John Stumpf, CEO of Wells Fargo, aptly dissected the recent behavior of many lenders: “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.”
That party is over. It’s a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by four percentage points or so. If the winds roar or the earth trembles, results could be far worse. So be prepared for lower insurance earnings during the next few years.
I expect we will average breakeven results or better in the future. If we do that, our investments can be viewed as an unencumbered source of value for Berkshire shareholders.
I also told you that Jay Pritzker —the young fellow mentioned above —was the business genius behind this tax-efficient idea, the possibilities for which had escaped all the other experts who had thought about buying Rockwood, including my bosses, Ben and Jerry.
Businesses —The Great, the Good and the Gruesome
Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.
It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.
A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.
Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.
Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.
But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes.
Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.
We bought See’s for $ 25 million when its sales were $ 30 million and pre-tax earnings were less than $ 5 million. The capital then required to conduct the business was $ 8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.
Last year See’s sales were $ 383 million, and pre-tax profits were $ 82 million. The capital now required to run the business is $ 40 million. This means we have had to reinvest only $ 32 million since 1972 to handle the modest physical growth —and somewhat immodest financial growth —of the business. In the meantime pre-tax earnings have totaled $ 1.35 billion. All of that, except for the $ 32 million, has been sent to Berkshire (or, in the early years, to Blue Chip).After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)
There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $ 5 million to $ 82 million require, say, $ 400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $ 82 million pre-tax on $ 400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.
Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $ 111 million, and its net investment in fixed assets was $ 570 million. Since our purchase, depreciation charges have totaled $ 923 million. But capital expenditures have totaled $ 1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $ 12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $ 1.079 billion. Pre-tax operating earnings in 2007 were $ 270 million, a gain of $ 159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $ 509 million.
Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.
Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.
To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.
And now it’s confession time. It should be noted that no consultant, board of directors or investment banker pushed me into the mistakes I will describe. In tennis parlance, they were all unforced errors.
To begin with, I almost blew the See’s purchase. The seller was asking $ 30 million, and I was adamant about not going above $ 25 million. Fortunately, he caved. Otherwise I would have balked, and that $ 1.35 billion would have gone to somebody else.
Tom Murphy called and offered me the Dallas-Fort Worth NBC station for $ 35 million. … In effect Murph whispered “buy” into my ear. But I didn’t listen. In 2006, the station earned $ 73 million pre-tax, bringing its total earnings since I turned down the deal to at least $ 1 billion. … “If his I.Q. was any lower, you would have to water him twice a day.”
Finally, I made an even worse mistake when I said “yes” to Dexter, a shoe business I bought in 1993 for $ 433 million in Berkshire stock (25,203 shares of A). … By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $ 400 million, but rather $ 3.5 billion. In essence, I gave away 1.6% of a wonderful business —one now valued at $ 220 billion —to buy a worthless business.
To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future —you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: “I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.”
“Honey, you weren’t in my wildest dreams.”
When we first entered the property/ casualty insurance business in 1967, my wildest dreams did not envision our current operation.
Here’s how we did in the first five years after purchasing National Indemnity:
This metamorphosis has been accomplished by some extraordinary managers.
This reputation, unfortunately, outlived its factual underpinnings, a flaw that I completely missed when I made the decision in 1998 to merge with General Re. The General Re of 1998 was not operated as the General Re of 1968 or 1978.
With that, I explained, they could tell their client they had wrung the last nickel out of me. At the time, it hurt…And yes, I’m glad I wilted and offered the extra nickel.
This motley group, which sells products ranging from lollipops to motor homes, earned a pleasing 23% on average tangible net worth last year. [4% of sales; 10% of net assets]
Susan came to Borsheims 25 years ago as a $ 4-an-hour saleswoman. Though she lacked a managerial background, I did not hesitate to make her CEO in 1994. She’s smart, she loves the business, and she loves her associates. That beats having an MBA degree any time.
(An aside: Charlie and I are not big fans of resumes. Instead, we focus on brains, passion and integrity.
The raw material for carbide is tungsten, mined in China.
Europe is the best example of how Rich’s tenacity leads to success.
In the strange world department, note that American Express and Wells Fargo were both organized by Henry Wells and William Fargo, Amex in 1850 and Wells in 1852. P& G and Coke began business in 1837 and 1886 respectively. Start-ups are not our game.
I should emphasize that we do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test, more subjective, is whether their “moats” —a metaphor for the superiorities they possess that make life difficult for their competitors —have widened during the year. All of the “big four” scored positively on that test.
In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $ 488 million, a price that valued the entire business at about $ 37 billion. Charlie and I then felt that the company was worth about $ 100 billion. By 2007, two factors had materially increased its value: the price of oil had climbed significantly, and PetroChina’s management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the company rose to $ 275 billion, about what we thought it was worth compared to other giant oil companies. So we sold our holdings for $ 4 billion. A footnote: We paid the IRS tax of $ 1.2 billion on our PetroChina gain.
At yearend we had received $ 3.2 billion in premiums on these contracts; had paid $ 472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $ 4.7 billion. We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $ 1.8 billion and is included in “Derivative Contract Liabilities” on our balance sheet.
put options we have sold on four stock indices (the S& P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $ 4.5 billion, and we recorded a liability at yearend of $ 4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written.
Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk. Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire’s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings —even though they could easily amount to $ 1 billion or more in a quarter —and we hope you won’t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.
Inevitably, that causes America to ship about $ 2 billion of IOUs and assets daily to the rest of the world. And over time, that puts pressure on the dollar.
When the dollar falls, it both makes our products cheaper for foreigners to buy and their products more expensive for U.S. citizens. That’s why a falling currency is supposed to cure a trade deficit. Indeed, the U.S. deficit has undoubtedly been tempered by the large drop in the dollar. But ponder this: In 2002 when the Euro averaged 94.6 ¢, our trade deficit with Germany (the fifth largest of our trading partners) was $ 36 billion, whereas in 2007, with the Euro averaging $ 1.37, our deficit with Germany was up to $ 45 billion. Similarly, the Canadian dollar averaged 64 ¢ in 2002 and 93 ¢ in 2007. Yet our trade deficit with Canada rose as well, from $ 50 billion in 2002 to $ 64 billion in 2007. So far, at least, a plunging dollar has not done much to bring our trade activity into balance.
This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $ 2 billion daily to the rest of the world, they must invest in something here.
(For other comments about the unsustainability of our trade deficits, see Alan Greenspan’s comments on November 19, 2004, the Federal Open Market Committee’s minutes of June 29, 2004, and Ben Bernanke’s statement on September 11, 2007.)
At Berkshire we held only one direct currency position during 2007. That was in —hold your breath —the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti.
As has been true in many countries whose currencies have periodically withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth. But any Brazilian who followed this apparently prudent course would have lost half his net worth over the past five years. Here’s the year-by-year record (indexed) of the real versus the dollar from the end of 2002 to yearend 2007: 100; 122; 133; 152; 166; 199. Every year the real went up and the dollar fell. Moreover, during much of this period the Brazilian government was actually holding down the value of the real and supporting our currency by buying dollars in the market.
Our direct currency positions have yielded $ 2.3 billion of pre-tax profits over the past five years, and in addition we have profited by holding bonds of U.S. companies that are denominated in other currencies. For example, in 2001 and 2002 we purchased € 310 million Amazon.com, Inc. 6 7/ 8 of 2010 at 57% of par. At the time, Amazon bonds were priced as “junk” credits, though they were anything but. (Yes, Virginia, you can occasionally find markets that are ridiculously inefficient —or at least you can find them anywhere except at the finance departments of some leading business schools.)
The Euro denomination of the Amazon bonds was a further, and important, attraction for us. The Euro was at 95 ¢ when we bought in 2002. Therefore, our cost in dollars came to only $ 169 million. Now the bonds sell at 102% of par and the Euro is worth $ 1.47. In 2005 and 2006 some of our bonds were called and we received $ 253 million for them. Our remaining bonds were valued at $ 162 million at yearend. Of our $ 246 million of realized and unrealized gain, about $ 118 million is attributable to the fall in the dollar. Currencies do matter.
At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country’s many imperfections and unrelenting problems of one sort or another, America’s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.
Before that rebuke the FASB had shown the audacity —by unanimous agreement, no less —to tell corporate chieftains that the stock options they were being awarded represented a form of compensation and that their value should be recorded as an expense.
To avoid that bothersome rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market.
Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.
This means that the remaining 72% of assets —which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments —must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.
How realistic is this expectation? Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appe
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 at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the market needed to travel in this hundred years to equal the 5.3% of the last.
It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?
Naturally, everyone expects to be above average. And those helpers —bless their hearts —will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group —the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group —the “know-nothings” —must win.
I should mention that people who expect to earn 10% annually from equities during this century —envisioning that 2% of that will come from dividends and 8% from price appreciation —are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-digit returns from equities, explain this math to him —not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees.
Some companies have pension plans in Europe as well as in the U.S. and, in their accounting, almost all assume that the U.S. plans will earn more than the non-U.S. plans. This discrepancy is puzzling: Why should these companies not put their U.S. managers in charge of the non-U.S. pension assets and let them work their magic on these assets as well? I’ve never seen this puzzle explained. But the auditors and actuaries who are charged with vetting the return assumptions seem to have no problem with it.
What is no puzzle, however, is why CEOs opt for a high investment assumption: It lets them report higher earnings. And if they are wrong, as I believe they are, the chickens won’t come home to roost until long after they retire.
After decades of pushing the envelope —or worse —in its attempt to report the highest number possible for current earnings, Corporate America should ease up. It should listen to my partner, Charlie: “If you’ve hit three balls out of bounds to the left, aim a little to the right on the next swing.”
Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement —sometimes to those in their low 40s —and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.
He paid up but a month later received a bill from the mortuary for $ 10. He paid that, too —and still another $ 10 charge he received a month later. When a third $ 10 invoice was sent to him the following month, the perplexed man called his sister to ask what was going on. “Oh,” she replied, “I forgot to tell you. We buried Dad in a rented suit.”