinderivativescontractsthat Buffett judges as mis-priced. But while proponents also believe thatderivativestendtoreduceoverallsystemicrisk,Buffettprescientlyobservedthattheymayhavetheoppositeeffect.Theyarehardtovalue,valuationscanchangerapidly and they create linkages and interdependencies among financialinstitutions.Buffettcautionedthat thecombinationof thesefactorscouldmeanthat, should a single event cause challenges in one sector, that could spreadrapidly to others with a domino effect bringing devastating systemicconsequences.Suchwasthecasewiththecrisisof2008.

Buffett acknowledges thathisviewonderivative risksmaybe influencedby his aversion to any kind of mega-catastrophe risk that would jeopardizeBerkshire’s status as a fortress of financial strength. But this is no arm-chairopinion, for Buffett endured several years of direct experience inmanaging aderivativesdealership that camealongwithBerkshire’s acquisitionof theGenRe reinsurance company. Buffett explains the unpleasant consequences of notdumping the business immediately but notes how it could not be sold andcontained a maze of long term liabilities that took several painful years tounwind.BuffettoffersextensivemeditationonthisexperiencesothatotherscanlearnfromtheBerkshiretrials.

Concluding essays in this Part address other macroeconomic lessons aswell, ranging from the U.S. international trade deficit to national policiestowardshomeownershipthatalsocontributedtothefinancialcrisisof2008.

COMMONSTOCKBuffett recalls that on the day Berkshire listed on the New York Stock

Exchangein1988,hetoldJimmyMaguire,thespecialistinBerkshirestock,“Iwillconsideryouanenormoussuccessifthenexttradeinthisstockisabouttwoyearsfromnow.”WhileBuffettjokesthatMaguire“didn’tseemtogetenthusedabout that,”heemphasizes thathismind-setwhenhebuysanystock is“ifwearen’t happyowningapieceof that businesswith theExchange closed,we’re

nothappyowningitwiththeExchangeopen.”WhileBerkshireandBuffettareinvestors for the longhaul, toomanyothers are temporary tradersof commonstock—whoseactionsposehighcosts.

Asignificantportionofcorporateearningsaredissipatedthroughfrictionalcosts associatedwith trading.Trading is the rearrangementofwhoownswhatshares. The rearrangement entails paying commissions to brokers, fees toinvestment managers and cash to financial planners and business consultantswho sell even more advice during this process. Of late, these frictional costshaveescalatedintowholeindustriesthatdescribethemselvesvariouslyashedgefunds andprivate equity firms.Buffett estimates that total costsmay consumesome20%ofthecountry’stotalannualcorporateearnings.

Unlike many CEOs, who desire their company’s stock to trade at thehighestpossiblepricesinthemarket,BuffettprefersBerkshirestocktotradeatorarounditsintrinsicvalue—neithermateriallyhighernorlower.Suchlinkagemeansthatbusinessresultsduringoneperiodwillbenefitthepeoplewhoownedthecompanyduringthatperiod.Maintainingthelinkagerequiresashareholdergroup with a collective long-term, business-oriented investment philosophy,ratherthanashort-term,market-orientedstrategy.

Buffett notesPhilFisher’s suggestion that a company is like a restaurant,offeringamenuthatattractspeoplewithparticulartastes.Berkshire’slong-termmenuemphasizesthatthecostsoftradingactivitycanimpairlong-termresults.Indeed,Buffett estimates that the transaction costs of actively traded stocks—brokercommissionsandmarket-makerspreads—oftenamountto10%ormoreof earnings. Avoiding or minimizing such costs is necessary for long-terminvestment success, and Berkshire’s listing on theNewYork Stock Exchangehelpedcontainthosecosts.

Corporate dividend policy is a major capital allocation issue, always ofinterest to investorsbut infrequentlyexplainedto them.Buffett’sessaysclarifythis subject, emphasizing that “capital allocation is crucial to business andinvestment management.” Since 1998, Berkshire’s common stock has beenpricedinthemarketatabove$50,000pershareandthecompany’sbookvalue,earnings, and intrinsic value have steadily increasedwell in excess of averageannualrates.Yetthecompanyhasnevereffectedastocksplit,andhasnotpaidacashdividendinoverthreedecades.

Apartfromreflectingthelong-termmenuandminimizationoftransactioncosts, Berkshire’s dividend policy also reflects Buffett’s conviction that acompany’searningspayoutversusretentiondecisionshouldbebasedonasingletest:eachdollarofearningsshouldberetainedifretentionwillincreasemarketvalue by at least a like amount; otherwise it should be paid out. Earnings

retentionisjustifiedonlywhen“capitalretainedproducesincrementalearningsequalto,orabove,thosegenerallyavailabletoinvestors.”

LikemanyofBuffett’ssimplerules,thisoneisoftenignoredbycorporatemanagers, except of course when they make dividend decisions for theirsubsidiaries. Earnings are often retained for non-owner reasons, such asexpanding the corporate empire or furnishing operational comfort formanagement.

Things are so different at Berkshire, Buffett said at the symposium, thatunderhis testBerkshire“mightdistributemore than100%of theearnings,” towhich Charlie Munger chimed in “You’re damn right.” That has not beennecessary, however, for throughout Buffett’s stewardship at Berkshire,opportunitiesforsuperiorreturnsoncapitalhavebeendiscovered,andexploited.

Share repurchases of underpriced stock can be a value-enhancingway toallocatecapital, thoughthesearenotalwayswhat theyseem.In the1980sandearly 1990s, share buy-backs were uncommon and Buffett credited managerswhorecognizedthatthepurchaseofasharepricedat$1butwithavalueof$2would rarely be inferior to any other use of corporate funds. Alas, as oftenhappens,theimitatorssteppedinandnowyoufrequentlyseecompaniespaying$2tobuybacksharesworth$1.Thesevalue-destroyingsharerepurchasesoftenare intended to prop up a sagging share price or to offset the simultaneousissuingofstockunderstockoptionsexercisedatmuchlowerprices.

BuffettlaysouttherationaleandtermsunderwhichBerkshireoccasionallyembarksonsharerepurchaseprograms:whenthestocktradesatadeepdiscountto intrinsic value. That makes the investment an easy case, of clear value tocontinuing holders, though Buffett has mixed feelings about repurchasing asBerkshire’s selling shareholders cash in at a discount. The solution: cleardisclosuretoenablesuchsellingholderstomakeaninformeddecision.

Stock splits areanother commonaction incorporateAmerica thatBuffettpointsoutdisserveowner interests.Stock splitshave threeconsequences: theyincrease transaction costs by promoting high share turnover; they attractshareholderswithshort-term,market-orientedviewswhoundulyfocusonstockmarketprices;and,asa resultofbothof thoseeffects, they lead toprices thatdepart materially from intrinsic business value. With no offsetting benefits,splittingBerkshire’sstockwouldbefoolish.Notonlythat,Buffettadds,itwouldthreaten to reverse over three decades of hard work that has attracted toBerkshire a shareholder group comprised of more focused and long-terminvestorsthanprobablyanyothermajorpubliccorporation.

Two important consequences have followed from Berkshire’s high stockpriceanditsdividendpolicy.First,theextraordinarilyhighsharepriceimpaired

the ability of Berkshire shareholders to effect gifts of their equity interest tofamilymembersorfriends,thoughBuffetthasofferedafewsensiblestrategieslikebargainsalestodoneestodealwiththat.Second,WallStreetengineerstriedto create securities that would purport to mimic Berkshire’s performance andthatwouldbesoldtopeoplelackinganunderstandingofBerkshire,itsbusiness,anditsinvestmentphilosophy.

Inresponsetotheseconsequences,Berkshireeffectedarecapitalizationbycreatinganewclassofstock,calledtheClassBshares,andsoldittothepublic.TheClassBshareshave1/30ththerightsoftheexistingClassAshares,exceptwith respect to voting rights they have 1/200th of those of the A shares.Accordingly,theClassBsharesshould(anddo)tradesomewhereinthevicinityof1/30thofthemarketpriceoftheClassAshares.

TheClassA shares are convertible intoClassB shares, givingBerkshireshareholders ado-it-yourselfmechanism toeffect a stock-split to facilitategiftgivingandsoon.Moreimportantly,theBerkshirerecapitalizationwouldhaltthemarketing of Berkshire clones that contradict all the basic principles Buffettbelieves in.Theseclones—investment trusts thatwouldbuyandsellBerkshiresharesaccordingtodemandforunitsinthetrust—wouldhaveimposedcostsonshareholders. IfheldbypeoplewhodonotunderstandBerkshire’sbusinessorphilosophy,theywouldhavecausedspikesinBerkshire’sstockprice,producingsubstantialdeviationsbetweenpriceandvalue.

TheClassBsharesaredesignedtobeattractiveonlytoinvestorswhoshareBuffett’sphilosophyof focused investing.Forexample, inconnectionwith theofferingof theClassB shares,Buffett andMunger emphasized thatBerkshirestockwas,atthattime,notunderpricedinthemarket.TheysaidthatneitherofthemwouldbuytheClassAsharesatthemarketpricenortheClassBsharesattheofferingprice.Themessagewassimple:donotbuy thesesecuritiesunlessyouarepreparedtoholdthemforthelongterm.Theefforttoattractonlylong-terminvestorstotheClassBsharesappearstohaveworked:tradingvolumeinthesharesaftertheofferingwasfarbelowaverageforBigBoardstocks.

Some expressed surprise at Buffett and Munger’s cautionary statement,sincemostmanagerstellthemarketthatnewly-issuedequityintheircompaniesisbeingofferedataverygoodprice.YoushouldnotbesurprisedbyBuffettandMunger’sdisclosure,however.Acompanythatsellsitsstockatapricelessthanits value is stealing from its existing shareholders. Quite plausibly, Buffettconsidersthatacrime.

MERGERSANDACQUISITIONS

Berkshire’s acquisition policy is the double-barreled approach: buyingportionsorallofbusinesseswithexcellenteconomiccharacteristicsandrunbymanagers Buffett and Munger like, trust, and admire. Contrary to commonpractice,Buffettarguesthatinbuyingallofabusiness,thereisrarelyanyreasontopayapremium.

Therarecasesinvolvebusinesseswithfranchisecharacteristics—thosethatcanraisepriceswithoutimpairingsalesvolumeormarketshareandonlyrequireincremental capital investment to increase both. Even ordinary managers canoperate franchise businesses to generate high returns on capital. The secondcategoryof rare cases iswhere extraordinarymanagers existwho can achievethe difficult feat of identifying underperforming businesses, and applyextraordinarytalenttounlockhiddenvalue.

Thesetwocategoriesareextremelylimited,andcertainlydonotexplainthehundredsofhigh-premiumtakeoversthatoccurannually.Buffettattributeshigh-premiumtakeoversoutsidethoseunusualcategoriestothreemotivesofbuying-managers:thethrillofanacquisition,thethrillofenhancedsize,andexcessiveoptimismaboutsynergies.

Inpayingforacquisitions,Berkshire issuesstockonlywhenitreceivesasmuch in business value as it gives. This has become increasingly difficult forBerkshiretodo.ThisisthecasebecauseBerkshirehasassembledthebusinessequivalentoftheartcollectionattheLouvre.EnhancingthevalueoftheexistingcollectionbyaddingasinglenewBotticelliisdifficultenough,andevenmoresoifyouhavetogiveuppartofyourRembrandtcollectiontogetit.

It has also been difficult formanagers of other companies to follow thisrule, but not somuch because of the wonderful collection of businesses theyhave. Instead, Buffett notes that sellers in stock acquisitions measure thepurchasepricebythemarketpriceofthebuyer’sstock,notbyitsintrinsicvalue.Ifabuyer’sstockistradingatapriceequalto,say,halfitsintrinsicvalue,thenabuyerwhogoesalongwiththatmeasuregivestwiceasmuchinbusinessvalueasitisgetting.Itsmanager,usuallyrationalizinghisorheractionsbyargumentsabout synergies or size, is elevating thrill or excessive optimism aboveshareholderinterests.

Moreover, acquisitions paid for in stock are too often (almost always)described as “buyer buys seller” or “buyer acquires seller.” Buffett suggestsclearer thinkingwouldfollowfromsaying“buyersellspartof itself toacquireseller,”orsomethingofthesort.Afterall,thatiswhatishappening;anditwouldenableonetoevaluatewhatthebuyerisgivinguptomaketheacquisition.

Another abuse of shares-as-currency is the practice of green-mail, therepurchaseofsharesfromanunwantedsuitoratapremiumpricetofendoffhis

acquisitionovertures.Whilesharerepurchasesavailabletoallshareholderscanbe value enhancing,Buffett condemns this practice as simply another formofcorporaterobbery.

Nearlyas reprehensible, a secondCharlieMungeressay in this collectionexplains, were the cascades of leveraged buy-outs (LBOs) in the 1980s.Permissive lawsmadeLBOshugelyprofitable,Munger tellsus,but theLBOsweakened corporations, put a heavy premium on cash generation to pay forenormousdebtobligations,andraisedtheaveragecostofacquisitions.

Value-enhancing acquisitions are hard enough to find without the addedburden of higher average costs for all of them. Indeed, most acquisitions arevalue-decreasing, Buffett says. Finding the best value-enhancing transactionsrequires concentrating on opportunity costs, measured principally against thealternativeofbuyingsmallpiecesofexcellentbusinessesthroughstockmarketpurchases.Suchconcentration is alien to themanagerobsessedwith synergiesandsize,butavitalpartofBerkshire’sdouble-barreledinvestmentapproach.

Berkshirehasadditionaladvantagesinacquisitions:ahighqualitystocktopaywithandasubstantialamountofmanagerialautonomytoofferonceadealisdone—bothrare inanacquiringcompany,Buffettsays.Buffettalsoputshismoney where his mouth is, reminding prospective sellers that Berkshire hasacquiredmanyof its businesses from familyor other closely-heldgroups, andinviting them to check with every previous seller about Berkshire’s initialpromisesmeasuredagainst its later actions. In short,Berkshire seeks tobe thebuyer of choice for attractive business sellers—a lesson so important that itexplains why Buffett prefers to retain rather than sell even those acquiredbusinessesthatstruggleagainstbusinessheadwinds.

VALUATIONANDACCOUNTING

Buffett’s essays provide an entertaining and illuminating tutorial onunderstandingandusingfinancial information. Indissectingsignificantaspectsof generally accepted accounting principles (GAAP),Buffett shows both theirimportanceandlimitsinunderstandingandvaluinganybusinessorinvestment.Buffettdemystifieskey topics thathighlight the importantdifferencesbetweenaccounting earnings and economic earnings, between accountinggoodwill andeconomic goodwill, and between accounting book value and intrinsic value.Theseareessentialtoolsforanyinvestor’sormanager’svaluationtoolbox.

AesopwastofablesoftheancientworldwhatBuffettistobusinessessaysin ours. The essayist invokes the fabulist to show that valuation has been thesameacross themillennia—Aesopsaid“abird in thehand isworth twoin the

bush”andBuffettextendstheprincipletodollars.Valuationiscountingcash,nothopesordreams, a lessonmany shouldhave learnedamid the late1990s techrushbubblethatburstwheneveryonefinallyrealizedtherewerefewbirdsinthebushes. It is doubtful everyone learned the lesson, however, for it has beentaughtrepeatedlysinceAesop’stimeandyet,well,ithasbeentaughtrepeatedlysinceAesop’stime.

A leading example of Buffett’s specialized toolkit is intrinsic value, “thediscounted value of the cash that can be taken out of a business during itsremaining life.” Though simple to state, calculating intrinsic value is neithereasy nor objective. It depends on estimation of both future cash flows andinterestratemovements.Butitiswhatultimatelymattersaboutabusiness.Bookvalue, in contrast, is easy to calculate, but of limited use. So toowithmarketprice,atleastformostcompanies.Differencesbetweenintrinsicvalueandbookvalueandmarketpricemaybehard topindown.Theycangoeitherway,buttherewillalmostcertainlybedifferences.

Buffett emphasizes that useful financial statementsmust enable a user toanswer three basic questions about a business: approximately how much acompanyisworth,itslikelyabilitytomeetitsfutureobligations,andhowgooda job its managers are doing in operating the business. Buffett laments thatGAAPconventionsmake thesedeterminationsdifficult,and indeedalmostanyaccountingsystemwillbehardpressed tofurnishcompletelyaccurateanswersgiventhecomplexitiesofbusiness.AcknowledgingthemonumentaldifficultyofinventinganaccountingsystemsuperiortoGAAP,Buffettarticulatesarangeofconcepts that go a longer way towardmaking financial information useful toinvestorsandmanagers.

Consider a concept Buffett calls “look-through earnings.” GAAPinvestment accounting calls for using the consolidation method for majority-owned equity,whichmeans full reportingof all line items from the investee’sfinancialstatementson theparent’s.Forequity investments from20%to50%,GAAPcalls for reporting the investor’s proportionate share of earnings of theinvesteeonitsstatements;forinvestmentsoflessthan20%,GAAPprovidesthatonly dividends actually received by the investor be recorded, rather than anyshareoftheinvestee’searnings.TheseaccountingrulesobscureamajorfactorinBerkshire’s economic performance: the undistributed earnings of its investeecompaniesareanenormouspartofBerkshire’svalue,butwouldnotbereportedonitsfinancialstatementspreparedusingGAAP.

Recognizingthat it isnot thesizeofanequityinvestment thatdeterminesitsvalue,buthowtheundistributedearningsaredeployed,Buffettdevelopstheconcept of look-through earnings to gaugeBerkshire’s economicperformance.

Look-through earnings add to Berkshire’s own net earnings the undistributedearnings in investee companies, less an incremental amount for taxes. Look-throughearningsarenotdifferentfromGAAPearningsformanybusinesses.Butthey are for Berkshire and probably are for many individual investors.Accordingly, individuals can adopt a similar approach for their ownportfoliosand try to design a portfolio that delivers the highest possible look-throughearningsoverthelongterm.

The difference between accounting goodwill and economic goodwill iswell-known, but Buffett’s lucidity makes the subject refreshing. Accountinggoodwill is essentially the amount by which the purchase price of a businessexceeds the fair value of the assets acquired (after deducting liabilities). It isrecorded as an asset on the balance sheet and then amortized as an annualexpense, usuallyover fortyyears.So the accountinggoodwill assigned to thatbusinessdecreasesovertimebytheaggregateamountofthatexpense.

Economic goodwill is something else. It is the combination of intangibleassets, likebrandnamerecognition, thatenableabusiness toproduceearningson tangible assets, like plant and equipment, in excess of average rates. Theamountofeconomicgoodwillisthecapitalizedvalueofthatexcess.Economicgoodwilltendstoincreaseovertime,atleastnominallyinproportiontoinflationformediocrebusinesses,andmorethanthatforbusinesseswithsolideconomicor franchise characteristics. Indeed, businesses with more economic goodwillrelativetotangibleassetsarehurtfarlessbyinflationthanbusinesseswithlessofthat.

These differences between accounting goodwill and economic goodwillentail the following insights. First, the best guide to the value of a business’seconomic goodwill is what it can earn on unleveraged net tangible assets,excluding charges for amortization of goodwill. Therefore when a businessacquiresotherbusinesses,andtheacquisitionsarereflectedinanassetaccountcalledgoodwill,analysisofthatbusinessshouldignoretheamortizationcharges.Second,sinceeconomicgoodwillshouldbemeasuredatitsfulleconomiccost,i.e.,beforeamortization,evaluationofapossiblebusinessacquisitionshouldbeconductedwithoutregardtothoseamortizationchargesaswell.

Buffettemphasizes,however, that thesamedoesnotholdfordepreciationcharges—theseshouldnotbeignoredbecausetheyarerealeconomiccosts.HemakesthispointinexplainingwhyBerkshirealwaysshowsitsshareholderstheresults of operations with respect to acquired businesses net of any purchasepriceadjustmentsGAAPrequires.

ItiscommononWallStreettovaluebusinessesusingacalculationofcashflows equal to (a) operating earnings plus (b) depreciation expense and other

non-cashcharges.Buffettregardsthatcalculationasincomplete.Aftertaking(a)operatingearningsandaddingback(b)non-cashcharges,Buffettarguesthatyoumust then subtract something else: (c) required reinvestment in the business.Buffettdefines(c)as“theaverageamountofcapitalizedexpendituresforplantand equipment, etc., that the business requires to fullymaintain its long-termcompetitivepositionanditsunitvolume.”Buffettcalls theresultof(a)+(b) -(c)“ownerearnings.”

When (b) and (c) differ, cash flow analysis and owner earnings analysisdiffer too. Formost businesses, (c) usually exceeds (b), so cash flow analysisusually overstates economic reality. In all cases where (c) differs from (b),calculation of owner earnings enables one to appraise performance moreaccurately than would analysis of GAAP earnings, or cash flows affected bypurchase price accounting adjustments. That is why Berkshire supplementallyreports owner earnings for its acquired businesses, rather than rely solely onGAAPearningsfigures,orcashflowfigures.

ACCOUNTINGSHENANIGANSTheultimatepointtounderstandaboutaccountingisthatitisaform.Asa

form,itcanbemanipulated.BuffettshowsjusthowseverethemanipulationcanbewithasatirewrittenbyBenGrahaminthe1930s.TheadvancedbookkeepingmethodsGrahampresentsenablehisphantomUSSteeltoreport“phenomenallyenhanced”earningswithoutcashoutlaysorchanges inoperatingconditionsorsales. Except in its lampooning spirit, Graham’s illustration of accountingchicanery is not all that different from what is often seen coming out ofcorporateAmerica.

GAAPhasenoughtrouble.Yettwogroupsofpeoplemakeitworse:thosewho try to overcome GAAP requirements by stretching their accountingimagination, and those who deliberately employ GAAP to facilitate financialfraud. The former is especially hard to deal with, as Buffett suggests inillustratinghowdebateonaccountingforstockoptionsrevealstheparochialismofmanyexecutives andaccountants.For example, criticizing theviewagainsttreating stock options as expenses when granted, Buffett delivers this laconicargument: “If options aren’t a form of compensation, what are they? Ifcompensationisn’tanexpense,whatis?And,ifexpensesshouldn’tgointothecalculation of earnings, where in the world should they go?” So far, he hasgottennoanswers.

Thequestforintegrityinfinancialreportingisendless,withnewflavorsofaccounting machinations developed regularly and periodically sweeping the

chieffinancialofficer(CFO)suitesofcorporateAmerica.Thelatestproducttocatch on is accounting for “restructurings,” a label given to awhole range ofmaneuversthatenablemanagerstoengageinage-oldearningsmanagementandsmoothingtechniqueswithgreaterfelicityanddeftnessthaneverbefore.Otherexamplesconcernestimatesrequiredwhencalculatingpensionliabilitiesandthetiming of sales of assets that generate gains or losses to influence reportedearnings.Investorsbeware.

ACCOUNTINGPOLICYDevotees of integrity in financial reporting sometimesmust takematters

into their own hands. Buffett does so regularly by furnishing Berkshireshareholders with information, such as segment data, that GAAP does notrequire but which Buffett wouldwant to see if their positions were reversed.Sometimesthecrusaderstriumph,however,asBuffettshowswasthecasewhenaccountingrulesbegantorequirecompanies torecordpromises tofundretireebenefitsthathadpreviouslynotbeenrequired.

OneclearlessonfromBuffett’sdiscussionsoffinancialinformationisthataccounting has inherent limits, even though it is absolutely essential. Despiteenormousmanagerialleewayinreportingearningsandpotentialabuse,financialinformationcanbeofgreatuse to investors.Buffettuses iteveryday,andhasallocated billions of dollars doing it. So it is possible to make importantinvestment decisions on the basis of available financial information if oneexercises knowledgeable judgment. That judgment may include makingadjustments to determine look-through earnings, owner earnings and intrinsicvalue.

TAXMATTERS

Bringingthiscollectionfullcircle, theconcludingessaysnotetheobviousbutoftenoverlookedtaxadvantagesoflong-terminvestment.Linkinglife’stwocertainties, the final essay includes one of Buffett’s many jokes about hispersonal longevity: if enjoying life promotes longevity, he is jeopardizingMethuselah’s record (969 years). At the symposium featuring this collection,someone asked what effect Buffett’s death would have on Berkshire stock.Anotheranswered,“anegativeeffect.”Withoutmissingabeat,Buffettquipped:“Itwon’tbeasnegativefortheholdersasitwillbeforme.”

PROLOGUE:OWNER-RELATEDBUSINESSPRINCIPLES1

In some ways, our shareholder group is a rather unusual one, and thisaffects ourmanner of reporting to you. For example, at the end of each yearabout 98% of the shares outstanding are held by people who also wereshareholders at the beginning of the year. Therefore, in our annual report webuilduponwhatwehavetoldyouinpreviousyearsinsteadofrestatingalotofmaterial.Yougetmoreusefulinformationthisway,andwedon’tgetbored.

Furthermore,perhaps90%ofoursharesareownedbyinvestorsforwhomBerkshire is their largest securityholding,veryoften farandaway the largest.Manyoftheseownersarewillingtospendasignificantamountoftimewiththeannual report, andwe attempt to provide themwith the same informationwewouldfindusefuliftheroleswerereversed.

Incontrast,weincludenonarrativewithourquarterlyreports.Ourownersandmanagersbothhaveverylongtime-horizonsinregardtothisbusiness,anditisdifficulttosayanythingnewormeaningfuleachquarterabouteventsoflong-termsignificance.

Butwhenyoudoreceiveacommunicationfromus,itwillcomefromthefellowyouarepayingtorunthebusiness.YourChairmanhasafirmbeliefthatownersareentitledtoheardirectlyfromtheCEOastowhatisgoingonandhowheevaluatesthebusiness,currentlyandprospectively.Youwoulddemandthatinaprivate company;you should expectno less in apublic company.Aonce-a-yearreportofstewardshipshouldnotbeturnedovertoastaffspecialistorpublicrelations consultant who is unlikely to be in a position to talk frankly on amanager-to-ownerbasis.

We feel that you, asowners, are entitled to the same sort of reportingbyyourmanagersaswefeelisowedtousatBerkshireHathawaybymanagersofourbusinessunits.Obviously,thedegreeofdetailmustbedifferent,particularlywhereinformationwouldbeusefultoabusinesscompetitororthelike.Butthegeneralscope,balance,andlevelofcandorshouldbesimilar.Wedon’texpectapublicrelationsdocumentwhenouroperatingmanagerstelluswhatisgoingon,andwedon’tfeelyoushouldreceivesuchadocument.

Inlargepart,companiesobtaintheshareholderconstituencythattheyseekand deserve. If they focus their thinking and communications on short-termresultsorshort-termstockmarketconsequences theywill, in largepart, attractshareholders who focus on the same factors. And if they are cynical in their

treatmentofinvestors,eventuallythatcynicismishighlylikelytobereturnedbytheinvestmentcommunity.

PhilFisher,arespectedinvestorandauthor,oncelikenedthepoliciesofthecorporationinattractingshareholderstothoseofarestaurantattractingpotentialcustomers. A restaurant could seek a given clientele—patrons of fast foods,elegantdining,Oriental food,etc.—andeventuallyobtainanappropriategroupof devotees. If the job were expertly done, that clientele, pleased with theservice, menu, and price level offered, would return consistently. But therestaurantcouldnotchangeitscharacterconstantlyandendupwithahappyandstable clientele. If thebusinessvacillatedbetweenFrenchcuisine and take-outchicken, the result would be a revolving door of confused and dissatisfiedcustomers.

Soit iswithcorporationsandtheshareholderconstituencytheyseek.Youcan’t be all things to allmen, simultaneously seeking different ownerswhoseprimaryinterestsrunfromhighcurrentyieldtolong-termcapitalgrowthtostockmarketpyrotechnics,etc.

The reasoning of managements that seek large trading activity in theirsharespuzzlesus.Ineffect,suchmanagementsaresayingthattheywantagoodmanyoftheexistingclientelecontinuallytodeserttheminfavorofnewones—because you can’t add lots of new owners (with new expectations) withoutlosinglotsofformerowners.

Wemuchpreferownerswholikeourserviceandmenuandwhoreturnyearafter year. It would be hard to find a better group to sit in the BerkshireHathawayshareholder“seats”thanthosealreadyoccupyingthem.Sowehopetocontinue to have a very low turnover among our owners, reflecting aconstituencythatunderstandsouroperation,approvesofourpolicies,andsharesourexpectations.Andwehopetodeliveronthoseexpectations.

1. Although our form is corporate, our attitude is partnership. CharlieMungerandIthinkofourshareholdersasowner-partners,andofourselvesasmanagingpartners. (Becauseof the sizeofour shareholdingswearealso, forbetterorworse,controllingpartners.)Wedonotviewthecompanyitselfastheultimateownerofourbusinessassetsbutinsteadviewthecompanyasaconduitthroughwhichourshareholdersowntheassets.

Charlie and I hope that youdo not think of yourself asmerely owning apieceofpaperwhosepricewigglesarounddailyandthatisacandidateforsalewhensomeeconomicorpoliticaleventmakesyounervous.Wehopeyouinsteadvisualize yourself as a part owner of a business that you expect to stay withindefinitely, much as you might if you owned a farm or apartment house inpartnershipwithmembersofyourfamily.Forourpart,wedonotviewBerkshire

shareholders as facelessmembers of an ever-shifting crowd, but rather as co-venturerswhohaveentrustedtheirfundstousforwhatmaywellturnouttobetheremainderoftheirlives.

The evidence suggests that most Berkshire shareholders have indeedembracedthislong-termpartnershipconcept.TheannualpercentageturnoverinBerkshire’s shares is a small fraction of that occurring in the stocks of othermajorAmericancorporations,evenwhenthesharesIownareexcludedfromthecalculation.

Ineffect,ourshareholdersbehaveinrespecttotheirBerkshirestockmuchas Berkshire itself behaves in respect to companies in which it has aninvestment. As owners of, say, Coca-Cola or Gillette shares, we think ofBerkshireasbeinganon-managingpartner in twoextraordinarybusinesses, inwhichwemeasureoursuccessbythelong-termprogressofthecompaniesratherthanby themonth-to-monthmovementsof their stocks. In fact,wewouldnotcare in the least if several years went by in which there was no trading, orquotationofprices,inthestocksofthosecompanies.Ifwehavegoodlong-termexpectations, short-term price changes are meaningless for us except to theextent they offer us an opportunity to increase our ownership at an attractiveprice.

2.InlinewithBerkshire’sowner-orientation,mostofourdirectorshaveamajor portion of their net worth invested in the company. We eat our owncooking.

Charlie’s familyhas [80–90%]of itsnetworth inBerkshire shares; and Ihave about [98–99%]. In addition, many of my relatives—my sisters andcousins,forexample—keepahugeportionoftheirnetworthinBerkshirestock.

CharlieandIfeeltotallycomfortablewiththiseggs-in-one-basketsituationbecauseBerkshire itselfownsawidevarietyof trulyextraordinarybusinesses.Indeed, we believe that Berkshire is close to being unique in the quality anddiversity of the businesses in which it owns either a controlling interest or aminorityinterestofsignificance.

Charlieand Icannotpromiseyou results.Butwecanguarantee thatyourfinancial fortuneswillmove in lockstepwithours forwhateverperiodof timeyouelect tobeourpartner.Wehaveno interest in large salariesoroptionsorothermeansofgainingan“edge”overyou.Wewanttomakemoneyonlywhenour partners do and in exactly the same proportion. Moreover, when I dosomethingdumb,Iwantyoutobeabletoderivesomesolacefromthefactthatmyfinancialsufferingisproportionaltoyours.

3.Ourlong-termeconomicgoal(subjecttosomequalificationsmentionedlater) is to maximize Berkshire’s average annual rate of gain in intrinsic

business value on a per-share basis. We do not measure the economicsignificanceorperformanceofBerkshireby its size;wemeasurebyper-shareprogress.Wearecertainthattherateofper-shareprogresswilldiminishinthefuture—a greatly enlarged capital base will see to that. But we will bedisappointed if our rate does not exceed that of the average large Americancorporation.

4. Our preference would be to reach our goal by directly owning adiversifiedgroupofbusinessesthatgeneratecashandconsistentlyearnabove-average returns on capital. Our second choice is to own parts of similarbusinesses,attainedprimarilythroughpurchasesofmarketablecommonstocksbyour insurancesubsidiaries.Thepriceandavailabilityofbusinessesandtheneedforinsurancecapitaldetermineanygivenyear’scapitalallocation.

In recent years,wemade a number of acquisitions.Though therewill bedry years also,we expect tomake a number of acquisitions in the decades tocome, andourhope is that theywill be large. If thesepurchases approach thequalityofthosewehavemadeinthepast,Berkshirewillbewellserved.

Thechallengeforusistogenerateideasasrapidlyaswegeneratecash.Inthis respect, a depressed stock market is likely to present us with significantadvantages. For one thing, it tends to reduce the prices at which entirecompaniesbecomeavailableforpurchase.Second,adepressedmarketmakesiteasierforourinsurancecompaniestobuysmallpiecesofwonderfulbusinesses—includingadditionalpiecesofbusinesswealreadyown—atattractiveprices.And third, some of those samewonderful businesses, such as Coca-Cola, areconsistentbuyersoftheirownshares,whichmeansthatthey,andwe,gainfromthecheaperpricesatwhichtheycanbuy.

Overall, Berkshire and its long-term shareholders benefit from a sinkingstockmarketmuchasaregularpurchaseroffoodbenefitsfromdecliningfoodprices. So when the market plummets—as it will from time to time—neitherpanicnormourn.It’sgoodnewsforBerkshire.

5. Because of our two-pronged approach to business ownership andbecause of the limitations of conventional accounting, consolidated reportedearnings may reveal relatively little about our true economic performance.CharlieandI,bothasownersandmanagers,virtuallyignoresuchconsolidatednumbers. However, we will also report to you the earnings of each majorbusinesswe control, numberswe consider of great importance. These figures,along with other information we will supply about the individual businesses,shouldgenerallyaidyouinmakingjudgmentsaboutthem.

Tostatethingssimply,wetrytogiveyouintheannualreportthenumbersand other information that really matter. Charlie and I pay a great deal of

attentiontohowwellourbusinessesaredoing,andwealsoworktounderstandtheenvironmentinwhicheachbusinessisoperating.Forexample,isoneofourbusinessesenjoyinganindustrytailwindorisitfacingaheadwind?CharlieandIneed toknowexactlywhich situationprevails and to adjustour expectationsaccordingly.Wewillalsopassalongourconclusionstoyou.

Over time, the large majority of our businesses have exceeded ourexpectations.Butsometimeswehavedisappointments,andwewilltrytobeascandid in informing you about those as we are in describing the happierexperiences.Whenwe use unconventionalmeasures to chart our progress,wewilltrytoexplaintheseconceptsandwhyweregardthemasimportant.Inotherwords,webelieveintellingyouhowwethinksothatyoucanevaluatenotonlyBerkshire’sbusinessesbutalsoassessourapproachtomanagementandcapitalallocation.

6. Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer topurchase$2ofearningsthatisnotreportablebyusunderstandardaccountingprinciples than topurchase$1of earnings that is reportable.This ispreciselythe choice that often faces us since entire businesses (whose earningswill befully reportable) frequently sell fordouble thepro-ratapriceof smallportions(whoseearningswillbe largelyunreportable). Inaggregateandover time,weexpect the unreported earnings to be fully reflected in our intrinsic businessvaluethroughcapitalgains.

Wehavefoundovertimethattheundistributedearningsofourinvestees,inaggregate, have been as fully as beneficial to Berkshire as if they had beendistributed tous (and thereforehadbeen included in theearningsweofficiallyreport). This pleasant result has occurred because most of our investees areengaged in truly outstanding businesses that can often employ incrementalcapitaltogreatadvantage,eitherbyputtingittoworkintheirbusinessesorbyrepurchasing their shares. Obviously, every capital decision that our investeeshavemadehasnotbenefittedusasshareholders,butoverallwehavegarneredfar more than a dollar of value for each dollar they have retained. Weconsequentlyregardlook-throughearningsasrealisticallyportrayingouryearlygainfromoperations.

7.Weusedebtsparinglyand,whenwedoborrow,weattempttostructureourloansonalong-termfixed-ratebasis.Wewillrejectinterestingopportunitiesrather than over-leverage our balance sheet. This conservatism has penalizedourresultsbutitistheonlybehaviorthatleavesuscomfortable,consideringourfiduciaryobligationstopolicyholders,lendersandthemanyequityholderswhohavecommittedunusuallylargeportionsoftheirnetworthtoourcare.(Asone

oftheIndianapolis“500”winnerssaid:“Tofinishfirst,youmustfirstfinish.”)The financial calculus thatCharlie and I employwould never permit our

tradingagoodnight’ssleepforashotatafewextrapercentagepointsofreturn.I’veneverbelievedinriskingwhatmyfamilyandfriendshaveandneedinordertopursuewhattheydon’thaveanddon’tneed.

Besides, Berkshire has access to two low-cost, non-perilous sources ofleveragethatallowustosafelyownfarmoreassetsthanourequitycapitalalonewouldpermit:deferredtaxesand“float,”thefundsofothersthatourinsurancebusinessholdsbecause it receivespremiumsbeforeneeding topayout losses.Both of these funding sources have grown rapidly and now total about $100billion.

Better yet, this funding todatehasbeen cost-free.Deferred tax liabilitiesbear no interest. And as long as we can break even in our insuranceunderwriting,thecostofthefloatdevelopedfromthatoperationiszero.Neitheritem, it should be understood, is equity; these are real liabilities.But they areliabilitieswithoutcovenantsorduedatesattachedtothem.Ineffect,theygiveusthebenefitofdebt—anabilitytohavemoreassetsworkingforus—butsaddleuswithnoneofitsdrawbacks.

Ofcourse,thereisnoguaranteethatwecanobtainourfloatinthefutureatnocost.Butwefeelourchancesofattaining thatgoalareasgoodas thoseofanyoneintheinsurancebusiness.Notonlyhavewereachedthegoalinthepast(despite a number of important mistakes by your Chairman), our 1996acquisitionofGEICOmateriallyimprovedourprospectsforgettingthereinthefuture.[Since2011],weexpectadditionalborrowingstobeconcentratedinourutilitiesandrailroadbusinesses,loansthatarenon-recoursetoBerkshire.Here,wewillfavorlong-term,fixed-rateloans.Whenwemakeatrulylargepurchase,aswedidwithBNSF,wewillborrowmoneyattheparentcompanylevelwiththeintentofquicklypayingitback.

8.Amanagerial“wish list”will notbe filledat shareholder expense.Wewill not diversify by purchasing entire businesses at control prices that ignorelong-term economic consequences to our shareholders. We will only do withyourmoneywhatwewoulddowithourown,weighingfullythevaluesyoucanobtainbydiversifyingyourownportfoliosthroughdirectpurchasesinthestockmarket.

Charlieand I are interestedonly inacquisitions thatwebelievewill raisetheper-share intrinsicvalueofBerskhire’sstock.ThesizeofourpaychecksorourofficeswillneverberelatedtothesizeofBerkshire’sbalancesheet.

9.Wefeelnoble intentionsshouldbecheckedperiodicallyagainstresults.We test thewisdomof retaining earnings by assessingwhether retention, over

time,deliversshareholdersatleast$1ofmarketvalueforeach$1retained.Todate, this testhasbeenmet.Wewillcontinue toapply itona five-yearrollingbasis.Asournetworthgrows,itismoredifficulttouseretainedearningswisely.

I shouldhavewritten the“five-year rollingbasis” sentencedifferently, anerror I didn’t realize until I received a question about this subject at the 2009annualmeeting.

When the stockmarket has declined sharply over a five-year stretch, ourmarket-price premium to book value has sometimes shrunk. And when thathappens,wefailthetestasIimproperlyformulatedit.Infact,wefellfarshortasearlyas1971-75,wellbeforeIwrotethisprinciplein1983.

Thefive-yeartestshouldbe:(1)duringtheperioddidourbook-valuegainexceedtheperformanceoftheS&P;and(2)didourstockconsistentlysellatapremiumtobook,meaningthatevery$1ofretainedearningswasalwaysworthmorethan$1?Ifthesetestsaremet,retainingearningshasmadesense.

10.Wewillissuecommonstockonlywhenwereceiveasmuchinbusinessvalueaswegive.Thisruleappliestoallformsofissuance—notonlymergersorpublic stockofferings,but stock-for-debt swaps, stockoptions,andconvertiblesecuritiesaswell.Wewillnotsellsmallportionsofyourcompany—andthatiswhattheissuanceofsharesamountsto—onabasisinconsistentwiththevalueoftheentireenterprise.

Whenwesold theClassBshares in1996,westated thatBerkshire stockwasnotundervalued—andsomepeoplefoundthatshocking.Thatreactionwasnot well-founded. Shock should have registered instead had we issued shareswhen our stock was undervalued. Managements that say or imply during apublicofferingthattheirstockisundervaluedareusuallybeingeconomicalwiththe truth or uneconomical with their existing shareholders’ money: Ownersunfairly lose if their managers deliberately sell assets for 80¢ that in fact areworth$1.Wedidn’tcommitthatkindofcrimeinourofferingofClassBsharesandwe neverwill. (We didnot, however, say at the time of the sale that ourstockwasovervalued,thoughmanymediahavereportedthatwedid.)

11.YoushouldbefullyawareofoneattitudeCharlieandIsharethathurtsour financial performance: Regardless of price, we have no interest at all insellinganygoodbusinesses thatBerkshireowns.Wearealsoveryreluctant tosellsub-parbusinessesaslongasweexpectthemtogenerateatleastsomecashandaslongaswefeelgoodabouttheirmanagersandlaborrelations.Wehopenot to repeat the capital-allocation mistakes that led us into such sub-parbusinesses. And we react with great caution to suggestions that our poorbusinesses can be restored to satisfactory profitability by major capitalexpenditures.(Theprojectionswillbedazzlingandtheadvocatessincere,but,in

the end,majoradditional investment in a terrible industry usually is about asrewarding as struggling in quicksand.) Nevertheless, gin rummy managerialbehavior(discardyourleastpromisingbusinessateachturn)isnotourstyle.Wewouldratherhaveouroverallresultspenalizedabitthanengageinthatkindofbehavior.

We continue to avoid gin rummy behavior. True, we closed our textilebusinessinthemid-1980safter20yearsofstrugglingwithit,butonlybecausewe felt it was doomed to run never-ending operating losses. We have not,however, given thought to selling operations thatwould command very fancypricesnor havewedumpedour laggards, thoughwe focushardon curing theproblemsthatcausethemtolag.

12.Wewillbecandidinourreportingtoyou,emphasizingtheplusesandminusesimportantinappraisingbusinessvalue.Ourguidelineistotellyouthebusiness facts thatwewouldwant to know if our positionswere reversed.Weowe you no less. Moreover, as a company with a major communicationsbusiness, itwouldbe inexcusable forus toapply lesserstandardsofaccuracy,balanceandincisivenesswhenreportingonourselvesthanwewouldexpectournewspeopletoapplywhenreportingonothers.Wealsobelievecandorbenefitsusasmanagers:TheCEOwhomisleadsothersinpublicmayeventuallymisleadhimselfinprivate.

At Berkshire you will find no “big bath” accounting maneuvers orrestructuring. And we won’t “smooth” quarterly or annual results: We willalways tellyouhowmanystrokeswehave takenoneachholeandneverplayaroundwiththescorecard.Whenthenumbersareaveryrough“guesstimate,”astheynecessarilymustbeininsurancereserving,wewilltrytobebothconsistentandconservativeinourapproach.

Wewillbecommunicatingwithyou in severalways.Through theannualreport,I trytogiveallshareholdersasmuchvalue-defininginformationascanbeconveyed inadocumentkept to reasonable length.Wealso try toconveyaliberalquantityofcondensedbutimportantinformationinourquarterlyreports,thoughIdon’twritethose(onerecitalayearisenough).StillanotherimportantoccasionforcommunicationisourAnnualMeeting,atwhichCharlieandIaredelightedtospendfivehoursormoreansweringquestionsaboutBerkshire.Butthere is one way we can’t communicate: on a one-on-one basis. That isn’tfeasiblegivenBerkshire’smanythousandsofowners.

In all of our communications, we try to make sure that no singleshareholdergetsanedge:Wedonotfollowtheusualpracticeofgivingearnings“guidance” to analysts or large shareholders. Our goal is to have all of ourownersupdatedatthesametime.

13. Despite our policy of candor we will discuss our activities inmarketablesecuritiesonlytotheextentlegallyrequired.Goodinvestmentideasarerare,valuableandsubjecttocompetitiveappropriationjustasgoodproductorbusinessacquisitionideasare.Thereforewenormallywillnottalkaboutourinvestmentideas.Thisbanextendseventosecuritieswehavesold(becausewemay purchase them again) and to stocks we are incorrectly rumored to bebuying.Ifwedenythosereportsbutsay“nocomment”onotheroccasions,theno-commentsbecomeconfirmation.

Thoughwecontinuetobeunwillingtotalkaboutspecificstocks,wefreelydiscuss our business and investment philosophy. I benefitted enormously fromtheintellectualgenerosityofBenGraham,thegreatestteacherinthehistoryoffinance,andIbelieveitappropriatetopassalongwhatIlearnedfromhim,evenifthatcreatesnewandable investmentcompetitorsforBerkshire justasBen’steachingsdidforhim.

14.To the extent possible, we would like each Berkshire shareholder torecord a gain or loss in market value during his period of ownership that isproportional to the gain or loss in per-share intrinsic value recorded by thecompany during that holding period. For this to come about, the relationshipbetweentheintrinsicvalueandthemarketpriceofaBerkshiresharewouldneedtoremainconstant,andbyourpreferencesat1-to-1.Asthatimplies,wewouldrather seeBerkshire’s stockpriceat a fair level than ahigh level. Obviously,Charlie and I can’t control Berkshire’s price. But by our policies andcommunications,wecanencourageinformed,rationalbehaviorbyownersthat,inturn,willtendtoproduceastockpricethatisalsorational.Ourit’s-as-bad-to-be-overvalued-as-to-be-undervalued approach may disappoint someshareholders, particularly those poised to sell. We believe, however, that itaffordsBerkshirethebestprospectofattractinglong-terminvestorswhoseektoprofitfromtheprogressofthecompanyratherthanfromtheinvestmentmistakesoftheirpartners.

15.Weregularlycompare thegain inBerkshire’sper-sharebookvalue totheperformanceoftheS&P500.Overtime,wehopetooutpacethisyardstick.Otherwise, why do our investors need us? The measurement, however, hascertain shortcomings. Moreover, it now is less meaningful on a year-to-yearbasis thanwas formerly the case. That is because our equity holdings,whosevaluetendstomovewiththeS&P500,areafarsmallerportionofournetworththan they were in earlier years. Additionally, gains in the S&P stocks arecounted in full in calculating that index, whereas gains in Berkshire’s equityholdingsarecountedat65%becauseofthefederaltaxweincur.We,therefore,expect to outperform the S&P in lackluster years for the stock market and

underperformwhenthemarkethasastrongyear.

1 [1979; 1996Owner’sManual—originally 1983, and annually beginningin1988,withoccasionalmodification.]

I.CORPORATEGOVERNANCE

Manyannualmeetings are awasteof time,both for shareholders and formanagement.Sometimesthatistruebecausemanagementisreluctanttoopenuponmattersofbusinesssubstance.Moreoftenanonproductivesessionisthefaultofshareholderparticipantswhoaremoreconcernedabouttheirownmomentonstagethantheyareabouttheaffairsofthecorporation.Whatshouldbeaforumfor business discussion becomes a forum for theatrics, spleen-venting andadvocacyofissues.(Thedealisirresistible:forthepriceofoneshareyougettotell a captive audience your ideas as to how theworld should be run.)Undersuch circumstances, the quality of themeeting often deteriorates from year toyear as the antics of those interested in themselves discourage attendance bythoseinterestedinthebusiness.

Berkshire’s meetings are a different story. The number of shareholdersattendinggrowsabiteachyearandwehaveyettoexperienceasillyquestionoran ego-inspired commentary.2 Instead, we get a wide variety of thoughtfulquestionsaboutthebusiness.Becausetheannualmeetingisthetimeandplacefor these, Charlie and I are happy to answer them all, nomatter how long ittakes. (We cannot, however, respond to written or phoned questions at othertimesof theyear;one-person-at-a-time reporting is apooruseofmanagementtimeinacompanywith[thousandsof]shareholders.)Theonlybusinessmattersthatareofflimitsattheannualmeetingarethoseaboutwhichcandormightcostour company real money. Our activities in securities would be the mainexample.3

A.FullandFairDisclosure4

At Berkshire, full reporting means giving you the information that wewouldwishyoutogivetousifourpositionswerereversed.WhatCharlieandIwould want under that circumstance would be all the important facts aboutcurrentoperationsaswellas theCEO’s frankviewof the long-termeconomiccharacteristicsof thebusiness.Wewould expectboth a lot of financial detailsand a discussion of any significant datawewould need to interpretwhatwaspresented.

When Charlie and I read reports, we have no interest in pictures ofpersonnel, plants or products. References to EBITDAmake us shudder—does

management think the tooth fairy pays for capital expenditures?5We’re verysuspiciousofaccountingmethodology that isvagueorunclear, since toooftenthatmeansmanagementwishes tohidesomething.Andwedon’twant to readmessagesthatapublicrelationsdepartmentorconsultanthasturnedout.Instead,we expect a company’s CEO to explain in his or her own words what’shappening.

Forus,fairreportingmeansgettinginformationtoour300,000“partners”simultaneously,orasclosetothatmarkaspossible.Wethereforeputourannualand quarterly financials on the Internet between the close of themarket on aFriday and the followingmorning. By our doing that, shareholders and otherinterestedinvestorshavetimelyaccesstotheseimportantreleasesandalsohavea reasonable amount of time to digest the information they include before themarketsopenonMonday.

WeapplaudtheworkthatArthurLevitt,Jr.,untilrecentlyChairmanoftheSEC, has done in cracking down on the corporate practice of “selectivedisclosure” that had spread like cancer in recent years. Indeed, it had becomevirtually standard practice for major corporations to “guide” analysts or largeholderstoearningsexpectationsthatwereintendedeithertobeonthenoseoratinybitbelowwhatthecompanytrulyexpectedtoearn.Throughtheselectivelydispersed hints, winks and nods that companies engaged in, speculatively-minded institutions and advisors were given an information edge overinvestment-oriented individuals. This was corrupt behavior, unfortunatelyembracedbybothWallStreetandcorporateAmerica.

Thanks to Chairman Levitt, whose general efforts on behalf of investorswerebothtirelessandeffective,corporationsarenowrequiredtotreatalloftheirownersequally.Thefactthatthisreformcameaboutbecauseofcoercionratherthan conscience should be a matter of shame for CEOs and their investorrelationsdepartments.

OnefurtherthoughtwhileI’monmysoapbox:CharlieandIthinkitisbothdeceptiveanddangerousforCEOstopredictgrowthratesfor theircompanies.Theyare,ofcourse,frequentlyeggedontodosobybothanalystsandtheirowninvestor relationsdepartments. They should resist, however, because too oftenthesepredictionsleadtotrouble.

It’sfineforaCEOtohavehisowninternalgoalsand,inourview,it’sevenappropriatefortheCEOtopubliclyexpresssomehopesaboutthefuture,iftheseexpectationsareaccompaniedbysensiblecaveats.Butforamajorcorporationtopredict that its per-share earnings will grow over the long term at, say, 15%annuallyistocourttrouble.

That’struebecauseagrowthrateofthatmagnitudecanonlybemaintained

byaverysmallpercentageoflargebusinesses.Here’satest:Examinetherecordof,say,the200highestearningcompaniesfrom1970to1980andtabulatehowmanyhaveincreasedper-shareearningsby15%annuallysincethosedates.Youwillfindthatonlyahandfulhave.Iwouldwageryouaverysignificantsumthatfewer than 10 of the 200most profitable companies in 2000 will attain 15%annualgrowthinearnings-per-shareoverthenext20years.

The problem arising from lofty predictions is not just that they spreadunwarrantedoptimism.EvenmoretroublesomeisthefactthattheycorrodeCEObehavior.Overtheyears,CharlieandIhaveobservedmanyinstancesinwhichCEOs engaged in uneconomic operating maneuvers so that they could meetearnings targets they had announced. Worse still, after exhausting all thatoperating acrobatics would do, they sometimes played a wide variety ofaccountinggamesto“makethenumbers.”Theseaccountingshenaniganshaveaway of snowballing: Once a company moves earnings from one period toanother,operatingshortfalls thatoccur thereafterrequire it toengageinfurtheraccountingmaneuversthatmustbeevenmore“heroic.”Thesecanturnfudgingintofraud.(Moremoney,ithasbeennoted,hasbeenstolenwiththepointofapenthanatthepointofagun.)

Charlie and I tend to be leery of companies run by CEOs who wooinvestorswithfancypredictions.Afewofthesemanagerswillproveprophetic—but others will turn out to be congenital optimists, or even charlatans.Unfortunately,it’snoteasyforinvestorstoknowinadvancewhichspeciestheyaredealingwith.

Three suggestions for investors: First, beware of companies displayingweakaccounting.Ifacompanystilldoesnotexpenseoptions,or if itspensionassumptions are fanciful,watch out.Whenmanagements take the low road inaspectsthatarevisible,it islikely theyarefollowingasimilarpathbehindthescenes.Thereisseldomjustonecockroachinthekitchen.

Trumpeting EBITDA (earnings before interest, taxes, depreciation andamortization) is a particularly pernicious practice. Doing so implies thatdepreciationisnottrulyanexpense,giventhatitisa“non-cash”charge.That’snonsense.Intruth,depreciationisaparticularlyunattractiveexpensebecausethecashoutlayitrepresentsispaidupfront,beforetheassetacquiredhasdeliveredanybenefits to thebusiness. Imagine, ifyouwill, that at thebeginningof thisyearacompanypaidallofitsemployeesforthenexttenyearsoftheirservice(inthewaytheywouldlayoutcashforafixedassettobeusefulfortenyears).In the following nine years, compensationwould be a “non-cash” expense—a

reductionofaprepaidcompensationassetestablished thisyear.Wouldanyonecaretoarguethattherecordingoftheexpenseinyearstwothroughtenwouldbesimplyabookkeepingformality?

Second, unintelligible footnotes usually indicate untrustworthymanagement.Ifyoucan’tunderstandafootnoteorothermanagerialexplanation,it’susuallybecausetheCEOdoesn’twantyouto.Enron’sdescriptionsofcertaintransactionsstillbaffleme.

Finally, be suspiciousof companies that trumpet earningsprojections andgrowth expectations. Businesses seldom operate in a tranquil, no-surpriseenvironment,andearningssimplydon’tadvancesmoothly(except,ofcourse,intheofferingbooksofinvestmentbankers).

CharlieandInotonlydon’tknowtodaywhatourbusinesseswillearnnextyear—wedon’tevenknowwhattheywillearnnextquarter.Wearesuspiciousof thoseCEOswho regularlyclaim theydoknow the future—andwebecomedownrightincredulousiftheyconsistentlyreachtheirdeclaredtargets.Managersthat always promise to “make the numbers”will at some point be tempted tomakeupthenumbers.

B.BoardsandManagers6

[The performance of CEOs of investee companies], which we haveobserved at close range, contrasts vividlywith that ofmanyCEOs,whichwehavefortunatelyobservedfromasafedistance.Sometimes theseCEOsclearlydonotbelongintheirjobs;theirpositions,nevertheless,areusuallysecure.Thesupremeironyofbusinessmanagementis that it isfareasierforaninadequateCEOtokeephisjobthanitisforaninadequatesubordinate.

Ifasecretary,say,ishiredforajobthatrequirestypingabilityofatleast80wordsaminuteandturnsouttobecapableofonly50wordsaminute,shewillloseher jobinnotime.Thereisa logicalstandardfor this job;performanceiseasilymeasured;andifyoucan’tmakethegrade,you’reout.Similarly,ifnewsalespeoplefailtogeneratesufficientbusinessquicklyenough,theywillbeletgo.Excuseswillnotbeacceptedasasubstitutefororders.

However, a CEO who doesn’t perform is frequently carried indefinitely.One reason is that performance standards forhis job seldomexist.When theydo, theyareoftenfuzzyor theymaybewaivedorexplainedaway,evenwhentheperformanceshortfallsaremajorandrepeated.Attoomanycompanies,theboss shoots the arrow of managerial performance and then hastily paints thebull's–eyearoundthespotwhereitlands.

Anotherimportant,butseldomrecognized,distinctionbetweenthebossandthefootsoldieristhattheCEOhasnoimmediatesuperiorwhoseperformanceisitselfgettingmeasured.Thesalesmanagerwhoretainsabunchoflemonsinhissalesforcewillsoonbeinhotwaterhimself.Itisinhisimmediateself–interesttopromptlyweedouthishiringmistakes.Otherwise,hehimselfmaybeweededout. An office manager who has hired inept secretaries faces the sameimperative.

ButtheCEO’sbossisaBoardofDirectorsthatseldommeasuresitselfandis infrequently held to account for substandard corporate performance. If theBoardmakesamistakeinhiring,andperpetuatesthatmistake,sowhat?Evenifthecompanyistakenoverbecauseofthemistake,thedealwillprobablybestowsubstantialbenefitson theoutgoingBoardmembers. (Thebigger theyare, thesoftertheyfall.)

Finally, relations between the Board and the CEO are expected to becongenial. At board meetings, criticism of the CEO’s performance is oftenviewed as the social equivalent of belching. No such inhibitions restrain theofficemanagerfromcriticallyevaluatingthesubstandardtypist.

ThesepointsshouldnotbeinterpretedasablanketcondemnationofCEOsorBoardsofDirectors:Mostareableandhardworking,andanumberaretrulyoutstanding.ButthemanagementfailingsthatCharlieandIhaveseenmakeusthankfulthatwearelinkedwiththemanagersofourthreepermanentholdings.Theylovetheirbusinesses,theythinklikeowners,andtheyexudeintegrityandability.

Atourannualmeetings,someoneusuallyasks“Whathappenstothisplaceifyougethitbyatruck?”I’mgladtheyarestillaskingthequestioninthisform.Itwon’tbe too longbefore thequerybecomes:“Whathappens to thisplace ifyoudon’tgethitbyatruck?”

Such questions, in any event, raise a reason for me to discuss corporategovernance,ahottopicduringthepastyear.Ingeneral,Ibelievethatdirectorshavestiffenedtheirspinesrecentlyandthatshareholdersarenowbeingtreatedsomewhatmoreliketrueownersthanwasthecasenotlongago.Commentatorson corporate governance, however, seldommake any distinction among threefundamentally different manager/owner situations that exist in publicly-heldcompanies.Though the legal responsibilityofdirectors is identical throughout,theirabilitytoeffectchangediffersineachofthecases.Attentionusuallyfallsonthefirstcase,becauseitprevailsonthecorporatescene.SinceBerkshirefallsintothesecondcategory,however,andwillsomedayfallintothethird,wewill

discussallthreevariations.The first, and by far most common, board situation is one in which a

corporation has no controlling shareholder. In that case, I believe directorsshouldbehave as if there is a single absenteeowner,whose long-term interestthey should try to further in all properways.Unfortunately, “long-term”givesdirectorsalotofwiggleroom.Iftheylackeitherintegrityortheabilitytothinkindependently, directors can do great violence to shareholders while stillclaiming to be acting in their long-term interest. But assume the board isfunctioningwell andmustdealwith amanagement that ismediocreorworse.Directorsthenhavetheresponsibilityforchangingthatmanagement,justasanintelligentownerwoulddoifhewerepresent.Andifablebutgreedymanagersoverreachandtrytodiptoodeeplyintotheshareholders’pockets,directorsmustslaptheirhands.

In this plain-vanilla case, a director who sees something he doesn’t likeshouldattempttopersuadetheotherdirectorsofhisview.Ifheissuccessful,theboardwill have themuscle tomake the appropriate change. Suppose, though,thattheunhappydirectorcan’tgetotherdirectorstoagreewithhim.Heshouldthenfeelfreetomakehisviewsknowntotheabsenteeowners.Directorsseldomdo that, of course. The temperament of many directors would in fact beincompatiblewith critical behavior of that sort.But I see nothing improper insuchactions,assumingtheissuesareserious.Naturally,thecomplainingdirectorcan expect a vigorous rebuttal from the unpersuaded directors, a prospect thatshoulddiscouragethedissenterfrompursuingtrivialornon-rationalcauses.

Fortheboardsjustdiscussed,Ibelievethedirectorsoughttoberelativelyfew innumber—say, tenor less—andought to comemostly from theoutside.The outside board members should establish standards for the CEO’sperformance and should also periodically meet, without his being present, toevaluatehisperformanceagainstthosestandards.

Therequisitesforboardmembershipshouldbebusinesssavvy, interest inthejob,andowner-orientation.Toooften,directorsareselectedsimplybecausethey are prominent or add diversity to the board. That practice is a mistake.Furthermore, mistakes in selecting directors are particularly serious becauseappointmentsaresohardtoundo:Thepleasantbutvacuousdirectorneedneverworryaboutjobsecurity.

ThesecondcaseisthatexistingatBerkshire,wherethecontrollingownerisalso the manager. At some companies, this arrangement is facilitated by theexistenceof twoclassesofstockendowedwithdisproportionatevotingpower.Inthesesituations,it’sobviousthattheboarddoesnotactasanagentbetweenowners and management and that the directors cannot effect change except

throughpersuasion.Therefore,iftheowner/managerismediocreorworse—orisoverreaching—there is little a director can do about it except object. If thedirectorshavingnoconnectionstotheowner/managermakeaunifiedargument,itmaywellhavesomeeffect.Morelikelyitwillnot.

Ifchangedoesnotcome,andthematterissufficientlyserious,theoutsidedirectors should resign. Their resignation will signal their doubts aboutmanagement,anditwillemphasizethatnooutsiderisinapositiontocorrecttheowner/manager’sshortcomings.

Thethirdgovernancecaseoccurswhenthereisacontrollingownerwhoisnot involvedinmanagement.Thiscase,examplesofwhichareHersheyFoodsandDowJones,putstheoutsidedirectorsinapotentiallyusefulposition.Iftheybecome unhappywith either the competence or integrity of themanager, theycan go directly to the owner (whomay also be on the board) and report theirdissatisfaction.Thissituationisidealforanoutsidedirector,sinceheneedmakehiscaseonlytoasingle,presumablyinterestedowner,whocanforthwitheffectchangeiftheargumentispersuasive.Evenso,thedissatisfieddirectorhasonlythatsinglecourseofaction.Ifheremainsunsatisfiedaboutacriticalmatter,hehasnochoicebuttoresign.

Logically,thethirdcaseshouldbethemosteffectiveininsuringfirst-classmanagement.Inthesecondcasetheownerisnotgoingtofirehimself,andinthefirst case, directors often find it very difficult to dealwithmediocrity ormildoverreaching.Unlesstheunhappydirectorscanwinoveramajorityoftheboard—anawkwardsocialandlogistical task,particularly ifmanagement’sbehavioris merely odious, not egregious—their hands are effectively tied. In practice,directors trapped insituationsof thiskindusuallyconvince themselves thatbystaying around they can do at least some good. Meanwhile, managementproceedsunfettered.

Inthethirdcase,theownerisneitherjudginghimselfnorburdenedwiththeproblem of garnering amajority.He can also insure that outside directors areselectedwhowill bring useful qualities to the board. These directors, in turn,will know that thegoodadvice theygivewill reach the right ears, rather thanbeingstifledbyarecalcitrantmanagement.Ifthecontrollingownerisintelligentand self-confident, he will make decisions in respect to management that aremeritocraticandpro-shareholder.Moreover—andthisiscriticallyimportant—hecanreadilycorrectanymistakehemakes.

AtBerkshireweoperateinthesecondmodenowandwillforaslongasIremainfunctional.Myhealth,letmeadd,isexcellent.Forbetterorworse,youare likely to have me as an owner/manager for some time. All in all, we’repreparedfor“thetruck.”

Both the ability and fidelity of managers have long needed monitoring.Indeed, nearly 2,000 years ago, Jesus Christ addressed this subject, speaking(Luke16:2)approvinglyof“acertainrichman”whotoldhismanager,“Giveanaccountofthystewardship;forthoumayestnolongerbesteward.”

Accountability and stewardship withered in the last decade, becomingqualitiesdeemedoflittleimportancebythosecaughtupintheGreatBubble.Asstockpriceswentup,thebehavioralnormsofmanagerswentdown.Bythelate‘90s, as a result, CEOs who traveled the high road did not encounter heavytraffic.

MostCEOs,itshouldbenoted,aremenandwomenyouwouldbehappytohaveastrusteesforyourchildren’sassetsorasnext-doorneighbors.Toomanyof these people, however, have in recent years behaved badly at the office,fudgingnumbersanddrawingobscenepayformediocrebusinessachievements.

Whyhaveintelligentanddecentdirectorsfailedsomiserably?Theanswerliesnotininadequatelaws—it’salwaysbeenclearthatdirectorsareobligatedtorepresent the interestsof shareholders—but rather inwhat I’dcall “boardroomatmosphere.”

It’s almost impossible, for example, in a boardroom populated by well-manneredpeople,toraisethequestionofwhethertheCEOshouldbereplaced.It’sequallyawkwardtoquestionaproposedacquisitionthathasbeenendorsedbytheCEO,particularlywhenhis insidestaffandoutsideadvisorsarepresentand unanimously support his decision. (Theywouldn’t be in the room if theydidn’t.) Finally, when the compensation committee—armed, as always, withsupportfromahigh-paidconsultant—reportsonamega-grantofoptionstotheCEO,itwouldbelikebelchingatthedinnertableforadirectortosuggestthatthecommitteereconsider.

These “social” difficulties argue for outside directors regularly meetingwithout the CEO—a reform that is being instituted and that I enthusiasticallyendorse. I doubt, however, that most of the other new governance rules andrecommendations will provide benefits commensurate with the monetary andothercoststheyimpose.

Thecurrentcryisfor“independent”directors.It iscertainlytruethat it isdesirable tohavedirectorswho thinkandspeak independently—but theymustalso be business-savvy, interested and shareholder oriented [as noted in thepreviousessay].

Over a span of 40 years, I have been on 19 public-company boards(excludingBerkshire’s)andhaveinteractedwithperhaps250directors.Mostofthemwere“independent”asdefinedbytoday’srules.Butthegreatmajorityof

thesedirectorslackedatleastoneofthethreequalitiesIvalue.Asaresult,theircontribution to shareholder well-being was minimal at best and, too often,negative.

Thesepeople,decentandintelligentthoughtheywere,simplydidnotknowenoughaboutbusinessand/orcareenoughaboutshareholderstoquestionfoolishacquisitionsoregregiouscompensation.Myownbehavior,Imustruefullyadd,frequently fell short as well: Too often I was silent when management madeproposals that I judged to be counter to the interests of shareholders. In thosecases,collegialitytrumpedindependence.

So thatwemay further see the failingsof “independence,” let’s lookat a62-year case study covering thousands of companies. Since 1940, federal lawhasmandated that a largeproportionof thedirectorsof investment companies(most of thesemutual funds) be independent. The requirement was originally40%andnowit is50%.Inanycase, thetypicalfundhaslongoperatedwithamajorityofdirectorswhoqualifyasindependent.

Thesedirectorsand theentireboardhavemanyperfunctoryduties,but inactuality have only two important responsibilities: obtaining the best possibleinvestmentmanager andnegotiatingwith thatmanager for the lowestpossiblefee.Whenyouareseekinginvestmenthelpyourself,thosetwogoalsaretheonlyonesthatcount,anddirectorsactingforotherinvestorsshouldhaveexactlythesamepriorities.Yetwhenitcomestoindependentdirectorspursuingeithergoal,theirrecordhasbeenabsolutelypathetic.

Manythousandsofinvestment-companyboardsmeetannuallytocarryoutthevitaljobofselectingwhowillmanagethesavingsofthemillionsofownerstheyrepresent.YearafteryearthedirectorsofFundAselectmanagerA,FundBdirectors select manager B, etc. . . . in a zombie-like process that makes amockeryofstewardship.Veryoccasionally,aboardwillrevolt.Butforthemostpart, a monkey will type out a Shakespeare play before an “independent”mutual-funddirectorwill suggest thathis fund lookatothermanagers,even ifthe incumbent manager has persistently delivered substandard performance.When they are handling their own money, of course, directors will look toalternative advisors—but it never enters their minds to do so when they areactingasfiduciariesforothers.

The hypocrisy permeating the system is vividly exposed when a fundmanagement company—call it “A”—is sold for a huge sum toManager “B”.Now the “independent” directors experience a “counter-revelation” anddecidethatManagerBisthebestthatcanbefound—eventhoughBwasavailable(andignored)inpreviousyears.Notsoincidentally,Balsocouldformerlyhavebeenhired at a far lower rate than is possible now that it has boughtManager A.

That’sbecauseBhaslaidoutafortunetoacquireA,andBmustnowrecoupthatcostthroughfeespaidbytheAshareholderswhowere“delivered”aspartofthedeal. (For a terrific discussion of themutual fund business, read JohnBogle’sCommonSenseonMutualFunds.)

Investment company directors have failed as well in negotiatingmanagementfees.IfyouorIwereempowered,Icanassureyouthatwecouldeasilynegotiatemateriallylowermanagementfeeswiththeincumbentmanagersofmostmutualfunds.And,believeme,ifdirectorswerepromisedaportionofanyfeesavingstheyrealized,theskieswouldbefilledwithfallingfees.Underthecurrentsystem,though,reductionsmeannothingto“independent”directorswhilemeaningeverythingtomanagers.Soguesswhowins?

Havingtherightmoneymanager,ofcourse,isfarmoreimportanttoafundthanreducingthemanager’sfee.Bothtasksarenonethelessthejobofdirectors.And in steppingup to theseall-important responsibilities, tensof thousandsof“independent” directors, over more than six decades, have failed miserably.(They’ve succeeded, however, in taking care of themselves; their fees fromservingonmultipleboardsofasingle“family”offundsoftenrunwellintosixfigures.)

Whenthemanagercaresdeeplyandthedirectorsdon’t,what’sneededisapowerful countervailing force—and that’s the missing element in today’scorporate governance. Getting rid of mediocre CEOs and eliminatingoverreaching by the able ones requires action by owners—big owners. Thelogistics aren’t that tough: The ownership of stock has grown increasinglyconcentrated in recent decades, and today it would be easy for institutionalmanagerstoexerttheirwillonproblemsituations.Twenty,orevenfewer,ofthelargest institutions, acting together, could effectively reform corporategovernanceatagivencompany,simplybywithholdingtheirvotesfordirectorswhoweretoleratingodiousbehavior.Inmyview,thiskindofconcertedactionistheonlywaythatcorporatestewardshipcanbemeaningfullyimproved.

Several institutional shareholders and their advisors decided I lacked“independence” inmy role as a director ofCoca-Cola.One groupwantedmeremoved from theboardandanother simplywantedmebooted from theauditcommittee.

My first impulsewas to secretly fund the group behind the second idea.Whyanyonewouldwishtobeonanauditcommittee isbeyondme.Butsincedirectorsmustbeassignedtoonecommitteeoranother,andsincenoCEOwantsme on his compensation committee, it’s often been my lot to get an audit

committeeassignment.Asit turnedout, theinstitutionsthatopposedmefailedandIwasre-electedtotheauditjob.(Ifoughtofftheurgetoaskforarecount.)

Some institutions questioned my “independence” because, among otherthings,McLaneandDairyQueenbuylotsofCokeproducts.(DotheywantustofavorPepsi?)ButindependenceisdefinedinWebster’sas“notsubjecttocontrolby others.” I’m puzzled how anyone could conclude that our Coke purchaseswould“control”mydecision-makingwhenthecounterweight is thewell-beingof$8billionofCoke stockheldbyBerkshire.Assuming I’mevenmarginallyrational, elementary arithmetic should make it clear that my heart and mindbelongtotheownersofCoke,nottoitsmanagement.

I can’t resist mentioning that Jesus understood the calibration ofindependence farmore clearly than do the protesting institutions. InMatthew6:21Heobserved: “Forwhereyour treasure is, therewill yourheart be also.”Even to an institutional investor, $8 billion should qualify as “treasure” thatdwarfsanyprofitsBerkshiremightearnonitsroutinetransactionswithCoke.

Measuredbythebiblicalstandard,theBerkshireboardisamodel:(a)everydirectorisamemberofafamilyowningatleast$4millionofstock;(b)noneoftheseshareswereacquiredfromBerkshireviaoptionsorgrants;(c)nodirectorsreceive committee, consulting or board fees from the company that are morethanatinyportionoftheirannualincome;and(d)althoughwehaveastandardcorporate indemnity arrangement,we carryno liability insurance for directors.AtBerkshire,boardmemberstravelthesameroadasshareholders.

Charlie and I have seenmuch behavior confirming theBible’s “treasure”point. In our view, based on our considerable boardroomexperience, the leastindependentdirectorsarelikelytobethosewhoreceiveanimportantfractionoftheirannualincomefromthefeestheyreceiveforboardservice(andwhohopeaswelltoberecommendedforelectiontootherboardsandtherebytoboosttheirincome further). Yet these are the very boardmembersmost often classed as“independent.”

Mostdirectorsof this typearedecentpeopleanddoa first-class job.Buttheywouldn’t be human if theyweren’t tempted to thwart actions thatwouldthreatentheirlivelihood.Somemaygoontosuccumbtosuchtemptations.

Let’s lookatanexamplebaseduponcircumstantialevidence.Ihavefirst-handknowledgeofarecentacquisitionproposal(notfromBerkshire) thatwasfavoredbymanagement,blessedbythecompany’sinvestmentbankerandslatedtogo forward at a price above the level atwhich the stockhad sold for someyears (or now sells for). In addition, a number of directors favored thetransactionandwanteditproposedtoshareholders.

Several of their brethren, however, each of whom received board and

committee fees totaling about $100,000 annually, scuttled the proposal,whichmeant that shareholders never learned of this multi-billion offer. Non-management directors owned little stock except for shares they had receivedfromthecompany.Theiropen-marketpurchasesinrecentyearshadmeanwhilebeen nominal, even though the stock had sold far below the acquisition priceproposed. In other words, these directors didn’t want the shareholders to beoffered X even though they had consistently declined the opportunity to buystockfortheirownaccountatafractionofX.

Idon’tknowwhichdirectorsopposedlettingshareholdersseetheoffer.ButIdoknowthat$100,000isanimportantportionoftheannualincomeofsomeofthose deemed “independent,” clearly meeting the Matthew 6:21 definition of“treasure.”Ifthedealhadgonethrough,thesefeeswouldhaveended.

Neither the shareholders nor I will ever know what motivated thedissenters. Indeedtheythemselveswillnot likelyknow,giventhatself-interestinevitably blurs introspection. We do know one thing, though: At the samemeeting at which the deal was rejected, the board voted itself a significantincreaseindirectors’fees.

Wenowhaveelevendirectorsandeachofthem,combinedwithmembersof their families,ownsmore than$4millionofBerkshire stock.Moreover, allhave heldmajor stakes inBerkshire formany years. In the case of six of theeleven, family ownership amounts to at least hundreds of millions and datesbackatleastthreedecades.Allelevendirectorspurchasedtheirholdingsinthemarket just as you did; we’ve never passed out options or restricted shares.CharlieandIlovesuchhonest-to-Godownership.Afterall,whoeverwashesarentalcar?

In addition, director fees at Berkshire are nominal (as my son, Howard,periodically reminds me). Thus, the upside from Berkshire for all eleven isproportionately the same as the upside for any Berkshire shareholder. And italwayswillbe.

ThedownsideforBerkshiredirectorsisactuallyworsethanyoursbecausewe carryno directors and officers liability insurance. Therefore, if somethingreallycatastrophichappensonourdirectors’watch, theyareexposed to lossesthatwillfarexceedyours.

Thebottomlineforourdirectors:Youwin,theywinbig;youlose,theylosebig.Ourapproachmightbecalledowner-capitalism.Weknowofnobetterwaytoengendertrueindependence.

In addition to being independent, directors should have business savvy, a

shareholderorientationandagenuineinterestinthecompany.Therarestofthesequalitiesisbusinesssavvy—andifitislacking,theothertwoareoflittlehelp.Manypeoplewhoaresmart,articulateandadmiredhavenorealunderstandingofbusiness.That’snosin;theymayshineelsewhere.Buttheydon’tbelongoncorporateboards.

Charlie and I really have only two jobs. One is to attract and keepoutstandingmanagers to run our various operations.7 This hasn’t been all thatdifficult. Usually the managers came with the companies we bought, havingdemonstrated their talents throughout careers that spanned a wide variety ofbusinesscircumstances.Theyweremanagerial stars longbefore theyknewus,andourmaincontributionhasbeentonotgetintheirway.Thisapproachseemselementary: if my job were to manage a golf team—and if Jack Nicklaus orArnoldPalmerwerewillingtoplayforme—neitherwouldgetalotofdirectivesfrommeabouthowtoswing.

Some of our keymanagers are independently wealthy (we hope they allbecome so), but that poses no threat to their continued interest: they workbecausetheylovewhattheydoandrelishthethrillofoutstandingperformance.They unfailingly think like owners (the highest compliment we can pay amanager)andfindallaspectsoftheirbusinessabsorbing.

(Ourprototype foroccupational fervor is theCatholic tailorwhousedhissmall savings ofmany years to finance a pilgrimage to theVatican.When hereturned, his parish held a specialmeeting to get his first-hand account of thePope.“Tellus,”saidtheeagerfaithful,“justwhatsortoffellowishe?”Ourherowastednowords:“He’saforty-fourmedium.”)

Charlie and I know that the right players will make almost any teammanager look good. We subscribe to the philosophy of Ogilvy & Mather’sfoundinggenius,DavidOgilvy:“Ifeachofushirespeoplewhoaresmallerthanweare,weshallbecomeacompanyofdwarfs.But, ifeachofushirespeoplewhoarebiggerthanweare,weshallbecomeacompanyofgiants.”

A by-product of our managerial style is the ability it gives us to easilyexpand Berkshire’s activities. We’ve read management treatises that specifyexactly howmany people should report to any one executive, but theymakelittle sense to us. When you have able managers of high character runningbusinesses about which they are passionate, you can have a dozen or morereportingtoyouandstillhavetimeforanafternoonnap.Conversely,ifyouhaveevenonepersonreportingtoyouwhoisdeceitful,ineptoruninterested,youwillfind yourself with more than you can handle. Charlie and I could work with

double the number of managers we now have, so long as they had the rarequalitiesofthepresentones.

Weintendtocontinueourpracticeofworkingonlywithpeoplewhomwelikeandadmire.Thispolicynotonlymaximizesourchancesforgoodresults,italsoensuresusanextraordinarilygood time.On theotherhand,workingwithpeoplewhocauseyourstomachtochurnseemsmuchlikemarryingformoney—probablyabadideaunderanycircumstances,butabsolutemadnessifyouarealreadyrich.

AtBerkshirewefeelthattellingoutstandingCEOs,suchasTony[NicelyofGEICO],howtoruntheircompanieswouldbetheheightoffoolishness.Mostofour managers wouldn’t work for us if they got a lot of backseat driving.(Generally, they don’t have to work for anyone, since 75% or so areindependentlywealthy.)Besides, they are theMarkMcGwires of the businessworldandneednoadvicefromusastohowtoholdthebatorwhentoswing.

Nevertheless,Berkshire’sownershipmaymakeeventhebestofmanagersmore effective. First, we eliminate all of the ritualistic and nonproductiveactivities that normally go with the job of CEO. Our managers are totally inchargeoftheirpersonalschedules.Second,wegiveeachasimplemission:Justrunyourbusinessas if: (1)youown100%of it; (2) it is theonlyasset in theworldthatyouandyourfamilyhaveorwilleverhave;and(3)youcan’tsellormerge it forat leastacentury.Asacorollary,we tell themtheyshouldnot letanyoftheirdecisionsbeaffectedevenslightlybyaccountingconsiderations.Wewantourmanagerstothinkaboutwhatcounts,nothowitwillbecounted.

Very few CEOs of public companies operate under a similar mandate,mainly because they have owners who focus on short-term prospects andreported earnings. Berkshire, however, has a shareholder base—which it willhavefordecadestocome—thathasthelongestinvestmenthorizontobefoundin the public-company universe. Indeed, a majority of our shares are held byinvestorswhoexpecttodiestillholdingthem.WecanthereforeaskourCEOstomanage formaximum long-termvalue, rather than fornextquarter’s earnings.Wecertainlydon’t ignore thecurrent resultsofourbusinesses—inmostcases,they are of great importance—but we never want them to be achieved at theexpenseofourbuildingever-greatercompetitivestrengths.

I believe the GEICO story demonstrates the benefits of Berkshire’sapproach.Charlie and I haven’t taughtTony a thing—andneverwill—butwehavecreatedanenvironmentthatallowshimtoapplyallofhistalentstowhat’simportant. He does not have to devote his time or energy to boardmeetings,

press interviews, presentations by investment bankers or talks with financialanalysts.Furthermore,heneedneverspendamomentthinkingaboutfinancing,credit ratings or “Street” expectations for earnings per share. Because of ourownershipstructure,healsoknowsthatthisoperationalframeworkwillendurefor decades to come. In this environment of freedom, both Tony and hiscompany can convert their almost limitless potential into matchingachievements.

Every day, in countless ways, the competitive position of each of ourbusinesses grows either weaker or stronger. If we are delighting customers,eliminatingunnecessarycostsandimprovingourproductsandservices,wegainstrength. But if we treat customers with indifference or tolerate bloat, ourbusinesses will wither. On a daily basis, the effects of our actions areimperceptible;cumulatively,though,theirconsequencesareenormous.

When our long-term competitive position improves as a result of thesealmost unnoticeable actions, we describe the phenomenon as “widening themoat.”Anddoingthatisessentialifwearetohavethekindofbusinesswewantadecadeortwofromnow.Wealways,ofcourse,hopetoearnmoremoneyintheshort-term.Butwhenshort-termandlong-termconflict,wideningthemoatmusttakeprecedence.

If amanagementmakes bad decisions in order to hit short-term earningstargets,andconsequentlygetsbehindtheeight-ball in termsofcosts,customersatisfactionorbrandstrength,noamountofsubsequentbrilliancewillovercomethedamagethathasbeeninflicted.Takealookatthedilemmasofmanagersinthe auto and airline industries today as they struggle with the huge problemshanded them by their predecessors. Charlie is fond of quotingBen Franklin’s“Anounceofpreventionisworthapoundofcure.”Butsometimesnoamountofcurewillovercomethemistakesofthepast.

C.TheAnxietiesofBusinessChange8

In July we decided to close our textile operation, and by year-end thisunpleasantjobwaslargelycompleted.Thehistoryofthisbusinessisinstructive.

WhenBuffettPartnership,Ltd., an investmentpartnershipofwhich Iwasgeneralpartner,boughtcontrolofBerkshireHathaway21yearsago, ithadanaccounting net worth of $22 million, all devoted to the textile business. Thecompany’sintrinsicbusinessvalue,however,wasconsiderablylessbecausethetextile assetswere unable to earn returns commensuratewith their accounting

value.Indeed,duringthepreviousnineyears(theperiodinwhichBerkshireandHathawayoperatedasamergedcompany)aggregatesalesof$530millionhadproducedanaggregatelossof$10million.Profitshadbeenreportedfromtimetotimebuttheneteffectwasalwaysonestepforward,twostepsback.

At the timewemade our purchase, southern textile plants—largely non-union—were believed to have an important competitive advantage. Mostnorthern textile operations had closed and many people thought we wouldliquidateourbusinessaswell.

We felt, however, that the businesswould be runmuch better by a long-timeemployeewhomwe immediately selected tobepresident,KenChace. Inthis respect we were 100% correct: Ken and his recent successor, GarryMorrison,havebeenexcellentmanagers,everybittheequalofmanagersatourmoreprofitablebusinesses.

Inearly1967cashgeneratedbythetextileoperationwasusedtofundourentryintoinsuranceviathepurchaseofNationalIndemnityCompany.Someofthe money came from earnings and some from reduced investment in textileinventories, receivables, and fixed assets.Thispullbackprovedwise: althoughmuchimprovedbyKen’smanagement,thetextilebusinessneverbecameagoodearner,notevenincyclicalupturns.

Further diversification for Berkshire followed, and gradually the textileoperation’s depressing effect on our overall return diminished as the businessbecameaprogressivelysmallerportionof thecorporation.Weremained in thebusinessforreasonsthatIstatedinthe1978annualreport(andsummarizedatother times also): “(1) our textile businesses are very important employers intheir communities, (2) management has been straightforward in reporting onproblems and energetic in attacking them, (3) labor has been cooperative andunderstanding in facing our common problems, and (4) the business shouldaveragemodestcashreturnsrelativetoinvestment.”Ifurthersaid,“Aslongastheseconditionsprevail—andweexpectthattheywill—weintendtocontinuetosupportourtextilebusinessdespitemoreattractivealternativeusesforcapital.”

ItturnedoutthatIwasverywrongabout(4).Though1979wasmoderatelyprofitable, the business thereafter consumedmajor amounts of cash. Bymid-1985itbecameclear,eventome,thatthisconditionwasalmostsuretocontinue.Could we have found a buyer who would continue operations, I would havecertainlypreferredtosellthebusinessratherthanliquidateit,evenifthatmeantsomewhatlowerproceedsforus.Buttheeconomicsthatwerefinallyobvioustomewerealsoobvioustoothers,andinterestwasnil.

Iwon’tclosedownbusinessesofsub-normalprofitabilitymerelytoaddafraction of a point to our corporate rate of return. However, I also feel it

inappropriateforevenanexceptionallyprofitablecompanytofundanoperationonceitappearstohaveunendinglossesinprospect.AdamSmithwoulddisagreewithmy first proposition, andKarlMarxwoulddisagreewithmy second; themiddlegroundistheonlypositionthatleavesmecomfortable.

IshouldreemphasizethatKenandGarryhavebeenresourceful,energeticandimaginativeinattemptingtomakeourtextileoperationasuccess.Tryingtoachieve sustainable profitability, they reworked product lines, machineryconfigurationsanddistributionarrangements.Wealsomadeamajoracquisition,WaumbecMills,withtheexpectationofimportantsynergy(atermwidelyusedinbusinesstoexplainanacquisitionthatotherwisemakesnosense).Butintheend nothingworked and I should be faulted for not quitting sooner. A recentBusinessWeekarticlestatedthat250textilemillshaveclosedsince1980.Theirownerswerenotprivytoanyinformationthatwasunknowntome;theysimplyprocesseditmoreobjectively.IignoredComte’sadvice—“theintellectshouldbethe servant of the heart, but not its slave”—and believed what I preferred tobelieve.

Thedomestictextileindustryoperatesinacommoditybusiness,competingin a world market in which substantial excess capacity exists. Much of thetrouble we experienced was attributable, both directly and indirectly, tocompetition fromforeigncountrieswhoseworkersarepaida small fractionoftheU.S.minimumwage.Butthatinnowaymeansthatourlaborforcedeservesanyblameforourclosing.Infact, incomparisonwithemployeesofAmericanindustry generally, our workers were poorly paid, as has been the casethroughout the textile business. In contract negotiations, union leaders andmemberswere sensitive toourdisadvantageouscostpositionanddidnotpushforunrealisticwage increasesorunproductiveworkpractices.To thecontrary,they tried just as hard as we did to keep us competitive. Even during ourliquidation period they performed superbly. (Ironically, we would have beenbetterofffinanciallyifourunionhadbehavedunreasonablysomeyearsago;wethenwouldhaverecognizedtheimpossiblefuturethatwefaced,promptlycloseddown,andavoidedsignificantfuturelosses.)

Over theyears,wehad theoptionofmakinglargecapitalexpenditures inthe textile operation thatwould have allowed us to somewhat reduce variablecosts. Each proposal to do so looked like an immediatewinner.Measured bystandard return-on-investment tests, in fact, these proposals usually promisedgreater economic benefits than would have resulted from comparableexpendituresinourhighly-profitablecandyandnewspaperbusinesses.

But the promised benefits from these textile investments were illusory.Many of our competitors, both domestic and foreign,were stepping up to the

same kind of expenditures and, once enough companies did so, their reducedcostsbecamethebaselineforreducedpricesindustry-wide.Viewedindividually,eachcompany’scapitalinvestmentdecisionappearedcost-effectiveandrational;viewedcollectively,thedecisionsneutralizedeachotherandwereirrational(justashappenswheneachpersonwatchingaparadedecideshecanseealittlebetterifhestandsontiptoes).Aftereachroundofinvestment,alltheplayershadmoremoneyinthegameandreturnsremainedanemic.

Thus, we faced a miserable choice: huge capital investment would havehelped to keep our textile business alive, butwould have left uswith terriblereturnsonever-growingamountsofcapital.Aftertheinvestment,moreover,theforeigncompetitionwouldstillhave retainedamajor, continuingadvantage inlabor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers. I alwaysthoughtmyselfinthepositiondescribedbyWoodyAlleninoneofhismovies:“Morethananyothertimeinhistory,mankindfacesacrossroads.Onepathleadsto despair andutter hopelessness, the other to total extinction.Let us praywehavethewisdomtochoosecorrectly.”

For anunderstandingof how the to-invest-or-not-to-invest dilemmaplaysoutinacommoditybusiness,itisinstructivetolookatBurlingtonIndustries,byfar the largest U.S. textile company both 21 years ago and now. In 1964Burlingtonhadsalesof$1.2billionagainstour$50million.Ithadstrengthsinbothdistributionandproductionthatwecouldneverhopetomatchandalso,ofcourse,hadanearningsrecordfarsuperiortoours.Itsstocksoldat60attheendof1964;ourswas13.

Burlingtonmadeadecisiontosticktothetextilebusiness,andin1985hadsales of about $2.8 billion. During the 1964–85 period, the company madecapital expenditures of about $3 billion, far more than any other U.S. textilecompanyandmorethan$200-per-shareonthat$60stock.Averylargepartofthe expenditures, I am sure,was devoted to cost improvement and expansion.GivenBurlington’sbasic commitment to stay in textiles, Iwould also surmisethatthecompany’scapitaldecisionswerequiterational.

Nevertheless,Burlingtonhas lost sales volume in real dollars andhas farlowerreturnsonsalesandequitynowthan20yearsago.Split2-for-1in1965,thestocknowsellsat34—onanadjustedbasis,justalittleoverits$60pricein1964. Meanwhile, the CPI has more than tripled. Therefore, each sharecommands about one-third the purchasing power it did at the end of 1964.Regular dividends have been paid but they, too, have shrunk significantly inpurchasingpower.

This devastating outcome for the shareholders indicateswhat can happen

whenmuchbrainpowerandenergyareappliedtoafaultypremise.Thesituationis suggestive of Samuel Johnson’s horse: “A horse that can count to ten is aremarkable horse—not a remarkable mathematician.” Likewise, a textilecompany that allocates capital brilliantly within its industry is a remarkabletextilecompany—butnotaremarkablebusiness.

My conclusion frommy own experiences and frommuch observation ofother businesses is that a good managerial record (measured by economicreturns) is farmorea functionofwhatbusinessboatyouget into than it isofhow effectively you row (though intelligence and effort help considerably, ofcourse,inanybusiness,goodorbad).Shouldyoufindyourselfinachronically-leakingboat,energydevotedtochangingvesselsislikelytobemoreproductivethanenergydevotedtopatchingleaks.

Not all of our businesses are destined to increase profits. When anindustry’sunderlyingeconomicsarecrumbling,talentedmanagementmayslowthe rate of decline. Eventually, though, eroding fundamentals will overwhelmmanagerialbrilliance.(Asawisefriendtoldmelongago,“Ifyouwanttogetareputation as a good businessman, be sure to get into a good business.”)Andfundamentalsaredefinitelyeroding in thenewspaper industry,a trend thathascausedtheprofitsofourBuffaloNewstodecline.Theskidwillalmostcertainlycontinue.

WhenCharlieandIwereyoung,thenewspaperbusinesswasaseasyawayto make huge returns as existed in America. As one not-too-bright publisherfamouslysaid,“IowemyfortunetotwogreatAmericaninstitutions:monopolyand nepotism.” No paper in a one-paper city, however bad the product orhoweverineptthemanagement,couldavoidgushingprofits.

The industry’s staggering returns could be simply explained. Formost ofthe 20th Century, newspapers were the primary source of information for theAmerican public. Whether the subject was sports, finance, or politics,newspapersreignedsupreme.Justasimportant,theiradsweretheeasiestwaytofind job opportunities or to learn the price of groceries at your town’ssupermarkets.

Thegreatmajorityoffamiliesthereforefelttheneedforapapereveryday,but understandablymost didn’twish to pay for two.Advertisers preferred thepaperwith themostcirculation,and readers tended towant thepaperwith themostadsandnewspages.Thiscircularityledtoalawofthenewspaperjungle:SurvivaloftheFattest.

Thus,whentwoormorepapersexistedinamajorcity(whichwasalmost

universallythecaseacenturyago),theonethatpulledaheadusuallyemergedasthestand-alonewinner.Aftercompetitiondisappeared,thepaper’spricingpowerin both advertising and circulation was unleashed. Typically, rates for bothadvertisersandreaderswouldberaisedannually—andtheprofitsrolledin.Forownersthiswaseconomicheaven.(Interestingly,thoughpapersregularly—andoften in a disapprovingway—reported on the profitability of, say, the auto orsteel industries, they never enlightened readers about their own Midas-likesituation.Hmmm...)

As longagoasmy1991 letter toshareholders, Inonethelessasserted thatthis insulatedworldwaschanging,writing that“themediabusinesses . . .willproveconsiderablylessmarvelousthanI,theindustry,orlendersthoughtwouldbe thecaseonlya fewyearsago.”Somepublishers tookumbrageatboth thisremark and other warnings from me that followed. Newspaper properties,moreover,continuedtosellasiftheywereindestructibleslotmachines.Infact,many intelligent newspaper executiveswho regularly chronicled and analyzedimportantworldwideeventswereeitherblindor indifferent towhatwasgoingonundertheirnoses.

Now,however,almostallnewspaperownersrealizethattheyareconstantlylosing ground in the battle for eyeballs. Simply put, if cable and satellitebroadcasting, aswell as the internet, had come along first, newspapers asweknow them probably would never have existed. In Berkshire’s world, StanLipseydoesaterrificjobrunningtheBuffaloNews,andIamenormouslyproudof its editor, Margaret Sullivan. The News’ penetration of its market is thehighest among that of this country’s large newspapers. We also do betterfinancially than most metropolitan newspapers, even though Buffalo’spopulationandbusinesstrendsarenotgood.

Nevertheless, this operation faces unrelenting pressures that will causeprofit margins to slide. True, we have the leading online news operation inBuffalo, and it will continue to attract more viewers and ads. However, theeconomic potential of a newspaper internet site—given the many alternativesourcesofinformationandentertainmentthatarefreeandonlyaclickaway—isatbestasmallfractionofthatexistinginthepastforaprintnewspaperfacingnocompetition.

Foralocalresident,ownershipofacity’spaper,likeownershipofasportsteam, still produces instant prominence. With it typically comes power andinfluence. These are ruboffs that appeal tomany peoplewithmoney. Beyondthat,civic-minded,wealthyindividualsmayfeelthatlocalownershipwillservetheircommunitywell.That’swhyPeterKiewitbought theOmahapapermorethan40yearsago.

We are likely therefore to see non-economic individual buyers ofnewspapers emerge, just as we have seen such buyers acquire major sportsfranchises.Aspiringpresslordsshouldbecareful,however:There’snorulethatsaysanewspaper’srevenuescan’t fallbelowitsexpensesand that lossescan’tmushroom.Fixedcostsarehighinthenewspaperbusiness,andthat’sbadnewswhen unit volume heads south. As the importance of newspapers diminishes,moreover, the“psychic”valueofpossessingonewillwane,whereasowningasportsfranchisewilllikelyretainitscachet.

Unlesswefaceanirreversiblecashdrain,wewillstickwiththeNews,justaswe’vesaidthatwewould.CharlieandIlovenewspapers—weeachreadfivea day—and believe that a free and energetic press is a key ingredient formaintaining a great democracy.We hope that some combination of print andonlinewillwardoffeconomicdoomsdayfornewspapers,andwewillworkhardinBuffalotodevelopasustainablebusinessmodel.Ithinkwewillbesuccessful.Butthedaysoflushprofitsfromournewspaperareover.

D.SocialCompacts9

Wehave twovery largebusinesses,BNSF[BurlingtonNorthernSantaFeRailroad Corporation] and MidAmerican Energy, with important commoncharacteristicsthatdistinguishthemfromourmanyothers.Akeycharacteristicofbothcompaniesisthehugeinvestmenttheyhaveinverylong-lived,regulatedassets, with these funded by large amounts of long-term debt that is notguaranteedbyBerkshire.Ourcreditisnotneeded:Bothbusinesseshaveearningpower that, even under very adverse business conditions, amply covers theirinterestrequirements.

Both companies are heavily regulated, andbothwill have a never-endingneed to make major investments in plant and equipment. Both also need toprovide efficient, customer-satisfying service to earn the respect of theircommunitiesandregulators.Inreturn,bothneedtobeassuredthattheywillbeallowedtoearnreasonableearningsonfuturecapitalinvestments.

[R]ailroadsare[vital]toourcountry’sfuture.Railmoves42%ofAmerica’sinter-cityfreight,measuredbyton-miles,andBNSFmovesmorethananyotherrailroad—about28%of the industry total.A littlemathwill tellyou thatmorethan11%ofallinter-cityton-milesoffreightintheU.S.istransportedbyBNSF.GiventheshiftofpopulationtotheWest,oursharemaywellinchhigher.

Allof this addsup toahuge responsibility.Weareamajorandessentialpart of the American economy’s circulatory system, obliged to constantly

maintainandimproveour23,000milesoftrackalongwithitsancillarybridges,tunnels,enginesandcars.Incarryingout this job,wemustanticipatesociety’sneeds, not merely react to them. Fulfilling our societal obligation, we willregularlyspendfarmorethanourdepreciation,withthisexcessamountingto$2billion in 2011. I’m confident we will earn appropriate returns on our hugeincremental investments.Wiseregulationandwise investmentare twosidesofthesamecoin.

At MidAmerican, we participate in a similar “social compact.” We areexpected to put up ever increasing sums to satisfy the future needs of ourcustomers. Ifwemeanwhile operate reliably and efficiently,we know thatwewillobtainafairreturnontheseinvestments.

MidAmerican supplies 2.4million customers in theU.S. with electricity,operatingasthelargestsupplierinIowa,WyomingandUtahandasanimportantprovider in other states as well. Our pipelines transport 8% of the country’snaturalgas.Obviously,manymillionsofAmericansdependonuseveryday.

MidAmerican has delivered outstanding results for both its owners(Berkshire’s interest is 89.8%) and its customers. Shortly after MidAmericanpurchasedNorthernNaturalGaspipeline in2002, thatcompany’sperformanceasapipelinewas rateddead last,43outof43,by the leadingauthority in thefield.Inthemostrecentreportpublished,NorthernNaturalwasrankedsecond.Thetopspotwasheldbyourotherpipeline,KernRiver.

Initselectricbusiness,MidAmericanhasacomparablerecord.Iowarateshavenot increasedsincewepurchasedouroperationthere in1999.Duringthesameperiod, theothermajorelectricutility in the statehas raisedpricesmorethan 70% and now has rates far above ours. In certain metropolitan areas inwhichthetwoutilitiesoperatesidebyside,electricbillsofourcustomersrunfarbelowthoseoftheirneighbors.Iamtoldthatcomparablehousessellathigherpricesinthesecitiesiftheyarelocatedinourservicearea.

MidAmericanwillhave2,909megawattsofwindgeneration inoperationbytheendof2011,morethananyotherregulatedelectricutilityinthecountry.The total amount that MidAmerican has invested or committed to wind is astaggering $5.4 billion. We can make this sort of investment becauseMidAmericanretainsallofitsearnings,unlikeotherutilitiesthatgenerallypayoutmostofwhattheyearn.

MidAmericanhasconsistentlykeptitsendofthebargainwithsocietyand,tosociety’scredit,ithasreciprocated:Withfewexceptions,ourregulatorshavepromptlyallowedustoearnafairreturnontheeverincreasingsumsofcapital

we must invest. Going forward, we will do whatever it takes to serve ourterritoriesinthemannertheyexpect.Webelievethat,inturn,wewillbeallowedthereturnwedeserveonthefundsweinvest.

We see a “social compact” existing between the public and our railroadbusiness,justasisthecasewithourutilities.Ifeithersideshirksitsobligations,bothsideswillinevitablysuffer.Therefore,bothpartiestothecompactshould—and we believe will—understand the benefit of behaving in a way thatencouragesgoodbehaviorbytheother.Itisinconceivablethatourcountrywillrealizeanythingclosetoitsfulleconomicpotentialwithoutitspossessingfirst-classelectricityandrailroadsystems.Wewilldoourparttoseethattheyexist.

E.AnOwner-BasedApproachtoCorporateCharity10

A recent survey reported that about 50% of major American companiesmatchcharitablecontributionsmadebydirectors(sometimesbyafactorofthreeto one). In effect, these representatives of the owners direct funds to theirfavoritecharities,andneverconsulttheownersastotheircharitablepreferences.(Iwonder how theywould feel if the processwere reversed and shareholderscould invade the directors’ pockets for charities favored by the shareholders.)WhenA takesmoney fromB togive toCandA isa legislator, theprocess iscalledtaxation.ButwhenAisanofficerordirectorofacorporation,itiscalledphilanthropy.We continue to believe that contributions, aside from thosewithquite clear direct benefits to the company, should reflect the charitablepreferencesofownersratherthanthoseofofficersanddirectors.

On September 30, 1981 Berkshire received a tax ruling from the U.S.TreasuryDepartmentthat,inmostyears,shouldproduceasignificantbenefitforcharitiesofyourchoice.

Each Berkshire shareholder—on a basis proportional to the number ofshares of Berkshire that he owns—will be able to designate recipients ofcharitablecontributionsbyourcompany.You’llnamethecharity;Berkshirewillwritethecheck.Therulingstatesthattherewillbenopersonaltaxconsequencestoourshareholdersfrommakingsuchdesignations.

Thus, our owners now can exercise a perquisite that, although routinelyexercised by the owners in closely-held businesses, is almost exclusivelyexercisedbythemanagersinmorewidely-heldbusinesses.

Inawidely-heldcorporationtheexecutivesordinarilyarrangeallcharitabledonations,withnoinputatallfromshareholders,intwomaincategories:

(1)Donations considered tobenefit the corporationdirectly in an amountroughlycommensuratewiththecostofthedonation;and

(2)Donationsconsideredtobenefitthecorporationindirectlythroughhard-to-measure,long-delayedfeedbackeffectsofvariouskinds.

I and other Berkshire executives have arranged in the past, as we willarrangeinthefuture,allcharitabledonationsinthefirstcategory.However,theaggregate levelofgiving in suchcategoryhasbeenquite low, andvery likelywillremainquitelow,becausenotmanygiftscanbeshowntoproduceroughlycommensuratedirectbenefitstoBerkshire.

Inthesecondcategory,Berkshire’scharitablegiftshavebeenvirtuallynil,becauseIamnotcomfortablewithordinarycorporatepracticeandhadnobetterpracticetosubstitute.Whatbothersmeaboutordinarycorporatepracticeis thewaygiftstendtobemadebasedmoreonwhodoestheaskingandhowcorporatepeers are responding than on an objective evaluation of the donee’s activities.Conventionalityoftenoverpowersrationality.

Acommon result is theuseof the stockholder’smoney to implement thecharitable inclinations of the corporate manager, who usually is heavilyinfluenced by specific social pressures on him. Frequently there is an addedincongruity; many corporatemanagers deplore governmental allocation of thetaxpayer’s dollar but embrace enthusiastically their own allocation of theshareholder’sdollar.

ForBerkshire,adifferentmodelseemsappropriate.JustasIwouldn’twantyou to implement your personal judgments by writing checks on my bankaccount for charities of your choice, I feel it inappropriate towrite checks onyour corporate “bank account” for charities of my choice. Your charitablepreferences are as good asmine and, for both you andme, funds available tofoster charitable interests in a tax-deductible manner reside largely at thecorporatelevelratherthaninourownhands.

Undersuchcircumstances,IbelieveBerkshireshouldimitatemoreclosely-heldcompanies,not largerpubliccompanies. Ifyouand Ieachown50%ofacorporation, our charitable decision making would be simple. Charities verydirectly related to theoperationsof thebusinesswouldhavefirstclaimonouravailablecharitable funds.Anybalanceavailableafter the“operations-related”contributionswouldbedividedamongvariouscharitableinterestsofthetwoofus,onabasisroughlyproportionaltoourownershipinterest.Ifthemanagerofour company had some suggestions, we would listen carefully—but the finaldecision would be ours. Despite our corporate form, in this aspect of thebusinessweprobablywouldbehaveasifwewereapartnership.

Wherever feasible, I believe in maintaining such a partnership frame of

mind, even thoughweoperate through a large, fairlywidely-held corporation.OurTreasuryrulingwillallowsuchpartnership-likebehaviorinthisarea.

I am pleased that Berkshire donations can become owner-directed. It isironic, but understandable, that a large and growing number of majorcorporations have charitable policies pursuant to which they will match giftsmadebytheiremployees(and—braceyourselffor thisone—manyevenmatchgifts made by directors) but none, to my knowledge, has a plan matchingcharitablegiftsbyowners.Isay“understandable”becausemuchofthestockofmanylargecorporationsisownedona“revolvingdoor”basisbyinstitutionsthathave short-term investment horizons, and that lack a long-term owner’sperspective.

Ourownshareholdersareadifferentbreed.[A]ttheendofeachyear,morethan 98% of our shares are owned by people who were shareholders at thebeginning of the year. This long-term commitment to the business reflects anownermentalitywhich,asyourmanager,Iintendtoacknowledgeinallfeasibleways.Thedesignatedcontributionspolicyisanexampleofthatintent.

Our new program enabling shareholders to designate the recipients ofcorporatecharitablecontributionswasgreetedwithextraordinaryenthusiasm.Of932,206 shares eligible for participation (shareswhere the name of the actualowner appearedonour stockholder record),95.6% responded.EvenexcludingBuffett-relatedshares,theresponsetopped90%.

Inaddition,more than3%ofourshareholdersvoluntarilywrote lettersornotes,allbutoneapprovingoftheprogram.Boththelevelofparticipationandofcommentarysurpassanyshareholderresponsewehavewitnessed,evenwhensuch responsehasbeen intensivelysolicitedbycorporatestaffandhighly-paidprofessional proxy organizations. In contrast, your extraordinary level ofresponse occurred without even the nudge of a company-provided returnenvelope.Thisself-propelledbehaviorspeakswellfortheprogram,andspeakswellforourshareholders.

Apparently the owners of our corporation like both possessing andexercisingtheabilitytodeterminewheregiftsoftheirfundsshallbemade.The“father-knows-best”schoolofcorporategovernancewillbesurprisedtofindthatnone of our shareholders sent in a designation sheetwith instructions that theofficersofBerkshire—in their superiorwisdom,ofcourse—make thedecisionon charitable funds applicable to his shares. Nor did anyone suggest that hisshare of our charitable funds be used to match contributions made by ourcorporatedirectors tocharitiesof thedirectors’choice (apopular,proliferating

andnon-publicizedpolicyatmanylargecorporations).Alltold,$1,783,655ofshareholder-designedcontributionsweredistributed

toabout675charities.Inaddition,Berkshireandsubsidiariescontinuetomakecertain contributions pursuant to local level decisions made by our operatingmanagers.

There will be some years, perhaps two or three out of ten, whencontributionsbyBerkshirewillproducesubstandardtaxdeductions—ornoneatall. In those years we will not effect our shareholder-designated charitableprogram.Inallotheryearsweexpect to informyouaboutOctober10thof theamount per share that you may designate. A reply form will accompany thenotice, and you will be given about three weeks to respond with yourdesignation.

Thedesignated-contributions idea, alongwithmanyother ideas that haveturned out well for us, was conceived by CharlieMunger, Vice Chairman ofBerkshire.Irrespectiveoftitles,CharlieandIworkaspartnersinmanagingallcontrolledcompanies.Toalmostasinfuldegree,weenjoyourworkasmanagingpartners.Andweenjoyhavingyouasourfinancialpartners.

In addition to the shareholder-designated contributions that Berkshiredistributes,managersofouroperatingbusinessesmakecontributions,includingmerchandise,averaging[between$1.5millionand$2.5million]annually.Thesecontributions support local charities, such as The United Way, and produceroughlycommensuratebenefitsforourbusinesses.

However, neither our operating managers nor officers of the parentcompanyuseBerkshirefundstomakecontributionstobroadnationalprogramsorcharitableactivitiesofspecialpersonal interest to them,except to theextenttheydosoasshareholders.Ifyouremployees,includingyourCEO,wishtogiveto their alma maters or other institutions to which they feel a personalattachment,webelievetheyshouldusetheirownmoney,notyours.

Let me add that our program is easy to administer. Last fall, for twomonths,weborrowedonepersonfromNationalIndemnitytohelpusimplementtheinstructionsthatcamefromour7,500registeredshareholders.I’dguessthattheaveragecorporateprogram inwhichemployeegiftsarematched incurs fargreater administrative costs. Indeed, our entire corporate overhead is less thanhalfthesizeofourcharitablecontributions.(Charlie,however,insiststhatItellyouthat$1.4millionofour$4.9millionoverheadisattributabletoourcorporatejet,TheIndefensible.)11

Below is a list showing the largest categories to which our shareholdershavesteeredtheircontributions.

(a)347churchesandsynagoguesreceived569gifts(b)238collegesanduniversitiesreceived670gifts(c) 244 K-12 schools (about two-thirds secular, one-third religious)received525gifts(d)288institutionsdedicatedtoart,cultureorthehumanitiesreceived447gifts(e) 180 religious social-service organizations (split about equallybetweenChristianandJewish)received411gifts(f)445secularsocial-serviceorganizations(about40%youth-related)received759gifts(g)153hospitalsreceived261gifts(h) 186 health-related organizations (American Heart Association,AmericanCancerSociety,etc.)received320gifts

Three things about this list seem particularly interesting to me. First, tosome degree it indicateswhat people choose to givemoney towhen they areactingoftheirownaccord,freeofpressurefromsolicitorsoremotionalappealsfromcharities.Second, the contributionsprogramsof publicly-held companiesalmost never allow gifts to churches and synagogues, yet clearly theseinstitutions arewhatmany shareholderswould like to support.Third, thegiftsmade by our shareholders display conflicting philosophies: 130 gifts weredirected toorganizations that believe inmakingabortions readily available forwomen and 30 gifts were directed to organizations (other than churches) thatdiscourageorareopposedtoabortion.

LastyearItoldyouthatIwasthinkingofraisingtheamountthatBerkshireshareholderscangiveunderourdesignated-contributionsprogramandaskedforyourcomments.Wereceivedafewwell-writtenlettersopposingtheentireidea,on thegrounds that itwasour job to run thebusinessandnotour job to forceshareholdersintomakingcharitablegifts.Mostof theshareholdersresponding,however, noted the tax efficiency of the plan and urged us to increase thedesignatedamount.Severalshareholderswhohavegivenstocktotheirchildrenorgrandchildrentoldmethattheyconsidertheprogramaparticularlygoodwayto get youngsters thinking at an early age about the subject of giving. Thesepeople, in otherwords, perceive the program to be an educational, aswell asphilanthropic,tool.Thebottomlineisthatwedidraisetheamountin1993,from$8pershareto$10.

We reluctantly terminated the [shareholder-designated contribution]programin2003becauseofcontroversyovertheabortionissue.Overtheyearsnumerousorganizationsonbothsidesof this issuehadbeendesignatedbyourshareholders to receive contributions.As a result,we regularly received someobjectionstothegiftsdesignatedforpro-choiceoperations.Afewofthesecamefrom people and organizations that proceeded to boycott products of oursubsidiaries.

In2003,manyindependentassociatesofThePamperedChefbegantofeeltheboycotts.Thisdevelopmentmeantthatpeoplewhotrustedus—butwhowereneither employees of ours nor had a voice in Berkshire decision-making—sufferedseriouslossesofincome.

For our shareholders, therewas somemodest tax efficiency in Berkshiredoing the giving rather than theirmaking their gifts directly.Additionally, theprogramwasconsistentwithour“partnership”approach.But theseadvantagespaledwhentheyweremeasuredagainstdamagedoneloyalassociateswhohadwithgreatpersonaleffortbuiltbusinessesoftheirown.Indeed,CharlieandIseenothingcharitable inharmingdecent,hardworkingpeoplejustsoweandothershareholderscangainsomeminortaxefficiencies.

Berkshire nowmakes no contributions at the parent company level. Ourvarioussubsidiariesfollowphilanthropicpoliciesconsistentwiththeirpracticesprior to their acquisition by Berkshire, except that any personal contributionsthat formerownershadearliermade from their corporatepocketbookarenowfundedbythempersonally.12

F.APrincipledApproachtoExecutivePay13

When returns on capital are ordinary, an earn-more-by-putting-up-morerecord is no great managerial achievement. You can get the same resultpersonallywhile operating fromyour rocking chair. Just quadruple the capitalyou commit to a savings account and you will quadruple your earnings. Youwould hardly expect hosannas for that particular accomplishment. Yet,retirement announcements regularly sing the praises of CEOs who have, say,quadrupled earnings of theirwidget companyduring their reign—with no oneexaminingwhether thisgainwasattributablesimply tomanyyearsof retainedearningsandtheworkingsofcompoundinterest.

If the widget company consistently earned a superior return on capitalthroughout the period, or if capital employed only doubled during the CEO’sreign, the praise for him may be well deserved. But if return on capital was

lacklusterandcapitalemployedincreasedinpacewithearnings,applauseshouldbewithheld.Asavingsaccountinwhichinterestwasreinvestedwouldachievethe same year-by-year increase in earnings—and, at only 8% interest, wouldquadrupleitsannualearningsin18years.

The power of this simple math is often ignored by companies to thedetriment of their shareholders. Many corporate compensation plans rewardmanagershandsomelyforearningsincreasesproducedsolely,orinlargepart,byretainedearnings—i.e., earningswithheld fromowners.For example, ten-year,fixed-price stock options are granted routinely, often by companies whosedividendsareonlyasmallpercentageofearnings.

Anexamplewillillustratetheinequitiespossibleundersuchcircumstances.Let’ssupposethatyouhada$100,000savingsaccountearning8%interestand“managed”byatrusteewhocoulddecideeachyearwhatportionoftheinterestyouweretobepaidincash.Interestnotpaidoutwouldbe“retainedearnings”addedtothesavingsaccounttocompound.Andlet’ssupposethatyourtrustee,in his superior wisdom, set the “pay-out ratio” at one-quarter of the annualearnings.

Undertheseassumptions,youraccountwouldbeworth$179,084attheendoftenyears.Additionally,yourannualearningswouldhaveincreasedabout70%from $8,000 to $13,515 under this inspired management. And, finally, your“dividends”wouldhaveincreasedcommensurately,risingregularlyfrom$2,000in the first year to $3,378 in the tenth year. Each year, when yourmanager’spublic relations firmpreparedhisannual report toyou,allof thechartswouldhavehadlinesmarchingskyward.

Now, just for fun, let’spushourscenarioonenotchfurtherandgiveyourtrustee-manager a ten-year fixed-price option on part of your “business” (i.e.,your savings account) based on its fair value in the first year. With such anoption,yourmanagerwouldreapasubstantialprofitatyourexpense—justfromhavingheldontomostofyourearnings.IfhewerebothMachiavellianandabitofamathematician,yourmanagermightalsohavecutthepay-outratiooncehewasfirmlyentrenched.

Thisscenarioisnotasfarfetchedasyoumightthink.Manystockoptionsinthecorporateworldhaveworkedinexactlythatfashion:theyhavegainedinvalue simply because management retained earnings, not because it did wellwiththecapitalinitshands.

Managers actually apply a double standard to options. Leaving asidewarrants (which deliver the issuing corporation immediate and substantialcompensation),Ibelieveitisfairtosaythatnowhereinthebusinessworldareten-year, fixed-price options on all or a portion of a business granted to

outsiders. Ten months, in fact, would be regarded as extreme. It would beparticularlyunthinkableformanagerstograntalong-termoptiononabusinessthatwasregularlyaddingtoitscapital.Anyoutsiderwantingtosecuresuchanoptionwouldberequiredtopayfullyforcapitaladdedduringtheoptionperiod.

The unwillingness of managers to do-unto-outsiders, however, is notmatchedbyanunwillingnesstodo-unto-themselves.(Negotiatingwithone’sselfseldomproducesabarroombrawl.)Managersregularlyengineerten-year,fixed-priceoptionsforthemselvesandassociatesthat,first,totallyignorethefactthatretainedearningsautomaticallybuildvalueand,second,ignorethecarryingcostofcapital.Asaresult,thesemanagersendupprofitingmuchastheywouldhavehadtheyhadanoptiononthatsavingsaccountthatwasautomaticallybuildingupinvalue.

Of course, stockoptionsoftengo to talented, value-addingmanagers andsometimes deliver them rewards that are perfectly appropriate. (Indeed,managers who are really exceptional almost always get far less than theyshould.) But when the result is equitable, it is accidental. Once granted, theoption is blind to individual performance. Because it is irrevocable andunconditional(solongasamanagerstaysinthecompany),thesluggardreceivesrewards from his options precisely as does the star. A managerial Rip VanWinkle, ready to doze for ten years, could not wish for a better “incentive”system.

(Ican’tresistcommentingononelong-termoptiongivenan“outsider”:thatgrantedtheU.S.GovernmentonChryslersharesaspartialconsiderationforthegovernment’sguaranteeof some life-saving loans.When theseoptionsworkedoutwellforthegovernment,Chryslersoughttomodifythepayoff,arguingthattherewardstothegovernmentwerebothfargreaterthanintendedandoutsize[d]in relation to its contribution to Chrysler’s recovery. The company’s anguishover what it saw as an imbalance between payoff and performance madenationalnews.Thatanguishmaywellbeunique:tomyknowledge,nomanagers—anywhere—havebeensimilarlyoffendedbyunwarrantedpayoffsarisingfromoptionsgrantedtothemselvesortheircolleagues.)

Ironically,therhetoricaboutoptionsfrequentlydescribesthemasdesirablebecausetheyputmanagersandownersinthesamefinancialboat.Inreality,theboatsare fardifferent.Noownerhaseverescaped theburdenofcapital costs,whereasaholderofafixed-priceoptionbearsnocapitalcostsatall.Anownermust weigh upside potential against downside risk; an option holder has nodownside. In fact, the business project in which you would wish to have anoption frequently is a project in which you would reject ownership. (I’ll behappytoacceptalotteryticketasagift—butI’llneverbuyone.)

In dividend policy also, the option holders’ interests are best served by apolicythatmayillservetheowner.Thinkbacktothesavingsaccountexample.The trustee, holding his option, would benefit from a no-dividend policy.Conversely,theowneroftheaccountshouldleantoatotalpayoutsothathecanprevent the option-holding manager from sharing in the account’s retainedearnings.14

Despite their shortcomings, options can be appropriate under somecircumstances. My criticism relates to their indiscriminate use and, in thatconnection,Iwouldliketoemphasizethreepoints:

First, stock options are inevitably tied to the overall performance of acorporation.Logically,therefore,theyshouldbeawardedonlytothosemanagerswithoverallresponsibility.Managerswithlimitedareasofresponsibilityshouldhave incentives thatpayoff in relation to resultsunder their control.The .350hitterexpects,andalsodeserves,abigpayoff forhisperformance—even ifheplaysforacellar-dwellingteam.Andthe.150hittershouldgetnoreward—evenifheplays forapennantwinner.Only thosewithoverall responsibility for theteamshouldhavetheirrewardstiedtoitsresults.

Second,optionsshouldbestructuredcarefully.Absentspecialfactors,theyshouldhavebuilt intothemaretained-earningsorcarrying-costfactor.Equallyimportant, they should be priced realistically.When managers are faced withoffers for their companies, they unfailingly point out how unrealistic marketprices can be as an index of real value. But why, then, should these samedepressed prices be the valuations at which managers sell portions of theirbusinesses to themselves? (They may go further: officers and directorssometimes consult theTaxCode to determine the lowest prices atwhich theycan,ineffect,sellpartofthebusinesstoinsiders.Whilethey’reatit,theyoftenelectplansthatproducetheworsttaxresultforthecompany.)Exceptinhighlyunusualcases,ownersarenotwellservedbythesaleofpartoftheirbusinessata bargain price—whether the sale is to outsiders or to insiders. The obviousconclusion:optionsshouldbepricedattruebusinessvalue.

Third,IwanttoemphasizethatsomemanagerswhomIadmireenormously—and whose operating records are far better than mine—disagree with meregardingfixed-priceoptions.Theyhavebuiltcorporateculturesthatwork,andfixed-priceoptionshavebeena tool thathelped them.By their leadershipandexample, and by the use of options as incentives, thesemanagers have taughttheir colleagues to think likeowners.Suchaculture is rareandwhen it existsshould perhaps be left intact—despite inefficiencies and inequities that mayinfesttheoptionprogram.“Ifitain’tbroke,don’tfixit”ispreferableto“purityatanyprice.”

Take, for instance, ten year, fixed-price options (and who wouldn’t?). IfFredFutile,CEOofStagnant,Inc.,receivesabundleofthese—let’ssayenoughto give him an option on 1% of the company—his self-interest is clear: Heshouldskipdividendsentirelyandinsteaduseallofthecompany’searningstorepurchasestock.

Let’sassumethatunderFred’sleadershipStagnantlivesuptoitsname.Ineachofthetenyearsaftertheoptiongrant,itearns$1billionon$10billionofnetworth,whichinitiallycomesto$10pershareonthe100millionsharesthenoutstanding. Fred eschews dividends and regularly uses all earnings torepurchaseshares.Ifthestockconstantlysellsattentimesearningspershare,itwill have appreciated 158% by the end of the option period. That’s becauserepurchaseswouldreducethenumberofsharesto38.7millionbythattime,andearnings per share would thereby increase to $25.80. Simply by withholdingearningsfromowners,Fredgetsveryrich,makingacool$158million,despitethe business itself improving not at all. Astonishingly, Fred could havemademorethan$100millionifStagnant’searningshaddeclinedby20%during theten-yearperiod.

Fredcanalsogetasplendidresultforhimselfbypayingnodividendsanddeploying the earnings he withholds from shareholders into a variety ofdisappointingprojectsandacquisitions.Eveniftheseinitiativesdeliverapaltry5%return,Fredwillstillmakeabundle.Specifically—withStagnant’sp/eratioremaining unchanged at ten—Fred’s option will deliver him $63 million.Meanwhile, his shareholderswillwonderwhat happened to the “alignment ofinterests”thatwassupposedtooccurwhenFredwasissuedoptions.

A“normal”dividendpolicy,ofcourse—one-thirdofearningspaidout,forexample—produces less extreme results but still can provide lush rewards formanagerswhoachievenothing.

CEOsunderstandthismathandknowthateverydimepaidoutindividendsreduces the value of all outstanding options. I’ve never, however, seen thismanager-ownerconflictreferencedinproxymaterialsthatrequestapprovalofafixed-pricedoptionplan.ThoughCEOsinvariablypreachinternallythatcapitalcomesatacost,theysomehowforgettotellshareholdersthatfixed-priceoptionsgivethemcapitalthatisfree.

Itdoesn’thavetobethisway:It’schild’splayforaboardtodesignoptionsthatgiveeffecttotheautomaticbuild-upinvaluethatoccurswhenearningsareretained.But—surprise,surprise—optionsof thatkindarealmostnever issued.Indeed, the very thought of options with strike prices that are adjusted forretainedearningsseemsforeigntocompensation“experts,”whoarenevertheless

encyclopedicabouteverymanagement-friendlyplanthatexists.(“WhosebreadIeat,hissongIsing.”)

Getting fired can produce a particularly bountiful payday for a CEO.Indeed,hecan“earn”moreinthatsingleday,whilecleaningouthisdesk,thananAmericanworkerearnsinalifetimeofcleaningtoilets.Forgettheoldmaximaboutnothingsucceedinglikesuccess:Today,intheexecutivesuite,thealltoo-prevalentruleisthatnothingsucceedslikefailure.

At Berkshire, however, we use an incentive-compensation system thatrewardskeymanagersformeetingtargetsintheirownbailiwicks.IfSee’sdoeswell,thatdoesnotproduceincentivecompensationattheNews—norviceversa.NeitherdowelookatthepriceofBerkshirestockwhenwewritebonuschecks.WebelievegoodunitperformanceshouldberewardedwhetherBerkshirestockrises, falls,orstayseven.Similarly,wethinkaverageperformanceshouldearnnospecialrewardsevenifourstockshouldsoar.“Performance”,furthermore,isdefined in different ways depending upon the underlying economics of thebusiness: in some our managers enjoy tailwinds not of their own making, inotherstheyfightunavoidableheadwinds.

Therewardsthatgowiththissystemcanbelarge.Atourvariousbusinessunits,topmanagerssometimesreceiveincentivebonusesoffivetimestheirbasesalary,ormore,anditwouldappearpossiblethatonemanager’sbonuscouldtop$2 million in 1986. (I hope so.) We do not put a cap on bonuses, and thepotentialforrewardsisnothierarchical.Themanagerofarelativelysmallunitcanearnfarmorethanthemanagerofalargerunitifresultsindicateheshould.We believe, further, that such factors as seniority and age should not affectincentivecompensation(thoughtheysometimesinfluencebasiccompensation.)A20year-oldwhocanhit.300isasvaluabletousasa40year-oldperformingaswell.

Obviously, all Berkshire managers can use their bonus money (or otherfunds, includingborrowedmoney) tobuyour stock in themarket.Manyhavedonejustthat—andsomenowhavelargeholdings.Byacceptingboththerisksandthecarryingcostthatgowithoutrightpurchases,thesemanagerstrulywalkintheshoesofowners.

AtBerkshire,we try tobeas logicalaboutcompensationasaboutcapitalallocation.Forexample,wecompensateRalphScheybasedupontheresultsofScottFetzerratherthanthoseofBerkshire.Whatcouldmakemoresense,sincehe’s responsible for one operation but not the other?A cash bonus or a stock

optiontiedtothefortunesofBerkshirewouldprovidetotallycapriciousrewardsto Ralph. He could, for example, be hitting home runs at Scott Fetzer whileCharlieandI rangupmistakesatBerkshire, therebynegatinghiseffortsmanytimes over.Conversely,why should option profits or bonuses be heaped uponRalphifgoodthingsareoccurringinotherpartsofBerkshirebutScottFetzerislagging?

In setting compensation,we like toholdout thepromiseof large carrots,butmakesuretheirdeliveryistieddirectlytoresultsintheareathatamanagercontrols. When capital invested in an operation is significant, we also bothchargemanagersahighrateforincrementalcapitaltheyemployandcreditthematanequallyhighrateforcapitaltheyrelease.

Theproductofthismoney’s-not-freeapproachisdefinitelyvisibleatScottFetzer.IfRalphcanemployincrementalfundsatgoodreturns,itpayshimtodoso:Hisbonusincreaseswhenearningsonadditionalcapitalexceedameaningfulhurdle charge. But our bonus calculation is symmetrical: If incrementalinvestmentyieldssubstandardreturns,theshortfalliscostlytoRalphaswellastoBerkshire.Theconsequenceofthistwo-wayarrangementisthatitpaysRalph—andpayshimwell—tosendtoOmahaanycashhecan’tadvantageouslyuseinhisbusiness.

It has become fashionable at public companies to describe almost everycompensation plan as aligning the interests of management with those ofshareholders. Inourbook,alignmentmeansbeingapartner inbothdirections,notjustontheupside.Many“alignment”plansflunkthisbasictest,beingartfulformsof“headsIwin,tailsyoulose.”

A common form of misalignment occurs in the typical stock optionarrangement, which does not periodically increase the option price tocompensateforthefactthatretainedearningsarebuildingupthewealthofthecompany.Indeed,thecombinationofaten-yearoption,alowdividendpayout,and compound interest can provide lush gains to amanagerwho has done nomorethantreadwaterinhisjob.Acynicmightevennotethatwhenpaymentstoownersarehelddown,theprofittotheoption-holdingmanagerincreases.Ihaveyettoseethisvitalpointspelledoutinaproxystatementaskingshareholderstoapproveanoptionplan.

I can’t resist mentioning that our compensation arrangement with RalphScheywasworkedoutinaboutfiveminutes,immediatelyuponourpurchaseofScottFetzerandwithoutthe“help”oflawyersorcompensationconsultants.Thisarrangementembodiesa fewverysimple ideas—not thekindof termsfavoredbyconsultantswhocannoteasilysenda largebillunless theyhaveestablishedthat you have a large problem (and one, of course, that requires an annual

review).Our agreementwithRalph has never been changed. Itmade sense tohimandtomein1986,anditmakessensenow.Ourcompensationarrangementswiththemanagersofallourotherunitsaresimilarlysimple,thoughthetermsofeachagreementvarytofittheeconomiccharacteristicsofthebusinessatissue,theexistenceinsomecasesofpartialownershipoftheunitbymanagers,etc.

In all instances, we pursue rationality. Arrangements that pay off incapriciousways,unrelatedtoamanager’spersonalaccomplishments,maywellbewelcomedbycertainmanagers.Who,afterall, refusesa free lottery ticket?But such arrangements arewasteful to the companyandcause themanager tolose focusonwhat shouldbehis realareasofconcern.Additionally, irrationalbehaviorattheparentmaywellencourageimitativebehavioratsubsidiaries.

AtBerkshire,onlyCharlieandIhavethemanagerialresponsibilityfortheentire business. Therefore, we are the only parties who should logically becompensatedonthebasisofwhattheenterprisedoesasawhole.Evenso,thatisnotacompensationarrangementwedesire.Wehavecarefullydesignedboththecompany and our jobs so that we do things we enjoy with people we like.Equallyimportant,weareforcedtodoveryfewboringorunpleasanttasks.Wearethebeneficiariesaswelloftheabundantarrayofmaterialandpsychicperksthat flow to theheadsofcorporations.Undersuch idyllicconditions,wedon’texpect shareholders to ante up loads of compensation for which we have nopossibleneed.

Indeed,ifwewerenotpaidatall,CharlieandIwouldbedelightedwiththecushy jobswe hold.At bottom,we subscribe toRonaldReagan’s creed: “It’sprobably true that hard work never killed anyone, but I figure why take thechance.”

We made a sizable acquisition in 1991—the H.H. Brown Shoe Co., theleading North American manufacturer of work shoes and boots, and it has ahistoryofearningunusuallyfinemarginsonsalesandassets.Shoesareatoughbusiness—of the billion pairs purchased in theUnited States each year, about85%areimported—andmostmanufacturersintheindustrydopoorly.Thewiderange of styles and sizes that producers offer causes inventories to be heavy;substantialcapitalisalsotiedupinreceivables.

Adistinguishing characteristic ofH.H.Brown is oneof themost unusualcompensation systems I’ve encountered—but one that warms my heart: Anumberofkeymanagersarepaidanannualsalaryof$7,800,towhichisaddedadesignatedpercentageoftheprofitsofthecompanyafterthesearereducedbyachargeforcapitalemployed.Thesemanagers thereforetrulystandintheshoes

of owners. In contrast, most managers talk the talk but don’t walk the walk,choosing instead to employcompensation systems that are longoncarrotsbutshortonsticks(andthatalmostinvariablytreatequitycapitalasifitwerecost-free).ThearrangementatBrown,inanycase,hasservedboththecompanyanditsmanagersexceptionallywell,whichshouldbenosurprise:Managerseagertobetheavilyontheirabilitiesusuallyhaveplentyofabilitytobeton.

It’s understandable how [CEO] pay got out of hand.When managementhires employees, or when companies bargain with a vendor, the intensity ofinterestisequalonbothsidesofthetable.Oneparty’sgainistheotherparty’sloss,andthemoneyinvolvedhasrealmeaningtoboth.Theresultisanhonest-to-Godnegotiation.

But when CEOs (or their representatives) have met with compensationcommittees, toooftenoneside—theCEO’s—hascaredfarmorethantheotherabout what bargain is struck. A CEO, for example, will always regard thedifference between receiving options for 100,000 shares or for 500,000 asmonumental. To a comp committee, however, the difference may seemunimportant—particularly if, as has been the case at most companies, neithergrant will have any effect on reported earnings. Under these conditions, thenegotiationoftenhasa“play-money”quality.

Overreaching byCEOs greatly accelerated in the 1990s as compensationpackages gained by themost avaricious—a title forwhich therewas vigorouscompetition—were promptly replicated elsewhere. The couriers for thisepidemic of greedwere usually consultants and human relations departments,whichhadnotroubleperceivingwhobutteredtheirbread.Asonecompensationconsultant commented: “There are two classes of clients you don’t want tooffend—actualandpotential.”

Inrecentyearscompensationcommitteestoooftenhavebeentail-waggingpuppy dogs meekly following recommendations by consultants, a breed notknown for allegiance to the faceless shareholders who pay their fees. (If youcan’t tell whose side someone is on, they are not on yours.) True, eachcommitteeisrequiredbytheSECtostateitsreasoningaboutpayintheproxy.But thewords are usually boilerplatewritten by the company’s lawyers or itshuman-relationsdepartment.

This costly charade should cease. Directors should not serve oncompensationcommitteesunless theyare themselvescapableofnegotiatingonbehalfofowners.Theyshouldexplainbothhowtheythinkaboutpayandhow

theymeasure performance.Dealingwith shareholders’money,moreover, theyshouldbehaveastheywouldwereittheirown.

In the 1890s, Samuel Gompers described the goal of organized labor as“More!”Inthe1990s,America’sCEOsadoptedhisbattlecry.TheupshotisthatCEOs have often amassed riches while their shareholders have experiencedfinancialdisasters.

Directorsshouldstopsuchpiracy.There’snothingwrongwithpayingwellfor trulyexceptionalbusinessperformance.But, foranythingshortof that, it’stimefordirectors toshout“Less!” Itwouldbea travesty if thebloatedpayofrecent years became a baseline for future compensation. Compensationcommitteesshouldgobacktothedrawingboards.

G.Risk,ReputationandOversight15

CharlieandIbelievethataCEOmustnotdelegateriskcontrol.It’ssimplytoo important. At Berkshire, [for example,] I both initiate and monitor everyderivatives contract on our books, with the exception of operations-relatedcontracts at a few of our subsidiaries, such as MidAmerican, and the minorrunoff contracts atGeneralRe. IfBerkshire evergets in trouble, itwill bemyfault. It will not be because of misjudgments made by a Risk Committee orChiefRiskOfficer.

Inmyviewaboardofdirectorsofahugefinancialinstitutionisderelictifitdoes not insist that its CEO bear full responsibility for risk control. If he’sincapableofhandlingthatjob,heshouldlookforotheremployment.Andifhefails at it—with the government thereupon required to step in with funds orguarantees—thefinancialconsequencesforhimandhisboardshouldbesevere.

Ithasnotbeen shareholderswhohavebotched theoperationsof someofourcountry’slargestfinancialinstitutions.Yettheyhavebornetheburden,with90%ormoreof thevalueof theirholdingswipedout inmostcasesof failure.Collectively, they have lost more than $500 billion in just the four largestfinancial fiascosof the last twoyears.Tosay theseownershavebeen“bailed-out”istomakeamockeryoftheterm.

The CEOs and directors of the failed companies, however, have largelygoneunscathed.Theirfortunesmayhavebeendiminishedbythedisasterstheyoversaw,buttheystill liveingrandstyle.It is thebehavioroftheseCEOsanddirectors that needs to be changed: If their institutions and the country areharmed by their recklessness, they should pay a heavy price—one notreimbursablebythecompaniesthey’vedamagednorbyinsurance.CEOsand,in

many cases, directors have long benefitted from oversized financial carrots;somemeaningfulsticksnowneedtobepartoftheiremploymentpictureaswell.

[The 2010 annual report included the following dated July 26, 2010 toBerkshire’smanagers.]ThisismybienniallettertoreemphasizeBerkshire’stoppriority [which] is that all of us continue to zealously guard Berkshire’sreputation.Wecan’tbeperfectbutwecantrytobe.AsI’vesaidinthesememosformorethan25years:“Wecanaffordtolosemoney—evenalotofmoney.Butwe can’t afford to lose reputation—even a shred of reputation.” We mustcontinue tomeasureeveryact againstnotonlywhat is legalbut alsowhatwewouldbehappytohavewrittenaboutonthefrontpageofanationalnewspaperinanarticlewrittenbyanunfriendlybutintelligentreporter.

Sometimes your associates will say “Everybody else is doing it.” Thisrationaleisalmostalwaysabadoneifitisthemainjustificationforabusinessaction. It is totally unacceptablewhen evaluating amoral decision.Wheneversomebody offers that phrase as a rationale, in effect they are saying that theycan’tcomeupwithagoodreason.Ifanyonegivesthisexplanation,tellthemtotryusingitwithareporterorajudgeandseehowfaritgetsthem.

Ifyouseeanythingwhoseproprietyor legalitycausesyou tohesitate,besuretogivemeacall.However,it’sverylikelythatifagivencourseofactionevokes such hesitation, it’s too close to the line and should be abandoned.There’splentyofmoneytobemadeinthecenterofthecourt.Ifit’squestionablewhethersomeactionisclosetotheline,justassumeitisoutsideandforgetit.

Asacorollary,letmeknowpromptlyifthere’sanysignificantbadnews.Ican handle bad news but I don’t like to deal with it after it has festered forawhile. A reluctance to face up immediately to bad news is what turned aproblematSalomonfromonethatcouldhaveeasilybeendisposedofintoonethatalmostcausedthedemiseofafirmwith8,000employees.

SomebodyisdoingsomethingtodayatBerkshirethatyouandIwouldbeunhappyabout ifweknewof it.That’s inevitable:Wenowemploymore than250,000peopleandthechancesofthatnumbergettingthroughthedaywithoutanybadbehavioroccurringisnil.Butwecanhaveahugeeffectinminimizingsuchactivitiesby jumpingonanything immediatelywhen there is theslightestodor of impropriety. Your attitude on such matters, expressed by behavior aswell as words, will be the most important factor in how the culture of yourbusiness develops. Culture, more than rule books, determines how anorganizationbehaves.

Inotherrespects,talktomeaboutwhatisgoingonaslittleorasmuchas

youwish.Eachofyoudoesafirst-classjobofrunningyouroperationwithyourownindividualstyleandyoudon’tneedmetohelp.Theonlyitemsyouneedtoclear with me are any changes in post-retirement benefits and any unusuallylargecapitalexpendituresoracquisitions.

Audit committees can’t audit. Only a company’s outside auditor candeterminewhether the earnings that amanagement purports to havemade aresuspect.Reformsthat ignore this realityandthat insteadfocuson thestructureand charter of the audit committee will accomplish little. The key job of theauditcommitteeissimplytogettheauditorstodivulgewhattheyknow.

Todothisjob,thecommitteemustmakesurethattheauditorsworrymoreaboutmisleadingitsmembersthanaboutoffendingmanagement.Inrecentyearsauditors have not felt thatway.Theyhave instead generally viewed theCEO,ratherthantheshareholdersordirectors,astheirclient.Thathasbeenanaturalresult of day-to-day working relationships and also of the auditors’understanding that,nomatterwhat thebooksays, theCEOandCFOpay theirfeesanddeterminewhethertheyareretainedforbothauditingandotherwork.

Therulesthathavebeenrecentlyinstituted[requiringcommitteememberstohavefinancialexpertise]won’tmateriallychangethisreality.Whatwillbreakthiscozyrelationshipisauditcommitteesunequivocallyputtingauditorsonthespot, making them understand they will become liable for major monetarypenaltiesiftheydon’tcomeforthwithwhattheyknoworsuspect.

Inmyopinion, audit committees canaccomplish thisgoalbyasking fourquestionsofauditors, theanswers towhichshouldberecordedandreportedtoshareholders.Thesequestionsare:

1. If theauditorwere solely responsible forpreparationof thecompany’sfinancialstatements,wouldtheyhaveinanywaybeenprepareddifferentlyfromthemannerselectedbymanagement?Thisquestionshouldcoverbothmaterialand non-material differences. If the auditor would have done somethingdifferently, bothmanagement’s argument and the auditor’s response should bedisclosed.Theauditcommitteeshouldthenevaluatethefacts.

2.Iftheauditorwereaninvestor,wouldhehavereceived—inplainEnglish—the information essential to his understanding the company’s financialperformanceduringthereportingperiod?

3. Is thecompanyfollowing thesame internalauditprocedure thatwouldbefollowediftheauditorhimselfwereCEO?Ifnot,whatarethedifferencesandwhy?

4.Is theauditorawareofanyactions—eitheraccountingoroperational—

thathavehadthepurposeandeffectofmovingrevenuesorexpensesfromonereportingperiodtoanother?

If theauditcommitteeasks thesequestions, itscomposition—thefocusofmostreforms—isofminorimportance.Inaddition,theprocedurewillsavetimeandexpense.Whenauditorsareputonthespot,theywilldotheirduty.Iftheyarenotputonthespot...well,wehaveseentheresultsofthat.

The primary advantage of our four questions is that they will act as aprophylactic.Oncetheauditorsknowthattheauditcommitteewillrequirethemtoaffirmativelyendorse,ratherthanmerelyacquiesceto,management’sactions,they will resist misdoings early in the process, well before specious figuresbecomeembeddedinthecompany’sbooks.Fearoftheplaintiff’sbarwillseetothat.

2 [Subsequent letters sometimes report on the turnout at prior annualmeetings.Theturnoutwentfrom12atthe1975meetingtoapproximately7,500at the 1997meeting to over 15,000 in the early 2000s and to 35,000 in 2008,withsteadyincreasessince1984.]

3[Introductoryessay,1984.]4[Dividedbyhashlines:2000;2002.]5[SeetheessayOwnerEarningsandtheCashFlowFallacyinPartVI.E.]6[Dividedbyhashlines:1988;1993;2002;2004;2003;1986;1998;2005.]7[Theotheriscapitalallocation,discussedinPartsIIandVI.]8[1985;2006.]9[2010withvariationsinsubsequentyears;2009]10 [Divided by hash lines: 1987; 1981 (reprinted 1988); 1981; 1990-93;

1993;2003.]11[Typesettinginoriginal][The1986lettercontainedthefollowing:]Weboughtacorporate jet lastyear.[Typesettinginoriginal]Whatyouhaveheard

aboutsuchplanesistrue:theyareveryexpensiveandaluxuryinsituationslikeourswherelittletraveltoout-of-the-wayplacesisrequired.Andplanesnotonlycostalottooperate, theycostalotjusttolookat.Pre-tax,costofcapitalplusdepreciationonanew$15millionplaneprobablyruns$3millionannually.Onour own plane, bought for $850,000 used, such costs run close to $200,000annually.

Cognizant of such figures, your Chairman, unfortunately, has in the pastmadeanumberofratherintemperateremarksaboutcorporatejets.Accordingly,prior to our purchase, I was forced into my Galileo mode. I promptlyexperienced the necessary “counter-revelation” and travel is now considerably

easier—andconsiderablycostlier—thaninthepast.WhetherBerkshirewillgetits money’s worth from the plane is an open question, but I will work atachievingsomebusinesstriumphthatIcan(nomatterhowdubiously)attributetoit.I’mafraidBenFranklinhadmynumber.Saidhe:“Soconvenientathingitistobeareasonablecreature,sinceitenablesonetofindormakeareasonforeverythingonehasamindtodo.”[The1989lettercontainedthefollowing:]

Lastsummerwesoldthecorporatejetthatwepurchasedfor$850,000threeyears ago and bought another used jet for $6.7 million. [Noting an amusinganecdote of Carl Sagan about obstacles that impede exponential growth ofbacteria—referred to in theEpiloguebelow,somereaders]willunderstandablypanic: If our net worth continues to increase at current rates, and the cost ofreplacing planes also continues to rise at the now-established rate of 100%compoundedannually,itwillnotbelongbeforeBerkshire’sentirenetworthisconsumedbyitsjet.

Charlie doesn’t like it when I equate the jet with bacteria; he feels it’sdegradingtothebacteria.Hisideaoftravelinginstyleisanair-conditionedbus,a luxuryhestepsup toonlywhenbargainfaresare ineffect.Myownattitudetoward the jet can be summarized by the prayer attributed, apocryphally I’msure, toSt.Augustineashecontemplated leavinga lifeofsecularpleasures tobecome a priest. Battling the conflict between intellect and glands, he pled:“Helpme,OhLord,tobecomechaste—butnotyet.”

Naming theplanehasnotbeeneasy. I initiallysuggested“TheCharlesT.Munger.”Charliecounteredwith“TheAberration.”Wefinallysettledon“TheIndefensible.”

[The 1998 letter indicates that Buffett sold the Berkshire plane and nowdoesallhisflyingwithBerkshire’sflightservicesbusinesses.]

12 [Each annual letter through 2002 states the approximate percentage ofeligible shares that participated in the shareholder-designated contributionsprogram, thedollar amountof thecontributions, and thenumberof recipients.The percentage of participating shares always exceeded 95% and usuallyexceeded97%;theannualdollaramountrosesteadily,from$1–2millionintheearly 1980s to around $17 million in 2002; the number of different charitiesgrew from fewer than 1,000 to some3,500 in the sameperiod; and aggregategivingthroughtheprogram’sterminationin2002was$197million.]

13[Dividedbyhashlines:1985;2005;1985;1994;1991;2003;2002.]14[SeetheessayDividendPolicyandShareRepurchasesinPartIV.C.]15[2009;appendixto2010annualreport;2002.]

II.FINANCEANDINVESTING

We bought all of our [Washington Post Company (“WPC”)] holdings inmid-1973atapriceofnotmorethanone-fourthof the thenper-sharebusinessvalue of the enterprise. Calculating the price/value ratio required no unusualinsights. Most security analysts, media brokers, and media executives wouldhaveestimatedWPC’sintrinsicbusinessvalueat$400to$500millionjustaswedid.Andits$100millionstockmarketvaluationwaspublisheddailyforall tosee.Ouradvantage,rather,wasattitude:wehadlearnedfromBenGrahamthatthe key to successful investingwas the purchase of shares in good businesseswhenmarketpriceswereatalargediscountfromunderlyingbusinessvalues.

Mostinstitutionalinvestorsintheearly1970s,ontheotherhand,regardedbusinessvalueasofonlyminorrelevancewhentheyweredecidingthepricesatwhichtheywouldbuyorsell.Thisnowseemshardtobelieve.However,theseinstitutions were then under the spell of academics at prestigious businessschools who were preaching a newly-fashioned theory: the stock market wastotallyefficient,andthereforecalculationsofbusinessvalue—andeventhought,itself—were of no importance in investment activities. (We are enormouslyindebtedtothoseacademics:whatcouldbemoreadvantageousinanintellectualcontest—whetheritbebridge,chess,orstockselection—thantohaveopponentswhohavebeentaughtthatthinkingisawasteofenergy?)16

A.Mr.Market17

Whenever Charlie and I buy common stocks for Berkshire’s insurancecompanies(leavingasidearbitragepurchases,discussed[inthenextessay])weapproachthetransactionasifwewerebuyingintoaprivatebusiness.Welookattheeconomicprospectsof thebusiness, thepeopleinchargeofrunningit,andthe 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 thebusinesstoincreaseinintrinsicvalueatasatisfactoryrate.Wheninvesting,weview ourselves as business analysts—not as market analysts, not asmacroeconomicanalysts,andnotevenassecurityanalysts.

Our approachmakes an active tradingmarketuseful, since it periodicallypresentsuswithmouth-wateringopportunities.Butbynomeansisitessential:aprolonged suspensionof trading in the securitiesweholdwouldnotbotherus

anymorethandoesthelackofdailyquotationsonWorldBookorFechheimer.Eventually, our economic fatewill be determined by the economic fate of thebusinessweown,whetherourownershipispartialortotal.

BenGraham,myfriendandteacher,longagodescribedthementalattitudetowardmarket fluctuations that I believe to bemost conducive to investmentsuccess.He said thatyou should imaginemarketquotations as coming fromaremarkablyaccommodatingfellownamedMr.Marketwhoisyourpartner inaprivate business.Without fail,Mr.Market appears daily and names a price atwhichhewilleitherbuyyourinterestorsellyouhis.

Even though the business that the two of you own may have economiccharacteristicsthatarestable,Mr.Market’squotationswillbeanythingbut.For,sadtosay,thepoorfellowhasincurableemotionalproblems.Attimeshefeelseuphoricandcanseeonlythefavorablefactorsaffectingthebusiness.Wheninthatmood,henamesaveryhighbuy-sellpricebecausehe fears thatyouwillsnap up his interest and rob him of imminent gains. At other times he isdepressedandcanseenothingbut troubleahead forboth thebusinessand theworld.On theseoccasionshewill nameavery lowprice, sincehe is terrifiedthatyouwillunloadyourinterestonhim.

Mr. Market has another endearing characteristic: He doesn’t mind beingignored.Ifhisquotationisuninterestingtoyoutoday,hewillbebackwithanewone tomorrow.Transactionsarestrictlyatyouroption.Under theseconditions,themoremanic-depressivehisbehavior,thebetterforyou.

But, likeCinderellaat theball,youmustheedonewarningoreverythingwillturnintopumpkinsandmice:Mr.Marketistheretoserveyou,nottoguideyou.Itishispocketbook,nothiswisdom,thatyouwillfinduseful.Ifheshowsupsomedayinaparticularlyfoolishmood,youarefreetoeitherignorehimortotakeadvantageofhim,butitwillbedisastrousifyoufallunderhisinfluence.Indeed,ifyouaren’tcertainthatyouunderstandandcanvalueyourbusinessfarbetterthanMr.Marketyoudon’tbelonginthegame.Astheysayinpoker,“Ifyou’ve been in the game 30 minutes and you don’t know who the patsy is,you’rethepatsy.”

Ben’s Mr. Market allegory may seem out-of-date in today’s investmentworld, inwhichmostprofessionalsandacademicians talkofefficientmarkets,dynamic hedging and betas. Their interest in such matters is understandable,since techniques shrouded in mystery clearly have value to the purveyor ofinvestment advice. After all, what witch doctor has ever achieved fame andfortunebysimplyadvising“Taketwoaspirins”?

The value ofmarket esoterica to the consumer of investment advice is adifferent story. In my opinion, investment success will not be produced by

arcaneformulae,computerprogramsorsignalsflashedbythepricebehaviorofstocksandmarkets.Ratheraninvestorwillsucceedbycouplinggoodbusinessjudgmentwithanability to insulatehis thoughtsandbehavior from the super-contagiousemotionsthatswirlaboutthemarketplace.Inmyowneffortstostayinsulated,IhavefoundithighlyusefultokeepBen’sMr.Marketconceptfirmlyinmind.

FollowingBen’steachings,CharlieandIletourmarketableequitiestellusbytheiroperatingresults—notbytheirdaily,orevenyearly,pricequotations—whetherourinvestmentsaresuccessful.Themarketmayignorebusinesssuccessfor awhile,but eventuallywill confirm it.AsBen said: “In the short run, themarket isavotingmachinebut in the longrun it isaweighingmachine.”Thespeed at which a business’s success is recognized, furthermore, is not thatimportantaslongasthecompany’sintrinsicvalueisincreasingatasatisfactoryrate.Infact,delayedrecognitioncanbeanadvantage:Itmaygiveusthechancetobuymoreofagoodthingatabargainprice.

Sometimes,ofcourse,themarketmayjudgeabusinesstobemorevaluablethan the underlying factswould indicate it is. In such a case,wewill sell ourholdings.Sometimes, also,wewill sell a security that is fairlyvaluedor evenundervaluedbecausewerequirefundsforastillmoreundervaluedinvestmentoronewebelieveweunderstandbetter.

Weneedtoemphasize,however,thatwedonotsellholdingsjustbecausetheyhaveappreciatedorbecausewehaveheld themfora long time.(OfWallStreetmaximsthemostfoolishmaybe“Youcan’tgobroketakingaprofit.”)Weare quite content to hold any security indefinitely, so long as the prospectivereturnonequitycapitaloftheunderlyingbusinessissatisfactory,managementiscompetentandhonest,andthemarketdoesnotovervaluethebusiness.

However, our insurance companies own threemarketable common stocksthatwewouldnotselleventhoughtheybecamefaroverpricedinthemarket.Ineffect, we view these investments exactly like our successful controlledbusinesses—a permanent part of Berkshire rather than merchandise to bedisposedofonceMr.Marketoffersusa sufficientlyhighprice.To that, Iwilladd one qualifier: These stocks are held by our insurance companies and wewould,ifabsolutelynecessary,sellportionsofourholdingstopayextraordinaryinsurance losses.We intend, however, to manage our affairs so that sales areneverrequired.

Adeterminationtohaveandtohold,whichCharlieandIshare,obviouslyinvolvesamixtureofpersonalandfinancialconsiderations.Tosome,ourstandmay seemhighly eccentric. (Charlie and I have long followedDavidOgilvy’sadvice:“Developyoureccentricitieswhileyouareyoung.Thatway,whenyou

getold,peoplewon’t thinkyou’regoingga-ga.”)Certainly, in the transaction-fixatedWallStreetofrecentyears,ourposturemustseemodd:Tomanyinthatarena,bothcompaniesandstocksareseenonlyasrawmaterialfortrades.

Ourattitude,however,fitsourpersonalitiesandthewaywewanttoliveourlives.Churchilloncesaid,“Youshapeyourhousesandthentheyshapeyou.”Weknow themanner inwhichwewish to be shaped. For that reason,wewouldrather achieve a return ofXwhile associatingwith peoplewhomwe stronglylike and admire than realize 110%ofX by exchanging these relationships foruninterestingorunpleasantones.

Ashortquiz:Ifyouplantoeathamburgersthroughoutyourlifeandarenotacattleproducer,shouldyouwishforhigherorlowerpricesforbeef?Likewise,ifyouaregoingtobuyacarfromtimetotimebutarenotanautomanufacturer,shouldyoupreferhigherorlowercarprices?Thesequestions,ofcourse,answerthemselves.

Butnowforthefinalexam:Ifyouexpecttobeanetsaverduringthenextfive years, should you hope for a higher or lower stock market during thatperiod?Manyinvestorsgetthisonewrong.Eventhoughtheyaregoingtobenetbuyersofstocksformanyyearstocome,theyareelatedwhenstockpricesriseanddepressedwhentheyfall.Ineffect,theyrejoicebecausepriceshaverisenforthe“hamburgers”theywillsoonbebuying.Thisreactionmakesnosense.Onlythosewhowillbesellersofequitiesinthenearfutureshouldbehappyatseeingstocksrise.Prospectivepurchasersshouldmuchprefersinkingprices.

ForshareholdersofBerkshirewhodonotexpecttosell,thechoiceisevenclearer.Tobeginwith,ourownersareautomaticallysavingeven if theyspendevery dime they personally earn: Berkshire “saves” for them by retaining allearnings, thereafter using these savings to purchase businesses and securities.Clearly,themorecheaplywemakethesebuys,themoreprofitableourowners’indirectsavingsprogramwillbe.

Furthermore,throughBerkshireyouownmajorpositionsincompaniesthatconsistentlyrepurchasetheirshares.Thebenefitsthattheseprogramssupplyusgrowaspricesfall:Whenstockpricesarelow,thefundsthataninvesteespendsonrepurchasesincreaseourownershipofthatcompanybyagreateramountthanisthecasewhenpricesarehigher.Forexample,therepurchasesthatCoca-Cola,TheWashington Post andWells Fargo made in past years at very low pricesbenefittedBerkshirefarmorethandotoday’srepurchases,madeatloftierprices.

[Sinceattheendofeveryyear,almostallBerkshiresharesareheldbythesameinvestorswhoownedthematthestartoftheyear,Berkshireshareholders

are]savers.Theyshouldthereforerejoicewhenmarketsdeclineandallowbothusandourinvesteestodeployfundsmoreadvantageously.

So smile when you read a headline that says “Investors lose as marketfalls.”Edit it inyourmindto“Disinvestors loseasmarket falls—but investorsgain.”Thoughwritersoftenforget this truism, there isabuyer foreverysellerandwhat hurts one necessarily helps the other. (As they say in golfmatches:“Everyputtmakessomeonehappy.”)

We gained enormously from the low prices placed onmany equities andbusinessesinthe1970sand1980s.Marketsthatthenwerehostiletoinvestmenttransientswerefriendlytothosetakinguppermanentresidence.Inrecentyears,theactionswetookinthosedecadeshavebeenvalidated,butwehavefoundfewnewopportunities.Initsroleasacorporate“saver,”Berkshirecontinuallylooksfor ways to sensibly deploy capital, but it may be some time before we findopportunitiesthatgetustrulyexcited.

B.Arbitrage18

[O]urinsurancesubsidiariessometimesengageinarbitrageasanalternativeto holding short-term cash equivalents. We prefer, of course, to make majorlong-termcommitments,butweoftenhavemorecashthangoodideas.Atsuchtimes, arbitrage sometimes promises much greater returns than Treasury Billsand,equallyimportant,coolsanytemptationwemayhavetorelaxourstandardsfor long-term investments. (Charlie’s signoff after we’ve talked about anarbitragecommitmentisusually:“Okay,atleastitwillkeepyououtofbars.”)

During1988wemadeunusuallylargeprofitsfromarbitrage,measuredbothbyabsolutedollarsandrateofreturn.Ourpre-taxgainwasabout$78milliononaverageinvestedfundsofabout$147million.

This levelofactivitymakessomedetaileddiscussionofarbitrageandourapproach to it appropriate. Once, the word applied only to the simultaneouspurchaseandsaleofsecuritiesorforeignexchangeintwodifferentmarkets.Thegoalwastoexploit tinypricedifferentials thatmightexistbetween,say,RoyalDutchstocktradinginguildersinAmsterdam,poundsinLondon,anddollarsinNew York. Some people might call this scalping: it won’t surprise you thatpractitionersoptedfortheFrenchterm,arbitrage.

SinceWorldWar I thedefinitionofarbitrage—or“riskarbitrage,”as it isnowsometimescalled—hasexpanded to include thepursuitofprofits fromanannouncedcorporateeventsuchassaleofthecompany,merger,recapitalization,reorganization,liquidation,self-tender,etc.Inmostcasesthearbitrageurexpects

to profit regardless of the behavior of the stock market. The major risk heusuallyfacesinsteadisthattheannouncedeventwon’thappen.

Some offbeat opportunities occasionally arise in the arbitrage field. Iparticipated in one of these when I was 24 and working in New York forGraham-NewmanCorp.Rockwood&Co.,aBrooklyn-basedchocolateproductscompanyof limitedprofitability, thathadadoptedLIFOinventoryvaluation in1941 when cocoa was selling for 5 cents per pound. In 1954 a temporaryshortage of cocoa caused the price to soar to over 60 cents. ConsequentlyRockwoodwished to unload its valuable inventory—quickly, before the pricedropped.But if the cocoa had simply been sold off, the companywould haveowedclosetoa50%taxontheproceeds.

The 1954TaxCode came to the rescue. It contained an arcane provisionthat eliminated the tax otherwise due on LIFO profits if inventory wasdistributedtoshareholdersaspartofaplanreducingthescopeofacorporation’sbusiness.Rockwooddecidedtoterminateoneofitsbusinesses,thesaleofcocoabutter,andsaid13millionpoundsofitscocoabeaninventorywasattributabletothat activity. Accordingly, the company offered to repurchase its stock inexchangeforthecocoabeansitnolongerneeded,paying80poundsofbeansforeachshare.

For severalweeks I busily bought shares, sold beans, andmade periodicstops atSchroederTrust to exchange stock certificates forwarehouse receipts.Theprofitsweregoodandmyonlyexpensewassubwaytokens.

The architect of Rockwood’s restructuringwas an unknown, but brilliantChicagoan,JayPritzker,then32.Ifyou’refamiliarwithJay’ssubsequentrecord,youwon’tbesurprisedtoheartheactionworkedoutratherwellforRockwood’scontinuingshareholdersalso.Fromshortlybeforethetenderuntilshortlyafterit,Rockwood stock appreciated from 15 to 100, even though the company wasexperiencinglargeoperatinglosses.Sometimesthereismoretostockvaluationthanprice-earningsratios.

Inrecentyears,mostarbitrageoperationshaveinvolvedtakeovers,friendlyandunfriendly.Withacquisitionfeverrampant,withanti-trustchallengesalmostnon-existent,andwithbidsoftenratchetingupward,arbitrageurshaveprosperedmightily.Theyhavenotneeded special talents todowell; the trick, à laPeterSellers in the movie, has simply been “Being There.” InWall Street the oldproverb has been reworded: “Give aman a fish and you feed him for a day.Teachhimhowtoarbitrageandyoufeedhimforever.”(If,however,hestudiedattheIvanBoeskySchoolofArbitrage,itmaybeastateinstitutionthatsupplieshismeals.)

Toevaluatearbitragesituationsyoumustanswer fourquestions: (1)How

likely is it that thepromised eventwill indeedoccur? (2)How longwill yourmoney be tied up? (3) What chance is there that something still better willtranspire—acompetingtakeoverbid,forexample?and(4)Whatwillhappenifthe 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 thedirectorsofArcataagreed inprinciple tosell thecompany toKohlbergKravisRoberts&Co.(KKR),thenandnowamajorleveraged-buyoutfirm.Arcatawasintheprintingandforestproductsbusinessesandhadoneotherthinggoingforit:In1978theU.S.Governmenthadtakentitleto10,700acresofArcatatimber,primarily old-growth redwood, to expand Redwood National Park. Thegovernmenthadpaid$97.9million, in several installments, for this acreage, asumArcatawascontestingasgrosslyinadequate.Thepartiesalsodisputedtheinterest rate that shouldapply to theperiodbetween the takingof thepropertyandfinalpaymentforit.Theenablinglegislationstipulated6%simpleinterest;Arcataarguedforamuchhigherandcompoundedrate.

Buyingacompanywithahighly-speculative,large-sizedclaiminlitigationcreatesanegotiatingproblem,whether theclaim isonbehalfoforagainst thecompany.Tosolvethisproblem,KKRoffered$37.00perArcatashareplustwo-thirdsofanyadditionalamountspaidbythegovernmentfortheredwoodlands.

Appraising this arbitrage opportunity, we had to ask ourselves whetherKKRwouldconsummatethetransactionsince,amongotherthings,itsofferwascontingent upon its obtaining “satisfactory financing.”A clause of this kind isalwaysdangerous for the seller: Itoffersaneasyexit fora suitorwhoseardorfades between proposal and marriage. However, we were not particularlyworriedabout thispossibilitybecauseKKR’spast record for closinghadbeengood.

Wealsohadtoaskourselveswhatwouldhappenif theKKRdealdidfallthrough,andherewealsofeltreasonablycomfortable:Arcata’smanagementanddirectors had been shopping the company for some time and were clearlydeterminedtosell.IfKKRwentaway,Arcatawouldlikelyfindanotherbuyer,thoughofcourse,thepricemightbelower.

Finally,wehad toaskourselveswhat theredwoodclaimmightbeworth.YourChairman,whocan’ttellanelmfromanoak,hadnotroublewiththatone:Hecoollyevaluatedtheclaimatsomewherebetweenzeroandawholelot.

WestartedbuyingArcatastock,thenaround$33.50,onSeptember30andin eight weeks purchased about 400,000 shares, or 5% of the company. Theinitial announcement said that the $37.00 would be paid in January, 1982.

Therefore,ifeverythinghadgoneperfectly,wewouldhaveachievedanannualrateofreturnofabout40%—notcountingtheredwoodclaim,whichwouldhavebeenfrosting.

All did not go perfectly. In December it was announced that the closingwould be delayed a bit. Nevertheless, a definitive agreement was signed onJanuary4.Encouraged,weraisedourstake,buyingataround$38.00pershareandincreasingourholdingsto655,000shares,orover7%ofthecompany.Ourwillingnesstopayup—eventhoughtheclosinghadbeenpostponed—reflectedourleaningtoward“awholelot”ratherthan“zero”fortheredwoods.

Then,onFebruary25thelenderssaidtheyweretakinga“secondlook”atfinancing terms “in view of the severely depressed housing industry and itsimpactonArcata’soutlook.”Thestockholders’meetingwaspostponedagain,toApril.AnArcata spokesman said he “did not think the fate of the acquisitionitself was imperiled.” When arbitrageurs hear such reassurances, their mindsflash to the old saying: “He lied like a finance minister on the eve ofdevaluation.”

OnMarch12KKRsaiditsearlierdealwouldn’twork,firstcuttingitsofferto$33.50, then twodays later raising it to$35.00.OnMarch15,however, thedirectorsturnedthisbiddownandacceptedanothergroup’sofferof$37.50plusone-half of any redwood recovery. The shareholders okayed the deal, and the$37.50waspaidonJune4.

We received $24.6million versus our cost of $22.9million; our averageholdingperiodwasclosetosixmonths.Consideringthetroublethistransactionencountered, our 15% annual rate of return—excluding any value for theredwoodclaim—wasmorethansatisfactory.

Butthebestwasyettocome.Thetrialjudgeappointedtwocommissions,onetolookatthetimber’svalue,theothertoconsidertheinterestratequestions.In January 1987, the first commission said the redwoods were worth $275.7millionand thesecondcommissionrecommendedacompounded,blendedrateofreturnworkingouttoabout14%.

In August 1987 the judge upheld these conclusions, which meant a netamount of about $600 million would be due Arcata. The government thenappealed. In1988, though,before thisappealwasheard, theclaimwas settledfor$519million.Consequently,wereceivedanadditional$29.48pershare,orabout$19.3million.Wewillgetanother$800,000orsoin1989.

Berkshire’sarbitrageactivitiesdifferfromthoseofmanyarbitrageurs.First,weparticipateinonlyafew,andusuallyverylarge,transactionseachyear.Mostpractitioners buy into a greatmanydeals—perhaps 50 ormore per year.Withthatmanyironsinthefire,theymustspendmostoftheirtimemonitoringboth

theprogressofdealsandthemarketmovementsoftherelatedstocks.ThisisnothowCharlienorIwishtospendourlives.(What’sthesenseingettingrichjusttostareatatickertapeallday?)

Because we diversify so little, one particularly profitable or unprofitabletransactionwillaffectouryearlyresult fromarbitragefarmore than itwill thetypicalarbitrageoperation.Sofar,Berkshirehasnothadareallybadexperience.Butwewill—andwhenithappenswe’llreportthegorydetailstoyou.

The other way we differ from some arbitrage operations is that weparticipate only in transactions that have been publicly announced.Wedonottrade on rumors or try to guess takeover candidates. We just read thenewspapers,thinkaboutafewofthebigpropositions,andgobyourownsenseofprobabilities.

Atyear-end,ouronlymajorarbitragepositionwas3,342,000sharesofRJRNabiscowithacostof$281.8millionandamarketvalueof$304.5million.InJanuary we increased our holdings to roughly four million shares and inFebruaryweeliminatedourposition.AboutthreemillionshareswereacceptedwhenwetenderedourholdingstoKKR,whichacquiredRJR,andthereturnedshareswerepromptly sold in themarket.Ourpre-taxprofitwas abetter-than-expected$64million.

Earlier, another familiar face turned up in the RJR bidding contest: JayPritzker,whowaspartofaFirstBostongroupthatmadeatax-orientedoffer.ToquoteYogiBerra:“Itwasdéjàvualloveragain.”

DuringmostofthetimewhenwenormallywouldhavebeenpurchasersofRJR, our activities in the stock were restricted because of Salomon’sparticipation in a bidding group. Customarily, Charlie and I, though we aredirectors of Salomon, are walled off from information about its merger andacquisitionwork.Wehaveaskedthatitbethatway:Theinformationwoulddous no good and could, in fact, occasionally inhibit Berkshire’s arbitrageoperations.

However,theunusuallylargecommitmentthatSalomonproposedtomakein the RJR deal required that all directors be fully informed and involved.Therefore,Berkshire’spurchasesofRJRweremadeatonlytwotimes:first, inthe few days immediately following management’s announcement of buyoutplans, before Salomon became involved; and considerably later, after theRJRboardmade its decision in favor ofKKR.Becausewe could not buy at othertimes,ourdirectorshipscostBerkshiresignificantmoney.

ConsideringBerkshire’sgoodresults in1988,youmightexpectus topileintoarbitrageduring1989.Instead,weexpecttobeonthesidelines.

One pleasant reason is that our cash holdings are down—because our

position inequities thatweexpect toholdforavery long time issubstantiallyup.Asregularreadersofthisreportknow,ournewcommitmentsarenotbasedon a judgment about short-term prospects for the stock market. Rather, theyreflectanopinionaboutlong-termbusinessprospectsforspecificcompanies.Wedonot have, never havehad, andneverwill have anopinion aboutwhere thestockmarket,interestrates,orbusinessactivitywillbeayearfromnow.

Even ifwe had a lot of cashwe probablywould do little in arbitrage in1989. Some extraordinary excesses have developed in the takeover field. AsDorothysays:“Toto,Ihaveafeelingwe’renotinKansasanymore.”

Wehavenoideahowlongtheexcesseswilllast,nordoweknowwhatwillchangetheattitudesofgovernment,lenderandbuyerthatfuelthem.Butwedoknow that the less the prudence with which others conduct their affairs, thegreatertheprudencewithwhichweshouldconductourownaffairs.Wehavenodesiretoarbitragetransactionsthatreflecttheunbridled—and,inourview,oftenunwarranted—optimism of both buyers and lenders. In our activities, wewillheedthewisdomofHerbStein:“Ifsomethingcan’tgoonforever,itwillend.”

Wetoldyoulastyearthatweexpectedtodolittleinarbitrageduring1989,and that’s theway it turnedout.Arbitragepositions are a substitute for short-termcashequivalents,andduringpartoftheyearweheldrelativelylowlevelsofcash.Intherestoftheyearwehadafairlygood-sizedcashpositionandevensochosenottoengageinarbitrage.Themainreasonwascorporatetransactionsthatmadeno economic sense to us; arbitraging suchdeals comes too close toplayingthegreater-foolgame.(AsWallStreeterRayDeVoesays:“Foolsrushinwhere angels fear to trade.”)Wewill engage in arbitrage from time to time—sometimesonalargescale—butonlywhenweliketheodds.

C.DebunkingStandardDogma19

The preceding discussion about arbitrage makes a small discussion of“efficient market theory” (EMT) also seem relevant. This doctrine becamehighly fashionable—indeed, almost holy scripture—in academic circles duringthe 1970s. Essentially, it said that analyzing stocks was useless because allpublic information about them was appropriately reflected in their prices. Inotherwords,themarketalwayskneweverything.Asacorollary,theprofessorswho taught EMT said that someone throwing darts at the stock tables couldselect a stock portfolio having prospects just as good as one selected by thebrightest,mosthard-working security analyst.Amazingly,EMTwasembraced

not only by academics, but by many investment professionals and corporatemanagersaswell.Observingcorrectly that themarketwas frequentlyefficient,theywentontoconcludeincorrectlythatitwasalwaysefficient.Thedifferencebetweenthesepropositionsisnightandday.

In my opinion, the continuous 63-year arbitrage experience of Graham-NewmanCorp., Buffett Partnership, andBerkshire illustrates just how foolishEMTis. (There’splentyofotherevidence,also.)WhileatGraham-Newman, Imadeastudyofitsearningsfromarbitrageduringtheentire1926-1956lifespanofthecompany.Unleveragedreturnsaveraged20%peryear.Startingin1956,IappliedBenGraham’sarbitrageprinciples, firstatBuffettPartnershipandthenBerkshire.ThoughI’venotmadeanexactcalculation,Ihavedoneenoughworkto know that the 1956-1988 returns averaged well over 20%. (Of course, IoperatedinanenvironmentfarmorefavorablethanBen’s;hehad1929-1932tocontendwith.)

Alloftheconditionsarepresentthatarerequiredforafairtestofportfolioperformance: (1) the threeorganizations tradedhundredsofdifferent securitieswhile building this 63-year record; (2) the results are not skewed by a fewfortunate experiences; (3)wedid not have to dig for obscure facts or developkeen insights about products or managements—we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identifieduniverse—theyhavenotbeenselectedbyhindsight.

Over the 63 years, the generalmarket delivered just under a 10%annualreturn,includingdividends.Thatmeans$1,000wouldhavegrownto$405,000if all incomehadbeen reinvested.A20%rateof return,however,wouldhaveproduced$97million.That strikesus a statistically-significantdifferential thatmight,conceivably,arouseone’scuriosity.

Yet proponents of the theory have never seemed interested in discordantevidence of this type. True, they don’t talk quite as much about their theorytodayastheyusedto.Butnoone,tomyknowledge,haseversaidhewaswrong,nomatterhowmanythousandsofstudentshehassentforthmisinstructed.EMT,moreover,continuestobeanintegralpartoftheinvestmentcurriculumatmajorbusiness schools.Apparently, a reluctance to recant, and thereby to demystifythepriesthood,isnotlimitedtotheologians.

Naturallythedisservicedonestudentsandgullibleinvestmentprofessionalswho have swallowed EMT has been an extraordinary service to us and otherfollowersofGraham.Inanysortofacontest—financial,mental,orphysical—it’s an enormous advantage to have opponents who have been taught that it’suseless to even try. From a selfish point of view,Grahamites should probablyendowchairstoensuretheperpetualteachingofEMT.

Allthissaid,awarningisappropriate.Arbitragehaslookedeasyrecently.Butthisisnotaformofinvestingthatguaranteesprofitsof20%ayearor,forthat matter, profits of any kind. As noted, the market is reasonably efficientmuch of the time: For every arbitrage opportunity we seized in that 63-yearperiod,manymorewereforegonebecausetheyseemedproperly-priced.

An investor cannot obtain superior profits from stocks by simplycommittingtoaspecificinvestmentcategoryorstyle.Hecanearnthemonlybycarefully evaluating facts and continuously exercising discipline. Investing inarbitrage situations,per se, isnobettera strategy thanselectingaportfoliobythrowingdarts.

[W]hen we own portions of outstanding businesses with outstandingmanagements,ourfavoriteholdingperiodisforever.Wearejusttheoppositeofthosewhohurrytosellandbookprofitswhencompaniesperformwellbutwhotenaciouslyhangontobusinessesthatdisappoint.PeterLynchaptlylikenssuchbehaviortocuttingtheflowersandwateringtheweeds.

[W]econtinuetothinkthatitisusuallyfoolishtopartwithaninterestinabusinessthatisbothunderstandableanddurablywonderful.Businessinterestsofthatkindaresimplytoohardtoreplace.

Interestingly,corporatemanagershavenotroubleunderstandingthatpointwhentheyarefocusingonabusinesstheyoperate:Aparentcompanythatownsa subsidiary with superb long-term economics is not likely to sell that entityregardlessofprice.“Why,” theCEOwouldask,“shouldIpartwithmycrownjewel?”Yet thatsameCEO,when itcomes to runninghispersonal investmentportfolio, will offhandedly—and even impetuously—move from business tobusinesswhenpresentedwithnomorethansuperficialargumentsbyhisbrokerfordoingso.Theworstoftheseisperhaps,“Youcan’tgobroketakingaprofit.”CanyouimagineaCEOusingthislinetourgehisboardtosellastarsubsidiary?In our view, what makes sense in business also makes sense in stocks: Aninvestorshouldordinarilyholdasmallpieceofanoutstandingbusinesswiththesametenacitythatanownerwouldexhibitifheownedallofthatbusiness.

Earlier Imentioned thefinancial results thatcouldhavebeenachievedbyinvesting$40inTheCoca-ColaCo.in1919.20In1938,morethan50yearsafterthe introductionofCoke,and longafter thedrinkwasfirmlyestablishedasanAmerican icon,Fortune did an excellent story on the company. In the secondparagraphthewriterreported:“Several timeseveryyearaweightyandseriousinvestorlookslongandwithprofoundrespectatCoca-Cola’srecord,butcomesregretfullytotheconclusionthatheislookingtoolate.Thespectersofsaturation

andcompetitionrisebeforehim.”Yes, competition there was in 1938 and in 1993 as well. But it’s worth

notingthatin1938TheCoca-ColaCo.sold207millioncasesofsoftdrinks(ifitsgallonage then isconverted into the192-ouncecasesused formeasurementtoday)andin1993itsoldabout10.7billioncases,a50-foldincreaseinphysicalvolume from a company that in 1938was already dominant in its verymajorindustry. Nor was the party over in 1938 for an investor: Though the $40investedin1919inonesharehad(withdividendsreinvested)turnedinto$3,277by the endof1938, a fresh$40 then invested inCoca-Cola stockwouldhavegrownto$25,000byyear-end1993.

I can’t resist onemore quote from that 1938Fortune story: “Itwouldbehard to name any company comparable in size to Coca-Cola and selling, asCoca-Cola does, an unchanged product that can point to a ten-year recordanything like Coca-Cola’s.” In the 55 years that have since passed, Coke’sproduct line has broadened somewhat, but it’s remarkable how well thatdescriptionstillfits.

CharlieandIdecidedlongagothatinaninvestmentlifetimeit’stoohardtomakehundredsofsmartdecisions.ThatjudgmentbecameevermorecompellingasBerkshire’s capitalmushroomed and the universe of investments that couldsignificantly affect our results shrank dramatically. Therefore, we adopted astrategy that requiredourbeingsmart—andnot toosmartat that—onlyaveryfewtimes. Indeed,we’llnowsettleforonegoodideaayear. (Charliesays it’smyturn.)

The strategy we’ve adopted precludes our following standarddiversificationdogma.Manypunditswould therefore say the strategymust beriskier than that employed by more conventional investors. We disagree. Webelievethatapolicyofportfolioconcentrationmaywelldecreaseriskifitraises,as it should, both the intensitywithwhich an investor thinks about a businessand the comfort-level he must feel with its economic characteristics beforebuyingintoit.Instatingthisopinion,wedefinerisk,usingdictionaryterms,as“thepossibilityoflossorinjury.”

Academics,however, like todefine investment“risk”differently,averringthat it is the relative volatility of a stock or portfolio of stocks—that is, theirvolatilityascomparedtothatofalargeuniverseofstocks.Employingdatabasesand statistical skills, these academics compute with precision the “beta” of astock—its relativevolatility in thepast—and thenbuildarcane investmentandcapital-allocation theories around this calculation. In their hunger for a singlestatistictomeasurerisk,however,theyforgetafundamentalprinciple:Itisbettertobeapproximatelyrightthanpreciselywrong.

Forownersofabusiness—and that’s thewaywe thinkof shareholders—theacademics’definitionofriskisfaroffthemark,somuchsothatitproducesabsurdities.Forexample,underbeta-basedtheory,astockthathasdroppedverysharplycomparedtothemarket—ashadWashingtonPostwhenweboughtitin1973—becomes “riskier” at the lower price than it was at the higher price.Wouldthatdescriptionhavethenmadeanysensetosomeonewhowasofferedtheentirecompanyatavastly-reducedprice?

Infact,thetrueinvestorwelcomesvolatility.BenGrahamexplainedwhyinChapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” anobligingfellow[notedabove]whoshowsupeverydaytoeitherbuyfromyouorsell to you,whichever youwish. Themoremanic-depressive this chap is, thegreater theopportunitiesavailable to the investor.That’s truebecauseawildlyfluctuating market means that irrationally low prices will periodically beattachedtosolidbusinesses.Itisimpossibletoseehowtheavailabilityofsuchpricescanbethoughtofasincreasingthehazardsforaninvestorwhoistotallyfreetoeitherignorethemarketorexploititsfolly.

In assessing risk, a beta purist will disdain examining what a companyproduces, what its competitors are doing, or howmuch borrowed money thebusinessemploys.Hemayevenprefernottoknowthecompany’sname.Whathe treasures is the price history of its stock. In contrast, we’ll happily forgoknowing the price history and instead will seek whatever information willfurther our understanding of the company’s business. After we buy a stock,consequently,wewouldnotbedisturbedifmarketsclosedforayearortwo.Wedon’t need a daily quote on our 100% position in See’s or H.H. Brown tovalidateourwellbeing.Why,then,shouldweneedaquoteonour7%interestinCoke?

Inouropinion,therealriskaninvestormustassessiswhetherhisaggregateafter-taxreceiptsfromaninvestment(includingthosehereceivesonsale)will,overhisprospectiveholdingperiod,givehimatleastasmuchpurchasingpoweras he had to begin with, plus a modest rate of interest on that initial stake.Thoughthisriskcannotbecalculatedwithengineeringprecision,itcaninsomecases be judgedwith a degree of accuracy that is useful. The primary factorsbearinguponthisevaluationare:

(1)Thecertaintywithwhichthelong-termeconomiccharacteristicsofthebusinesscanbeevaluated;(2)Thecertaintywithwhichmanagementcanbeevaluated,bothastoits ability to realize the full potential of the business and to wiselyemployitscashflows;(3) The certainty with which management can be counted on to

channeltherewardfromthebusinesstotheshareholdersratherthantoitself;(4)Thepurchasepriceofthebusiness;(5)The levels of taxation and inflation thatwill be experienced andthat will determine the degree by which an investor’s purchasing-powerreturnisreducedfromhisgrossreturn.

Thesefactorswillprobablystrikemanyanalystsasunbearablyfuzzysincethey cannot be extracted from a data base of any kind. But the difficulty ofprecisely quantifying these matters does not negate their importance nor is itinsuperable. Just as JusticeStewart found it impossible to formulate a test forobscenity but nevertheless asserted, “I know it when I see it,” so also caninvestors—in an inexact but useful way—“see” the risks inherent in certaininvestmentswithoutreferencetocomplexequationsorpricehistories.

Is it reallysodifficult toconclude thatCoca-ColaandGillettepossessfarless business risk over the long term than, say, any computer company orretailer?21Worldwide,Cokesellsabout44%ofallsoftdrinks,andGillettehasmore thana60%share (invalue)of theblademarket.Leavingaside chewinggum,inwhichWrigleyisdominant,Iknowofnoothersignificantbusinessesinwhichtheleadingcompanyhaslongenjoyedsuchglobalpower.

Moreover,bothCokeandGillettehaveactuallyincreasedtheirworldwidesharesofmarketinrecentyears.Themightoftheirbrandnames,theattributesof their products, and the strength of their distribution systems give them anenormous competitive advantage, setting up a protective moat around theireconomic castles. The average company, in contrast, does battle dailywithoutanysuchmeansofprotection.AsPeterLynchsays,stocksofcompaniessellingcommodity-likeproductsshouldcomewithawarninglabel:“Competitionmayprovehazardoustohumanwealth.”

The competitive strengths of a Coke or Gillette are obvious to even thecasual observer of business.Yet the beta of their stocks is similar to that of agreat many run-of-the-mill companies who possess little or no competitiveadvantage.ShouldweconcludefromthissimilaritythatthecompetitivestrengthofCokeandGillettegainsthemnothingwhenbusinessriskisbeingmeasured?Orshouldweconcludethattheriskinowningapieceofacompany—itsstock—is somehow divorced from the long-term risk inherent in its businessoperations?Webelieve neither conclusionmakes sense and that equating betawithinvestmentriskmakesnosense.

Thetheoreticianbredonbetahasnomechanismfordifferentiatingtheriskinherent in, say, a single-product toy company sellingpet rocksor hula hoopsfrom that of another toy companywhose soleproduct isMonopolyorBarbie.

But it’s quite possible for ordinary investors tomake such distinctions if theyhave a reasonable understanding of consumer behavior and the factors thatcreate long-term competitive strength or weakness. Obviously, every investorwill make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person canjudgeinvestmentriskswithausefuldegreeofaccuracy.

Inmanyindustries,ofcourse,CharlieandIcan’tdeterminewhetherwearedealing with a “pet rock” or a “Barbie.” We couldn’t solve this problem,moreover, even ifwewere to spend years intensely studying those industries.Sometimes our own intellectual shortcomings would stand in the way ofunderstanding, and in other cases the nature of the industry would be theroadblock.Forexample,abusinessthatmustdealwithfast-movingtechnologyisnotgoingtolenditselftoreliableevaluationsofitslong-termeconomics.Didweforeseethirtyyearsagowhatwouldtranspireinthetelevision-manufacturingor computer industries? Of course not. (Nor did most of the investors andcorporatemanagers who enthusiastically entered those industries.)Why, then,should Charlie and I now think we can predict the future of other rapidly-evolvingbusinesses?We’llstick insteadwith theeasycases.Whysearchforaneedleburiedinahaystackwhenoneissittinginplainsight?

Ofcourse,someinvestmentstrategies—forinstance,oureffortsinarbitrageovertheyears—requirewidediversification.Ifsignificantriskexistsinasingletransaction,overallriskshouldbereducedbymakingthatpurchaseoneofmanymutually-independent commitments. Thus, you may consciously purchase ariskyinvestment—onethatindeedhasasignificantpossibilityofcausinglossorinjury—if you believe that your gain,weighted for probabilities, considerablyexceedsyourloss,comparablyweighted,andifyoucancommittoanumberofsimilar, but unrelated opportunities. Most venture capitalists employ thisstrategy.Shouldyouchoosetopursuethiscourse,youshouldadopttheoutlookof thecasino thatownsa roulettewheel,whichwillwant to see lotsofactionbecauseitisfavoredbyprobabilities,butwillrefusetoacceptasingle,hugebet.

Another situation requiring wide diversification occurs when an investorwho does not understand the economics of specific businesses neverthelessbelieves it in his interest to be a long-term owner ofAmerican industry. Thatinvestorshouldbothownalargenumberofequitiesandspaceouthispurchases.By periodically investing in an index fund, for example, the know-nothinginvestorcanactuallyout-performmostinvestmentprofessionals.Paradoxically,when“dumb”moneyacknowledgesitslimitations,itceasestobedumb.

Ontheotherhand,ifyouareaknow-somethinginvestor,abletounderstandbusiness economics and to find five to ten sensibly-priced companies that

possess important long-term competitive advantages, conventionaldiversificationmakesnosenseforyou.Itisaptsimplytohurtyourresultsandincreaseyourrisk.Icannotunderstandwhyaninvestorofthatsortelectstoputmoney into a business that is his 20th favorite rather than simply adding thatmoney tohis topchoices—thebusinessesheunderstandsbestand thatpresenttheleastrisk,alongwiththegreatestprofitpotential.InthewordsoftheprophetMaeWest:“Toomuchofagoodthingcanbewonderful.”

We should note that we expect to keep permanently our three primaryholdings, Capital Cities/ABC, Inc., GEICOCorporation, and TheWashingtonPost.22 Even if these securities were to appear significantly overpriced, wewould not anticipate selling them, just as wewould not sell See’s or BuffaloEveningNews if someonewere to offer us a price far abovewhatwebelievethosebusinessesareworth.

Thisattitudemayseemold-fashionedinacorporateworldinwhichactivityhasbecometheorderoftheday.Themodernmanagerreferstohis“portfolio”ofbusinesses—meaning that all of them are candidates for “restructuring”whenever such a move is dictated by Wall Street preferences, operatingconditions or a new corporate “concept.” (Restructuring is defined narrowly,however: itextendsonly todumpingoffendingbusinesses,not todumping theofficersanddirectorswhoboughtthebusinessesinthefirstplace.“Hatethesinbut lovethesinner”isa theologyaspopularwiththeFortune500as it iswiththeSalvationArmy.)

Investment managers are even more hyperkinetic: their behavior duringtradinghoursmakeswhirlingdervishesappearsedatedbycomparison. Indeed,the term “institutional investor” is becoming one of those self-contradictionscalled an oxymoron, comparable to “jumbo shrimp,” “lady mudwrestler” and“inexpensivelawyer.”

Despite the enthusiasm for activity that has swept business and financialAmerica, we will stick with our ‘til-death-do-us-part policy. It’s the only onewithwhichCharlieandIarecomfortable,itproducesdecentresults,anditletsourmanagersandthoseofourinvesteesruntheirbusinessesfreeofdistractions.

Our stay-put behavior reflects our view that the stockmarket serves as arelocationcenteratwhichmoneyismovedfromtheactivetothepatient.(Withtongueonlypartlyincheck,Isuggestthatrecenteventsindicatethatthemuch-maligned“idlerich”havereceivedabadrap:Theyhavemaintainedorincreasedtheir wealth while many of the “energetic rich”—aggressive real estate

operators, corporate acquirers, oil drillers, etc.—have seen their fortunesdisappear.)

We continually search for large businesseswith understandable, enduringand mouth-watering economics that are run by able and shareholder-orientedmanagements. This focus doesn’t guarantee results:We both have to buy at asensiblepriceandgetbusinessperformance fromourcompanies thatvalidatesour assessment. But this investment approach—searching for the superstars—offers us our only chance for real success.Charlie and I are simply not smartenough,consideringthelargesumsweworkwith,togetgreatresultsbyadroitlybuyingandsellingportionsoffar-from-greatbusinesses.Nordowethinkmanyothers can achieve long-term investment success by flitting from flower toflower. Indeed, we believe that according the name “investors” to institutionsthattradeactivelyislikecallingsomeonewhorepeatedlyengagesinone-nightstandsaromantic.

If my universe of business possibilities was limited, say, to privatecompanies in Omaha, I would, first, try to assess the long-term economiccharacteristics of each business; second, assess the quality of the people inchargeofrunningit;and,third,trytobuyintoafewofthebestoperationsatasensibleprice.Icertainlywouldnotwishtoownanequalpartofeverybusinessintown.Why,then,shouldBerkshiretakeadifferenttackwhendealingwiththelarger universe of public companies? And since finding great businesses andoutstandingmanagersissodifficult,whyshouldwediscardprovenproducts?(Iwastemptedtosay“thereal thing.”)Ourmotto is:“Ifatfirstyoudosucceed,quittrying.”

JohnMaynardKeynes,whose brilliance as a practicing investormatchedhis brilliance in thought, wrote a letter to a business associate, F.C. Scott, onAugust 15, 1934 that says it all: “As time goes on, I get more and moreconvinced that the rightmethod in investment is to put fairly large sums intoenterpriseswhichonethinksoneknowssomethingaboutandinthemanagementofwhichone thoroughlybelieves. It isamistake to think thatone limitsone’srisk by spreading toomuch between enterprises aboutwhich one knows littleandhasnoreasonforspecialconfidence.One’sknowledgeandexperiencearedefinitelylimitedandthereareseldommorethantwoorthreeenterprisesatanygiventimeinwhichIpersonallyfeelmyselfentitledtoputfullconfidence.”

During1987thestockmarketwasanareaofmuchexcitementbutlittlenetmovement:TheDowadvanced2.3%fortheyear.Youareaware,ofcourse,ofthe roller coaster ride that produced thisminor change.Mr.Market was on a

manicrampageuntilOctoberandthenexperiencedasudden,massiveseizure.We have “professional” investors, those who manage many billions, to

thankformostofthisturmoil.Insteadoffocusingonwhatbusinesseswilldointhe years ahead, many prestigious money managers now focus on what theyexpect other money managers to do in the days ahead. For them, stocks aremerelytokensinagame,likethethimbleandflatironinMonopoly.

Anextremeexampleofwhattheirattitudeleadstois“portfolioinsurance,”amoney-managementstrategythatmanyleadinginvestmentadvisorsembracedin 1986-1987.This strategy—which is simply an exotically-labeled version ofthesmallspeculator’sstop-lossorder—dictatesthatever-increasingportionsofastockportfolio,ortheir index-futureequivalents,besoldaspricesdecline.Thestrategy says nothing else matters: A downtick of a given magnitudeautomatically produces a huge sell order.According to theBradyReport, $60billionto$90billionofequitieswerepoisedonthishairtriggerinmid-Octoberof1987.

Ifyou’vethoughtthatinvestmentadvisorswerehiredtoinvest,youmaybebewilderedbythistechnique.Afterbuyingafarm,wouldarationalownernextorderhisrealestateagenttostartsellingoffpiecesofitwheneveraneighboringpropertywassoldata lowerprice?Orwouldyousellyourhouse towhateverbidderwasavailableat9:31onsomemorningmerelybecauseat9:30asimilarhousesoldforlessthanitwouldhavebroughtonthepreviousday?

Moveslikethat,however,arewhatportfolioinsurancetellsapensionfundor university to make when it owns a portion of enterprises such as Ford orGeneral Electric. The less these companies are being valued at, says thisapproach,themorevigorouslytheyshouldbesold.Asa“logical”corollary,theapproach commands the institutions to repurchase these companies—I’m notmakingthisup—oncetheirpriceshavereboundedsignificantly.Consideringthathuge sums are controlled by managers following such Alice-in-Wonderlandpractices, is it any surprise that markets sometimes behave in aberrationalfashion?

Many commentators, however, have drawn an incorrect conclusion uponobservingrecentevents:Theyarefondofsayingthatthesmallinvestorhasnochanceinamarketnowdominatedbytheerraticbehaviorofthebigboys.Thisconclusion is dead wrong: Suchmarkets are ideal for any investor—small orlarge—so long as he sticks to his investment knitting. Volatility caused bymoneymanagerswhospeculate irrationallywithhuge sumswilloffer the trueinvestormorechancestomakeintelligentinvestmentmoves.Hecanbehurtbysuchvolatilityonlyifheisforced,byeitherfinancialorpsychologicalpressures,tosellatuntowardtimes.

D.“Value”Investing:ARedundancy23

Wereallydon’tseemanyfundamentaldifferencesbetweenthepurchaseofacontrolledbusinessandthepurchaseofmarketableholdings.Ineachcasewetry to buy into businesseswith favorable long-term economics.Our goal is tofind an outstanding business at a sensible price, not amediocre business at abargainprice.CharlieandIhavefoundthatmakingsilkpursesoutofsilkisthebestthatwecando;withsow’sears,wefail.

(ItmustbenotedthatyourChairman,alwaysaquickstudy,requiredonly20 years to recognize how important it was to buy good businesses. In theinterim, I searched for “bargains”—and had themisfortune to find some.Mypunishment was an education in the economics of short-line farm implementmanufacturers, third-place department stores, and New England textilemanufacturers.)

Of course, Charlie and I may misread the fundamental economics of abusiness.Whenthathappens,wewillencounterproblemswhetherthatbusinessisawholly-ownedsubsidiaryoramarketablesecurity,althoughitisusuallyfareasier to exit from the latter. (Indeed, businesses can bemisread:Witness theEuropean reporter who, after being sent to this country to profile AndrewCarnegie, cabled his editor, “MyGod, you’ll never believe the sort ofmoneythereisinrunninglibraries.”)

Inmakingboth control purchases and stockpurchases,we try to buynotonly good businesses, but ones run by high-grade, talented and likeablemanagers. If we make a mistake about the managers we link up with, thecontrolled company offers a certain advantage becausewe have the power toeffect change. In practice, however, this advantage is somewhat illusory:Management changes, like marital changes, are painful, time-consuming andchancy.Inanyevent,atourthreemarketable-but-permanentholdings,thispointismoot:WithTomMurphyandDanBurkeatCapCities,BillSnyderandLouSimpson at GEICO, andKayGraham andDick Simmons at TheWashingtonPost,wesimplycouldn’tbeinbetterhands.

Iwouldsaythatthecontrolledcompanyofferstwomainadvantages.First,whenwecontrolacompanywegettoallocatecapital,whereaswearelikelytohave littleornothing to sayabout thisprocesswithmarketableholdings.Thispointcanbeimportantbecausetheheadsofmanycompaniesarenotskilledincapitalallocation.Theirinadequacyisnotsurprising.Mostbossesrisetothetopbecause they have excelled in an area such as marketing, production,engineering,administration—or,sometimes,institutionalpolitics.

Once they becomeCEOs, they face new responsibilities. They nowmust

makecapitalallocationdecisions,acriticaljobthattheymayhavenevertackledandthatisnoteasilymastered.Tostretchthepoint,it’sasifthefinalstepforahighly-talentedmusicianwasnottoperformatCarnegieHallbut,instead,tobenamedChairmanoftheFederalReserve.

The lack of skill that many CEOs have at capital allocation is no smallmatter: After ten years on the job, a CEO whose company annually retainsearnings equal to 10% of net worth will have been responsible for thedeploymentofmorethan60%ofallthecapitalatworkinthebusiness.

CEOswho recognize their lack of capital-allocation skills (which not alldo) will often try to compensate by turning to their staffs, managementconsultants,or investmentbankers.Charlieand Ihave frequentlyobserved theconsequencesofsuch“help.”Onbalance,wefeelitismorelikelytoaccentuatethecapital-allocationproblemthantosolveit.

Intheend,plentyofunintelligentcapitalallocationtakesplaceincorporateAmerica. (That’s why you hear so much about “restructuring.”) Berkshire,however,hasbeenfortunate.Atthecompaniesthatareourmajornon-controlledholdings,capitalhasgenerallybeenwell-deployedand,insomecases,brilliantlyso.

Thesecondadvantageofacontrolledcompanyoveramarketablesecurityhastodowithtaxes.Berkshire,asacorporateholder,absorbssomesignificanttax costs through the ownership of partial positions that we do not when ourownershipis80%orgreater.Suchtaxdisadvantageshavelongbeenwithus,butchangesinthetaxcodecausedthemtoincreasesignificantlyduring[1986].Asaconsequence,agivenbusinessresultcannowdeliverBerkshirefinancialresultsthat are asmuch as 50% better if they come from an 80%-or-greater holdingratherthanfromalesserholding.

Thedisadvantagesofowningmarketablesecuritiesaresometimesoffsetbya huge advantage: Occasionally the stockmarket offers us the chance to buynon-controlling pieces of extraordinary businesses at truly ridiculous prices—dramatically below those commanded in negotiated transactions that transfercontrol.Forexample,wepurchasedourWashingtonPoststockin1973at$5.63per 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 anaverageof$6.67pershare,andafter-taxoperatingearningspershare lastyearwere$9.01.Incasessuchasthese,Mr.Markethasproventobeamightygoodfriend.

Ourequity-investingstrategyremainslittlechangedfromwhatitwaswhen

wesaidinthe1977annualreport:“Weselectourmarketableequitysecuritiesinmuch thewaywewouldevaluateabusiness foracquisition in its entirety.Wewantthebusinesstobeone(a)thatwecanunderstand;(b)withfavorablelong-termprospects;(c)operatedbyhonestandcompetentpeople;and(d)availableataveryattractiveprice.”Wehaveseencausetomakeonlyonechangeinthiscreed:Becauseofbothmarket conditions andour size,wenowsubstitute “anattractiveprice”for“averyattractiveprice.”

Buthow,youwill ask,doesonedecidewhat’s “attractive”? Inansweringthis question, most analysts feel they must choose between two approachescustomarily thought to be in opposition: “value” and “growth.” Indeed,manyinvestment professionals see any mixing of the two terms as a form ofintellectualcross-dressing.

Weview that as fuzzy thinking (inwhich, itmust be confessed, Imyselfengagedsomeyearsago). Inouropinion, the twoapproachesare joinedat thehip:Growth isalways a component in the calculation of value, constituting avariablewhose importance can range from negligible to enormous andwhoseimpactcanbenegativeaswellaspositive.

Inaddition,wethinktheveryterm“valueinvesting”isredundant.Whatis“investing” if it isnot theactof seekingvalueat least sufficient to justify theamountpaid?Consciouslypayingmoreforastockthanitscalculatedvalue—inthe hope that it can soon be sold for a still-higher price—should be labeledspeculation (which is neither illegal, immoral nor—in our view—financiallyfattening).

Whether appropriate or not, the term “value investing” is widely used.Typically,itconnotesthepurchaseofstockshavingattributessuchasalowratioof price to book value, a low price-earnings ratio, or a high dividend yield.Unfortunately, suchcharacteristics, even if theyappear incombination, are farfrom determinative as to whether an investor is indeed buying something forwhat it isworth and is therefore truly operating on the principle of obtainingvalueinhisinvestments.Correspondingly,oppositecharacteristics—ahighratioofpricetobookvalue,ahighprice-earningsratio,andalowdividendyield—areinnowayinconsistentwitha“value”purchase.

Similarly,businessgrowth,per se, tellsus little aboutvalue. It’s true thatgrowth often has a positive impact on value, sometimes one of spectacularproportions.Butsuchaneffectisfarfromcertain.Forexample,investorshaveregularlypouredmoney into thedomesticairlinebusiness to financeprofitless(orworse)growth.For these investors, itwouldhavebeenfarbetter ifOrvillehadfailedtogetoffthegroundatKittyHawk:Themoretheindustryhasgrown,theworsethedisasterforowners.

Growth benefits investors only when the business in point can invest atincremental returns that are enticing—in other words, only when each dollarusedtofinancethegrowthcreatesoveradollaroflong-termmarketvalue.Inthecase of a low-return business requiring incremental funds, growth hurts theinvestor.

InTheTheory of InvestmentValue,written over 50 years ago, JohnBurrWilliamssetforththeequationforvalue,whichwecondensehere:Thevalueofanystock,bondorbusinesstodayisdeterminedbythecashinflowsandoutflows—discounted at an appropriate interest rate—that can be expected to occurduring the remaining life of the asset. Note that the formula is the same forstocks as for bonds.Even so, there is an important, and difficult to dealwith,differencebetweenthetwo:Abondhasacouponandmaturitydatethatdefinefuturecashflows;butinthecaseofequities,theinvestmentanalystmusthimselfestimate the future“coupons.”Furthermore, thequalityofmanagementaffectsthebondcoupononlyrarely—chieflywhenmanagementissoineptordishonestthatpaymentofinterestissuspended.Incontrast,theabilityofmanagementcandramaticallyaffecttheequity“coupons.”

The investment shown by the discounted-flows-of-cash calculation to bethe cheapest is the one that the investor should purchase—irrespective ofwhether thebusinessgrowsor doesn’t, displaysvolatilityor smoothness in itsearnings,orcarriesahighpriceorlow[price]inrelationtoitscurrentearningsandbookvalue.Moreover,thoughthevalueequationhasusuallyshownequitiestobecheaperthanbonds,thatresultisnotinevitable:Whenbondsarecalculatedtobethemoreattractiveinvestment,theyshouldbebought.

Leaving the question of price aside, the best business to own is one thatoveranextendedperiodcanemploylargeamountsofincrementalcapitalatveryhighratesofreturn.Theworstbusinesstoownisonethatmust,orwill,dotheopposite—that is, consistently employ ever-greater amounts of capital at verylowratesofreturn.Unfortunately,thefirsttypeofbusinessisveryhardtofind:Mosthigh-returnbusinessesneedrelativelylittlecapital.Shareholdersofsuchabusinessusuallywillbenefit if itpaysoutmostof itsearnings individendsormakessignificantstockrepurchases.

Thoughthemathematicalcalculationsrequiredtoevaluateequitiesarenotdifficult,ananalyst—evenonewhoisexperiencedandintelligent—caneasilygowronginestimatingfuture“coupons.”AtBerkshire,weattempttodealwiththisproblem in two ways. First, we try to stick to businesses we believe weunderstand.Thatmeanstheymustberelativelysimpleandstableincharacter.Ifabusinessiscomplexorsubjecttoconstantchange,we’renotsmartenoughtopredictfuturecashflows.Incidentally,thatshortcomingdoesn’tbotherus.What

countsformostpeopleininvestingisnothowmuchtheyknow,butratherhowrealisticallytheydefinewhattheydon’tknow.Aninvestorneedstodoveryfewthingsrightaslongasheorsheavoidsbigmistakes.

Second, and equally important, we insist on a margin of safety in ourpurchaseprice.Ifwecalculatethevalueofacommonstocktobeonlyslightlyhigherthanitsprice,we’renotinterestedinbuying.Webelievethismargin-of-safetyprinciple,sostronglyemphasizedbyBenGraham,tobethecornerstoneofinvestmentsuccess.

[A]nintelligentinvestorincommonstockswilldobetterinthesecondarymarket thanhewilldobuyingnew issues.The reasonhas todowith thewaypricesaresetineachinstance.Thesecondarymarket,whichisperiodicallyruledbymassfolly,isconstantlysettinga“clearing”price.Nomatterhowfoolishthatpricemaybe, it’swhatcounts for theholderofa stockorbondwhoneedsorwishes tosell,ofwhomtherearealwaysgoing tobeafewatanymoment. Inmanyinstances,sharesworthxinbusinessvaluehavesoldinthemarketfor½xorless.

The new-issue market, on the other hand, is ruled by controllingstockholdersandcorporations,whocanusuallyselectthetimingofofferingsor,if the market looks unfavorable, can avoid an offering altogether.Understandably,thesesellersarenotgoingtoofferanybargains,eitherbywayofapublicofferingorinanegotiatedtransaction:It’srareyou’llfindx for½xhere. Indeed, in the case of common-stock offerings, selling shareholders areoftenmotivatedtounloadonlywhentheyfeelthemarketisoverpaying.(Thesesellers, of course, would state that proposition somewhat differently, averringinsteadthat theysimplyresistsellingwhenthemarket isunderpayingfor theirgoods.)

Right after year-end, Berkshire purchased 3 million shares of CapitalCities/ABC, Inc. (“CapCities”)at$172.50pershare, themarketpriceofsuchsharesatthetimethecommitmentwasmadeearlyinMarch,1985.I’vebeenonrecordformanyyearsaboutthemanagementofCapCities:Ithinkitisthebestof any publicly-owned company in the country. And Tom Murphy and DanBurkearenotonlygreatmanagers,theyarepreciselythesortoffellowsthatyouwouldwantyourdaughtertomarry.Itisaprivilegetobeassociatedwiththem—andalsoalotoffun,asanyofyouwhoknowthemwillunderstand.

OurpurchaseofstockhelpedCapCitiesfinancethe$3.5billionacquisitionof American Broadcasting Companies. For Cap Cities, ABC is a majorundertaking whose economics are likely to be unexciting over the next few

years.Thisbothersusnotaniota;wecanbeverypatient.(Nomatterhowgreatthetalentoreffort,somethingsjusttaketime:youcan’tproduceababyinonemonthbygettingninewomenpregnant.)

Asevidenceofourconfidence,wehaveexecutedanunusualagreement:foranextendedperiodTom,asCEO(orDan,shouldhebeCEO)votesourstock.This arrangementwas initiatedbyCharlie andme, not byTom.Wealsohaverestrictedourselves invariouswaysregardingsaleofourshares.Theobjectoftheserestrictionsistomakesurethatourblockdoesnotgetsoldtoanyonewhoisa largeholder (or intends tobecomea largeholder)without theapprovalofmanagement, an arrangement similar to ones we initiated some years ago atGEICOandWashingtonPost.

Sincelargeblocksfrequentlycommandpremiumprices,somemightthinkwehaveinjuredBerkshirefinanciallybycreatingsuchrestrictions.Ourviewisjusttheopposite.Wefeelthelong-termeconomicprospectsforthesebusinesses—and, thus,forourselvesasowners—areenhancedbythearrangements.Withthem in place, the first-classmanagerswithwhomwe have aligned ourselvescan focus their efforts entirely upon running the businesses and maximizinglong-term values for owners. Certainly this is much better than having thosemanagersdistractedby“revolving-doorcapitalists”hoping toput thecompany“inplay.” (Ofcourse, somemanagersplace theirown interests above thoseofthe company and its owners and deserve to be shaken up—but, in makinginvestments,wetrytosteerclearofthistype.)

Today,corporateinstabilityisaninevitableconsequenceofwidely-diffusedownership of voting stock. At any time a major holder can surface, usuallymouthing reassuring rhetoric but frequently harboring uncivil intentions. Bycircumscribingourblocksofstockasweoftendo,weintendtopromotestabilitywhere it otherwisemight be lacking. That kind of certainty, combinedwith agoodmanagerandagoodbusiness,providesexcellent soil fora rich financialharvest.That’stheeconomiccaseforourarrangements.

Thehumansideisjustasimportant.Wedon’twantmanagerswelikeandadmire—andwhohavewelcomedamajorfinancialcommitmentbyus—toeverlose any sleepwonderingwhether surprisesmight occur because of our largeownership.Ihavetoldthemtherewillbenosurprises,andtheseagreementsputBerkshire’s signature where my mouth is. That signature also means themanagers have a corporate commitment and therefore need not worry if mypersonalparticipationinBerkshire’saffairsendsprematurely(atermIdefineasanyageshortofthreedigits).

Our Cap Cities purchase was made at a full price, reflecting the veryconsiderable enthusiasm for both media stocks and media properties that has

developedinrecentyears(andthat,inthecaseofsomepropertypurchases,hasapproached a mania). It’s no field for bargains. However, our Cap Citiesinvestmentalliesuswithanexceptionalcombinationofpropertiesandpeople—andweliketheopportunitytoparticipateinsize.

Of course, some of you probably wonder why we are now buying CapCitiesat$172.50persharegiventhatyourChairman,inacharacteristicburstofbrilliance, soldBerkshire’s holdings in the same company at $43 per share in1978–80.Anticipatingyourquestion,Ispentmuchof1985workingonasnappyanswerthatwouldreconciletheseacts.

Alittlemoretime,please.

E.IntelligentInvesting24

Inactivity strikes us as intelligent behavior.Neitherwenormost businessmanagers would dream of feverishly trading highly-profitable subsidiariesbecause a smallmove in theFederalReserve’s discount ratewas predicted orbecause someWall Street pundit had reversed his views on themarket.Why,then, should we behave differently with our minority positions in wonderfulbusinesses? The art of investing in public companies successfully is littledifferent from the art of successfully acquiring subsidiaries. In each case yousimplywanttoacquire,atasensibleprice,abusinesswithexcellenteconomicsandable,honestmanagement.Thereafter,youneedonlymonitorwhetherthesequalitiesarebeingpreserved.

When carried out capably, an investment strategy of that type will oftenresult in its practitioner owning a few securities thatwill come to represent averylargeportionofhisportfolio.Thisinvestorwouldgetasimilarresultifhefollowedapolicyofpurchasinganinterestin,say,20%ofthefutureearningsofanumberofoutstandingcollegebasketballstars.Ahandfulofthesewouldgoonto achieve NBA stardom, and the investor’s take from them would soondominatehisroyaltystream.TosuggestthatthisinvestorshouldselloffportionsofhismostsuccessfulinvestmentssimplybecausetheyhavecometodominatehisportfolioisakintosuggestingthattheBullstradeMichaelJordanbecausehehasbecomesoimportanttotheteam.

In studying the investmentswe havemade in both subsidiary companiesand common stocks, you will see that we favor businesses and industriesunlikely to experience major change. The reason for that is simple: Makingeither type of purchase, we are searching for operations that we believe arevirtually certain to possess enormous competitive strength ten or twenty years

fromnow.Afast-changingindustryenvironmentmayofferthechanceforhugewins,butitprecludesthecertaintyweseek.

Ishouldemphasizethat,ascitizens,CharlieandIwelcomechange:Freshideas, new products, innovative processes and the like cause our country’sstandard of living to rise, and that’s clearly good. As investors, however, ourreaction to a fermenting industry is much like our attitude toward spaceexploration:Weapplaudtheendeavorbutprefertoskiptheride.

Obviouslyallbusinesseschangetosomeextent.Today,See’sisdifferentinmanyways fromwhat itwas in 1972whenwebought it: It offers a differentassortment of candy, employs different machinery and sells through differentdistributionchannels.But thereasonswhypeople todaybuyboxedchocolates,andwhy they buy them from us rather than from someone else, are virtuallyunchangedfromwhattheywereinthe1920swhentheSeefamilywasbuildingthebusiness.Moreover,thesemotivationsarenotlikelytochangeoverthenext20years,oreven50.

Welookforsimilarpredictabilityinmarketablesecurities.TakeCoca-Cola:The zeal and imagination with which Coke products are sold has burgeonedunderRobertoGoizueta,whohasdoneanabsolutely incredible job increatingvalueforhisshareholders.AidedbyDonKeoughandDougIvester,Robertohasrethoughtand improvedeveryaspectof thecompany.But thefundamentalsofthe business—the qualities that underlie Coke’s competitive dominance andstunningeconomics—haveremainedconstantthroughtheyears.

Iwasrecentlystudyingthe1896reportofCoke(andyouthinkthatyouarebehind inyour reading!).At that timeCoke, though itwasalready the leadingsoftdrink,hadbeenaroundforonlyadecade.Butitsblueprintforthenext100yearswasalreadydrawn.Reportingsalesof$148,000thatyear,AsaCandler,thecompany’spresident,said:“Wehavenotlaggedinoureffortstogointoalltheworld teaching thatCoca-Cola is thearticle,parexcellence, for thehealthandgoodfeelingofallpeople.”Though“health”mayhavebeenareach,Ilovethefact that Coke still relies on Candler’s basic theme today—a century later.Candlerwentontosay,justasRobertocouldnow,“Noarticleoflikecharacterhas ever so firmly entrenched itself in public favor.” Sales of syrup that year,incidentally,were116,492gallonsversusabout3.2billionin1996.

Ican’tresistonemoreCandlerquote:“BeginningthisyearaboutMarch1st. . .we employed ten traveling salesmen bymeans ofwhich,with systematiccorrespondencefromtheoffice,wecoveredalmost theterritoryof theUnion.”That’smykindofsalesforce.

Companies such as Coca-Cola and Gillette might well be labeled “TheInevitables.” Forecasters may differ a bit in their predictions of exactly how

muchsoftdrinkorshaving-equipmentbusinessthesecompanieswillbedoingintenortwentyyears.Norisourtalkofinevitabilitymeanttoplaydownthevitalwork that these companies must continue to carry out, in such areas asmanufacturing, distribution, packaging and product innovation. In the end,however, no sensible observer—not even these companies’ most vigorouscompetitors, assuming they are assessing the matter honestly—questions thatCoke and Gillette will dominate their fields worldwide for an investmentlifetime.Indeed,theirdominancewillprobablystrengthen.Bothcompanieshavesignificantly expanded their alreadyhuge shares ofmarket during the past tenyears,andallsignspointtotheirrepeatingthatperformanceinthenextdecade.

Obviouslymanycompaniesinhigh-techbusinessesorembryonicindustrieswillgrowmuchfasterinpercentagetermsthanwillTheInevitables.ButIwouldratherbecertainofagoodresultthanhopefulofagreatone.

Of course,Charlie and I can identifyonly a few Inevitables, even after alifetimeof lookingfor them.Leadershipaloneprovidesnocertainties:WitnesstheshockssomeyearsbackatGeneralMotors,IBMandSears,allofwhichhadenjoyed longperiodsofseeming invincibility.Thoughsome industriesor linesof business exhibit characteristics that endow leaders with virtuallyinsurmountableadvantages,andthattendtoestablishSurvivaloftheFattestasalmostanaturallaw,mostdonot.Thus,foreveryInevitable,therearedozensofImpostors, companies now riding high but vulnerable to competitive attacks.Consideringwhat it takes tobe an Inevitable,Charlie and I recognize thatwewillneverbeabletocomeupwithaNiftyFiftyorevenaTwinklingTwenty.TotheInevitablesinourportfolio,therefore,weaddafew“HighlyProbables.”

You can, of course, pay too much for even the best of businesses. Theoverpayment risk surfaces periodically and, in our opinion,may nowbe quitehighforthepurchasersofvirtuallyallstocks,TheInevitablesincluded.Investorsmakingpurchases inanoverheatedmarketneed to recognize that itmayoftentakeanextendedperiodforthevalueofevenanoutstandingcompanytocatchupwiththepricetheypaid.

A far more serious problem occurs when the management of a greatcompany gets sidetracked and neglects its wonderful base business whilepurchasing other businesses that are so-so or worse. When that happens, thesuffering of investors is often prolonged.Unfortunately, that is preciselywhattranspiredyears ago at bothCoke andGillette. (Wouldyoubelieve that a fewdecades back they were growing shrimp at Coke and exploring for oil atGillette?) Loss of focus is what most worries Charlie and me when wecontemplate investing in businesses that in general look outstanding. All toooften,we’ve seen value stagnate in the presence of hubris or of boredom that

causedtheattentionofmanagerstowander.That’snotgoingtohappenagainatCoke and Gillette, however—not given their current and prospectivemanagements.

*Letme add a few thoughts about your own investments.Most investors,

both institutional and individual, will find that the best way to own commonstocksisthroughanindexfundthatchargesminimalfees.Thosefollowingthispath are sure to beat the net results (after fees and expenses) delivered by thegreatmajorityofinvestmentprofessionals.

Shouldyouchoose,however, to constructyourownportfolio, there are afew thoughtsworth remembering. Intelligent investing is not complex, thoughthat is far from saying that it is easy.What an investor needs is the ability tocorrectly evaluate selected businesses. Note that word “selected”: You don’thavetobeanexpertoneverycompany,orevenmany.Youonlyhavetobeabletoevaluatecompanieswithinyourcircleofcompetence.Thesizeofthatcircleisnotveryimportant;knowingitsboundaries,however,isvital.

To invest successfully, you need not understand beta, efficient markets,modernportfoliotheory,optionpricing,oremergingmarkets.Youmay,infact,bebetteroffknowingnothingofthese.That,ofcourse,isnottheprevailingviewatmost business schools,whose finance curriculum tends to be dominated bysuch subjects. In our view, though, investment students need only two well-taught courses—How to Value a Business, and How to Think About MarketPrices.

Yourgoalasaninvestorshouldsimplybetopurchase,atarationalprice,apart interest in an easily-understandable businesswhose earnings are virtuallycertaintobemateriallyhigherfive,tenandtwentyyearsfromnow.Overtime,youwillfindonlyafewcompaniesthatmeetthesestandards—sowhenyouseeonethatqualifies,youshouldbuyameaningfulamountofstock.Youmustalsoresistthetemptationtostrayfromyourguidelines:Ifyouaren’twillingtoownastock for ten years, don’t even think about owning it for ten minutes. Puttogetheraportfolioofcompanieswhoseaggregateearningsmarchupwardovertheyears,andsoalsowilltheportfolio’smarketvalue.

Thoughit’sseldomrecognized,thisistheexactapproachthathasproducedgains for Berkshire shareholders: Our look-through earnings have grown at agood clip over the years, and our stock price has risen correspondingly. Hadthosegainsinearningsnotmaterialized,therewouldhavebeenlittleincreaseinBerkshire’svalue.

Overthepast35years,Americanbusinesshasdeliveredterrificresults.Itshouldthereforehavebeeneasyforinvestorstoearnjuicyreturns:AlltheyhadtodowaspiggybackCorporateAmericainadiversified,low-expenseway.Anindex fund that they never touched would have done the job. Instead manyinvestorshavehadexperiencesrangingfrommediocretodisastrous.

There have been three primary causes: first, high costs, usually becauseinvestors tradedexcessivelyorspentfar toomuchoninvestmentmanagement;second, portfolio decisions based on tips and fads rather than on thoughtful,quantified evaluationof businesses; and third, a start-and-stop approach to themarketmarkedbyuntimelyentries (afteranadvancehasbeen longunderway)andexits(afterperiodsofstagnationordecline).Investorsshouldrememberthatexcitementandexpensesaretheirenemies.Andiftheyinsistontryingtotimetheir participation in equities, they should try to be fearful when others aregreedyandgreedyonlywhenothersarefearful.

[S]everal of the companies in which we have large investments haddisappointing business results last year. Nevertheless, we believe thesecompanies have important competitive advantages that will endure over time.This attribute, which makes for good long-term investment results, is oneCharlie and I occasionally believe we can identify. More often, however, wecan’t—notatleastwithahighdegreeofconviction.Thisexplains,bytheway,whywedon’townstocksoftechcompanies,eventhoughwesharethegeneralview that our societywill be transformed by their products and services.Ourproblem—whichwecan’tsolvebystudyingup—isthatwehavenoinsightsintowhich participants in the tech field possess a truly durable competitiveadvantage.

Our lack of tech insights, we should add, does not distress us. After all,there are a greatmany business areas inwhichCharlie and I have no specialcapital-allocationexpertise.For instance,webringnothing to the tablewhenitcomes to evaluating patents,manufacturing processes or geological prospects.Sowesimplydon’tgetintojudgmentsinthosefields.

Ifwehaveastrength,itisinrecognizingwhenweareoperatingwellwithinourcircleofcompetenceandwhenweareapproachingtheperimeter.Predictingthelong-termeconomicsofcompaniesthatoperateinfast-changingindustriesissimply far beyond our perimeter. If others claim predictive skill in thoseindustries—andseemtohavetheirclaimsvalidatedbythebehaviorofthestockmarket—weneitherenvynoremulatethem.Instead,wejuststickwithwhatweunderstand.Ifwestray,wewillhavedonesoinadvertently,notbecausewegot

restlessandsubstitutedhopeforrationality.Fortunately,it’salmostcertaintherewillbeopportunitiesfromtimetotimeforBerkshiretodowellwithinthecirclewe’vestakedout.

Rightnow,thepricesofthefinebusinesseswealreadyownarejustnotthatattractive. In otherwords,we feelmuchbetter about the businesses than theirstocks.That’swhywehaven’taddedtoourpresentholdings.Nevertheless,wehaven’tyetscaledbackourportfolioinamajorway:Ifthechoiceisbetweenaquestionable business at a comfortable price or a comfortable business at aquestionable price, we much prefer the latter. What really gets our attention,however,isacomfortablebusinessatacomfortableprice.

Our reservations about the prices of securities we own apply also to thegeneral level of equity prices.We have never attempted to forecast what thestockmarket isgoingtodointhenextmonthor thenextyear,andwearenottrying to do that now. But [as of late 1999] equity investors currently seemwildlyoptimisticintheirexpectationsaboutfuturereturns.

Weseethegrowthincorporateprofitsasbeinglargelytiedtothebusinessdoneinthecountry(GDP),andweseeGDPgrowingatarealrateofabout3%.Inaddition,wehavehypothesized2%inflation.CharlieandIhavenoparticularconvictionabouttheaccuracyof2%.However,it’sthemarket’sview:TreasuryInflation-ProtectedSecurities(TIPS)yieldabouttwopercentagepointslessthanthe standard treasury bond, and if you believe inflation rates are going to behigher than that, you can profit by simply buying TIPS and shortingGovernments.

IfprofitsdoindeedgrowalongwithGDP,atabouta5%rate,thevaluationplacedonAmericanbusinessisunlikelytoclimbbymuchmorethanthat.Addinsomethingfordividends,andyouemergewithreturnsfromequitiesthataredramatically less than most investors have either experienced in the past orexpect in the future. If investor expectations becomemore realistic—and theyalmostcertainlywill—themarketadjustmentisapttobesevere,particularlyinsectors in which speculation has been concentrated. Berkshire will somedayhaveopportunitiestodeploymajoramountsofcashinequitymarkets—weareconfident of that. But, as the song goes, “Who knows where or when?”Meanwhile, if anyone starts explaining to you what is going on in the truly-manic portions of this “enchanted”market, youmight remember still anotherlineofsong:“Foolsgiveyoureasons,wisemennevertry.”

[At timeswhenpricesarehigh forbothbusinessesandstocks],we try toexertaTedWilliamskindofdiscipline.InhisbookTheScienceofHitting,Ted

explainsthathecarvedthestrikezoneinto77cells,eachthesizeofabaseball.Swingingonlyatballsinhis“best”cell,heknew,wouldallowhimtobat.400;reachingforballsinhis“worst”spot,thelowoutsidecornerofthestrikezone,wouldreducehimto.230.Inotherwords,waitingforthefatpitchwouldmeanatrip to theHallofFame;swinging indiscriminatelywouldmeana ticket to theminors.

If theyareinthestrikezoneatall, thebusiness“pitches”wenowseearejustcatchingtheloweroutsidecorner.Ifweswing,wewillbelockedintolowreturns.Butifweletalloftoday’sballsgoby,therecanbenoassurancethatthenextonesweseewillbemoretoourliking.Perhapstheattractivepricesofthepastwere theaberrations,not the fullpricesof today.UnlikeTed,wecan’tbecalled out if we resist three pitches that are barely in the strike zone;nevertheless, just standing there,dayafterday,withmybatonmyshoulder isnotmyideaoffun.

F.CigarButtsandtheInstitutionalImperative25

To quote Robert Benchley, “Having a dog teaches a boy fidelity,perseverance,and to turnaround three timesbefore lyingdown.”Suchare theshortcomings of experience. Nevertheless, it’s a good idea to review pastmistakesbeforecommittingnewones.So let’s takeaquick lookat the last25years.

•Myfirstmistake,ofcourse,wasinbuyingcontrolofBerkshire.ThoughIknewitsbusiness—textilemanufacturing—tobeunpromising,Iwasenticedtobuy because the price looked cheap. Stock purchases of that kind had provedreasonably rewarding in my early years, though by the time Berkshire camealongin1965Iwasbecomingawarethatthestrategywasnotideal.

If youbuy a stock at a sufficiently lowprice, therewill usually be somehiccup in the fortunes of the business that gives you a chance to unload at adecent profit, even though the long-term performance of the businessmay beterrible.Icallthisthe“cigarbutt”approachtoinvesting.Acigarbuttfoundonthestreetthathasonlyonepuffleftinitmaynotoffermuchofasmoke,butthe“bargainpurchase”willmakethatpuffallprofit.

Unlessyouarea liquidator, thatkindofapproach tobuyingbusinesses isfoolish.First,theoriginal“bargain”priceprobablywillnotturnouttobesuchasteal after all. In a difficult business, no sooner is one problem solved thananothersurfaces—neveristherejustonecockroachinthekitchen.Second,anyinitial advantage you securewill be quickly eroded by the low return that the

business earns. For example, if you buy a business for $8million that can besold or liquidated for $10 million and promptly take either course, you canrealizeahigh return.But the investmentwilldisappoint if thebusiness is soldfor $10 million in ten years and in the interim has annually earned anddistributed only a few percent on cost. Time is the friend of the wonderfulbusiness,theenemyofthemediocre.

Youmightthinkthisprincipleisobvious,butIhadtolearnitthehardway—infact,Ihadtolearnitseveraltimesover.ShortlyafterpurchasingBerkshire,I acquired aBaltimore department store,Hochschild,Kohn, buying through acompanycalledDiversifiedRetailingthatlatermergedwithBerkshire.Iboughtat a substantial discount frombook value, the peoplewere first-class, and thedealincludedsomeextras—unrecordedrealestatevaluesandasignificantLIFOinventorycushion.HowcouldImiss?So-o-o—threeyearslaterIwasluckytosellthebusinessforaboutwhatIhadpaid.

•Thatleadsrightintoarelatedlesson:Goodjockeyswilldowellongoodhorses, but not on broken-down nags. Both Berkshire’s textile business andHochschild,Kohnhadableandhonestpeoplerunningthem.Thesamemanagersemployedinabusinesswithgoodeconomiccharacteristicswouldhaveachievedfinerecords.Buttheywerenevergoingtomakeanyprogresswhilerunninginquicksand.26

I’ve said many times that when a management with a reputation forbrilliance tackles a business with a reputation for bad economics, it is thereputation of the business that remains intact. I just wish I hadn’t been soenergeticincreatingexamples.MybehaviorhasmatchedthatadmittedbyMaeWest:“IwasSnowWhite,butIdrifted.”

• A further related lesson: Easy does it. After 25 years of buying andsupervisingagreatvarietyofbusinesses,CharlieandIhavenotlearnedhowtosolvedifficultbusinessproblems.Whatwehavelearnedistoavoidthem.Totheextent we have been successful, it is because we concentrated on identifyingone-foot hurdles thatwe could step over rather than becausewe acquired anyabilitytoclearseven-footers.

The findingmay seem unfair, but in both business and investments it isusuallyfarmoreprofitabletosimplystickwiththeeasyandobviousthanitistoresolve the difficult.On occasion, tough problemsmust be tackled aswas thecasewhenwe startedourSundaypaper inBuffalo. In other instances, a greatinvestmentopportunityoccurswhenamarvelousbusinessencountersaone-timehuge,butsolvable,problemaswasthecasemanyyearsbackatbothAmericanExpressandGEICO.Overall,however,we’vedonebetterbyavoidingdragonsthanbyslayingthem.

•Mymostsurprisingdiscovery:theoverwhelmingimportanceinbusinessofanunseenforcethatwemightcall“theinstitutionalimperative.”Inbusinessschool,Iwasgivennohintoftheimperative’sexistenceandIdidnotintuitivelyunderstand it when I entered the business world. I thought then that decent,intelligent, and experienced managers would automatically make rationalbusiness decisions. But I learned over time that isn’t so. Instead, rationalityfrequentlywiltswhentheinstitutionalimperativecomesintoplay.

For example: (1) As if governed by Newton’s First Law of Motion, aninstitution will resist any change in its current direction; (2) Just as workexpandstofillavailabletime,corporateprojectsoracquisitionswillmaterializeto soak up available funds; (3) Any business craving of the leader, howeverfoolish,willbequicklysupportedbydetailedrate-of-returnandstrategicstudiespreparedbyhis troops; and (4)Thebehaviorofpeercompanies,whether theyare expanding, acquiring, setting executive compensation orwhatever,will bemindlesslyimitated.

Institutional dynamics, not venality or stupidity, set businesses on thesecourses,whicharetoooftenmisguided.Aftermakingsomeexpensivemistakesbecause I ignored the power of the imperative, I have tried to organize andmanageBerkshireinwaysthatminimizeitsinfluence.Furthermore,CharlieandIhaveattemptedtoconcentrateourinvestmentsincompaniesthatappearalerttotheproblem.

•Aftersomeothermistakes,IlearnedtogointobusinessonlywithpeoplewhomI like, trust,andadmire.As Inotedbefore, thispolicyof itselfwillnotensure success: A second-class textile or department-store company won’tprospersimplybecauseitsmanagersarementhatyouwouldbepleasedtoseeyour daughter marry. However, an owner—or investor—can accomplishwondersifhemanagestoassociatehimselfwithsuchpeopleinbusinessesthatpossessdecenteconomiccharacteristics.Conversely,wedonotwishtojoinwithmanagerswholackadmirablequalities,nomatterhowattractivetheprospectsoftheirbusiness.We’veneversucceededinmakingagooddealwithabadperson.

•Someofmyworstmistakeswerenotpubliclyvisible.ThesewerestockandbusinesspurchaseswhosevirtuesIunderstoodandyetdidn’tmake.It’snosin tomiss a great opportunity outside one’s area of competence. But I havepassedonacoupleofreallybigpurchasesthatwereserveduptomeonaplatterand that I was fully capable of understanding. For Berkshire’s shareholders,myselfincluded,thecostofthisthumb-suckinghasbeenhuge.

•Ourconsistently-conservativefinancialpoliciesmayappeartohavebeenamistake, but inmyviewwerenot. In retrospect, it is clear that significantlyhigher, though still conventional, leverage ratios at Berkshire would have

producedconsiderablybetterreturnsonequitythanthe23.8%wehaveactuallyaveraged. Even in 1965, perhaps we could have judged there to be a 99%probability that higher leverage would lead to nothing but good.Correspondingly,wemighthaveseenonlya1%chancethatsomeshockfactor,external or internal,would cause a conventional debt ratio to produce a resultfallingsomewherebetweentemporaryanguishanddefault.

Wewouldn’thavelikedthose99:1odds—andneverwill.Asmallchanceofdistress or disgrace cannot, in our view, be offset by a large chance of extrareturns.Ifyouractionsaresensible,youarecertaintogetgoodresults;inmostsuch cases, leverage just moves things along faster. Charlie and I have neverbeeninabighurry:Weenjoytheprocessfarmorethantheproceeds—thoughwehavelearnedtolivewiththosealso.

G.LifeandDebt27

Except for token amounts, we shun debt, turning to it for only threepurposes:(1)Weoccasionallyusereposasapartofcertainshort-terminvestingstrategiesthatincorporateownershipofU.S.government(oragency)securities.Purchasesofthiskindarehighlyopportunisticandinvolveonlythemostliquidof securities. (2) We borrow money against portfolios of interest-bearingreceivableswhoseriskcharacteristicsweunderstand.(3)[Subsidiaries,suchasMidAmerican,mayincurdebtthatappearsonBerkshire’sconsolidatedbalancesheet,butBerkshiredoesnotguaranteetheobligation.]

Fromariskstandpoint,itisfarsafertohaveearningsfromtendiverseanduncorrelatedutilityoperationsthatcoverinterestchargesby,say,a2:1ratiothanitistohavefargreatercoverageprovidedbyasingleutility.Acatastrophiceventcan render a single utility insolvent—witness what Katrina did to the localelectricutility inNewOrleans—nomatterhowconservative itsdebtpolicy.Ageographical disaster—say, an earthquake in a Western state—can’t have thesameeffectonMidAmerican.AndevenaworrierlikeCharliecan’tthinkofanevent that would systemically decrease utility earnings in any major way.BecauseofMidAmerican’sever-wideningdiversityofregulatedearnings,itwillalwaysutilizemajoramountsofdebt.

Andthat’saboutit.WearenotinterestedinincurringanysignificantdebtatBerkshireforacquisitionsoroperatingpurposes.Conventionalbusinesswisdom,of course, would argue that we are being too conservative and that there areaddedprofits thatcouldbesafelyearnedifwe injectedmoderate leverage intoourbalancesheet.Maybeso.ButmanyofBerkshire’shundredsofthousandsof

investors have a large portion of their networth in our stock (among them, itshould be emphasized, a large number of our board and keymanagers) and adisasterforthecompanywouldbeadisasterforthem.

Moreover, there are peoplewho have been permanently injured towhomweoweinsurancepaymentsthatstretchoutforfiftyyearsormore.Totheseandotherconstituencieswehavepromisedtotalsecurity,whatevercomes:financialpanics, stock-exchange closures (an extended one occurred in 1914) or evendomesticnuclear,chemicalorbiologicalattacks.Wearequitewillingtoaccepthugerisks.Indeed,morethananyotherinsurer,wewritehigh-limitpoliciesthataretiedtosinglecatastrophicevents.

We also own a large investment portfolio whosemarket value could falldramaticallyandquicklyundercertainconditions(ashappenedonOctober19,1987).Whateveroccurs,though,Berkshirewillhavethenetworth,theearningsstreamsandtheliquiditytohandletheproblemwithease.Anyotherapproachisdangerous.Overtheyears,anumberofverysmartpeoplehavelearnedthehardwaythatalongstringofimpressivenumbersmultipliedbyasinglezeroalwaysequals zero. That is not an equationwhose effects Iwould like to experiencepersonally,andIwouldlikeevenlesstoberesponsibleforimposingitspenaltiesuponothers.

Unquestionably, some people have become very rich through the use ofborrowed money. However, that’s also been a way to get very poor. Whenleverageworks, itmagnifiesyourgains.Yourspouse thinksyou’reclever,andyourneighborsgetenvious.Butleverageisaddictive.Oncehavingprofitedfromitswonders,veryfewpeopleretreattomoreconservativepractices.Andasweall learned in thirdgrade—andsomerelearned in2008—anyseriesofpositivenumbers,howeverimpressivethenumbersmaybe,evaporateswhenmultipliedbyasinglezero.Historytellsusthatleveragealltoooftenproduceszeroes,evenwhenitisemployedbyverysmartpeople.

Leverage, of course, can be lethal to businesses aswell.Companieswithlargedebtsoftenassumethattheseobligationscanberefinancedastheymature.That assumption is usually valid. Occasionally, though, either because ofcompany-specific problemsor aworldwide shortage of credit,maturitiesmustactuallybemetbypayment.Forthat,onlycashwilldothejob.

Borrowersthenlearnthatcreditislikeoxygen.Wheneitherisabundant,itspresencegoesunnoticed.Wheneitherismissing,that’sallthatisnoticed.Evenashortabsenceofcreditcanbringacompanytoitsknees.InSeptember2008,infact, its overnight disappearance in many sectors of the economy came

dangerouslyclosetobringingourentirecountrytoitsknees.CharlieandIhaveno interest inanyactivity thatcouldpose theslightest

threattoBerkshire’swellbeing.(Withourhavingacombinedageof167,startingoverisnotonourbucketlist.)Weareforeverconsciousofthefactthatyou,ourpartners,haveentrusteduswithwhat inmanycasesisamajorportionofyoursavings. In addition, important philanthropy is dependent on our prudence.Finally,manydisabledvictimsofaccidentscausedbyourinsuredsarecountingonustodeliversumspayabledecadesfromnow.Itwouldbeirresponsibleforusto riskwhat all these constituencies need just to pursue a few points of extrareturn.

AtBerkshire,wewillholdatleast$10billionofcash,excludingthatheldatourregulatedutilityandrailroadbusinesses.Becauseofthatcommitment,wecustomarily keep at least $20 billion on hand so that we can both withstandunprecedentedinsurancelosses(ourlargesttodatehavingbeenabout$3billionfromKatrina,theinsuranceindustry’smostexpensivecatastrophe)andquicklyseize acquisition or investment opportunities, even during times of financialturmoil.

WekeepourcashlargelyinU.S.Treasurybillsandavoidothershort-termsecuritiesyieldingafewmorebasispoints,apolicyweadheredtolongbeforethe frailtiesof commercialpaperandmoneymarket fundsbecameapparent inSeptember 2008. We agree with investment writer Ray DeVoe’s observation,“Moremoneyhas been lost reaching for yield than at the point of a gun.”AtBerkshire,we don’t rely on bank lines, andwe don’t enter into contracts thatcouldrequirepostingsofcollateralexceptforamountsthataretinyinrelationtoourliquidassets.

Furthermore,notadimeofcashhas leftBerkshire fordividendsor sharerepurchases during the past 40 years. Instead, we have retained all of ourearnings to strengthen our business, a reinforcement now running about $1billionpermonth.Ournetworthhas thus increased from$48million to$157billionduringthosefourdecadesandourintrinsicvaluehasgrownfarmore.NootherAmericancorporationhascomeclosetobuildingupitsfinancialstrengthinthisunrelentingway.

Bybeing so cautious in respect to leverage,wepenalizeour returnsbyaminoramount.Having loadsof liquidity, though, letsussleepwell.Moreover,during the episodesof financial chaos that occasionally erupt inour economy,we will be equipped both financially and emotionally to play offense whileothersscrambleforsurvival.

That’swhatallowedustoinvest$15.6billionin25daysofpanicfollowingtheLehmanbankruptcyin2008.

16[Introductoryessay,1985.]17[Dividedbyhashlines:1987;1997.]18[Dividedbyhashlines:1988;1989.]19[Dividedbyhashlines:1988;1993;1986;1991;1987.]20[Aseparateparagraphfromthis1993letterprovidedasfollows:]Letme add a lesson from history: Cokewent public in 1919 at $40 per

share. By the end of 1920 the market, coldly reevaluating Coke’s futureprospects,hadbattered thestockdownbymore than50%, to$19.50.Atyear-end1993,thatsingleshare,withdividendsreinvested,wasworthmorethan$2.1million.AsBenGrahamsaid:“Intheshort-run,themarketisavotingmachine—reflectingavoter-registrationtestthatrequiresonlymoney,notintelligenceoremotionalstability—butinthelong-run,themarketisaweighingmachine.”

21 [GillettemergedwithProcter&Gamble(P&G)inlate2005.The2005letterstates:“Wedidn’tintendtosellourGillettesharesbeforethemerger;wedon’tintendtosellourP&Gsharesnow.”]

22 [Berkshire’s Capital Cities/ABC holdings left the “primary andpermanent”categoryfollowingits1996acquisition,forstockandcash,byTheWaltDisneyCompany.]

23[Dividedbyhashlines:1987;1992;1985.]24[Dividedbyhashlines:1996;2004;1999;1997.]25[1989.]26[SeetheessayTheAnxietiesofBusinessChangeinPartI.C.]27[2005;2010.]

III.INVESTMENTALTERNATIVES

In addition to our permanent common stock holdings, we hold largequantities of marketable securities in our insurance companies. In selectingthese,wecanchooseamongfivemajorcategories:(1)long-termcommonstockinvestments, (2) medium-term fixed-income securities, (3) long-term fixedincomesecurities, (4) short-termcashequivalents, and (5) short-termarbitragecommitments[asdiscussedintheessayArbitrageinPartII.B].

We have no particular bias when it comes to choosing from thesecategories.We just continuously search among them for the highest after-taxreturnsasmeasuredby“mathematicalexpectation,”limitingourselvesalwaystoinvestmentalternativeswethinkweunderstand.Ourcriteriahavenothingtodowith maximizing immediately reportable earnings; our goal, rather, is tomaximizeeventualnetworth.28

A.SurveyingtheField29

Investment possibilities are bothmany and varied. There are threemajorcategories,however,andit’simportanttounderstandthecharacteristicsofeach.Solet’ssurveythefield.

Investments that are denominated in a given currency include money-marketfunds,bonds,mortgages,bankdeposits,andother instruments.Mostofthese currency-based investments are thought of as “safe.” In truth they areamong themost dangerous of assets.Their betamay be zero, but their risk ishuge.

Over the past century these instruments have destroyed the purchasingpowerof investors inmanycountries,evenas theholderscontinued toreceivetimely payments of interest and principal. This ugly result, moreover, willforeverrecur.Governmentsdeterminetheultimatevalueofmoney,andsystemicforceswillsometimescausethemtogravitatetopoliciesthatproduceinflation.Fromtimetotimesuchpoliciesspinoutofcontrol.

EvenintheU.S.,wherethewishforastablecurrencyisstrong,thedollarhasfallenastaggering86%invaluesince1965,whenItookovermanagementof Berkshire. It takes no less than $7 today to buy what $1 did at that time.Consequently, a tax-free institutionwould have needed 4.3% interest annuallyfrombondinvestmentsoverthatperiodtosimplymaintainitspurchasingpower.

Itsmanagerswouldhavebeenkiddingthemselvesiftheythoughtofanyportionofthatinterestas“income.”

For taxpaying investors, the picture has been farworse.During the same47-year period, continuous rolling of U.S. Treasury bills produced 5.7%annually. That sounds satisfactory. But if an individual investor paid personalincome taxes at a rate averaging 25%, this 5.7% return would have yieldednothinginthewayofrealincome.Thisinvestor’svisibleincometaxwouldhavestripped him of 1.4 points of the stated yield, and the invisible inflation taxwouldhavedevouredtheremaining4.3points.It’snoteworthythattheimplicitinflation “tax” was more than triple the explicit income tax that our investorprobablythoughtofashismainburden.“InGodWeTrust”maybeimprintedonour currency, but the hand that activates our government’s printing press hasbeenalltoohuman.

High interest rates,ofcourse,cancompensatepurchasers for the inflationrisk they facewith currency-based investments—and indeed, rates in the early1980sdidthatjobnicely.Currentrates,however,donotcomeclosetooffsettingthepurchasing-powerriskthatinvestorsassume.Rightnowbondsshouldcomewithawarninglabel.

Under today’s conditions, therefore, I do not like currency-basedinvestments.Evenso,Berkshireholdssignificantamountsofthem,primarilyoftheshort-termvariety.AtBerkshiretheneedforampleliquidityoccupiescenterstage and will never be slighted, however inadequate rates may be.Accommodating this need, we primarily hold U.S. Treasury bills, the onlyinvestment that can be counted on for liquidity under the most chaotic ofeconomicconditions.Ourworkinglevelforliquidityis$20billion;$10billionisourabsoluteminimum.

Beyondtherequirementsthatliquidityandregulatorsimposeonus,wewillpurchasecurrency-relatedsecuritiesonlyiftheyofferthepossibilityofunusualgain—either because a particular credit ismispriced, as can occur in periodicjunk-bonddebacles,orbecauseratesrisetoalevelthatoffersthepossibilityofrealizingsubstantialcapitalgainsonhigh-gradebondswhenratesfall.Thoughwe’veexploitedbothopportunities in thepast—andmaydo soagain—wearenow180degreesremovedfromsuchprospects.Today,awrycommentthatWallStreeter ShelbyCullomDavismade long ago seems apt: “Bonds promoted asofferingrisk-freereturnsarenowpricedtodeliverreturn-freerisk.”

The secondmajor categoryof investments involves assets thatwill neverproduceanything,butthatarepurchasedinthebuyer’shopethatsomeoneelse—whoalsoknowsthat theassetswillbeforeverunproductive—willpaymorefor them in the future. Tulips, of all things, briefly became a favorite of such

buyersinthe17thcentury.Thistypeofinvestmentrequiresanexpandingpoolofbuyers,who,inturn,

are enticed because they believe the buying pool will expand still further.Owners are not inspired by what the asset itself can produce—it will remainlifeless forever—but rather by the belief that others will desire it even moreavidlyinthefuture.

The major asset in this category is gold, currently a huge favorite ofinvestors who fear almost all other assets, especially paper money (of whosevalue,asnoted,theyarerighttobefearful).Gold,however,hastwosignificantshortcomings,beingneitherofmuchusenorprocreative.True,goldhas someindustrial and decorative utility, but the demand for these purposes is bothlimitedandincapableofsoakingupnewproduction.Meanwhile,ifyouownoneounceofgoldforaneternity,youwillstillownoneounceatitsend.

Whatmotivatesmost gold purchasers is their belief that the ranks of thefearfulwillgrow.Duringthepastdecadethatbeliefhasprovedcorrect.Beyondthat, the rising price has on its own generated additional buying enthusiasm,attracting purchasers who see the rise as validating an investment thesis. As“bandwagon”investorsjoinanyparty,theycreatetheirowntruth—forawhile.

Overthepast15years,bothInternetstocksandhouseshavedemonstratedtheextraordinaryexcessesthatcanbecreatedbycombininganinitiallysensiblethesiswithwell-publicizedrisingprices.Inthesebubbles,anarmyoforiginallyskeptical investors succumbed to the “proof” deliveredby themarket, and thepool of buyers—for a time—expanded sufficiently to keep the bandwagonrolling.Butbubblesblownlargeenoughinevitablypop.

Todaytheworld’sgoldstockisabout170,000metrictons.Ifallofthisgoldweremeldedtogether,itwouldformacubeofabout68feetperside.(Pictureitfittingcomfortablywithinabaseballinfield.)At$1,750perounce—gold’spriceasIwritethis—itsvaluewouldbe$9.6trillion.CallthiscubepileA.

Let’snowcreateapileBcostinganequalamount.Forthat,wecouldbuyallU.S.cropland(400millionacreswithoutputofabout$200billionannually),plus16ExxonMobils(theworld’smostprofitablecompany,oneearningmorethan $40 billion annually). After these purchases, we would have about $1trillionleftoverforwalking-aroundmoney(nosensefeelingstrappedafterthisbuyingbinge).Canyou imaginean investorwith$9.6 trillion selectingpileAoverpileB?

Beyond the staggering valuation given the existing stock of gold, currentprices make today’s annual production of gold command about $160 billion.Buyers—whether jewelry and industrial users, frightened individuals, orspeculators—mustcontinuallyabsorbthisadditionalsupplytomerelymaintain

anequilibriumatpresentprices.Acenturyfromnowthe400millionacresoffarmlandwillhaveproduced

staggeringamountsofcorn,wheat,cotton,andothercrops—andwillcontinuetoproducethatvaluablebounty,whateverthecurrencymaybe.ExxonMobilwillprobablyhavedelivered trillionsofdollars individends to itsowners andwillalsoholdassetsworthmanymoretrillions(and,remember,youget16Exxons).The 170,000 tons of gold will be unchanged in size and still incapable ofproducinganything.Youcanfondlethecube,butitwillnotrespond.

Admittedly,whenpeopleacentury fromnoware fearful, it’s likelymanywill still rush to gold. I’m confident, however, that the $9.6 trillion currentvaluationofpileAwillcompoundoverthecenturyataratefarinferiortothatachievedbypileB.

Ourfirsttwocategoriesenjoymaximumpopularityatpeaksoffear:Terrorover economic collapse drives individuals to currency-based assets, mostparticularlyU.S.obligations,andfearofcurrencycollapsefostersmovementtosterileassetssuchasgold.Weheard“cashisking”inlate2008,justwhencashshouldhavebeendeployedratherthanheld.Similarly,weheard“cashistrash”in the early 1980s just when fixed-dollar investments were at their mostattractive level in memory. On those occasions, investors who required asupportivecrowdpaiddearlyforthatcomfort.

My own preference—and you knew this was coming—is our thirdcategory: investment in productive assets, whether businesses, farms, or realestate.Ideally,theseassetsshouldhavetheabilityininflationarytimestodeliveroutputthatwillretainitspurchasing-powervaluewhilerequiringaminimumofnewcapital investment.Farms,realestate,andmanybusinessessuchasCoca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certainother companies—thinkof our regulatedutilities, for example—fail it becauseinflationplacesheavycapitalrequirementsonthem.Toearnmore,theirownersmust invest more. Even so, these investments will remain superior tononproductiveorcurrency-basedassets.

Whetherthecurrencyacenturyfromnowisbasedongold,seashells,sharkteeth,orapieceofpaper(astoday),peoplewillbewillingtoexchangeacoupleofminutesoftheirdailylaborforaCoca-ColaorsomeSee’speanutbrittle.InthefuturetheU.S.populationwillmovemoregoods,consumemorefood,andrequiremore livingspace than itdoesnow.Peoplewill foreverexchangewhattheyproduceforwhatothersproduce.

Our country’s businesses will continue to efficiently deliver goods andserviceswantedbyourcitizens.Metaphorically, thesecommercial“cows”willliveforcenturiesandgiveevergreaterquantitiesof“milk”toboot.Theirvalue

willbedeterminednotbythemediumofexchangebutratherbytheircapacitytodelivermilk.Proceedsfromthesaleofthemilkwillcompoundfortheownersofthecows,justastheydidduringthe20thcenturywhentheDowincreasedfrom66 to11,497(andpaid loadsofdividendsaswell).Berkshire’sgoalwillbe toincrease itsownershipoffirst-classbusinesses.Ourfirstchoicewillbe toownthem in their entirety—butwewill also be owners byway of holding sizableamountsofmarketable stocks. Ibelieve thatoveranyextendedperiodof timethiscategoryofinvestingwillprovetobetherunawaywinneramongthethreewe’veexamined.Moreimportant,itwillbebyfarthesafest.

B.JunkBonds30

Investing in junkbonds and investing in stocks are alike in certainways:Both activities require us to make a price-value calculation and also to scanhundredsofsecuritiestofindtheveryfewthathaveattractivereward/riskratios.But there are important differences between the two disciplines as well. Instocks,weexpecteverycommitment toworkoutwellbecauseweconcentrateonconservativelyfinancedbusinesseswithstrongcompetitivestrengths,runbyableandhonestpeople.Ifwebuyintothesecompaniesatsensibleprices,lossesshouldberare.Indeed,duringthe38yearswehaverunthecompany’saffairs,gains from the equities we manage at Berkshire (that is, excluding thosemanagedatGeneralReandGEICO)haveexceeded lossesbya ratioofabout100toone.

Purchasing junk bonds,we are dealingwith enterprises that are farmoremarginal.Thesebusinessesareusuallyoverloadedwithdebtandoftenoperateinindustries characterized by low returns on capital. Additionally, the quality ofmanagement is sometimes questionable.Managementmay even have intereststhataredirectlycounter to thoseofdebt-holders.Therefore,weexpect thatwewillhaveoccasionallargelossesinjunkissues.Sofar,however,wehavedonereasonablywellinthisfield.

Lethargy bordering on sloth remains the cornerstone of our investmentstyle: This year we neither bought nor sold a share of five of our six majorholdings. The exception was Wells Fargo, a superbly-managed, high-returnbankingoperationinwhichweincreasedourownershiptojustunder10%,themostwecanownwithouttheapprovaloftheFederalReserveBoard.Aboutone-sixthofourpositionwasboughtin1989,therestin1990.

Thebankingbusinessisnofavoriteofours.Whenassetsaretwentytimes

equity—a common ratio in this industry—mistakes that involve only a smallportionofassetscandestroyamajorportionofequity.Andmistakeshavebeentheruleratherthantheexceptionatmanymajorbanks.Mosthaveresultedfroma managerial failing that we described last year when discussing the“institutional imperative”: the tendencyof executives tomindlessly imitate thebehavior of their peers, no matter how foolish it may be to do so. In theirlending, many bankers played follow-the-leader with lemming-like zeal; nowtheyareexperiencingalemming-likefate.

Becauseleverageof20:1magnifiestheeffectsofmanagerialstrengthsandweaknesses,wehavenointerestinpurchasingsharesofapoorly-managedbankat a “cheap” price. Instead, our only interest is in buying into well-managedbanksatfairprices.

With Wells Fargo, we think we have obtained the best managers in thebusiness,CarlReichardtandPaulHazen.InmanywaysthecombinationofCarland Paul reminds me of another—Tom Murphy and Dan Burke at CapitalCities/ABC.First, eachpair is stronger than the sumof its parts because eachpartnerunderstands,trustsandadmirestheother.Second,bothmanagerialteamspay able people well, but abhor having a bigger head count than is needed.Third,bothattackcostsasvigorouslywhenprofitsareatrecordlevelsaswhenthey are under pressure. Finally, both stickwithwhat they understand and lettheirabilities,not theiregos,determinewhat theyattempt. (ThomasJ.WatsonSr.ofIBMfollowedthesamerule:“I’mnogenius,”hesaid.“I’msmartinspots—butIstayaroundthosespots.”)

OurpurchasesofWellsFargoin1990werehelpedbyachaoticmarketinbank stocks. The disarray was appropriate: Month by month the foolish loandecisionsofoncewell-regardedbankswereputonpublicdisplay.Asonehugeloss after another was unveiled—often on the heels of managerial assurancesthat allwaswell—investorsunderstandably concluded that nobank’snumberswere to be trusted.Aided by their flight from bank stocks,we purchased our10% interest in Wells Fargo for $290 million, less than five times after-taxearnings,andlessthanthreetimespre-taxearnings.

WellsFargoisbig—ithas$56billioninassets—andhasbeenearningmorethan20%onequityand1.25%onassets.Ourpurchaseofone-tenthofthebankmaybethoughtofasroughlyequivalenttoourbuying100%ofa$5billionbankwithidenticalfinancialcharacteristics.Butwerewetomakesuchapurchase,wewould have to pay about twice the $290 million we paid for Wells Fargo.Moreover,that$5billionbank,commandingapremiumprice,wouldpresentuswithanotherproblem:WewouldnotbeabletofindaCarlReichardttorunit.Inrecentyears,WellsFargoexecutiveshavebeenmoreavidlyrecruited thanany

othersinthebankingbusiness;noonehowever,hasbeenabletohirethedean.Ofcourse,ownershipofabank—oraboutanyotherbusiness—isfarfrom

riskless. California banks face the specific risk of a major earthquake, whichmightwreakenoughhavoconborrowerstointurndestroythebankslendingtothem. A second risk is systemic—the possibility of a business contraction orfinancialpanicsosevere that itwouldendangeralmosteveryhighly-leveragedinstitution, nomatter how intelligently run.Finally, themarket’smajor fear ofthe moment is that West Coast real estate values will tumble because ofoverbuildinganddeliverhugelossestobanksthathavefinancedtheexpansion.Because it is a leading real estate lender, Wells Fargo is thought to beparticularlyvulnerable.

Noneoftheseeventualitiescanberuledout.Theprobabilityofthefirsttwooccurring,however, is lowandevenameaningfuldrop in realestatevalues isunlikelytocausemajorproblemsforwell-managedinstitutions.Considersomemathematics:WellsFargocurrentlyearnswellover$1billionpre-taxannuallyafterexpensingmorethan$300millionforloanlosses.If10%ofall$48billionofthebank’sloans—notjustitsrealestateloans—werehitbyproblemsin1991,and these produced losses (including foregone interest) averaging 30% ofprincipal,thecompanywouldroughlybreakeven.

A year like that—which we consider only a low-level possibility, not alikelihood—wouldnotdistressus.Infact,atBerkshirewewouldlovetoacquirebusinessesorinvestincapitalprojectsthatproducednoreturnforayear,butthatcouldthenbeexpectedtoearn20%ongrowingequity.Nevertheless,fearsofaCaliforniarealestatedisastersimilartothatexperiencedinNewEnglandcausedthepriceofWellsFargo stock to fall almost50%withina fewmonthsduring1990.Eventhoughwehadboughtsomesharesatthepricesprevailingbeforethefall, we welcomed the decline because it allowed us to pick up many moresharesatthenew,panicprices.

Wewillbebuyingbusinesses—orsmallpartsofbusinesses,calledstocks—yearin,yearoutaslongasIlive(andlonger,ifBerkshire’sdirectorsattendtheseances I have scheduled). Given these intentions, declining prices forbusinessesbenefitus,andrisingpriceshurtus.

Themostcommoncauseoflowpricesispessimism—sometimespervasive,sometimesspecifictoacompanyorindustry.Wewanttodobusinessinsuchanenvironment, not becausewe like pessimismbut becausewe like the prices itproduces.It’soptimismthatistheenemyoftherationalbuyer.

None of this means, however, that a business or stock is an intelligentpurchasesimplybecauseitisunpopular;acontrarianapproachisjustasfoolishasa follow-the-crowdstrategy.What’s required is thinking rather thanpolling.

Unfortunately,BertrandRussell’sobservationaboutlife ingeneralapplieswithunusual force in the financial world: “Mostmenwould rather die than think.Manydo.”

*Our other major portfolio change last year was large additions to our

holdingsofRJRNabiscobonds,securitiesthatwefirstboughtinlate1989.Atyear-end1990wehad$440millioninvestedinthesesecurities,anamountthatapproximatedmarket value. (As I write this, however, theirmarket value hasrisenbymorethan$150million.)

Justasbuyingintothebankingbusinessisunusualforus,soisthepurchaseofbelow-investment-gradebonds.Butopportunitiesthatinterestusandthatarealso largeenough tohaveaworthwhile impactonBerkshire’s results are rare.Therefore,wewilllookatanycategoryofinvestment,solongasweunderstandthe business we’re buying into and believe that price and value may differsignificantly. (Woody Allen, in another context, pointed out the advantage ofopen-mindedness:“Ican’tunderstandwhymorepeoplearen’tbi-sexualbecauseitdoublesyourchancesforadateonSaturdaynight.”)

In the past we have bought a few below-investment-grade bonds withsuccess, though thesewere all old-fashioned “fallen angels”—bonds thatwereinitiallyofinvestmentgradebutthatweredowngradedwhentheissuersfellonbadtimes.

Akind of bastardized fallen angel burst onto the investment scene in the1980s—“junkbonds”thatwerefarbelowinvestment-gradewhenissued.Asthedecadeprogressed,newofferingsofmanufacturedjunkbecameeverjunkierandultimatelythepredictableoutcomeoccurred:Junkbondsliveduptotheirname.In 1990—even before the recession dealt its blows—the financial sky becamedarkwiththebodiesoffailingcorporations.

Thedisciplesofdebtassuredus that thiscollapsewouldn’thappen:Hugedebt, we were told, would cause operating managers to focus their efforts asneverbefore,muchasadaggermountedonthesteeringwheelofacarcouldbeexpected tomake its driver proceedwith intensified care.We’ll acknowledgethat such an attention-getter would produce a very alert driver. But anothercertain consequencewould be a deadly—andunnecessary—accident if the carhiteventhetiniestpotholeorsliverofice.Theroadsofbusinessareriddledwithpotholes;aplanthatrequiresdodgingthemallisaplanfordisaster.

In the final chapter of The Intelligent Investor Ben Graham forcefullyrejected thedagger thesis: “Confrontedwithachallenge todistill the secretofsound investment into three words, we venture themotto,Margin of Safety.”

Forty-twoyears after reading that, I still think those are the right threewords.The failure of investors to heed this simple message caused them staggeringlossesasthe1990sbegan.

At the height of the debt mania, capital structures were concocted thatguaranteed failure: In some cases, so much debt was issued that even highlyfavorable business results could not produce the funds to service it. Oneparticularly egregious “kill-’em-at-birth” case a few years back involved thepurchaseofamaturetelevisionstationinTampa,boughtwithsomuchdebtthattheinterestonitexceededthestation’sgrossrevenues.Evenifyouassumethatalllabor,programsandservicesweredonatedratherthanpurchased,thiscapitalstructure required revenues to explode—or else the stationwas doomed to gobroke. (Manyof thebonds that financed thepurchasewere sold tonow-failedsavingsandloanassociations;asataxpayer,youarepickingupthetabforthisfolly.)

All of this seems impossible now. When these misdeeds were done,however,dagger-sellinginvestmentbankerspointedto the“scholarly”researchof academics, which reported that over the years the higher interest ratesreceivedfromlow-gradebondshadmorethancompensatedfortheirhigherrateofdefault.Thus,saidthefriendlysalesmen,adiversifiedportfolioofjunkbondswouldproducegreaternet returns thanwouldaportfolioofhigh-gradebonds.(Bewareofpast-performance“proofs”infinance:Ifhistorybookswerethekeytoriches,theForbes400wouldconsistoflibrarians.)

Therewasa flaw in the salesmen’s logic—one that a first-year student instatisticsistaughttorecognize.Anassumptionwasbeingmadethattheuniverseof newly-minted junk bondswas identical to the universe of low-grade fallenangels and that, therefore, the default experience of the latter group wasmeaningfulinpredictingthedefaultexperienceofthenewissues.(ThatwasanerrorsimilartocheckingthehistoricaldeathratefromKool-AidbeforedrinkingtheversionservedatJonestown.)

The universes were of course dissimilar in several vital respects. Foropeners, the manager of a fallen angel almost invariably yearned to regaininvestment-grade status andworked toward that goal. The junk-bond operatorwasusuallyanentirelydifferentbreed.Behavingmuchasaheroinusermight,hedevotedhisenergiesnot to findingacure forhisdebt-riddencondition,butrather to finding another fix. Additionally, the fiduciary sensitivities of theexecutives managing the typical fallen angel were often, though not always,morefinelydevelopedthanwerethoseofthejunk-bond-issuingfinanciopath.

Wall Street cared little for such distinctions. As usual, the Street’senthusiasmforanideawasproportionalnottoitsmerit,butrathertotherevenue

itwouldproduce.Mountainsofjunkbondsweresoldbythosewhodidn’tcaretothosewhodidn’tthink—andtherewasnoshortageofeither.

Junkbondsremainaminefield,evenatpricesthattodayareoftenasmallfractionofissueprice.Aswesaidlastyear,wehaveneverboughtanewissueofajunkbond.(Theonlytimetobuytheseisonadaywithno“y”init.)Weare,however,willingtolookatthefield,nowthatitisindisarray.

In thecaseofRJRNabisco,wefeel theCompany’scredit isconsiderablybetterthanwasgenerallyperceivedforawhileandthattheyieldwereceive,aswell as the potential for capital gain, more than compensates for the risk weincur(thoughthatisfarfromnil).RJRhasmadeassetsalesatfavorableprices,hasaddedmajoramountsofequity,andingeneralisbeingrunwell.

However, as we survey the field, most low-grade bonds still lookunattractive.ThehandiworkoftheWallStreetofthe1980sisevenworsethanwehad thought:Many importantbusinesseshavebeenmortallywounded.Wewill, though, keep looking for opportunities as the junk market continues tounravel.

It is interesting to compare Wesco’s approach (deliberate non-diversificationof investments inanattempt tobemoreskillfulper transaction)withanapproachpromotedforyearsbyMichaelMilkentohelpselljunkbonds.TheMilkenapproach,supportedbytheoriesofmanyfinanceprofessors,arguedthat(1)marketpriceswereefficientinaworldwhereinvestorsgetpaidextraforenduringvolatility(wideswingsinoutcomes);(2)therefore,thepricesatwhichnew issues of junk bonds came to market were fair in a probabilistic sense(meaning that the high promised interest rates covered increased statisticalexpectancyof loss)andalsoprovidedsomepremiumreturn tocovervolatilityexposure; and (3) therefore, if a savings and loan association (or otherinstitution)arrangeddiversification,say,bybuying,withoutmuchexamination,alargepartofeachnewMilkenissueofjunkbonds,theassociationwouldworkitself into the sure-to-get-better-than-average-results position of a gamblinghouseproprietorwitha“house”edge.Thistypeoftheorizinghasnowwreakedhavocatinstitutions,governedbytrue-believers,whichbackedtheirconclusionsby buying Milken’s “bonds.” Contrary to the theorizing, widely diversifiedpurchasesofsuch“bonds”haveinmostcasesproduceddismalresults.Wecanall understand why Milken behaved as he did and believed what he had tobelieve inorder tomaintainanendurable self-image.ButhowcanweexplainwhyanyoneelsebelievedthatMilkenwaspaid5%commissionstoput“bond”buyersinthepositionofthehouseinLasVegas?Wesuggestthiscause:manyof

the foolish buyers, and their advisers,were trained by finance professorswhopushed belovedmodels (efficient market theory andmodern portfolio theory)waytoofar,whiletheyignoredothermodelsthatwouldhavewarnedofdanger.Thisisacommontypeof“expert”error.

C.Zero-CouponBonds31

Berkshire issued $902.6 million principal amount of Zero-CouponConvertible SubordinatedDebentures,which are now listed on theNewYorkStockExchange.SalomonBrothershandledtheunderwritinginsuperbfashion,providingushelpfuladviceandaflawlessexecution.

Mostbonds,ofcourse, requireregularpaymentsof interest,usuallysemi-annually.Azero-couponbond,conversely,requiresnocurrentinterestpayments;instead,theinvestorreceiveshisyieldbypurchasingthesecurityatasignificantdiscount frommaturity value. The effective interest rate is determined by theoriginalissueprice,thematurityvalue,andtheamountoftimebetweenissuanceandmaturity.

Inourcase,thebondswereissuedat44.314%ofmaturityvalueandareduein 15 years. For investors purchasing the bonds, that is the mathematicalequivalentofa5.5%currentpaymentcompoundedsemi-annually.Becausewereceived only 44.31 cents on the dollar, our proceeds from this offeringwere$400million(lessabout$9.5millionofofferingexpenses).

The bonds were issued in denominations of $10,000 and each bond isconvertible into .4515 sharesofBerkshireHathaway.Because a$10,000bondcost $4,431, this means that the conversion price was $9,815 per Berkshireshare,a15%premiumtothemarketpricethenexisting.Berkshirecancall thebondsatanytimeafterSeptember28,1992attheiraccretedvalue(theoriginalissue price plus 5.5% compounded semi-annually) and on two specified days,September28of1994and1999, thebondholderscanrequireBerkshire tobuythesecuritiesattheiraccretedvalue.

For taxpurposes,Berkshire isentitled todeduct the5.5% interestaccrualeachyear,eventhoughwemakenopaymentstothebondholders.Thustheneteffecttous,resultingfromthereducedtaxes,ispositivecashflow.Thatisaverysignificantbenefit.Someunknowablevariablespreventusfromcalculatingourexacteffectiverateofinterest,butunderallcircumstancesitwillbewellbelow5.5%.Thereismeanwhileasymmetrytothetaxlaw:Anytaxableholderofthebondsmustpaytaxeachyearonthe5.5%interest,eventhoughhereceivesnocash.

Neitherourbondsnorthoseofcertainothercompaniesthatissuedsimilarbondslastyear(notablyLoewsandMotorola)resemblethegreatbulkofzero-couponbondsthathavebeenissuedinrecentyears.Ofthese,CharlieandIhavebeen, andwill continue to be, outspoken critics. As I will later explain, suchbonds have often been used in the most deceptive of ways and with deadlyconsequencestoinvestors.Butbeforewetacklethatsubject,let’stravelbacktoEden,toatimewhentheapplehadnotyetbeenbitten.

If you’remy age you bought your first zero-coupon bonds duringWorldWarII,bypurchasingthefamousSeriesEU.S.SavingsBond,themostwidely-soldbondissueinhistory.(Afterthewar, thesebondswereheldbyoneoutoftwo U.S. households.) Nobody, of course, called the Series E a zero-couponbond,aterminfactthatIdoubthadbeeninvented.Butthat’spreciselywhattheSeriesEwas.

These bonds came in denominations as small as $18.75. That amountpurchased a $25 obligation of theUnited States government due in 10 years,termsthatgavethebuyeracompoundedannualreturnof2.9%.Atthetime,thiswasanattractiveoffer:the2.9%ratewashigherthanthatgenerallyavailableonGovernment bonds and the holder faced no market-fluctuation risk, since hecouldatanytimecashinhisbondswithonlyaminorreductionininterest.

Asecondformofzero-couponU.S.Treasuryissue,alsobenignanduseful,surfacedinthelastdecade.Oneproblemwithanormalbondisthateventhoughit pays a given interest rate—say 10%—the holder cannot be assured that acompounded10%returnwillberealized.Forthatratetomaterialize,eachsemi-annual couponmust be reinvested at 10% as it is received. If current interestratesare,say,only6%or7%whenthesecouponscomedue,theholderwillbeunabletocompoundhismoneyoverthelifeof thebondat theadvertisedrate.For pension funds or other investors with long-term liabilities, “reinvestmentrisk”ofthistypecanbeaseriousproblem.SavingsBondsmighthavesolvedit,except that they are issued only to individuals and are unavailable in largedenominations.Whatbigbuyersneededwashugequantitiesof“SavingsBondEquivalents.”

Enter some ingenious and, in this case, highly useful investment bankers(led, I’m happy to say, by Salomon Brothers). They created the instrumentdesired by “stripping” the semi-annual coupons from standard Governmentissues.Eachcoupon,oncedetached,takesontheessentialcharacterofaSavingsBondsinceitrepresentsasinglesumduesometimeinthefuture.Forexample,ifyoustripthe40semi-annualcouponsfromaU.S.GovernmentBonddueintheyear2010,youwillhave40zero-couponbonds,withmaturitiesfromsixmonthsto 20 years, each of which can then be bundled with other coupons of like

maturityandmarketed.Ifcurrent interestratesare,say,10%forallmaturities,thesix-monthissuewillsellfor95.24%ofmaturityvalueandthe20-yearissuewillsell for14.20%.Thepurchaserofanygivenmaturity is thusguaranteedacompoundedrateof10%forhisentireholdingperiod.Strippingofgovernmentbonds has occurred on a large scale in recent years, as long-term investors,rangingfrompensionfundstoindividualIRAaccounts,recognizedthesehigh-grade,zero-couponissuestobewellsuitedtotheirneeds.

But as happens in Wall Street all too often, what the wise do in thebeginning,foolsdointheend.Inthelastfewyearszero-couponbonds(andtheirfunctionalequivalent,pay-in-kindbonds,whichdistributeadditionalPIKbondssemi-annuallyasinterestinsteadofpayingcash)havebeenissuedinenormousquantitiesbyever-junkiercredits.Totheseissuers,zero(orPIK)bondsofferoneoverwhelmingadvantage:Itisimpossibletodefaultonapromisetopaynothing.Indeed, ifLDCgovernmentshad issuednodebt in the1970sother than long-termzero-couponobligations,theywouldnowhaveaspotlessrecordasdebtors.

This principle atwork—that you need not default for a long time if yousolemnly promise to pay nothing for a long time—has not been lost onpromotersandinvestmentbankersseekingtofinanceever-shakierdeals.Butitsacceptance by lenders took awhile:When the leveraged buy-out craze begansomeyearsback,purchaserscouldborrowonlyonareasonablysoundbasis,inwhichconservatively-estimatedfreecashflow—thatis,operatingearningsplusdepreciation and amortization less normalized capital expenditures—wasadequatetocoverbothinterestandmodestreductionsindebt.

Later, as the adrenaline of deal-makers surged, businesses began to bepurchasedatpricessohighthatallfreecashflownecessarilyhadtobeallocatedtothepaymentofinterest.Thatleftnothingforthepaydownofdebt.Ineffect,aScarlettO’Hara “I’ll think about it tomorrow” position in respect to principalpaymentswas takenbyborrowers and acceptedby anewbreedof lender, thebuyer of original-issue junk bonds. Debt now became something to berefinancedratherthanrepaid.ThechangebringstomindaNewYorkercartoonin which the grateful borrower rises to shake the hand of the bank’s lendingofficerandgushes:“Idon’tknowhowI’lleverrepayyou.”

Soonborrowersfoundeventhenew,laxstandardsintolerablybinding.Toinduce lenders to finance even sillier transactions, they introduced anabomination,EBDIT—EarningsBeforeDepreciation,InterestandTaxes—asthetest of a company’s ability to pay interest.Using this sawed-off yardstick, theborrowerignoreddepreciationasanexpenseonthetheorythatitdidnotrequireacurrentcashoutlay.

Such an attitude is clearly delusional. At 95% of American businesses,

capital expenditures that over time roughly approximate depreciation are anecessity andare everybit as real anexpenseas labororutility costs.Evenahighschooldropoutknowsthattofinanceacarhemusthaveincomethatcoversnot only interest and operating expenses, but also realistically-calculateddepreciation.Hewould be laughed out of the bank if he started talking aboutEBDIT.

Capitaloutlaysatabusinesscanbeskipped,ofcourse,inanygivenmonth,just as a human can skip a day or even aweek of eating.But if the skippingbecomes routine and is not made up, the body weakens and eventually dies.Furthermore, a start and-stop feeding policy will over time produce a lesshealthyorganism,humanorcorporate, than thatproducedbyasteadydiet.Asbusinessmen, Charlie and I relish having competitors who are unable to fundcapitalexpenditures.

Youmightthinkthatwavingawayamajorexpensesuchasdepreciationinanattempt tomakea terribledeal look likeagoodonehits the limitsofWallStreet’s ingenuity. Ifso,youhaven’tbeenpayingattentionduring thepast fewyears. Promoters needed to find a way to justify even pricier acquisitions.Otherwise, they risked—heaven forbid—losing deals to other promoters withmore“imagination.”

So, stepping through the Looking Glass, promoters and their investmentbankers proclaimed thatEBDIT shouldnowbemeasured against cash interestonly,whichmeantthatinterestaccruingonzero-couponorPIKbondscouldbeignoredwhenthefinancialfeasibilityofatransactionwasbeingassessed.Thisapproach not only relegated depreciation expense to the let’s-ignore-it corner,butgavesimilar treatment towhatwasusuallya significantportionof interestexpense. To their shame, many professional investment managers went alongwiththisnonsense,thoughtheyusuallywerecarefultodosoonlywithclients’money, not their own. (Calling thesemanagers “professionals” is actually tookind;theyshouldbedesignated“promotees.”)

Underthisnewstandard,abusinessearning,say,$100millionpre-taxandhavingdebtonwhich$90millionofinterestmustbepaidcurrently,mightuseazero-coupon of PIK issue to incur another $60million of annual interest thatwouldaccrueandcompoundbutnotcomedueforsomeyears.Therateontheseissueswould typically be very high,whichmeans that the situation in year 2mightbe$90millioncashinterestplus$69millionaccruedinterest,andsoonasthe compoundingproceeds.Suchhigh-rate reborrowing schemes,which a fewyearsagowereappropriatelyconfinedtothewaterfront,soonbecamemodelsoffinanceatvirtuallyallmajorinvestmentbankinghouses.

When they make these offerings, investment bankers display their

humorousside:Theydispense incomeandbalancesheetprojectionsextendingfiveormoreyearsintothefutureforcompaniestheybarelyhadheardofafewmonthsearlier.Ifyouareshownsuchschedules,Isuggestthatyoujointhefun:Asktheinvestmentbankerfortheone-yearbudgetsthathisownfirmpreparedasthelastfewyearsbeganandthencomparethesewithwhatactuallyhappened.

SometimeagoKenGalbraith,inhiswittyandinsightfulTheGreatCrash,coined a new economic term: “the bezzle,” defined as the current amount ofundiscoveredembezzlement.Thisfinancialcreaturehasamagicalquality:Theembezzlersarericherbytheamountofthebezzle,whiletheembezzleesdonotyetfeelpoorer.

ProfessorGalbraith astutely pointedout that this sum should be added tothe National Wealth so that we might know the Psychic National Wealth.Logically, a society that wanted to feel enormously prosperous would bothencourageitscitizenstoembezzleandtrynottodetectthecrime.Bythismeans,“wealth”wouldballoonthoughnotanergofproductiveworkhadbeendone.

Thesatiricalnonsenseofthebezzleisdwarfedbythereal-worldnonsenseof the zero-coupon bond.With zeros, one party to a contract can experience“income” without his opposite experiencing the pain of expenditure. In ourillustration,acompanycapableofearningonly$100milliondollarsannually—and therefore capable of paying only thatmuch in interest—magically creates“earnings”forbondholdersof$150million.AslongasmajorinvestorswillinglydontheirPeterPanwingsandrepeatedlysay“Ibelieve,”thereisnolimittohowmuch“income”canbecreatedbythezero-couponbond.

WallStreetwelcomed this inventionwith the enthusiasm less-enlightenedfolkmight reserve for thewheel or the plow.Here, finally,was an instrumentthatwouldlettheStreetmakedealsatpricesnolongerlimitedbyactualearningpower. The result, obviously, would be more transactions: Silly prices willalwaysattractsellers.And,asJesseUnruhmighthaveputit,transactionsarethemother’smilkoffinance.

The zero-coupon or PIK bond possesses an additional attraction for thepromoterand investmentbanker,which is that the timeelapsingbetweenfollyandfailurecanbestretchedout.Thisisnosmallbenefit.Iftheperiodbeforeallcostsmustbefacedislong,promoterscancreateastringoffoolishdeals—andtakeinlotsoffees—beforeanychickenscomehometoroostfromtheirearlierventures.

But in the end, alchemy,whether it ismetallurgical or financial, fails. Abase business can not be transformed into a golden business by tricks ofaccounting or capital structure. Theman claiming to be a financial alchemistmaybecomerich.Butgullibleinvestorsratherthanbusinessachievementswill

usuallybethesourceofhiswealth.Whatever their weaknesses, we should add, many zero-coupon and PIK

bondswillnotdefault.Wehaveinfactownedsomeandmaybuymoreiftheirmarket becomes sufficiently distressed. (We’ve not, however, even consideredbuyinganewissuefromaweakcredit.)Nofinancialinstrumentisevilperse;it’sjustthatsomevariationshavefarmorepotentialformischiefthanothers.

Theblue ribbon formischief-making shouldgo to thezero-coupon issuerunable tomakeits interestpaymentsonacurrentbasis.Ouradvice:WheneveraninvestmentbankerstartstalkingaboutEBDIT—orwheneversomeonecreatesacapitalstructurethatdoesnotallowall interest,bothpayableandaccrued, tobecomfortablymetoutofcurrentcashflownetofamplecapitalexpenditures—zipupyourwallet.Turnthetablesbysuggestingthatthepromoterandhishigh-priced entourage accept zero-coupon fees, deferring their take until the zero-couponbondshavebeenpaidinfull.Seethenhowmuchenthusiasmforthedealendures.

Ourcommentsaboutinvestmentbankersmayseemharsh.ButCharlieandI—in our hopelessly old-fashioned way—believe that they should perform agatekeepingrole,guardinginvestorsagainstthepromoter’spropensitytoindulgein excess. Promoters, after all, have throughout time exercised the samejudgment and restraint in accepting money that alcoholics have exercised inaccepting liquor.Ataminimum, therefore, thebanker’sconduct should rise tothatofaresponsiblebartenderwho,whennecessary,refusestheprofitfromthenext drink to avoid sending a drunk out on the highway. In recent years,unfortunately,manyleadinginvestmentfirmshavefoundbartendermorality tobean intolerably restrictive standard.Lately, thosewhohave traveled thehighroadinWallStreethavenotencounteredheavytraffic.

One distressing footnote: The cost of the zero-coupon folly will not beborne solely by the direct participants. Certain savings and loan associationswere heavy buyers of such bonds, using cash that came from FSLIC-insureddeposits. Straining to show splendid earnings, these buyers recorded—but didnot receive—ultra-high interest income on these issues. Many of theseassociationsarenowinmajortrouble.Hadtheirloanstoshakycreditsworked,the owners of the associations would have pocketed the profits. In the manycases in which the loans will fail, the taxpayer will pick up the bill. ToparaphraseJackieMason,attheseassociationsitwasthemanagerswhoshouldhavebeenwearingtheskimasks.

D.PreferredStock32

Weonlywanttolinkupwithpeoplewhomwelike,admire,andtrust.JohnGutfreund atSalomon,ColmanMockler, Jr. atGillette,EdColodny atUSAir,andAndySigleratChampionmeetthistestinspades.

They in turn have demonstrated some confidence in us, insisting in eachcase that our preferreds have unrestricted voting rights on a fully-convertedbasis, an arrangement that is far from standard in corporate finance. In effecttheyaretrustingustobeintelligentowners,thinkingabouttomorrowinsteadoftoday, just as we are trusting them to be intelligentmanagers, thinking abouttomorrowaswellastoday.

Thepreferred-stockstructureswehavenegotiatedwillprovideamediocrereturnforusifindustryeconomicshindertheperformanceofourinvestees,butwill produce reasonably attractive results for us if they can earn a returncomparable to that of American industry in general.We believe that Gillette,underColman’smanagement,willfarexceedthatreturnandbelievethatJohn,Ed,andAndywillreachitunlessindustryconditionsareharsh.

Under almost any conditions,we expect these preferreds to return us ourmoney plus dividends. If that is all we get, though, the result will bedisappointing,becausewewillhavegivenup flexibilityandconsequentlywillhavemissedsomesignificantopportunitiesthatareboundtopresentthemselvesduringthedecade.Underthatscenario,wewillhaveobtainedonlyapreferred-stockyieldduringaperiodwhen the typicalpreferred stockwillhaveheldnoappeal for us whatsoever. The only way Berkshire can achieve satisfactoryresults from its four preferred issues is to have the common stocks of theinvesteecompaniesdowell.

Goodmanagementandatleasttolerableindustryconditionswillbeneededifthatistohappen.ButwebelieveBerkshire’sinvestmentwillalsohelpandthattheothershareholdersofeachinvesteewillprofitovertheyearsaheadfromourpreferred-stockpurchase.Thehelpwillcomefromthe fact thateachcompanynowhas amajor, stable, and interested shareholderwhoseChairmanandViceChairman have, through Berkshire’s investments, indirectly committed a verylarge amount of their own money to these undertakings. In dealing with ourinvestees, Charlie and I will be supportive, analytical, and objective. Werecognize thatwe areworkingwith experiencedCEOswho are verymuch incommand of their own business but who nevertheless, at certain moments,appreciate the chance to test their thinking on someone without ties to theirindustryortodecisionsofthepast.

Asagroup,theseconvertiblepreferredswillnotproducethereturnswecanachieve when we find a business with wonderful economic prospects that isunappreciated by the market. Nor will the returns be as attractive as those

producedwhenwemakeourfavoriteformofcapitaldeployment,theacquisitionof 80% or more of a fine business with a fine management. But bothopportunitiesarerare,particularlyinasizebefittingourpresentandanticipatedresources.

In summation, Charlie and I feel that our preferred stock investmentsshouldproducereturnsmoderatelyabovethoseachievedbymostfixed-incomeportfoliosandthatwecanplayaminorbutenjoyableandconstructiveroleintheinvesteecompanies.

Mistakesoccuratthetimeofdecision.Wecanonlymakeourmistake-du-jour award,however,when the foolishnessofadecisionbecomesobvious.Bythismeasure,1994wasavintageyearwithkeencompetitionforthegoldmedal.Here, Iwould like to tell you that themistakes Iwill describeoriginatedwithCharlie.ButwheneverItrytoexplainthingsthatway,mynosebeginstogrow.

Andthenomineesare...Latein1993Isold10millionsharesofCapCitiesat$63;atyear-end1994,

thepricewas$85¼.(Thedifferenceis$222.5millionforthoseofyouwhowishtoavoid thepainofcalculating thedamageyourself.)Whenwepurchased thestock at $17.25 in 1986, I told you that I had previously sold our CapCitiesholdings at $4.30per shareduring1978–80, and added that Iwas at a loss toexplainmyearlierbehavior.33Now I’ve become a repeat offender.Maybe it’stimetogetaguardianappointed.

Egregious as it is, theCapCities decision earnsonly a silvermedal.Tophonors go to amistake Imade five years ago that fully ripened in 1994:Our$358 million purchase of USAir preferred stock, on which the dividend wassuspended inSeptember. [T]hisdeal [w]asan“unforcederror,”meaning that Iwasneitherpushed into the investmentnormisledbyanyonewhenmaking it.Rather,thiswasacaseofsloppyanalysis,alapsethatmayhavebeencausedbythefactthatwewerebuyingaseniorsecurityorbyhubris.Whateverthereason,themistakewaslarge.

Before thispurchase, I simply failed to focuson theproblems thatwouldinevitablybesetacarrierwhosecostswerebothhighandextremelydifficulttolower.Inearlieryears,theselife-threateningcostsposedfewproblems.Airlineswere thenprotected fromcompetitionby regulation, and carriers could absorbhighcostsbecause theycouldpass themalongbywayof fares thatwerealsohigh.

Whenderegulationcamealong,itdidnotimmediatelychangethepicture:Thecapacityoflow-costcarrierswassosmallthatthehigh-costlinescould,in

large part,maintain their existing fare structures. During this period, with thelonger-term problems largely invisible but slowlymetastasizing, the costs thatwerenon-sustainablebecamefurtherembedded.

Astheseatcapacityofthelow-costoperatorsexpanded,theirfaresbegantoforcetheold-line,high-costairlinestocut theirown.Thedayofreckoningfortheseairlinescouldbedelayedbyinfusionsofcapital(suchasoursintoUSAir),but eventually a fundamental rule of economics prevailed: In an unregulatedcommodity business, a companymust lower its costs to competitive levels orfaceextinction.ThisprincipleshouldhavebeenobvioustoyourChairman,butImissedit.

SethSchofield,[then]CEOofUSAir,hasworkeddiligentlytocorrectthecompany’s historical cost problemsbut, to date, has notmanaged to do so. Inpart,thisisbecausehehashadtodealwithamovingtarget,theresultofcertainmajor carriers having obtained labor concessions and other carriers havingbenefittedfrom“fresh-start”coststhatcameoutofbankruptcyproceedings.(AsHerb Kelleher, CEO of Southwest Airlines, has said: “Bankruptcy court forairlines has become a health spa.”) Additionally, it should be no surprise toanyone that those airline employees who contractually receive above-marketsalaries will resist any reduction in these as long as their checks continue toclear.

Despitethisdifficultsituation,USAirmayyetachievethecostreductionsitneedstomaintainitsviabilitylong-term.Butitisfarfromsurethatwillhappen.

Accordingly,wewroteourUSAirinvestmentdownto$89.5million,or25¢onthedollar,atyear-end1994.Thisvaluationreflectsbothapossibilitythatourpreferredwillhaveitsvaluefullyorlargelyrestoredandanoppositepossibilitythatthestockwilleventuallybecomeworthless.Whatevertheoutcome,wewillheedaprimeruleofinvesting:Youdon’thavetomakeitbackthewaythatyoulostit.

The accounting effects of ourUSAirwritedown are complicated.On ourbalance sheet,we carry all stocks at estimatedmarket value.Therefore, at theendof lastyear’s thirdquarter,wewerecarryingourUSAirpreferredat$89.5million,or25%ofcost.Inotherwords,ournetworthwasatthattimereflectingavalueforUSAirthatwasfarbelowour$358millioncost.

But in the fourth quarter,we concluded that the decline in valuewas, inaccountingterms,“otherthantemporary,”andthatjudgmentrequiredustosendthewritedownof$268.5millionthroughourincomestatement.Theamounthadnootherfourth-quartereffect.That is, itdidnotreduceournetworth,becausethediminutionofvaluehadalreadybeenreflectedthere.

CharlieandIwillnotstandforreelectiontoUSAir’sboardattheupcoming

annual meeting. Should Seth wish to consult with us, however, we will bepleasedtobeofanyhelpthatwecan.

WhenRichardBranson,thewealthyownerofVirginAtlanticAirways,wasasked how to become a millionaire, he had a quick answer: “There’s reallynothingtoit.Startasabillionaireandthenbuyanairline.”UnwillingtoacceptBranson’s proposition on faith, your Chairman decided in 1989 to test it byinvesting$358millionina9¼%preferredstockofUSAir.

I likedandadmiredEdColodny, thecompany’s then-CEO,and I stilldo.ButmyanalysisofUSAir’sbusinesswasbothsuperficialandwrong.Iwassobeguiled by the company’s long history of profitable operations, and by theprotection that ownership of a senior security seemingly offered me, that Ioverlooked the crucial point: USAir’s revenues would increasingly feel theeffectsofanunregulated,fiercelycompetitivemarketwhereasitscoststructurewasaholdoverfromthedayswhenregulationprotectedprofits.Thesecosts,ifleftunchecked,portendeddisaster,however reassuring theairline’spast recordmightbe.

Torationalizeitscosts,however,USAirneededmajorimprovementsinitslaborcontracts—andthat’ssomethingmostairlineshavefounditextraordinarilydifficult to get, short of credibly threatening, or actually entering, bankruptcy.USAirwas to be no exception. Immediately afterwe purchased our preferredstock,theimbalancebetweenthecompany’scostsandrevenuesbegantogrowexplosively.Inthe1990–1994period,USAirlostanaggregateof$2.4billion,aperformancethattotallywipedoutthebookequityofitscommonstock.

Formuchofthisperiod,thecompanypaidusourpreferreddividends,butin 1994 payment was suspended. A bit later, with the situation lookingparticularlygloomy,wewrotedownour investmentby75%, to$89.5million.Thereafter, during much of 1995, I offered to sell our shares at 50% of facevalue.Fortunately,Iwasunsuccessful.

Mixed in with my many mistakes at USAir was one thing I got right:Making our investment, we wrote into the preferred contract a somewhatunusual provision stipulating that “penalty dividends”—to run five percentagepointsovertheprimerate—wouldbeaccruedonanyarrearages.Thismeantthatwhen our 9¼% dividend was omitted for two years, the unpaid amountscompoundedatratesrangingbetween13¼%and14%.

Facingthispenaltyprovision,USAirhadeveryincentivetopayarrearagesjustaspromptlyasitcould.Andinthesecondhalfof1996,whenUSAirturnedprofitable, it indeed began to pay, giving us $47.9 million. We owe Stephen

Wolf,thecompany’sCEO,ahugethank-youforextractingaperformancefromthe airline that permitted this payment. Even so, USAir’s performance hasrecentlybeenhelpedsignificantlybyanindustrytailwindthatmaybecyclicalinnature.Thecompanystillhasbasiccostproblemsthatmustbesolved.

Inanyevent,thepricesofUSAir’spublicly-tradedsecuritiestellusthatourpreferredstockisnowprobablyworthitsparvalueof$358million,giveortakea little. In addition, we have over the years collected an aggregate of $240.5millionindividends(including$30millionreceivedin1997).

Early in 1996, before any accrued dividends had been paid, I tried oncemoretounloadourholdings—thistimeforabout$335million.You’relucky:Iagainfailedinmyattempttosnatchdefeatfromthejawsofvictory.

Inanothercontext,a friendonceaskedme:“Ifyou’resorich,whyaren’tyou smart?” After reviewing my sorry performance with USAir, you mayconcludehehadapoint.

InmakingtheUSAirpurchase,yourChairmandisplayedexquisitetiming:Iplunged into the business at almost the exact moment that it ran into severeproblems. (No one pushed me; in tennis parlance, I committed an “unforcederror.”)Thecompany’stroubleswerebroughtonbothbyindustryconditionsandby the post-merger difficulties it encountered in integrating Piedmont, anaffliction I should have expected since almost all airline mergers have beenfollowedbyoperationalturmoil.

Inshortorder,EdColodnyandSethSchofieldresolvedthesecondproblem:Theairlinenowgetsexcellentmarks forservice. Industry-wideproblemshaveprovedtobefarmoreserious.Sinceourpurchase,theeconomicsoftheairlineindustry have deteriorated at an alarming pace, accelerated by the kamikazepricing tacticsof certain carriers.The trouble thispricinghasproduced for allcarriers illustrates an important truth: In a business selling a commodity-typeproduct,it’simpossibletobealotsmarterthanyourdumbestcompetitor.

However, unless the industry is decimatedduring thenext fewyears, ourUSAir investment shouldworkout all right.EdandSethdecisivelyaddressedthe current turbulence by making major changes in operations. Even so, ourinvestmentisnowlesssecurethanatthetimeImadeit.

Our convertible preferred stocks are relatively simple securities, yet Ishouldwarnyouthat,if thepastisanyguide,youmayfromtimetotimereadinaccurateormisleadingstatementsaboutthem.Lastyear,forexample,severalmembersofthepresscalculatedthevalueofallourpreferredsasequaltothatofthe common stock intowhich they are convertible.By their logic, that is, our

Salomon preferred, convertible into common at $38, would be worth 60% offace value if Salomon common were selling at $22.80. But there is a smallproblemwiththislineofreasoning:Usingit,onemustconcludethatallofthevalueofaconvertiblepreferredresidesintheconversionprivilegeandthatvalueof a non-convertible preferred of Salomonwould be zero, nomatter what itscouponortermsforredemption.

The point you should keep in mind is that most of the value of ourconvertible preferreds is derived from their fixed-income characteristics. Thatmeansthesecuritiescannotbeworthlessthanthevaluetheywouldpossessasnon-convertiblepreferredsandmaybeworthmorebecauseof theirconversionoptions.

Berkshire made five private purchases of convertible preferred stocksduringthe1987–91periodandthetimeseemsrighttodiscusstheirstatus.

Ineachcasewehad theoptionofstickingwith thesepreferredsas fixed-incomesecuritiesorconvertingthemintocommonstock.Initially,theirvaluetouscameprimarilyfromtheirfixed-incomecharacteristics.Theoptionwehadtoconvertwasakicker.

Our $300 million private purchase of American Express “Percs” was amodifiedformofcommonstockwhosefixed-incomecharacteristicscontributedonlyaminorportionof its initialvalue.Threeyearsafterweboughtthem,thePercs automatically were converted to common stock. In contrast, [our otherconvertible preferred stocks] were set to become common stocks only if wewishedthemto—acrucialdifference.

Whenwepurchasedourconvertiblesecurities,Itoldyouthatweexpectedtoearnafter-tax returns from them that“moderately”exceededwhatwecouldearnfromthemedium-termfixed-incomesecuritiestheyreplaced.Webeatthisexpectation—butonlybecauseof theperformanceofasingle issue. Ialso toldyou that these securities, as a group, would “not produce the returns we canachieve when we find a business with wonderful economic prospects.”Unfortunately,thatpredictionwasfulfilled.Finally,Isaidthat“underalmostanyconditions,weexpect thesepreferreds to returnusourmoneyplusdividends.”That’soneIwouldliketohaveback.WinstonChurchilloncesaidthat“eatingmywordshasnevergivenme indigestion.”Myassertion,however, that itwasalmost impossible forus to losemoneyonourpreferredshascausedmesomewell-deservedheartburn.

OurbestholdinghasbeenGillette,whichwetoldyoufromthestartwasasuperiorbusiness. Ironically, though, this isalso thepurchase inwhich Imade

my biggest mistake—of a kind, however, never recognized on financialstatements.

We paid $600 million in 1989 for Gillette preferred shares that wereconvertibleinto48million(split-adjusted)commonshares.Takinganalternativeroutewiththe$600million,Iprobablycouldhavepurchased60millionsharesof common from the company. The market on the common was then about$10.50,andgiventhatthiswouldhavebeenahugeprivateplacementcarryingimportantrestrictions,Iprobablycouldhaveboughtthestockatadiscountofatleast 5%. I can’t be sure about this, but it’s likely thatGillette’smanagementwouldhavebeenjustashappytohaveBerkshireoptforcommon.

But I was far too clever to do that. Instead, for less than two years, wereceived some extra dividend income (the difference between the preferred’syieldand thatof thecommon),atwhichpoint thecompany—quiteproperly—calledtheissue,movingtodothatasquicklyaswaspossible.IfIhadnegotiatedfor common rather than preferred,wewould have been better off at year-end1995by$625million,minusthe“excess”dividendsofabout$70million.

InthecaseofChampion,theabilityofthecompanytocallourpreferredat115%of cost forced amove out of us lastAugust thatwewould rather havedelayed.Inthisinstance,weconvertedoursharesjustpriortothependingcallandofferedthemtothecompanyatamodestdiscount.

Charlie and I have never had a conviction about the paper industry—actually,Ican’tremembereverowningthecommonstockofapaperproducerinmy54yearsof investing—soour choice inAugustwaswhether to sell in themarket or to the company. Our Champion capital gain was moderate—about19%aftertaxfromasix-yearinvestment—butthepreferreddeliveredusagoodafter-taxdividendyield throughout our holdingperiod. (That said,manypressaccounts have overstated the after-tax yields earned by property-casualtyinsurance companies on dividends paid to them.)What the press has failed totake into account is a change in the tax law that took effect in 1987 and thatsignificantlyreducedthedividendsreceivedcreditapplicabletoinsurers.

Our First Empire preferred [was to] be called on March 31, 1996, theearliestdateallowable.Wearecomfortableowningstockinwell-runbanks,andwewillconvertandkeepourFirstEmpirecommonshares.BobWilmers,CEOof the company, is an outstanding banker, and we love being associated withhim.

Our other two preferreds have been disappointing, though the Salomonpreferred has modestly outperformed the fixed-income securities for which itwasasubstitute.However,theamountofmanagementtimeCharlieandIhavedevotedtothisholdinghasbeenvastlygreaterthanitseconomicsignificanceto

Berkshire. Certainly I never dreamed I would take a new job at age 60—Salomon interim chairman, that is—because of an earlier purchase of a fixed-incomesecurity.

SoonafterourpurchaseoftheSalomonpreferredin1987,IwrotethatIhad“nospecialinsightsregardingthedirectionorfutureprofitabilityofinvestmentbanking.” Even the most charitable commentator would conclude that I havesinceprovedmypoint.

To date, our option to convert into Salomon common has not proven ofvalue.Furthermore,theDowIndustrialshavedoubledsinceIcommittedtobuythe preferred, and the brokerage group has performed equally as well. Thatmeansmydecision togowithSalomonbecause I sawvalue in theconversionoptionmustbegradedasverypoor.Evenso,thepreferredhascontinuedundersome trying conditions to deliver as a fixed-income security, and the 9%dividendiscurrentlyquiteattractive.

Unless thepreferred isconverted, its terms require redemptionof20%oftheissueonOctober31ofeachyear,1995–99,and$140millionofouroriginal$700millionwastakenonschedulelastyear.(Somepressreportslabeledthisasale,butaseniorsecuritythatmaturesisnot“sold.”)Thoughwedidnotelecttoconvert the preferred that matured last year, we have four more bites at theconversionapple,andIbelieveitquitelikelythatwewillyetfindvalueinourrighttoconvert.

The common stocks of both Gillette and First Empire [into whichBerkshire’spreferredshadbeenconverted]haverisensubstantially,inlinewiththecompanies’excellentperformance.Atyearend,the$600millionweputintoGillette in 1989 had appreciated to $4.8 billion, and the $40 million wecommittedtoFirstEmpirein1991hadrisento$236million.

Ourtwolaggards[USAirandSalomon],meanwhile,havecometolifeinavery major way. In a transaction that finally rewarded its long-sufferingshareholders,SalomonrecentlymergedintoTravelersGroup.AllofBerkshire’sshareholders—including me, very personally—owe a huge debt to DeryckMaughanandBobDenhamfor,first,playingkeyrolesinsavingSalomonfromextinction following its 1991 scandal and, second, restoring the vitality of thecompany to a level thatmade it an attractive acquisition forTravelers. I haveoftensaid that Iwish toworkwithexecutives that I like, trustandadmire.NotwofitthatdescriptionbetterthanDeryckandBob.

Berkshire’s final results from itsSalomon investmentwon’t be tallied forsometime,butitissafetosaythattheywillbefarbetterthanIanticipatedtwo

yearsago.Lookingback,IthinkofmySalomonexperienceashavingbeenbothfascinatingandinstructional,thoughforatimein1991-92[whenservingasitschairman]Ifeltlikethedramacriticwhowrote:“IwouldhaveenjoyedtheplayexceptthatIhadanunfortunateseat.Itfacedthestage.”

The resuscitation of US Airways borders on the miraculous. Those whohavewatchedmymovesinthisinvestmentknowthatIhavecompiledarecordthatisunblemishedbysuccess.Iwaswronginoriginallypurchasingthestock,andIwaswronglater,inrepeatedlytryingtounloadourholdingsat50centsonthedollar.

Two changes at the company coincidedwith its remarkable rebound: (1)Charlie and I left the board of directors and (2) StephenWolf became CEO.Fortunately for our egos, the second event was the key: Stephen Wolf’saccomplishmentsattheairlinehavebeenphenomenal.

TherestillismuchtodoatUSAirways,butsurvivalisnolongeranissue.Consequently, the companymade up the dividend arrearages on our preferredduring1997,addingextrapaymentstocompensateusforthedelaywesuffered.The company’s common stock, furthermore, has risen from a low of $4 to arecenthighof$73.

OurpreferredhasbeencalledforredemptiononMarch15.Buttheriseinthe company’s stock has given our conversion rights, which we thoughtworthlessnotlongago,greatvalue.ItisnowalmostcertainthatourUSAirwaysshareswillproduceadecentprofit—thatis,ifmycostforMaaloxisexcluded—andthegaincouldevenproveindecent.

NexttimeImakeabig,dumbdecision,Berkshireshareholderswillknowwhattodo:PhoneMr.Wolf.

*In addition to the convertible preferreds, we purchased one other private

placementin1991,$300millionofAmericanExpressPercs.Thissecuritywasessentially a common stock that featureda tradeoff in its first threeyears:Wereceivedextradividendpaymentsduringthatperiod,butwewerealsocappedinthepriceappreciationwecouldrealize.Despitethecap,thisholdinghasprovedextraordinarily profitable thanks to a move by your Chairman that combinedluckandskill—110%luck,thebalanceskill.

OurPercswereduetoconvertintocommonstockinAugust1994,andinthemonthbeforeIwasmullingwhethertoselluponconversion.Onereasontohold was Amex’s outstanding CEO, Harvey Golub, who seemed likely tomaximizewhateverpotentialthecompanyhad(asuppositionthathassincebeenproved—inspades).Butthesizeofthatpotentialwasinquestion:Amexfaced

relentless competition fromamultitudeof card-issuers, ledbyVisa.Weighingthearguments,Ileanedtowardsale.

Here’swhere Igot lucky.During thatmonthofdecision, I playedgolf atProuts Neck, Maine with Frank Olson, CEO of Hertz. Frank is a brilliantmanager,withintimateknowledgeofthecardbusiness.SofromthefirstteeonIwasquizzinghimabouttheindustry.Bythetimewereachedthesecondgreen,FrankhadconvincedmethatAmex’scorporatecardwasaterrificfranchise,andIhaddecidednottosell.OnthebacknineIturnedbuyer,andinafewmonthsBerkshireowned10%ofthecompany.

Wenowhavea$3billiongaininourAmexshares,andInaturallyfeelverygrateful to Frank. But George Gillespie, our mutual friend, says that I amconfusedaboutwheremygratitudeshouldgo.Afterall,hepointsout,itwashewhoarrangedthegameandassignedmetoFrank’sfoursome.

E.Derivatives34

Charlie and I are of onemind in howwe feel about derivatives and thetradingactivitiesthatgowiththem:Weviewthemastimebombs,bothforthepartiesthatdealinthemandtheeconomicsystem.

Having delivered that thought, which I’ll get back to, let me retreat toexplainingderivatives,thoughtheexplanationmustbegeneralbecausethewordcovers an extraordinarily wide range of financial contracts. Essentially, theseinstrumentscallformoneytochangehandsatsomefuturedate,withtheamountto be determined by one ormore reference items, such as interest rates, stockpricesorcurrencyvalues.If, forexample,youareeither longorshortanS&P500futurescontract,youareaparty toaverysimplederivatives transaction—with your gain or loss derived from movements in the index. Derivativescontractsareofvaryingduration(runningsometimes to20ormoreyears)andtheirvalueisoftentiedtoseveralvariables.

Unlessderivativescontractsarecollateralizedorguaranteed,theirultimatevaluealsodependsonthecreditworthinessofthecounterpartiestothem.Inthemeantime, though,beforeacontract issettled, thecounterpartiesrecordprofitsandlosses—oftenhugeinamount—intheircurrentearningsstatementswithoutsomuchasapennychanginghands.

Therangeofderivativescontractsislimitedonlybytheimaginationofman(or sometimes, so it seems, madmen). At Enron, for example, newsprint andbroadbandderivatives,due tobesettledmanyyears in the future,wereputonthe books. Or say youwant towrite a contract speculating on the number of

twins tobeborn inNebraska in2020.Noproblem—ataprice,youwilleasilyfindanobligingcounterparty.

When we purchased Gen Re, it came with General Re Securities, aderivativesdealerthatCharlieandIdidn’twant,judgingittobedangerous.Wefailedinourattemptstoselltheoperation,however,andarenowterminatingit.

Butclosingdownaderivativesbusinessiseasiersaidthandone.Infact,thereinsurance and derivatives businesses are similar:LikeHell, both are easy toenterandalmostimpossibletoexit.Ineitherindustry,onceyouwriteacontract—whichmayrequirealargepaymentdecadeslater—youareusuallystuckwithit. True, there aremethods bywhich the risk can be laid offwith others. Butmoststrategiesofthatkindleaveyouwithresidualliability.

Another commonalityof reinsurance andderivatives is that bothgeneratereported earnings that are oftenwildly overstated. That’s true because today’searningsareinasignificantwaybasedonestimateswhoseinaccuracymaynotbeexposedformanyyears.

Errorswillusuallybehonest,reflectingonlythehumantendencytotakeanoptimisticviewofone’scommitments.But theparties toderivativesalsohaveenormous incentives to cheat in accounting for them. Those who tradederivativesareusuallypaid(inwholeorpart)on“earnings”calculatedbymark-to-marketaccounting.Butoftenthereisnorealmarket(thinkaboutourcontractinvolvingtwins)and“mark-to-model”isutilized.

This substitution can bring on large-scale mischief. As a general rule,contractsinvolvingmultiplereferenceitemsanddistantsettlementdatesincreasethe opportunities for counterparties to use fanciful assumptions. In the twinsscenario, for example, the two parties to the contractmightwell use differingmodels allowing both to show substantial profits for many years. In extremecases,mark-to-modeldegeneratesintowhatIwouldcallmark-to-myth.

Ofcourse,bothinternalandoutsideauditorsreviewthenumbers,butthat’snoeasyjob.Forexample,GeneralReSecuritiesatyear-end(aftertenmonthsofwinding down its operation) had 14,384 contracts outstanding, involving 672counterpartiesaroundtheworld.Eachcontracthadaplusorminusvaluederivedfromoneormorereferenceitems,includingsomeofmindbogglingcomplexity.Valuing a portfolio like that, expert auditors could easily and honestly havewidelyvaryingopinions.

Thevaluationproblem is far fromacademic: In recent years, somehuge-scale frauds andnear-frauds havebeen facilitated byderivatives trades. In theenergyandelectricutilitysectors,forexample,companiesusedderivativesandtrading activities to report great “earnings”—until the roof fell in when theyactually tried to convert the derivatives-related receivables on their balance

sheetsintocash.“Mark-to-market”thenturnedouttobetruly“mark-to-myth.”Icanassureyouthatthemarkingerrorsinthederivativesbusinesshavenot

been symmetrical. Almost invariably, they have favored either the traderwhowas eyeing a multi-million dollar bonus or the CEO who wanted to reportimpressive“earnings”(orboth).Thebonuseswerepaid,and theCEOprofitedfrom his options. Only much later did shareholders learn that the reportedearningswereasham.

Anotherproblemaboutderivativesisthattheycanexacerbatetroublethatacorporation has run into for completely unrelated reasons. This pile-on effectoccurs becausemany derivatives contracts require that a company suffering acreditdowngradeimmediatelysupplycollateraltocounterparties.Imagine,then,that a company is downgraded because of general adversity and that itsderivativesinstantlykickinwiththeirrequirement,imposinganunexpectedandenormous demand for cash collateral on the company. The need to meet thisdemand can then throw the company into a liquidity crisis thatmay, in somecases, trigger stillmoredowngrades. It all becomes a spiral that can lead to acorporatemeltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run byinsurers or reinsurers that lay offmuch of their business with others. In bothcases,hugereceivablesfrommanycounterpartiestendtobuildupovertime.Aparticipantmayseehimselfasprudent,believinghislargecreditexposurestobediversifiedandthereforenotdangerous.Undercertaincircumstances,though,anexogenouseventthatcausesthereceivablefromCompanyAtogobadwillalsoaffectthosefromCompaniesBthroughZ.Historyteachesusthatacrisisoftencausesproblemstocorrelateinamannerundreamedofinmoretranquiltimes.

Inbanking,therecognitionofa“linkage”problemwasoneofthereasonsfortheformationoftheFederalReserveSystem.BeforetheFedwasestablished,the failure of weak banks would sometimes put sudden and unanticipatedliquiditydemandsonpreviously-strongbanks,causingthemtofailinturn.TheFed now insulates the strong from the troubles of the weak. But there is nocentral bank assigned to the job of preventing the dominoes toppling ininsuranceorderivatives. In these industries, firms thatare fundamentally solidcanbecometroubledsimplybecauseofthetravailsofotherfirmsfurtherdownthe chain.When a “chain reaction” threat existswithin an industry, it pays tominimize links of any kind. That’s howwe conduct our reinsurance business,andit’sonereasonweareexitingderivatives.

Many people argue that derivatives reduce systemic problems, in thatparticipants who can’t bear certain risks are able to transfer them to strongerhands. These people believe that derivatives act to stabilize the economy,

facilitatetrade,andeliminatebumpsforindividualparticipants.And,onamicrolevel,what they say isoften true. Indeed,atBerkshire, I sometimesengage inlarge-scale derivatives transactions in order to facilitate certain investmentstrategies.

Charlie and I believe, however, that the macro picture is dangerous andgettingmore so. Large amounts of risk, particularly credit risk, have becomeconcentratedinthehandsofrelativelyfewderivativesdealers,whoinadditiontrade extensivelywith one other. The troubles of one could quickly infect theothers. On top of that, these dealers are owed huge amounts by non-dealercounterparties. Some of these counterparties, as I’vementioned, are linked inwaysthatcouldcausethemtocontemporaneouslyrunintoaproblembecauseofasingleevent(suchastheimplosionofthetelecomindustryortheprecipitousdecline in the value of merchant power projects). Linkage, when it suddenlysurfaces,cantriggerserioussystemicproblems.

Indeed, in1998, the leveragedandderivatives-heavyactivitiesofasinglehedge fund, Long-Term Capital Management, caused the Federal Reserveanxieties so severe that it hastily orchestrated a rescue effort. In laterCongressional testimony, Fed officials acknowledged that, had they notintervened, the outstanding trades of LTCM—a firm unknown to the generalpublic and employing only a few hundred people—could well have posed aseriousthreattothestabilityofAmericanmarkets.Inotherwords,theFedactedbecauseitsleaderswerefearfulofwhatmighthavehappenedtootherfinancialinstitutionshadtheLTCMdominotoppled.Andthisaffair,thoughitparalyzedmany parts of the fixed-incomemarket for weeks, was far from aworst-casescenario.

OneofthederivativesinstrumentsthatLTCMusedwastotal-returnswaps,contractsthatfacilitate100%leverageinvariousmarkets,includingstocks.Forexample,PartyAtoacontract,usuallyabank,putsupallofthemoneyforthepurchaseofastockwhilePartyB,withoutputtingupanycapital,agreesthatatafuturedateitwillreceiveanygainorpayanylossthatthebankrealizes.

Total-return swaps of this type make a joke of margin requirements.Beyondthat,other typesofderivativesseverelycurtail theabilityofregulatorstocurbleverageandgenerallyget theirarmsaroundtheriskprofilesofbanks,insurers and other financial institutions. Similarly, even experienced investorsand analysts encountermajor problems in analyzing the financial condition offirms that areheavily involvedwithderivatives contracts.WhenCharlie and Ifinish reading the long footnotes detailing the derivatives activities of majorbanks,theonlythingweunderstandisthatwedon’tunderstandhowmuchrisktheinstitutionisrunning.

Thederivativesgenie isnowwelloutof thebottle,and these instrumentswill almost certainly multiply in variety and number until some event makestheirtoxicityclear.Knowledgeofhowdangeroustheyarehasalreadypermeatedtheelectricityandgasbusinesses,inwhichtheeruptionofmajortroublescausedthe use of derivatives to diminish dramatically. Elsewhere, however, thederivatives business continues to expand unchecked. Central banks andgovernmentshavesofarfoundnoeffectivewaytocontrol,orevenmonitor,therisksposedbythesecontracts.

CharlieandIbelieveBerkshireshouldbeafortressoffinancialstrength—forthesakeofourowners,creditors,policyholdersandemployees.Wetrytobealerttoanysortofmega-catastropherisk,andthatposturemaymakeusundulyapprehensiveabouttheburgeoningquantitiesoflong-termderivativescontractsand the massive amount of uncollateralized receivables that are growingalongside. In our view, however, derivatives are financial weapons of massdestruction,carryingdangersthat,whilenowlatent,arepotentiallylethal.

Longago,MarkTwainsaid:“Amanwhotriestocarryacathomebyitstailwill learna lesson thatcanbe learned innootherway.”IfTwainwerearoundnow,hemighttrywindingupaderivativesbusiness.Afterafewdays,hewouldoptforcats.

Welost$104millionpre-taxlastyearinourcontinuingattempttoexitGenRe’s derivative operation. Our aggregate losses since we began this endeavortotal$404million.Originallywehad23,218contractsoutstanding.Bythestartof2005weweredownto2,890.Youmightexpect thatour losseswouldhavebeen stemmed by this point, but the blood has kept flowing. Reducing ourinventory to741contracts lastyearcostus the$104millionmentionedabove.[T]herationaleforestablishingthisunitin1990wasGenRe’swishtomeettheneedsofinsuranceclients.

Yetoneofthecontractsweliquidatedin2005hadatermof100years!It’sdifficulttoimaginewhat“need”suchacontractcouldfulfillexcept,perhaps,theneed of a compensation-conscious trader to have a long-dated contract on hisbooks. Long contracts, or alternatively those with multiple variables, are themostdifficulttomarktomarket(thestandardprocedureusedinaccountingforderivatives)andprovidethemostopportunityfor“imagination”whentradersareestimatingtheirvalue.

Smallwonderthattraderspromotethem.Abusinessinwhichhugeamountsofcompensationflowfromassumednumbersisobviouslyfraughtwithdanger.When two traders execute a transaction that has several, sometimes esoteric,

variablesandafar-offsettlementdate,theirrespectivefirmsmustsubsequentlyvalue these contractswhenever they calculate their earnings.A given contractmaybevaluedatonepricebyFirmAandatanotherbyFirmB.Youcanbetthatthe valuation differences—and I’m personally familiar with several that werehuge—tendtobetiltedinadirectionfavoringhigherearningsateachfirm.It’sastrangeworld inwhich twoparties can carryout a paper transaction that eachcanpromptlyreportasprofitable.

I dwell onour experience inderivatives for two reasons.One is personaland unpleasant. The hard fact is that I have cost you a lot of money by notmovingimmediatelytoclosedownGenRe’stradingoperation.BothCharlieandI knew at the time of theGenRe purchase that itwas a problem and told itsmanagement that we wanted to exit the business. It wasmy responsibility tomakesurethathappened.Ratherthanaddressthesituationheadon,however,Iwasted several years while we attempted to sell the operation. That was adoomedendeavorbecausenorealisticsolutioncouldhaveextricatedusfromthemazeofliabilitiesthatwasgoingtoexistfordecades.

Our obligations were particularly worrisome because their potential toexplodecouldnotbemeasured.Moreover,ifseveretroubleoccurred,weknewitwaslikelytocorrelatewithproblemselsewhereinfinancialmarkets.SoIfailedinmyattempt toexitpainlessly,and in themeantimemore tradeswereputonthe books. Fault me for dithering. (Charlie calls it thumb-sucking.) When aproblemexists,whetherinpersonnelorinbusinessoperations,thetimetoactisnow.

ThesecondreasonIregularlydescribeourproblemsinthisarealiesinthehope that our experiences may prove instructive for managers, auditors andregulators.Inasense,weareacanaryinthisbusinesscoalmineandshouldsingasongofwarningasweexpire.Thenumberandvalueofderivativecontractsoutstandingintheworldcontinuestomushroomandisnowamultipleofwhatexistedin1998,thelasttimethatfinancialchaoserupted.Ourexperienceshouldbeparticularlysoberingbecausewewereabetter-than-averagecandidatetoexitgracefully.

Additionally,weknowofnobadbehaviorbyanyoneinvolved.Itcouldbeadifferentstoryforothersinthefuture.Imagine,ifyouwill,oneormorefirms(troublesoftenspread)withpositionsthataremanymultiplesofoursattemptingto liquidate in chaotic markets and under extreme, and well-publicized,pressures.Thisisascenariotowhichmuchattentionshouldbegivennowratherthanafterthefact.Thetimetohaveconsidered—andimproved—thereliabilityofNewOrleans’ leveeswasbeforeKatrina.WhenwefinallywindupGenReSecurities,my feelingsabout itsdeparturewillbeakin to thoseexpressed ina

country song, “Mywife ran awaywithmybest friend, and I suremiss him alot.” [The2006 letter indicates thatGenRe’s derivative operationwas finallyclosed.]

[W]ehave entered into [various] typesofderivatives contracts.Thatmayseem odd [given] the systemic problems that could result from the enormousgrowthintheuseofderivatives.Why,youmaywonder,arewefoolingaroundwithsuchpotentiallytoxicmaterial?

The answer is that derivatives, just like stocks and bonds, are sometimeswildly mispriced. For many years, accordingly, we have selectively writtenderivativecontracts—fewinnumberbutsometimesforlargedollaramounts.Wecurrentlyhave62contractsoutstanding.Imanagethempersonally,andtheyarefreeof counterparty credit risk.So far, thesederivative contracts haveworkedoutwellforus,producingpre-taxprofitsinthehundredsofmillionsofdollars.Thoughwewillexperiencelossesfromtimetotime,wearelikelytocontinuetoearn—overall—significantprofitsfrommispricedderivatives.

Derivatives aredangerous.Theyhavedramatically increased the leverageand risks in our financial system. They have made it almost impossible forinvestors to understand and analyze our largest commercial banks andinvestment banks. They allowed Fannie Mae and Freddie Mac to engage inmassive misstatements of earnings for years. So indecipherable were Freddieand Fannie that their federal regulator, OFHEO, whose more than 100employees had no job except the oversight of these two institutions, totallymissedtheircookingofthebooks.

Indeed, recent events demonstrate that certainbig-nameCEOs (or formerCEOs) at major financial institutions were simply incapable of managing abusinesswithahuge, complexbookofderivatives. IncludeCharlie andme inthishaplessgroup:WhenBerkshirepurchasedGeneralRein1998,weknewwecouldnotgetourmindsaround itsbookof23,218derivativescontracts,madewith884counterparties(manyofwhichwehadneverheardof).Sowedecidedto close up shop. Though we were under no pressure and were operating inbenignmarketsasweexited,ittookusfiveyearsandmorethan$400millioninlossestolargelycompletethetask.Uponleaving,ourfeelingsaboutthebusinessmirroredalineinacountrysong:“IlikedyoubetterbeforeIgottoknowyousowell.”

Improved“transparency”—afavorite remedyofpoliticians,commentatorsand financial regulators for averting future train wrecks—won’t cure the

problems that derivatives pose. I knowof no reportingmechanism thatwouldcome close to describing and measuring the risks in a huge and complexportfolioofderivatives.Auditorscan’tauditthesecontracts,andregulatorscan’tregulatethem.WhenIreadthepagesof“disclosure”in10-Ksofcompaniesthatareentangledwiththeseinstruments,allIendupknowingisthatIdon’tknowwhatisgoingonintheirportfolios(andthenIreachforsomeaspirin).

Foracasestudyonregulatoryeffectiveness,let’slookharderattheFreddieandFannieexample.Thesegiant institutionswerecreatedbyCongress,whichretainedcontroloverthem,dictatingwhattheycouldandcouldnotdo.Toaiditsoversight,CongresscreatedOFHEO in1992, admonishing it tomake sure thetwobehemothswerebehavingthemselves.Withthatmove,FannieandFreddiebecame the most intensely-regulated companies of which I am aware, asmeasuredbymanpowerassignedtothetask.

On June 15, 2003, OFHEO (whose annual reports are available on theInternet)sentits2002reporttoCongress—specificallytoitsfourbossesintheSenate andHouse, among them none other thanMessrs. Sarbanes andOxley.The report’s 127 pages included a self-congratulatory cover-line: “Celebrating10Years ofExcellence.”The transmittal letter and reportwere delivered ninedaysaftertheCEOandCFOofFreddiehadresignedindisgraceandtheCOOhadbeenfired.Nomentionoftheirdepartureswasmadeintheletter,evenwhilethe report concluded, as it always did, that “BothEnterpriseswere financiallysoundandwellmanaged.”

In truth, both enterpriseshad engaged inmassive accounting shenanigansforsometime.Finally,in2006,OFHEOissueda340-pagescathingchronicleofthesinsofFanniethat,moreorless,blamedthefiascooneverypartybut—youguessedit—CongressandOFHEO.

TheBearStearnscollapsehighlightsthecounterpartyproblemembeddedinderivativestransactions,atimebombIfirstdiscussedinBerkshire’s2002report[excerptedabove].OnApril3,2008,TimGeithner,thentheablepresidentoftheNew York Fed, explained the need for a rescue: “The sudden discovery byBear’sderivativecounterpartiesthatimportantfinancialpositionstheyhadputinplacetoprotectthemselvesfromfinancialriskwerenolongeroperativewouldhave triggered substantial further dislocation in markets. This would haveprecipitatedarushbyBear’scounterparties to liquidate thecollateral theyheldagainstthosepositionsandtoattempttoreplicatethosepositionsinalreadyveryfragilemarkets.”ThisisFedspeakfor“Westeppedintoavoidafinancialchainreactionofunpredictablemagnitude.”Inmyopinion,theFedwasrighttodoso.

A normal stock or bond trade is completed in a fewdayswith one partygetting its cash, the other its securities. Counterparty risk therefore quickly

disappears,whichmeanscreditproblemscan’taccumulate.Thisrapidsettlementprocessiskeytomaintainingtheintegrityofmarkets.That,infact,isareasonfor NYSE and NASDAQ shortening the settlement period from five days tothreedaysin1995.

Derivatives contracts, in contrast, often go unsettled for years, or evendecades,withcounterpartiesbuildinguphugeclaimsagainsteachother.“Paper”assets and liabilities—often hard to quantify—become important parts offinancial statements though these items will not be validated for many years.Additionally, a frightening web of mutual dependence develops among hugefinancial institutions. Receivables and payables by the billions becomeconcentrated in the hands of a few large dealers who are apt to be highly-leveragedinotherwaysaswell.Participantsseekingtododgetroublesfacethesameproblemassomeoneseekingtoavoidvenerealdisease:It’snotjustwhomyousleepwith,butalsowhomtheyaresleepingwith.

Sleepingaround,tocontinueourmetaphor,canactuallybeusefulforlargederivatives dealers because it assures them government aid if trouble hits. Inother words, only companies having problems that can infect the entireneighborhood—Iwon’tmentionnames—arecertaintobecomeaconcernofthestate (an outcome, I’m sad to say, that is proper). From this irritating realitycomesThe First Law of Corporate Survival for ambitiousCEOswho pile onleverage and run large and unfathomable derivatives books: Modestincompetencesimplywon’tdo;it’smindbogglingscrew-upsthatarerequired.

F.ForeignCurrenciesandEquities35

During2002weenteredtheforeigncurrencymarketforthefirsttimeinmylife,andin2003weenlargedourposition,asIbecameincreasinglybearishonthedollar.Ishouldnotethatthecemeteryforseershasahugesectionsetasideformacroforecasters.Wehave in factmadefewmacroforecastsatBerkshire,andwehaveseldomseenothersmakethemwithsustainedsuccess.

Wehave—andwillcontinuetohave—thebulkofBerkshire’snetworthinU.S.assets.Butinrecentyearsourcountry’stradedeficithasbeenforce-feedinghugeamountsofclaimson,andownershipin,Americatotherestoftheworld.Foratime,foreignappetitefortheseassetsreadilyabsorbedthesupply.Latein2002, however, the world started choking on this diet, and the dollar’s valuebegantoslideagainstmajorcurrencies.Evenso,prevailingexchangerateswillnotleadtoamaterialletupinourtradedeficit.Sowhetherforeigninvestorslikeitornot,theywillcontinuetobefloodedwithdollars.Theconsequencesofthis

areanybody’sguess.Theycould,however,betroublesome—andreach,infact,wellbeyondcurrencymarkets.

AsanAmerican,Ihopethereisabenignendingtothisproblem.[P]erhapsthe alarms I have raised will prove needless: Our country’s dynamism andresiliencyhaverepeatedlymadefoolsofnay-sayers.ButBerkshireholdsmanybillionsofcash-equivalentsdenominatedindollars.SoIfeelmorecomfortableowning foreign-exchange contracts that are at least a partial offset to thatposition.

Berkshireownedabout$21.4billionofforeignexchangecontractsatyear-end, spread among 12 currencies. [As mentioned in the preceding essay],holdingsof thiskindareadecidedchange forus.BeforeMarch2002,neitherBerkshirenor Ihadever traded incurrencies.But theevidencegrows thatourtradepolicieswillputunremittingpressureonthedollarformanyyearstocome—sosince2002we’veheededthatwarninginsettingourinvestmentcourse.(AsW.C.Fieldsonce saidwhenasked for ahandout: “Sorry, son, allmymoney’stiedupincurrency.”)

Beclearononepoint:InnowaydoesourthinkingaboutcurrenciesrestondoubtsaboutAmerica.Weliveinanextraordinarilyrichcountry,theproductofa system that values market economics, the rule of law and equality ofopportunity.Our economy is far and away the strongest in theworld andwillcontinuetobe.Weareluckytolivehere.

Butourcountry’stradepracticesareweighingdownthedollar.Thedeclinein itsvaluehasalreadybeensubstantial,but isnevertheless likely tocontinue.Without policy changes, currency markets could even become disorderly andgenerate spillover effects, both political and financial.No one knowswhetherthese problems will materialize. But such a scenario is a far-from-remotepossibilitythatpolicymakersshouldbeconsideringnow.Theirbent,however,isto lean toward not-so-benign neglect: A 318-page Congressional study of theconsequencesofunremittingtradedeficitswaspublishedinNovember2000andhasbeengatheringdusteversince.Thestudywasorderedafterthedeficithitathen-alarming$263billionin1999;bylastyearithadrisento$618billion.

CharlieandI,itshouldbeemphasized,believethattruetrade—thatis,theexchangeofgoodsandserviceswithothercountries—isenormouslybeneficialforbothusandthem.Lastyearwehad$1.15trillionofsuchhonest-to-Godtradeand themore of this, the better. But, as noted, our country also purchased anadditional$618billioningoodsandservicesfromtherestoftheworldthatwasunreciprocated. That is a staggering figure and one that has important

consequences.The balancing item to this one-way pseudo-trade—in economics there is

alwaysanoffset—isatransferofwealthfromtheU.S.totherestoftheworld.The transfermaymaterialize in the formof IOUsourprivateorgovernmentalinstitutions give to foreigners, or by way of their assuming ownership of ourassets,suchasstocksandrealestate.Ineithercase,Americansendupowningareduced portion of our countrywhile non-Americans own a greater part. Thisforce-feedingofAmericanwealthtotherestoftheworldisnowproceedingatthe rate of $1.8 billion daily, an increase of 20% since I wrote you last year.Consequently, other countries and their citizens now own a net of about $3trillionoftheU.S.Adecadeagotheirnetownershipwasnegligible.

Thementionoftrillionsnumbsmostbrains.Afurthersourceofconfusionisthatthecurrentaccountdeficit(thesumofthreeitems,themostimportantbyfarbeing the tradedeficit)andournationalbudgetdeficitareoften lumpedas“twins.” They are anything but. They have different causes and differentconsequences.

Abudgetdeficitinnowayreducestheportionofthenationalpiethatgoesto Americans. As long as other countries and their citizens have no netownership of the U.S., 100% of our country’s output belongs to our citizensunderanybudgetscenario,evenoneinvolvingahugedeficit.

As a rich “family” awash in goods, Americans will argue through theirlegislatorsastohowgovernmentshouldredistributethenationaloutput—thatiswho pays taxes and who receives governmental benefits. If “entitlement”promises from an earlier day have to be reexamined, “family members” willangrilydebateamongthemselvesastowhofeelsthepain.Maybetaxeswillgoup;maybepromiseswillbemodified;maybemoreinternaldebtwillbeissued.Butwhenthefightisfinished,allofthefamily’shugepieremainsavailableforitsmembers,howeveritisdivided.Noslicemustbesentabroad.

Largeandpersistingcurrent accountdeficitsproduceanentirelydifferentresult.As timepasses,andasclaimsagainstusgrow,weown lessand lessofwhatweproduce.Ineffect,therestoftheworldenjoysanever-growingroyaltyonAmericanoutput.Here,wearelikeafamilythatconsistentlyoverspendsitsincome.Astimepasses,thefamilyfindsthatitisworkingmoreandmoreforthe“financecompany”andlessforitself.

Shouldwecontinuetoruncurrentaccountdeficitscomparabletothosenowprevailing,thenetownershipoftheU.S.byothercountriesandtheircitizensadecadefromnowwillamount toroughly$11trillion.And, ifforeigninvestorsweretoearnonly5%onthatnetholding,wewouldneedtosendanetof$.55trillion of goods and services abroad every year merely to service the U.S.

investmentsthenheldbyforeigners.Atthatdate,adecadeout,ourGDPwouldprobably total about $18 trillion (assuming low inflation, which is far from asure thing). Therefore, our U.S. “family” would then be delivering 3% of itsannualoutputtotherestoftheworldsimplyastributefortheoverindulgencesofthepast.Inthiscase,unlikethatinvolvingbudgetdeficits,thesonswouldtrulypayforthesinsoftheirfathers.

Thisannualroyaltypaidtheworld—whichwouldnotdisappearunlesstheU.S. massively under-consumed and began to run consistent and large tradesurpluses—would undoubtedly produce significant political unrest in the U.S.Americanswouldstillbelivingverywell,indeedbetterthannowbecauseofthegrowthinoureconomy.Buttheywouldchafeattheideaofperpetuallypayingtributetotheircreditorsandownersabroad.Acountrythatisnowaspiringtoan“OwnershipSociety”willnotfindhappinessin—andI’llusehyperbolehereforemphasis—a “Sharecropper’s Society.” But that’s precisely where our tradepolicies,supportedbyRepublicansandDemocratsalike,aretakingus.

Many prominent U.S. financial figures, both in and out of government,have stated that our current-account deficits cannot persist. For instance, theminutes of the FederalReserveOpenMarketCommittee of June 29-30, 2004say: “The staff noted that outsized external deficits could not be sustainedindefinitely.”But,despite theconstanthand-wringingby luminaries, theyoffernosubstantivesuggestionstotametheburgeoningimbalance.

[Sixteenmonthsearlier,Buffetthad]warnedthat“agentlydecliningdollarwouldnotprovidetheanswer.”Andsofarithasn’t.Yetpolicymakerscontinuetohopefora“softlanding,”meanwhilecounselingothercountriestostimulate(read“inflate”)theireconomiesandAmericanstosavemore.Inmyviewtheseadmonitionsmissthemark:Therearedeep-rootedstructuralproblemsthatwillcause America to continue to run a huge current-account deficit unless tradepolicies either changematerially or the dollar declines by a degree that couldproveunsettlingtofinancialmarkets.

ProponentsofthetradestatusquoarefondofquotingAdamSmith:“Whatisprudenceintheconductofeveryfamilycanscarcebefollyinthatofagreatkingdom.Ifaforeigncountrycansupplyuswithacommoditycheaperthanweourselvescanmakeit,betterbuyitofthemwithsomepartoftheproduceofourownindustry,employedinawayinwhichwehavesomeadvantage.”

Iagree.Note,however,thatMr.Smith’sstatementreferstotradeofproductforproduct,notofwealthforproductasourcountryisdoingtothetuneof$.6trillionannually.Moreover, Iamsure thathewouldneverhavesuggested that“prudence” consisted of his “family” selling off part of its farm every day inordertofinanceitsover-consumption.Yetthatisjustwhatthe“greatkingdom”

calledtheUnitedStatesisdoing.IftheU.S.wasrunninga$.6trillioncurrent-accountsurplus,commentators

worldwidewouldviolentlycondemnourpolicy,viewingitasanextremeformof“mercantilism”—along-discreditedeconomicstrategyunderwhichcountriesfosteredexports,discouraged imports, andpiledup treasure. Iwouldcondemnsuch a policy as well. But, in effect if not in intent, the rest of the world ispracticingmercantilisminrespecttotheU.S.,anactmadepossiblebyourvaststoreofassetsandourpristinecredithistory.Indeed,theworldwouldneverletany other country use a credit card denominated in its own currency to theinsatiable extentwe are employing ours. Presently,most foreign investors aresanguine: they may view us as spending junkies, but they know we are richjunkiesaswell.

Our spendthrift behavior won’t, however, be tolerated indefinitely. Andthoughit’s impossibletoforecast justwhenandhowthetradeproblemwillberesolved,it’simprobablethattheresolutionwillfosteranincreaseinthevalueofourcurrencyrelativetothatofourtradingpartners.

WehopetheU.S.adoptspoliciesthatwillquicklyandsubstantiallyreducethecurrent-accountdeficit.True,apromptsolutionwouldlikelycauseBerkshireto record losses on its foreign-exchange contracts. But Berkshire’s resourcesremainheavilyconcentratedindollar-basedassets,andbothastrongdollarandalow-inflationenvironmentareverymuchinourinterest.

JohnMaynardKeynessaidinhismasterfulTheGeneralTheory:“Worldlywisdom teaches that it is better for reputation to fail conventionally than tosucceed unconventionally.” (Or, to put it in less elegant terms, lemmings as aclassmaybederidedbutneverdoesanindividuallemminggetcriticized.)Froma reputational standpoint, Charlie and I run a clear risk with our foreign-exchangecommitment.Butwebelieve inmanagingBerkshireas ifweowned100% of it ourselves. And, were that the case, we would not be following adollar-onlypolicy.

When we have a long-term position in stocks or bonds, year-to-yearchangesinvaluearereflectedinourbalancesheetbut,aslongastheassetisnotsold,arerarelyreflectedinearnings.Forexample,ourCoca-Colaholdingswentfrom$1billioninvalueearlyonto$13.4billionatyearend1998andhavesincedeclined to $8.1 billion—with none of these moves affecting our earningsstatement.Long-termcurrencypositions, however, aredailymarked tomarketandthereforehaveaneffectonearningsineveryreportingperiod.

Fromthedatewefirstenteredintocurrencycontracts,weare$2.0billionin

theblack.Wereducedourdirectpositionincurrenciessomewhatduring2005.Wepartiallyoffsetthischange,however,bypurchasingequitieswhosepricesaredenominatedinavarietyofforeigncurrenciesandthatearnalargepartoftheirprofits internationally.Charlieand Iprefer thismethodofacquiringnon-dollarexposure.That’slargelybecauseofchangesininterestrates:AsU.S.rateshaverisenrelative to thoseof therestof theworld,holdingmostforeigncurrenciesnowinvolvesasignificantnegative“carry.”

Incontrast,theownershipofforeignequitiesislikely,overtime,tocreateapositive carry—perhaps a substantial one.Theunderlying factors affecting theU.S.currentaccountdeficitcontinuetoworsen,andnoletupisinsight.Notonlydidourtradedeficit—thelargestandmostfamiliariteminthecurrentaccount—hitanall-timehighin2005,butwealsocanexpectaseconditem—thebalanceof investment income—to soon turn negative. As foreigners increase theirownershipofU.S. assets (orof claimsagainstus) relative toU.S. investmentsabroad,theseinvestorswillbeginearningmoreontheirholdingsthanwedoonours.

Finally, the thirdcomponentof thecurrentaccount,unilateral transfers, isalwaysnegative.TheU.S., itshouldbeemphasized, isextraordinarilyrichandwill get richer. As a result, the huge imbalances in its current account maycontinue for a long timewithout their havingnoticeable deleterious effects ontheU.S.economyoronmarkets.Idoubt,however,thatthesituationwillforeverremainbenign.EitherAmericansaddresstheproblemsooninawayweselect,oratsomepointtheproblemwill likelyaddressusinanunpleasantwayofitsown.

As our U.S. trade problems worsen, the probability that the dollar willweaken over time continues to be high. I fervently believe in real trade—themore the better for both us and theworld.Wehad about $1.44 trillionof thishonest-to-Godtradein2006.ButtheU.S.alsohad$.76trillionofpseudo-tradelastyear—importsforwhichweexchangednogoodsorservices.(Ponder,foramoment, how commentators would describe the situation if our imports were$.76trillion—afull6%ofGDP—andwehadnoexports.)

Making these purchases that weren’t reciprocated by sales, the U.S.necessarilytransferredownershipofitsassetsorIOUstotherestoftheworld.Like a verywealthy but self-indulgent family,wepeeled off a bit ofwhatweownedinordertoconsumemorethanweproduced.

TheU.S.candoalotofthisbecauseweareanextraordinarilyrichcountrythathasbehavedresponsiblyinthepast.Theworldisthereforewillingtoaccept

ourbonds,realestate,stocksandbusinesses.Andwehaveavaststoreofthesetohandover.

Thesetransferswillhaveconsequences,however.AlreadythepredictionImade lastyearaboutone fall-out fromourspendingbingehascome true:The“investment income” account of our country—positive in every previous yearsince1915—turnednegative in2006.Foreignersnowearnmoreon theirU.S.investmentsthanwedoonourinvestmentsabroad.Ineffect,we’veusedupourbankaccountandturnedtoourcreditcard.And,likeeveryonewhogetsinhock,theU.S.willnowexperience“reversecompounding”aswepayever-increasingamountsofinterestoninterest.

Iwanttoemphasizethateventhoughourcourseisunwise,Americanswilllivebetter tenor twentyyears fromnowthan theydo today.Per-capitawealthwillincrease.Butourcitizenswillalsobeforcedeveryyeartoshipasignificantportionoftheircurrentproductionabroadmerelytoservicethecostofourhugedebtorposition.Itwon’tbepleasanttoworkpartofeachdaytopayfortheover-consumptionof your ancestors. I believe that at somepoint in the futureU.S.workersandvoterswillfindthisannual“tribute”soonerousthattherewillbeasevere political backlash. How that will play out in markets is impossible topredict—buttoexpecta“softlanding”seemslikewishfulthinking.

G.HomeOwnership:PracticeandPolicy36

As iswell-known, theU.S.went off the rails in its home-ownership andmortgage-lendingpolicies,andforthesemistakesoureconomyisnowpayingahuge price. All of us participated in the destructive behavior—government,lenders,borrowers, themedia, ratingagencies,youname it.At thecoreof thefolly was the almost universal belief that the value of houses was certain toincreaseovertimeandthatanydipswouldbeinconsequential.Theacceptanceof this premise justified almost anyprice andpractice inhousing transactions.Homeowners everywhere felt richer and rushed to “monetize” the increasedvalue of their homes by refinancings. These massive cash infusions fueled aconsumption binge throughout our economy. It all seemed great fun while itlasted.(Alargelyunnotedfact:Largenumbersofpeoplewhohave“lost” theirhouse through foreclosure have actually realized a profit because they carriedout refinancings earlier that gave them cash in excess of their cost. In thesecases,theevictedhomeownerwasthewinner,andthevictimwasthelender.)

Iwillwrite here at some length about themortgageoperationofClayton

HomesbecauseClayton’srecentexperiencemaybeuseful in thepublic-policydebateabouthousingandmortgages.

Clayton is the largest company in the manufactured home industry,delivering 27,499 units last year. This came to about 34% of the industry’s81,889total.Oursharewilllikelygrowin2009,partlybecausemuchoftherestof the industry is in acute distress. Industry wide, units sold have steadilydeclinedsincetheyhitapeakof372,843in1998.

At that time, much of the industry employed sales practices that wereatrocious.Writing about theperiod somewhat later, I described it as involving“borrowers who shouldn’t have borrowed being financed by lenders whoshouldn’thavelent.”

To begin with, the need for meaningful down payments was frequentlyignored.Sometimesfakerywasinvolved.(“Thatcertainlylookslikea$2,000cattome”saysthesalesmanwhowillreceivea$3,000commissioniftheloangoesthrough.)Moreover,impossible-to-meetmonthlypaymentswerebeingagreedtoby borrowers who signed up because they had nothing to lose. The resultingmortgageswereusuallypackaged(“securitized”)andsoldbyWallStreetfirmstounsuspectinginvestors.Thischainoffollyhadtoendbadly,anditdid.

Clayton, it shouldbeemphasized, followed farmore sensiblepractices initsown lending throughout that time. Indeed,nopurchaserof themortgages itoriginatedandthensecuritizedhaseverlostadimeofprincipalorinterest.ButClaytonwas the exception; industry losseswere staggering.And thehangovercontinuestothisday.

This 1997-2000 fiasco should have served as a canary-in-the-coal-minewarning for the far-larger conventional housing market. But investors,governmentandratingagencieslearnedexactlynothingfromthemanufactured-homedebacle.Instead,inaneeriererunofthatdisaster,thesamemistakeswererepeatedwithconventionalhomesinthe2004-07period:Lendershappilymadeloansthatborrowerscouldn’trepayoutoftheirincomes,andborrowersjustashappilysigneduptomeetthosepayments.Bothpartiescountedon“house-priceappreciation” to make this otherwise impossible arrangement work. It wasScarlettO’Haraalloveragain:“I’llthinkaboutittomorrow.”Theconsequencesofthisbehaviorarenowreverberatingthrougheverycornerofoureconomy.

Clayton’s 198,888 borrowers, however, have continued to pay normallythroughout the housing crash, handing us no unexpected losses. This is notbecause these borrowers are unusually credit-worthy, a point proved by FICOscores (a standard measure of credit risk). Their median FICO score is 644,compared to a national median of 723, and about 35% are below 620, thesegmentusuallydesignated“sub-prime.”Manydisastrouspoolsofmortgageson

conventional homes are populated by borrowers with far better credit, asmeasuredbyFICOscores.

Yet at year-end, our delinquency rate on loans we have originated was3.6%,uponlymodestlyfrom2.9%in2006and2.9%in2004.(Inadditiontoouroriginatedloans,we’vealsoboughtbulkportfoliosofvarioustypesfromotherfinancial institutions.) Clayton’s foreclosures during 2008 were 3.0% oforiginatedloanscomparedto3.8%in2006and5.3%in2004.

Whyareourborrowers—characteristicallypeoplewithmodestincomesandfar-from-great credit scores—performing so well? The answer is elementary,goingrightbacktoLending101.Ourborrowerssimplylookedathowfull-boremortgage paymentswould comparewith their actual—not hoped-for—incomeand then decided whether they could live with that commitment. Simply put,theytookoutamortgagewiththeintentionofpayingitoff,whateverthecourseofhomeprices.

Justasimportantiswhatourborrowersdidnotdo.Theydidnotcountonmakingtheir loanpaymentsbymeansofrefinancing.Theydidnotsignupfor“teaser” rates that upon resetwereoutsized relative to their income.And theydid not assume that they could always sell their home at a profit if theirmortgage payments became onerous. Jimmy Stewart would have loved thesefolks.

Ofcourse,anumberofourborrowerswillrunintotrouble.Theygenerallyhavenomorethanminorsavingstotidethemoverifadversityhits.Themajorcauseofdelinquencyorforeclosure is the lossofa job,butdeath,divorceandmedicalexpensesallcauseproblems.Ifunemploymentratesrise—astheysurelywillin2009—moreofClayton’sborrowerswillhavetroubles,andwewillhavelarger, though stillmanageable, losses.Butourproblemswill notbedriven toanyextentbythetrendofhomeprices.

Commentaryaboutthecurrenthousingcrisisoftenignoresthecrucialfactthat most foreclosures do not occur because a house is worth less than itsmortgage (so-called “upside-down” loans). Rather, foreclosures take placebecause borrowers can’t pay the monthly payment that they agreed to pay.Homeowners who have made a meaningful down-payment—derived fromsavings and not from other borrowing—seldom walk away from a primaryresidencesimplybecauseitsvaluetodayislessthanthemortgage.Instead,theywalkwhentheycan’tmakethemonthlypayments.

Homeownership isawonderful thing.Myfamilyand Ihaveenjoyedmypresenthomefor50years,withmoretocome.Butenjoymentandutilityshouldbe the primary motives for purchase, not profit or refi possibilities. And thehomepurchasedoughttofittheincomeofthepurchaser.

The present housing debacle should teach home buyers, lenders, brokersand government some simple lessons that will ensure stability in the future.Homepurchasesshouldinvolveanhonest-to-Goddownpaymentofatleast10%and monthly payments that can be comfortably handled by the borrower’sincome.Thatincomeshouldbecarefullyverified.

Putting people into homes, though a desirable goal, shouldn’t be ourcountry’s primary objective. Keeping them in their homes should be theambition.

28[Introductoryessay,1987;repeatedwithoutthefirstsentencein1988and1989.]

29[2011.]30 [Dividedbyhash lines:2002;1990;1990WescoFinancialCorporation

LettertoShareholders,byCharlesT.Munger.Reprintedwithpermission.]31[1989.]32[Dividedbyhashlines:1989;1994;1996;1990;1995;1997.]33 [See the essay “Value” Investing:ARedundancy in Part II.D. The per

sharefiguresinthetwoessaysdifferbecauseofstocksplits.]34[2002;2005;2006;2008.]35[Dividedbyhashlines:2003;2004;2005;2006.]36[2011;2008.]

IV.COMMONSTOCK

Occasional outbreaks of those two super-contagious diseases, fear andgreed, will forever occur in the investment community. The timing of theseepidemicswillbeunpredictable.Andthemarketaberrationsproducedbythemwill be equally unpredictable, both as to duration and degree. Therefore, wenevertrytoanticipatethearrivalordepartureofeitherdisease.Ourgoalismoremodest:wesimplyattempttobefearfulwhenothersaregreedyandtobegreedyonlywhenothersarefearful.

As this is written, little fear is visible in Wall Street. Instead, euphoriaprevails—andwhynot?Whatcouldbemoreexhilaratingthantoparticipateinabull market in which the rewards to owners of businesses become gloriouslyuncoupled from the plodding performances of the businesses themselves.Unfortunately,however,stockscan’toutperformbusinessesindefinitely.

Indeed,becauseoftheheavytransactionandinvestmentmanagementcoststhey bear, stockholders as a whole and over the long term must inevitablyunderperformthecompaniestheyown.IfAmericanbusiness,inaggregate,earnsabout12%onequityannually,investorsmustendupearningsignificantlyless.Bullmarketscanobscuremathematicallaws,buttheycannotrepealthem.37

A.TheBaneofTrading:TransactionCosts38

It’s been an easy matter for Berkshire and other owners of Americanequities toprosperover theyears.BetweenDecember31,1899andDecember31,1999,togiveareallylong-termexample,theDowrosefrom66to11,497.(Guesswhatannualgrowthrateisrequiredtoproducethisresult;thesurprisinganswer is at the end of this [essay].) This huge rise came about for a simplereason: Over the century American businesses did extraordinarily well andinvestorsrodethewaveoftheirprosperity.Businessescontinuetodowell.Butnowshareholders,throughaseriesofself-inflictedwounds,areinamajorwaycuttingthereturnstheywillrealizefromtheirinvestments.

Theexplanationofhowthisishappeningbeginswithafundamentaltruth:With unimportant exceptions, such as bankruptcies in which some of acompany’slossesarebornebycreditors,themostthatownersinaggregatecanearnbetweennowandJudgmentDayiswhattheirbusinessesinaggregateearn.True, by buying and selling that is clever or lucky, investorAmay takemore

thanhisshareofthepieattheexpenseofinvestorB.And,yes,allinvestorsfeelricherwhenstockssoar.Butanownercanexitonlybyhavingsomeonetakehisplace.Ifoneinvestorsellshigh,anothermustbuyhigh.Forownersasawhole,there is simply no magic—no shower of money from outer space—that willenable themtoextractwealthfromtheircompaniesbeyondthatcreatedbythecompaniesthemselves.

Indeed, owners must earn less than their businesses earn because of“frictional” costs.And that’smypoint:These costs are nowbeing incurred inamountsthatwillcauseshareholderstoearnfarlessthantheyhistoricallyhave.

Tounderstandhow this tollhasballooned, imagine for amoment that allAmericancorporationsare,andalwayswillbe,ownedbyasinglefamily.We’llcallthemtheGotrocks.Afterpayingtaxesondividends,thisfamily—generationafter generation—becomes richer by the aggregate amount earned by itscompanies. Today that amount is about $700 billion annually. Naturally, thefamilyspendssomeofthesedollars.Buttheportionitsavessteadilycompoundsforitsbenefit.IntheGotrockshouseholdeveryonegrowswealthieratthesamepace,andallisharmonious.

But let’s nowassume that a few fast-talkingHelpers approach the familyand persuade each of its members to try to outsmart his relatives by buyingcertainoftheirholdingsandsellingthemcertainothers.TheHelpers—forafee,ofcourse—obliginglyagreetohandlethesetransactions.TheGotrocksstillownall of corporate America; the trades just rearrange who owns what. So thefamily’s annual gain inwealth diminishes, equaling the earnings ofAmericanbusinessminus commissions paid. The more that family members trade, thesmaller their share of the pie and the larger the slice receivedby theHelpers.Thisfactisnotlostuponthesebroker-Helpers:Activityistheirfriendand,inawidevarietyofways,theyurgeiton.

Afterawhile,mostofthefamilymembersrealizethattheyarenotdoingsowell at this new “beat-my-brother” game. Enter another set ofHelpers. Thesenewcomers explain to eachmemberof theGotrocksclan thatbyhimselfhe’llneveroutsmarttherestofthefamily.Thesuggestedcure:“Hireamanager—yes,us—and get the job done professionally.” Thesemanager-Helpers continue tousethebroker-Helperstoexecutetrades;themanagersmayevenincreasetheiractivitysoastopermitthebrokerstoprosperstillmore.Overall,abiggersliceofthepienowgoestothetwoclassesofHelpers.

Thefamily’sdisappointmentgrows.Eachofitsmembersisnowemployingprofessionals.Yetoverall,thegroup’sfinanceshavetakenaturnfortheworse.Thesolution?Morehelp,ofcourse.

Itarrivesintheformoffinancialplannersandinstitutionalconsultants,who

weigh in to advise theGotrocks on selectingmanager-Helpers.The befuddledfamily welcomes this assistance. By now its members know they can pickneithertherightstocksnortherightstock-pickers.Why,onemightask,shouldtheyexpect success inpicking the rightconsultant?But thisquestiondoesnotoccur to theGotrocks, and the consultant-Helpers certainly don’t suggest it tothem.

TheGotrocks,nowsupportingthreeclassesofexpensiveHelpers,findthattheirresultsgetworse,andtheysinkintodespair.Butjustashopeseemslost,afourthgroup—we’llcall themthehyper-Helpers—appears.ThesefriendlyfolkexplaintotheGotrocksthattheirunsatisfactoryresultsareoccurringbecausetheexisting Helpers—brokers, managers, consultants—are not sufficientlymotivatedandaresimplygoingthroughthemotions.“What,”thenewHelpersask,“canyouexpectfromsuchabunchofzombies?”

Thenewarrivalsofferabreathtakinglysimplesolution:Paymoremoney.Brimmingwith self-confidence, the hyper-Helpers assert that huge contingentpayments—in addition to stiff fixed fees—arewhat each familymembermustforkoverinordertoreallyoutmaneuverhisrelatives.

The more observant members of the family see that some of the hyper-Helpersarereallyjustmanager-Helperswearingnewuniforms,bearingsewn-onsexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers,however, assure the Gotrocks that this change of clothing is all-important,bestowing on its wearers magical powers similar to those acquired by mild-manneredClarkKentwhenhechangedintohisSupermancostume.Calmedbythisexplanation,thefamilydecidestopayup.

Andthat’swherewearetoday:Arecordportionoftheearningsthatwouldgointheirentiretytoowners—iftheyalljuststayedintheirrockingchairs—isnowgoing to a swelling army ofHelpers. Particularly expensive is the recentpandemicofprofitarrangementsunderwhichHelpersreceivelargeportionsofthewinningswhentheyaresmartorlucky,andleavefamilymemberswithallofthelosses—andlargefixedfeestoboot—whentheHelpersaredumborunlucky(oroccasionallycrooked).

A sufficient number of arrangements like this—heads, the Helper takesmuchofthewinnings;tails,theGotrocksloseandpaydearlyfortheprivilegeofdoingso—maymakeitmoreaccuratetocallthefamilytheHadrocks.Today,infact, the family’s frictional costs of all sortsmaywell amount to 20% of theearnings ofAmerican business. In otherwords, the burden of payingHelpersmaycauseAmericanequity investors,overall, toearnonly80%orsoofwhattheywouldearniftheyjustsatstillandlistenedtonoone.

Longago,SirIsaacNewtongaveusthreelawsofmotion,whichwerethe

work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost abundleintheSouthSeaBubble,explaininglater,“Icancalculatethemovementofthestars,butnotthemadnessofmen.”Ifhehadnotbeentraumatizedbythisloss,SirIsaacmightwellhavegoneontodiscovertheFourthLawofMotion:Forinvestorsasawhole,returnsdecreaseasmotionincreases.

Here’stheanswertothequestionposedatthebeginningofthis[essay]:Togetveryspecific,theDowincreasedfrom65.73to11,497.12inthe20thcentury,andthatamountstoagainof5.3%compoundedannually.(Investorswouldalsohavereceiveddividends,ofcourse.)Toachieveanequalrateofgaininthe21stcentury,theDowwillhavetorisebyDecember31,2099to—braceyourself—precisely2,011,011.23.ButI’mwillingtosettlefor2,000,000;sixyearsintothiscentury,theDowhasgainednotatall.

ItislikelythatinafewmonthsBerkshireshareswillbetradedontheNewYorkStockExchange.Ourmovetherewouldbemadepossiblebyanewlistingrule that theExchange’sBoardofGovernorshaspassedandasked theSECtoapprove.Ifthatapprovalisforthcoming,weexpecttoapplyforalisting,whichwebelievewillbegranted.

Up to now, the Exchange has required newly-listed companies to have aminimumof2,000shareholderswhoeachown100sharesormore.Thepurposeof this rule is to insure that NYSE-listed companies enjoy the broad investorinterestthatfacilitatesanorderlymarket.The100-sharestandardcorrespondstothetradingunit(“roundlot”)forallcommonstocksnowlistedontheExchange.

Because [in 1988] Berkshire ha[d] relatively few shares outstanding(1,146,642),it[did]nothavethenumberof100-shares-or-moreholdersthattheExchangehasrequired.Aten-shareholdingofBerkshire,however,representsasignificant investment commitment. In fact, tenBerkshire shares have a valuegreater than that of 100 shares of any NYSE-listed stock. The Exchange,therefore,iswillingtohaveBerkshiresharestradeinten-share“roundlots.”

The Exchange’s proposed rule simply changes the 2,000 shareholderminimumfromonemeasuredbyholdersof100sharesormoretoonemeasuredbyholdersofaroundlotormore.Berkshirecaneasilymeetthisamendedtest.

Charlie Munger, Berkshire’s Vice Chairman, and I are delighted at theprospectoflisting,sincewebelievethismovewillbenefitourshareholders.Wehave two criteria by which we judge what marketplace would be best forBerkshire stock. First, we hope for the stock to consistently trade at a pricerationallyrelatedtoitsintrinsicbusinessvalue.Ifitdoes,theinvestmentresultachieved by each shareholder will approximate Berkshire’s business result

duringhisperiodofownership.Suchanoutcomeisfarfromautomatic.Manystocksswingbetweenlevels

of severe undervaluation and overvaluation. When this happens, owners arerewardedorpenalizedinamannerwildlyatvariancewithhowthebusinesshasperformedduring theirperiodofownership.Wewant toavoidsuchcapriciousresults. Our goal is to have our shareholder-partners profit from theachievementsof thebusinessrather thanfromthefoolishbehaviorof theirco-owners.

Consistently rationalprices areproducedby rationalowners,bothcurrentandprospective.Allofourpoliciesandcommunicationsaredesignedtoattractthe business-oriented long-term owner and to filter out possible buyerswhosefocusisshort-termandmarket-oriented.Todatewehavebeensuccessfulinthisattempt, and Berkshire shares have consistently sold in an unusually narrowrangearoundintrinsicbusinessvalue.WedonotbelievethataNYSElistingwillimprove or diminish Berkshire’s prospects for consistently selling at anappropriate price; the quality of our shareholders will produce a good resultwhateverthemarketplace.

But we do believe that the listing will reduce transaction costs forBerkshire’s shareholders—and that is important. Though we want to attractshareholderswhowillstayaroundforalongtime,wealsowanttominimizethecosts incurred by shareholders when they enter or exit. In the long run, theaggregatepre-taxrewardstoourownerswillequalthebusinessgainsachievedbythecompanylessthetransactioncostsimposedbythemarketplace—thatis,commissionschargedbybrokersplusthenetrealizedspreadsofmarket-makers.Overall, we believe these transaction costs will be reduced materially by aNYSElisting.

[T]ransaction costs are very heavy for active stocks, often amounting to10%ormoreoftheearningsofapubliccompany.Ineffect,thesecostsactasaheftytaxonowners,albeitonebasedonindividualdecisionsto“changechairs”andonethatispaidtothefinancialcommunityratherthantoWashington.Ourpolicies and your investment attitude have reduced this “tax” on Berkshireownerstowhatwebelieveisthelowestlevelamonglargepubliccompanies.ANYSE listing should further reduce this cost for Berkshire’s owners bynarrowingthemarket-maker’sspread.

Onefinalcomment:Youshouldclearlyunderstandthatwearenotseekinga NYSE listing for the purpose of achieving a higher valuation on Berkshireshares. Berkshire should sell, and we hope will sell, on the NYSE at pricessimilartothoseitwouldhavecommandedintheover-the-countermarket,givensimilareconomiccircumstances.TheNYSElistingshouldnotinduceyoutobuy

orsell;itsimplyshouldcutyourcostssomewhatshouldyoudecidetodoeither.

B.AttractingtheRightSortofInvestor39

Berkshire’sshareswerelistedonthe[NYSE]onNovember29,1988.Letme clarify onepoint not dealtwith in the letter [set forth above]:ThoughourroundlotfortradingontheNYSEistenshares,anynumberofsharesfromoneonupcanbeboughtorsold.

Asthe[foregoing]letterexplains,ourprimarygoalinlistingwastoreducetransaction costs, and we believe this goal is being achieved. Generally, thespreadbetween thebidandaskedpriceon theNYSEhasbeenwellbelowthespreadthatprevailedintheover-the-countermarket.

Henderson Brothers, Inc., the specialist in our shares, is the oldestcontinuing specialist firm on the Exchange; its progenitor, William ThomasHenderson,boughthisseatfor$500onSeptember8,1861.(Recently,seatsweresellingforabout$625,000.)Amongthe54firmsactingasspecialists,HBIrankssecondinnumberofstocksassigned,with83.WewerepleasedwhenBerkshirewasallocatedtoHBI,andhavebeendelightedwiththefirm’sperformance.JimMaguire,ChairmanofHBI,personallymanagesthetradinginBerkshire,andwecouldnotbeinbetterhands.

In two respects our goals probably differ somewhat from those of mostlistedcompanies.First,wedonotwanttomaximizethepriceatwhichBerkshireshares trade.Wewish instead for them to trade in a narrow range centered atintrinsicbusinessvalue(whichwehopeincreasesatareasonable—or,betteryet,unreasonable—rate). Charlie and I are bothered as much by significantovervaluation as significant undervaluation. Both extremes will inevitablyproduceresults formanyshareholders thatwilldiffersharplyfromBerkshire’sbusiness results. If our stockprice instead consistentlymirrors business value,eachofourshareholderswillreceiveaninvestmentresultthatroughlyparallelsthebusinessresultsofBerkshireduringhisholdingperiod.

Second,wewishforverylittletradingactivity.Ifweranaprivatebusinesswith a few passive partners, we would be disappointed if those partners, andtheirreplacements,frequentlywantedtoleavethepartnership.Runningapubliccompany,wefeelthesameway.

Ourgoalistoattractlong-termownerswho,atthetimeofpurchase,havenotimetableorpricetargetforsalebutplaninsteadtostaywithusindefinitely.Wedon’tunderstand theCEOwhowants lotsofstockactivity, for thatcanbeachieved only if many of his owners are constantly exiting. At what other

organization—school, club, church, etc.—do leaders cheer when membersleave? (However if there were a broker whose livelihood depended upon themembershipturnoverinsuchorganizations,youcouldbesurethattherewouldbeatleastoneproponentofactivity,asin:“Therehasn’tbeenmuchgoingoninChristianityforawhile;maybeweshouldswitchtoBuddhismnextweek.”)

Of course, someBerkshireownerswill needorwant to sell from time totime, and we wish for good replacements who will pay them a fair price.Therefore we try, through our policies, performance, and communications, toattractnewshareholderswhounderstandouroperations,shareourtimehorizons,andmeasureusaswemeasureourselves.Ifwecancontinuetoattractthissortofshareholder—and, just as important, can continue to be uninteresting to thosewith short-term or unrealistic expectations—Berkshire shares shouldconsistentlysellatpricesreasonablyrelatedtobusinessvalue.40

C.DividendPolicyandShareRepurchases41

Dividendpolicyisoftenreportedtoshareholders,butseldomexplained.Acompany will say something like, “Our goal is to pay out 40% to 50% ofearningsandtoincreasedividendsatarateatleastequaltotheriseintheCPI.”Andthat’sit—noanalysiswillbesuppliedastowhythatparticularpolicyisbestfortheownersofthebusiness.Yet,allocationofcapitaliscrucialtobusinessandinvestmentmanagement.Becauseitis,webelievemanagersandownersshouldthinkhardaboutthecircumstancesunderwhichearningsshouldberetainedandunderwhichtheyshouldbedistributed.

The first point to understand is that all earnings are not created equal. Inmanybusinesses—particularlythosethathavehighasset/profitratios—inflationcausessomeorallofthereportedearningstobecomeersatz.Theersatzportion—let’s call these earnings “restricted”—cannot, if the business is to retain itseconomicposition,bedistributedasdividends.Were theseearnings tobepaidout, thebusinesswould loseground inoneormoreof the followingareas: itsabilitytomaintainitsunitvolumeofsales,itslong-termcompetitiveposition,itsfinancialstrength.Nomatterhowconservativeitspayoutratio,acompanythatconsistentlydistributesrestrictedearningsisdestinedforoblivionunlessequitycapitalisotherwiseinfused.

Restrictedearningsareseldomvaluelesstoowners,buttheyoftenmustbediscountedheavily.Ineffect,theyareconscriptedbythebusiness,nomatterhowpoor its economic potential. (This retention-no-matter-how-unattractive-the-returnsituationwascommunicatedunwittingly inamarvelously ironicwayby

ConsolidatedEdisonadecadeago.Atthetime,apunitiveregulatorypolicywasamajorfactorcausingthecompany’sstocktosellaslowasone-fourthofbookvalue: i.e.,everytimeadollarofearningswasretainedforreinvestment in thebusiness,thatdollarwastransformedintoonly25¢ofmarketvalue.But,despitethisgold-into-leadprocess,mostearningswerereinvestedinthebusinessratherthan paid to owners. Meanwhile, at construction and maintenance sitesthroughoutNewYork,signsproudlyproclaimedthecorporateslogan,“DigWeMust.”)

Restrictedearningsneednotconcernusfurtherinthisdividenddiscussion.Let’s turn to the much-more-valued unrestricted variety. These earnings may,with equal feasibility, be retained or distributed. In our opinion, managementshould choose whichever course makes greater sense for the owners of thebusiness.

This principle is not universally accepted. For a number of reasonsmanagers like to withhold unrestricted, readily distributable earnings fromshareholders—toexpandthecorporateempireoverwhichthemanagersrule,tooperate from a position of exceptional financial comfort, etc. But we believethere is only one valid reason for retention. Unrestricted earnings should beretained only when there is a reasonable prospect—backed preferably byhistoricalevidenceor,whenappropriate,byathoughtfulanalysisofthefuture—that foreverydollarretainedby thecorporation,at leastonedollarofmarketvaluewill be created forowners. Thiswill happen only if the capital retainedproduces incremental earnings equal to, or above, those generally available toinvestors.

To illustrate, let’sassume thatan investorownsa risk-free10%perpetualbondwithoneveryunusual feature.Eachyear the investor can elect either totakehis10%couponincash,ortoreinvestthecouponinmore10%bondswithidentical terms: i.e., a perpetual life and coupons offering the same cash-or-reinvestoptions.If,inanygivenyear,theprevailinginterestrateonlong-term,risk-freebondsis5%,itwouldbefoolishfortheinvestortotakehiscouponincashsincethe10%bondshecouldinsteadchoosewouldbeworthconsiderablymorethan100¢onthedollar.Underthesecircumstances,theinvestorwantingtoget his hands on cash should take his coupon in additional bonds and thenimmediatelysellthem.Bydoingthat,hewouldrealizemorecashthanifhehadtaken his coupon directly in cash. Assuming all bonds were held by rationalinvestors, no onewould opt for cash in an era of 5% interest, not even thosebondholdersneedingcashforlivingpurposes.

If, however, interest rateswere 15%,no rational investorwouldwant hismoneyinvestedforhimat10%.Instead, the investorwouldchooseto takehis

couponincash,evenifhispersonalcashneedswerenil.Theoppositecourse—reinvestment of the coupon—would give an investor additional bonds withmarketvaluefarlessthanthecashhecouldhaveelected.Ifheshouldwant10%bonds,hecansimplytakethecashreceivedandbuytheminthemarket,wheretheywillbeavailableatalargediscount.

An analysis similar to that made by our hypothetical bondholder isappropriate for owners in thinking about whether a company’s unrestrictedearnings shouldbe retainedor paid out.Of course, the analysis ismuchmoredifficultandsubjecttoerrorbecausetherateearnedonreinvestedearningsisnotacontractualfigure,asinourbondcase,butratherafluctuatingfigure.Ownersmust guess as to what the rate will average over the intermediate future.However,onceaninformedguessismade,therestoftheanalysisissimple:youshouldwishyourearningstobereinvestediftheycanbeexpectedtoearnhighreturns, and you should wish them paid to you if low returns are the likelyoutcomeofreinvestment.

Many corporate managers reason very much along these lines indetermining whether subsidiaries should distribute earnings to their parentcompany.At that level, themanagers have no trouble thinking like intelligentowners.Butpayoutdecisionsat theparentcompany leveloftenareadifferentstory.Heremanagersfrequentlyhavetroubleputtingthemselvesintheshoesoftheirshareholder-owners.

With this schizoid approach, theCEOof amulti-divisional companywillinstructSubsidiaryA,whoseearningsonincrementalcapitalmaybeexpectedtoaverage 5%, to distribute all available earnings in order that they may beinvestedinSubsidiaryB,whoseearningsonincrementalcapitalareexpectedtobe15%.TheCEO’sbusinessschooloathwillallownolesserbehavior.Butifhisownlong-termrecordwithincrementalcapitalis5%—andmarketratesare10%—he is likely to impose a dividend policy on shareholders of the parentcompany thatmerely follows some historical or industry-wide payout pattern.Furthermore,hewillexpectmanagersofsubsidiariestogivehimafullaccountas towhy itmakes sense for earnings to be retained in their operations ratherthandistributedtotheparent-owner.Butseldomwillhesupplyhisownerswithasimilaranalysispertainingtothewholecompany.

In judgingwhethermanagers should retain earnings, shareholders shouldnot simply compare total incremental earnings in recent years to totalincrementalcapitalbecausethatrelationshipmaybedistortedbywhatisgoingon in a core business. During an inflationary period, companies with a corebusiness characterized by extraordinary economics can use small amounts ofincrementalcapitalinthatbusinessatveryhighratesofreturn(aswasdiscussed

in last year’s section on Goodwill).42 But, unless they are experiencingtremendous unit growth, outstanding businesses by definition generate largeamounts of excess cash. If a company sinks most of this money in otherbusinessesthatearnlowreturns,thecompany’soverallreturnonretainedcapitalmay nevertheless appear excellent because of the extraordinary returns beingearned by the portion of earnings incrementally invested in the core business.ThesituationisanalogoustoaPro-Amgolfevent:evenifalloftheamateursarehopeless duffers, the team’s best-ball scorewill be respectable because of thedominatingskillsoftheprofessional.

Manycorporationsthatconsistentlyshowgoodreturnsbothonequityandon overall incremental capital have, indeed, employed a large portion of theirretainedearningsonaneconomicallyunattractive,evendisastrous,basis.Theirmarvelous core businesses, however, whose earnings grow year after year,camouflage repeated failures in capital allocation elsewhere (usually involvinghigh-pricedacquisitionofbusinessesthathaveinherentlymediocreeconomics).Themanagersat faultperiodicallyreporton the lessontheyhave learnedfromthe latest disappointment. They then usually seek out future lessons. (Failureseemstogototheirheads.)

Insuchcases,shareholderswouldbefarbetteroffifearningswereretainedonly to expand thehigh-returnbusiness,with thebalancepaid individendsorused to repurchase stock (an action that increases the owners’ interest in theexceptional business while sparing them participation in subpar businesses).Managersofhigh-returnbusinesseswhoconsistentlyemploymuchof thecashthrownoffbythosebusinessesinotherventureswithlowreturnsshouldbeheldtoaccountforthoseallocationdecisions,regardlessofhowprofitabletheoverallenterpriseis.

Nothing in this discussion is intended to argue for dividends that bouncearound from quarter to quarterwith eachwiggle in earnings or in investmentopportunities. Shareholders of public corporations understandably prefer thatdividends be consistent and predictable. Payments, therefore, should reflectlong-term expectations for both earnings and returns on incremental capital.Since the long-term corporate outlook changes only infrequently, dividendpatternsshouldchangenomoreoften.Butovertimedistributableearningsthathavebeenwithheldbymanagersshouldearn theirkeep. Ifearningshavebeenunwiselyretained,itislikelythatmanagers,too,havebeenunwiselyretained.

Thecompaniesinwhichwehaveourlargestinvestmentshaveallengagedin significant stock repurchases at times when wide discrepancies existed

between price and value. As shareholders, we find this encouraging andrewardingfortwoimportantreasons—onethatisobvious,andonethatissubtleandnotalwaysunderstood.Theobviouspoint involvesbasicarithmetic:majorrepurchasesatpriceswellbelowper-shareintrinsicbusinessvalueimmediatelyincrease,inahighlysignificantway,thatvalue.Whencompaniespurchasetheirownstock, theyoften find it easy toget$2ofpresentvalue for$1.Corporateacquisition programs almost never do as well and, in a discouragingly largenumberofcases,failtogetanythingcloseto$1ofvalueforeach$1expended.

Theotherbenefitofrepurchasesislesssubjecttoprecisemeasurementbutcanbefullyasimportantovertime.Bymakingrepurchaseswhenacompany’smarketvalueiswellbelowitsbusinessvalue,managementclearlydemonstratesthatitisgiventoactionsthatenhancethewealthofshareholders,ratherthantoactionsthatexpandmanagement’sdomainbutthatdonothingfor(orevenharm)shareholders.Seeingthis,shareholdersandpotentialshareholdersincreasetheirestimates of future returns from the business. This upward revision, in turn,producesmarketpricesmoreinlinewithintrinsicbusinessvalue.Thesepricesareentirelyrational.Investorsshouldpaymoreforabusinessthat is lodgedinthehandsofamanagerwithdemonstratedpro-shareholderleaningsthanforoneinthehandsofaself-interestedmanagermarchingtoadifferentdrummer.(Tomakethepointextreme,howmuchwouldyoupaytobeaminorityshareholderofacompanycontrolledbyRobertVesco?)

The key word is “demonstrated.” A manager who consistently turns hisbackon repurchases,when theseclearlyare in the interestsofowners, revealsmorethanheknowsofhismotivations.Nomatterhowoftenorhoweloquentlyhe mouths some public relations-inspired phrase such as “maximizingshareholderwealth”(thisseason’sfavorite),themarketcorrectlydiscountsassetslodged with him. His heart is not listening to his mouth—and, after a while,neitherwillthemarket.

[A]numberofshareholdershavesuggestedtousthatBerkshirerepurchaseits shares. Usually the requests were rationally based, but a few leaned onspuriouslogic.

There is only one combination of facts that makes it advisable for acompanytorepurchaseitsshares:First,thecompanyhasavailablefunds—cashplus sensibleborrowing capacity—beyond thenear-termneedsof thebusinessand, second, finds its stock selling in the market below its intrinsic value,conservatively-calculated. To this we add a caveat: Shareholders should havebeensuppliedalltheinformationtheyneedforestimatingthatvalue.Otherwise,

insiders could take advantage of their uninformed partners and buy out theirinterests at a fraction of true worth. We have, on rare occasions, seen thathappen.Usually,ofcourse,chicaneryisemployedtodrivestockpricesup,notdown.

Thebusiness“needs” that I speakofareof twokinds:First,expendituresthat a company must make to maintain its competitive position (e.g., theremodeling of stores at Helzberg’s) and, second, optional outlays, aimed atbusiness growth, thatmanagement expectswill producemore than a dollar ofvalueforeachdollarspent(R.C.Willey’sexpansionintoIdaho).

When available funds exceed needs of those kinds, a company with agrowth-oriented shareholder population can buy new businesses or repurchaseshares. If a company’s stock is sellingwell below intrinsic value, repurchasesusuallymakethemostsense.Inthemid-1970s,thewisdomofmakingthesewasvirtually screaming at managements, but few responded. Inmost cases, thosethatdidmadetheirownersmuchwealthierthanifalternativecoursesofactionhadbeenpursued.Indeed,duringthe1970s(and,spasmodically,forsomeyearsthereafter) we searched for companies that were large repurchasers of theirshares.Thisoftenwasatipoffthatthecompanywasbothundervaluedandrunbyashareholder-orientedmanagement.

That day is past. Now, repurchases are all the rage, but are all too oftenmadeforanunstatedand, inourview, ignoble reason: topumporsupport thestockprice.Theshareholderwhochooses tosell today,ofcourse, isbenefittedbyanybuyer,whateverhisoriginormotives.Butthecontinuingshareholderispenalizedbyrepurchasesaboveintrinsicvalue.Buyingdollarbillsfor$1.10isnotgoodbusinessforthosewhostickaround.

CharlieandIadmitthatwefeelconfidentinestimatingintrinsicvalueforonly a portion of traded equities and then only when we employ a range ofvalues, rather than some pseudo-precise figure. Nevertheless, it appears to usthat many companies now making repurchases are overpaying departingshareholdersattheexpenseofthosewhostay.Indefenseofthosecompanies,IwouldsaythatitisnaturalforCEOstobeoptimisticabouttheirownbusinesses.Theyalsoknowawhole lotmoreabout themthanIdo.However, Ican’thelpbutfeel thattoooftentoday’srepurchasesaredictatedbymanagement’sdesireto “showconfidence” or be in fashion rather than by a desire to enhance per-sharevalue.

Sometimes, too, companies say they are repurchasing shares to offset theshares issuedwhen stock options granted atmuch lower prices are exercised.This “buy high, sell low” strategy is one many unfortunate investors haveemployed—butneverintentionally!Managements,however,seemtofollowthis

perverseactivityverycheerfully.Of course, both option grants and repurchases may make sense—but if

that’sthecase,it’snotbecausethetwoactivitiesarelogicallyrelated.Rationally,acompany’sdecisiontorepurchasesharesor to issuethemshouldstandonitsownfeet.Justbecausestockhasbeenissuedtosatisfyoptions—orforanyotherreason—does not mean that stock should be repurchased at a price aboveintrinsic value. Correspondingly, a stock that sells well below intrinsic valueshouldberepurchasedwhetherornotstockhaspreviouslybeenissued(ormaybebecauseofoutstandingoptions).

Youshouldbeaware that,atcertain times in thepast, Ihaveerred innotmaking repurchases. My appraisal of Berkshire’s value was then tooconservativeorIwastooenthusedaboutsomealternativeuseoffunds.Wehavetherefore missed some opportunities—though Berkshire’s trading volume atthesepointswas too light forus tohavedonemuchbuying,whichmeans thatthegaininourper-sharevaluewouldhavebeenminimal.(Arepurchaseof,say,2% of a company’s shares at a 25% discount from per-share intrinsic valueproducesonlya½%gaininthatvalueatmost—andevenlessifthefundscouldalternativelyhavebeendeployedinvalue-buildingmoves.)

Some of the letters we’ve received clearly imply that the writer isunconcernedaboutintrinsicvalueconsiderationsbutinsteadwantsustotrumpetanintentiontorepurchasesothatthestockwillrise(orquitgoingdown).Ifthewriterwants to sell tomorrow, his thinkingmakes sense—for him!—but if heintends to hold, he should instead hope the stock falls and trades in enoughvolumeforustobuyalotofit.That’stheonlywayarepurchaseprogramcanhaveanyrealbenefitforacontinuingshareholder.

WewillnotrepurchasesharesunlesswebelieveBerkshirestockissellingwellbelowintrinsicvalue,conservativelycalculated.Norwillweattempttotalkthestockupordown.(NeitherpubliclyorprivatelyhaveIevertoldanyonetobuy or sell Berkshire shares.) Instead we will give all shareholders—andpotential shareholders—the samevaluation-related informationwewouldwishtohaveifourpositionswerereversed.

Recently, when the A shares fell below $45,000, we considered makingrepurchases.Wedecided,however,todelaybuying,ifindeedweelecttodoany,untilshareholdershavehadthechancetoreviewthisreport.Ifwedofindthatrepurchasesmakesense,wewillonlyrarelyplacebidsontheNewYorkStockExchange(“NYSE”).Instead,wewillrespondtooffersmadedirectlytousatorbelow theNYSE bid. If youwish to offer stock, have your broker callMarkMillardat402-346-1400.Whenatradeoccurs,thebrokercaneitherrecorditinthe“thirdmarket”oron theNYSE.Wewill favorpurchaseof theBshares if

they are selling atmore than a 2% discount to theA.Wewill not engage intransactionsinvolvingfewerthan10sharesofAor50sharesofB.

Please be clear about one point:Wewill nevermake purchaseswith theintentionofstemmingadeclineinBerkshire’sprice.Ratherwewillmakethemifandwhenwebelieve that they representanattractiveuseof theCompany’smoney.Atbest, repurchasesare likely tohaveonlyaveryminoreffecton thefuturerateofgaininourstock’sintrinsicvalue.

[In September 2011], we announced that Berkshire would repurchase itssharesatapriceofupto110%ofbookvalue.Wewereinthemarketforonlyafewdays—buying$67millionofstock—beforethepriceadvancedbeyondourlimit.Nonetheless,thegeneralimportanceofsharerepurchasessuggestsIshouldfocusforabitonthesubject.

Charlie and I favor repurchases when two conditions are met: first, acompanyhasamplefundstotakecareoftheoperationalandliquidityneedsofitsbusiness;second,itsstockissellingatamaterialdiscounttothecompany’sintrinsicbusinessvalue,conservativelycalculated.

Wehavewitnessedmanyboutsofrepurchasingthatfailedoursecondtest.Sometimes, of course, infractions—even serious ones—are innocent; manyCEOsneverstopbelievingtheirstockischeap.Inotherinstances,alessbenignconclusionseemswarranted.Itdoesn’tsufficetosaythatrepurchasesarebeingmade tooffset thedilution fromstock issuancesor simplybecauseacompanyhas excess cash.Continuing shareholders arehurt unless shares are purchasedbelowintrinsicvalue.Thefirstlawofcapitalallocation—whetherthemoneyisslatedforacquisitionsorsharerepurchases—isthatwhatissmartatonepriceisdumb at another. (One CEO who always stresses the price/value factor inrepurchasedecisionsisJamieDimonatJ.P.Morgan;Irecommendthatyoureadhisannualletter.)

CharlieandIhavemixedemotionswhenBerkshiresharessellwellbelowintrinsicvalue.Welikemakingmoneyforcontinuingshareholders,andthereisnosurerwaytodothatthanbybuyinganasset—ourownstock—thatweknowtobeworthatleastxforlessthanthat—for.9x,.8xorevenlower.(Asoneofour directors says, it’s like shooting fish in a barrel,after the barrel has beendrainedand the fishhavequit flopping.)Nevertheless,wedon’tenjoycashingout partners at a discount, even though our doing so may give the sellingshareholders a slightly higher price than they would receive if our bid wasabsent.When we are buying, therefore, we want those exiting partners to befullyinformedaboutthevalueoftheassetstheyareselling.

At our limit price of 110% of book value, repurchases clearly increaseBerkshire’sper-shareintrinsicvalue.Andthemoreandthecheaperwebuy,thegreaterthegainforcontinuingshareholders.Therefore,ifgiventheopportunity,we will likely repurchase stock aggressively at our price limit or lower. Youshouldknow,however,thatwehavenointerestinsupportingthestockandthatourbidswill fade inparticularlyweakmarkets.Norwillwebuy shares ifourcash-equivalentholdingsarebelow$20billion.AtBerkshire,financialstrengththatisunquestionabletakesprecedenceoverallelse.

Thisdiscussionofrepurchasesoffersmethechancetoaddresstheirrationalreaction of many investors to changes in stock prices. When Berkshire buysstockinacompanythatisrepurchasingshares,wehopefortwoevents:First,wehavethenormalhopethatearningsof thebusinesswill increaseatagoodclipforalongtimetocome;andsecond,wealsohopethatthestockunderperformsinthemarketforalongtimeaswell.Acorollarytothissecondpoint:“Talkingourbook”abouta stockweown–were that tobeeffective—wouldactuallybeharmfultoBerkshire,nothelpfulascommentatorscustomarilyassume.

Let’suseIBMasanexample.Asallbusinessobserversknow,CEOsLouGerstner and Sam Palmisano did a superb job in moving IBM from near-bankruptcy twenty years ago to its prominence today. Their operationalaccomplishmentsweretrulyextraordinary.

Buttheirfinancialmanagementwasequallybrilliant,particularlyinrecentyearsasthecompany’sfinancialflexibilityimproved.Indeed,Icanthinkofnomajor company that has had better financial management, a skill that hasmateriallyincreasedthegainsenjoyedbyIBMshareholders.Thecompanyhasused debt wisely, made value-adding acquisitions almost exclusively for cashandaggressivelyrepurchaseditsownstock.

Today, IBM has 1.16 billion shares outstanding, of whichwe own about63.9millionor5.5%.Naturally,whathappens to thecompany’searningsoverthenextfiveyearsisofenormousimportancetous.Beyondthat,thecompanywilllikelyspend$50billionorsointhoseyearstorepurchaseshares.Ourquizfor theday:Whatshoulda long-termshareholder,suchasBerkshire,cheerforduringthatperiod?

I won’t keep you in suspense.We should wish for IBM’s stock price tolanguishthroughoutthefiveyears.

Let’s do the math. If IBM’s stock price averages, say, $200 during theperiod, the companywill acquire 250million shares for its $50 billion.Therewouldconsequentlybe910millionsharesoutstanding,andwewouldownabout7%ofthecompany.Ifthestockconverselysellsforanaverageof$300duringthefive-yearperiod,IBMwillacquireonly167millionshares.Thatwouldleave

about990millionsharesoutstandingafter fiveyears,ofwhichwewouldown6.5%.

If IBMwere to earn, say,$20billion in the fifthyear, our shareof thoseearningswouldbeafull$100milliongreaterunderthe“disappointing”scenarioofa lowerstockprice than theywouldhavebeenat thehigherprice.Atsomelater point our shares would be worth perhaps $11/2 billion more than if the“high-price”repurchasescenariohadtakenplace.

The logic is simple: If you are going to be a net buyer of stocks in thefuture, either directly with your own money or indirectly (through yourownershipofacompanythatisrepurchasingshares),youarehurtwhenstocksrise.Youbenefitwhenstocksswoon.Emotions,however, toooftencomplicatethematter:Most people, including thosewhowill benet buyers in the future,take comfort in seeing stock prices advance. These shareholders resemble acommuterwhorejoicesafterthepriceofgasincreases,simplybecausehistankcontainsaday’ssupply.

CharlieandIdon’texpecttowinmanyofyouovertoourwayofthinking—we’veobservedenoughhumanbehaviortoknowthefutilityofthat—butwedowantyou tobeawareofourpersonalcalculus.Andhereaconfession is inorder: In my early days I, too, rejoiced when the market rose. Then I readChapterEightofBenGraham’sTheIntelligentInvestor,thechapterdealingwithhow investors shouldview fluctuations in stockprices. Immediately the scalesfellfrommyeyes,andlowpricesbecamemyfriend.Pickingupthatbookwasoneoftheluckiestmomentsinmylife.

Intheend,thesuccessofourIBMinvestmentwillbedeterminedprimarilyby its future earnings. But an important secondary factor will be how manysharesthecompanypurchaseswiththesubstantialsumsitislikelytodevotetothisactivity.AndifrepurchaseseverreducetheIBMsharesoutstandingto63.9million,IwillabandonmyfamedfrugalityandgiveBerkshireemployeesapaidholiday.

D.StockSplitsandTradingActivity43

WeoftenareaskedwhyBerkshiredoesnotsplititsstock.Theassumptionbehindthisquestionusuallyappearstobethatasplitwouldbeapro-shareholderaction.Wedisagree.Letmetellyouwhy.

One of our goals is to have Berkshire Hathaway stock sell at a pricerationally related to its intrinsic business value. (But note “rationally related,”not“identical”:ifwell-regardedcompaniesaregenerallysellinginthemarketat

largediscountsfromvalue,Berkshiremightwellbepricedsimilarly.)Thekeytoarationalstockpriceisrationalshareholders,bothcurrentandprospective.

Iftheholdersofacompany’sstockand/ortheprospectivebuyersattractedto itareprone tomake irrationaloremotion-baseddecisions,someprettysillystock prices are going to appear periodically. Manic-depressive personalitiesproducemanic-depressive valuations. Such aberrationsmay help us in buyingandsellingthestocksofothercompanies.ButwethinkitisinbothyourinterestandourstominimizetheiroccurrenceinthemarketforBerkshire.

To obtain only high quality shareholders is no cinch. Mrs. Astor couldselecther400,butanyonecanbuyanystock.Enteringmembersofashareholder“club” cannot be screened for intellectual capacity, emotional stability, moralsensitivityoracceptabledress.Shareholdereugenics,therefore,mightappeartobeahopelessundertaking.

Inlargepart,however,wefeelthathighqualityownershipcanbeattractedand maintained if we consistently communicate our business and ownershipphilosophy—along with no other conflicting messages—and then let selfselectionfollowitscourse.Forexample,selfselectionwilldrawafardifferentcrowd toamusicaleventadvertisedasanopera thanoneadvertisedasa rockconcert—eventhoughanyonecanbuyatickettoeither.

Throughourpoliciesandcommunications—our“advertisements”—wetryto attract investors who will understand our operations, attitudes andexpectations.(And,fullyasimportant,wetrytodissuadethosewhowon’t.)Wewantthosewhothinkofthemselvesasbusinessownersandinvestincompanieswith the intention of staying a long time.And,wewant thosewho keep theireyesfocusedonbusinessresults,notmarketprices.

Investors possessing those characteristics are in a smallminority, but wehaveanexceptionalcollectionofthem.Ibelievewellover90%—probablyover95%—of our shares are held by thosewhowere shareholders ofBerkshire orBlueChip fiveyears ago.And Iwouldguess thatover95%ofour shares areheldbyinvestorsforwhomtheholdingisat leastdoublethesizeof theirnextlargest.Amongcompanieswithatleastseveralthousandpublicshareholdersandmore than$1billionofmarketvalue,wearealmostcertainly the leader in thedegree to which our shareholders think and act like owners. Upgrading ashareholdergroupthatpossessesthesecharacteristicsisnoteasy.

Were we to split the stock or take other actions focusing on stock priceratherthanbusinessvalue,wewouldattractanenteringclassofbuyersinferiortotheexitingclassofsellers.At$1300,thereareveryfewinvestorswhocan’taffordaBerkshireshare.Wouldapotentialone-sharepurchaserbebetteroff ifwe split 100 for 1 so he could buy 100 shares?Thosewho think so andwho

would buy the stock because of the split or in anticipation of one woulddefinitely downgrade the quality of our present shareholder group. (Couldwereally improve our shareholder group by trading some of our present clear-thinkingmembersfor impressionablenewoneswho,preferringpapertovalue,feelwealthierwithnine$10billsthanwithone$100bill?)Peoplewhobuyfornon-valuereasonsarelikelytosellfornon-valuereasons.Theirpresenceinthepicture will accentuate erratic price swings unrelated to underlying businessdevelopments.

Wewilltrytoavoidpoliciesthatattractbuyerswithashort-termfocusonourstockpriceandtrytoallowpoliciesthatattractinformedlong-terminvestorsfocusingonbusinessvalues. Just asyoupurchasedyourBerkshire shares in amarketpopulatedbyrationalinformedinvestors,youdeserveachancetosell—shouldyoueverwantto—inthesamekindofmarket.Wewillworktokeepitinexistence.

Oneoftheironiesofthestockmarketistheemphasisonactivity.Brokers,using terms such as “marketability” and “liquidity,” sing the praises ofcompanies with high share turnover (those who cannot fill your pocket willconfidentlyfillyourear).Butinvestorsshouldunderstandthatwhatisgoodforthe croupier is not good for the customer. A hyperactive stock market is thepickpocketofenterprise.

For example, consider a typical company earning, say, 12% on equity.Assumeaveryhighturnoverrate in itssharesof100%peryear. Ifapurchaseand sale of the stock trades at book value, the owners of our hypotheticalcompanywillpay,inaggregate,2%ofthecompany’snetworthannuallyfortheprivilegeoftransferringownership.Thisactivitydoesnothingfortheearningsofthe business, and means that 1/6 of them are lost to the owners through the“frictional”costoftransfer.(Andthiscalculationdoesnotcountoptiontrading,whichwouldincreasefrictionalcostsstillfurther.)

All that makes for a rather expensive game of musical chairs. Can youimaginetheagonizedcrythatwouldariseifagovernmentalunitweretoimposeanew162⁄3%taxonearningsof corporationsor investors?Bymarket activity,investorscanimposeuponthemselvestheequivalentofsuchatax.

(Weareawareofthepie-expandingargumentthatsaysthatsuchactivitiesimprove the rationality of the capital allocation process. We think that thisargument is specious and that, on balance, hyperactive equitymarkets subvertrational capital allocation and act as pie shrinkers. Adam Smith felt that allnoncollusiveactsinafreemarketwereguidedbyaninvisiblehandthatledaneconomytomaximumprogress;ourviewis thatcasino-typemarketsandhair-

trigger investmentmanagementact asan invisible foot that tripsupandslowsdownaforward-movingeconomy.)

E.ShareholderStrategies44

LatelastyearBerkshire’sstockpricecrossed$10,000.Severalshareholdershavementioned tome that the high price causes themproblems:They like togive shares away each year and find themselves impeded by the tax rule thatdraws a distinction between annual gifts of $10,000 or under to a singleindividualandthoseabove$10,000.Thatis,thosegiftsnogreaterthan$10,000are completely tax-free; those above $10,000 require the donor to use up aportion of his or her lifetime exemption from gift and estate taxes, or, if thatexemptionhasbeenexhausted,topaygifttaxes.

Icansuggestthreewaystoaddressthisproblem.Thefirstwouldbeusefulto a married shareholder, who can give up to $20,000 annually to a singlerecipient, as long as the donor files a gift tax return containing his or herspouse’swrittenconsenttogiftsmadeduringtheyear.

Secondly,ashareholder,marriedornot,canmakeabargainsale.Imagine,forexample, thatBerkshire issellingfor$12,000andthatonewishes tomakeonlya$10,000gift.Inthatcase,sellthestocktothegifteefor$2,000.(Caution:Youwillbetaxedontheamount,ifany,bywhichthesalespricetoyourgifteeexceedsyourtaxbasis.)

Finally, you can establish a partnership with people to whom you aremakinggifts,funditwithBerkshireshares,andsimplygivepercentageinterestsinthepartnershipawayeachyear.Theseinterestscanbeforanyvaluethatyouselect.Ifthevalueis$10,000orless,thegiftwillbetax-free.

Weissuethecustomarywarning:Consultwithyourowntaxadvisorbeforetakingactiononanyofthemoreesotericmethodsofgift-making.

Wehold to theviewabout stocksplits thatweset forth in the [precedingessay]. Overall, we believe our owner-related policies—including the no-splitpolicy—have helped us assemble a body of shareholders that is the bestassociatedwithanywidely-heldAmericancorporation.Our shareholders thinkand behave like rational long-term owners and view the business much asCharlieandIdo.Consequently,ourstockconsistentlytradesinapricerangethatissensiblyrelatedtointrinsicvalue.

Additionally,webelievethatoursharesturnoverfarlessactivelythandothesharesofanyotherwidely-heldcompany.The frictionalcostsof trading—whichactasamajor“tax”ontheownersofmanycompanies—arevirtuallynon-

existentatBerkshire.(Themarket-makingskillsofJimMaguire,ourNewYorkStockExchangespecialist,definitelyhelptokeepthesecostslow.)Obviouslyasplitwouldnotchangethissituationdramatically.Nonetheless,thereisnowaythatourshareholdergroupwouldbeupgradedbythenewshareholdersenticedbyasplit.Insteadwebelievethatmodestdegradationwouldoccur.

F.Berkshire’sRecapitalization45

At theAnnualMeetingyouwillbeasked toapprovea recapitalizationofBerkshire, creating two classes of stock. If the plan is adopted, our existingcommonstockwillbedesignatedasClassACommonStockandanewClassBCommonStockwillbeauthorized.

Eachshareof the“B”willhavetherightsof1/30thofan“A”sharewiththese exceptions: First, aB sharewill have 1/200th of the vote of anA share(ratherthan1/30thofthevote).Second,theBwillnotbeeligibletoparticipateinBerkshire’sshareholder-designatedcharitablecontributionsprogram.

When the recapitalization is complete, each share of A will becomeconvertible, at the holder’s option and at any time, into 30 shares of B. Thisconversionprivilegewillnotextendintheoppositedirection.Thatis,holdersofBshareswillnotbeabletoconvertthemintoAshares.

WeexpecttolisttheBsharesontheNewYorkStockExchange,wheretheywilltradealongsidetheAstock.Tocreatetheshareholderbasenecessaryforalisting—andtoensurealiquidmarketintheBstock—Berkshireexpectstomakeapublicofferingforcashofatleast$100millionofnewBshares.Theofferingwillbemadeonlybymeansofaprospectus.

ThemarketwillultimatelydeterminethepriceoftheBshares.Theirprice,though,shouldbeintheneighborhoodof1/30thofthepriceoftheAshares.

Class A shareholders who wish to give gifts may find it convenient toconvertashareortwooftheirstockintoClassBshares.Additionally,arbitrage-relatedconversionswilloccurifdemandfortheBisstrongenoughtopushitspricetoslightlyabove1/30thofthepriceofA.

However, because theClassA stockwill entitle its holders to full votingrights,theseshareswillbesuperiortotheClassBsharesandwewouldexpectmostshareholderstoremainholdersoftheClassA—whichispreciselywhattheBuffett and Munger families plan to do, except in those instances when weourselvesmightconverta fewshares to facilitategifts.Theprospect thatmostshareholders will stick to the A stock suggests that it will enjoy a somewhatmoreliquidmarketthantheB.

There are tradeoffs forBerkshire in this recapitalization.But they do notarise from theproceedsof theoffering—wewill findconstructiveuses for themoney—norinanydegreefromthepriceatwhichwewillselltheBshares.AsIwrite this—with Berkshire stock at $36,000—Charlie and I do not believe itundervalued.Therefore,theofferingweproposewillnotdiminishtheper-shareintrinsic value of our existing stock. Let me also put our thoughts aboutvaluation more baldly: Berkshire is selling at a price at which Charlie and Iwouldnotconsiderbuyingit.

WhatBerkshirewill incurbywayof theB stockarecertainaddedcosts,including those involving the mechanics of handling a larger number ofshareholders.On theotherhand, thestockshouldbeaconvenience forpeoplewishingtomakegifts.Andthoseofyouwhohavehopedforasplithavegainedado-it-yourselfmethodofbringingoneabout.

Wearemakingthismove,though,forotherreasons—havingtodowiththeappearanceofexpense-ladenunittrustspurportingtobelow-priced“clones”ofBerkshireandsuretobeaggressivelymarketed.Theideabehindthesevehiclesisnotnew:Inrecentyears,anumberofpeoplehavetoldmeabouttheirwishtocreatean“all-Berkshire” investment fund tobe soldat a lowdollarprice.Butuntil recently, thepromotersof these investmentsheardoutmyobjectionsandbackedoff.

I did not discourage these people because I prefer large investors oversmall.Wereitpossible,CharlieandIwouldlovetoturn$1,000into$3,000formultitudes of people who would find that gain an important answer to theirimmediateproblems.

Inorder toquickly triplesmallstakes,however,wewouldhave to justasquickly turn our presentmarket capitalization of $43 billion into $129 billion(roughly the market cap of General Electric, America’s most highly valuedcompany).Wecan’tcomeclosetodoingthat.Theverybestwehopeforis—onaverage—to double Berkshire’s per-share intrinsic value every five years, andwemaywellfallfarshortofthatgoal.

In the end, Charlie and I do not care whether our shareholders ownBerkshireinlargeorsmallamounts.Whatwewishforareshareholdersofanysizewhoareknowledgeableaboutouroperations,shareourobjectivesandlong-term perspective, and are aware of our limitations, most particularly thoseimposedbyourlargecapitalbase.

The unit trusts that have recently surfaced fly in the face of these goals.They would be sold by brokers working for big commissions, would imposeotherburdensomecostsontheirshareholders,andwouldbemarketedenmassetounsophisticatedbuyers,apttobeseducedbyourpastrecordandbeguiledby

thepublicityBerkshireandIhavereceivedinrecentyears.Thesureoutcome:amultitudeofinvestorsdestinedtobedisappointed.

Through our creation of the B stock—a low-denomination product farsuperior to Berkshire-only trusts—we hope to make the clonesunmerchandisable.

ButbothpresentandprospectiveBerkshireshareholdersshouldpayspecialattention to one point: Though the per-share intrinsic value of our stock hasgrownatanexcellentrateduringthepastfiveyears,itsmarketpricehasgrownstillfaster.Thestock,inotherwords,hasoutperformedthebusiness.

Thatkindofmarketoverperformancecannotpersistindefinitely,neitherforBerkshire nor any other stock. Inevitably, there will be periods ofunderperformanceaswell.Theprice volatility that results, though endemic topublicmarkets,isnottoourliking.WhatwewouldpreferinsteadistohavethemarketpriceofBerkshirepreciselytrackitsintrinsicvalue.Werethestocktodothat, every shareholderwould benefit during his period of ownership in exactproportiontotheprogressBerkshireitselfmadeintheperiod.

Obviously,themarketbehaviorofBerkshire’sstockwillneverconformtothisideal.Butwewillcomeclosertothisgoalthanwewouldotherwiseifourpresent and prospective shareholders are informed, business-oriented and notexposed to high-commission salesmanship when making their investmentdecisions.Tothatend,wearebetteroffifwecanbluntthemerchandisingeffortsoftheunittrust—andthatisthereasonwearecreatingtheBstock.

[W]emadetwogood-sizedofferingsthroughSalomon[during1996],bothwithinterestingaspects.ThefirstwasoursaleinMayof517,500sharesofClassBCommon,whichgeneratednetproceedsof$565million.AsIhavetoldyoubefore,wemadethissaleinresponsetothethreatenedcreationofunittruststhatwouldhavemarketed themselvesasBerkshire look-alikes. In theprocess, theywouldhaveusedourpast, anddefinitelynonrepeatable, record to enticenaivesmall investors and would have charged these innocents high fees andcommissions.

I think it would have been quite easy for such trusts to have soldmanybillions of dollars worth of units, and I also believe that early marketingsuccesses by these trusts would have led to the formation of others. (In thesecurities business,whatever can be soldwill be sold.)The trustswould havemeanwhileindiscriminatelypouredtheproceedsoftheirofferingsintoasupplyof Berkshire shares that is fixed and limited. The likely result: a speculativebubble inour stock.For at least a time, theprice jumpwouldhavebeen self-

validating,inthatitwouldhavepullednewwavesofnaiveandimpressionableinvestorsintothetrustsandsetoffstillmorebuyingofBerkshireshares.

Some Berkshire shareholders choosing to exit might have found thatoutcome ideal, since they could have profited at the expense of the buyersentering with false hopes. Continuing shareholders, however, would havesufferedoncerealitysetin,foratthatpointBerkshirewouldhavebeenburdenedwithbothhundredsofthousandsofunhappy,indirectowners(trustholders,thatis)andastainedreputation.

Our issuance of theB shares not only arrested the sale of the trusts, butprovidedalow-costwayforpeopletoinvestinBerkshireiftheystillwishedtoafter hearing the warnings we issued. To blunt the enthusiasm that brokersnormallyhaveforpushingnewissues—becausethat’swherethemoneyis—wearrangedforourofferingtocarryacommissionofonly1½%,thelowestpayoffthatwehaveever seen in commonstockunderwriting.Additionally,wemadetheamountoftheofferingopen-ended,therebyrepellingthetypicalIPObuyerwholooksforashort-termpricespurtarisingfromacombinationofhypeandscarcity.

Overall,wetriedtomakesurethattheBstockwouldbepurchasedonlybyinvestorswithalong-termperspective.Thoseeffortsweregenerallysuccessful:Trading volume in the B shares immediately following the offering—a roughindex of “flipping”—was far below the norm for a new issue. In the endweadded about 40,000 shareholders, most of whom we believe both understandwhattheyownandshareourtimehorizons.

Salomon could not have performed better in the handling of this unusualtransaction.Itsinvestmentbankersunderstoodperfectlywhatweweretryingtoachieveand tailoredeveryaspectof theoffering tomeet theseobjectives.Thefirm would have made far more money—perhaps ten times as much—if ourofferinghadbeenstandardinitsmake-up.Buttheinvestmentbankersinvolvedmadenoattempt to tweak thespecifics in thatdirection. Instead theycameupwith ideas that were counter to Salomon’s financial interest but that made itmuch more certain Berkshire’s goals would be reached. Terry Fitzgeraldcaptainedthiseffort,andwethankhimforthejobthathedid.

Giventhatbackground,itwon’tsurpriseyoutolearnthatweagainwenttoTerrywhenwedecided late in theyear tosellan issueofBerkshirenotes thatcan be exchanged for a portion of the Salomon shares that we hold. In thisinstance, once again, Salomon did an absolutely first-class job, selling $500millionprincipalamountoffive-yearnotesfor$447.1million.Each$1,000noteisexchangeableinto17.65sharesandiscallableinthreeyearsataccretedvalue.Countingtheoriginalissuediscountanda1%coupon,thesecuritieswillprovide

ayieldof3% tomaturity forholderswhodonot exchange them forSalomonstock. But it seems quite likely that the notes will be exchanged before theirmaturity.Ifthathappens,ourinterestcostwillbeabout1.1%fortheperiodpriortoexchange.

Inrecentyears,ithasbeenwrittenthatCharlieandIareunhappyaboutallinvestment-banking fees. That’s deadwrong.We have paid a greatmany feesover the last 30 years—beginningwith the checkwewrote toCharlieHeiderupon our purchase of National Indemnity in 1967—and we are delighted tomakepaymentsthatarecommensuratewithperformance.Inthecaseofthe1996transactionsatSalomonBrotherswemorethangotourmoney’sworth.

37[Introductoryessay,1986.]38 [2005;Letter datedAugust 5, 1988 sent toBerkshire shareholders and

reprinted1988.]39[1988.]40[Thefollowingisfrom1989:]WithmorethanayearbehindhimoftradingBerkshire’sstockontheNew

York Stock Exchange, our specialist, Jim Maguire of [HBI] continues hisoutstanding performance. Before we listed, dealer spreads often were 3% ormoreofmarketprice.Jimhasmaintainedthespreadat50pointsorless,whichat current prices is well under 1%. Shareholders who buy or sell benefitsignificantlyfromthisreductionintransactioncosts.

BecausewearedelightedbyourexperiencewithJim,HBIandtheNYSE,IsaidasmuchinadsthathavebeenruninaseriesplacedbytheNYSE.NormallyIshuntestimonials,butIwaspleasedinthisinstancetopubliclycomplimenttheExchange.

41[Dividedbyhashlines:1984;1984;1999;2011.]42[SeetheessayEconomicversusAccountingGoodwillinPartVI.D.]43[1983.]44[1992.]45[Dividedbyhashlines:1995;1996.]

V.MERGERSANDACQUISITIONS

OfallouractivitiesatBerkshire,themostexhilaratingforCharlieandmeisthe acquisition of a business with excellent economic characteristics and amanagement that we like, trust and admire. Such acquisitions are not easy tomakebutwelookforthemconstantly.Inthesearch,weadoptthesameattitudeone might find appropriate in looking for a spouse: It pays to be active,interested,andopen-minded,butitdoesnotpaytobeinahurry.

In the past, I’ve observed that many acquisition-hungry managers wereapparentlymesmerizedby their childhood readingof the story about the frog-kissingprincess.Rememberinghersuccess,theypaydearlyfortherighttokisscorporate toads, expecting wondrous transfigurations. Initially, disappointingresults only deepen their desire to round up new toads. (“Fanaticism,” said[Santayana], “consists of redoubling your effort when you’ve forgotten youraim.”)Ultimately,eventhemostoptimisticmanagermustfacereality.Standingknee-deep in unresponsive toads, he then announces an enormous“restructuring”charge.InthiscorporateequivalentofaHeadStartprogram,theCEOreceivestheeducationbutthestockholderspaythetuition.

InmyearlydaysasamanagerI,too,datedafewtoads.Theywerecheapdates—I’ve never been much of a sport—but my results matched those ofacquirerswhocourtedhigher-pricedtoads.Ikissedandtheycroaked.

Afterseveralfailuresofthistype,IfinallyrememberedsomeusefuladviceIoncegotfromagolfpro(who,likeallproswhohavehadanythingtodowithmygame,wishes to remainanonymous).Said thepro:“Practicedoesn’tmakeperfect; practicemakes permanent.” And thereafter I revisedmy strategy andtried to buy good businesses at fair prices rather than fair businesses at goodprices.46

A.BadMotivesandHighPrices47

Asourhistory indicates,wearecomfortablebothwith totalownershipofbusinesses and with marketable securities representing small portions ofbusinesses.We continually look forways to employ large sums in each area.(Butwetrytoavoidsmallcommitments—“Ifsomething’snotworthdoingatall,it’snotworthdoingwell.”) Indeed, the liquidity requirementsofour insurancebusinessesmandatemajorinvestmentsinmarketablesecurities.

Our acquisition decisions will be aimed at maximizing real economicbenefits, not atmaximizing eithermanagerial domain or reported numbers foraccounting purposes. (In the long run, managements stressing accountingappearanceovereconomicsubstanceusuallyachievelittleofeither.)

Regardlessoftheimpactuponimmediatelyreportableearnings,wewouldratherbuy10%ofWonderfulBusinessTatXpersharethan100%ofTat2Xpershare.Mostcorporatemanagerspreferjustthereverse,andhavenoshortageofstatedrationalesfortheirbehavior.

However,we suspect threemotivations—usually unspoken—tobe, singlyorincombination,theimportantonesinmosthigh-premiumtakeovers:

(1) Leaders, business or otherwise, seldom are deficient in animalspiritsandoftenrelishincreasedactivityandchallenge.AtBerkshire,the corporate pulse never beats faster thanwhen an acquisition is inprospect.(2)Mostorganizations,businessorotherwise,measurethemselves,aremeasuredbyothers, and compensate theirmanagers farmoreby theyardstick of size than by any other yardstick. (Ask a Fortune 500manager where his corporation stands on that famous list and,invariably,thenumberrespondedwillbefromthelistrankedbysizeofsales;hemaywellnotevenknowwherehiscorporationplacesonthe list Fortune just as faithfully compiles ranking the same 500corporationsbyprofitability.)(3) Many managements apparently were overexposed inimpressionable childhoodyears to the story inwhich the imprisonedhandsome prince is released from a toad’s body by a kiss from abeautifulprincess.Consequently,theyarecertaintheirmanagerialkisswilldowondersfortheprofitabilityofCompanyT(arget).

Such optimism is essential. Absent that rosy view, why else should theshareholders ofCompanyA(cquisitor)want to own an interest inT at the 2Xtakeover cost rather than at the Xmarket price they would pay if theymadedirectpurchasesontheirown?

Inotherwords,investorscanalwaysbuytoadsatthegoingpricefortoads.Ifinvestorsinsteadbankrollprincesseswhowishtopaydoublefortherighttokissthetoad,thosekisseshadbetterpacksomerealdynamite.We’veobservedmany kisses but very fewmiracles.Nevertheless,manymanagerial princessesremain serenely confident about the future potency of their kisses—even aftertheir corporatebackyards areknee-deep inunresponsive toads. In fairness,weshould acknowledge that some acquisition records have been dazzling. Twomajorcategoriesstandout.

The first involves companies that, through design or accident, havepurchased only businesses that are particularlywell adapted to an inflationaryenvironment.Suchfavoredbusinessmusthavetwocharacteristics:(1)anabilitytoincreasepricesrathereasily(evenwhenproductdemandisflatandcapacityisnotfullyutilized)withoutfearofsignificant lossofeithermarketshareorunitvolume, and (2) an ability to accommodate large dollar volume increases inbusiness(oftenproducedmorebyinflationthanbyrealgrowth)withonlyminoradditionalinvestmentofcapital.Managersofordinaryability,focusingsolelyonacquisition possibilitiesmeeting these tests, have achieved excellent results inrecentdecades.However,veryfewenterprisespossessbothcharacteristics,andcompetition to buy those that dohas nowbecome fierce to thepoint of beingself-defeating.

The second category involves the managerial superstars—men who canrecognizethatrareprincewhoisdisguisedasatoad,andwhohavemanagerialabilitiesthatenablethemtopeelawaythedisguise.WesalutesuchmanagersasBen Heineman at Northwest Industries, Henry Singleton at Teledyne, ErwinZaban at National Service Industries, and especially Tom Murphy at CapitalCities Communications (a real managerial “twofer,” whose acquisition effortshavebeenproperlyfocusedinCategory1andwhoseoperatingtalentsalsomakehim a leader of Category 2). From both direct and vicarious experience, werecognize the difficulty and rarity of these executives’ achievements. (So dothey; these champs havemade very fewdeals in recent years, and often havefound repurchase of their own shares to be themost sensible employment ofcorporatecapital.)

Your Chairman, unfortunately, does not qualify for Category 2. And,despite a reasonably good understanding of the economic factors compellingconcentrationinCategory1,ouractualacquisitionactivityinthatcategoryhasbeensporadicand inadequate.Ourpreachingwasbetter thanourperformance.(Weneglected theNoahprinciple: predicting rain doesn’t count, building arksdoes.)

Wehavetriedoccasionally tobuytoadsatbargainpriceswithresults thathavebeenchronicledinpastreports.Clearlyourkissesfellflat.Wehavedonewellwithacoupleofprinces—buttheywereprinceswhenpurchased.Atleastourkissesdidn’t turn theminto toads.And,finally,wehaveoccasionallybeenquitesuccessfulinpurchasingfractionalinterestsineasily-identifiableprincesattoad-likeprices.

BerkshireandBlueChipareconsideringmergerin1983.Ifittakesplace,it

will involve an exchange of stock based upon an identical valuation methodapplied to both companies. The one other significant issuance of shares byBerkshireoritsaffiliatedcompaniesthatoccurredduringpresentmanagement’stenurewasinthe1978mergerofBerkshirewithDiversifiedRetailingCompany.

Our share issuances follow a simple basic rule: wewill not issue sharesunlesswe receive asmuch intrinsic business value aswe give. Such a policymightseemaxiomatic.Why,youmightask,wouldanyoneissuedollarbills inexchange for fifty-cent pieces? Unfortunately, many corporate managers havebeenwillingtodojustthat.

The first choice of thesemanagers inmaking acquisitionsmay be to usecash or debt. But frequently the CEO’s cravings outpace cash and creditresources (certainlymine always have). Frequently, also, these cravings occurwhenhis own stock is selling far below intrinsic business value.This state ofaffairsproducesamomentoftruth.Atthatpoint,asYogiBerrahassaid,“Youcan observe a lot just by watching.” For shareholders then will find whichobjective themanagement truly prefers—expansion of domain ormaintenanceofowners’wealth.

The need to choose between these objectives occurs for some simplereasons.Companiesoftensellinthestockmarketbelowtheirintrinsicbusinessvalue. But when a company wishes to sell out completely, in a negotiatedtransaction,itinevitablywantsto—andusuallycan—receivefullbusinessvalueinwhateverkindofcurrencythevalueistobedelivered.Ifcashistobeusedinpayment,theseller’scalculationofvaluereceivedcouldn’tbeeasier.Ifstockofthebuyeristobethecurrency,theseller’scalculationisstillrelativelyeasy:justfigurethemarketvalueincashofwhatistobereceivedinstock.

Meanwhile, the buyer wishing to use his own stock as currency for thepurchase has no problems if the stock is selling in themarket at full intrinsicvalue.

Butsupposeitissellingatonlyhalfintrinsicvalue.Inthatcase,thebuyerisfacedwiththeunhappyprospectofusingasubstantiallyundervaluedcurrencytomakeitspurchase.

Ironically,werethebuyertoinsteadbeasellerofitsentirebusiness,ittoocouldnegotiatefor,andprobablyget,fullintrinsicbusinessvalue.Butwhenthebuyermakesapartialsaleof itself—andthat iswhat the issuanceofshares tomakeanacquisitionamountsto—itcancustomarilygetnohighervaluesetonitssharesthanthemarketchoosestograntit.

Theacquirerwhoneverthelessbargesaheadendsupusinganundervalued(marketvalue)currencytopayforafullyvalued(negotiatedvalue)property.Ineffect,theacquirermustgiveup$2ofvaluetoreceive$1ofvalue.Undersuch

circumstances, amarvelousbusinesspurchased at a fair salespricebecomes aterriblebuy.Forgoldvaluedasgoldcannotbepurchased intelligently throughtheutilizationofgold—orevensilver—valuedaslead.

If, however, the thirst for size andaction is strongenough, the acquirer’smanagerwillfindamplerationalizationsforsuchavalue-destroyingissuanceofstock.Friendlyinvestmentbankerswillreassurehimastothesoundnessofhisactions.(Don’taskthebarberwhetheryouneedahaircut.)

A few favorite rationalizations employed by stock-issuing managementsfollow:

(a)“Thecompanywe’rebuyingisgoingtobeworthalotmoreinthefuture.”(Presumablysoistheinterestintheoldbusinessthatisbeingtraded away; future prospects are implicit in the business valuationprocess. If 2X is issued for X, the imbalance still exists when bothpartsdoubleinbusinessvalue.)(b) “We have to grow.” (Who, it might be asked, is the “we”? Forpresent shareholders, the reality is that all existing businesses shrinkwhensharesare issued.WereBerkshire to issueshares tomorrowforanacquisition,Berkshirewouldowneverythingthatitnowownsplusthenewbusiness,butyourinterestinsuchhard-to-matchbusinessesasSee’sCandyShops,National Indemnity,etc.would automatically bereduced.If(1)yourfamilyownsa120-acrefarmand(2)youinviteaneighborwith60acresofcomparablelandtomergehisfarmintoanequal partnership—with you to be managing partner, then (3) yourmanagerial domainwill have grown to 180 acres but youwill havepermanentlyshrunkby25%your family’sownership interest inbothacreageandcrops.Managerswhowanttoexpandtheirdomainattheexpenseofownersmightbetterconsideracareeringovernment.)(c)“Ourstockisundervaluedandwe’veminimizeditsuseinthisdeal—butweneedtogivethesellingshareholder51%instockand49%incashsothatcertainofthoseshareholderscangetthetax-freeexchangetheywant.” (This argument acknowledges that it is beneficial to theacquirertoholddowntheissuanceofshares,andwelikethat.Butifithurtsoldownerstoutilizesharesona100%basis,itverylikelyhurtsona51%basis.Afterall,amanisnotcharmedifaspanieldefaceshislawn,justbecauseit’saspanielandnotaSt.Bernard.Andthewishesofsellerscan’tbethedeterminantofthebestinterestsofthebuyer—what would happen if, heaven forbid, the seller insisted that as aconditionofmergertheCEOoftheacquirerbereplaced?)

There are three ways to avoid destruction of value for old owners when

shares are issued for acquisitions. One is to have a true business-value-for-business-valuemerger,suchastheBerkshire-BlueChipcombinationisintendedtobe.Suchamergerattemptstobefairtoshareholdersofbothparties,witheachreceivingjustasmuchasitgivesintermsofintrinsicbusinessvalue.TheDartIndustries-Kraft and Nabisco-Standard Brands mergers appeared to be of thistype,buttheyaretheexceptions.It’snotthatacquirerswishtoavoidsuchdeals;it’sjustthattheyareveryhardtodo.

Thesecondroutepresentsitselfwhentheacquirer’sstocksellsatoraboveitsintrinsicbusinessvalue.Inthatsituation,theuseofstockascurrencyactuallymayenhancethewealthoftheacquiringcompany’sowners.Manymergerswereaccomplishedonthisbasisinthe1965–69period.Theresultsweretheconverseofmost of the activity since 1970: the shareholders of the acquired companyreceived very inflated currency (frequently pumped up by dubious accountingand promotional techniques) and were the losers of wealth through suchtransactions.

Duringrecentyearsthesecondsolutionhasbeenavailabletoveryfewlargecompanies.Theexceptionshaveprimarilybeen thosecompanies inglamorousorpromotionalbusinessestowhichthemarkettemporarilyattachesvaluationsatoraboveintrinsicbusinessvaluation.

Thethirdsolutionisfor theacquirer togoaheadwith theacquisition,butthensubsequentlyrepurchaseaquantityofsharesequaltothenumberissuedinthemerger.Inthismanner,whatoriginallywasastock-for-stockmergercanbeconverted,effectively,intoacash-for-stockacquisition.Repurchasesofthiskindare damage-repair moves. Regular readers will correctly guess that we muchprefer repurchases that directly enhance the wealth of owners instead ofrepurchases thatmerely repair previous damage. Scoring touchdowns ismoreexhilarating than recovering one’s fumbles.But,when a fumble has occurred,recovery is important and we heartily recommend damage-repair repurchasesthatturnabadstockdealintoafaircashdeal.

Thelanguageutilizedinmergerstendstoconfusetheissuesandencourageirrational actions by managers. For example, “dilution” is usually carefullycalculated on a pro forma basis for both book value and current earnings pershare. Particular emphasis is given to the latter item.When that calculation isnegative (dilutive) from the acquiring company’s standpoint, a justifyingexplanationwillbemade (internally, ifnot elsewhere) that the lineswill crossfavorably at some point in the future. (While deals often fail in practice, theynever fail in projections—if the CEO is visibly panting over a prospectiveacquisition,subordinatesandconsultantswillsupplytherequisiteprojectionstorationalize any price.) Should the calculation produce numbers that are

immediately positive—that is, anti-dilutive—for the acquirer, no comment isthoughttobenecessary.

Theattentiongiventhisformofdilutionisoverdone:currentearningspershare(orevenearningspershareofthenextfewyears)areanimportantvariableinmostbusinessvaluations,butfarfromall-powerful.

Therehavebeenplentyofmergers,non-dilutiveinthis limitedsense, thatwere instantly value-destroying for the acquirer. And somemergers that havediluted current and near-term earnings per share have in fact been value-enhancing.Whatreallycountsiswhetheramergerisdilutiveoranti-dilutiveintermsof intrinsic business value (a judgment involving considerationofmanyvariables). We believe calculation of dilution from this viewpoint to be all-important(andtooseldommade).

A second language problem relates to the equation of exchange. IfCompanyAannounces that itwill issueshares tomergewithCompanyB, theprocessiscustomarilydescribedas“CompanyAtoAcquireCompanyB”,or“BSells toA.”Clearer thinkingabout thematterwould result ifamoreawkwardbut more accurate description were used: “Part of A sold to acquire B”, or“OwnersofBtoreceivepartofAinexchangefortheirproperties”.Inatrade,whatyouaregiving is justas importantaswhatyouaregetting.This remainstrue evenwhen the final tally on what is being given is delayed. Subsequentsalesofcommonstockorconvertibleissues,eithertocompletethefinancingforadealor to restorebalancesheetstrength,mustbe fullycounted inevaluatingthefundamentalmathematicsoftheoriginalacquisition.(Ifcorporatepregnancyisgoingtobetheconsequenceofcorporatemating,thetimetofacethatfactisbeforethemomentofecstasy.)

Managersanddirectorsmightsharpentheirthinkingbyaskingthemselvesiftheywouldsell100%oftheirbusinessonthesamebasistheyarebeingaskedtosellpartofit.Andifitisn’tsmarttosellallonsuchabasis,theyshouldaskthemselveswhyit issmart tosellaportion.Acumulationofsmallmanagerialstupiditieswillproduceamajorstupidity—notamajortriumph.(LasVegashasbeen built upon the wealth transfers that occur when people engage inseemingly-smalldisadvantageouscapitaltransactions.)

The“givingversusgetting”factorcanmosteasilybecalculatedinthecaseofregisteredinvestmentcompanies.AssumeInvestmentCompanyX,sellingat50%ofassetvalue,wishestomergewithInvestmentCompanyY.Assume,also,thatCompanyXthereforedecidestoissuesharesequalinmarketvalueto100%ofY’sassetvalue.

Such a share exchangewould leaveX trading$2of its previous intrinsicvalue for $1 ofY’s intrinsic value. Protestswould promptly come forth from

both X’s shareholders and the SEC, which rules on the fairness of registeredinvestmentcompanymergers.Suchatransactionsimplywouldnotbeallowed.

Inthecaseofmanufacturing,service,financialcompanies,etc.,valuesarenotnormallyaspreciselycalculableasinthecaseofinvestmentcompanies.Butwe have seen mergers in these industries that just as dramatically destroyedvalue for the owners of the acquiring company as was the case in thehypotheticalillustrationabove.Thisdestructioncouldnothappenifmanagementand directors would assess the fairness of any transaction by using the sameyardstickinthemeasurementofbothbusinesses.

Finally, a word should be said about the “double whammy” effect uponowners of the acquiring company when value-diluting stock issuances occur.Under suchcircumstances, the firstblow is the lossof intrinsicbusinessvaluethat occurs through themerger itself.The second is the downward revision inmarket valuation that, quite rationally, is given to that now-diluted businessvalue.Forcurrentandprospectiveownersunderstandablywillnotpayasmuchfor assets lodged in the hands of a management that has a record of wealth-destruction through unintelligent share issuances as they will pay for assetsentrusted toamanagementwithpreciselyequaloperating talents,butaknowndistasteforanti-owneractions.Oncemanagementshowsitselfinsensitivetotheinterests of owners, shareholders will suffer a long time from the price/valueratio afforded their stock (relative to other stocks), nomatterwhat assurancesmanagement gives that the value-diluting action taken was a one-of-a-kindevent.

Those assurances are treated by themarketmuch as one-bug-in-the-saladexplanations are treated at restaurants. Such explanations, even whenaccompaniedbyanewwaiter,donoteliminateadropinthedemand(andhencemarket value) for salads, both on the part of the offended customer and hisneighborsponderingwhat toorder.Other thingsbeingequal, thehighest stockmarketpricesrelativetointrinsicbusinessvaluearegiventocompanieswhosemanagershavedemonstratedtheirunwillingnessto issuesharesatanytimeontermsunfavorabletotheownersofthebusiness.

I’vementioned that we strongly prefer to use cash rather than Berkshirestockinacquisitions.Astudyoftherecordwilltellyouwhy:Ifyouaggregateallof our stock-only mergers (excluding those we did with two affiliatedcompanies,DiversifiedRetailingandBlueChipStamps),youwillfindthatourshareholdersareslightlyworseoffthantheywouldhavebeenhadInotdonethetransactions.Thoughithurtsmetosayit,whenI’veissuedstock,I’vecostyou

money.Be clear about one thing: This cost has not occurred because we were

misled in anywayby sellers or because they thereafter failed tomanagewithdiligenceandskill.Onthecontrary,thesellerswerecompletelycandidwhenwewerenegotiatingourdealsandhavebeenenergeticandeffectiveeversince.

Instead,ourproblemhasbeenthatweownatrulymarvelouscollectionofbusinesses,whichmeansthattradingawayaportionofthemforsomethingnewalmostnevermakessense.Whenwe issueshares inamerger,we reduceyourownershipinallofourbusinesses—partly-ownedcompaniessuchasCoca-Cola,Gillette andAmerican Express, and all of our terrific operating companies aswell.Anexamplefromsportswillillustratethedifficultyweface:Forabaseballteam, acquiring a playerwho can be expected to bat .350 is almost always awonderful event—except when the teammust trade a .380 hitter tomake thedeal.

Becauseourrosterisfilledwith.380hitters,wehavetriedtopaycashforacquisitions, and here our record has been far better. Starting with NationalIndemnity in 1967, and continuing with, among others, See’s, Buffalo News,Scott Fetzer and GEICO, we have acquired—for cash—a number of largebusinesses that have performed incredibly well since we bought them. TheseacquisitionshavedeliveredBerkshiretremendousvalue—indeed,farmorethanIanticipatedwhenwemadeourpurchases.

Webelievethatitisalmostimpossibleforusto“tradeup”fromourpresentbusinesses and managements. Our situation is the opposite of Camelot’sMordred,ofwhomGueneverecommented,“TheonethingIcansayforhimisthat he is bound to marry well. Everybody is above him.” Marrying well isextremelydifficultforBerkshire.

[I]ncontemplatingbusinessmergersandacquisitions,manymanagerstendto focus onwhether the transaction is immediately dilutive or anti-dilutive toearnings per share (or, at financial institutions, to per-share book value). Anemphasisofthissortcarriesgreatdangers.[I]maginethata25-year-oldfirst-yearMBAstudentisconsideringmerginghisfutureeconomicinterestswiththoseofa 25-year-old day laborer. TheMBA student, a non-earner, would find that a“share-for-share”merger of his equity interest in himselfwith that of the daylaborerwouldenhancehisnear-termearnings(inabigway!).Butwhatcouldbesillierforthestudentthanadealofthiskind?

In corporate transactions, it’s equally silly for the would-be purchaser tofocus on current earnings when the prospective acquiree has either different

prospects, a differentmixof operating andnon-operating assets, or a differentcapital structure. At Berkshire, we have rejected many merger and purchaseopportunities thatwould have boosted current and near-term earnings but thatwouldhavereducedper-shareintrinsicvalue.Ourapproach,rather,hasbeentofollowWayneGretzky’s advice: “Go towhere the puck is going to be, not towhereitis.”Asaresult,ourshareholdersarenowmanybillionsofdollarsricherthantheywouldhavebeenifwehadusedthestandardcatechism.

Thesadfactisthatmostmajoracquisitionsdisplayanegregiousimbalance:They are a bonanza for the shareholders of the acquiree; they increase theincomeandstatusof theacquirer’smanagement; and theyareahoneypot forthe investment bankers and other professionals on both sides. But, alas, theyusually reduce thewealth of the acquirer’s shareholders, often to a substantialextent.Thathappensbecausetheacquirertypicallygivesupmoreintrinsicvaluethanitreceives.Dothatenough,saysJohnMedlin,theretiredheadofWachoviaCorp.,and“youarerunningachainletterinreverse.”

Overtime,theskillwithwhichacompany’smanagersallocatecapitalhasan enormous impact on the enterprise’s value. Almost by definition, a reallygoodbusinessgeneratesfarmoremoney(atleastafteritsearlyyears)thanitcanuse internally. The company could, of course, distribute the money toshareholdersbywayofdividendsorsharerepurchases.ButoftentheCEOasksastrategic planning staff, consultants or investment bankers whether anacquisitionortwomightmakesense.That’slikeaskingyourinteriordecoratorwhetheryouneeda$50,000rug.

Theacquisitionproblem isoftencompoundedbyabiologicalbias:ManyCEOsattaintheirpositionsinpartbecausetheypossessanabundanceofanimalspiritsandego.Ifanexecutiveisheavilyendowedwiththesequalities—which,it should be acknowledged, sometimes have their advantages—they won’tdisappear when he reaches the top. When such a CEO is encouraged by hisadvisors to make deals, he responds much as would a teenage boy who isencouragedbyhisfathertohaveanormalsexlife.It’snotapushheneeds.

Some years back, a CEO friend of mine—in jest, it must be said—unintentionallydescribedthepathologyofmanybigdeals.Thisfriend,whorana property-casualty insurer, was explaining to his directors why hewanted toacquire a certain life insurance company. After droning rather unpersuasivelythrough the economics and strategic rationale for the acquisition, he abruptlyabandoned thescript.Withan impish look,hesimplysaid:“Aw, fellas,all theotherkidshaveone.”

AtBerkshire,ourmanagerswillcontinuetoearnextraordinaryreturnsfromwhatappeartobeordinarybusinesses.Asafirststep,thesemanagerswilllook

forwaystodeploytheirearningsadvantageouslyintheirbusinesses.What’sleft,theywillsendtoCharlieandme.Wethenwilltrytousethosefundsinwaysthatbuildper-share intrinsicvalue.Ourgoalwillbe toacquireeitherpartor all ofbusinessesthatwebelieveweunderstand,thathavegood,sustainableunderlyingeconomics,andthatarerunbymanagerswhomwelike,admireandtrust.

B.SensibleShareRepurchasesVersusGreenmail48

Ourendorsementofrepurchasesislimitedtothosedictatedbyprice/valuerelationshipsanddoesnotextendtothe“green-mail”repurchase—apracticewefind odious and repugnant. In these transactions, two parties achieve theirpersonal ends by exploitation of an innocent and unconsulted third party. Theplayers are: (1) the “shareholder” extortionistwho, evenbefore the inkonhisstock certificate dries, delivers his “your-money-or-your-life” message tomanagers; (2) the corporate insiderswho quickly seek peace at any price—aslongasthepriceispaidbysomeoneelse;and(3)theshareholderswhosemoneyisusedby(2) tomake(1)goaway.As thedustsettles, themugging, transientshareholdergiveshisspeechon“freeenterprise,”themuggeemanagementgivesitsspeechon“thebest interestsof thecompany,”andtheinnocentshareholderstandingbymutelyfundsthepayoff.

C.LeveragedBuyouts49

If successful corporate business acquisition is so hard, how does oneexplainthewidespreadrecentsuccessofmostoftheleveraged-buy-out(“LBO”)operatorswhohavepurchasedcorporations?Ahugepart of the answer comesfrom income-taxeffectsandother simpleeffects.When, ina typicalLBO, thetypicalmostlyequitycorporatecapitalizationwasreplacedby90%debtplusanew10%-of-capitalizationcommonstockposition:

(1) thecombinedmarketvalueofall thenewcommonstockplusallthenewdebtbecamemuchhigher than thepreviousmarketvalueofall the older common stock, because the existing stream of pre-taxearnings was no longer shared with corporate income tax collectorswho,inmanycases,hadpreviouslyreceivedmorecasheachyearthanshareholders;and(2)evenafterthevalue-enhancingeffectofthecorporatetaxreductionwassharedwithformershareholdersbypayingthemextra-highpricestoleave,aretainedresidueofvalue-enhancingtaxeffectmadethenew

common stock (which now becamemuch like a speculativewarrantwithgood terms)worthconsiderablymore thancostas the inkdriedonacquisitionpapers;and(3) the new “owners” then resorted to strategies, difficult neither toconceivenorimplement,includingthefollowing:

(a) they eliminatedmany of the easily removable costs (largelypersonnel costs) and sub-par segments which in some mix (i)bedevil successful corporations (including ours) with sloth andfolly and (ii) create their humane grace and, through presentsacrifice,good long-termprospects, justifyingsacrificeendured;and(b)theysoldoffafewoperationsatsuper-highprices,sometimesexercisingtheeasiestmicroeconomicinsightbysellingtoadirectcompetitor and sometimes selling to a surprisingly easy-to-findnon-competitive corporate buyer, not owned by its managers,willingtopayalmostashighapriceasacompetitorwould;and

(4) thenew“owners” thenprofited, induecourse,notonlyfromthetaxeffectandothersimplereshufflingactivitiesdescribedabove,butalso from thewonderful upside effects of extreme financial leverageduringalongbusinessboomaccompaniedbyarisingstockmarket.

Whether the country wants a large number (or even any) of its largecorporations to have extremely leveraged capitalizations, except throughoccasionaladversity,presentsinterestingsocialquestions.Isonesocialfunctionof corporations to be financially strong so that they act as shock absorbers,protecting dependent employees, suppliers and customers from part of thevolatility implicit in capitalism?WasBenFranklin rightwhenhe included thefollowingfolkwisdominPoorRichard’sAlmanac:“Itishardforanemptysackto stand upright.” Is a weak corporation, borrowed to the hilt, the socialequivalent of a bridge with an inadequate reserve of structural strength?Granting that leveraged buy outs have some favorable effects (as well asunfavorableeffects)onlongtermefficiency,howmanythousandsofablepeopledowewishtoattractintopromotionalcorporaterecapitalizationactivitywhich(1)reducescorporateincometaxes,(2)oftenteststhelimitsofantitrustlaw,and(3) focuses business attention on short-term cash generation to pay downoppressive levels of debt? Finally, as Columbia Law School’s Professor LouLowenstein puts it (more or less): “Do we really want entire corporatebusinesses, as important social institutions, continuously traded likeporkbellycontracts?”

However the social questions are answered, three aspects of the present

situationareclear.First,thecorporatetaxeffectissolargeinLBOtransactionsthat easy success in such transactions does not imply that success is easy inordinary corporate acquisitions. Second, the hordes of leveraged-buy-outoperators now with us raise the general level of acquisition prices to thedetrimentofotherwould-beacquirers,includingWesco,whicharenotwillingtomaximize tax benefits through maximized borrowing. And, third, the LBOoperatorwillnotgoawaysolongaspresentpermissivelawslast.Theoperatorshavearealadvantageundersuchlaws,notjustafigleafaidingpromotion.Eventhough failure and disgrace will reduce their number, and prices paid inleveraged-buy-out transactions will fall, the capitalized value of reducing thecorporate income tax will remain. Therefore, plenty of rational incentive willremain for transactions.TheLBOgeniewill encounter reverses, but he is notgoingbackinthebottleunlessorderedtodosobynewlaws.

ItshouldalsobenotedthattheLBOoperators’incentivestobidhighdonotend with real advantages derived from tax law and willingness to reshufflebusinesses with much speed and few scruples. Additional incentives for highbidscomefromtypicalstructuresinwhichgeneralpartnersofLBOpartnershipsrisk little of their own money (often less than none after fees are taken intoaccount),yet share significantly ingains.Sucharrangementsare similar to thesystemoftheracetracktout.Andwhohaseverseenatoutwhodidn’twanthisbackertomakealotofbets?

To Wesco, as a non-LBO operator, the good-corporate-acquisition gamewas always tough. And that game in each recent year has becomemore likefishing for muskies at Leech Lake, in Minnesota, where the writer’s earliestbusiness partner, Ed Hoskins, had the following conversation with his Indianguide:

“Areanymuskiescaughtinthislake?”“MoremuskiesarecaughtinthislakethaninanyotherlakeinMinnesota.

Thislakeisfamousformuskies.”“Howlonghaveyoubeenfishinghere?”“19years.”“Andhowmanymuskieshaveyoucaught?”“None.”When a management has our point of view, infrequency of business

acquisitionmaysafelybepredicted.Whetherthishappens,asweliketobelieve,because the game is hard for almost everyone, ormerely because the game ishard for us, the result for Wesco shareholders is the same: less worthwhileactivity thanweallwould like.But theremaybeoneconsolation:A seriesofbig, incorrectable acquisition troubles, with nomeaningful salvage, is seldom

causedbypeoplewhothinktheacquisitiongameis likefishingformuskiesatLeechLake.

D.SoundAcquisitionPolicies50

It may seem strange that we exult over a year in which we made threeacquisitions, given that we have regularly used these pages to question theacquisitionactivitiesofmostmanagers.Restassured,CharlieandIhaven’tlostour skepticism:We believe most deals do damage to the shareholders of theacquiringcompany.Toooften,thewordsfromHMSPinaforeapply:“Thingsareseldomwhattheyseem,skimmilkmasqueradesascream.”Specifically,sellersand their representatives invariably present financial projections having moreentertainmentvaluethaneducationalvalue.Intheproductionofrosyscenarios,WallStreetcanholditsownagainstWashington.

In any case, why potential buyers even look at projections prepared bysellersbafflesme.Charlieand Inevergive themaglance,but insteadkeep inmind thestoryof themanwithanailinghorse.Visiting thevet,hesaid:“Canyouhelpme?Sometimesmyhorsewalksjustfineandsometimeshelimps.”Thevet’sreplywaspointed:“Noproblem—whenhe’swalkingfine,sellhim.”Intheworldofmergersandacquisitions,thathorsewouldbepeddledasSecretariat.

AtBerkshire,wehaveallthedifficultiesinperceivingthefuturethatotheracquisition-minded companies do. Like [them] also, we face the inherentproblemthatthesellerofabusinesspracticallyalwaysknowsfarmoreaboutitthanthebuyerandalsopicksthetimeofsale—atimewhenthebusinessislikelytobewalking“justfine.”

Evenso,wedohaveafewadvantages,perhapsthegreatestbeingthatwedon’t have a strategic plan. Thus we feel no need to proceed in an ordaineddirection (a course leading almost invariably to silly purchase prices) but caninstead simply decide what makes sense for our owners. In doing that, wealwaysmentallycompareanymovewearecontemplatingwithdozensofotheropportunities open to us, including the purchase of small pieces of the bestbusinesses in the world via the stock market. Our practice of making thiscomparison—acquisitions against passive investments—is a discipline thatmanagersfocusedsimplyonexpansionseldomuse.

TalkingtoTimemagazineafewyearsback,PeterDruckergottotheheartof things: “Iwill tell you a secret:Dealmaking beatsworking.Dealmaking isexciting and fun, and working is grubby. Running anything is primarily anenormous amount of grubby detail work . . . dealmaking is romantic, sexy.

That’swhyyouhavedealsthatmakenosense.”Inmakingacquisitions,wehaveafurtheradvantage:Aspayment,wecan

offer sellers a stock backed by an extraordinary collection of outstandingbusinesses. An individual or a family wishing to dispose of a single finebusiness, but also wishing to defer personal taxes indefinitely, is apt to findBerkshire stock a particularly comfortable holding. I believe, in fact, that thiscalculus played an important part in the two acquisitions for which we paidsharesin1995.

Beyond that, sellers sometimes care about placing their companies in acorporatehomethatwillbothendureandprovidepleasant,productiveworkingconditions for theirmanagers.Here again,Berkshire offers something special.Ourmanagersoperatewithextraordinaryautonomy.Additionally,ourownershipstructure enables sellers to know that when I say we are buying to keep, thepromisemeanssomething.Forourpart,welikedealingwithownerswhocarewhat happens to their companies and people. A buyer is likely to find fewerunpleasant surprises dealing with that type of seller than with one simplyauctioningoffhisbusiness.

Inadditiontotheforegoingbeinganexplanationofouracquisitionstyle,itis, of course, a not-so-subtle sales pitch. If you own or represent a businessearning$[75]millionormorebeforetax,anditfitsthecriteria[setforthbelow],just give me a call. Our discussion will be confidential. And if you aren’tinterestednow,fileourpropositioninthebackofyourmind:Wearenevergoingto lose our appetite for buying companieswith good economics and excellentmanagement.

Concludingthislittledissertationonacquisitions,Ican’tresistrepeatingataletoldmelastyearbyacorporateexecutive.Thebusinesshegrewupinwasafineone,withalong-timerecordofleadershipinitsindustry.Itsmainproduct,however, was distressingly glamorless. So several decades ago, the companyhired a management consultant who—naturally—advised diversification, thethen-current fad. (“Focus” was not yet in style.) Before long, the companyacquired a number of businesses, each after the consulting firm had gonethrougha long—andexpensive—acquisitionstudy.And theoutcome?Said theexecutivesadly,“Whenwestarted,weweregetting100%ofourearningsfromtheoriginalbusiness.Aftertenyears,weweregetting150%.”

It’sdiscouragingtonotethatthoughwehaveonfouroccasionsmademajorpurchasesofcompanieswhosesellerswererepresentedbyprominentinvestmentbanks,wewereinonlyoneoftheseinstancescontactedbytheinvestmentbank.

In the other three cases, Imyself or a friend initiated the transaction at somepointaftertheinvestmentbankhadsoliciteditsownlistofprospects.Wewouldlovetoseeanintermediaryearnitsfeebythinkingofus—andthereforerepeatherewhatwe’relookingfor:

(1)Largepurchases,(2)Demonstrated consistent earningpower (future projections are ofnointeresttous,norare“turnaround”situations),(3)Businessesearninggoodreturnsonequitywhileemployinglittleornodebt,(4)Managementinplace(wecan’tsupplyit),(5) Simple businesses (if there’s lots of technology, we won’tunderstandit),(6)Anofferingprice(wedon’twant towasteour timeor thatof thesellerbytalking,evenpreliminarily,aboutatransactionwhenpriceisunknown).

We will not engage in unfriendly takeovers. We can promise completeconfidentialityandaveryfastanswer—customarilywithinfiveminutes—astowhetherwe’re interested.We prefer to buy for cash, butwill consider issuingstockwhenwereceiveasmuchinintrinsicbusinessvalueaswegive.

Our favorite form of purchase is one [in which] the company’s owner-managers wish to generate significant amounts of cash, sometimes forthemselves, but often for their families or inactive shareholders. At the sametime, these managers wish to remain significant owners who continue to runtheir companies just as theyhave in thepast.We thinkweoffer aparticularlygoodfitforownerswithsuchobjectives,andweinvitepotentialsellerstocheckusoutbycontactingpeoplewithwhomwehavedonebusinessinthepast.

CharlieandIfrequentlygetapproachedaboutacquisitionsthatdon’tcomeclose to meeting our tests: We’ve found that if you advertise an interest inbuyingcollies,alotofpeoplewillcallhopingtosellyoutheircockerspaniels.Alinefromacountrysongexpressesourfeelingaboutnewventures,turnarounds,orauction-likesales:“Whenthephonedon’tring,you’llknowit’sme.”51

E.OnSellingOne’sBusiness52

Mostbusinessownersspendthebetterpartoftheirlifetimesbuildingtheirbusinesses.Byexperiencebuiltuponendlessrepetition,theysharpentheirskillsinmerchandising, purchasing, personnel selection, etc. It’s a learning process,andmistakesmade in one year often contribute to competence and success in

succeedingyears.Incontrast,owner-managersselltheirbusinessonlyonce—frequentlyinan

emotionally-charged atmosphere with a multitude of pressures coming fromdifferent directions. Often, much of the pressure comes from brokers whosecompensation is contingent upon consummation of a sale, regardless of itsconsequences for both buyer and seller. The fact that the decision is soimportant, both financially and personally, to the owner canmake the processmore, rather than less, prone to error. And, mistakes made in the once-in-a-lifetimesaleofabusinessarenotreversible.

Priceisveryimportant,butoftenisnotthemostcriticalaspectofthesale.Youandyourfamilyhaveanextraordinarybusiness—oneofakindinyourfield—andanybuyerisgoingtorecognizethat.It’salsoabusinessthatisgoingtogetmorevaluableastheyearsgoby.Soifyoudecidenottosellnow,youarevery likely to realizemoremoney lateron.With thatknowledgeyoucandealfromstrengthandtakethetimerequiredtoselectthebuyeryouwant.

If you should decide to sell, I think Berkshire Hathaway offers someadvantagesthatmostotherbuyersdonot.Practicallyallofthesebuyerswillfallintooneoftwocategories:

(1)A company located elsewhere but operating in your business or in abusiness somewhatakin toyours.Suchabuyer—nomatterwhatpromisesaremade—will usually have managers who feel they know how to run yourbusiness operations and, sooner or later, will want to apply some hands-on“help.” If the acquiring company ismuch larger, it oftenwill have squads ofmanagers,recruitedovertheyearsinpartbypromisesthattheywillgettorunfuture acquisitions. They will have their own way of doing things and, eventhoughyour business recordundoubtedlywill be far better than theirs, humannaturewillatsomepointcausethemtobelievethattheirmethodsofoperatingare superior. You and your family probably have friends who have sold theirbusinessestolargercompanies,andIsuspectthattheirexperienceswillconfirmthetendencyofparentcompaniestotakeovertherunningoftheirsubsidiaries,particularlywhentheparentknowstheindustry,orthinksitdoes.

(2) A financial maneuverer, invariably operating with large amounts ofborrowed money, who plans to resell either to the public or to anothercorporation as soon as the time is favorable. Frequently, this buyer’s majorcontribution will be to change accounting methods so that earnings can bepresentedinthemostfavorablelightjustpriortohisbailingout.[T]hissortoftransaction is becomingmuchmore frequent because of a rising stockmarketandthegreatsupplyoffundsavailableforsuchtransactions.

If thesolemotiveof thepresentowners is tocash theirchipsandput the

businessbehindthem—andplentyofsellersfallinthiscategory—eithertypeofbuyer that I’ve just described is satisfactory. But if the sellers’ businessrepresents the creative work of a lifetime and forms an integral part of theirpersonalityandsenseofbeing,buyersofeithertypehaveseriousflaws.

Berkshireisanotherkindofbuyer—aratherunusualone.Webuytokeep,but we don’t have, and don’t expect to have, operating people in our parentorganization. All of the businesses we own are run autonomously to anextraordinary degree. Inmost cases, themanagers of important businesseswehave owned formany years have not been toOmaha or evenmet each other.Whenwebuyabusiness,thesellersgoonrunningitjustastheydidbeforethesale;weadapttotheirmethodsratherthanviceversa.

Wehavenoone—family,recentlyrecruitedMBAs,etc.—towhomwehavepromisedachancetorunbusinesseswehaveboughtfromowner-managers.Andwewon’thave.

Youknowofsomeofourpastpurchases.I’menclosingalistofeveryonefromwhomwehaveeverboughtabusiness,andIinviteyoutocheckwiththemastoourperformanceversusourpromises.Youshouldbeparticularlyinterestedincheckingwiththefewwhosebusinessesdidnotdowellinordertoascertainhowwebehavedunderdifficultconditions.

Any buyerwill tell you that he needs you personally—and if he has anybrains,hemostcertainlydoesneedyou.Butagreatmanybuyers,forthereasonsmentionedabove,don’tmatchtheirsubsequentactionstotheirearlierwords.Wewill behave exactly as promised, both because we have so promised, andbecauseweneedtoinordertoachievethebestbusinessresults.

This need explains why we would want the operating members of yourfamily to retain a 20% interest in the business.We need 80% to consolidateearningsfortaxpurposes,whichisastepimportanttous.Itisequallyimportantto us that the family members who run the business remain as owners. Verysimply, we would not want to buy unless we felt key members of presentmanagement would stay on as our partners. Contracts cannot guarantee yourcontinuedinterest;wewouldsimplyrelyonyourword.

The areas I get involved in are capital allocation and selection andcompensation of the topman. Other personnel decisions, operating strategies,etc. are his bailiwick. Some Berkshire managers talk over some of theirdecisionswithme; some don’t. It depends upon their personalities and, to anextent,upontheirownpersonalrelationshipwithme.

IfyoushoulddecidetodobusinesswithBerkshire,wewouldpayincash.YourbusinesswouldnotbeusedascollateralforanyloanbyBerkshire.Therewouldbenobrokersinvolved.

Furthermore,therewouldbenochancethatadealwouldbeannouncedandthat the buyer would then back off or start suggesting adjustments (withapologies, of course, and with an explanation that banks, lawyers, boards ofdirectors,etc. were to be blamed).And finally, youwould know exactlywithwhom you are dealing. Youwould not have one executive negotiate the dealonly to have someone else in charge a few years later, or have the presidentregretfully tell you that his board of directors required this change or that (orpossibly required sale of your business to finance some new interest of theparent’s).

It’sonlyfairtotellyouthatyouwouldbenoricherafterthesalethannow.The ownership of your business already makes you wealthy and soundlyinvested.Asalewouldchangetheformofyourwealth,but itwouldn’tchangeitsamount. Ifyousell,youwillhaveexchangeda100%-ownedvaluableassetthat you understand for another valuable asset—cash—that will probably beinvested in small pieces (stocks) of other businesses that you understand lesswell.Thereisoftenasoundreasontosellbut,ifthetransactionisafairone,thereasonisnotsothatthesellercanbecomewealthier.

Iwillnotpesteryou; ifyouhaveanypossible interest inselling, Iwouldappreciateyourcall. IwouldbeextraordinarilyproudtohaveBerkshire,alongwiththekeymembersofyourfamily,own_______;Ibelievewewoulddoverywell financially; and I believe you would have just as much fun running thebusinessoverthenext20yearsasyouhavehadduringthepast20.

Sincerely,

/s/WarrenE.Buffett

Our acquisitions usually develop [as referrals from other managers whohave sold to us in the past]. At other companies, executives may devotethemselves to pursuing acquisition possibilities with investment bankers,utilizing an auction process that has become standardized. In this exercise thebankerspreparea“book” thatmakesme thinkof theSupermancomicsofmyyouth. In theWallStreetversion,a formerlymild-manneredcompanyemergesfrom the investment banker’s phone booth able to leap over competitors in asingleboundandwithearningsmovingfaster thanaspeedingbullet.Titillatedbythebook’sdescriptionoftheacquiree’spowers,acquisition-hungryCEOs—LoisLanesall,beneaththeircoolexteriors—promptlyswoon.

What’sparticularlyentertaininginthesebooksistheprecisionwithwhichearnings are projected for many years ahead. If you ask the author-banker,however,whathisown firmwill earnnextmonth, hewill go intoaprotective

crouchand tell you that business andmarkets are far toouncertain forhim toventureaforecast.

Here’sonestoryIcan’tresistrelating:In1985,amajorinvestmentbankinghouse undertook to sell Scott Fetzer, offering it widely—butwith no success.Uponreadingofthisstrikeout,IwroteRalphSchey,thenandnowScottFetzer’sCEO,expressinganinterestinbuyingthebusiness.IhadnevermetRalph,butwithinaweekwehadadeal.Unfortunately,ScottFetzer’sletterofengagementwith the banking firm provided it a $2.5million fee upon sale, even if it hadnothingtodowithfindingthebuyer. Iguess the leadbanker feltheshoulddosomething forhispayment, sohegraciouslyofferedusacopyof thebookonScott Fetzer that his firm had prepared. With his customary tact, Charlieresponded:“I’llpay$2.5millionnottoreadit.”

AtBerkshire,ourcarefully-craftedacquisitionstrategyissimplytowaitforthephonetoring.Happily,itsometimesdoesso,usuallybecauseamanagerwhosoldtousearlierhasrecommendedtoafriendthathethinkaboutfollowingsuit.

F.TheBuyerofChoice53

Two economic factors probably contributed to the rush of acquisitionactivity we experienced last year. First, many managers and owners foresawnear-term slowdowns in their businesses—and, in fact, we purchased severalcompanies whose earnings will almost certainly decline this year from peakstheyreachedin1999or2000.Thedeclinesmakenodifferencetous,giventhatweexpectallofourbusinessestonowandthenhaveupsanddowns.(Onlyinthesalespresentationsof investmentbanksdoearningsmoveforeverupward.)We don’t care about the bumps; what matters are the overall results. But thedecisions of other people are sometimes affected by the near-term outlook,whichcanbothspursellersandtempertheenthusiasmofpurchaserswhomightotherwisecompetewithus.

Asecondfactorthathelpedusin2000wasthatthemarketforjunkbondsdried up as the year progressed. In the two preceding years, junk bondpurchasers had relaxed their standards, buying the obligations of ever-weakerissuersat inappropriateprices.Theeffectsofthislaxitywerefelt lastyearinaballooningofdefaults. In thisenvironment, “financial”buyersofbusinesses—thosewhowishtobuyusingonlyasliverofequity—becameunabletoborrowalltheythoughttheyneeded.Whattheycouldstillborrow,moreover,cameatahighprice.Consequently,LBOoperatorsbecamelessaggressiveintheirbiddingwhenbusinessescameupforsalelastyear.Becauseweanalyzepurchasesonan

all-equity basis, our evaluations did not change, which means we becameconsiderablymorecompetitive.

Asidefromtheeconomicfactors thatbenefitedus,wenowenjoyamajorandgrowingadvantageinmakingacquisitionsinthatweareoftenthebuyerofchoicefortheseller.Thatfact,ofcourse,doesn’tassureadeal—sellershavetolikeourprice,andwehavetoliketheirbusinessandmanagement—butitdoeshelp.

We find itmeaningfulwhen an ownercares aboutwhomhe sells to.Welike to do businesswith someonewho loves his company, not just themoneythatasalewillbringhim(thoughwecertainlyunderstandwhyhelikesthataswell).Whenthisemotionalattachmentexists, itsignalsthatimportantqualitieswill likely be foundwithin the business: honest accounting, pride of product,respectforcustomers,anda loyalgroupofassociateshavingastrongsenseofdirection. The reverse is apt to be true, also.When an owner auctions off hisbusiness,exhibitingatotallackofinterestinwhatfollows,youwillfrequentlyfind that it has been dressed up for sale, particularly when the seller is a“financialowner.”Andifownersbehavewithlittleregardfortheirbusinessandits people, their conduct will often contaminate attitudes and practicesthroughoutthecompany.

When a businessmasterpiece has been created by a lifetime—or severallifetimes—ofunstintingcareandexceptionaltalent,itshouldbeimportanttotheownerwhatcorporationisentrustedtocarryonitshistory.CharlieandIbelieveBerkshire provides an almost unique home. We take our obligations to thepeople who created a business very seriously, and Berkshire’s ownershipstructureensuresthatwecanfulfillourpromises.WhenwetellJohnJustinthathis business (Justin Industries) will remain headquartered in Fort Worth, orassure the Bridge family that its operation (Ben Bridge Jeweler) will not bemergedwithanotherjeweler,thesesellerscantakethosepromisestothebank.

How much better it is for the “painter” of a business Rembrandt topersonallyselectitspermanenthomethantohaveatrustofficeroruninterestedheirs auction it off. Throughout the yearswe have had great experienceswiththose who recognize that truth and apply it to their business creations.We’llleavetheauctionstoothers.

Our long-avowed goal is to be the “buyer of choice” for businesses—particularlythosebuiltandownedbyfamilies.Thewaytoachievethisgoalistodeserveit.Thatmeanswemustkeepourpromises;avoidleveragingupacquiredbusinesses; grant unusual autonomy to ourmanagers; and hold the purchased

companiesthroughthickandthin(thoughwepreferthickandthicker).Our record matches our rhetoric. Most buyers competing against us,

however, follow a different path. For them, acquisitions are “merchandise.”Before the ink dries on their purchase contracts, these operators arecontemplating“exit strategies.”Wehaveadecidedadvantage, therefore,whenweencountersellerswhotrulycareaboutthefutureoftheirbusinesses.

Some years back our competitors were known as “leveraged-buyoutoperators.”ButLBObecameabadname.So inOrwellian fashion, thebuyoutfirmsdecidedtochangetheirmoniker.Whattheydidnotchange,though,werethe essential ingredients of their previous operations, including their cherishedfeestructuresandloveofleverage.

Theirnewlabelbecame“privateequity,”anamethatturnsthefactsupside-down: A purchase of a business by these firms almost invariably results indramatic reductions in the equity portion of the acquiree’s capital structurecompared to that previously existing.A number of these acquirees, purchasedonlytwotothreeyearsago,arenowinmortaldangerbecauseofthedebtpiledonthembytheirprivate-equitybuyers.Muchofthebankdebtissellingbelow70¢onthedollar,andthepublicdebthastakenafargreaterbeating.Theprivateequityfirms,itshouldbenoted,arenotrushingintoinjecttheequitytheirwardsnow desperately need. Instead, they’re keeping their remaining funds veryprivate.

In the regulated utility field there are no large family-owned businesses.Here,Berkshirehopestobethe“buyerofchoice”ofregulators.Itisthey,ratherthansellingshareholders,whojudgethefitnessofpurchaserswhentransactionsareproposed.

There is no hiding your history when you stand before these regulators.Theycan—anddo—calltheircounterpartsinotherstateswhereyouoperateandaskhowyouhavebehavedinrespecttoallaspectsofthebusiness,includingawillingnesstocommitadequateequitycapital.

When MidAmerican proposed its purchase of PacifiCorp in 2005,regulators in thesixnewstateswewouldbeserving immediatelycheckedourrecord in Iowa. They also carefully evaluated our financing plans andcapabilities.Wepassedthisexamination,justasweexpecttopassfutureones.

[W]ehopetobuymoreregulatedutilitiesinthefuture—andweknowthatour business behavior in jurisdictions where we are operating today willdeterminehowwearewelcomedbynewjurisdictionstomorrow.

46[Introductoryessay,1992.]

47[Dividedbyhashlines:1981;1982;1997;1994.]48[1984.]49[1989WescoFinancialCorporationLettertoShareholders,byCharlesT.

Munger.Reprintedwithpermission.]50 [Divided by hash lines: 1995; 1991 (the latter with similar versions

beginningin1982andcontinutingthereafter).]51[In1988and1989,thelastsentenceread:“Ourinterestinnewventures,

turnarounds, or auction-like sales can best be expressed by the Goldwynism:‘Pleaseincludemeout.’”]

52 [Divided by hash lines: 1990 Appendix B—form of letter sent topotentialsellersofbusinesses;1999.]

53[2000;2008.]

VI.VALUATIONANDACCOUNTING

To those of youwho are uninterested in accounting, I apologize for thisdissertation.Irealizethatmanyofyoudonotporeoverourfigures,butinsteadholdBerkshireprimarilybecauseyouknowthat:(1)CharlieandIhavethebulkof ourmoney in Berkshire; (2) we intend to run things so that your gains orlossesareindirectproportiontoours;(3)therecordhassofarbeensatisfactory.There is nothing necessarily wrong with this kind of “faith” approach toinvesting.Other shareholders, however, prefer an “analysis” approach andwewant tosupply the information theyneed. Inourown investing,wesearch forsituationsinwhichbothapproachesgiveusthesameanswer.54

A.AesopandInefficientBushTheory55

Theformulaforvaluingallassetsthatarepurchasedforfinancialgainhasbeenunchangedsinceitwasfirstlaidoutbyaverysmartmaninabout600B.C.(thoughhewasn’tsmartenoughtoknowitwas600B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete,investmentinsightwas“abirdinthehandisworthtwointhebush.”Tofleshoutthisprinciple,youmustansweronly threequestions.Howcertainareyou thatthereareindeedbirdsinthebush?Whenwill theyemergeandhowmanywilltherebe?Whatistherisk-freeinterestrate(whichweconsidertobetheyieldonlong-termU.S.bonds)?Ifyoucananswerthesethreequestions,youwillknowthemaximum value of the bush—and themaximum number of the birds younowpossess that shouldbe offered for it.And, of course, don’t literally thinkbirds.Thinkdollars.

Aesop’s investment axiom, thus expanded and converted into dollars, isimmutable. It applies to outlays for farms, oil royalties, bonds, stocks, lotterytickets, andmanufacturingplants.Andneither theadventof the steamengine,the harnessing of electricity nor the creation of the automobile changed theformulaoneiota—norwilltheInternet.Justinsertthecorrectnumbers,andyoucanranktheattractivenessofallpossibleusesofcapitalthroughouttheuniverse.

Commonyardstickssuchasdividendyield,theratioofpricetoearningsortobookvalue,andevengrowthrateshavenothingtodowithvaluationexcepttotheextent theyprovideclues to theamountand timingof cash flows intoandfromthebusiness.Indeed,growthcandestroyvalueifitrequirescashinputsin

theearlyyearsofaprojectorenterprisethatexceedthediscountedvalueofthecash that those assets will generate in later years. Market commentators andinvestment managers who glibly refer to “growth” and “value” styles ascontrasting approaches to investment are displaying their ignorance, not theirsophistication. Growth is simply a component—usually a plus, sometimes aminus—inthevalueequation.

Alas, thoughAesop’s proposition and the third variable—that is, interestrates—aresimple,plugginginnumbersfortheothertwovariablesisadifficulttask. Using precise numbers is, in fact, foolish; working with a range ofpossibilitiesisthebetterapproach.

Usually, the range must be so wide that no useful conclusion can bereached.Occasionally,though,evenveryconservativeestimatesaboutthefutureemergenceof birds reveal that the price quoted is startingly low in relation tovalue. (Let’s call this phenomenon the IBT—Inefficient Bush Theory.) To besure, an investor needs some general understanding of business economics aswell as the ability to think independently to reach a well-founded positiveconclusion.Buttheinvestordoesnotneedbrilliancenorblindinginsights.

At the other extreme, there are many times when the most brilliant ofinvestorscan’tmusteraconvictionaboutthebirdstoemerge,notevenwhenaverybroadrangeofestimates isemployed.Thiskindofuncertaintyfrequentlyoccurs when new businesses and rapidly changing industries are underexamination. In cases of this sort, any capital commitment must be labeledspeculative.

Now,speculation—inwhichthefocusisnotonwhatanassetwillproducebutratheronwhatthenextfellowwillpayforit—isneitherillegal,immoralnorun-American.ButitisnotagameinwhichCharlieandIwishtoplay.Webringnothingtotheparty,sowhyshouldweexpecttotakeanythinghome?

The lineseparating investmentandspeculation,which isneverbrightandclear,becomesblurredstillfurtherwhenmostmarketparticipantshaverecentlyenjoyed triumphs. Nothing sedates rationality like large doses of effortlessmoney.Afteraheadyexperienceofthatkind,normallysensiblepeopledriftintobehaviorakin to thatofCinderellaat theball.Theyknow thatoverstaying thefestivities—that is, continuing to speculate in companies that have giganticvaluations relative to the cash they are likely to generate in the future—willeventually bring on pumpkins andmice. But they nevertheless hate tomiss asingleminuteofwhatisonehelluvaparty.Therefore,thegiddyparticipantsallplantoleavejustsecondsbeforemidnight.There’saproblem,though:Theyaredancinginaroominwhichtheclockshavenohands.

Lastyear,wecommentedontheexuberance—and,yes,itwasirrational—

that prevailed, noting that investor expectations had grown to be severalmultiplesofprobablereturns.OnepieceofevidencecamefromaPaineWebber-Gallup survey of investors conducted in December 1999, in which theparticipantswere asked their opinion about the annual returns investors couldexpecttorealizeoverthedecadeahead.Theiranswersaveraged19%.That,forsure, was an irrational expectation: For American business as a whole, therecouldn’tpossiblybeenoughbirdsinthe2009bushtodeliversuchareturn.

Farmore irrational stillwere the huge valuations thatmarket participantswerethenputtingonbusinessesalmostcertaintoendupbeingofmodestornovalue.Yet investors,mesmerizedbysoaringstockpricesand ignoringall else,piled into these enterprises. It was as if some virus, racing wildly amonginvestment professionals aswell as amateurs, induced hallucinations inwhichthevaluesofstocksincertainsectorsbecamedecoupledfromthevaluesofthebusinessesthatunderlaythem.

This surreal scene was accompanied by much loose talk about “valuecreation.”We readily acknowledge that there has been a huge amount of truevaluecreated in thepastdecadebyneworyoungbusinesses,and that there ismuchmore to come.Butvalue is destroyed, not created, by anybusiness thatlosesmoneyoveritslifetime,nomatterhowhighitsinterimvaluationmayget.

Whatactuallyoccurs in thesecases iswealth transfer,oftenonamassivescale.Byshamelesslymerchandisingbirdlessbushes,promotershave inrecentyears moved billions of dollars from the pockets of the public to their ownpurses (and to those of their friends and associates). The fact is that a bubblemarket has allowed the creation of bubble companies, entities designedmorewithaneye tomakingmoneyoff investors rather than for them.Toooften, anIPO,notprofits,wastheprimarygoalofacompany’spromoters.Atbottom,the“businessmodel” for these companies has been the old-fashioned chain letter,forwhichmanyfee-hungryinvestmentbankersactedaseagerpostmen.

Butapinliesinwaitforeverybubble.Andwhenthetwoeventuallymeet,anewwaveofinvestorslearnssomeveryoldlessons:First,manyinWallStreet—a community in which quality control is not prized—will sell investorsanything they will buy. Second, speculation is most dangerous when it lookseasiest.

AtBerkshire,wemakenoattempttopickthefewwinnersthatwillemergefromanoceanofunprovenenterprises.We’renotsmartenoughtodothat,andwe know it. Instead, we try to apply Aesop’s 2,600-year-old equation toopportunitiesinwhichwehavereasonableconfidenceastohowmanybirdsareinthebushandwhentheywillemerge(aformulationthatmygrandsonswouldprobablyupdate to“Agirl inaconvertible isworth five in thephonebook.”).

Obviously,wecanneverpreciselypredictthetimingofcashflowsinandoutofa business or their exact amount. We try, therefore, to keep our estimatesconservativeandtofocusonindustrieswherebusinesssurprisesareunlikelytowreak havoc on owners. Even so, we make many mistakes: I’m the fellow,remember,who thoughtheunderstood thefutureeconomicsof tradingstamps,textiles,shoesandsecond-tierdepartmentstores.

Lately, themostpromising“bushes”havebeennegotiatedtransactionsforentirebusinesses,andthatpleasesus.Youshouldclearlyunderstand,however,that these acquisitions will at best provide us only reasonable returns. Reallyjuicyresultsfromnegotiateddealscanbeanticipatedonlywhencapitalmarketsareseverelyconstrainedandthewholebusinessworldispessimistic.Weare180degreesfromthatpoint.

B.IntrinsicValue,BookValue,andMarketPrice56

[Intrinsic value is] an all-important concept that offers the only logicalapproachtoevaluatingtherelativeattractivenessofinvestmentsandbusinesses.Intrinsicvaluecanbedefinedsimply:Itisthediscountedvalueofthecashthatcanbetakenoutofabusinessduringitsremaininglife.

The calculation of intrinsic value, though, is not so simple. As ourdefinitionsuggests,intrinsicvalueisanestimateratherthanaprecisefigure,andit is additionally an estimate that must be changed if interest rates move orforecastsoffuturecashflowsarerevised.Twopeoplelookingatthesamesetoffacts, moreover—and this would apply even to Charlie and me—will almostinevitablycomeupwithatleastslightlydifferentintrinsicvaluefigures.Thatisonereasonwenevergiveyouourestimatesofintrinsicvalue.Whatourannualreports do supply, though, are the facts thatwe ourselves use to calculate thisvalue.

Meanwhile, we regularly report our per-share book value, an easilycalculablenumber,thoughoneoflimiteduse.Thelimitationsdonotarisefromour holdings ofmarketable securities,which are carried on our books at theircurrent prices. Rather the inadequacies of book value have to do with thecompanieswecontrol,whosevaluesasstatedonourbooksmaybefardifferentfromtheirintrinsicvalues.

The disparity can go in either direction. For example, in 1964 we couldstatewithcertitudethatBerkshire’sper-sharebookvaluewas$19.46.However,thatfigureconsiderablyoverstatedthecompany’sintrinsicvalue,sinceallofthecompany’sresourcesweretiedupinasub-profitabletextilebusiness.Ourtextile

assets had neither going-concern nor liquidation values equal to their carryingvalues.Today,however,Berkshire’s situation is reversed:OurMarch31,1996book value of $15,180 far understatesBerkshire’s intrinsic value, a point truebecause many of the businesses we control are worth much more than theircarryingvalue.

Inadequate though they are in telling the story, we give you Berkshire’sbook-value figures because they today serve as a rough, albeit significantlyunderstated,trackingmeasureforBerkshire’sintrinsicvalue.Inotherwords,thepercentage change in book value in any given year is likely to be reasonablyclosetothatyear’schangeinintrinsicvalue.

You can gain some insight into the differences between book value andintrinsicvaluebylookingatoneformofinvestment,acollegeeducation.Thinkoftheeducation’scostasits“bookvalue.”Ifthiscostistobeaccurate,itshouldincludetheearningsthatwereforegonebythestudentbecausehechosecollegeratherthanajob.

Forthisexercise,wewillignoretheimportantnon-economicbenefitsofaneducationandfocusstrictlyon itseconomicvalue.First,wemustestimate theearnings that thegraduatewill receiveoverhis lifetimeand subtract from thatfigureanestimateofwhathewouldhaveearnedhadhe lackedhis education.Thatgivesus anexcess earnings figure,whichmust thenbediscounted, at anappropriate interest rate, back to graduation day. The dollar result equals theintrinsiceconomicvalueoftheeducation.

Somegraduateswillfindthatthebookvalueoftheireducationexceedsitsintrinsicvalue,whichmeansthatwhoeverpaidfor theeducationdidn’tgethismoney’sworth.Inothercases,theintrinsicvalueofaneducationwillfarexceedits book value, a result that proves capital was wisely deployed. In all cases,whatisclearisthatbookvalueismeaninglessasanindicatorofintrinsicvalue.

An interesting accounting irony overlays a comparison of the reportedfinancial results of our controlled companies with those of the permanentminorityholdings.[Theseholdings]haveamarketvalueofover$2billion.Yetthey produced only $11million in reported after-tax earnings forBerkshire in1987.

Accountingrulesdictatethatwetakeintoincomeonlythedividendsthesecompaniespayus—whicharelittlemorethannominal—ratherthanourshareoftheirearnings,whichin1987amountedtowellover$100million.Ontheotherhand,accountingrulesprovidethatthecarryingvalueofthesethreeholdings—owned,astheyare,byinsurancecompanies—mustberecordedonourbalance

sheetatcurrentmarketprices.Theresult:GAAPaccountingletsusreflectinournetworth theup-to-dateunderlyingvaluesof thebusinesseswepartiallyown,butdoesnotletusreflecttheirunderlyingearningsinourincomeaccount.

Inthecaseofourcontrolledcompanies,justtheoppositeistrue.Here,weshowfullearningsinourincomeaccountbutneverchangeassetvaluesonourbalancesheet,nomatterhowmuchthevalueofabusinessmighthaveincreasedsincewepurchasedit.

Ourmental approach to this accounting schizophrenia is to ignoreGAAPfigures and to focus solelyon the future earningpowerof bothour controlledandnon-controlledbusinesses.Usingthisapproach,weestablishourownideasof business value, keeping these independent fromboth the accounting valuesshown on our books for controlled companies and the values placed by asometimesfoolishmarketonourpartially-ownedcompanies.It isthisbusinessvaluethatwehopetoincreaseatareasonable(or,preferably,unreasonable)rateintheyearsahead.

Historically,Berkshireshareshavesoldmodestlybelow intrinsicbusinessvalue.Withthepricethere,purchaserscouldbecertain(aslongastheydidnotexperienceawideningofthisdiscount)thattheirpersonalinvestmentexperiencewould at least equal the financial experience of the business.But recently thediscounthasdisappeared,andoccasionallyamodestpremiumhasprevailed.

The elimination of the discount means that Berkshire’s market valueincreasedevenfasterthanbusinessvalue(which,itself,grewatapleasingpace).Thatwasgoodnewsforanyownerholdingwhilethatmovetookplace,butitisbadnewsfor theneworprospectiveowner. If the financialexperienceofnewowners ofBerkshire ismerely tomatch the future financial experience of thecompany,anypremiumofmarketvalueover intrinsicbusinessvalue that theypaymustbemaintained.

Over the long term therehasbeenamoreconsistent relationshipbetweenBerkshire’s market value and business value than has existed for any otherpublicly-tradedequitywithwhichIamfamiliar.Thisisatributetoyou.Becauseyouhavebeenrational,interested,andinvestment-oriented,themarketpriceforBerkshire stockhasalmost alwaysbeen sensible.Thisunusual resulthasbeenachievedbyashareholdergroupwithunusualdemographics:virtuallyallofourshareholdersareindividuals,notinstitutions.Nootherpubliccompanyoursizecanclaimthesame.

Ben Graham told a story 40 years ago that illustrates why investmentprofessionals behave as they do: An oil prospector, moving to his heavenly

reward,wasmetbySt.Peterwithbadnews. “You’requalified for residence,”saidSt.Peter,“but,asyoucansee,thecompoundreservedforoilmenispacked.There’s no way to squeeze you in.” After thinking a moment, the prospectorasked if he might say just four words to the present occupants. That seemedharmless to St. Peter, so the prospector cupped his hands and yelled, “Oildiscoveredinhell.”Immediatelythegatetothecompoundopenedandalloftheoilmenmarchedouttoheadforthenetherregions.Impressed,St.Peterinvitedtheprospectortomoveinandmakehimselfcomfortable.Theprospectorpaused.“No,”he said, “I think I’llgoalongwith the restof theboys.Theremightbesometruthtothatrumorafterall.”

In[the1995]letter,withBerkshiresharessellingat$36,000,Itoldyou:(1)Berkshire’s gain in market value in recent years had outstripped its gain inintrinsicvalue,eventhoughthelattergainhadbeenhighlysatisfactory;(2)thatkindofoverperformancecouldnot continue indefinitely; (3)Charlie and IdidnotatthatmomentconsiderBerkshiretobeundervalued.

Since I set down those cautions,Berkshire’s intrinsic value has increasedverysignificantlywhilethemarketpriceofourshareshaschangedlittle.This,of course,means that in 1996Berkshire’s stock underperformed the business.Consequently,today’sprice/valuerelationshipisbothmuchdifferentfromwhatitwasayearagoand,asCharlieandIseeit,moreappropriate.

Over time, the aggregate gains made by Berkshire shareholders must ofnecessitymatchthebusinessgainsofthecompany.Whenthestocktemporarilyoverperformsorunderperformsthebusiness,alimitednumberofshareholders—either sellersorbuyers—receiveoutsizedbenefitsat theexpenseof those theytradewith.Generally, thesophisticatedhaveanedgeover theinnocents in thisgame.

Thoughourprimarygoalistomaximizetheamountthatourshareholders,in total, reap fromtheirownershipofBerkshire,wewishalso tominimize thebenefitsgoingtosomeshareholdersattheexpenseofothers.Thesearegoalswewouldhavewerewemanagingafamilypartnership,andwebelievetheymakeequal sense for the manager of a public company. In a partnership, fairnessrequires that partnership interests be valued equitably when partners enter orexit;inapubliccompany,fairnessprevailswhenmarketpriceandintrinsicvalueareinsync.Obviously,theywon’talwaysmeetthatideal,butamanager—byhispoliciesandcommunications—candomuchtofosterequity.

Of course, the longer a shareholder holds his shares, the more bearingBerkshire’sbusinessresultswillhaveonhisfinancialexperience—andthelessit

willmatterwhatpremiumordiscount to intrinsicvalueprevailswhenhebuysandsellshisstock.That’sonereasonwehopetoattractownerswithlong-termhorizons.Overall,Ithinkwehavesucceededinthatpursuit.Berkshireprobablyranksnumberoneamong largeAmericancorporations in thepercentageof itssharesheldbyownerswithalong-termview.

[C]alculations of intrinsic value, though all-important, are necessarilyimprecise and often seriously wrong. The more uncertain the future of abusiness,themorepossibilitythereisthatthecalculationwillbewildlyoff-base.HereBerkshirehassomeadvantages:awidevarietyofrelatively-stableearningsstreams,combinedwithgreat liquidityandminimumdebt.Thesefactorsmeanthat Berkshire’s intrinsic value can bemore precisely calculated than can theintrinsicvalueofmostcompanies.

YetifprecisionisaidedbyBerkshire’sfinancialcharacteristics, thejobofcalculatingintrinsicvaluehasbeenmademorecomplexbythemerepresenceofsomanyearnings streams.Back in1965,whenweownedonlya small textileoperation, the task of calculating intrinsic valuewas a snap.Nowwe own 68distinctbusinesseswithwidelydisparateoperatingandfinancialcharacteristics.This array of unrelated enterprises, coupled with our massive investmentholdings, makes it impossible for you to simply examine our consolidatedfinancialstatementsandarriveataninformedestimateofintrinsicvalue.

Wehaveattempted toease thisproblembyclusteringourbusinesses intofourlogicalgroups,eachofwhichwediscusslaterinthisreport.Ofcourse,thevalueofBerkshiremaybeeithergreaterorlessthanthesumofthesefourparts.The outcome depends onwhether ourmany units function better orworse bybeing part of a larger enterprise and whether capital allocation improves ordeteriorateswhenitisunderthedirectionofaholdingcompany.Inotherwords,doesBerkshireownershipbringanythingtotheparty,orwouldourshareholdersbebetteroff if theydirectlyownedsharesineachofour68businesses?Theseareimportantquestionsbutonesthatyouwillhavetoanswerforyourself.

[L]et’s review two setsof figures that showwherewe’ve come fromandwherewearenow.Thefirstsetistheamountofinvestments(includingcashandcash-equivalents)weownon a per-share basis. Inmaking this calculation,weexclude investments held in our finance operation because these are largelyoffsetbyborrowings:

Year Per-ShareInvestments*1965 $4

1975 159

19852,407

199521,817

200574,129

CompoundGrowthRate1965–2005 28.0%CompoundGrowthRate1995–2005 13.0%*Netofminorityinterests

Inadditiontothesemarketablesecurities,whichwithminorexceptionsareheld in our insurance companies, we own a wide variety of non-insurancebusinesses. Below, we show the pre-tax earnings (excluding goodwillamortization)ofthesebusinesses,againonaper-sharebasis:

Year Per-ShareEarnings*1965 $41975

4

198552

1995175

20052,441

CompoundGrowthRate1965-2005 17.2%CompoundGrowthRate1995-2005 30.2%*Pre-taxandnetofminorityinterests

Whengrowthratesareunderdiscussion,itwillpayyoutobesuspiciousastowhythebeginningandterminalyearshavebeenselected.Ifeitheryearwasaberrational, any calculation of growth will be distorted. In particular, a baseyearinwhichearningswerepoorcanproduceabreathtaking,butmeaningless,growthrate.Inthetableabove,however,thebaseyearof1965wasabnormallygood;Berkshireearnedmoremoneyinthatyearthanitdidinallbutoneofthepreviousten.

As you can see from the two tables, the comparative growth rates ofBerkshire’s two elements of value have changed in the last decade, a resultreflecting our ever-increasing emphasis on business acquisitions.Nevertheless,CharlieandIwanttoincreasethefiguresinbothtables.

C.Look-ThroughEarnings57

Whenonecompanyownspartofanothercompany,appropriateaccountingprocedures pertaining to that ownership interestmust be selected from one ofthreemajor categories. The percentage of voting stock that is owned, in largepart,determineswhichcategoryofaccountingprinciplesshouldbeutilized.

Generally accepted accounting principles require (subject to exceptions,naturally . . . ) full consolidation of sales, expenses, taxes, and earnings ofbusiness holdings more than 50% owned. Blue Chip Stamps, 60% owned byBerkshire Hathaway Inc., falls into this category. Therefore, all Blue Chipincome and expense items are included in full in Berkshire’s ConsolidatedStatementofEarnings,withthe40%ownershipinterestofothersinBlueChip’snetearningsreflectedintheStatementasadeductionfor“minorityinterest.”

Full inclusion of underlying earnings from another class of holdings,companies owned 20% to 50% (usually called “investees”), also normallyoccurs. Earnings from such companies—for example, Wesco Financial,controlledbyBerkshirebutonly48%owned—areincludedviaaone-lineentryintheowner’sStatementofEarnings.Unliketheover-50%category,allitemsofrevenue and expense are omitted; just the proportional share of net income isincluded.Thus,ifCorporationAownsone-thirdofCorporationB,one-thirdofB’searnings,whetherornotdistributedbyB,willendupinA’searnings.Thereare some modifications, both in this and the over-50% category, forintercorporate taxes and purchase price adjustments, the explanation of which

wewillsaveforalaterday.(Weknowyoucanhardlywait.)Finally come holdings representing less than 20% ownership of another

corporation’svoting securities. In thesecases, accounting rulesdictate that theowningcompanies include in theirearningsonlydividendsreceivedfromsuchholdings. Undistributed earnings are ignored. Thus, should we own 10% ofCorporationXwith earnings of $10million in 1980, wewould report in ourearnings(ignoringrelativelyminortaxesonintercorporatedividends)either(a)$1millionifXdeclaredthefull$10millionindividends;(b)$500,000ifXpaidout50%,or$5million,individends;or(c)zeroifXreinvestedallearnings.

Weimposethisshort—andover-simplified—courseinaccountinguponyoubecauseBerkshire’sconcentrationofresourcesintheinsurancefieldproducesacorresponding concentration of its assets in companies in that third (less than20% owned) category. Many of these companies pay out relatively smallproportions of their earnings in dividends. This means that only a smallproportion of their current earning power is recorded in our own currentoperating earnings.But,while our reportedoperating earnings reflect only thedividendsreceivedfromsuchcompanies,oureconomicwell-beingisdeterminedbytheirearnings,nottheirdividends.

Our holdings in this third category of companies have increaseddramatically in recent years as our insurance business has prospered and assecurities markets have presented particularly attractive opportunities in thecommon stock area. The large increase in such holdings, plus the growth ofearnings experienced by those partially-owned companies, has produced anunusualresult;thepartof“our”earningsthatthesecompaniesretainedlastyear(the part not paid to us in dividends) exceeded the total reported annualoperatingearningsofBerkshireHathaway.Thus,conventionalaccountingonlyallows less thanhalfofour earnings“iceberg” toappear above the surface, inplainview.Withinthecorporateworldsucharesultisquiterare;inourcaseitislikelytoberecurring.

Our own analysis of earnings reality differs somewhat from generallyaccepted accounting principles, particularly when those principles must beappliedinaworldofhighanduncertainratesofinflation.(Butit’smucheasierto criticize than to improve such accounting rules. The inherent problems aremonumental.) We have owned 100% of businesses whose reported earningswere not worth close to 100 cents on the dollar to us even though, in anaccounting sense, we totally controlled their disposition. (The “control” wastheoretical.Unlesswereinvestedallearnings,massivedeteriorationinthevalueof assets already in place would occur. But those reinvested earnings had noprospectofearninganythingclosetoamarketreturnoncapital.)Wehavealso

ownedsmallfractionsofbusinesseswithextraordinaryreinvestmentpossibilitieswhoseretainedearningshadaneconomicvaluetousfarinexcessof100centsonthedollar.

ThevaluetoBerkshireHathawayofretainedearningsisnotdeterminedbywhetherweown100%,50%,20%or1%ofthebusinessesinwhichtheyreside.Rather, thevalueof those retainedearnings isdeterminedby theuse towhichtheyareputandthesubsequentlevelofearningsproducedbythatusage.Thisistruewhetherwedeterminetheusage,orwhethermanagerswedidnothire—butdidelecttojoin—determinethatusage.(It’stheactthatcounts,nottheactors.)And thevalue is innowayaffectedby the inclusionornon-inclusionof thoseretained earnings in our own reported operating earnings. If a tree grows in aforest partially owned by us, but we don’t record the growth in our financialstatements,westillownpartofthetree.

Our view, we warn you, is non-conventional. But we would rather haveearningsforwhichwedidnotgetaccountingcreditput togooduseina10%-owned company by a management we did not personally hire, than haveearningsforwhichwedidgetcreditputintoprojectsofmoredubiouspotentialbyanothermanagement—evenifwearethatmanagement.

Theterm“earnings”hasapreciseringtoit.Andwhenanearningsfigureisaccompaniedbyanunqualifiedauditor’scertificate,anaivereadermightthinkitcomparableincertitudetop,calculatedtodozensofdecimalplaces.

In reality, however, earnings can be as pliable as puttywhen a charlatanheads the company reporting them. Eventually truth will surface, but in themeantimealotofmoneycanchangehands.Indeed,someimportantAmericanfortuneshavebeencreatedbythemonetizationofaccountingmirages.

Berkshire’s own reported earnings are misleading in a different, butimportant, way:We have huge investments in companies (“investees”) whoseearningsfarexceedtheirdividendsandinwhichwerecordourshareofearningsonly to the extent of the dividends we receive. The extreme case is CapitalCities/ABC, Inc.Our17%shareof thecompany’searningsamounted tomorethan $83million last year.Yet only about $530,000 ($600,000 of dividends itpaiduslesssome$70,000oftax)iscountedinBerkshire’sGAAPearnings.Theresidual $82 million-plus stayed with Cap Cities as retained earnings, whichworkforourbenefitbutgounrecordedonourbooks.

Ourperspectiveon such“forgotten-but-not-gone”earnings is simple:Theway they are accounted for is of no importance, but their ownership andsubsequentutilizationisall-important.Wecarenotwhether theauditorsheara

treefallintheforest;wedocarewhoownsthetreeandwhat’snextdonewithit.When Coca-Cola uses retained earnings to repurchase its shares, the

company increases our percentage ownership inwhat I regard to be themostvaluablefranchiseintheworld.(Cokealso,ofcourse,usesretainedearningsinmany other value-enhancing ways.) Instead of repurchasing stock, Coca-Colacouldpaythosefundstousindividends,whichwecouldthenusetopurchasemoreCokeshares.Thatwouldbealessefficientscenario:Becauseoftaxeswewould pay on dividend income, we would not be able to increase ourproportionateownership to thedegree thatCokecan,acting forus. If this lessefficientprocedurewerefollowed,however,Berkshirewouldreport fargreater“earnings.”

I believe the best way to think about our earnings is in terms of “look-through”results,calculatedasfollows:Take$250million,whichisroughlyourshare of the 1990 operating earnings retained by our investees; subtract $30million, for the incremental taxeswewould have owed had that $250millionbeen paid to us in dividends; and add the remainder, $220 million, to ourreported operating earnings of $371 million. Thus our 1990 “look-throughearnings”wereabout$590million.

Inourview, thevaluetoallownersof theretainedearningsofabusinessenterpriseisdeterminedbytheeffectivenesswithwhichthoseearningsareused—andnotbythesizeofone’sownershippercentage.Ifyouhaveowned.01of1%ofBerkshireduringthepastdecade,youhavebenefitedeconomicallyinfullmeasure from your share of our retained earnings, no matter what youraccounting system. Proportionately, you have done just as well as if you hadowned themagic20%.But if youhaveowned100%of agreatmanycapital-intensivebusinessesduringthedecade,retainedearningsthatwerecreditedfullyandwithpainstakingprecisiontoyouunderstandardaccountingmethodshaveresultedinminororzeroeconomicvalue.Thisisnotacriticismofaccountingprocedures.Wewouldnotliketohavethejobofdesigningabettersystem.It’ssimplytosaythatmanagersandinvestorsalikemustunderstandthataccountingnumbersarethebeginning,nottheend,ofbusinessvaluation.

Inmost corporations, less-than-20% ownership positions are unimportant(perhaps, in part, because they prevent maximization of cherished reportedearnings)andthedistinctionbetweenaccountingandeconomicresultswehavejustdiscussedmatterslittle.Butinourowncase,suchpositionsareofverylargeand growing importance. Their magnitude, we believe, is what makes ourreportedoperatingearningsfigureoflimitedsignificance.

Within[the]giganticauctionarena[composedoftheentirearrayofmajorAmerican corporations], it is our job to select businesses with economiccharacteristics allowing each dollar of retained earnings to be translatedeventually intoat least adollarofmarketvalue.Despitea lotofmistakes,wehave so far achieved this goal. In doing so,we have been greatly assisted byArthurOkun’s patron saint for economists—St.Offset. In some cases, that is,retainedearningsattributabletoourownershippositionhavehadinsignificantorevennegative impact onmarket value,while in othermajor positions a dollarretainedbyaninvesteecorporationhasbeentranslatedintotwoormoredollarsofmarketvalue.Todate,ourcorporateover-achievershavemorethanoffsetthelaggards.Ifwecancontinuethisrecord,itwillvalidateoureffortstomaximize“economic”earnings,regardlessoftheimpactupon“accounting”earnings.

Wealsobelieve that investorscanbenefitby focusingon theirown look-through earnings. To calculate these, they should determine the underlyingearningsattributabletothesharestheyholdintheirportfolioandtotalthese.Thegoalofeachinvestorshouldbetocreateaportfolio(ineffect,a“company”)thatwilldeliverhimorherthehighestpossiblelook-throughearningsadecadeorsofromnow.

Anapproachof this kindwill force the investor to think about long-termbusinessprospects rather thanshort-termstockmarketprospects,aperspectivelikelytoimproveresults.It’strue,ofcourse,that,inthelongrun,thescoreboardforinvestmentdecisionsismarketprice.Butpriceswillbedeterminedbyfutureearnings.Ininvesting,justasinbaseball,toputrunsonthescoreboardonemustwatchtheplayingfield,notthescoreboard.

Theprimary testofmanagerialeconomicperformance is theachievementof a high earnings rate on equity capital employed (without undue leverage,accounting gimmickry, etc.) and not the achievement of consistent gains inearningspershare.Inourview,manybusinesseswouldbebetterunderstoodbytheir shareholder owners, as well as the general public, if managements andfinancialanalystsmodified theprimaryemphasis theyplaceuponearningspershare,anduponyearlychangesinthatfigure.

D.EconomicversusAccountingGoodwill58

[O]ur intrinsicbusinessvalueconsiderablyexceedsbookvalue.Therearetwomajorreasons:

(1)Standardaccountingprinciplesrequirethatcommonstocksheldby

ourinsurancesubsidiariesbestatedonourbooksatmarketvalue,butthatotherstocksweownbecarriedat the lowerofaggregatecostormarket. At the end of 1983, the market value of this latter groupexceededcarryingvalueby$70millionpre-tax,orabout$50millionaftertax.Thisexcessbelongsinourintrinsicbusinessvalue,butisnotincludedinthecalculationofbookvalue;(2)Moreimportant,weownseveralbusinessesthatpossesseconomicGoodwill(whichisproperlyincludableinintrinsicbusinessvalue)farlarger than the accounting Goodwill that is carried on our balancesheetandreflectedinbookvalue.

YoucanliveafullandrewardinglifewithouteverthinkingaboutGoodwilland its amortization. But students of investment and management shouldunderstandthenuancesofthesubject.Myownthinkinghaschangeddrasticallyfrom 35 years ago when I was taught to favor tangible assets and to shunbusinesseswhose value depended largely upon economicGoodwill. This biascaused me to make many important business mistakes of omission, althoughrelativelyfewofcommission.

Keynesidentifiedmyproblem:“Thedifficultyliesnotinthenewideasbutin escaping from the old ones.”My escapewas long delayed, in part becausemostofwhatIhadbeentaughtbythesameteacherhadbeen(andcontinuestobe) so extraordinarily valuable. Ultimately, business experience, direct andvicarious, produced my present strong preference for businesses that possesslarge amounts of enduring Goodwill and that utilize a minimum of tangibleassets.

I recommend the [following essay] to those who are comfortable withaccountingterminologyandwhohaveaninterestinunderstandingthebusinessaspectsofGoodwill.Whetherornotyouwishtotacklethe[essay]youshouldbe aware that Charlie and I believe that Berkshire possesses very significanteconomicGoodwillvalueabovethatreflectedinourbookvalue.

[The following discussion] deals only with economic and accountingGoodwill—notthegoodwillofeverydayusage.Forexample,abusinessmaybewell liked, even loved, by most of its customers but possess no economicgoodwill. (AT&T, before the breakup, was generally well thought of, butpossessednotadimeofeconomicGoodwill.)And,regrettably,abusinessmaybe disliked by its customers but possess substantial, and growing economicGoodwill.So,justforthemoment,forgetemotionsandfocusonlyoneconomicsandaccounting.

When a business is purchased, accounting principles require that thepurchasepricefirstbeassignedtothefairvalueoftheidentifiableassetsthatareacquired. Frequently the sum of the fair values put on the assets (after thedeductionof liabilities) is less than the totalpurchasepriceof thebusiness. Inthat case, the difference is assigned to an asset entitled “excess of cost overequityinnetassetsacquired.”Toavoidconstantrepetitionofthismouthful,wewillsubstitute“Goodwill.”

AccountingGoodwillarisingfrombusinessespurchasedbeforeNovember1970hasaspecialstanding.Exceptunderrarecircumstances, itcanremainanassetonthebalancesheetaslongasthebusinessboughtisretained.Thatmeansnoamortizationchargestograduallyextinguishthatassetneedbemadeagainstearnings.

Thecaseisdifferent,however,withpurchasesmadefromNovember1970on.When these createGoodwill, itmust be amortized over notmore than 40yearsthroughcharges—ofequalamountineveryyear—totheearningsaccount.Since40yearsisthemaximumperiodallowed,40yearsiswhatmanagements(includingus)usuallyelect.

That’s how accounting Goodwill works. To see how it differs fromeconomic reality, let’s look at an example close at hand. We’ll round somefigures, and greatly oversimplify, tomake the example easier to follow.We’llalsomentionsomeimplicationsforinvestorandmanager.

BlueChipStampsboughtSee’searlyin1972for$25million,atwhichtimeSee’shadabout$8millionofnet tangible assets. (Throughout thisdiscussion,accounts receivablewillbeclassifiedas tangibleassets,adefinitionproper forbusiness analysis.) This level of tangible assets was adequate to conduct thebusiness without use of debt, except for short periods seasonally. See’s wasearning about $2 million after tax at the time, and such earnings seemedconservativelyrepresentativeoffutureearningpowerinconstant1972dollars.

Thus our first lesson: businesses logically are worth far more than nettangible assetswhen they can be expected to produce earnings on such assetsconsiderably in excess ofmarket rates of return. The capitalized value of thisexcessreturniseconomicGoodwill.

In 1972 (and now) relatively few businesses could be expected toconsistently earn the 25% after tax on net tangible assets that was earned bySee’s—doing it, furthermore, with conservative accounting and no financialleverage.Itwasnotthefairmarketvalueoftheinventories,receivablesorfixedassetsthatproducedthepremiumratesofreturn.Ratheritwasacombinationofintangible assets, particularly a pervasive favorable reputationwith consumersbaseduponcountlesspleasantexperiencestheyhavehadwithbothproductand

personnel.Suchareputationcreatesaconsumerfranchisethatallowsthevalueofthe

product to the purchaser, rather than its production cost, to be the majordeterminant of selling price. Consumer franchises are a prime source ofeconomicGoodwill.Othersourcesincludegovernmentalfranchisesnotsubjecttoprofitregulation,suchas televisionstations,andanenduringpositionas thelowcostproducerinanindustry.

Let’sreturntotheaccountingintheSee’sexample.BlueChip’spurchaseofSee’sat$17millionovernettangibleassetsrequiredthataGoodwillaccountofthisamountbeestablishedasanassetonBlueChip’sbooksandthat$425,000bechargedtoincomeannuallyfor40yearstoamortizethatasset.By1983,after11 years of such charges, the $17 million had been reduced to about $12.5million. Berkshire, meanwhile, owned 60% of Blue Chip and, therefore, also60% of See’s. This ownership meant that Berkshire’s balance sheet reflected60%ofSee’sGoodwill,orabout$7.5million.

In1983BerkshireacquiredtherestofBlueChipinamergerthatrequiredpurchaseaccountingascontrasted to the“pooling” treatmentallowedforsomemergers.Underpurchaseaccounting, the“fairvalue”of theshareswegave to(or“paid”)BlueChipholdershadtobespreadoverthenetassetsacquiredfromBlueChip.This“fairvalue”wasmeasured,asitalmostalwaysiswhenpubliccompanies use their shares to make acquisitions, by the market value of thesharesgivenup.

The assets “purchased” consisted of 40% of everything owned by BlueChip(asnoted,Berkshirealreadyownedtheother60%).WhatBerkshire“paid”wasmorethanthenetidentifiableassetswereceivedby$51.7million,andwasassignedtotwopiecesofGoodwill:$28.4milliontoSee’sand$23.3milliontoBuffaloEveningNews.

After themerger, therefore, Berkshirewas leftwith aGoodwill asset forSee’s that had two components: the $7.5 million remaining from the 1971purchase,and$28.4millionnewlycreatedbythe40%“purchased”in1983.Ouramortizationchargenowwillbeabout$1.0millionforthenext28years,and$.7millionforthefollowing12years,2002through2013.

In other words, different purchase dates and prices have given us vastlydifferentassetvaluesandamortizationchargesfortwopiecesofthesameasset.(Werepeatourusualdisclaimer:wehavenobetteraccountingsystemtosuggest.Theproblemstobedealtwitharemindbogglingandrequirearbitraryrules.)

But what are the economic realities? One reality is that the amortizationcharges that have been deducted as costs in the earnings statement each yearsinceacquisitionofSee’swerenottrueeconomiccosts.Weknowthatbecause

See’s last year earned $13 million after taxes on about $20 million of nettangible assets—aperformance indicating the existenceof economicGoodwillfarlargerthanthetotaloriginalcostofouraccountingGoodwill.Inotherwords,while accountingGoodwill regularly decreased from themoment of purchase,economicGoodwillincreasedinirregularbutverysubstantialfashion.

Another reality is that annual amortization charges in the future will notcorrespond to economic costs. It is possible, of course, that See’s economicGoodwill will disappear. But it won’t shrink in even decrements or anythingremotelyresemblingthem.WhatismorelikelyisthattheGoodwillwillincrease—incurrent,ifnotinconstant,dollars—becauseofinflation.

That probability exists because true economic Goodwill tends to rise innominal value proportionallywith inflation.To illustrate how thisworks, let’scontrast a See’s kind of business with a more mundane business. When wepurchasedSee’sin1972,itwillberecalled,itwasearningabout$2millionon$8millionofnet tangibleassets.Letusassumethatourhypotheticalmundanebusiness then had $2million of earnings also, but needed $18million in nettangible assets for normal operations. Earning only 11% on required tangibleassets,thatmundanebusinesswouldpossesslittleornoeconomicGoodwill.

Abusinesslikethat,therefore,mightwellhavesoldforthevalueofitsnettangible assets, or for $18million. In contrast,we paid $25million for See’s,eventhoughithadnomoreinearningsandlessthanhalfasmuchin“honest-to-God”assets.Could less reallyhavebeenmore,asourpurchaseprice implied?The answer is “yes”—even if both businesses were expected to have flat unitvolume—as longasyouanticipated,aswedid in1972,aworldofcontinuousinflation.

To understand why, imagine the effect that a doubling of the price levelwouldsubsequentlyhaveonthetwobusinesses.Bothwouldneedtodoubletheirnominal earnings to $4 million to keep themselves even with inflation. Thiswould seem to be no great trick: just sell the samenumber of units at doubleearlierpricesand,assumingprofitmarginsremainunchanged,profitsalsomustdouble.

But,crucially,tobringthatabout,bothbusinessesprobablywouldhavetodoubletheirnominal investmentinnet tangibleassets,sincethat is thekindofeconomic requirement that inflation usually imposes on businesses, both goodandbad.Adoublingofdollarsalesmeanscorrespondinglymoredollarsmustbeemployedimmediatelyinreceivablesandinventories.Dollarsemployedinfixedassetswillrespondmoreslowlytoinflation,butprobablyjustassurely.Andallof this inflation-required investment will produce no improvement in rate ofreturn.Themotivationforthisinvestmentisthesurvivalofthebusiness,notthe

prosperityoftheowner.Remember,however,thatSee’shadnettangibleassetsofonly$8million.

So it would only have had to commit an additional $8million to finance thecapital needs imposed by inflation. Themundane business, meanwhile, had aburdenovertwiceaslarge—aneedfor$18millionofadditionalcapital.

After thedusthad settled, themundanebusiness, nowearning$4millionannually,mightstillbeworththevalueofitstangibleassets,or$36million.Thatmeans its ownerswouldhavegainedonly a dollar of nominal value for everynewdollar invested. (This is the samedollar-for-dollar result theywouldhaveachievediftheyhadaddedmoneytoasavingsaccount.)

See’s, however, also earning $4 million, might be worth $50 million ifvalued(asit logicallywouldbe)onthesamebasisasitwasatthetimeofourpurchase. So it would have gained $25 million in nominal value while theowners were putting up only $8 million in additional capital—over $3 ofnominalvaluegainedforeach$1invested.

Remember, even so, that the owners of the See’s kind of business wereforcedbyinflationtoanteup$8millioninadditionalcapitaljusttostayeveninrealprofits.Anyunleveragedbusiness thatrequiressomenet tangibleassets tooperate(andalmostalldo) ishurtbyinflation.Businessesneedinglittle in thewayoftangibleassetssimplyarehurttheleast.

Andthatfact,ofcourse,hasbeenhardformanypeopletograsp.Foryearsthetraditionalwisdom—longontradition,shortonwisdom—heldthatinflationprotectionwasbestprovidedbybusinessesladenwithnaturalresources,plantsandmachinery,orothertangibleassets(“InGoodsWeTrust”).Itdoesn’tworkthatway.Asset-heavybusinessesgenerallyearn lowratesof return—rates thatoftenbarelyprovideenoughcapitaltofundtheinflationaryneedsoftheexistingbusiness,withnothingleftoverforrealgrowth,fordistributiontoowners,orforacquisitionofnewbusinesses.

Incontrast, adisproportionatenumberof thegreatbusiness fortunesbuiltup during the inflationary years arose from ownership of operations thatcombined intangibles of lasting value with relatively minor requirements fortangibleassets.Insuchcasesearningshaveboundedupwardinnominaldollars,and these dollars have been largely available for the acquisition of additionalbusinesses. This phenomenon has been particularly evident in thecommunicationsbusiness.Thatbusinesshasrequiredlittleinthewayoftangibleinvestment—yet its franchises have endured.During inflation,Goodwill is thegiftthatkeepsgiving.

But that statement applies, naturally, only to true economic Goodwill.Spurious accounting Goodwill—and there is plenty of it around—is another

matter.Whenanoverexcitedmanagementpurchasesabusinessatasillyprice,thesameaccountingnicetiesdescribedearlierareobserved.Becauseitcan’tgoanywhere else, the silliness ends up in theGoodwill account.Considering thelackofmanagerialdisciplinethatcreatedtheaccount,undersuchcircumstancesit might better be labeled “No-Will”. Whatever the term, the 40-year ritualtypicallyisobservedandtheadrenalinsocapitalizedremainsonthebooksasan“asset”justasiftheacquisitionhadbeenasensibleone.

*IfyouclingtoanybeliefthataccountingtreatmentofGoodwillisthebest

measureofeconomicreality,Isuggestonefinalitemtoponder.Assume a company with $20 per share of net worth, all tangible assets.

Further assume the company has internally developed some magnificentconsumer franchise, or that it was fortunate enough to obtain some importanttelevision stations by original FCC grant. Therefore, it earns a great deal ontangibleassets,say$5pershare,or25%.

Withsucheconomics,itmightsellfor$100pershareormore,anditmightwellalsobringthatpriceinanegotiatedsaleoftheentirebusiness.

Assumeaninvestorbuysthestockat$100pershare,payingineffect$80per share forGoodwill (just aswould a corporate purchaser buying thewholecompany). Should the investor impute a $2 per share amortization chargeannually($80dividedby40years)tocalculate“true”earningspershare?And,if so, should thenew“true” earningsof $3per share causehim to rethinkhispurchaseprice?

*Webelievemanagersandinvestorsalikeshouldviewintangibleassetsfrom

twoperspectives:(1) In analysis of operating results—that is, in evaluating theunderlyingeconomicsofabusinessunit—amortizationchargesshouldbe ignored.Whatabusinesscanbeexpected toearnonunleveragednet tangible assets, excluding any charges against earnings foramortization of Goodwill, is the best guide to the economicattractivenessof theoperation. It isalso thebestguide to thecurrentvalueoftheoperation’seconomicGoodwill.(2) In evaluating the wisdom of business acquisitions, amortizationchargesshouldbeignoredalso.Theyshouldbedeductedneitherfromearningsnorfromthecostofthebusiness.Thismeansforeverviewingpurchased Goodwill at its full cost, before any amortization.Furthermore, cost should be defined as including the full intrinsic

business value—not just the recorded accounting value—of allconsideration given, irrespective of market prices of the securitiesinvolved at the time of merger and irrespective of whether poolingtreatmentwas allowed.For example,whatwe trulypaid in theBlueChip merger for 40% of the Goodwill of See’s and the News wasconsiderablymore than the$51.7millionenteredonourbooks.ThisdisparityexistsbecausethemarketvalueoftheBerkshiresharesgivenupinthemergerwaslessthantheirintrinsicbusinessvalue,whichisthevaluethatdefinesthetruecosttous.

Operationsthatappeartobewinnersbaseduponperspective(1)maypalewhen viewed from perspective (2). A good business is not always a goodpurchase—althoughit’sagoodplacetolookforone.

WhenBerkshirebuysabusinessforapremiumovertheGAAPnetworthoftheacquiree—aswillusuallybethecase,sincemostcompanieswe’dwanttobuydon’tcomeatadiscount—thatpremiumhastobeenteredontheassetsideofourbalancesheet.Thereareloadsofrulesaboutjusthowacompanyshouldrecord the premium. But to simplify this discussion, we will focus on“Goodwill,” the asset item to which almost all of Berkshire’s acquisitionpremiumshavebeenallocated.Forexample,whenwerecentlyacquiredthehalfofGEICOwedidn’tpreviouslyown,werecordedgoodwillofabout$1.6billion.

GAAP requires Goodwill to be amortized—that is, written off—over aperiod no longer than 40 years. Therefore, to extinguish our $1.6 billion inGEICOGoodwill,wewill annually take charges of about $40million againstourearnings.

Inanaccountingsense,consequently,ourGEICOGoodwillwilldisappeargradually ineven-sizedbites.But theone thingIcanguaranteeyou is that theeconomicGoodwillwehavepurchasedatGEICOwillnotdecline in thesamemeasuredway.Infact,mybestguessisthattheeconomicgoodwillassignabletoGEICOwillnotdeclineatall,butratherwillincrease—andprobablyinaverysubstantialway.

Imadeasimilarstatementinour1983AnnualReportabouttheGoodwillattributed to See’s Candy, when I used that company as an example in adiscussionofGoodwillaccounting.Atthattime,ourbalancesheetcarriedabout$36millionofSee’sGoodwill.Wehave sincebeenchargingabout$1millionagainst earnings every year in order to amortize the asset, and the See’sGoodwill on our balance sheet is now down to about $23 million. In otherwords, fromanaccountingstandpoint,See’s isnowpresentedashaving losta

gooddealofgoodwillsince1983.The economic facts could not be more different. In 1983, See’s earned

about $27 million pre-tax on $11 million of net operating assets; in 1995 itearned $50 million on only $5 million of net operating assets. Clearly See’seconomic Goodwill has increased dramatically during the interval rather thandecreased. Just asclearly,See’s isworthmanyhundredsofmillionsofdollarsmorethanitsstatedvalueonourbooks.

We could, of course, be wrong, but we expect GEICO’s gradual loss ofaccountingvaluetobepairedwithincreasesinitseconomicvalue.Certainlythathasbeenthepatternatmostofoursubsidiaries,notjustSee’s.Thatiswhyweregularlypresentouroperatingearnings inaway thatallowsyou to ignoreallpurchase-accountingadjustments.

Inthefuture,also,wewilladoptasimilarpolicyforlook-throughearnings,movingtoaformofpresentationthatridstheseearningsofthemajorpurchase-accountingadjustmentsofinvestees.Wewillnotapplythispolicytocompaniesthathaveonlysmallamountsofgoodwillontheirbooks,suchasCoca-ColaorGillette.Wewillextendit,however,toWellsFargoandDisney,whichhavebothrecentlymadehugeacquisitionsandareconsequentlydealingwithexceptionallylargegoodwillcharges.

Before leaving this subject, we should issue an important warning:Investors are often led astray by CEOs andWall Street analysts who equatedepreciationchargeswiththeamortizationchargeswehavejustdiscussed.Innowayarethetwothesame:Withrareexceptions,depreciationisaneconomiccosteverybitasrealaswages,materials,ortaxes.CertainlythatistrueatBerkshireandatvirtuallyalltheotherbusinesseswehavestudied.Furthermore,wedonotthink so-called EBITDA (earnings before interest, taxes, depreciation andamortization) is a meaningful measure of performance. Managements thatdismisstheimportanceofdepreciation—andemphasize“cashflow”orEBITDA—are apt tomake faulty decisions, and you should keep that inmind as youmakeyourowninvestmentdecisions.

E.OwnerEarningsandtheCashFlowFallacy59

[Many business acquisitions require] major purchase-price accountingadjustments,asprescribedbygenerallyacceptedaccountingprinciples(GAAP).TheGAAP figures, of course, are the ones used in our consolidated financialstatements. But, in our view, the GAAP figures are not necessarily the mostusefulonesforinvestorsormanagers.Therefore,thefiguresshownforspecific

operating units are earnings before purchase-price adjustments are taken intoaccount. Ineffect, theseare theearnings thatwouldhavebeenreportedby thebusinessesifwehadnotpurchasedthem.

A discussion of our reasons for preferring this form of presentation[follows. It] will never substitute for a steamy novel and definitely is notrequiredreading.However,Iknowthatamongour6,000shareholderstherearethosewhoarethrilledbymyessaysonaccounting—andIhopethatbothofyouenjoy[it].

First a short quiz: below are abbreviated 1986 statements of earnings fortwocompanies.Whichbusinessisthemorevaluable?

Asyou’veprobablyguessed,CompaniesOandNarethesamebusiness—ScottFetzer.Inthe“O”(for“old”)columnwehaveshownwhatthecompany’s1986GAAPearningswouldhavebeen ifwehadnotpurchased it; in the “N”(for “new”) columnwehave shownScottFetzer’sGAAPearnings as actuallyreportedbyBerkshire.

Itshouldbeemphasizedthatthetwocolumnsdepictidenticaleconomics—i.e.,thesamesales,wages,taxes,etc.Andboth“companies”generatethesameamountofcashforowners.Onlytheaccountingisdifferent.

So, fellowphilosophers,whichcolumnpresents truth?Uponwhichsetofnumbersshouldmanagersandinvestorsfocus?

Beforewetacklethosequestions,let’slookatwhatproducesthedisparitybetween O and N.We will simplify our discussion in some respects, but thesimplificationshouldnotproduceanyinaccuraciesinanalysisorconclusions.

ThecontrastbetweenOandNcomesaboutbecausewepaidanamountforScott Fetzer that was different from its stated net worth. Under GAAP, suchdifferences—suchpremiumsordiscounts—mustbeaccountedforby“purchase-price adjustments.” InScottFetzer’s case,wepaid$315million fornet assetsthatwerecarriedonitsbooksat$172.4million.Sowepaidapremiumof$142.6million.

Thefirststepinaccountingforanypremiumpaidistoadjustthecarryingvalue of current assets to current values. In practice, this requirement usuallydoesnotaffectreceivables,whichareroutinelycarriedatcurrentvalue,butoftenaffects inventories. Because of a $22.9 million LIFO reserve and otheraccountingintricacies,60ScottFetzer’sinventoryaccountwascarriedata$37.3milliondiscountfromcurrentvalue.So,makingourfirstaccountingmove,weused$37.3millionofour$142.6millionpremiumtoincreasethecarryingvalueoftheinventory.

Assuminganypremiumisleftaftercurrentassetsareadjusted,thenextstepis to adjust fixed assets to current value. In our case, this adjustment alsorequired a few accounting acrobatics relating to deferred taxes. Since this hasbeenbilled as a simplified discussion, Iwill skip the details andgive you thebottom line: $68.0 million was added to fixed assets and $13.0 million waseliminated from deferred tax liabilities. After making this $81.0 millionadjustment,wewereleftwith$24.3millionofpremiumtoallocate.

Hadoursituationcalledforthem,twostepswouldnexthavebeenrequired:the adjustment of intangible assets other thanGoodwill to current fair values,and the restatement of liabilities to current fair values, a requirement thattypically affectsonly long-termdebt andunfundedpension liabilities. InScottFetzer’scase,however,neitherofthesestepswasnecessary.

The final accounting adjustment we needed tomake, after recording fairmarket values for all assets and liabilities,was the assignment of the residualpremiumtoGoodwill(technicallyknownas“excessofcostoverthefairvalueof net assets acquired”). This residual amounted to $24.3 million. Thus, thebalance sheet of Scott Fetzer immediately before the acquisition, which issummarized below in column O, was transformed by the purchase into thebalancesheetshownincolumnN.Inrealterms,bothbalancesheetsdepictthesame assets and liabilities—but, as you can see, certain figures differ

significantly.

The higher balance sheet figures shown in column N produce the lowerincomefiguresshownincolumnNof theearningsstatementpresentedearlier.Thisistheresultoftheassetwrite-upsandofthefactthatsomeofthewritten-upassetsmustbedepreciatedoramortized.Thehighertheassetfigure,thehighertheannualdepreciationoramortizationchargetoearningsmustbe.Thechargesthat flowed to the earnings statement because of the balance sheet write-upswerenumberedinthestatementofearningsshownearlier:1. $4,979,000 for non-cash inventory costs resulting, primarily, from

reductionsthatScottFetzermadeinitsinventoriesduring1986;chargesofthiskindareapttobesmallornon-existentinfutureyears.

2. $5,054,000 for extra depreciation attributable to the write-up of fixedassets;achargeapproximatingthisamountwillprobablybemadeannuallyfor12moreyears.

3. $595,000foramortizationofGoodwill; thischargewillbemadeannuallyfor 39more years in a slightly larger amount because our purchase wasmadeonJanuary6and, therefore, the1986figureapplies toonly98%oftheyear.

4. $998,000fordeferred-taxacrobatics thatarebeyondmyabilitytoexplainbriefly (orperhapsevennon-briefly);achargeapproximating thisamountwillprobablybemadeannuallyfor12moreyears.

Bytheendof1986thedifferencebetweenthenetworthof the“old”and“new”ScottFetzerhadbeenreducedfrom$142.6millionto$131.0millionbymeansoftheextra$11.6millionthatwaschargedtoearningsofthenewentity.Astheyearsgoby,similarchargestoearningswillcausemostofthepremiumtodisappear,andthetwobalancesheetswillconverge.However,thehigherlandvaluesandmostofthehigherinventoryvaluesthatwereestablishedonthenewbalance sheet will remain unless land is disposed of or inventory levels arefurtherreduced.

*Whatdoesallthismeanforowners?DidtheshareholdersofBerkshirebuy

abusinessthatearned$40.2millionin1986ordidtheybuyoneearning$28.6million?Were those$11.6millionofnewchargesa real economiccost tous?Should investors paymore for the stock ofCompanyO than ofCompanyN?And, if a business isworth somegivenmultipleof earnings,wasScottFetzerworth considerably more the day before we bought it than it was worth thefollowingday?

Ifwethinkthroughthesequestions,wecangainsomeinsightsaboutwhatmaybecalled“ownerearnings.”Theserepresent(a)reportedearningsplus(b)depreciation,depletion,amortization,andcertainothernon-cashchargessuchasCompanyN’sitems(1)and(4)less(c)theaverageannualamountofcapitalizedexpenditures for plant and equipment, etc. that the business requires to fullymaintainitslong-termcompetitivepositionanditsunitvolume.(Ifthebusinessrequiresadditionalworkingcapitaltomaintainitscompetitivepositionandunitvolume, the increment also should be included in (c). However, businessesfollowingtheLIFOinventorymethodusuallydonotrequireadditionalworkingcapitalifunitvolumedoesnotchange.)

Ourowner-earningsequationdoesnotyieldthedeceptivelyprecisefigures

providedbyGAAP,since(c)mustbeaguess—andonesometimesverydifficulttomake.Despite thisproblem,weconsider theowner earnings figure,not theGAAPfigure,tobetherelevantitemforvaluationpurposes—bothforinvestorsinbuyingstocksandformanagersinbuyingentirebusinesses.

Theapproachwehaveoutlinedproduces“ownerearnings”forCompanyOandCompanyN that are identical, whichmeans valuations are also identical,justascommonsensewouldtellyoushouldbethecase.Thisresult isreachedbecausethesumof(a)and(b)isthesameinbothcolumnsOandN,andbecause(c)isnecessarilythesameinbothcases.

AndwhatdoCharlieandI,asownersandmanagers,believeisthecorrectfigurefortheownerearningsofScottFetzer?Undercurrentcircumstances,webelieve(c)isveryclosetothe“old”company’s(b)numberof$8.3millionandmuchbelow the“new”company’s (b)numberof$19.9million.Therefore,webelievethatownerearningsarefarbetterdepictedbythereportedearningsintheOcolumnthanbythoseintheNcolumn.Inotherwords,wefeelownerearningsofScottFetzerareconsiderablylargerthantheGAAPfiguresthatwereport.

That is obviously a happy state of affairs. But calculations of this sortusually do not provide such pleasant news. Most managers probably willacknowledge that they need to spend something more than (b) on theirbusinessesover the longer term just tohold theirground in termsofbothunitvolumeandcompetitiveposition.Whenthisimperativeexists—thatis,when(c)exceeds (b)—GAAP earnings overstate owner earnings. Frequently thisoverstatement is substantial. The oil industry has in recent years provided aconspicuousexampleofthisphenomenon.Hadmostmajoroilcompaniesspentonly(b)eachyear,theywouldhaveguaranteedtheirshrinkageinrealterms.

Allofthispointsuptheabsurdityofthe“cashflow”numbersthatareoftensetforth inWallStreetreports.Thesenumbersroutinelyinclude(a)plus(b)—butdonotsubtract(c).Mostsalesbrochuresofinvestmentbankersalsofeaturedeceptivepresentationsofthiskind.Theseimplythatthebusinessbeingofferedis the commercial counterpart of the Pyramids—forever state-of-the-art, neverneedingtobereplaced,improvedorrefurbished.Indeed,ifallU.S.corporationswere to be offered simultaneously for sale through our leading investmentbankers—and if the sales brochures describing them were to be believed—governmentalprojectionsofnationalplantandequipmentspendingwouldhavetobeslashedby90%.

“CashFlow,”true,mayserveasashorthandofsomeutilityindescriptionsof certain real estate businesses or other enterprises that make huge initialoutlays and only tiny outlays thereafter. A company whose only holding is abridge or an extremely long-lived gas field would be an example. But “cash

flow” ismeaningless in suchbusinesses asmanufacturing, retailing, extractivecompanies,andutilitiesbecause,forthem,(c)isalwayssignificant.Tobesure,businessesofthiskindmayinagivenyearbeabletodefercapitalspending.Butoverafive-orten-yearperiod,theymustmaketheinvestment—orthebusinessdecays.

Why, then, are “cash flow” numbers so popular today? In answer, weconfess our cynicism: we believe these numbers are frequently used bymarketersofbusinessesandsecuritiesinattemptstojustifytheunjustifiable(andthereby to sell what should be the unsaleable). When (a)—that is, GAAPearnings—looksbyitself inadequatetoservicedebtofa junkbondorjustifyafoolish stockprice,howconvenient it becomes for salesmen to focuson (a)+(b).Butyoushouldn’tadd(b)withoutsubtracting(c):thoughdentistscorrectlyclaimthatifyouignoreyourteeththey’llgoaway,thesameisnottruefor(c).Thecompanyor investorbelieving that thedebt-servicingabilityor theequityvaluation of an enterprise can be measured by totalling (a) and (b) whileignoring(c)isheadedforcertaintrouble.

*To sumup: in the caseofbothScottFetzer andourotherbusinesses,we

feel that (b) on an historical-cost basis—i.e., with both amortization ofintangibles and other purchase-price adjustments excluded—is quite close inamountto(c).(Thetwoitemsarenotidentical,ofcourse.Forexample,atSee’sweannuallymakecapitalizedexpendituresthatexceeddepreciationby$500,000to$1million, simply toholdourground competitively.)Our conviction aboutthis point is the reason we show our amortization and other purchase-priceadjustmentitemsseparately...andisalsoourreasonforviewingtheearningsof the individual businesses . . . as much more closely approximating ownerearningsthantheGAAPfigures.

QuestioningGAAPfiguresmayseemimpioustosome.Afterall,whatarewe paying the accountants for if it is not to deliver us the “truth” about ourbusiness.But theaccountants’ job is to record,not toevaluate.Theevaluationjobfallstoinvestorsandmanagers.

Accountingnumbersofcourse,arethelanguageofbusinessandassuchareofenormoushelptoanyoneevaluatingtheworthofabusinessandtrackingitsprogress.CharlieandIwouldbelostwithoutthesenumbers:theyinvariablyarethe startingpoint for us in evaluatingourownbusinesses and thoseof others.Managersandownersneedtoremember,however,thataccountingisbutanaidtobusinessthinking,neverasubstituteforit.

F.OptionValuation61

The Black-Scholes formula has approached the status of holy writ infinance, and we use it when valuing our equity put options for financialstatementpurposes.Key inputs to the calculation include a contract’smaturityandstrikeprice,aswellastheanalyst’sexpectationsforvolatility,interestratesanddividends.

Iftheformulaisappliedtoextendedtimeperiods,however,itcanproduceabsurd results. In fairness,Black andScholes almost certainly understood thispointwell. But their devoted followersmay be ignoringwhatever caveats thetwomenattachedwhentheyfirstunveiledtheformula.

It’softenusefulintestingatheorytopushittoextremes.Solet’spostulatethatwesella100-year$1billionputoptionontheS&P500atastrikepriceof903(theindex’slevelon12/31/08).Usingtheimpliedvolatilityassumptionforlong-datedcontractsthatwedo,andcombiningthatwithappropriateinterestanddividendassumptions,wewould find the“proper”Black-Scholespremiumforthiscontracttobe$2.5million.

To judge the rationality of that premium, we need to assess whether theS&Pwillbevaluedacenturyfromnowat lessthantoday.Certainlythedollarwill thenbeworthasmall fractionof itspresentvalue (atonly2%inflation itwillbeworthroughly14¢).Sothatwillbeafactorpushingthestatedvalueofthe index higher. Far more important, however, is that one hundred years ofretainedearningswillhugelyincreasethevalueofmostofthecompaniesintheindex.Inthe20thCentury,theDow-JonesIndustrialAverageincreasedbyabout175-fold,mainlybecauseofthisretained-earningsfactor.

Consideringeverything, Ibelieve theprobabilityofadecline in the indexoveraone-hundred-yearperiodtobefar lessthan1%.Butlet’susethatfigureandalsoassumethatthemostlikelydecline—shouldoneoccur—is50%.Undertheseassumptions, themathematicalexpectationof lossonourcontractwouldbe$5million($1billionX1%X50%).

Butifwehadreceivedourtheoreticalpremiumof$2.5millionupfront,wewouldhaveonlyhadtoinvestitat0.7%compoundedannuallytocoverthislossexpectancy. Everything earned above thatwould have been profit.Would youliketoborrowmoneyfor100yearsata0.7%rate?

Let’s look at my example from a worst-case standpoint. Remember that99%ofthetimewewouldpaynothingifmyassumptionsarecorrect.Butevenin the worst case among the remaining 1% of possibilities—that is, oneassuming a total loss of $1 billion—our borrowing cost would come to only6.2%.Clearly,eithermyassumptionsarecrazyortheformulaisinappropriate.

TheridiculouspremiumthatBlack-Scholesdictatesinmyextremeexampleis caused by the inclusion of volatility in the formula and by the fact thatvolatility isdeterminedbyhowmuch stockshavemovedaround in somepastperiodofdays,monthsoryears.Thismetric is simply irrelevant in estimatingtheprobabilityweighted rangeofvaluesofAmericanbusiness100years fromnow.(Imagine, ifyouwill,gettingaquoteeverydayonafarmfromamanic-depressiveneighborandthenusingthevolatilitycalculatedfromthesechangingquotes as an important ingredient in an equation that predicts a probability-weightedrangeofvaluesforthefarmacenturyfromnow.)

Thoughhistoricalvolatilityisauseful—butfarfromfoolproof—conceptinvaluing short-termoptions, its utility diminishes rapidly as the duration of theoptionlengthens. Inmyopinion, thevaluations that theBlack-Scholesformulanow place on our long-term put options overstate our liability, though theoverstatementwilldiminishasthecontractsapproachmaturity.

Evenso,wewillcontinuetouseBlack-Scholeswhenweareestimatingourfinancial-statement liability for long-term equity puts. The formula representsconventional wisdom and any substitute that I might offer would engenderextreme skepticism. Thatwould be perfectly understandable: CEOswho haveconcocted their own valuations for esoteric financial instruments have seldomerredonthesideofconservatism.ThatclubofoptimistsisonethatCharlieandIhavenodesiretojoin.

Both Charlie and I believe that Black-Scholes produces wildlyinappropriate values when applied to long-dated options. [Besides thehypotheticalexamplegivenabove,]weputourmoneywhereourmouthwasbyentering intoourequityputcontracts.Bydoing so,we implicitlyasserted thatthe Black-Scholes calculations used by our counterparties or their customerswerefaulty.

Wecontinue, nevertheless, to use that formula in presentingour financialstatements.Black-Scholesistheacceptedstandardforoptionvaluation—almostall leading business schools teach it—and we would be accused of shoddyaccountingifwedeviatedfromit.Moreover,wewouldpresentourauditorswithan insurmountableproblemwerewetodo that:TheyhaveclientswhoareourcounterpartiesandwhouseBlack-Scholesvaluesforthesamecontractswehold.Itwould be impossible for our auditors to attest to the accuracy of both theirvaluesandourswerethetwofarapart.

Part of the appeal of Black-Scholes to auditors and regulators is that itproducesaprecisenumber.CharlieandIcan’tsupplyoneofthose.Webelieve

the true liabilityofourcontracts tobefar lower thanthatcalculatedbyBlack-Scholes,butwecan’tcomeupwithanexactfigure—anymorethanwecancomeupwithaprecisevalueforGEICO,BNSF,orforBerkshireHathawayitself.Ourinability to pinpoint a number doesn’t bother us: We would rather beapproximatelyrightthanpreciselywrong.

John Kenneth Galbraith once slyly observed that economists were mosteconomical with ideas: Theymade the ones learned in graduate school last alifetime. University finance departments often behave similarly. Witness thetenacity with which almost all clung to the theory of efficient marketsthroughoutthe1970sand1980s,dismissivelycallingpowerfulfactsthatrefutedit“anomalies.”(Ialwaysloveexplanationsofthatkind:TheFlatEarthSocietyprobably views a ship’s circling of the globe as an annoying, butinconsequential,anomaly.)

54[Introductoryessay,1988.]55[2000.]56[Dividedbyhashlines:1996Owner’sManual;1987;1985;1996;2005,

withcondensedupdatedversionin2006.]57[Dividedbyhashlines:1980;1990;1982;1991,1979.]58[Dividedbyhashlines:1983;1983Appendix;1996Owner’sManual.]59[Dividedbyhashlines:1986;1986Appendix]60 [A LIFO reserve is the difference between the current cost to replace

inventory and the amount shown as the cost of inventory on a balance sheet.Thisdifferencecangrowsignificantly,especiallyduringinflationaryperiods.]

61[2008;2010.]

VII.ACCOUNTINGSHENANIGANS

Despite the shortcomings of generally accepted accounting principles(GAAP), I would hate to have the job of devising a better set of rules. Thelimitationsoftheexistingset,however,neednotbeinhibiting:CEOsarefreetotreatGAAPstatementsasabeginning rather thananend to theirobligation toinformownersandcreditors—andindeedtheyshould.Afterall,anymanagerofasubsidiarycompanywouldfindhimselfinhotwaterifhereportedbarebonesGAAP numbers that omitted key information needed by his boss, the parentcorporation’s CEO.Why, then, should the CEO himself withhold informationvitallyusefultohisbosses—theshareholder-ownersofthecorporation?

Whatneeds tobe reported isdata—whetherGAAP,non-GAAP,or extra-GAAP—that helps financially-literate readers answer three key questions: (1)Approximatelyhowmuchisthiscompanyworth?(2)Whatisthelikelihoodthatit can meet its future obligations? and (3) How good a job are its managersdoing,giventhehandtheyhavebeendealt?

Inmost cases, answers to one ormore of these questions are somewherebetween difficult and impossible to glean from the minimum GAAPpresentation.Thebusinessworldissimplytoocomplexforasinglesetofrulesto effectively describe economic reality for all enterprises, particularly thoseoperatinginawidevarietyofbusinesses,suchasBerkshire.

FurthercomplicatingtheproblemisthefactthatmanymanagementsviewGAAPnot as a standard tobemet,but as anobstacle toovercome.Toooftentheir accountantswillingly assist them. (“Howmuch,” says the client, “is twoplus two?”Replies thecooperativeaccountant,“Whatnumberdidyouhave inmind?”) Even honest and well-intentioned managements sometimes stretchGAAP a bit in order to present figures they think will more appropriatelydescribe theirperformance.Both thesmoothingofearningsand the“bigbath”quarterare“whitelie”techniquesemployedbyotherwiseuprightmanagements.

Then therearemanagerswhoactivelyuseGAAPtodeceiveanddefraud.TheyknowthatmanyinvestorsandcreditorsacceptGAAPresultsasgospel.Sothese charlatans interpret the rules “imaginatively” and record businesstransactionsinwaysthattechnicallycomplywithGAAPbutactuallydisplayaneconomicillusiontotheworld.

As long as investors—including supposedly sophisticated institutions—place fancyvaluationson reported“earnings” thatmarchsteadily upward, you

canbe sure that somemanagers andpromoterswill exploitGAAP to producesuchnumbers,nomatterwhat the truthmaybe.Over theyears,Charlie and Ihave observed many accounting-based frauds of staggering size. Few of theperpetratorshavebeenpunished;manyhavenotevenbeencensured.Ithasbeenfarsafertosteallargesumswithapenthansmallsumswithagun.62

A.ASatireonAccountingShenanigans63

U.S.STEELANNOUNCESSWEEPINGMODERNIZATIONSCHEME*MyronC.Taylor,ChairmanofU.S.SteelCorporation,todayannouncedthe

long awaited plan for completely modernizing the world’s largest industrialenterprise.Contrarytoexpectations,nochangeswillbemadeinthecompany’smanufacturing or selling policies. Instead, the bookkeeping system is to beentirely revamped. By adopting and further improving a number of modernaccounting and financial devices the corporation’s earning power will beamazingly transformed. Even under the subnormal conditions of 1935, it isestimated that the new bookkeeping methods would have yielded a reportedprofit of close to $50 per share on the common stock. The scheme ofimprovement is the result of a comprehensive surveymade byMessrs. Price,Bacon,Guthrie&Colpitts;itincludesthefollowingsixpoints:1. WritingdownofPlantAccounttoMinus$1,000,000,000.2. ParValueofCommonStocktobereducedto1¢.3. Paymentofallwagesandsalariesinoptionwarrants.4. Inventoriestobecarriedat$1.5. PreferredStocktobereplacedbynon-interestbearingbondsredeemableat

50%discount.6. A$1,000,000,000ContingencyReservetobeestablished.

Theofficialstatementof thisextraordinaryModernizationPlanfollows infull:

TheBoard ofDirectors ofU.S. SteelCorporation is pleased to announcethatafterintensivestudyoftheproblemsarisingfromchangedconditionsintheindustry,ithasapprovedacomprehensiveplanforremodelingtheCorporation’saccountingmethods.A survey by a Special Committee, aided and abetted byMessrs.Price,Bacon,Guthrie&Colpitts,revealedthatourcompanyhaslaggedsomewhat behind other American business enterprises in utilizing certainadvancedbookkeepingmethods,bymeansofwhichtheearningpowermaybe

phenomenally enhanced without requiring any cash outlay or any changes inoperatingorsalesconditions.Ithasbeendecidednotonlytoadoptthesenewermethods,but todevelopthemtoastillhigherstageofperfection.ThechangesadoptedbytheBoardmaybesummarizedundersixheads,asfollows:1.FixedAssetstobewrittendowntoMinus$1,000,000,000.

Manyrepresentativecompanieshaverelievedtheir incomeaccountsofallchargesfordepreciationbywritingdowntheirplantaccountto$1.TheSpecialCommitteepointsout that if theirplantsareworthonly$1, the fixedassetsofU.S.SteelCorporationareworthagooddeallessthanthatsum.Itisnowawell-recognized fact thatmany plants are in reality a liability rather than an asset,entailing not only depreciation charges, but taxes, maintenance, and otherexpenditures. Accordingly, the Board has decided to extend the writedownpolicy initiated in the 1935 report, and to mark down the Fixed Assets from$1,338,522,858.96toaroundMinus$1,000,000,000.

Theadvantagesofthismoveshouldbeevident.Astheplantwearsout,theliability becomes correspondingly reduced. Hence, instead of the presentdepreciation charge of some $47,000,000 yearly there will be an annualappreciationcreditof5%,or$50,000,000.Thiswillincreaseearningsbynolessthan$97,000,000perannum.2.ReductionofParValueofCommonStockto1¢,and3.PaymentofSalariesandWagesinOptionWarrants.

Many corporations have been able to reduce their overhead expensessubstantially by paying a large part of their executive salaries in the form ofoptions to buy stock, which carry no charge against earnings. The fullpossibilitiesofthismoderndevicehaveapparentlynotbeenadequatelyrealized.TheBoardofDirectorshaveadoptedthefollowingadvancedformofthisidea:

TheentirepersonneloftheCorporationaretoreceivetheircompensationinthe form of rights to buy common stock at $50 per share, at the rate of onepurchaserightforeach$50ofsalaryand/orwagesintheirpresentamounts.Theparvalueofthecommonstockistobereducedto1¢.

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

A.Thepayrollof theCorporationwillbeentirelyeliminated, a savingof$250,000,000perannum,basedon1935operations.

B.Atthesametime,theeffectivecompensationofallouremployeeswillbeincreasedseveralfold.Becauseofthelargeearningspersharetobeshownonour common stock under the new methods, it is certain that the shares willcommand a price in the market far above the option level of $50 per share,

makingthereadilyrealizablevalueoftheseoptionwarrantsgreatlyinexcessofthepresentcashwagesthattheywillreplace.

C.TheCorporationwillrealizeanadditionallargeannualprofitthroughtheexerciseofthesewarrants.Sincetheparvalueofthecommonstockwillbefixedat1¢,therewillbeagainof$49.99oneachsharesubscribedfor.Intheinterestof conservative accounting, however, this profit will not be included in theincomeaccount,butwillbeshownseparatelyasacredittoCapitalSurplus.

D. The Corporation’s cash position will be enormously strengthened. Inplaceofthepresentannualcashoutgoof$250,000,000forwages(1935basis),there will be annual cash inflow of $250,000,000 through exercise of thesubscriptionwarrants for 5,000,000 shares of common stock. The Company’slarge earnings and strong cash position will permit the payment of a liberaldividend which, in turn, will result in the exercise of these option warrantsimmediatelyafterissuancewhich,inturn,willfurtherimprovethecashpositionwhich,inturn,willpermitahigherdividendrate—andsoon,indefinitely.4.Inventoriestobecarriedat$1.

Seriouslosseshavebeentakenduringthedepressionduetothenecessityofadjusting inventory value tomarket.Various enterprises—notably in themetalandcotton-textilefields—havesuccessfullydealtwiththisproblembycarryingall or part of their inventories at extremely low unit prices. The U.S. SteelCorporationhasdecidedtoadoptastillmoreprogressivepolicy,andtocarryitsentireinventoryat$1.Thiswillbeeffectedbyanappropriatewritedownattheendofeachyear,theamountofsaidwritedowntobechargedtotheContingencyReservehereinafterreferredto.

Thebenefits tobederivedfromthisnewmethodareverygreat.Notonlywill itobviateallpossibilityof inventorydepreciation,but itwill substantiallyenhance the annual earningsof theCorporation.The inventoryonhand at thebeginningoftheyear,valuedat$1,willbesoldduringtheyearatanexcellentprofit.Itisestimatedthatourincomewillbeincreasedbymeansofthismethodtotheextentofat least$150,000,000perannumwhich,byacoincidence,willabout equal the amount of the writedown to be made each year againstContingencyReserve.

A minority report of the Special Committee recommends that AccountsReceivableandCashalsobewrittendownto$1, in the interestofconsistencyandtogainadditionaladvantagessimilartothosejustdiscussed.Thisproposalhasbeen rejected for the timebeingbecauseourauditors still require that anyrecoveriesofreceivablesandcashsochargedoffbecreditedtosurplusinsteadoftotheyear’sincome.Itisexpected,however,thatthisauditingrule—whichis

rather reminiscent of the horse-and-buggy days—will soon be changed in linewith modern tendencies. Should this occur, the minority report will be givenfurtherandfavorableconsideration.5.ReplacementofPreferredStockbyNon-InterestBearingBondsRedeemableat50%Discount.

Duringtherecentdepressionmanycompanieshavebeenabletooffsettheiroperatinglossesbyincludinginincomeprofitsarisingfromrepurchasesoftheirownbondsat a substantialdiscount frompar.Unfortunately thecreditofU.S.SteelCorporationhasalwaysstoodsohighthatthislucrativesourceofrevenuehasnothithertobeenavailabletoit.TheModernizationSchemewillremedythiscondition.

Itisproposedthateachshareofpreferredstockbeexchangedfor$300facevalue of non-interest-bearing sinking-fund notes, redeemable by lot at 50%offace value in 10 equal annual installments. This will require the issuance of$1,080,000,000ofnewnotes,ofwhich$108,000,000willberetiredeachyearatacosttotheCorporationofonly$54,000,000,thuscreatinganannualprofitofthesameamount.

Like the wage-and/or-salary plan described under 3. above, thisarrangement will benefit both the Corporation and its preferred stockholders.Thelatterareassuredpaymentfortheirpresentsharesat150%ofparvalueoveranaverageperiodoffiveyears.Sinceshort-termsecuritiesyieldpracticallynoreturnatpresent, thenon-interest-bearingfeature isofnoreal importance.TheCorporationwillconvertitspresentannualchargeof$25,000,000forpreferreddividends into an annual bond-retirementprofit of $54,000,000—an aggregateyearlygainof$79,000,000.6.EstablishmentofaContingencyReserveof$1,000,000,000.

TheDirectorsareconfident that the improvementshereinbeforedescribedwillassuretheCorporationofasatisfactoryearningpowerunderallconditionsinthefuture.Undermodernaccountingmethods,however, it isunnecessarytoincur the slightest risk of loss through adverse business developments of anysort,sinceallthesemaybeprovidedforinadvancebymeansofaContingencyReserve.

TheSpecialCommitteehasrecommendedthattheCorporationcreatesuchaContingencyReserve in the fairly substantial amount of $1,000,000,000.Aspreviouslyset forth, theannualwritedownof inventoryof$1willbeabsorbedby this reserve.Topreventeventualexhaustionof theContingencyReserve, ithas been further decided that it be replenished each year by transfer of anappropriate sum fromCapital Surplus. Since the latter is expected to increase

each year by not less than $250,000,000 through the exercise of the StockOptionWarrants (see 3. above), it will readily make good any drains on theContingencyReserve.

In setting up this arrangement, the Board of Directors must confessregretfully that they have been unable to improve upon the devices alreadyemployedbyimportantcorporationsintransferringlargesumsbetweenCapital,Capital Surplus, Contingency Reserves and other Balance Sheet Accounts. Infact,itmustbeadmittedthatourentrieswillbesomewhattoosimple,andwilllackthatelementofextrememystificationthatcharacterizesthemostadvancedprocedure in this field. The Board of Directors, however, have insisted uponclarityandsimplicityinframingtheirModernizationPlan,evenatthesacrificeofpossibleadvantagetotheCorporation’searningpower.

In order to show the combined effect of the new proposals upon theCorporation’searningpower,wesubmitherewithacondensedIncomeAccountfor1935ontwobases,viz:

A.AsReported

B.Pro-FormaGivingEffecttoChangesProposed

HerewithGrossReceiptsfromallSources(IncludingInterCompany)

$765,000,000 $765,000,000

SalariesandWages 251,000,000—

OtherOperatingExpensesandTaxes 461,000,000 311,000,000

Depreciation 47,000,000 (50,000,000)

Interest 5,000,000 5,000,000

DiscountonBondsRetired — (54,000,000)

PreferredDividends 25,000,000—

BalanceforCommon (24,000,000) 553,000,000

AverageSharesOutstanding 8,703,252 11,203,252

EarnedPerShare ($2.76)$49.80

In accordance with a somewhat antiquated custom there is appendedherewithacondensedpro-formaBalanceSheetoftheU.S.SteelCorporationasof December 31, 1935, after giving effect to proposed changes in asset andliabilityaccounts.

ASSETSFixedAssets,net ($1,000,000,000)

CashAssets 142,000,000

Receivables 56,000,000

Inventory 1

MiscellaneousAssets 27,000,000Total ($774,999,999)

LIABILITIESCommonStockPar1¢(ParValue$87,032.52)StatedValue* ($3,500,000,000)Subsidiaries’BondsandStocks 113,000,000

NewSinkingFundNotes 1,080,000,000

CurrentLiabilities 69,000,000

ContingencyReserve 1,000,000,000

OtherReserves 74,000,000

InitialSurplus 389,000,001Total ($774,999,999)*Given a StatedValue differing fromParValue, in accordancewith the

lawsoftheStateofVirginia,wherethecompanywillbere-incorporated.

It is perhaps unnecessary to point out to our stockholders that modernaccounting methods give rise to balance sheets differing somewhat inappearance from those of a less advanced period. In view of the very largeearningpower thatwill result fromthesechanges in theCorporation’sBalanceSheet,itisnotexpectedthatundueattentionwillbepaidtothedetailsofassetsandliabilities.

Inconclusion,theBoarddesirestopointoutthatthecombinedprocedure,wherebyplantwillbecarriedataminusfigure,ourwagebillwillbeeliminated,andinventorywillstandonourbooksatvirtuallynothing,willgiveU.S.SteelCorporation an enormous competitive advantage in the industry. We shall beable to sell our products at exceedingly lowprices and still showa handsomemarginofprofit.It is theconsideredviewoftheBoardofDirectorsthatundertheModernizationSchemeweshallbeabletoundersellallcompetitorstosuchapointthattheanti-trustlawswillconstitutetheonlybarrierto100%dominationoftheindustry.

Inmakingthisstatement,theBoardisnotunmindfulofthepossibilitythatsome of our competitors may seek to offset our new advantages by adoptingsimilar accounting improvements.We are confident, however, that U.S. Steelwill be able to retain the loyalty of its customers, old and new, through theuniqueprestigethatwillaccruetoitastheoriginatorandpioneerinthesenewfieldsofservicetotheuserofsteel.Shouldnecessityarise,moreover,webelieveweshallbeable tomaintainourdeservedsuperiorityby introducingstillmoreadvancedbookkeepingmethods,whichareevennowunderdevelopmentinourExperimentalAccountingLaboratory.

B.StandardSetting64

Afewdecadesago,anArthurAndersenauditopinionwasthegoldstandardoftheprofession.Withinthefirm,aneliteProfessionalStandardsGroup(PSG)insistedonhonestreporting,nomatterwhatpressureswereappliedbytheclient.Stickingtotheseprinciples,thePSGtookastandin1992thatthecostofstockoptionsshouldberecordedastheexpenseitclearlywas.ThePSG’spositionwasreversed, however, by the “rainmaking” partners ofAndersenwhoknewwhat

theirclientswanted—higherreportedearningsnomatterwhatthereality.ManyCEOsalsofoughtexpensingbecausetheyknewthattheobscenemega-grantsofoptions they craved would be slashed if the true costs of these had to berecorded.

Soon after the Andersen reversal, the independent accounting standardsboard (FASB)voted7-0 forexpensingoptions.Predictably, themajorauditingfirmsandanarmyofCEOsstormedWashington topressure theSenate—whatbetterinstitutiontodecideaccountingquestions?—intocastratingtheFASB.Thevoices of the protesters were amplified by their large political contributions,usuallymadewith corporatemoneybelonging to the very owners about to bebamboozled.Itwasnotasightforacivicsclass.

To itsshame, theSenatevoted88-9againstexpensing.SeveralprominentSenatorsevencalledforthedemiseoftheFASBifitdidn’tabandonitsposition.(Somuchforindependence.)ArthurLevitt,Jr.,thenChairmanoftheSEC—andgenerallyavigilantchampionofshareholders—hassincedescribedhisreluctantbowingtoCongressionalandcorporatepressuresastheactofhischairmanshipthat he most regrets. (The details of this sordid affair are related in Levitt’sexcellentbook,TakeontheStreet.)

With theSenate in itspocket and theSECoutgunned, corporateAmericaknewthatitwasnowbosswhenitcametoaccounting.Withthat,aneweraofanything-goesearningsreports—blessedand,insomecases,encouragedbybig-name auditors—was launched. The licentious behavior that followed quicklybecameanairpumpforTheGreatBubble.

AfterbeingthreatenedbytheSenate,FASBbackedoffitsoriginalpositionandadoptedan“honorsystem”approach,declaringexpensingtobepreferablebutalsoallowingcompaniestoignorethecostiftheywished.Thedishearteningresult:Ofthe500companiesintheS&P,498adoptedthemethoddeemedlessdesirable, which of course let them report higher “earnings.” Compensation-hungry CEOs loved this outcome: Let FASB have the honor; they had thesystem.

C.StockOptions65

The most egregious case of let’s-not-face-up-to-reality behavior byexecutives and accountants has occurred in the world of stock options. InBerkshire’s1985annualreport,Ilaidoutmyopinionsabouttheuseandmisuseofoptions.66Butevenwhenoptionsarestructuredproperly,theyareaccountedforinwaysthatmakenosense.Thelackoflogicisnotaccidental:Fordecades,

muchofthebusinessworldhaswagedwaragainstaccountingrulemakers,tryingto keep the costs of stock options from being reflected in the profits of thecorporationsthatissuethem.

Typically, executives have argued that options are hard to value and thatthereforetheircostsshouldbeignored.Atother timesmanagershavesaidthatassigning a cost to optionswould injure small start-up businesses. Sometimestheyhave even solemnlydeclared that “out-of-the-money”options (thosewithanexercisepriceequaltoorabovethecurrentmarketprice)havenovaluewhentheyareissued.

Oddly,theCouncilofInstitutionalInvestorshaschimedinwithavariationonthattheme,opiningthatoptionsshouldnotbeviewedasacostbecausethey“aren’t dollars out of a company’s coffers.” I see this line of reasoning asofferingexcitingpossibilities toAmericancorporationsfor instantly improvingtheirreportedprofits.Forexample,theycouldeliminatethecostofinsurancebypayingforitwithoptions.Soifyou’reaCEOandsubscribetothis“nocash-nocost”theoryofaccounting,I’llmakeyouanofferyoucan’trefuse:GiveusacallatBerkshireandwewillhappilysellyouinsuranceinexchangeforabundleoflong-termoptionsonyourcompany’sstock.

Shareholders should understand that companies incur costs when theydeliver something of value to another party and not just when cash changeshands.Moreover,itisbothsillyandcynicaltosaythatanimportantitemofcostshould not be recognized simply because it can’t be quantified with pinpointprecision. Right now, accounting abounds with imprecision. After all, nomanagerorauditorknowshowlonga747isgoingtolast,whichmeanshealsodoesnotknowwhattheyearlydepreciationchargefortheplaneshouldbe.Nooneknowswithanycertaintywhatabank’sannualloanlosschargeoughttobe.And the estimates of losses that property casualty companies make arenotoriouslyinaccurate.

Doesthismeanthattheseimportantitemsofcostshouldbeignoredsimplybecausetheycan’tbequantifiedwithabsoluteaccuracy?Ofcoursenot.Rather,these costs should be estimated by honest and experienced people and thenrecorded.Whenyougetrightdowntoit,whatotheritemofmajorbuthard-to-precisely-calculatecost—other,thatis,thanstockoptions—doestheaccountingprofessionsayshouldbeignoredinthecalculationofearnings?

Moreover, options are just not that difficult to value. Admittedly, thedifficulty is increased by the fact that the options given to executives arerestrictedinvariousways.Theserestrictionsaffectvalue.Theydonot,however,eliminate it. In fact, since I’m in the mood for offers, I’ll make one to anyexecutivewho isgranteda restrictedoption, even though itmaybeoutof the

money:Onthedayofissue,Berkshirewillpayhimorherasubstantialsumfortherighttoanyfuturegainheorsherealizesontheoption.SoifyoufindaCEOwhosayshisnewly-issuedoptionshavelittleornovalue,tellhimtotryusout.Intruth,wehavefarmoreconfidenceinourabilitytodetermineanappropriateprice topay for anoption thanwehave inour ability todetermine theproperdepreciationratefor[a]corporatejet.

TheaccountingprofessionandtheSECshouldbeshamedbythefactthattheyhavelongletthemselvesbemuscledbybusinessexecutivesontheoption-accountingissue.Additionally,thelobbyingthatexecutivesengageinmayhavean unfortunate by-product: In my opinion, the business elite risks losing itscredibilityonissuesofsignificancetosociety—aboutwhichitmayhavemuchof value to say—when it advocates the incredible on issues of significance toitself.

Our General Re acquisition put a spotlight on an egregious flaw inaccounting procedure. Sharp-eyed shareholders reading our proxy statementprobably noticed an unusual item on page 60. In the pro-forma statement ofincome—which detailed how the combined 1997 earnings of the two entitieswould have been affected by the merger—there was an item stating thatcompensationexpensewouldhavebeenincreasedby$63million.

This item,wehasten to add, doesnot signal that eitherCharlieor I haveexperiencedamajorpersonalitychange.(Hestill travelscoachandquotesBenFranklin.) Nor does it indicate any shortcoming in General Re’s accountingpractices, which have followed GAAP to the letter. Instead, the pro-formaadjustment came about because we are replacing General Re’s longstandingstock option plan with a cash plan that ties the incentive compensation ofGeneralRemanagers to their operating achievements. Formerlywhat countedfor thesemanagerswasGeneralRe’s stock price; now their payoffwill comefromthebusinessperformancetheydeliver.

The new plan and the terminated option arrangement have matchingeconomics,whichmeansthattherewardstheydelivertoemployeesshould,foragiven level of performance, be the same. But what these people could haveformerlyanticipatedearning fromnewoptiongrantswillnowbepaid incash.(Optionsgrantedinpastyearsremainoutstanding.)

Thoughthetwoplansareaneconomicwash,thecashplanweareputtinginwill produce a vastly different accounting result. ThisAlice-in-Wonderlandoutcomeoccursbecauseexistingaccountingprinciples ignore thecostofstockoptionswhenearningsarebeingcalculated,eventhoughoptionsareahugeand

increasingexpenseatagreatmanycorporations.Ineffect,accountingprinciplesoffermanagementachoice:Payemployees inone formandcount thecost,orpaytheminanotherformandignorethecost.Smallwonderthenthattheuseofoptionshasmushroomed.Thislop-sidedchoicehasabigdownsideforowners,however:Thoughoptions,ifproperlystructured,canbeanappropriate,andevenideal,waytocompensateandmotivatetopmanagers,theyaremoreoftenwildlycapricious in their distribution of rewards, inefficient as motivators, andinordinatelyexpensiveforshareholders.

Whatever the merits of options may be, their accounting treatment isoutrageous.Thinkforamomentofthat$190millionwearegoingtospendforadvertisingatGEICOthisyear.Supposethatinsteadofpayingcashforourads,wepaid themedia in ten-year, at-the-marketBerkshireoptions.WouldanyonethencaretoarguethatBerkshirehadnotborneacostforadvertising,orshouldnotbechargedthiscostonitsbooks?

PerhapsBishopBerkeley—youmayrememberhimasthephilosopherwhomusedabout trees falling ina forestwhennoonewasaround—wouldbelievethatanexpenseunseenbyanaccountantdoesnotexist.CharlieandI,however,have trouble being philosophical about unrecorded costs. When we considerinvesting in an option-issuing company, we make an appropriate downwardadjustmenttoreportedearnings,simplysubtractinganamountequaltowhatthecompany could have realized by publicly selling options of like quantity andstructure. Similarly, if we contemplate an acquisition, we include in ourevaluation the cost of replacing anyoptionplan.Then, ifwemake adeal,wepromptlytakethatcostoutofhiding.

Readerswhodisagreewithmeaboutoptionswillbythistimebementallyquarrelingwithmyequatingthecostofoptionsissuedtoemployeeswiththosethatmight theoretically be sold and traded publicly. It is true, to state one ofthese arguments, that employee options are sometimes forfeited—that lessensthedamagedone to shareholders—whereaspublicly-offeredoptionswouldnotbe. It is true, also, that companies receive a tax deduction when employeeoptions are exercised; publicly-traded options deliver no such benefit. Butthere’sanoffsettothesepoints:Optionsissuedtoemployeesareoftenrepriced,atransformationthatmakesthemmuchmorecostlythanthepublicvariety.

It’ssometimesarguedthatanon-transferableoptiongiventoanemployeeis less valuable to him than would be a publicly-traded option that he couldfreelysell.Thatfact,however,doesnotreducethecostofthenon-transferableoption: Giving an employee a company car that can only be used for certainpurposesdiminishesitsvaluetotheemployee,butdoesnotintheleastdiminishitscosttotheemployer.

The earning revisions thatCharlie and I havemade for options in recentyearshavefrequentlycutthereportedper-sharefiguresby5%,with10%notallthatuncommon.Onoccasion,thedownwardadjustmenthasbeensogreatthatithasaffectedourportfoliodecisions,causinguseithertomakeasaleortopassonastockpurchasewemightotherwisehavemade.

A few years ago we asked three questions to which we have not yetreceivedananswer:“Ifoptionsaren’taformofcompensation,whatarethey?Ifcompensationisn’tanexpense,whatisit?And,ifexpensesshouldn’tgointothecalculationofearnings,whereintheworldshouldtheygo?”

[T]hemost important accountingmechanism still available toCEOswhowish to overstate earnings [is] the non-expensing of stock options. Theaccomplices in perpetuating this absurdity have been many members ofCongresswhohavedefiedtheargumentsputforthbyallBigFourauditors,allmembers of the Financial Accounting Standards Board and virtually allinvestment professionals. [T]o his great credit, Bill Donaldson, the investor-mindedChairmanof theSEC[from2003to2005],stoodfirmagainstmassivepolitical pressure, generated by the check-waving CEOs who first muscledCongress in 1993 about the issue of option accounting and then repeated thetacticlastyear.

Because the attempts to obfuscate the stock-option issue continue, it’sworthpointingoutthatnoone—neithertheFASB,norinvestorsgenerally,norI—are talking about restricting the use of options in any way. Indeed, mysuccessor at Berkshire may well receive much of his pay via options, albeitlogically-structured ones in respect to (1) an appropriate strike price, (2) anescalation in price that reflects the retention of earnings, and (3) a ban on hisquickly disposing of any shares purchased through options. We cheerarrangementsthatmotivatemanagers,whetherthesebecashbonusesoroptions.And if a company is truly receivingvalue for the options it issues,we see noreasonwhyrecordingtheircostshouldcutdownontheiruse.

ThesimplefactisthatcertainCEOsknowtheirowncompensationwouldbe farmore rationallydetermined ifoptionswereexpensed.Theyalsosuspectthattheirstockwouldsellatalowerpriceifrealisticaccountingwereemployed,meaning that they would reap less in the market when they unloaded theirpersonal holdings. To these CEOs such unpleasant prospects are a fate to befoughtwithalltheresourcestheyhaveathand—eventhoughthefundstheyusein that fight normally don’t belong to them, but are instead put up by theirshareholders.Option-expensing[became]mandatoryonJune15[2005].

D.“Restructuring”Charges67

The role that managements have played in stock-option accounting hashardly been benign:A distressing number of bothCEOs and auditors have inrecentyearsbitterlyfoughtFASB’sattemptstoreplaceoptionfictionwithtruthand virtually none have spoken out in support of FASB. Its opponents evenenlistedCongressinthefight,pushingthecasethatinflatedfigureswereinthenationalinterest.

Still,Ibelievethatthebehaviorofmanagementshasbeenevenworsewhenit comes to restructurings and merger accounting. Here, many managementspurposefully work at manipulating numbers and deceiving investors. And, asMichaelKinsleyhassaidaboutWashington:“Thescandal isn’t inwhat’sdonethat’sillegalbutratherinwhat’slegal.”

Itwasoncerelativelyeasytotellthegoodguysinaccountingfromthebad:Thelate1960’s,forexample,broughtonanorgyofwhatonecharlatandubbed“bold, imaginative accounting” (the practice ofwhich, incidentally,made himlovedforatimebyWallStreetbecausehenevermissedexpectations).Butmostinvestors of that period knew who was playing games. And, to their credit,virtuallyallofAmerica’smost-admiredcompaniesthenshunneddeception.

In recent years, probity has eroded. Many major corporations still playthings straight, but a significant and growing number of otherwise high-grademanagers—CEOsyouwouldbehappytohaveasspousesforyourchildrenorastrustees under your will—have come to the view that it’s okay tomanipulateearnings to satisfy what they believe are Wall Street’s desires. Indeed, manyCEOsthinkthiskindofmanipulationisnotonlyokay,butactuallytheirduty.

Thesemanagersstartwiththeassumption,alltoocommon,thattheirjobatalltimesistoencouragethehigheststockpricepossible(apremisewithwhichwe adamantly disagree). To pump the price, they strive, admirably, foroperationalexcellence.Butwhenoperationsdon’tproducetheresulthopedfor,these CEOs resort to unadmirable accounting stratagems. These eithermanufacturethedesired“earnings”orsetthestagefortheminthefuture.

Rationalizingthisbehavior,thesemanagersoftensaythattheirshareholderswillbehurt if theircurrencyfordoingdeals—that is, theirstock—isnotfully-priced, and they also argue that in using accounting shenanigans to get thefigurestheywant,theyareonlydoingwhateverybodyelsedoes.Oncesuchaneverybody’s-doing-it attitude takes hold, ethical misgivings vanish. Call thisbehaviorSonofGresham:Badaccountingdrivesoutgood.

Thedistortiondujouristhe“restructuringcharge,”anaccountingentrythatcan, of course, be legitimate but that too often is a device for manipulating

earnings.Inthisbitoflegerdemain,alargechunkofcoststhatshouldproperlybeattributedtoanumberofyearsisdumpedintoasinglequarter,typicallyonealreadyfatedtodisappointinvestors.Insomecases,thepurposeofthechargeistocleanupearningsmisrepresentationsofthepast,andinothersitistopreparetheground for futuremisrepresentations. In either case, the size and timingofthesechargesisdictatedbythecynicalpropositionthatWallStreetwillnotmindif earnings fall short by $5 per share in a given quarter, just as long as thisdeficiencyensuresthatquarterlyearningsinthefuturewillconsistentlyexceedexpectationsbyfivecentspershare.

This dump-everything-into-one-quarter behavior suggests a corresponding“bold,imaginative”approachto—golfscores.Inhisfirstroundoftheseason,agolfer should ignore his actual performance and simply fill his card withatrociousnumbers—double, triple,quadruplebogeys—andthenturn inascoreof,say,140.Havingestablishedthis“reserve,”heshouldgotothegolfshopandtellhisprothathewishesto“restructure”hisimperfectswing.Next,ashetakeshisnewswingontothecourse,heshouldcounthisgoodholes,butnotthebadones. These remnants from his old swing should be charged instead to thereserve established earlier. At the end of five rounds, then, his recordwill be140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92. OnWall Street, they willignore the140—which,afterall,camefroma“discontinued”swing—andwillclassifyourheroasan80shooter(andonewhoneverdisappoints).

For those who prefer to cheat up front, there would be a variant of thisstrategy. The golfer, playing alone with a cooperative caddy-auditor, shoulddefer the recordingofbadholes, take four80s, accept theplauditshegets forsuch athleticism and consistency, and then turn in a fifth card carrying a 140score.Afterrectifyinghisearlierscorekeepingsinswiththis“bigbath,”hemaymumble a few apologies but will refrain from returning the sums he haspreviously collected from comparing scorecards in the clubhouse. (The caddy,needweadd,willhaveacquiredaloyalpatron.)

Unfortunately,CEOswhouse variations of these scoring schemes in reallifetendtobecomeaddictedtothegamesthey’replaying—afterall,it’seasiertofiddle with the scorecard than to spend hours on the practice tee—and nevermuster the will to give them up. Their behavior brings to mind Voltaire’scommentonsexualexperimentation:“Onceaphilosopher,twiceapervert.”

In the acquisition arena, restructuring has been raised to an art form:Managementsnowfrequentlyusemergerstodishonestlyrearrangethevalueofassets and liabilities in ways that will allow them to both smooth and swellfutureearnings.Indeed,atdeal time,majorauditingfirmssometimespointoutthepossibilitiesforalittleaccountingmagic(orforalot).Gettingthispushfrom

the pulpit, first-class people will frequently stoop to third-class tactics. CEOsunderstandablydonotfinditeasytorejectauditor-blessedstrategiesthatleadtoincreasedfuture“earnings.”

An example from theproperty-casualty insurance industrywill illuminatethe possibilities. When a p-c company is acquired, the buyer sometimessimultaneously increases its loss reserves, often substantially. This boost maymerely reflect theprevious inadequacyof reserves—though it is uncannyhowoftenanactuarial“revelation”ofthiskindcoincideswiththeinkingofadeal.Inanycase,themovesetsupthepossibilityof“earnings”flowingintoincomeatsomelaterdate,asreservesarereleased.

Berkshirehaskeptentirelyclearofthesepractices:Ifwearetodisappointyou,wewouldratheritbewithourearningsthanwithouraccounting.Inallofouracquisitions,wehaveleftthelossreservefiguresexactlyaswefoundthem.After all,wehaveconsistently joinedwith insurancemanagersknowledgeableabouttheirbusinessandhonestintheirfinancialreporting.Whendealsoccurinwhich liabilitiesare increased immediatelyandsubstantially, simple logic saysthatatleastoneofthosevirtuesmusthavebeenlacking—or,alternatively,thattheacquirerislayingthegroundworkforfutureinfusionsof“earnings.”

Here’s a true story that illustrates an all-too-common view in corporateAmerica.TheCEOsoftwolargebanks,oneofthemamanwho’dmademanyacquisitions,wereinvolvednotlongagoinafriendlymergerdiscussion(whichin theenddidn’tproduceadeal).Theveteranacquirerwasexpoundingon themerits of the possible combination, only to be skeptically interrupted by theotherCEO:“Butwon’tthatmeanahugecharge,”heasked,“perhapsasmuchas$1billion?”The“sophisticate”wastednowords:“We’llmakeitbiggerthanthat—that’swhywe’redoingthedeal.”

A preliminary tally by R.G. Associates, of Baltimore, of special chargestaken or announced during 1998—that is, charges for restructuring, in-processR&D,merger-related items, andwritedowns—identified no less than 1,369 ofthese,totaling$72.1billion.Thatisastaggeringamountasevidencedbythisbitofperspective:The1997earningsofthe500companiesinFortune’sfamouslisttotaled$324billion.

Clearly the attitude of disrespect that many executives have today foraccurate reporting is a business disgrace. And auditors, as we have alreadysuggested,havedonelittleon thepositiveside.Thoughauditorsshould regardtheinvestingpublicastheirclient,theytendtokowtowinsteadtothemanagerswhochoosethemanddoleouttheirpay.(“WhosebreadIeat,hissongIsing.”)

Abigpieceofnews,however,isthattheSEC,ledbyitschairman,ArthurLevitt, seems determined to get corporate America to clean up its act. In a

landmark speech last September, Levitt called for an end to “earningsmanagement.”Hecorrectlyobserved,“Toomanycorporatemanagers,auditorsandanalystsareparticipantsinagameofnodsandwinks.”Andthenhelaidonarealindictment:“Managingmaybegivingwaytomanipulating;integritymaybelosingouttoillusion.”

IurgeyoutoreadtheChairman’sspeech(youcanfinditontheInternetatwww.sec.gov) and to support him in his efforts to get corporate America todeliverastraightstorytoitsowners.Levitt’sjobwillbeHerculean,butitishardtothinkofanothermoreimportantforhimtotakeon.

E.PensionEstimates68

[Continuing problem-areas arise from] accounting choices—importantamong these the investment-return assumption a company uses in calculatingpensionexpense. Itwill comeasno surprise thatmanycompaniescontinue tochooseanassumptionthatallowsthemtoreportless-than-solid“earnings.”Forthe363companiesintheS&Pthathavepensionplans,thisassumptionin2006averaged8%.Let’slookatthechancesofthatbeingachieved.

Theaverageholdingsofbondsandcashforallpensionfundsisabout28%,and on these assets returns can be expected to be no more than 5%. Higheryields,ofcourse,areobtainablebuttheycarrywiththemariskofcommensurate(orgreater)loss.

Thismeansthattheremaining72%ofassets—whicharemostlyinequities,either held directly or through vehicles such as hedge funds or private-equityinvestments—must earn 9.2% in order for the fund overall to achieve thepostulated8%.Andthatreturnmustbedeliveredafterall fees,whicharenowfarhigherthantheyhaveeverbeen.

How realistic is this expectation? During the 20th Century, the Dowadvancedfrom66to11,497.Thisgain,thoughitappearshuge,shrinksto5.3%when compounded annually.An investorwho owned theDow throughout thecenturywouldalsohavereceivedgenerousdividendsformuchoftheperiod,butonlyabout2%orsointhefinalyears.Itwasawonderfulcentury.

Think now about this century. For investors to merely match that 5.3%market-value gain, the Dow—recently below 13,000—would need to close atabout 2,000,000 on December 31, 2099. We are now eight years into thiscentury,andwehaverackeduplessthan2,000ofthe1,988,000Dowpointsthemarketneededtotravelinthishundredyearstoequalthe5.3%ofthelast.

It’samusing thatcommentators regularlyhyperventilateat theprospectof

theDow crossing an even number of thousands, such as 14,000 or 15,000. Iftheykeepreactingthatway,a5.3%annualgainforthecenturywillmeantheyexperience at least 1,986 seizures during the next 92 years.While anything ispossible,doesanyonereallybelievethisisthemostlikelyoutcome?

Dividends continue to run about 2%. Even if stockswere to average the5.3% annual appreciation of the 1900s, the equity portion of plan assets—allowingforexpensesof.5%—wouldproducenomorethan7%orso.And.5%maywellunderstatecosts,giventhepresenceoflayersofconsultantsandhighpricedmanagers(“helpers”).

Naturally,everyoneexpectstobeaboveaverage.Andthosehelpers—blesstheirhearts—willcertainlyencouragetheirclientsinthisbelief.But,asaclass,the helper-aided group must be below average. The reason is simple: 1)Investors, overall, will necessarily earn an average return, minus costs theyincur;2)Passiveandindexinvestors,throughtheirveryinactivity,willearnthataverage minus costs that are very low; 3) With that group earning averagereturns,somust theremaininggroup—theactiveinvestors.But thisgroupwillincur high transaction,management, and advisory costs. Therefore, the activeinvestorswillhavetheirreturnsdiminishedbyafargreaterpercentagethanwilltheir inactive brethren. That means that the passive group—the “know-nothings”—mustwin.

I should mention that people who expect to earn 10% annually fromequities during this century—envisioning that 2% of that will come fromdividendsand8%frompriceappreciation—areimplicitlyforecastingalevelofabout24,000,000ontheDowby2100.Ifyouradvisertalkstoyouaboutdoubledigit returnsfromequities,explain thismath tohim—not that itwill fazehim.Many helpers are apparently direct descendants of the queen in Alice inWonderland, who said: “Why, sometimes I’ve believed as many as siximpossiblethingsbeforebreakfast.”Bewaretheglibhelperwhofillsyourheadwithfantasieswhilehefillshispocketswithfees.

SomecompanieshavepensionplansinEuropeaswellasintheU.S.and,intheiraccounting,almostallassumethat theU.S.planswillearnmore than thenon-U.S.plans.Thisdiscrepancyispuzzling:Whyshouldthesecompaniesnotput theirU.S.managers in chargeof thenon-U.S.pensionassets and let themworktheirmagicontheseassetsaswell?I’veneverseenthispuzzleexplained.But the auditors and actuaries who are charged with vetting the returnassumptionsseemtohavenoproblemwithit.

F.RealizationEvents69

Let’sfocusonanumber[that]manyinthemediafeatureaboveallothers:net income. Important though that number may be at most companies, it isalmost always meaningless at Berkshire. Regardless of how our businessesmight be doing, Charlie and I could—quite legally—cause net income in anygivenperiodtobealmostanynumberwewouldlike.

Wehavethatflexibilitybecauserealizedgainsorlossesoninvestmentsgointothenetincomefigure,whereasunrealizedgains(and,inmostcases,losses)areexcluded.Forexample,imaginethatBerkshirehada$10billionincreaseinunrealized gains in a given year and concurrently had $1 billion of realizedlosses.Ournetincome—whichwouldcountonlytheloss—wouldbereportedasless than our operating income. If we had meanwhile realized gains in thepreviousyear,headlinesmightproclaimthatourearningsweredownX%wheninrealityourbusinessmightbemuchimproved.

Ifwereallythoughtnetincomeimportant,wecouldregularlyfeedrealizedgains into it simplybecausewehave ahuge amount of unrealizedgainsuponwhich to draw. Rest assured, though, that Charlie and I have never sold asecuritybecauseoftheeffectasalewouldhaveonthenetincomeweweresoonto report. We both have a deep disgust for “game playing” with numbers, apractice thatwas rampant throughout corporateAmerica in the1990sand stillpersists,thoughitoccurslessfrequentlyandlessblatantlythanitusedto.

Operating earnings, despite having some shortcomings, are in general areasonable guide as to how our businesses are doing. Ignore our net incomefigure, however. Regulations require that we report it to you. But if you findreportersfocusingonit,thatwillspeakmoretotheirperformancethanours.

Both realized and unrealized gains and losses are fully reflected in thecalculationofourbookvalue.Payattentiontothechangesinthatmetricandtothecourseofouroperatingearnings,andyouwillbeontherighttrack.

62[Introductoryessay,1988.]63[1990AppendixA.]*AnunpublishedsatirebyBenGraham,writtenin1936andgivenbythe

authortoWarrenBuffettin1954.64[2002.]65[Dividedbyhashlines:1992;1998;2004.]66[SeetheessayAPrincipledApproachtoExecutivePayinPartI.F.]67[1998.]68[2007.]69[2010.]

VIII.ACCOUNTINGPOLICY

A.Mergers70

[The application of accounting to acquisitions] is currently a verycontentious topic and, before the dust settles,Congressmay even intervene (atrulyterribleidea).

When a company is acquired, generally accepted accounting principles(“GAAP”) currently condone two very different ways of recording thetransaction:“purchase”and“pooling.”Inapooling,stockmustbethecurrency;in a purchase, payment can be made in either cash or stock. Whatever thecurrency, managements usually detest purchase accounting because it almostalways requires that a “goodwill” account be established and subsequentlywritten off—a process that saddles earnings with a large annual charge thatnormally persists for decades. In contrast, pooling avoids a goodwill account,whichiswhymanagementsloveit.

Now,theFinancialAccountingStandardsBoard(“FASB”)hasproposedanend topooling, andmanyCEOsaregirding forbattle. Itwill be an importantfight, sowe’llventure someopinions.Tobeginwith,weagreewith themanymanagerswhoarguethatgoodwillamortizationchargesareusuallyspurious.71

For accounting rules tomandate amortization thatwill, in the usual case,conflictwith reality is deeply troublesome:Most accounting charges relate towhat’s going on, even if they don’t precisely measure it. As an example,depreciation charges can’t with precision calibrate the decline in value thatphysical assets suffer, but these charges do at least describe something that istruly occurring: Physical assets invariably deteriorate. Correspondingly,obsolescence charges for inventories, bad debt charges for receivables andaccrualsforwarrantiesareamongthechargesthatreflecttruecosts.Theannualcharges for these expenses can’t be exactly measured, but the necessity forestimatingthemisobvious.

Incontrast,economicgoodwilldoesnot, inmanycases,diminish.Indeed,inagreatmanyinstances—perhapsmost—itactuallygrowsinvalueovertime.Incharacter,economicgoodwill ismuch like land:Thevalueofbothassets issure to fluctuate, but thedirection inwhichvalue is going to go is in nowayordained.AtSee’s, forexample,economicgoodwillhasgrown, inan irregularbut very substantial manner, for 78 years. And, if we run the business right,

growthofthatkindwillprobablycontinueforatleastanother78years.To escape from the fiction of goodwill charges, managers embrace the

fictionofpooling.Thisaccountingconventionisgroundedinthepoeticnotionthatwhen tworiversmerge their streamsbecome indistinguishable.Under thisconcept,acompany thathasbeenmerged intoa largerenterprisehasnotbeen“purchased” (even though it will often have received a large “sell-out”premium). Consequently, no goodwill is created, and those pesky subsequentchargestoearningsareeliminated.Instead,theaccountingfortheongoingentityishandledasifthebusinesseshadforeverbeenoneunit.

Somuchforpoetry.Therealityofmergingisusuallyfardifferent:Thereisindisputablyanacquirerandanacquiree,andthelatterhasbeen“purchased,”nomatter how the deal has been structured. If you think otherwise, just askemployeesseveredfromtheirjobswhichcompanywastheconquerorandwhichwas the conquered.Youwill find no confusion. So on this point the FASB iscorrect: Inmostmergers, a purchase has beenmade.Yes, there are some true“mergersofequals,”buttheyarefewandfarbetween.

Charlie and I believe there’s a reality-based approach that should bothsatisfy the FASB, which correctly wishes to record a purchase, and meet theobjectionsofmanagements tononsensical charges for diminutionof goodwill.Wewouldfirsthavetheacquiringcompanyrecorditspurchaseprice—whetherpaidinstockorcash—atfairvalue.Inmostcases,thisprocedurewouldcreatealargeasset representingeconomicgoodwill.Wewould then leave thisassetonthebooks,notrequiringitsamortization.Later,iftheeconomicgoodwillbecameimpaired, as it sometimeswould, itwould bewritten down just aswould anyotherassetjudgedtobeimpaired.

Ifourproposedruleweretobeadopted,itshouldbeappliedretroactivelyso that acquisition accountingwould be consistent throughoutAmerica—a farcry from what exists today. One prediction: If this plan were to take effect,managementswould structure acquisitionsmore sensibly, decidingwhether touse cash or stock based on the real consequences for their shareholders ratherthanontheunrealconsequencesfortheirreportedearnings.

B.SegmentDataandConsolidation72

Under one major change mandated by GAAP for 1988, we have beenrequired to fully consolidate all our subsidiaries in our balance sheet andearnings statement. In the past, Mutual Savings and Loan, and Scott FetzerFinancial (a credit company that primarily finances installment sales ofWorld

BookandKirbyproducts)wereconsolidatedona“one-line”basis.Thatmeantwe(1)showedourequityintheircombinednetworthsasasingle-entryassetonBerkshire’s consolidated balance sheet and (2) included our equity in theircombined annual earnings as a single-line income entry in our consolidatedstatementofearnings.Nowtherulesrequirethatweconsolidateeachassetandliabilityofthesecompaniesinourbalancesheetandeachitemoftheirincomeandexpenseinourearningsstatement.

Thischangeunderscores theneedforcompaniesalso to reportsegmenteddata: The greater the number of economically diverse business operationslumped together in conventional financial statements, the less useful thosepresentations are and the less able investors are to answer the three questionsposed earlier. Indeed, the only reasonwe ever prepare consolidated figures atBerkshire is to meet outside requirements. On the other hand, Charlie and Iconstantlystudyoursegmentdata.

NowthatwearerequiredtobundlemorenumbersinourGAAPstatements,wehavedecidedtopublishadditionalsupplementaryinformationthatwethinkwill help you measure both business value and managerial performance.(Berkshire’s ability todischarge itsobligations to creditors—the thirdquestionwe listed[in the introductoryessay in thisPart]—shouldbeobvious,whateverstatements you examine.) In these supplementary presentations, we will notnecessarily follow GAAP procedures, or even corporate structure. Rather, wewill attempt to lumpmajorbusinessactivities inways that aidanalysisbutdonotswampyouwithdetail.Ourgoal is togiveyouimportant information inaformthatwewouldwishtogetitifourroleswerereversed.

C.DeferredTaxes73

IreferredearliertoamajorchangeinGAAPthatisexpectedin1990.Thischangerelatestothecalculationofdeferredtaxes,andisbothcomplicatedandcontroversial—so much so that its imposition, originally scheduled for 1989,waspostponedforayear.

When implemented, the new rule will affect us in various ways. Mostimportant,wewillbe required tochange thewaywecalculateour liability fordeferred taxes on the unrealized appreciation of stocks held by our insurancecompanies.

Rightnow,ourliabilityislayered.Fortheunrealizedappreciationthatdatesbackto1986andearlieryears,$1.2billion,wehavebookeda28%taxliability.Fortheunrealizedappreciationbuiltupsince,$600million,thetaxliabilityhas

beenbookedat34%.Thedifferencereflects the increase in taxrates thatwentintoeffectin1987.

It now appears, however, that the new accounting rulewill require us toestablish the entire liability at 34% in 1990, taking the charge against ourearnings.Assuming no change in tax rates by 1990, this stepwill reduce ourearnings in thatyear (and therebyour reportednetworth)by$71million.Theproposedrulewillalsoaffectotheritemsonourbalancesheet,butthesechangeswillhaveonlyaminorimpactonearningsandnetworth.

Wehavenostrongviewsaboutthedesirabilityofthischangeincalculationofdeferredtaxes.Weshouldpointout,however,thatneithera28%nora34%tax liability precisely depicts economic reality at Berkshire since we have noplanstosellthestocksinwhichwehavethegreatbulkofourgains.

Anewaccountingruleislikelytobeadoptedthatwillrequirecompaniestoreserveagainstallgainsatthecurrenttaxrate,whateveritmaybe.Withtherateat34%,sucha rulewould increaseourdeferred tax liability,anddecreaseournetworth, by about $71million—the result of raising the reserve on our pre-1987 gain by six percentage points. Because the proposed rule has sparkedwidespreadcontroversyanditsfinalformisunclear,wehavenotyetmadethischange.

[W]ewouldowetaxesofmorethan$1.1billionwerewetosellallofoursecurities at yearendmarketvalues. Is this$1.1billion liability equal, or evensimilar,toa$1.1billionliabilitypayabletoatradecreditor15daysaftertheendof the year?Obviously not—despite the fact that both items have exactly thesameeffectonauditednetworth,reducingitby$1.1billion.

On the other hand, is this liability for deferred taxes a meaninglessaccounting fiction because its payment can be triggered only by the sale ofstocksthat,inverylargepart,wehavenointentionofselling?Again,theanswerisno.

In economic terms, the liability resembles an interest-free loan from theU.S.Treasury thatcomesdueonlyatourelection(unless,ofcourse,Congressmoves to tax gains before they are realized). This “loan” is peculiar in otherrespectsaswell:Itcanbeusedonlytofinancetheownershipoftheparticular,appreciatedstocksand it fluctuates insize—dailyasmarketpriceschangeandperiodicallyiftaxrateschange.Ineffect,thisdeferredtaxliabilityisequivalentto a very large transfer tax that is payable only ifwe elect tomove fromoneasset to another. Indeed, we sold some relatively small holdings in 1989,incurringabout$76millionof“transfer”taxon$224millionofgains.

Because of the way the tax law works, the Rip Van Winkle style ofinvesting that we favor—if successful—has an important mathematical edgeover a more frenzied approach. We have not, we should stress, adopted ourstrategy favoring long-term investment commitments because of thesemathematics. Indeed, it is possible we could earn greater after-tax returns bymovingratherfrequentlyfromoneinvestmenttoanother.Manyyearsago,that’sexactlywhatCharlieandIdid.

Nowwewould rather stay put, even if thatmeans slightly lower returns.Our reason is simple:We have found splendid business relationships to be sorare and so enjoyable that wewant to retain all we develop. This decision isparticularly easy for us because we feel that these relationships will producegood—thoughperhapsnotoptimal—financialresults.Consideringthat,wethinkitmakeslittlesenseforustogiveuptimewithpeopleweknowtobeinterestingandadmirablefortimewithotherswedonotknowandwhoarelikelytohavehumanqualitiesfarclosertoaverage.

Anewaccountingrulehavingtodowithdeferredtaxesbecomeseffectivein1993. Itundoesadichotomy inourbooks that Ihavedescribed inpreviousannualreportsandthatrelatestotheaccruedtaxescarriedagainsttheunrealizedappreciation in our investment portfolio. At yearend 1992, that appreciationamounted to $7.6 billion.Against $6.4 billion of that,we carried taxes at thecurrent34%rate.Againsttheremainderof$1.2billion,wecarriedanaccrualof28%, the taxrate ineffectwhen thatportionof theappreciationoccurred.Thenew accounting rule says we must henceforth accrue all deferred tax at thecurrentrate,whichtousseemssensible.

The newmarching ordersmean that in the first quarter of 1993wewillapplya34%ratetoallofourunrealizedappreciation,therebyincreasingthetaxliabilityandreducingnetworthby$70million.Thenewrulealsowillcauseustomakeotherminorchangesinourcalculationofdeferredtaxes.

Futurechangesintaxrateswillbereflectedimmediatelyintheliabilityfordeferred taxes and, correspondingly, in net worth. The impact could well besubstantial.Nevertheless,whatisimportantintheendisthetaxrateatthetimewesellsecurities,whenunrealizedappreciationbecomesrealized.

D.RetireeBenefits74

Another major accounting change, whose implementation is required byJanuary1,1993,mandatesthatbusinessesrecognizetheirpresent-valueliability

for post-retirement health benefits. Though GAAP has previously requiredrecognition of pensions to be paid in the future, it has illogically ignored thecoststhatcompanieswillthenhavetobearforhealthbenefits.Thenewrulewillforcemanycompaniestorecordahugebalance-sheetliability(andaconsequentreduction in net worth) and also henceforth to recognize substantially highercostswhentheyarecalculatingannualprofits.

Inmakingacquisitions,CharlieandIhavetendedtoavoidcompanieswithsignificant post-retirement liabilities. As a result, Berkshire’s present liabilityandfuturecostsforpost-retirementhealthbenefits—thoughwenowhave[tensofthousandsof]employees—areinconsequential. Ineedtoadmit, though, thatwe had a near miss: In 1982 I made a hugemistake in committing to buy acompanyburdenedbyextraordinarypost-retirementhealthobligations.Luckily,though,thetransactionfellthroughforreasonsbeyondourcontrol.Reportingonthisepisodeinthe1982annualreport,Isaid:“Ifweweretointroducegraphicstothisreport,illustratingfavorablebusinessdevelopmentsofthepastyear,twoblank pages depicting this blown deal would be the appropriate centerfold.”Even so, I wasn’t expecting things to get as bad as they did. Another buyerappeared,thebusinesssoonwentbankruptandwasshutdown,andthousandsofworkersfoundthosebountifulhealth-carepromisestobelargelyworthless.

Inrecentdecades,noCEOwouldhavedreamedofgoingtohisboardwiththepropositionthathiscompanybecomeaninsurerofuncappedpost-retirementhealthbenefitsthatothercorporationschosetoinstall.ACEOdidn’tneedtobeamedical expert to know that lengthening life expectancies and soaring healthcosts would guarantee an insurer a financial battering from such a business.Nevertheless,many amanagerblithely committedhis owncompany to a self-insurance plan embodying precisely the same promises—and thereby doomedhis shareholders to suffer the inevitable consequences. In health-care, open-endedpromiseshavecreatedopen-endedliabilitiesthat inafewcasesloomsolargeastothreatentheglobalcompetitivenessofmajorAmericanindustries.

Ibelievepartof the reasonfor this recklessbehaviorwas thataccountingrulesdidnot,forsolong,requirethebookingofpost-retirementhealthcostsasthey were incurred. Instead, the rules allowed cash-basis accounting, whichvastlyunderstated the liabilities thatwerebuildingup. Ineffect, theattitudeofboth managements and their accountants toward these liabilities was “out-of-sight,out-of-mind.”Ironically,someofthesesamemanagerswouldbequicktocriticize Congress for employing “cash-basis” thinking in respect to SocialSecuritypromisesorotherprogramscreatingfutureliabilitiesofsize.

Managers thinking about accounting issues should never forget one ofAbrahamLincoln’sfavoriteriddles:“Howmanylegsdoesadoghaveifyoucall

histailaleg?”Theanswer:“Four,becausecallingatailalegdoesnotmakeitaleg.” It behoovesmanagers to remember thatAbe’s right even if an auditor iswillingtocertifythatthetailisaleg.

70[1999.]71[SeetheessayEconomicversusAccountingGoodwillinPartVI.D.]72[1988.]73[Dividedbyhashlines:1988;1989;1992.]74[1992.]

IX.TAXMATTERS

A.DistributionoftheCorporateTaxBurden75

TheTaxReformAct of 1986 affects our various businesses in importantand divergent ways. Although we find much to praise in the Act, the netfinancialeffectforBerkshireisnegative:ourrateofincreaseinbusinessvalueislikelytobeatleastmoderatelyslowerunderthenewlawthanundertheold.Theneteffectforourshareholdersisevenmorenegative:everydollarofincreaseinper-sharebusinessvalue,assumingtheincreaseisaccompaniedbyanequivalentdollargaininthemarketvalueofBerkshirestock,willproduce72¢ofafter-taxgainforourshareholders rather than the80¢producedunder theold law.Thisresult, of course, reflects the rise in themaximum tax rate onpersonal capitalgainsfrom20%to28%.

HerearethemaintaxchangesthataffectBerkshire:•Thetaxrateoncorporateordinaryincomeisscheduledtodecreasefrom

46%in1986to34%in1988.Thischangeobviouslyaffectsuspositively—andit also has a significant positive effect on two of our three major investees,CapitalCities/ABCandTheWashingtonPostCompany.

Isaythisknowingthatovertheyearstherehasbeenalotoffuzzyandoftenpartisancommentaryaboutwhoreallypayscorporatetaxes—businessesortheircustomers.Theargument,ofcourse,hasusuallyturnedaroundtaxincreases,notdecreases. Those people resisting increases in corporate rates frequently arguethatcorporationsinrealitypaynoneofthetaxesleviedonthembut,instead,actas a sort of economic pipeline, passing all taxes through to consumers.According to these advocates, any corporate-tax increase will simply lead tohigher prices that, for the corporation, offset the increase. Having taken thisposition, proponents of the “pipeline” theory must also conclude that a taxdecrease for corporations will not help profits but will instead flow through,leadingtocorrespondinglylowerpricesforconsumers.

Conversely, others argue that corporations not only pay the taxes leviedupon them, but absorb them also. Consumers, this school says, will beunaffectedbychangesincorporaterates.

What really happens?When the corporate rate is cut, do Berkshire, TheWashingtonPost,CapCities,etc., themselvessoakupthebenefits,ordothesecompaniespassthebenefitsalongtotheircustomersintheformoflowerprices?

This is an important question for investors and managers, as well as forpolicymakers.

Ourconclusionis that insomecases thebenefitsof lowercorporate taxesfallexclusively,oralmostexclusively,uponthecorporationanditsshareholders,andthatinothercasesthebenefitsareentirely,oralmostentirely,passedthroughto the customer. What determines the outcome is the strength of thecorporation’sbusinessfranchiseandwhethertheprofitabilityofthefranchiseisregulated.

Forexample,whenthefranchiseisstrongandafter-taxprofitsareregulatedin a relatively precisemanner, as is the casewith electric utilities, changes incorporatetaxratesarelargelyreflectedinprices,notinprofits.Whentaxesarecut, prices will usually be reduced in short order. When taxes are increased,priceswillrise,thoughoftennotaspromptly.

Asimilarresultoccursinasecondarena—intheprice-competitiveindustry,whosecompaniestypicallyoperatewithveryweakbusinessfranchises.Insuchindustries,thefreemarket“regulates”after-taxprofitsinadelayedandirregular,butgenerallyeffective,manner.Themarketplace, ineffect,performsmuch thesame function in dealing with the price-competitive industry as the PublicUtilitiesCommissiondoes indealingwithelectricutilities. In these industries,therefore,taxchangeseventuallyaffectpricesmorethanprofits.

In the case of unregulated businesses blessed with strong franchises,however, it’sadifferentstory: thecorporationanditsshareholdersarethenthemajorbeneficiariesoftaxcuts.Thesecompaniesbenefitfromataxcutmuchastheelectriccompanywouldifitlackedaregulatortoforcedownprices.

Manyofourbusinesses,both thoseweowninwholeand inpart,possesssuch franchises. Consequently, reductions in their taxes largely end up in ourpocketsratherthanthepocketsofourcustomers.Whilethismaybeimpolitictostate,itisimpossibletodeny.Ifyouaretemptedtobelieveotherwise,thinkforamoment of themost able brain surgeonor lawyer in your area.Doyou reallyexpectthefeesofthisexpert(thelocal“franchise-holder”inhisorherspecialty)tobereducednowthatthetoppersonaltaxrateisbeingcutfrom50%to28%?

Your joy at our conclusion that lower rates benefit a number of ouroperating businesses and investees should be severely tempered, however, byanother of our convictions: scheduled 1988 tax rates, both individual andcorporate, seem totally unrealistic to us.These rateswill very likely bestow afiscalproblemonWashington thatwillprove incompatiblewithpricestability.Webelieve,therefore,thatultimately—within,say,fiveyears—eitherhighertaxratesorhigherinflationratesarealmostcertaintomaterialize.Anditwouldnotsurpriseustoseeboth.

•Corporatecapitalgainstaxrateshavebeenincreasedfrom28%to34%,effective in 1987. This change will have an important adverse effect onBerkshirebecauseweexpectmuchofourgaininbusinessvalueinthefuture,asinthepast,toarisefromcapitalgains.Forexample,ourthreemajorinvestmentholdings—CapCities,GEICO,andWashingtonPost—atyear-endhadamarketvalueofover$1.7billion,closeto75%ofthetotalnetworthofBerkshire,andyet they deliver us only about $9million in annual income. Instead, all threeretainaveryhighpercentageof their earnings,whichweexpect to eventuallydeliveruscapitalgains.

Thenewlawincreasestherateforallgainsrealizedinthefuture,includingtheunrealizedgainsthatexistedbeforethelawwasenacted.Atyear-end,wehad$1.2billionofsuchunrealizedgainsinourequityinvestments.Theeffectofthenew lawonourbalance sheetwillbedelayedbecauseaGAAPrule stipulatesthat thedeferred tax liabilityapplicable tounrealizedgains shouldbestatedatlastyear’s28%taxrateratherthanthecurrent34%rate.Thisruleisexpectedtochange soon. Themoment it does, about $73millionwill disappear from ourGAAPnetworthandbeaddedtothedeferredtaxaccount.

•Dividendandinterestincomereceivedbyourinsurancecompanieswillbetaxedfarmoreheavilyunderthenewlaw.First,allcorporationswillbetaxedon20%of the dividends they receive from other domestic corporations, up from15%under theoldlaw.Second, there isachangeconcerningtheresidual80%that applies only to property/casualty companies: 15%of that residualwill betaxedifthestockspayingthedividendswerepurchasedafterAugust7,1986.Athirdchange,againapplyingonlytoproperty/casualtycompanies,concernstax-exemptbonds:interestonbondspurchasedbyinsurersafterAugust7,1986willonlybe85%tax-exempt.

Thelasttwochangesareveryimportant.Theymeanthatourincomefromtheinvestmentswemakeinfutureyearswillbesignificantlylowerthanwouldhavebeenthecaseundertheoldlaw.Mybestguessisthatthesechangesalonewilleventuallyreducetheearningpowerofourinsuranceoperationbyat least10%fromwhatwecouldpreviouslyhaveexpected.

•Thenew tax lawalsomateriallychanges the timingof taxpaymentsbyproperty/casualtyinsurancecompanies.Onenewrulerequiresustodiscountourloss reserves in our tax returns, a change that will decrease deductions andincreasetaxableincome.Anotherrule,tobephasedinoversixyears,requiresustoinclude20%ofourunearnedpremiumreserveintaxableincome.

Neitherrulechangestheamountoftheannualtaxaccrualinourreportstoyou, but each materially accelerates the schedule of payments. That is, taxesformerlydeferredwillnowbe front-ended,achange thatwill significantlycut

the profitability of our business. An analogy will suggest the toll: if, uponturning21,youwere required to immediatelypay taxonall incomeyouweredue to receive throughout your life, both your lifetimewealth and your estatewouldbeasmallfractionofwhattheywouldbeifalltaxesonyourincomewerepayableonlywhenyoudied.

Attentive readers may spot an inconsistency in what we say. Earlier,discussing companies in price-competitive industries, we suggested that taxincreases or reductions affect these companies relatively little, but instead arelargelypassedalongtotheircustomers.ButnowwearesayingthattaxincreaseswillaffectprofitsofBerkshire’sproperty/casualtycompanieseventhoughtheyoperateinanintenselyprice-competitiveindustry.

Thereasonthis industry is likely tobeanexception toourgeneral rule isthat not all major insurers will be working with identical tax equations.Importantdifferenceswillexistforseveralreasons:anewalternativeminimumtaxwillmateriallyaffectsomecompaniesbutnotothers;certainmajorinsurershave huge loss carry-forwards that will largely shield their income fromsignificant taxesforat leastafewyears;andtheresultsofsomelargeinsurerswill be folded into the consolidated returns of companies with non-insurancebusinesses.Thesedisparateconditionswillproducewidely-varyingmarginaltaxrates in the property/casualty industry. That will not be the case, however, inmostotherprice-competitiveindustries,suchasaluminum,autosanddepartmentstores, in which the major players will generally contend with similar taxequations.

The absence of a common tax calculus for property/casualty companiesmeansthattheincreasedtaxesfallingontheindustrywillprobablynotbepassedalongtocustomerstothedegreethat theywouldinatypicalprice-competitiveindustry. Insurers, in other words, will themselves bear much of the new taxburdens.

•Apartialoffsettotheseburdensisa“freshstart”adjustmentthatoccurredon January 1, 1987 when our December 31, 1986 loss reserve figures wereconverted for tax purposes to the newly-required discounted basis. (In ourreportstoyou,however,reserveswillremainonexactlythesamebasisasinthepast—undiscountedexceptinspecialcasessuchasstructuredsettlements.)Theneteffectofthe“freshstart”istogiveusadoublededuction:wewillgetataxdeduction in 1987 and future years for a portion of our incurred-but-unpaidinsurance losses that have already been fully deducted as costs in 1986 andearlieryears.

Theincreaseinnetworththatisproducedbythischangeisnotyetreflectedin our financial statements.Rather, under presentGAAP rules (whichmay be

changed), the benefit will flow into the earnings statement and, consequently,intonetworthoverthenextfewyearsbywayofreducedtaxcharges.Weexpectthe total benefit from the fresh-start adjustment to be in the $30-$40 millionrange. It shouldbenoted,however, that this isaone-timebenefit,whereas thenegative impactof theother insurance-related taxchanges isnotonlyongoingbut,inimportantrespects,willbecomemoresevereastimepasses.

• The General Utilities Doctrine was repealed by the new tax law. Thismeans that in 1987 and thereafter there will be a double tax on corporateliquidations,oneat thecorporate level andanotherat the shareholder level. Inthe past, the tax at the corporate level could be avoided. If Berkshire, forexample,weretobeliquidated—whichitmostcertainlywon’tbe—shareholderswould,underthenewlaw,receivefarlessfromthesalesofourpropertiesthantheywouldhaveif thepropertieshadbeensoldin thepast,assumingidenticalpricesineachsale.Thoughthisoutcomeistheoreticalinourcase,thechangeinthelawwillverymateriallyaffectmanycompanies.Therefore,italsoaffectsourevaluationsofprospectiveinvestments.Take,forexample,producingoilandgasbusinesses, selected media companies, real estate companies, etc. that mightwish to sell out.Thevalues that their shareholders can realize are likely tobesignificantly reduced simply because the General Utilities Doctrine has beenrepealed—though the companies’ operating economics will not have changedadverselyatall.Myimpressionisthatthisimportantchangeinthelawhasnotyetbeenfullycomprehendedbyeitherinvestorsormanagers.

Berkshire’s tax situation is sometimesmisunderstood. First, capital gainshave no special attraction for us: A corporation pays a 35% rate on taxableincome,whether itcomes fromcapitalgainsor fromordinaryoperations.ThismeansthatBerkshire’staxonalong-termcapitalgainisfully75%higherthanwhatanindividualwouldpayonanidenticalgain.

Somepeopleharboranothermisconception,believingthatwecanexclude70%ofalldividendswereceivefromourtaxableincome.Indeed,the70%rateapplies tomost corporations and also applies to Berkshire in cases wherewehold stocks in non-insurance subsidiaries. However, almost all of our equityinvestments are owned by our insurance companies, and in that case theexclusionis59.5%.Thatstillmeansadollarofdividendsisconsiderablymorevaluable to us than a dollar of ordinary income, but not to the degree oftenassumed.

B.TaxationandInvestmentPhilosophy76

Berkshire is a substantialpayerof federal income taxes. Inaggregate,wewillpay1993federalincometaxesof$390million,about$200millionofthatattributable to operating earnings and $190million to realized capital gains.77Furthermore,ourshareofthe1993federalandforeignincometaxespaidbyourinvestees is well over $400 million, a figure you don’t see on our financialstatementsbutthatisnonethelessreal.Directlyandindirectly,Berkshire’s1993federalincometaxpaymentswillbeabout½of1%ofthetotalpaidlastyearbyallAmericancorporations.78

Speaking for ourown shares,Charlie and I have absolutelyno complaintabout these taxes.Weknowwework inamarket-basedeconomythat rewardsoureffortsfarmorebountifullythanitdoestheeffortsofotherswhoseoutputisofequalorgreaterbenefittosociety.Taxationshould,anddoes,partiallyredressthisinequity.Butwestillremainextraordinarilywell-treated.

Berkshireanditsshareholders, incombination,wouldpayamuchsmallertax ifBerkshireoperatedapartnershipor“S”corporation, twostructuresoftenused for business activities. For a variety of reasons, that’s not feasible forBerkshiretodo.However,thepenaltyourcorporateformimposesismitigated—though far from eliminated—by our strategy of investing for the long term.CharlieandIwouldfollowabuy-and-holdpolicyevenifwerana tax-exemptinstitution.We think it the soundestway to invest, and it also goes down thegrainofourpersonalities.Athirdreasontofavorthispolicy,however,isthefactthattaxesaredueonlywhengainsarerealized.

Through my favorite comic strip, Li’l Abner, I got a chance during myyouthtoseethebenefitsofdelayedtaxes,thoughImissedthelessonatthetime.Makinghis readers feel superior,Li’lAbnerbungledhappily,butmoronically,through life inDogpatch.Atonepointhebecame infatuatedwithaNewYorktemptress,AppassionattaVanClimax,butdespairedofmarryingherbecausehehad only a single silver dollar and she was interested solely in millionaires.Dejected,AbnertookhisproblemtoOldManMose,thefontofallknowledgeinDogpatch.Saidthesage:Doubleyourmoney20timesandAppassionattawillbeyours(1,2,4,8....1,048,576).

My lastmemoryof the strip isAbner entering a roadhouse, droppinghisdollar intoaslotmachine,andhittingajackpotthatspilledmoneyalloverthefloor.Meticulously followingMose’sadvice,Abnerpickedup twodollarsandwentofftofindhisnextdouble.WhereuponIdumpedAbnerandbeganreadingBenGraham.

Moseclearlywasoverratedasaguru:BesidesfailingtoanticipateAbner’sslavish obedience to instructions, he also forgot about taxes.HadAbner been

subject,say,tothe35%federaltaxratethatBerkshirepays,andhadhemanagedonedouble annually, hewould after 20yearsonlyhave accumulated$22,370.Indeed,hadhekeptonbothgettinghisannualdoublesandpayinga35%taxoneach,hewouldhaveneeded7½yearsmoretoreachthe$1millionrequiredtowinAppassionatta.

ButwhatifAbnerhadinsteadputhisdollarinasingleinvestmentandheldit until it doubled the same 27½ times? In that case, he would have realizedabout$200millionpre-taxor, afterpayinga$70million tax in the finalyear,about $130 million after-tax. For that, Appassionatta would have crawled toDogpatch.Ofcourse,with27½yearshavingpassed,howAppassionattawouldhavelookedtoafellowsittingon$130millionisanotherquestion.

Whatthislittletaletellsusisthattaxpayinginvestorswillrealizeafar,fargreatersumfromasingleinvestmentthatcompoundsinternallyatagivenratethan from a succession of investments compounding at the same rate. But IsuspectmanyBerkshireshareholdersfiguredthatoutlongago.

There’s a powerful financial reason behind Berkshire’s preference [toacquire100%ofabusinessratherthanasmallfraction],andthathastodowithtaxes.The tax codemakesBerkshire’s owning80%ormore of a business farmoreprofitableforus,proportionately,thanourowningasmallershare.Whenacompanyweownallofearns$1millionaftertax,theentireamountinurestoourbenefit. If the $1 million is upstreamed to Berkshire, we owe no tax on thedividend.And,iftheearningsareretainedandweweretosellthesubsidiary—notlikelyatBerkshire!—for$1millionmorethanwepaidforit,wewouldowenocapitalgainstax.That’sbecauseour“taxcost”uponsalewouldincludebothwhatwepaidforthebusinessandallearningsitsubsequentlyretained.

Contrast that situation towhat happenswhenweown an investment in amarketable security. There, ifwe own a 10% stake in a business earning $10million after tax, our $1million share of the earnings is subject to additionalstateandfederaltaxesof(1)about$140,000ifitisdistributedtous(ourtaxrateonmost dividends is 14%); or (2) no less than $350,000 if the $1million isretainedandsubsequentlycapturedbyusintheformofacapitalgain(onwhichour tax rate is usually about 35%, though it sometimes approaches 40%).Wemay defer paying the $350,000 by not immediately realizing our gain, buteventuallywemustpaythetax.Ineffect,thegovernmentisour“partner”twicewhenweownpartofabusinessthroughastockinvestment,butonlyoncewhenweownatleast80%.

OnMay20,2003,TheWashingtonPostrananop-edpiecebymethatwascriticalof theBush taxproposals.Thirteendays later,PamelaOlson,AssistantSecretaryforTaxPolicyattheU.S.Treasury,deliveredaspeechaboutthenewtaxlegislationsaying,“Thatmeansacertainmid-westernoracle,who,itmustbenoted, has played the tax code like a fiddle, is still safe retaining all hisearnings.”Ithinkshewastalkingaboutme.

Alas,my“fiddleplaying”willnotgetme toCarnegieHall—oreven toahighschoolrecital.Berkshire,onyourbehalfandmine,willsendtheTreasury$3.3billionfortaxonits2003income,asumequaling2½%ofthetotalincometaxpaidbyallU.S.corporationsinfiscal2003.(Incontrast,Berkshire’smarketvaluationisabout1%ofthevalueofallAmericancorporations.)

Our payment will almost certainly place us among our country’s top tentaxpayers.Indeed,ifonly540taxpayerspaidtheamountBerkshirewillpay,nootherindividualorcorporationwouldhavetopayanythingtoUncleSam.That’sright:290millionAmericansandallotherbusinesseswouldnothave topayadimeinincome,socialsecurity,exciseorestatetaxestothefederalgovernment.(Here’sthemath:Federaltaxreceipts,includingsocialsecurityreceipts,infiscal2003 totaled $1.782 trillion and 540 “Berkshires,” each paying $3.3 billion,woulddeliverthesame$1.782trillion.)

Ourfederaltaxreturnfor2002,whenwepaid$1.75billion,coveredamere8,905pages.Asisrequired,wedutifullyfiledtwocopiesofthisreturn,creatingapileofpaper seven feet tall.AtWorldHeadquarters,our smallbandof15.8[personnel], though exhausted,momentarily flushedwith pride: Berkshire,wefelt,wassurelypullingitsshareofourcountry’sfiscalload.

I can understand why the Treasury is now frustrated with CorporateAmerica and prone to outbursts. But it should look to Congress and theAdministration for redress, not to Berkshire. Corporate income taxes in fiscal2003accountedfor7.4%ofallfederaltaxreceipts,downfromapost-warpeakof32%in1952.Withoneexception(1983),lastyear’spercentageisthelowestrecordedsincedatawasfirstpublishedin1934.

Evenso,taxbreaksforcorporations(andtheirinvestors,particularlylargeones) were amajor part of the Administration’s 2002 and 2003 initiatives. Ifclasswarfare is beingwaged inAmerica,my class is clearlywinning. Today,manylargecorporations—runbyCEOswhosefiddle-playingtalentsmakeyourChairmanlooklikeheisallthumbs—paynothingclosetothestatedfederaltaxrateof35%.

In 1985, Berkshire paid $132 million in federal income taxes, and allcorporations paid $61 billion. The comparable amounts in 1995 were $286millionand$157billionrespectively.And,asmentioned,wewillpayabout$3.3

billion for 2003, a yearwhen all corporations paid $132billion.Wehope ourtaxescontinuetoriseinthefuture—itwillmeanweareprospering—butwealsohopethattherestofCorporateAmericaantesupalongwithus.ThismightbeaprojectforMs.Olsontoworkon.

75[Dividedbyhashlines:1986;1998.]76[Dividedbyhashlines:1993;2000;2003.]77[For1996,theaggregatefigurewas$860million;for1998,$2.7billion;

for2003,$3.3billion.]78[The1998letterincludesthefollowing:]One beneficiary of our increased size has been the U.S. Treasury. The

federalincometaxesthatBerkshireandGeneralRehavepaid,orwillsoonpay,inrespect to1998earnings total$2.7billion.ThatmeansweshoulderedalloftheU.S.Government’sexpensesformorethanahalf-day.

Follow that thought a little further: If only 625 otherU.S. taxpayers hadpaid theTreasury asmuch aswe andGeneralRedid last year, noone else—neither corporations nor 270million citizens—would have had to pay federalincome taxes or any other kind of federal tax (for example, social security orestatetaxes).Ourshareholderscantrulysaythatthey“gaveattheoffice.”

EPILOGUE79

Wewillkeepmostofourmajorholdings,regardlessofhowtheyarepricedrelativetointrinsicbusinessvalue.This‘til-death-do-us-partattitude,combinedwiththefullpricestheseholdingscommand,meansthattheycannotbeexpectedto push up Berkshire’s value in the future as sharply as in the past. In otherwords, our performance to date has benefited from a double-dip: (1) theexceptionalgainsinintrinsicvaluethatourportfoliocompanieshaveachieved;(2)theadditionalbonuswerealizedasthemarketappropriately“corrected”theprices of these companies, raising their valuations in relation to those of theaveragebusiness.Wewillcontinuetobenefitfromgoodgainsinbusinessvaluethat we feel confident our portfolio companies will make. But our “catchup”rewardshavebeenrealized,whichmeanswe’llhavetosettleforasingle-dipinthefuture.

We face another obstacle: In a finiteworld, high growth ratesmust self-destruct.Ifthebasefromwhichthegrowthistakingplaceistiny,thislawmaynot operate for a time. But when the base balloons, the party ends: A highgrowthrateeventuallyforgesitsownanchor.

CarlSaganhasentertaininglydescribedthisphenomenon,musingaboutthedestinyofbacteria that reproducebydividing into twoevery15minutes.SaysSagan:“Thatmeansfourdoublingsanhour,and96doublingsaday.Althoughabacteriumweighsonlyaboutatrillionthofagram,itsdescendants,afteradayofwildasexualabandon,willcollectivelyweighasmuchasamountain[...]intwodays,morethanthesun—andbeforeverylong,everythingintheuniversewill be made of bacteria.” Not to worry, says Sagan: Some obstacle alwaysimpedes this kind of exponential growth. “The bugs run out of food, or theypoisoneachother,ortheyareshyaboutreproducinginpublic.”

Even on bad days, Charlie Munger (Berkshire’s Vice Chairman and mypartner) and I do not think ofBerkshire as a bacterium.Nor, to our unendingsorrow, have we found a way to double its net worth every 15 minutes.Furthermore, we are not the least bit shy about reproducing—financially—inpublic.Nevertheless,Sagan’sobservationsapply.

Afatwalletistheenemyofsuperiorinvestmentresults.AndBerkshirenowhasanetworthof$11.9billioncomparedtoabout$22millionwhenCharlieandIbegantomanagethecompany.Thoughthereareasmanygoodbusinessesas

ever,itisuselessforustomakepurchasesthatareinconsequentialinrelationtoBerkshire’scapital.Wenowconsiderasecurityforpurchaseonlyifwebelievewe can deploy at least $100 million in it. Given that minimum, Berkshire’sinvestmentuniversehasshrunkdramatically.

Nevertheless,wewillstickwiththeapproachthatgotushereandtrynottorelaxourstandards.TedWilliams,inTheStoryofMyLife,explainswhy:“Myargumentis,tobeagoodhitter,you’vegottogetagoodballtohit.It’sthefirstruleinthebook.IfIhavetobiteatstuffthatisoutofmyhappyzone,I’mnota.344hitter.Imightonlybea.250hitter.”CharlieandIagreeandwilltrytowaitforopportunitiesthatarewellwithinourown“happyzone.”

Wewillcontinue to ignorepoliticalandeconomicforecasts,whichareanexpensivedistractionformanyinvestorsandbusinessmen.Thirtyyearsago,noonecouldhaveforeseenthehugeexpansionoftheVietnamWar,wageandpricecontrols, two oil shocks, the resignation of a president, the dissolution of theSovietUnion,aone-daydrop in theDowof508points,or treasurybillyieldsfluctuatingbetween2.8%and17.4%.

But,surprise—noneoftheseblockbustereventsmadetheslightestdentinBenGraham’sinvestmentprinciples.Nordidtheyrenderunsoundthenegotiatedpurchasesoffinebusinessesatsensibleprices.Imaginethecosttous,then,ifwehadletafearofunknownscauseustodeferoralterthedeploymentofcapital.Indeed, we have usually made our best purchases when apprehensions aboutsomemacroeventwereatapeak.Fearisthefoeofthefaddist,butthefriendofthefundamentalist.

Adifferentsetofmajorshocksissuretooccurinthenext30years.Wewillneithertrytopredictthesenortoprofitfromthem.Ifwecanidentifybusinessessimilartothosewehavepurchasedinthepast,externalsurpriseswillhavelittleeffectonourlong-termresults.

Whatwepromiseyou—alongwithmoremodestgains—isthatduringyourownershipofBerkshire,youwillfarejustasCharlieandIdo.Ifyousuffer,wewill suffer; if we prosper, so will you. And we will not break this bond byintroducingcompensationarrangementsthatgiveusagreaterparticipationintheupsidethanthedownside.

We further promise you that our personal fortunes will remainoverwhelminglyconcentratedinBerkshireshares:Wewillnotaskyoutoinvestwithusandthenputourownmoneyelsewhere.Inaddition,Berkshiredominatesboth the investmentportfoliosofmostmembersofour familiesandofagreatmanyfriendswhobelongedtopartnershipsthatCharlieandIraninthe1960s.Wecouldnotbemoremotivatedtodoourbest.

We achievedour gains through the efforts of a superb corps of operating

managers who get extraordinary results from some ordinary-appearingbusinesses.CaseyStengeldescribedmanagingabaseball teamas“gettingpaidforhomerunsotherfellowshit.”That’smyformulaatBerkshire,also.

It’sfarbettertoownasignificantportionoftheHopediamondthan100%ofa rhinestone,and thecompanies justmentionedeasilyqualifyas raregems.Bestofall,wearen’tlimitedtosimplyafewofthisbreed,butinsteadpossessagrowingcollection.

Stock prices will continue to fluctuate—sometimes sharply—and theeconomy will have its ups and downs. Over time, however, we believe it ishighlyprobable that thesortofbusinessesweownwillcontinueto increaseinvalueatasatisfactoryrate.

I think it’s appropriate that I conclude with a discussion of Berkshire’smanagement, todayand in the future.Asour firstowner-relatedprinciple tellsyou,CharlieandIare themanagingpartnersofBerkshire.Butwesubcontractalloftheheavyliftinginthisbusinesstothemanagersofoursubsidiaries.

CharlieandImainlyattendtocapitalallocationandthecareandfeedingofourkeymanagers.Mostofthesemanagersarehappiestwhentheyareleftalonetoruntheirbusinesses,andthatiscustomarilyjusthowweleavethem.Thatputstheminchargeofalloperatingdecisionsandofdispatchingtheexcesscashtheygenerate to headquarters. By sending it to us, they don’t get diverted by thevarious enticements that would come their way were they responsible fordeploying the cash their businesses throw off. Furthermore, Charlie and I areexposedtoamuchwiderrangeofpossibilitiesforinvestingthesefundsthananyofourmanagerscouldfindinhisorherownindustry.

Mostofourmanagersareindependentlywealthy,andit’sthereforeuptoustocreateaclimatethatencouragesthemtochooseworkingwithBerkshireovergolfingorfishing.Thisleavesusneedingtotreatthemfairlyandinthemannerthatwewouldwishtobetreatedifourpositionswerereversed.

Asfor theallocationofcapital, that’sanactivitybothCharlieandIenjoyandinwhichwehaveacquiredsomeusefulexperience.Inageneralsense,greyhair doesn’t hurt on this playing field: You don’t need good hand-eyecoordinationorwell-tonedmuscles topushmoneyaround(thankheavens).Aslong as ourminds continue to function effectively,Charlie and I can keep ondoingourjobsprettymuchaswehaveinthepast.

As owners, you are naturally concerned about whether I will insist oncontinuingasCEOafterIbegintofadeand,ifso,howtheboardwillhandlethat

problem. You also want to know what happens if I should die tonight. Thatsecond question is easy to answer.Most of our many businesses have strongmarket positions, significant momentum, and terrific managers. The specialBerkshire culture is deeply ingrained throughout our subsidiaries, and theseoperationswon’tmissabeatwhenIdie.Moreover,wehavethreemanagersatBerkshirewhoarereasonablyyoungandfullycapableofbeingCEO.AnyofthethreewouldbemuchbetteratcertainmanagementaspectsofmyjobthanI.

Ontheminusside,nonehasmycrossoverexperiencethatallowsmetobecomfortable making decisions in either the business arena or in investments.Thatproblemwillbesolvedbyhavinganotherpersonintheorganizationhandlemarketablesecurities.That’san interesting jobatBerkshire,and thenewCEOwillhavenoprobleminhiringatalentedindividualtodoit.Indeed,that’swhatwe have done at GEICO for 26 years, and our results have been terrific.Berkshire’sboardhasfullydiscussedeachofthethreeCEOcandidatesandhasunanimouslyagreedonthepersonwhoshouldsucceedmeifareplacementwereneededtoday.

The directors stay updated on this subject and could alter their view ascircumstanceschange—newmanagerialstarsmayemergeandpresentoneswillage.Theimportantpointisthatthedirectorsknownow—andwillalwaysknowinthefuture—exactlywhattheywilldowhentheneedarises.

The other question that must be addressed is whether the Board will bepreparedtomakeachangeifthatneedshouldarisenotfrommydeathbutratherfrommy decay, particularly if this decay is accompanied by my delusionallythinking that I am reaching newpeaks ofmanagerial brilliance. That problemwouldnotbeuniquetome.CharlieandIhavefacedthissituationfromtimetotimeatBerkshire’ssubsidiaries.

Humansageatgreatlyvarying rates—butsooneror later their talentsandvigordecline.Somemanagersremaineffectivewellintotheir80s—Charlieisawonderat82—andothersnoticeablyfadeintheir60s.Whentheirabilitiesebb,sousuallydotheirpowersofself-assessment.Someoneelseoftenneedstoblowthewhistle.Whenthattimecomesforme,ourboardwillhavetostepuptothejob.Fromafinancialstandpoint,itsmembersareunusuallymotivatedtodoso.Iknow of no other board in the country in which the financial interests ofdirectorsaresocompletelyalignedwiththoseofshareholders.Fewboardsevencomeclose.Onapersonallevel,however,itisextraordinarilydifficultformostpeopletotellsomeone,particularlyafriend,thatheorsheisnolongercapable.

IfIbecomeacandidateforthatmessage,however,ourboardwillbedoingmeafavorbydeliveringit.EveryshareofBerkshirethatIownisdestinedtogotophilanthropies,andIwantsocietytoreapthemaximumgoodfromthesegifts

andbequests.Itwouldbeatragedyifthephilanthropicpotentialofmyholdingswasdiminishedbecausemyassociatesshirkedtheirresponsibilityto(tenderly,Ihope) showme the door.But don’tworry about this.We have an outstandinggroupofdirectors,andtheywillalwaysdowhat’srightforshareholders.

BerkshirehasthreeoutstandingcandidatestoreplacemeasCEOandthattheBoardknowsexactlywhoshouldtakeoverifIshoulddietonight.Eachofthe three ismuchyounger than I.The directors believe it’s important thatmysuccessorhavetheprospectofalongtenure.

Frankly,wearenotaswell-preparedontheinvestmentsideofourbusiness.AtourOctoberboardmeeting,wediscussedthatsubjectfully.Andweemergedwithaplan.Underthisplan,Iintendtohireayoungermanorwomanwiththepotential to manage a very large portfolio, who we hope will succeed me asBerkshire’schiefinvestmentofficerwhentheneedforsomeonetodothatarises.Aspartoftheselectionprocess,wemayinfacttakeonseveralcandidates.

Pickingtherightperson(s)willnotbeaneasytask.It’snothard,ofcourse,tofindsmartpeople,amongthemindividualswhohave impressive investmentrecords.Butthereisfarmoretosuccessfullong-terminvestingthanbrainsandperformancethathasrecentlybeengood.

Overtime,marketswilldoextraordinary,evenbizarre,things.Asingle,bigmistakecouldwipeouta longstringofsuccesses.Wethereforeneedsomeonegenetically programmed to recognize and avoid serious risks, including thoseneverbeforeencountered.Certainperilsthatlurkininvestmentstrategiescannotbe spotted by use of the models commonly employed today by financialinstitutions.

Temperament is also important. Independent thinking, emotional stability,and a keen understanding of both human and institutional behavior is vital tolong-term investment success. I’ve seen a lot of very smart people who havelackedthesevirtues.

Finally, we have a special problem to consider: our ability to keep theperson we hire. Being able to list Berkshire on a resume would materiallyenhancethemarketabilityofaninvestmentmanager.Wewillneed,therefore,tobesurewecanretainourchoice,eventhoughheorshecould leaveandmakemuchmoremoneyelsewhere.

I [have] arranged for the bulk of my Berkshire holdings to go to fivecharitable foundations, thuscarryingoutpartofmy lifelongplan toeventuallyuseallofmyshares forphilanthropicpurposes. Inmywill I’vestipulated that

the proceeds from all Berkshire shares I still own at death are to be used forphilanthropic purposeswithin ten years aftermy estate is closed.Becausemyaffairsarenotcomplicated,itshouldtakethreeyearsatmostforthisclosingtooccur. Adding this 13-year period to my expected lifespan of about 12 years(though, naturally, I’m aiming formore)means that proceeds from all ofmyBerkshireshareswilllikelybedistributedforsocietalpurposesoverthenext25yearsorso.

I’ve set this schedule because I want the money to be spent relativelypromptly by people I know to be capable, vigorous and motivated. Thesemanagerialattributessometimeswaneasinstitutions—particularlythosethatareexemptfrommarketforces—age.Today,thereareterrificpeopleinchargeatthefive foundations. So atmy death,why should they notmovewith dispatch tojudiciouslyspendthemoneythatremains?

Thosepeoplefavoringperpetualfoundationsarguethat in thefuture therewillmost certainly be large and important societal problems that philanthropywill need to address. I agree. But there will then also be many super-richindividualsandfamilieswhosewealthwillexceedthatoftoday’sAmericansandtowhomphilanthropicorganizationscanmaketheircaseforfunding.

These funders can then judge first-hand which operations have both thevitalityandthefocustobestaddressthemajorsocietalproblemsthatthenexist.In this way, a market test of ideas and effectiveness can be applied. Someorganizationswill deservemajor supportwhile otherswill have outlived theirusefulness.Even if the people above groundmake their decisions imperfectly,they should be able to allocate fundsmore rationally than a decedent six feetunder will have ordained decades earlier. Wills, of course, can always berewritten,butit’sveryunlikelythatmythinkingwillchangeinamaterialway.

Lestweendonamorbidnote,IalsowanttoassureyouthatIhaveneverfelt better. I love running Berkshire, and if enjoying life promotes longevity,Methuselah’srecordisinjeopardy.80

79 [Divided by hash lines: 1989; 1994; 1996 Owner’s Manual, updatedannually;2005;2006;2006;1996Owner’sManualupdatedannually.]

80[AccordingtotheBible,Methuselahlived969years.Genesis5:27.]

INDEX

Acquisitionphilosophy,30-31,197-208,211-214Aesop,221-224Airlineindustry,142-145AliceinWonderland,101,266,273Allen,Woody,55-56,131AmericanCancerSociety,66AmericanExpress,117,146,150,204AmericanHeartAssn.,66Annualmeetings,37ArcataCorp.,87-89ArthurAndersen,262Assetintensity,235-241Astor,Lady,188AT&T,236Auditcommittees,47,79-80Autoracing(analogies),32

Bankingindustry,128-130Bargainpurchases,102,115-118,197Baseball(analogies),51,73,115,206,235,295Basketball(analogies),109BearStearns,158BeingThere,87Benchley,Robert,115Berkeley,Bishop,266Berra,Yogi,90,200Beverageindustry,94,110Black-Scholesformula,251-253BlueChipStamps,189,200,202,205,230,237-238,242Boardsofdirectors,40-53Boesky,Ivan,86Bogle,John,46Bonds,

junk,127-134

pay-in-kind,136-139zero-coupon,134-140

BradyReport,101Branson,Richard,144Bridge,Ben,219BridgeJeweler,219Broadcastingbusiness,107BuffaloNews,The,57,58,206Buffett,Howard,49BuffettPartnership,Ltd.,53,92Burke,Dan,102,107,128BurlingtonIndustries,56BurlingtonNorthernSantaFeCorporation(BNSF),33,56,59,253

Camelot,206Candler,Asa,110CapitalCities/ABC,Inc.,99,107,128,199,233,283Carnegie,Andrew,102CarnegieHall,103,291Cashflow,96,105-106,136,139,222-224,244-251Chace,Ken,53ChampionInternational,140,147Chiefexecutiveofficers(CEOs),51-52,67-68,72,75-77,79,93,103,141,152,

157, 159, 177, 180, 184-185, 197, 200, 202-203, 207, 218, 243, 252, 255,262-271,280,291

ChryslerCorporation,69Churchill,Winston,84,146Cigarbuttinvesting,115-118Cinderella,82,222Circleofcompetence,97-98,112-114ClassBshares,127,192-196ClaytonHomes,166-168Coca-ColaCompany,The,29,30,47,85,94,96,110,126,127,164,205,233,

243Colodny,Ed,140,144,145CommonSenseonMutualFunds(JohnBogle),46Competitiveadvantages,97-98,113Comte,Auguste,54Concentrationofinvestments,94-95,100,109,231

ConsolidatedEdison,178Corporatecompliance,77-79Corporatephilanthropy,61-67CouncilofInstitutionalInvestors,264Crash,market(1987),100-102Currentaccountdeficit(US),161-166

DairyQueen,48DartIndustries,202Davis,Shelby,124Debt,32-33,118,119-121(seealsoLeverage)Deferredtaxliabilities,246,248,

277-280Denham,Robert,149Departmentstores,102,116,118,224,286Depreciation,39-40,136-137,243-244,247-251Derivatives,150-159DeVoe,Ray,91Dimon,Jamie,186Disclosure,37-40DisneyCompany,TheWalt,99,243Diversificationofinvestments,94,98,133,213DiversifiedRetailing,116,200,205Dividends,178-188D&O(Directors’&Officers’)insurance,49Donaldson,Bill,267DowJones,43,251Drucker,Peter,212

Earnings,accounting,230-231ersatz,178-179look-through,32,113,230-235owner,244-251restricted,178-179

EBITD(A),38,40,244Efficientmarkettheory,81-85,91-102,112,133,221-224,253EnronCorp.,40,151Executivecompensation,67-77,117ExxonMobil,125-126

FannieMae,157FechheimerBrothersCo.,82FederalSavingsandLoanInsuranceCorporation(FSLIC),140Fields,W.C.,160Financetheory,

generally,82-85,91-102junkbonds,127-134marketefficiency,81-85,91-102optionvaluation,251-252risk,95-98

FinancialAccountingStandardsBoard(FASB),262-263,267-268,275-276Financialcrisisof2008,120-121,126,158-159,168FirstBoston,90FirstEmpire,148Fisher,Phil,28Fitzgerald,Terry,196FlatEarthSociety,253Float,32FordMotorCo.,101Foreignexchange,159-166Franklin,Benjamin,52,65(note),209,265FreddieMac,157

Galbraith,Kenneth,138Galileo,65(note)Gambling(analogies),133,204GEICOCorporation,32,51,52,99,102,104,107,117,127,206,242,243,253,

266,285,296GeneralElectricCo.,101,193GeneralMotorsCo.,111GeneralTheory,The(JohnMaynardKeynes),164GeneralUtilitiesDoctrine,287

Generallyacceptedaccountingprinciples(GAAP),226,233,242,244,245,248-250,255-256,265,275,277,280,285,287

GenReCorporation,151,155-157Gerstner,Lou,186Gillespie,George,150GilletteCompany,The,29,96-97,110-112,140,147,148,205,243Ginrummytradingbehavior,34Goizueta,Roberto,110Gold,125-127,201Goldwyn,Samuel,214(note)Golf(analogies),35,50,85,101,197,269,270Golub,Harvey,150Gompers,Samuel,76Goodwill,235-244,246-247,275-276Graham,Benjamin,35,81,82,86,92,94(note),95,106,131,188, 227, 256,

289,294Graham,Kay,102Graham-NewmanCorp.,92GreatCrash,The(KennethGalbraith),138Greenmail,208Gretzky,Wayne,206Gutfreund,John,140

Hazen,Paul,128Hedgefunds,154,173Heider,Charlie,196Heineman,Ben,199Helzberg’s,183HendersonBrothers,Inc.,176Henderson,WilliamThomas,176HersheyFoods,43Hertz,150H.H.BrownShoeCo.,75,96HMSPinafore,211Hochschild,Kohn,116Hockey(analogies),206Homeownership,166-169Horseracing(analogies),116,211

Hoskins,Ed,210Housingmarket,166-169

IBM,111,126,128,186-188Independentdirectors,45-49Indexfunds,98,112,113Inevitables,the110-111Inflation,114,123-124,126,162,164,178,180,199,232,239-241,251,285Initialpublicofferings,195,223Insurancebusiness,30,32,35,53,83-84,119,121,151,153,155,198IntelligentInvestor,The(BenjaminGraham),95,131,188Internetstocks,125 (seealsoTechnology) Intrinsicvalue,33,36,81,83, 121,

183-186,191-194,200-201,204,206,207,224-230,293Investmentbanking,138,148,195-196,217Ivester,Doug,110

JesusChrist,44,48Johnson,Samuel,56Jordan,Michael,109Junkbonds,127-134JustinIndustries,219Justin,John,219

Katrina,Hurricane,119,121,156Kelleher,Herb,143Kent,Clark,173Keough,Don,110Keynes,JohnMaynard,100,164,236Kiewit,Peter,58Kinsley,Michael,268KirbyCo.,277KittyHawk,105KohlbergKravisRoberts&Co.,87-91Kraft,202

Lane,Lois,217LasVegas,133,204LehmanBrothers,121Leverage,32, 118, 119-121, 128-129, 136, 154, 157, 159, 208-211, 210, 235,

237(seealsoDebt)Leveragedbuyouts,208-211Levitt,Arthur,263,271Li’lAbner,289Lincoln,Abraham,281Loews,135LongTermCapitalManagement(LTCM),154Lowenstein,Lou,209-210Lynch,Peter,93,97

Maguire,Jim,176,177(note),192Managementandintegrity,49,50,108,110,117,182Manufacturedhousingindustry,166-168Marginofsafety,106,131Marketprices,33,36,70,78,81,112,133,134,182,189,194,205,224-230,

235Marriage(analogies),51,88,102,107,118,206Marx,Karl,54Mason,Jackie,140Maughan,Deryck,149McGwire,Mark,51Medlin,John,207Methuselah,299MidAmericanEnergy,60,77,119,220Milken,Michael,133Millard,Mark,185Moat(protectivebusiness),52,97Mockler,Colman,Jr.,140Morrison,Garry,53Motorola,135Mr.Market,81-85,95,101,104Munger,CharlesT.,passimMurphy,Tom,102,107,128,199Mutualfunds,46-47MutualSavings&Loan,277

NationalIndemnity,53,65,196,201,206NationalServiceIndustries,199Newspaperbusiness,55,57-59Newton,Isaac,117,174

NewYorkFederalReserve,158NewYorkStockExchange,134,174,177(note),185,192Nicely,Tony,51Nicklaus,Jack,50Noah,199NorthernNaturalGas,60NorthwestIndustries,199

OFHEO,157-158Ogilvy,David,50,84Ogilvy&Mather,50O’Hara,Scarlett,136,167Okun,Arthur,234Olson,Frank,150Olson,Pamela,290,292Optimism,38-39,91,130,198Optionvaluation,251-253Ownerorientation,29,43Oxley,Michael,158

PacifiCorp,220Palmer,Arnold,50Palmisano,Sam,186PamperedChef,The,67Pensionliabilities,272-273PeterPan,138Philanthropy,

corporate,61-67personal,298-299

Piedmont,145Poker(analogies),82PoorRichard’sAlmanac(BenjaminFranklin),209Pope,The,50Portfolioinsurance,101Preferredstock,140-150Pritzker,Jay,87,90Privateequity,173,220,272Procter&Gamble,96(note)

Railroadbusiness,121Ratios(financial),104-105,221-222R.C.Willey,183Reagan,Ronald,75Realization(accounting),273-274Regulatedindustries,59-61,121,126,158,220,284Regulation,60,142,144,237Regulators,59-61,124,154,156,157,158Regulatoryeffectiveness,158-159Reichardt,Carl,128Reputation(seealsoManagementandintegrity),57,77,117,164,195,237Restructurings,35,99,103,197,268-271Risk,

aversionto,117-118,155meaning,94-98

Riskcontrolandmanagement,77RJRNabisco,90,130,133Rockwood&Co.,86-87Russell,Bertrand,130

Sagan,Carl,65(note),293SalomonInc,78,90,134,135,140,146,148,149,194,195-196SalvationArmy,99Santayana,George,197Sarbanes,Paul,158Schey,Ralph,73-74,217Schofield,Seth,143,145SchroederTrust,87ScienceofHitting,The(TedWilliams),115Scott,F.C.,100Scott&FetzerCo.(ScottFetzer),73-74,206,217-218,245-250,277Sears,111Secretariat,211Securities andExchangeCommission (SEC),38,76,174,204, 263, 265, 267,

271See’sCandies,72,96,99,110,126,127,201,206,237-241,243,250,275Sellers,Peter,87Sharerepurchases,178-188Sigler,Andy,140

Simmons,Dick,102Simpson,Louis,102Singleton,Henry,199Smith,Adam,54,163,190Snyder,Bill,102Socialcompact,59-61SouthwestAirlines,143SovietUnion,294StandardBrands,202St.Augustine,65(note)Stein,Herb,91Stewart,Potter,96

Stockoptionsaccountingfor,263-268useof,33-34,68-77,184

Stocksplits,188-190StoryofMyLife,The(TedWilliams),294Stengel,Casey,295St.Peter,227Succession(atBerkshire),42-44,295-299Superman,173,217

TakeontheStreet(ArthurLevitt,Jr.),263TaxReformActof1986,283Technology,97-98,109,111,213Teledyne,199Tennis(analogies),145Textileindustry,34,53-57,102,115,116,118,224,225,228,258TheoryofInvestmentValue,The(JohnBurrWilliams),105Totalreturnswap,154Tradeaccountdeficit(US),159-166Tradingandtransactioncosts,171-176,188-192TravelersGroup,149

TreasuryInflation-ProtectedSecurities(TIPS),114

Twain,Mark,155

UnitedWay,62Unruh,Jesse,129USAir,149

Valuationbookvalue,33,36,104-105,116,178,185,186,190,203,206,221,224-230,235-236,274cashflows,38,96,105,106,134,136,139,222,224,244-251economicgoodwill,235-249,275-276generally,102-108intrinsicvalue,seethisindexVanWinkle,Rip,69,279

Vesco,Robert,182VietnamWar,294VirginAtlanticAirways,144Visa,150

WachoviaCorp.,207WashingtonPostCompany,The,81,85,95,99,102,104,107,283,285,290Watson,ThomasJ.,Sr.,128WaumbecMills,54WellsFargo&Co.,85,128-130,243WescoFinancialCorporation,127(note),133,208(note),210-211,231West,Mae,98,117Williams,JohnBurr,105Williams,Ted,115,294Wilmers,Bob,148WizardofOz,91Wolf,Stephen,144,149WorldBook,82,277Wright,Orville,105Wrigley,97

Zaban,Erwin,199Zero-couponbonds,134-140

CONCEPTGLOSSARY

CigarButtInvesting.Afoolishmethodofinvestingakintotakingthelastpuffonacigar,itisthepurchaseofastockatasufficientlylowpricethattherewillbesomeshort-termprofit,thoughthebusiness’long-termperformanceislikelytobeterrible.SeePartII.F.Circle ofCompetence. The limits of one’s ability to judge the economics ofbusinesses,intelligentinvestorsdrawathickboundaryandstickwithcompaniestheycanunderstand.SeePartII.E.DividendTest. Retention of earnings is only justified if each dollar retainedproducesatleastaonedollarincreaseinpersharemarketvalue.SeePartIV.C.Double-Barreled Acquisition Style. A sensible acquisition policy of buyingeither100%ofbusinessesinnegotiatedacquisitionsorlessthan100%instockmarketpurchases.SeePrologue.Institutional Imperative. A pervasive force in organizations that leads toirrationalbusinessdecisionsfromresistance tochange,absorptionofcorporatefundsinsuboptimalprojectsoracquisitions,indulgenceofthecravingsofseniorexecutives,andmindlessimitationofpeercompanies.SeePartII.F.IntrinsicValue.Ahard-to-calculatebutcrucialmeasureofbusinessvalue,itisthe discounted present value of the cash that can be taken out of a businessduringitsremaininglife.SeePartVI.B.Look-throughEarnings.Analternative toGAAPrulesgoverninginvestmentsin marketable securities of the investee less than 20%, this measures theinvestor’s economic performance based on its percentage interest of theinvestee’s undistributed earnings (after an incremental reduction for incometaxes).SeePartVI.C.Margin-of-Safety. Probably the singlemost important principle of sound andsuccessful investing, Ben Graham’s principle says not to purchase a securityunlessthepricebeingpaidissubstantiallylowerthanthevaluebeingdelivered.SeePartII.D.Mr. Market. Ben Graham’s allegory for the overall stock market, a moodymanic-depressive where price and value diverge, making superior intelligentinvestingpossible.SeePartII.A.OwnerEarnings.AbettermeasureofeconomicperformancethancashfloworGAAPearnings,equalto(a)operatingearningsplus(b)depreciationandothernon-cash charges minus (c) required reinvestment in a business to maintain

presentcompetitivepositionandunitvolume.SeePartVI.E.

DISPOSITIONSUMMARY

Thedisposition tableon theoppositepage showswhere in this collectionyoumayfindexcerptsfromvariousannual letters.Thefarcolumnsontheleftandrightindicatetheyearofeachletter,beginningwith79for1979andgoingthrough11for2011.AcrossthetopoftherowsthetabledividesthecollectionaccordingtoitsParts(IthroughIX)anditssub-headings(suchasAthroughG).LettersexcerptedintheopeningparagraphsofaPartarereportedinthetableasbeingexcerptedinSectionAofthatPart.ThePrologueisfrom1979and1996;theEpilogue contains selections from1989, 1994, 1996, 2005 and 2006.Thisdisposition table may be of special interest to those who have read previouseditionscarefully, toseewhat isnewandsomerearrangements thathavebeenmade.