To the Stockholders of Berkshire Hathaway Inc.:
Operating earnings in 1977 of $21,904,000, or $22.54 per
share, were moderately better than anticipated a year ago. Of
these earnings, $1.43 per share resulted from substantial
realized capital gains by Blue Chip Stamps which, to the extent
of our proportional interest in that company, are included in our
operating earnings figure. Capital gains or losses realized
directly by Berkshire Hathaway Inc. or its insurance subsidiaries
are not included in our calculation of operating earnings. While
too much attention should not be paid to the figure for any
single year, over the longer term the record regarding aggregate
capital gains or losses obviously is of significance.
Textile operations came in well below forecast, while the
results of the Illinois National Bank as well as the operating
earnings attributable to our equity interest in Blue Chip Stamps
were about as anticipated. However, insurance operations, led
again by the truly outstanding results of Phil Liesche’s
managerial group at National Indemnity Company, were even better
than our optimistic expectations.
Most companies define “record” earnings as a new high in
earnings per share. Since businesses customarily add from year
to year to their equity base, we find nothing particularly
noteworthy in a management performance combining, say, a 10%
increase in equity capital and a 5% increase in earnings per
share. After all, even a totally dormant savings account will
produce steadily rising interest earnings each year because of
compounding.
Except for special cases (for example, companies with
unusual debt-equity ratios or those with important assets carried
at unrealistic balance sheet values), we believe a more
appropriate measure of managerial economic performance to be
return on equity capital. In 1977 our operating earnings on
beginning equity capital amounted to 19%, slightly better than
last year and above both our own long-term average and that of
American industry in aggregate. But, while our operating
earnings per share were up 37% from the year before, our
beginning capital was up 24%, making the gain in earnings per
share considerably less impressive than it might appear at first
glance.
We expect difficulty in matching our 1977 rate of return
during the forthcoming year. Beginning equity capital is up 23%
from a year ago, and we expect the trend of insurance
underwriting profit margins to turn down well before the end of
the year. Nevertheless, we expect a reasonably good year and our
present estimate, subject to the usual caveats regarding the
frailties of forecasts, is that operating earnings will improve
somewhat on a per share basis during 1978.
Textile Operations
The textile business again had a very poor year in 1977. We
have mistakenly predicted better results in each of the last two
years. This may say something about our forecasting abilities,
the nature of the textile industry, or both. Despite strenuous
efforts, problems in marketing and manufacturing have persisted.
Many difficulties experienced in the marketing area are due
primarily to industry conditions, but some of the problems have
been of our own making.
A few shareholders have questioned the wisdom of remaining
in the textile business which, over the longer term, is unlikely
to produce returns on capital comparable to those available in
many other businesses. Our reasons are several: (1) Our mills in
both New Bedford and Manchester are among the largest employers
in each town, utilizing a labor force of high average age
possessing relatively non-transferable skills. Our workers and
unions have exhibited unusual understanding and effort in
cooperating with management to achieve a cost structure and
product mix which might allow us to maintain a viable operation.
(2) Management also has been energetic and straightforward in its
approach to our textile problems. In particular, Ken Chace’s
efforts after the change in corporate control took place in 1965
generated capital from the textile division needed to finance the
acquisition and expansion of our profitable insurance operation.
(3) With hard work and some imagination regarding manufacturing
and marketing configurations, it seems reasonable that at least
modest profits in the textile division can be achieved in the
future.
Insurance Underwriting
Our insurance operation continued to grow significantly in
1977. It was early in 1967 that we made our entry into this
industry through the purchase of National Indemnity Company and
National Fire and Marine Insurance Company (sister companies) for
approximately $8.6 million. In that year their premium volume
amounted to $22 million. In 1977 our aggregate insurance premium
volume was $151 million. No additional shares of Berkshire
Hathaway stock have been issued to achieve any of this growth.
Rather, this almost 600% increase has been achieved through
large gains in National Indemnity’s traditional liability areas
plus the starting of new companies (Cornhusker Casualty Company
in 1970, Lakeland Fire and Casualty Company in 1971, Texas United
Insurance Company in 1972, The Insurance Company of Iowa in 1973,
and Kansas Fire and Casualty Company in late 1977), the purchase
for cash of other insurance companies (Home and Automobile
Insurance Company in 1971, Kerkling Reinsurance Corporation, now
named Central Fire and Casualty Company, in 1976, and Cypress
Insurance Company at yearend 1977), and finally through the
marketing of additional products, most significantly reinsurance,
within the National Indemnity Company corporate structure.
In aggregate, the insurance business has worked out very
well. But it hasn’t been a one-way street. Some major mistakes
have been made during the decade, both in products and personnel.
We experienced significant problems from (1) a surety operation
initiated in 1969, (2) the 1973 expansion of Home and
Automobile’s urban auto marketing into the Miami, Florida area,
(3) a still unresolved aviation “fronting” arrangement, and (4)
our Worker’s Compensation operation in California, which we
believe retains an interesting potential upon completion of a
reorganization now in progress. It is comforting to be in a
business where some mistakes can be made and yet a quite
satisfactory overall performance can be achieved. In a sense,
this is the opposite case from our textile business where even
very good management probably can average only modest results.
One of the lessons your management has learned - and,
unfortunately, sometimes re-learned - is the importance of being
in businesses where tailwinds prevail rather than headwinds.
In 1977 the winds in insurance underwriting were squarely
behind us. Very large rate increases were effected throughout
the industry in 1976 to offset the disastrous underwriting
results of 1974 and 1975. But, because insurance policies
typically are written for one-year periods, with pricing mistakes
capable of correction only upon renewal, it was 1977 before the
full impact was felt upon earnings of those earlier rate
increases.
The pendulum now is beginning to swing the other way. We
estimate that costs involved in the insurance areas in which we
operate rise at close to 1% per month. This is due to continuous
monetary inflation affecting the cost of repairing humans and
property, as well as “social inflation”, a broadening definition
by society and juries of what is covered by insurance policies.
Unless rates rise at a comparable 1% per month, underwriting
profits must shrink. Recently the pace of rate increases has
slowed dramatically, and it is our expectation that underwriting
margins generally will be declining by the second half of the
year.
We must again give credit to Phil Liesche, greatly assisted
by Roland Miller in Underwriting and Bill Lyons in Claims, for an
extraordinary underwriting achievement in National Indemnity’s
traditional auto and general liability business during 1977.
Large volume gains have been accompanied by excellent
underwriting margins following contraction or withdrawal by many
competitors in the wake of the 1974-75 crisis period. These
conditions will reverse before long. In the meantime, National
Indemnity’s underwriting profitability has increased dramatically
and, in addition, large sums have been made available for
investment. As markets loosen and rates become inadequate, we
again will face the challenge of philosophically accepting
reduced volume. Unusual managerial discipline will be required,
as it runs counter to normal institutional behavior to let the
other fellow take away business - even at foolish prices.
Our reinsurance department, managed by George Young,
improved its underwriting performance during 1977. Although the
combined ratio (see definition on page 12) of 107.1 was
unsatisfactory, its trend was downward throughout the year. In
addition, reinsurance generates unusually high funds for
investment as a percentage of premium volume.
At Home and Auto, John Seward continued to make progress on
all fronts. John was a battlefield promotion several years ago
when Home and Auto’s underwriting was awash in red ink and the
company faced possible extinction. Under his management it
currently is sound, profitable, and growing.
John Ringwalt’s homestate operation now consists of five
companies, with Kansas Fire and Casualty Company becoming
operational late in 1977 under the direction of Floyd Taylor.
The homestate companies had net premium volume of $23 million, up
from $5.5 million just three years ago. All four companies that
operated throughout the year achieved combined ratios below 100,
with Cornhusker Casualty Company, at 93.8, the leader. In
addition to actively supervising the other four homestate
operations, John Ringwalt manages the operations of Cornhusker
which has recorded combined ratios below 100 in six of its seven
full years of existence and, from a standing start in 1970, has
grown to be one of the leading insurance companies operating in
Nebraska utilizing the conventional independent agency system.
Lakeland Fire and Casualty Company, managed by Jim Stodolka, was
the winner of the Chairman’s Cup in 1977 for achieving the lowest
loss ratio among the homestate companies. All in all, the
homestate operation continues to make excellent progress.
The newest addition to our insurance group is Cypress
Insurance Company of South Pasadena, California. This Worker’s
Compensation insurer was purchased for cash in the final days of
1977 and, therefore, its approximate $12.5 million of volume for
that year was not included in our results. Cypress and National
Indemnity’s present California Worker’s Compensation operation
will not be combined, but will operate independently utilizing
somewhat different marketing strategies. Milt Thornton,
President of Cypress since 1968, runs a first-class operation for
policyholders, agents, employees and owners alike. We look
forward to working with him.
Insurance companies offer standardized policies which can be
copied by anyone. Their only products are promises. It is not
difficult to be licensed, and rates are an open book. There are
no important advantages from trademarks, patents, location,
corporate longevity, raw material sources, etc., and very little
consumer differentiation to produce insulation from competition.
It is commonplace, in corporate annual reports, to stress the
difference that people make. Sometimes this is true and
sometimes it isn’t. But there is no question that the nature of
the insurance business magnifies the effect which individual
managers have on company performance. We are very fortunate to
have the group of managers that are associated with us.
Insurance Investments
During the past two years insurance investments at cost
(excluding the investment in our affiliate, Blue Chip Stamps)
have grown from $134.6 million to $252.8 million. Growth in
insurance reserves, produced by our large gain in premium volume,
plus retained earnings, have accounted for this increase in
marketable securities. In turn, net investment income of the
Insurance Group has improved from $8.4 million pre-tax in 1975 to
$12.3 million pre-tax in 1977.
In addition to this income from dividends and interest, we
realized capital gains of $6.9 million before tax, about one-
quarter from bonds and the balance from stocks. Our unrealized
gain in stocks at yearend 1977 was approximately $74 million but
this figure, like any other figure of a single date (we had an
unrealized loss of $17 million at the end of 1974), should not be
taken too seriously. Most of our large stock positions are going
to be held for many years and the scorecard on our investment
decisions will be provided by business results over that period,
and not by prices on any given day. Just as it would be foolish
to focus unduly on short-term prospects when acquiring an entire
company, we think it equally unsound to become mesmerized by
prospective near term earnings or recent trends in earnings when
purchasing small pieces of a company; i.e., marketable common
stocks.
A little digression illustrating this point may be
interesting. Berkshire Fine Spinning Associates and Hathaway
Manufacturing were merged in 1955 to form Berkshire Hathaway Inc.
In 1948, on a pro forma combined basis, they had earnings after
tax of almost $18 million and employed 10,000 people at a dozen
large mills throughout New England. In the business world of
that period they were an economic powerhouse. For example, in
that same year earnings of IBM were $28 million (now $2.7
billion), Safeway Stores, $10 million, Minnesota Mining, $13
million, and Time, Inc., $9 million. But, in the decade
following the 1955 merger aggregate sales of $595 million
produced an aggregate loss for Berkshire Hathaway of $10 million.
By 1964 the operation had been reduced to two mills and net worth
had shrunk to $22 million, from $53 million at the time of the
merger. So much for single year snapshots as adequate portrayals
of a business.
Equity holdings of our insurance companies with a market
value of over $5 million on December 31, 1977 were as follows:
No. of Shares Company Cost Market
------------- ------- -------- --------
(000’s omitted)
220,000 Capital Cities Communications, Inc. ..... $ 10,909 $ 13,228
1,986,953 Government Employees Insurance
Company Convertible Preferred ........ 19,417 33,033
1,294,308 Government Employees Insurance
Company Common Stock ................. 4,116 10,516
592,650 The Interpublic Group of Companies, Inc. 4,531 17,187
324,580 Kaiser Aluminum& Chemical Corporation ... 11,218 9,981
1,305,800 Kaiser Industries, Inc. ................. 778 6,039
226,900 Knight-Ridder Newspapers, Inc. .......... 7,534 8,736
170,800 Ogilvy & Mather International, Inc. ..... 2,762 6,960
934,300 The Washington Post Company Class B ..... 10,628 33,401
-------- --------
Total ................................... $ 71,893 $139,081
All Other Holdings ...................... 34,996 41,992
-------- --------
Total Equities .......................... $106,889 $181,073
======== ========
We select our marketable equity securities in much the same
way we would evaluate a business for acquisition in its entirety.
We want the business to be (1) one that we can understand, (2)
with favorable long-term prospects, (3) operated by honest and
competent people, and (4) available at a very attractive price.
We ordinarily make no attempt to buy equities for anticipated
favorable stock price behavior in the short term. In fact, if
their business experience continues to satisfy us, we welcome
lower market prices of stocks we own as an opportunity to acquire
even more of a good thing at a better price.
Our experience has been that pro-rata portions of truly
outstanding businesses sometimes sell in the securities markets
at very large discounts from the prices they would command in
negotiated transactions involving entire companies.
Consequently, bargains in business ownership, which simply are
not available directly through corporate acquisition, can be
obtained indirectly through stock ownership. When prices are
appropriate, we are willing to take very large positions in
selected companies, not with any intention of taking control and
not foreseeing sell-out or merger, but with the expectation that
excellent business results by corporations will translate over
the long term into correspondingly excellent market value and
dividend results for owners, minority as well as majority.
Such investments initially may have negligible impact on our
operating earnings. For example, we invested $10.9 million in
Capital Cities Communications during 1977. Earnings attributable
to the shares we purchased totaled about $1.3 million last year.
But only the cash dividend, which currently provides $40,000
annually, is reflected in our operating earnings figure.
Capital Cities possesses both extraordinary properties and
extraordinary management. And these management skills extend
equally to operations and employment of corporate capital. To
purchase, directly, properties such as Capital Cities owns would
cost in the area of twice our cost of purchase via the stock
market, and direct ownership would offer no important advantages
to us. While control would give us the opportunity - and the
responsibility - to manage operations and corporate resources, we
would not be able to provide management in either of those
respects equal to that now in place. In effect, we can obtain a
better management result through non-control than control. This
is an unorthodox view, but one we believe to be sound.
Banking
In 1977 the Illinois National Bank continued to achieve a
rate of earnings on assets about three times that of most large
banks. As usual, this record was achieved while the bank paid
maximum rates to savers and maintained an asset position
combining low risk and exceptional liquidity. Gene Abegg formed
the bank in 1931 with $250,000. In its first full year of
operation, earnings amounted to $8,782. Since that time, no new
capital has been contributed to the bank; on the contrary, since
our purchase in 1969, dividends of $20 million have been paid.
Earnings in 1977 amounted to $3.6 million, more than achieved by
many banks two or three times its size.
Late last year Gene, now 80 and still running a banking
operation without peer, asked that a successor be brought in.
Accordingly, Peter Jeffrey, formerly President and Chief
Executive Officer of American National Bank of Omaha, has joined
the Illinois National Bank effective March 1st as President and
Chief Executive Officer.
Gene continues in good health as Chairman. We expect a
continued successful operation at Rockford’s leading bank.
Blue Chip Stamps
We again increased our equity interest in Blue Chip Stamps,
and owned approximately 36 1/2% at the end of 1977. Blue Chip
had a fine year, earning approximately $12.9 million from
operations and, in addition, had realized securities gains of
$4.1 million.
Both Wesco Financial Corp., an 80% owned subsidiary of Blue
Chip Stamps, managed by Louis Vincenti, and See’s Candies, a 99%
owned subsidiary, managed by Chuck Huggins, made good progress in
1977. Since See’s was purchased by Blue Chip Stamps at the
beginning of 1972, pre-tax operating earnings have grown from
$4.2 million to $12.6 million with little additional capital
investment. See’s achieved this record while operating in an
industry experiencing practically no unit growth. Shareholders
of Berkshire Hathaway Inc. may obtain the annual report of Blue
Chip Stamps by requesting it from Mr. Robert H. Bird, Blue Chip
Stamps, 5801 South Eastern Avenue, Los Angeles, California 90040.
Warren E. Buffett, Chairman
March 14,1978