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最好的投资者基本都出书:George Soros,Peter Lynch,David Neff,不胜枚举;不出书的,至少也定期发表与投资相关的看法:巴菲特、Jeremy Grantham、William Gross,不胜枚举。好的投资者得有好判断,好判断得有经得起敲打的思想过程;思想过程一旦展开,就会形成表达,进入公共领域。藏私很难。





The insurance industry is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way.  In such a commodity- like business, only a very low-cost operator or someone operating in a protected, and usually small, niche can sustain high profitability levels.

When shortages exist, however, even commodity businesses flourish.  The insurance industry enjoyed that kind of climate for a while but it is now gone.  One of the ironies of capitalism is that most managers in commodity industries abhor shortage conditions - even though those are the only circumstances permitting them good returns.  Whenever shortages appear, the typical manager simply can't wait to expand capacity and thereby plug the hole through which money is showering upon him.  This is precisely what insurance managers did in 1985-87, confirming again Disraeli's observation: "What we learn from history is that we do not learn from history."

At Berkshire, we work to escape the industry's commodity economics in two ways. First, we differentiate our product by our financial strength, which exceeds that of all others in the industry.  This strength, however, is limited in its usefulness. It means nothing in the personal insurance field:  The buyer of an auto or homeowners policy is going to get his claim paid even if his insurer fails (as many have).  It often means nothing in the commercial insurance arena: When times are good, many major corporate purchasers of insurance and their brokers pay scant attention to the insurer's ability to perform under the more adverse conditions that may exist, say, five years later when a complicated claim is finally resolved. (Out of sight, out of mind - and, later on, maybe out-of-pocket.)

Periodically, however, buyers remember Ben Franklin's observation that it is hard for an empty sack to stand upright and recognize their need to buy promises only from insurers that have enduring financial strength.  It is then that we have a major competitive advantage.  When a buyer really focuses on whether a $10 million claim can be easily paid by his insurer five or ten years down the road, and when he takes into account the possibility that poor underwriting conditions may then coincide with depressed financial markets and defaults by reinsurer, he will find only a few companies he can trust.  Among those, Berkshire will lead the pack.

Our second method of differentiating ourselves is the total indifference to volume that we maintain.  In 1989, we will be perfectly willing to write five times as much business as we write in 1988 - or only one-fifth as much.  We hope, of course, that conditions will allow us large volume.  But we cannot control market prices.  If they are unsatisfactory, we will simply do very little business.  No other major insurer acts with equal restraint.      Three conditions that prevail in insurance, but not in most businesses, allow us our flexibility.  First, market share is not an important determinant of profitability: In this business, in contrast to the newspaper or grocery businesses, the economic rule is not survival of the fattest.  Second, in many sectors of insurance, including most of those in which we operate, distribution channels are not proprietary and can be easily entered: Small volume this year does not preclude huge volume next year.  Third, idle capacity - which in this industry largely means people - does not result in intolerable costs.  In a way that industries such as printing or steel cannot, we can operate at quarter-speed much of the time and still enjoy long-term  prosperity.

We follow a price-based-on-exposure, not-on-competition policy because it makes sense for our shareholders.  But we're happy to report that it is also pro-social.  This policy means that we are always available, given prices that we believe are adequate, to write huge volumes of almost any type of property- casualty insurance.  Many other insurers follow an in-and-out approach.  When they are "out" - because of mounting losses, capital inadequacy, or whatever - we are available.  Of course, when others are panting to do business we are also available - but at such times we often find ourselves priced above the market.  In effect, we supply insurance buyers and brokers with a large reservoir of standby capacity.




In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas.  At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long- term investments.  (Charlie抯 sign off after we抳e talked about an arbitrage commitment is usually: 揙kay, at least it will keep you out of bars.)      During 1988 we made unusually large profits from arbitrage, measured both by absolute dollars and rate of return.  Our pre- tax gain was about $78 million on average invested funds of about $147 million.

This level of activity makes some detailed discussion of arbitrage and our approach to it appropriate.  Once, the word  applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets.  The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in London, and dollars in New York.  Some people might call this scalping; it won抰 surprise you that practitioners opted for the French term, arbitrage.

Since World War I the definition of arbitrage - or 搑isk arbitrage, as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc.  In most cases the arbitrageur expects to profit regardless of the behavior of the stock market.  The major risk he usually faces instead is that the announced event won‘t happen. 

Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 5¢ per pound.  In 1954 a temporary shortage of cocoa caused the price to soar to over 60¢.  Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

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

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

The architect of Rockwood‘s restructuring was an unknown, but brilliant Chicagoan, Jay Pritzker, then 32.  If you抮e familiar with Jay’s subsequent record, you won抰 be surprised to hear the action worked out rather well for Rockwood‘s continuing shareholders also.  From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses.  Sometimes there is more to stock valuation than price-earnings ratios.  

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

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

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

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

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

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

Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can抰 tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.  

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

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

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

On March 12 KKR said its earlier deal wouldn't work, first cutting its offer to $33.50, then two days later raising it to $35.00. On March 15, however, the directors turned this bid down and accepted another group's offer of $37.50 plus one-half of any redwood recovery.  The shareholders okayed the deal, and the $37.50 was paid on June 4.      We received $24.6 million versus our cost of $22.9 million; our average holding period was close to six months.  Considering the trouble this transaction encountered, our 15% annual rate of return excluding any value for the redwood claim - was more than satisfactory.  

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

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

Berkshire抯 arbitrage activities differ from those of many arbitrageurs.  First, we participate in only a few, and usually very large, transactions each year.  Most practitioners buy into a great many deals perhaps 50 or more per year.  With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks.  This is not how Charlie nor I wish to spend our lives. (What抯 the sense in getting rich just to stare at a ticker tape all day?)      Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation.  So far, Berkshire has not had a really bad experience.  But we will - and when it happens we抣l report the gory details to you.  

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

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

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

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

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

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

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

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

We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them.  But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.  We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders.  In our activities, we will heed the wisdom of Herb Stein: if something can‘t go on forever, it will end.



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

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

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long- term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.      Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price  probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces -  never is there just one cockroach in the kitchen. Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return. But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost. Time is the friend of the wonderful business, the enemy of the mediocre.  

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

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

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

I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. I just wish I hadn't been so energetic in creating examples. My behavior has matched that admitted by  Mae West: "I was Snow White, but I drifted." o     A further related lesson: Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

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

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

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

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

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

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

Our consistently-conservative financial policies may appear to have been a mistake, but in my view were not. In retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly, we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt ratio to produce a result falling somewhere between temporary anguish and default.      We wouldn't have liked those 99:1 odds - and never will. A  small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far more than the proceeds - though we have learned to live with those also.

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




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

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

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

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

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

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

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

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

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

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

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

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



Our equity-investing strategy remains little changed from what it was fifteen years ago, when we said in the 1977 annual report:  "We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety.  We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price."  We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute "an attractive price" for "a very attractive price."      But how, you will ask, does one decide what's "attractive"?  In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:  "value" and "growth."  Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross- dressing.  

We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).  In our opinion, the two approaches are joined at the hip:  Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

In addition, we think the very term "value investing" is redundant.  What is "investing" if it is not the act of seeking value at least sufficient to justify the amount paid?  Consciously paying more for a stock than its calculated value - in the hope that it can soon be sold for a still-higher price - should be labeled speculation (which is neither illegal, immoral nor - in our view - financially fattening).  

Whether appropriate or not, the term "value investing" is widely used.  Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price- earnings ratio, or a high dividend yield.  Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.  Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.      Similarly, business growth, per se, tells us little about value.  It's true that growth often has a positive impact on value, sometimes one of spectacular proportions.  But such an effect is far from certain.  For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth.  For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.  In the case of a low-return business requiring incremental funds, growth hurts the investor.

In The Theory of Investment Value, written over 50 years ago,  John Burr Williams set forth the equation for value, which we condense here:  The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset.  Note that the formula is the same for stocks as for bonds.  Even so, there is an important, and difficult to deal with, difference between the two:  A bond has a coupon and maturity date that define future cash flows; but in the case of equities, the investment analyst must himself estimate the future "coupons."  Furthermore, the quality of management affects the bond coupon only rarely - chiefly when management is so inept or dishonest that payment of interest is suspended.  In contrast, the ability of management can dramatically affect the equity "coupons."

The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.  Moreover, though the value equation has usually shown equities to be cheaper than bonds, that result is not inevitable:  When bonds are calculated to be the more attractive investment, they should be bought.

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.  The worst business to own is one that must, or will, do the opposite - that is, consistently employ ever-greater amounts of capital at very low rates of return.  Unfortunately, the first type of business is very hard to find:  Most high-return businesses need relatively little capital.  Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.  

Though the mathematical calculations required to evaluate equities are not difficult, an analyst - even one who is experienced and intelligent - can easily go wrong in estimating future "coupons."  At Berkshire, we attempt to deal with this problem in two ways.  First, we try to stick to businesses we believe we understand.  That means they must be relatively simple and stable in character.  If a business is complex or subject to constant change, we're not smart enough to predict future cash flows.  Incidentally, that shortcoming doesn't bother us.  What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know.  An investor needs to do very few things right as long as he or she avoids big mistakes.

Second, and equally important, we insist on a margin of safety in our purchase price.  If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying.  We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.



Retailing is a tough business.  During my investment career, I have watched a large number of retailers enjoy terrific growth and superb returns on equity for a period, and then suddenly nosedive, often all the way into bankruptcy.  This shooting-star phenomenon is far more common in retailing than it is in manufacturing or service businesses.  In part, this is because a retailer must stay smart, day after day.  Your competitor is always copying and then topping whatever you do.  Shoppers are meanwhile beckoned in every conceivable way to try a stream of new merchants.  In retailing, to coast is to fail. 

      In contrast to this have-to-be-smart-every-day business, there is what I call the have-to-be-smart-once business.  For example, if you were smart enough to buy a network TV station very early in the game, you could put in a shiftless and backward nephew to run things, and the business would still do well for decades.  You'd do far better, of course, if you put in Tom Murphy, but you could stay comfortably in the black without him. For a retailer, hiring that nephew would be an express ticket to bankruptcy.



In studying the investments we have made in both subsidiary companies and common stocks, you will see that we favor businesses and industries unlikely to experience major change.  The reason for that is simple:  Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now.  A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek. 

I should emphasize that, as citizens, Charlie and I welcome change: Fresh ideas, new products, innovative processes and the like cause our country's standard of living to rise, and that's clearly good.  As investors, however, our reaction to a fermenting industry is much like our attitude toward space exploration:  We applaud the endeavor but prefer to skip the ride.

Obviously all businesses change to some extent.  Today, See's is  different in many ways from what it was in 1972 when we bought it:  It offers a different assortment of candy, employs different machinery and sells through different distribution channels.  But the reasons why people today buy boxed chocolates, and why they buy them from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See family was building the business.  Moreover, these motivations are not likely to change over the next 20 years, or even 50.

We look for similar predictability in marketable securities.  Take Coca-Cola:  The zeal and imagination with which Coke products are sold has burgeoned under Roberto Goizueta, who has done an absolutely incredible job in creating value for his shareholders.  Aided by Don Keough and Doug Ivester, Roberto has rethought and improved every aspect of the company.  But the fundamentals of the business - the qualities that underlie Coke's competitive dominance and stunning economics - have remained constant through the years.  

I was recently studying the 1896 report of Coke (and you think that you are behind in your reading!).  At that time Coke, though it was already the leading soft drink, had been around for only a decade.  But its blueprint for the next 100 years was already drawn.  Reporting sales of $148,000 that year, Asa Candler, the company's president, said:  "We have not lagged in our efforts to go into all the world teaching that Coca-Cola is the article, par excellence, for the health and good feeling of all people."  Though "health" may have been a reach, I love the fact that Coke still relies on Candler's basic theme today - a century later. Candler went on to say, just as Roberto could now, "No article of like character has ever so firmly entrenched itself in public favor."  Sales of syrup that year, incidentally, were 116,492 gallons versus about 3.2 billion in 1996.  

I can't resist one more Candler quote:  "Beginning this year about March 1st . . . we employed ten traveling salesmen by means of which, with systematic correspondence from the office, we covered almost the territory of the Union."  That's my kind of sales force.  

Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables."  Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years.  Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation.  In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime.  Indeed, their dominance will probably strengthen.  Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables.  But I would rather be certain of a good result than hopeful of a great one.  

Of course, Charlie and I can identify only a few Inevitables, even after a lifetime of looking for them.  Leadership alone provides no certainties:  Witness the shocks some years back at General Motors, IBM and Sears, all of which had enjoyed long periods of seeming invincibility.  Though some industries or lines of business exhibit characteristics that endow leaders with virtually insurmountable advantages, and that tend to establish Survival of the Fattest as almost a natural law, most do not.  Thus, for every Inevitable, there are dozens of Impostors, companies now riding high but vulnerable to competitive attacks.  Considering what it takes to be an Inevitable, Charlie and I recognize that we will never be able to come up with a Nifty Fifty or even a Twinkling Twenty.  To the Inevitables in our portfolio, therefore, we add a few "Highly Probables."

You can, of course, pay too much for even the best of businesses.  The overpayment risk surfaces periodically and, in our opinion, may now be quite high for the purchasers of virtually all stocks, The Inevitables included.  Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.

A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse.  When that happens, the suffering of investors is often prolonged.  Unfortunately, that is precisely what transpired years ago at both Coke and Gillette.  (Would you believe that a few decades back they were growing shrimp at Coke and exploring for oil at Gillette?)  Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding.  All too often, we've seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.  That's not going to happen again at Coke and Gillette, however - not given their current and prospective managements.                      

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

Let me add a few thoughts about your own investments.  Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. 

Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering.  Intelligent investing is not complex, though that is far from saying that it is easy.  What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected":  You don't have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets.  You may, in fact, be better off knowing nothing of these.  That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects.  In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.  

Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.  Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock.  You must also resist the temptation to stray from your guidelines:  If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.  Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.  

Though it's seldom recognized, this is the exact approach that has produced gains for Berkshire shareholders:  Our look-through earnings have grown at a good clip over the years, and our stock price has risen correspondingly.  Had those gains in earnings not materialized, there would have been little increase in Berkshire's value.      The greatly enlarged earnings base we now enjoy will inevitably cause our future gains to lag those of the past.  We will continue, however, to push in the directions we always have.  We will try to build earnings by running our present businesses well - a job made easy because of the extraordinary talents of our operating managers - and by purchasing other businesses, in whole or in part, that are not likely to be roiled by change and that possess important competitive advantages.

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