2003 Annual Letter

--- Page 1 --- 2Note: The following table appears in the printed Annual Report on the facing page of the Chairman's Letter and is referred to in that letter. Berkshire’s Corporate Performance vs. the S&P 500 Annual Percentage Change in Per-Share in S&P 500 Book Value of with Dividends Relative Berkshire Included Results Year (1) (2) (1)-(2) 1965 .................................................. 23.8 10.0 13.8 1966 .................................................. 20.3 (11.7) 32.0 1967 .................................................. 11.0 30.9 (19.9) 1968 .................................................. 19.0 11.0 8.0 1969 .................................................. 16.2 (8.4) 24.6 1970 .................................................. 12.0 3.9 8.1 1971 .................................................. 16.4 14.6 1.8 1972 .................................................. 21.7 18.9 2.8 1973 .................................................. 4.7 (14.8) 19.5 1974 .................................................. 5.5 (26.4) 31.9 1975 .................................................. 21.9 37.2 (15.3) 1976 .................................................. 59.3 23.6 35.7 1977 .................................................. 31.9 (7.4) 39.3 1978 .................................................. 24.0 6.4 17.6 1979 .................................................. 35.7 18.2 17.5 1980 .................................................. 19.3 32.3 (13.0) 1981 .................................................. 31.4 (5.0) 36.4 1982 .................................................. 40.0 21.4 18.6 1983 .................................................. 32.3 22.4 9.9 1984 .................................................. 13.6 6.1 7.5 1985 .................................................. 48.2 31.6 16.6 1986 .................................................. 26.1 18.6 7.5 1987 .................................................. 19.5 5.1 14.4 1988 .................................................. 20.1 16.6 3.5 1989 .................................................. 44.4 31.7 12.7 1990 .................................................. 7.4 (3.1) 10.5 1991 .................................................. 39.6 30.5 9.1 1992 .................................................. 20.3 7.6 12.7 1993 .................................................. 14.3 10.1 4.2 1994 .................................................. 13.9 1.3 12.6 1995 .................................................. 43.1 37.6 5.5 1996 .................................................. 31.8 23.0 8.8 1997 .................................................. 34.1 33.4 .7 1998 .................................................. 48.3 28.6 19.7 1999 .................................................. .5 21.0 (20.5) 2000 .................................................. 6.5 (9.1) 15.6 2001 .................................................. (6.2) (11.9) 5.7 2002 .................................................. 10.0 (22.1) 32.1 2003 .................................................. 21.0 28.7 (7.7) Average Annual Gain — 1965-2003 22.2 10.4 11.8 Overall Gain — 1964-2003 259,485 4,743 Notes: Data are for calendar years with these exceptions: 1965 and 1966, year ended 9/30; 1967, 15 months ended 12/31. Starting in 1979, accounting rules required insurance companie s to value the equity securities they hold at market rather than at the lower of cost or market, which was prev iously the requirement. In th is table, Berkshire's results through 1978 have been restated to conform to the changed rule s. In all other respects, the results are calculated using the numbers originally reported. The S&P 500 numbers are pre-tax whereas the Berkshire numbers are after-tax . If a corporation such as Berkshire were simply to have owned the S&P 500 and accrued the appr opriate taxes, its results would have lagged the S&P 500 in years when that index showed a pos itive return, but would have exceeded the S&P in years when the index showed a negative return. Over the years, the tax costs woul d have caused the aggregate lag to be substantial. --- Page 2 --- 3BERKSHIRE HATHAWAY INC. To the Shareholders of Berkshire Hathaway Inc.: Our gain in net worth during 2003 was $13.6 billion, which increased the per-share book value of both our Class A and Class B stock by 21%. Over the last 39 years (that is, since present management took over) per-share book value has grown from $19 to $50,498, a rate of 22.2% compounded annually.* It’s per-share intrinsic value that counts, however, not book value. Here, the news is good: Between 1964 and 2003, Berkshire morphed from a st ruggling northern textile bu siness whose intrinsic value was less than book into a widely diversified enterprise worth far more than book. Our 39-year gainin intrinsic value has therefore some what exceeded our 22.2% gain in boo k. (For a better understanding of intrinsic value and the economic principles that guide Charlie Munger, my partner and Berkshire’s vice- chairman, and me in running Berkshire, please read our Owner’s Manual, beginning on page 69.) Despite their shortcomings, book value calculati ons are useful at Berkshire as a slightly understated gauge for measuring the long-term rate of increase in our intrinsic value. The calculation is less relevant, however, than it once was in rating any single year’s performance versus the S&P 500 index (a comparison we display on the facing page). Our equity holdings, including convertible preferreds, have fallen considerably as a percentage of our net worth, from an average of 114% in the 1980s, for example, toan average of 50% in 2000-03. Th erefore, yearly movements in th e stock market now affect a much smaller portion of our net worth than was once the case. Nonetheless, Berkshire’s long-term performance versus the S&P remains all-important. Our shareholders can buy the S&P through an index fund at very low cost. Unless we achieve gains in per- share intrinsic value in the future that outdo the S&P’ s performance, Charlie and I will be adding nothing to what you can accomplish on your own. If we fail, we will have no excuses. Charlie and I operate in an ideal environment. To begin with, we are supported by an incredible group of men and women who run our operating units. If there were a Corporate Cooperstown, its roster would surely includ e many of our CEOs. Any shortfall in Berkshire’s results will not be caused by our managers. Additionally, we enjoy a rare sort of managerial freedom. Most companies are saddled with institutional constraints. A company’s history, for example, may commit it to an industry that now offers limited opportunity. A more common problem is a sh areholder constituency that pressures its manager to dance to Wall Street’s tune. Many CEOs resist, but others give in and adopt operating and capital-allocation policies far different from those they would choose if left to themselves. At Berkshire, neither history nor the demands of owners impede intelligent decision-making. When Charlie and I make mistakes, they ar e – in tennis parlance – unforced errors. *All figures used in this report apply to Berksh ire’s A shares, the successor to the only stock that the company had outstanding before 1996. The B shares have an economic interest equal to 1/30th that of the A. --- Page 3 --- 4Operating Earnings When valuations are similar, we strongly prefer owning businesses to owning stocks. During most of our years of operation, however, stocks were much the cheaper choice. We therefore sharply tilted our asset allocation in those years toward equitie s, as illustrated by the percentages cited earlier. In recent years, however, we’ve found it hard to find significantly undervalued stocks, a difficulty greatly accentuated by the mushrooming of the funds we must deploy. Today, the number of stocks that can be purchased in large enough quantities to move the performance needle at Berkshire is a small fractionof the number that existed a decade ago. (Investment managers often profit far more from piling up assets than from handling those assets well. So when one tells you that increased funds won’t hurt his investment performance, step back: His nose is about to grow.) The shortage of attractively-priced stocks in which we can put large sums doesn’t bother us, providing we can find companies to purchase that (1) have favorable and enduring economic charac- teristics; (2) are run by talented and honest managers and (3) are available at a sensible price. We have purchased a number of such businesses in recent years, though not enough to fu lly employ the gusher of cash that has come our way. In buying businesses, I’ve made some terrible mistakes, both of commission and omission. Overall, however, our acquisitions have led to decent gains in per-share earnings. Below is a table that quantifies that point. But first we need to warn you that growth-rate presentations can be significantly distorted by a calculate d selection of either initial or terminal dates. For example, if earnings are tiny in a beginning year, a long-term performance that was only mediocre can be made to appear sensational. That kind of distor tion can come about because the company at issue was minuscule in the base year – which means that only a handful of insiders actually benefited from the touted performance – or because a larger company was then ope rating at just above breake ven. Picking a terminal year that is particularly buoyant will al so favorably bias a calculation of growth. The Berkshire Hathaway that present manageme nt assumed control of in 1965 had long been sizable. But in 1964, it earned only $175,586 or 15 cents per share, so close to breakeven that any calculation of earnings growth from that base would be meaningless. At the time, however, even those meager earnings looked good: Over the decade following the 1955 me rger of Berkshire Fine Spinning Associates and Hathaway Manufacturing, the comb ined operation had lost $10.1 million and many thousands of employees had been let go. It was not a marriage made in heaven. Against this background, we give you a picture of Berkshire’s earnings growth that begins in 1968, but also includes subsequent base years spaced five years apart. A series of calculations is presented so that you can decide for yourself which period is most meaningful. I’ve started with 1968 because it was the first full year we operated National Indemnity, the initial acquisition we made as we began to expand Berkshire’s business. I don’t believe that using 2003 as the terminal year distorts our calculations. It was a terrific year for our insurance business, but the big boost that gave to earnings was largely offset by the pathetically low interest rates we earned on our large holdings of cash equivalents (a condition that will not last). All figures shown below, it should be noted, exclude capital gains. Operatin g Earnin gs Operatin g Earnin gs Subse quent Com pounded Year in $ millions Per Share in $ Growth Rate o f Per-Share Earnin gs 1964 .2 .15 Not meanin gful (1964-2003 ) 1968 2.7 2.69 22.8% (1968-2003 ) 1973 11.9 12.18 20.8% (1973-2003 ) 1978 30.0 29.15 21.1% (1978-2003 ) 1983 48.6 45.60 24.3% (1983-2003 ) 1988 313.4 273.37 18.6% (1988-2003 ) 1993 477.8 413.19 23.9% (1993-2003 ) 1998 1,277.0 1,020.49 28.2% (1998-2003 ) 2003 5,422.0 3,531.32 --- Page 4 --- 5We will continue the capital allocation practices we have used in the past. If stocks become significantly cheaper than entire businesses, we will buy them aggressively. If selected bonds become attractive, as they did in 2002, we will ag ain load up on these securities. Under any market or economic conditions, we will be happy to buy businesses that meet our standards. And, for those that do, the bigger the better. Our capital is underutilized now, but that will happen periodically. It’s a painful condition to be in – but not as painful as doing something stupid. (I speak from experience.) Overall, we are certain Berkshire’s performance in the future will fall far short of what it has been in the past. Nonetheless, Charlie and I remain hopeful that we can deliver results that are modestly aboveaverage. That’s what we’re being paid for. Acquisitions As regular readers know, our acquisitions have often come about in strange ways. None, however, had a more unusual genesis than our purchase last year of Clayton Homes. The unlikely source was a group of finance students from the University of Tennessee, and their teacher, Dr. Al Auxier. For the past five years, Al has br ought his class to Omaha, where the group tours Nebraska Furniture Mart and Borshe im’s, eats at Gorat’s and then comes to Kiewit Plaza for a session with me. Usually about 40 students participate. After two hours of give-and-take, the group traditio nally presents me with a thank-you gift. (The doors stay locked until they do.) In past years it’s been items such as a football signed by Phil Fulmer anda basketball from Tennessee’s famous women’s team. This past February, the group opted for a book – which, luckily for me, was the recently-published autobiography of Jim Clayton, founder of Clayton Home s. I already knew the co mpany to be the class act of the manufactured housing industry, knowledge I acquired after earlier making the mistake of buying some distressed junk debt of Oakwood Homes, one of the industry’s largest companies. At the time of thatpurchase, I did not understand how atrocious consume r-financing practices had become throughout most of the manufactured housing industry. But I learned: Oakwood rather promptly went bankrupt. Manufactured housing, it should be emphasized, can deliver very good value to home purchasers. Indeed, for decades, the industry has accounted for mo re than 15% of the homes built in the U.S. During those years, moreover, both the quality and variety of manufactured houses consistently improved. Progress in design and construction was not matched, however, by progress in distribution and financing. Instead, as the years went by, the industry’s business model increasingly centered on the ability of both the retailer and manufacturer to unload terrib le loans on naive lenders. When “securitization” then became popular in the 1990s, furthe r distancing the supplier of funds from the lend ing transaction, the industry’s conduct went from bad to worse. Much of its volume a few years back came from buyers who shouldn’t have bought, financed by lenders who shouldn’t have lent. The consequence has been huge numbers of repossessions and pitifully lo w recoveries on the units repossessed. Oakwood participated fully in the insanity. Bu t Clayton, though it could not isolate itself from industry practices, behaved considerably better than its major competitors. Upon receiving Jim Clayton’s book, I told the st udents how much I admire d his record and they took that message back to Knoxville, home of both the University of Tennessee and Clayton Homes. Althen suggested that I call Kevin Clayton, Jim’s son and the CEO, to express my views directly. As I talked with Kevin, it became clear that he was both able and a straight-shooter. Soon thereafter, I made an offer for the business based solely on Jim’s book, my evaluation of Kevin, the public financials of Clayton and what I had learned from the Oakwood experience. Clayton’sboard was receptive, since it understo od that the large-scale financing Clayton would need in the future might be hard to get. Lenders had fled the industry and securitizations, when possible at all, carried far --- Page 5 --- 6more expensive and restrictive terms than was previously the case. This tightening was particularly serious for Clayton, whose earnings significantly depended on securitizations. Today, the manufactured housing industry remain s awash in problems. Delinquencies continue high, repossessed units still abound and the number of retailers has been halved. A different business model is required, one that eliminates the ability of the retailer and salesman to pocket substantial moneyup front by making sales financed by loans that are destined to default. Such transactions cause hardship to both buyer and lender and lead to a flood of repossessions that then undercut the sale of new units. Under a proper model – one requiring significant down payments and shorter-term loans – the industry will likelyremain much smaller than it was in the 90s. But it w ill deliver to home buyers an asset in which they will have equity, rather than disappointment, upon resale. In the “full circle” department, Clayton has agr eed to buy the assets of Oakwood. When the transaction closes, Clayton’s manufacturing capac ity, geographical reach and sales outlets will be substantially increased. As a byproduct, the debt of Oakwood that we own, which we bought at a deep discount, will probably return a small profit to us. And the students? In October, we had a surprise “graduation” ceremony in Knoxville for the 40 who sparked my interest in Clayton. I donned a mortarboard and presented each student with both a PhD (for phenomenal, hard-working dealmaker) from Berkshire and a B share. Al got an A share. If you meetsome of the new Tennessee shareholders at our annual meeting, give them your thanks. And ask them if they’ve read any good books lately. * * * * * * * * * * * * In early spring, Byron Trott, a Managing Director of Goldman Sachs, told me that Wal-Mart wished to sell its McLane subsidiary. McLane distributes groceries and nonfood items to convenience stores, drug stores, wholesale clubs, mass merchandisers , quick service restaurants, theaters and others. It’s a good business, but one not in the mainstream of Wal-Mart’s future. It’s made to order, however, for us. McLane has sales of about $23 billion, but operat es on paper-thin margins – about 1% pre-tax – and will swell Berkshire’s sales figures far more than our income. In the past, some retailers had shunned McLane because it was owned by their major competitor. Grady Rosier, McLane’s superb CEO, has already landed some of these accounts – he was in full stride the day the deal closed – and more will come. For several years, I have given my vote to Wal-Mart in the balloting for Fortune Magazine’s “Most Admired” list. Our McLane transaction reinforced my opinion. To make the McLane deal, I had asingle meeting of about two hours with Tom Schoewe, Wal-Mart’s CFO, and we then shook hands. (He did, however, first call Bentonville). Twenty-nine da ys later Wal-Mart had its money. We did no “due diligence.” We knew everything would be exactly as Wal-Mart said it would be – and it was. I should add that Byron has now been instru mental in three Berkshire acquisitions. He understands Berkshire far better than any investment banker with whom we have talked and – it hurts me tosay this – earns his fee. I’m looking forward to deal number four (as, I am sure, is he). Taxes On May 20, 2003, The Wash ington Post ran an op-ed piece by me that was critical of the Bush tax proposals. Thirteen days later, Pamela Olson, A ssistant Secretary for Tax Po licy at the U.S. Treasury, delivered a speech about the new tax legislation saying , “That means a certain midwestern oracle, who, it must be noted, has played the tax code like a fiddle, is still safe retaining all his earnings.” I think she was talking about me. Alas, my “fiddle playing” will not get me to Carnegie Hall – or even to a high school recital. Berkshire, on your behalf and mine, will send the Tr easury $3.3 billion for tax on its 2003 income, a sum equaling 2½% of the total income tax paid by all U.S. corporations in fiscal 2003. (In contrast, Berkshire’s market valuation is about 1% of the value of all American corporations.) Our payment will almost --- Page 6 --- 7certainly place us among our country’s top ten taxpaye rs. Indeed, if only 5 40 taxpayers paid the amount Berkshire will pay, no other individual or corporation would have to pay anything to Uncle Sam. That’s right: 290 million Americans and all other businesses would not have to pay a dime in income, socialsecurity, excise or estate taxes to the federal govern ment. (Here’s the math: Federal tax receipts, including social security receipts, in fis cal 2003 totaled $1.782 trillion and 540 “Berkshires,” each paying $3.3 billion, would deliver the same $1.782 trillion.) Our federal tax return for 2002 (2003 is not fina lized), when we paid $1.75 billion, covered a mere 8,905 pages. As is required, we dutifully filed two copies of this return, creating a pile of paper seven feettall. At World Headquarters, our small band of 15.8, though exhausted, momentarily flushed with pride: Berkshire, we felt, was surely pulling its share of our country’s fiscal load. But Ms. Olson sees things otherwise. And if that means Charlie and I need to try harder, we are ready to do so. I do wish, however, that Ms. Olson would give me some credit for the progress I’ve already made. In 1944, I filed my first 1040, reporting my income as a thirteen-year-old newspaper carrier. The return covered three pages. After I claimed the appropriate business deductions, such as $35 for a bicycle, my tax bill was $7. I sent my check to the Treasury and it – without comment – promptly cashed it. We lived in peace. * * * * * * * * * * * * I can understand why the Treasury is now frus trated with Corporate America and prone to outbursts. But it should look to Congress and the Administration for redress, not to Berkshire. Corporate income taxes in fiscal 2003 accounted for 7.4% of all federal tax receipts, down from a post-war peak of 32% in 1952. With one exception (1 983), last year’s percenta ge is the lowest recorded since data was first published in 1934. Even so, tax breaks for corporations (and their investors, particularly large ones) were a major part of the Administration’s 2002 and 2003 initiatives. If cl ass warfare is being waged in America, my class is clearly winning. Today, many large corporations – run by CEOs whose fiddle-playing talents make your Chairman look like he is all thumbs – pay nothing close to the stated federal tax rate of 35%. In 1985, Berkshire paid $132 million in federal income taxes, and all corporations paid $61 billion. The comparable amounts in 1995 were $286 million and $1 57 billion respectiv ely. And, as mentioned, we will pay about $3.3 billion for 2003, a y ear when all corporations paid $132 billion. We hope our taxes continue to rise in the future – it will mean we are prospering – but we also hope that the rest of Corporate America antes up along with us. This might be a project for Ms. Olson to work on. Corporate Governance In judging whether Corporate Amer ica is serious about reforming itself, CEO pay remains the acid test. To date, the results aren’t encouraging. A fe w CEOs, such as Jeff Immelt of General Electric, have led the way in initiating programs that are fair to mana gers and shareholders alike. Generally, however, his example has been more admired than followed. It’s understandable how pay got out of hand. When management hires employees, or when companies bargain with a vendor, the intensity of intere st is equal on both sides of the table. One party’s gain is the other party’s loss, and the money involved has real meaning to both. The result is an honest-to- God negotiation. But when CEOs (or their representatives) have met with compensation committees, too often one side – the CEO’s – has cared far more than the other about what bargain is struck. A CEO, for example, will always regard the difference between receiving options for 100,000 sh ares or for 500,000 as monumental. To a comp committee, however, the difference may seem unimportant – particularly if, as --- Page 7 --- 8has been the case at most companies, neither grant w ill have any effect on reported earnings. Under these conditions, the negotiation often has a “play-money” quality. Overreaching by CEOs greatly accel erated in the 1990s as compen sation packages gained by the most avaricious– a title for which there was vigorous competition – were promptly replicated elsewhere. The couriers for this epidemic of greed were usually consultants and human relations departments, whichhad no trouble perceiving who buttered their bread. As one compensation consultant commented: “There are two classes of clients you don’t want to offend – actual and potential.” In proposals for reforming this malfunctioning system, the cry has been for “independent” directors. But the question of what truly motiv ates independence has largely been neglected. In last year’s report, I took a look at how “independent” directors – as defined by statute – had performed in the mutual fund field. The Investment Company Act of 1940 mandated such directors, andthat means we’ve had an extended test of what statut ory standards produce. In our examination last year, we looked at the record of fund directors in respect to the two key tasks board members should perform – whether at a mutual fund business or any other. These two all-important functions are, first, to obtain (orretain) an able and honest manager and then to compensate that manager fairly. Our survey was not encouraging. Year after year , at literally thousands of funds, directors had routinely rehired the incumbent management company, however pathetic its performance had been. Just as routinely, the directors had mindlessl y approved fees that in many cases far exceeded those that could have been negotiated. Then, when a management company was sold – invariably at a huge price relative totangible assets – the directors experienced a “counter-revelation” and immediately signed on with the new manager and accepted its fee schedule. In effect, th e directors decided that whoever would pay the most for the old management company was the party that should manage the shareholders’ money in the future. Despite the lapdog behavior of independent fund directors, we did not conclude that they are bad people. They’re not. But sadly, “boardroom atmos phere” almost invariably se dates their fiduciary genes. On May 22, 2003, not long after Berkshire’s report appeared, the Chairman of the Investment Company Institute addressed its membership about “The State of our Industry.” Responding to those who have “weighed in about our perceived failings,” he mused, “It makes me wonder what life would be like if we’d actually done something wrong.” Be careful what you wish for. Within a few months, the world began to lear n that many fund-management companies had followed policies that hurt the owners of the funds they managed, while simultaneously boosting the fees of the managers. Prior to their transgressions, it should be noted, these management companies were earning profit margins and returns on tangible equity that were the envy of Corporate America. Yet to swell profits further, they trampled on the interests of fund shareholders in an appalling manner. So what are the directors of these looted funds doing? As I write this, I have seen none that have terminated the contract of the offending management company (though naturally that entity has often fired some of its employees). Can you imagine directors who had been personally defrauded taking such a boys-will-be-boys attitude? To top it all off, at least one miscreant ma nagement company has put itself up for sale, undoubtedly hoping to receive a huge sum for “delivering” the mutual funds it has managed to the highest bidder among other managers. This is a travesty. Why in the world don’t the directors of those funds simply select whomever they think is best among the bidding organizations and sign up with that party directly? The winner would consequently be spared a huge “payoff” to the former manager who, having flouted the principles of stewardship, deserves not a dime. Not having to bear that acquisition cost, the winner could surely manage the funds in question for a far lower ongoing fee than would otherwise have been the case. Any truly independent director should insist on this approach to obtaining a new manager. --- Page 8 --- 9The reality is that neither the decades-old rules regulating invest ment company directors nor the new rules bearing down on Corporate America foster the elec tion of truly independent directors. In both instances, an individual who is recei ving 100% of his income from dir ector fees – and who may wish to enhance his income through election to other boards – is deemed independent. Th at is nonsense. The same rules say that Berkshire director an d lawyer Ron Olson, who receives from us perhaps 3% of his very large income, does not qualify as independent because that 3% comes from legal fees Berkshire pays his firm rather than from fees he earns as a Berkshire director. Rest assured, 3% from any source would not torpedo Ron’s independence. But getting 20%, 30% or 50% of their income from director fees might well temper the independence of many individuals, particularly if their overall income is not large. Indeed, I think it’s clear that at mutual funds, it has. * * * * * * * * * * * Let me make a small suggestion to “independent” mutual fund directors. Why not simply affirm in each annual report that “(1) We have looked at other management companies and believe the one we have retained for the upcoming year is among the better operations in the field; and (2) we have negotiated a fee with our managers comparable to what other clients with equivalent funds would negotiate.” It does not seem unreasonable for shareholders to expect fund directors – who are often receiving fees that exceed $100,000 annually – to declare themselves on these points. Certainly these directors would satisfy themselves on both matters were they handing over a large chunk of their own money to the manager. If directors are unwilling to make these tw o declarations, shareholders should heed the maxim “If you don’t know whose side someone is on, he’s probably not on yours.” Finally, a disclaimer. A great many funds have been run well and conscientiously despite the opportunities for malfeasance that exist. The share holders of these funds have benefited, and their managers have earned their pay. Indeed, if I were a director of certain funds, including some that charge above-average fees, I would enthusiastically make th e two declarations I have suggested. Additionally, those index funds that are very low-cost (such as Vanguard’s) are investor-frie ndly by definition and are the best selection for most of those who wish to own equities. I am on my soapbox now only because the blatant wrongdoing that has occurred has betrayed the trust of so many millions of shareholders. Hundreds of industry insiders had to know what was going on, yet none publicly said a word. It took Eliot Spit zer, and the whistleblowers who aided him, to initiate a housecleaning. We urge fund directors to continue the job. Like directors throughout Corp orate America, these fiduciaries must now decide whether their job is to work for owners or for managers. Berkshire Governance True independence – meaning the willingness to challenge a forceful CEO when something is wrong or foolish – is an enormously valuable trait in a director. It is also rare. The place to look for it is among high-grade people whose interests are in line with those of rank-and-file shareholders – and are in line in a very big way . We’ve made that search at Berkshire. We now have eleven directors and each of them, combined with members of their families, owns more than $4 million of Berkshire stock. Moreover, all have held major stakes in Berkshire for many years. In the case of six of the eleven, family ownership amounts to at least hundreds of millions and dates back at least three decades. All eleven directors purchased their holdings in the market just as you did; we’ve never passed out options or restricted shares. Charlie and Ilove such honest-to-God ownership. After all, who ever washes a rental car? In addition, director fees at Berkshire are nominal (as my son, Howard, periodically reminds me). Thus, the upside from Berkshire for all eleven is propo rtionately the same as the upside for any Berkshire shareholder. And it always will be. --- Page 9 --- 10The downside for Berkshire di rectors is actually worse than yours because we carry no directors and officers liability insurance. Therefore, if so mething really catastrophic happens on our directors’ watch, they are exposed to lo sses that will far exceed yours. The bottom line for our directors: You win, they win big; you lose, they lose big. Our approach might be called owner-capitalism. We know of no better way to engender true independence. (Thisstructure does not guarantee perfect behavior, however: I’ve sat on boards of companies in which Berkshire had huge stakes and remained silent as questionable proposals were rubber-stamped.) In addition to being independent, directors should have business savvy, a shareholder orientation and a genuine interest in the company. The rarest of these qualities is business savvy – and if it is lacking, the other two are of little help. Many people wh o are smart, articulate and admired have no real understanding of business. That’s no sin; they may shine elsewhere. But they don’t belong on corporate boards. Similarly, I would be useless on a medical or scientific board (though I would likely be welcomedby a chairman who wanted to run things his way). My name would dress up the list of directors, but I wouldn’t know enough to critically evaluate proposals. Moreover, to cloak my ignorance, I would keep my mouth shut (if you can imagine that). In effect, I could be replaced, without loss, by a potted plant. Last year, as we moved to change our board, I asked for self-nominations from shareholders who believed they had the requisite qualities to be a Berksh ire director. Despite the lack of either liability insurance or meaningful compensatio n, we received more than twenty applications. Most were good, coming from owner-oriented individuals having family holdings of Berkshire worth well over $1 million. After considering them, Charlie and I – with the concurrence of our incumbent directors – asked fourshareholders who did not nominate themselves to join the board: David Gottesman, Charlotte Guyman, Don Keough and Tom Murphy. These four people are all friends of mine, and I know their strengths well. They bring an extraordinary amount of business talent to Berkshire’s board. The primary job of our directors is to select my successor, either upon my death or disability, or when I begin to lose my marbles. (David Ogilvy had it right when he said: “Develop your eccentricities when young. That way, when you get older, people won’t think you are going gaga.” Charlie’s family and mine feel that we overr eacted to David’s advice.) At our directors’ meetings we cover the usual run of housekeeping matters. But the real discussion – both with me in the room and absent – centers on the strengths and weaknesses of the fourinternal candidates to replace me. Our board knows that th e ultimate scorecard on its performance will be determined by the record of my successor. He or she will need to maintain Berkshire’s culture, allocate capital and keep a group of America’s best managers happy in their jobs. This isn’ t the toughest task in the world – the train is already moving at a good clip down the track – and I’m totall y comfortable about it being done well by any of the four candidates we have identified. I have more than 99% of my net worth in Berkshire and will be happy to have my wife or foundation (depending on the order in which she and I die) continue this concentration. Sector Results As managers, Charlie and I want to give our owners the financial information and commentary we would wish to receive if our roles were reversed. To do this with both clarity and reasonable brevity becomes more difficult as Berkshire’s scope widens. Some of our businesses have vastly different economic characteristics from others, which means that our co nsolidated statements, with their jumble of figures, make useful analysis almost impossible. On the following pages, therefor e, we will present some balance sheet and earnings figures from our four major categories of businesses along with co mmentary about each. We particularly want you to understand the limited circumstances under which we will use debt, since typically we shun it. We will not, however, inundate you with data that has no r eal value in calculating Berkshire’s intrinsic value. Doing so would likely obfuscate the most important f acts. One warning: When analyzing Berkshire, be --- Page 10 --- 11sure to remember that the company should be viewed as an unfolding movie, not as a still photograph. Those who focused in the past on only the snapshot of the day sometimes reached erroneous conclusions. Insurance Let’s start with insurance – si nce that’s where the money is. The fountain of funds we enjoy in our insurance operations comes from “float,” which is money that doesn’t belong to us but that we temporarily hold . Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, since it sometimes takes years for losses to be re ported (think asbestos), negotiated and settled. Float is wonderful – if it doesn’t come at a high price. The cost of float is determined by underwriting results, meaning how lo sses and expenses paid compare with premiums received. The property-casualty industry as a whole regularly operates at a substantial underwriting loss, and therefore often has a cost of float that is unattractive. Overall, our results have been good. True, we’ve had five terrible years in which float cost us more than 10%. But in 18 of the 37 years Berkshire has been in the insurance business, we have operated at an underwriting profit, meaning we were actually paid for holding money. And the quantity of this cheap money has grown far beyond what I dreamed it could when we entered the business in 1967. Yearend Float (in $ millions) Other Other Year GEICO General Re Reinsurance Primary Total 1967 20 20 1977 40 131 171 1987 701 807 1,508 1997 2,917 4,014 455 7,386 1998 3,125 14,909 4,305 415 22,754 1999 3,444 15,166 6,285 403 25,298 2000 3,943 15,525 7,805 598 27,871 2001 4,251 19,310 11,262 685 35,508 2002 4,678 22,207 13,396 943 41,224 2003 5,287 23,654 13,948 1,331 44,220 Last year was a standout. Float reached record levels and it came without cost as all major segments contributed to Berkshire’s $1.7 billion pre-tax underwriting profit. Our results have been exceptional for one reason: We have truly exceptional managers. Insurers sell a non-proprietary piece of paper containing a non-proprietary promise. Anyone can copy anyone else’s product. No installed base, key patents, critical real estate or natural resource position protects an insurer’s competitive position. Typically, brands do not mean much either. The critical variables, therefore, are managerial brains, discipline and integrity. Our managers have all of these attributes – in spades. Let’s take a look at these all-stars and their operations. • General Re had been Berkshire’s problem child in the years following our acquisition of it in 1998. Unfortunately, it was a 400-pound child, and its negative impact on our overall performance was large. That’s behind us: Gen Re is fixed. Thank Joe Brandon, its CEO, and his partner, TadMontross, for that. When I wrote you last year, I thought that discipline had been restored toboth underwriting and reserving, and events during 2003 solidified my view. --- Page 11 --- 12That does not mean we will never have setbacks. Reinsurance is a business that is certain to deliver blows from time to time. But, under Joe and Tad, this operation will be a powerful engine driving Berkshire’s future profitability. Gen Re’s financial strength, unmatched among reinsurers even as we started 2003, furtherimproved during the year. Many of the comp any’s competitors suff ered credit downgrades last year, leaving Gen Re, and its sister operation at National Indemnity, as the only AAA- rated companies among the world’s major reinsurers. When insurers purchase reinsurance, they buy only a promise – one whose validity may notbe tested for decades – and there are no prom ises in the reinsurance world equaling those offered by Gen Re and National Indemnity. Fu rthermore, unlike most reinsurers, we retain virtually all of the risks we assume. Therefore, our ability to pay is not dependent on the ability or willingness of others to reimburse us. This independent financial strength could be enormously important when the industry expe riences the mega-catastrophe it surely will. • Regular readers of our annual reports know of Ajit Jain’s incredible contributions to Berkshire’s prosperity over the past 18 years. He continued to pour it on in 2003. With a staff of only 23, Ajit runs one of the world’ s largest reinsurance operations, specializing in mammoth and unusual risks. Often, these involve assuming catastrophe risk s – say, the threat of a large California earthquake – of a size far greater than any ot her reinsurer will accept. This means Ajit’s results (and Berkshire’s) will be lumpy. You should, therefore, expect his operation to have an occasional horrible year. Over time, however, you can be confident of a terrific result from this one-of-a-kind manager. Ajit writes some very unusual policies. Last year, for example, PepsiCo promoted a drawingthat offered participants a chance to win a $1 billion prize. Understandably, Pepsi wished to lay off this risk, and we were the logical party to assume it. So we wrote a $1 billion policy, retaining the risk entirely for our own account. Because the prize, if won, was payable over time, our exposure in present-value terms was $250 million. (I helpfully suggested that any winner be paid $1 a year for a billion years, but that proposal didn’t fly.) The drawing was held on September 14. Ajit and I held our breath, as did the finalist in the contest, and we lefthappier than he. PepsiCo has renewed for a repeat contest in 2004. • GEICO was a fine insurance company when Tony Nicely took over as CEO in 1992. Now it is a great one. During his tenure, premium volume has increased from $2.2 billion to $8.1 billion, and our share of the personal-auto market has grown from 2.1% to 5.0%. More important, GEICO has paired these gains with outstanding underwriting performance. (We now pause for a commercial) It’s been 67 years since Leo Goodwin created a great business idea at GEICO, one designed to save policyholders significant money. Go to Geico.com or call 1-800-847-7536 to see what we can do for you. (End of commercial) In 2003, both the number of inquiries coming into GEICO and its closure rate on these increased significantly. As a result our preferred policyholder count grew 8.2%, and ourstandard and non-standard policies grew 21.4%. GEICO’s business growth creates a never-end ing need for more employees and facilities. Our most recent expansio n, announced in December, is a cu stomer service center in – I’m delighted to say – Buffalo. Stan Lipsey, the publisher of our Buffalo News, was instrumental in bringing the city and GEICO together. --- Page 12 --- 13The key figure in this matter, however, was Governor George Pataki. His leadership and tenacity are why Buffalo will have 2,500 new jobs when our expansion is fully rolled out.Stan, Tony, and I – along with Buffalo – thank him for his help. • Berkshire’s smaller insurers had another terrific year. This group, run by Rod Eldred, John Kizer, Tom Nerney, Don Towle and Don Wurs ter, increased its float by 41%, while delivering an excellent underwriting profit. Thes e men, though operating in unexciting ways, produce truly exciting results. * * * * * * * * * * * * We should point out again that in any given year a company writing long-tail insurance (coverages giving rise to claims that are often settled many y ears after the loss-causing event takes place) can report almost any earnings that the CEO desi res. Too often the industry has re ported wildly inaccurate figures by misstating liabilities. Most of the mistakes have be en innocent. Sometimes, however, they have been intentional, their object being to fool investors and regulators. Auditors and actuaries have usually failed toprevent both varieties of misstatement. I have failed on occasion too, particularly in not spotting Gen Re’s unw itting underreserving a few years back. Not only did that mean we reported inaccurate figures to you , but the error also resulted in our paying very substantial taxes earlier than was necessary. Aaarrrggghh. I told you last year, however, that I thought our current reserving was at appropriate levels. So far, that judgment is holding up. Here are Berkshire’s pre-tax underwriting results by segment: Gain (Loss) in $ millions 2003 2002 Gen Re...................................................................................................... $ 145 $(1,393) Ajit’s business excluding retroactive contracts ........................................ 1,434 980 Ajit’s retroactiv e contracts* ..................................................................... (387) (433) GEICO...................................................................................................... 452 416 Other Primary........................................................................................... 74 32 Total ......................................................................................................... $1,718 $ (398) *These contracts were explained on page 10 of the 2002 annual report, available on the Internet at www.berkshirehathaway.com . In brief, this segment consists of a few jumbo policies that are likely to produce underwriting losses (which are capped) but also provide un usually large amounts of float. Regulated Utility Businesses Through MidAmerican Energy Holdings, we own an 80.5% (fully diluted) interest in a wide variety of utility operations. The largest are (1) York shire Electricity and Northern Electric, whose 3.7 million electric customers make it the third largest di stributor of electricity in the U.K.; (2) MidAmerican Energy, which serves 689,000 elect ric customers in Iowa and; (3) Kern River and Northern Natural pipelines, which carry 7.8% of the natural gas transported in the United States. Berkshire has three partners, who own the remaining 19.5%: Dave Sokol and Greg Abel, the brilliant managers of the business, and Walter Scott, a long-time friend of mine who introduced me to the company. Because MidAmerican is subject to the Public Utility Holding Company Act (“PUHCA”),Berkshire’s voting interest is limited to 9.9%. Walter has the controlling vote. Our limited voting interest forces us to account for MidAmerican in our financial statements in an abbreviated manner. Instead of our fully including its assets, liabilities, revenues and expenses in our statements, we record only a one-lin e entry in both our balance sheet and income account. It’s likely that --- Page 13 --- 14some day, perhaps soon, either PUHCA will be rep ealed or accounting rules will change. Berkshire’s consolidated figures would then take in all of MidAmerican, including the substantial debt it utilizes. The size of this debt (which is not now, nor w ill it be, an obligation of Berkshire) is entirely appropriate. MidAmerican’s diverse and stable utility operations assure that, even under harsh economic conditions, aggregate earnings will be ample to very comfortably service all debt. At yearend, $1.578 billion of MidAmerican’s most junior debt was payable to Berkshire. This debt has allowed acquisitions to be financed without our three partners needing to increase their alreadysubstantial investments in MidAmerican. By charging 11% interest, Berkshire is compensated fairly for putting up the funds needed for purchases, while our pa rtners are spared dilution of their equity interests. MidAmerican also owns a significant non-utility business, Home Services of America, the second largest real estate broker in the country. Unlike our utility operations, this business is highly cyclical, but nevertheless one we view enthusiastically. We have an exceptional manager, Ron Peltier, who, through both his acquisition and operational skills, is building a brokerage powerhouse. Last year, Home Services participated in $48.6 billion of transactions, a gain of $11.7 billion from 2002. About 23% of the increase came from four acquisitions made during the year. Through our 16 brokerage firms – all of which retain their local identities – we employ 16,343 brokers in 16 states. HomeServices is almost certain to grow substantially in the next decade as we continue to acquire leading localized operations. * * * * * * * * * * * * Here’s a tidbit for fans of free enterprise. On March 31, 1990, the day electric utilities in the U.K. were denationalized, Northern and Yorkshire had 6,800 employees in functions these companies continue today to perform. Now they employ 2,539. Yet the companies are serving about the same number of customers as when they were government ow ned and are distributing more electricity. This is not, it should be noted, a triumph of de regulation. Prices and earnings continue to be regulated in a fair manner by the government, just as they should be. It is a victory, however, for those who believe that profit-motivated managers, even though th ey recognize that the benefits will largely flow to customers, will find efficiencies that government never will. Here are some key figures on MidAmerican’s operations: Earnings (in $ millions) 2003 2002 U.K. U tilities ...................................................................................................... $ 289 $ 267 Iowa.................................................................................................................... 269 241 Pipelines ............................................................................................................. 261 104 Home Services.................................................................................................... 113 70 Other (Net) ......................................................................................................... 144 108 Earnings before corpor ate interest and tax ......................................................... 1,076 790 Corporate Interest, othe r than to Berkshire......................................................... (225) (192) Interest Payments to Berkshire........................................................................... (184) (118) Tax...................................................................................................................... (251) (100) Net Earn ings....................................................................................................... $ 416 $ 380 Earnings Applicable to Berkshire*..................................................................... $ 429 $ 359 Debt Owed to Others.......................................................................................... 10,296 10,286 Debt Owed to Berkshire ..................................................................................... 1,578 1,728 *Includes interest paid to Berkshire (net of related income taxes) of $118 in 2003 and $75 in 2002. --- Page 14 --- 15Finance and Financial Products This sector includes a wide-ranging group of activities. Here’s some commentary on the most important. • I manage a few opportunistic strategies in AAA fixed-income securities that have been quite profitable in the last few years. These opport unities come and go – and at present, they are going. We sped their departure somewhat last year, thereby realizing 24% of the capital gains we show in the table that follows. Though far from foolproof, these transactions involve no credit risk and are conducted in exceptionally liquid securities. We therefor e finance the positions almost entirely with borrowed money. As the assets are reduced , so also are the borrowings. The smaller portfolio we now have means that in the near future our earnings in this category will declinesignificantly. It was fun while it lasted, and at some point we’ll get another turn at bat. • A far less pleasant unwinding ope ration is taking place at Gen Re Securities, the trading and derivatives operation we inherited wh en we purchased General Reinsurance. When we began to liquidate Gen Re Securities in early 2002, it had 23,218 outstanding tickets with 884 counterparties (some having names I couldn’t pronounce, much less creditworthiness I could evaluate). Since then, the unit’s managers have been skillful and diligent in unwinding positions. Yet, at yearen d – nearly two years la ter – we still had 7,580 tickets outstanding with 453 counterparties. (As the country song laments, “How can I miss you if you won’t go away?”) The shrinking of this business has been costly. We’ve had pre-tax losses of $173 million in 2002 and $99 million in 2003. These losses, it should be noted, came from a portfolio ofcontracts that – in full compliance with GAAP – had been regularly marked-to-market with standard allowances for future credit-loss and administrative costs. Moreover, our liquidation has taken place both in a benign market – we’v e had no credit losses of significance – and in an orderly manner. This is just the opposite of what might be expected if a financial crisis forced a number of derivatives dealer s to cease operations simultaneously. If our derivatives experience – and the Freddi e Mac shenanigans of mind-blowing size and audacity that were revealed last year – ma kes you suspicious of accounting in this arena, consider yourself wised up. No matter how fi nancially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures no rmally proffered you. In Darwin’s words, “Ignorance more frequently begets confidence than does knowledge.” * * * * * * * * * * * * And now it’s confession time: I’m sure I could have saved you $100 million or so, pre-tax, if I had acted more promptly to shut down Gen Re Securities. Both Charlie and I knew at the time of the General Reinsurance merger that its derivatives business was unattractive. Reported profits struck us as illusory, and we felt that the business carried sizable risks thatcould not effectively be measured or limited. Moreover, we knew that any major problems the operation might experience would likely correlate with troubles in the financial or insurance world that would affect Berkshire elsewhere. In other words, if the derivativesbusiness were ever to need shoring up, it would commandeer the capital and credit of Berkshire at just the time we could otherwise deploy those resources to huge advantage. (A historical note: We had just such an experience in 1974 when we were the victim of a majorinsurance fraud. We could not determine for some time how much the fraud would ultimately cost us and therefore kept more funds in cash-equivalents than we normally would have. --- Page 15 --- 16Absent this precaution, we would have made larger purchases of stocks that were then extraordinarily cheap.) Charlie would have moved swiftly to close dow n Gen Re Securities – no question about that. I, however, dithered. As a consequence, our shareholders are paying a far higher price than was necessary to exit this business. • Though we include Gen Re’s sizable life and he alth reinsurance business in the “insurance” sector, we show the results for Ajit Jain’s life and annuity business in this section. That’s because this business, in larg e part, involves arbitraging m oney. Our annuities range from a retail product sold directly on the Internet to structured settlements that require us to makepayments for 70 years or more to people severely injured in accidents. We’ve realized some extra inco me in this business because of accelerated principal payments we received from certain fixed-income secur ities we had purchased at discounts. This phenomenon has ended, and earnings are therefore likely to be lower in this segment during the next few years. • We have a $604 million investment in Value Capital, a partnership run by Mark Byrne, a member of a family that has helped Berkshire over the years in many ways. Berkshire is a limited partner in, and has no say in the management of, Mark’s enterprise, which specializes in highly-hedged fixed-income opportunities. Mark is smart and honest and, along with his family, has a significant investment in Value. Because of accounting abuses at Enron and elsewh ere, rules will soon be instituted that are likely to require that Value’s assets and liab ilities be consolidated on Berkshire’s balance sheet. We regard this requirement as inappr opriate, given that Value’s liabilities – which usually are above $20 billion – are in no way ours . Over time, other investors will join us as partners in Value. When enough do, the need for us to consolidate Value will disappear. • We have told you in the past about Berkadia, the partnership we formed three years ago with Leucadia to finance and manage the wind-down of Finova, a bankrupt lending operation. The plan was that we would supply most of the capital and Leucadia would supply most of the brains. And that’s the way it has worked. Indeed, Joe Steinberg and Ian Cumming, whotogether run Leucadia, have done such a fine job in liquidating Finova’s portfolio that the $5.6 billion guarantee we took on in connection with the transaction has been extinguished. The unfortunate byproduct of this fast payoff is that our future income will be much reduced. Overall, Berkadia has made excellent money for us, and Joe and Ian have been terrific partners. • Our leasing businesses are XTRA (transporta tion equipment) and CORT (office furniture). Both operations have had poor earnings during the past two years as the recession caused demand to drop considerably more than was antic ipated. They remain leaders in their fields, and I expect at least a modest impr ovement in their ear nings this year. • Through our Clayton purchase, we acquired a significant manufactured-housing finance operation. Clayton, like others in this business, had traditionally securitized the loans it originated. The practice relieved stress on Clay ton’s balance sheet, but a by-product was the “front-ending” of income (a result dictated by GAAP). We are in no hurry to record income, have enormous balance-sheet strength, and believe thatover the long-term the economics of holding our consumer paper are superior to what we can now realize through securitization. So Clayton has begun to retain its loans. We believe it’s appropriate to finance a soundly-selected book of interest-bearing receivables almost entirely with debt (just as a bank woul d). Therefore, Berksh ire will borrow money to finance Clayton’s portfolio and re-lend these funds to Clayton at our cost plus one percentage --- Page 16 --- 17point. This markup fairly compensates Berksh ire for putting its exceptional creditworthiness to work, but it still delivers money to Clayton at an attractive price. In 2003, Berkshire did $2 billion of such borrowing and re-lending, with Clayton using muchof this money to fund several large purchase s of portfolios from lenders exiting the business. A portion of our loans to Clay ton also provided “catch-up” funding for paper it had generated earlier in the year from its own operatio n and had found difficult to securitize. You may wonder why we borrow money while sitti ng on a mountain of cash. It’s because of our “every tub on its own bottom” philosophy. We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent. Otherwise, having a rich daddy can lead to sloppy decisions. Meanwhile, the cash we accumulate at Berkshire is destined for business acquisitions or for the purchase of securities that offer opportun ities for significant profit. Clayton’s loan portfolio will likely grow to at least $5 billion in not too many years and, with sensible credit standards in place, should deliver significant earnings. For simplicity’s sake, we include all of Clayton’s earnings in this sector, though a sizable portion is derived from areas other than consumer finance. (in $ millions) Pre-Tax Earnings Interest-bearing Liabilities 2003 2002 2003 2002 Trading – Ordinary Income ........................... $ 379 $ 553 $7,826 $13,762 Gen Re Se curities ........................................... (99) (173) 8,041* 10,631* Life and annuity operation.............................. 99 83 2,331 1,568 Value Capital.................................................. 31 61 18,238* 20,359* Berkadia ......................................................... 101 115 525 2,175 Leasing op erations.......................................... 34 34 482 503 Manufactured housing finance (Clayton) ....... 37** — 2,032 — Other............................................................... 84 102 618 630 Income before capital gains............................ 666 775 Trading – Cap ital Gains.................................. 1,215 578 N.A. N.A. Total ............................................................... $1,881 $1,353 * Includes all liabilities ** From date of acquisition, August 7, 2003 Manufacturing, Service and Retailing Operations Our activities in this category cover the waterfront . But let’s look at a simplified balance sheet and earnings statement cons olidating the entire group. Balance Sheet 12/31/03 (in $ millions) Assets Liabilities and Equity Cash and eq uivalents ................................. $ 1,250 Notes payable ............................... $ 1,593 Accounts and notes receivable .................. 2,796 Other current liabilities................. 4,300 Inventory ................................................... 3,656 Total current liabilities ................. 5,893 Other current assets ................................... 262 Total current assets.................................... 7,964 Goodwill and other intangibles.................. 8,351 Deferred taxes............................... 105 Fixed a ssets ............................................... 5,898 Term debt and other liabilities...... 1,890 Other assets ............................................... 1,054 Equity ........................................... 15,379 $23,267 $23,267 --- Page 17 --- 18Earnings Statement (in $ millions) 2003 2002 Revenues ............................................................................................................ $32,106 $16,970 Operating expenses (including depreciation of $605 in 2003 and $477 in 2002)........................................................................................ 29,885 14,921 Interest expense (net).......................................................................................... 64 108 Pre-tax income.................................................................................................... 2,157 1,941 Income taxes....................................................................................................... 813 743 Net income ......................................................................................................... $ 1,344 $ 1,198 This eclectic group, which sells pr oducts ranging from Dilly Bars to B-737s, earned a hefty 20.7% on average tangible net worth last year. However, we purchased these businesses at substantial premiums to net worth – that fact is reflected in the goodwill item shown on the balance sheet – and that reduces theearnings on our average carrying value to 9.2%. Here are the pre-tax earnings for the larger categories or units. Pre-Tax Earnings (in $ millions) 2003 2002 Building Products................................................................................................... $ 559 $ 516 Shaw Industries ...................................................................................................... 436 424 Apparel................................................................................................................... 289 229 Retail Oper ations.................................................................................................... 224 219 Flight Se rvices........................................................................................................ 72 225 McLane *................................................................................................................ 150 — Other businesses..................................................................................................... 427 328 $2,157 $1,941 * From date of acquisition, May 23, 2003. • Three of our building-materials businesses – Acme Brick, Benjamin Moore and MiTek – had record operating earnings last year. And earnings at Johns Manville, the fourth, were trending upward at yearend. Collectively, th ese companies earned 21.0 % on tangible net worth. • Shaw Industries, the world’s largest manufacturer of broadloom carpet, also had a record year. Led by Bob Shaw, who built this huge enterprise from a standing start, the company will likely set another earnings record in 2004. In November, Shaw acquired various carpet operations from Dixie Group, which should add about $240 million to sales this year, boosting Shaw’s volume to nearly $5 billion. • Within the apparel group, Fruit of the Loom is our largest operation. Fruit has three major assets: a 148-year-old universally-recognized brand, a low-cost manufacturing operation, and John Holland, its CEO. In 2003, Fruit accounted for 42.3% of the men’s and boys’ underwear that was sold by mass marketers (Wal-Mart, Target, K-Mart , etc.) and increased its share of the women’s and girls’ business in that channel to 13.9%, up from 11.3% in 2002. • In retailing, our furniture group earned $106 million pre-tax, our jewelers $59 million and See’s, which is both a manufacturer and retailer, $59 million. Both R.C. Willey and Nebraska Furniture Mart (“ NFM”) opened hugely successful stores last year, Willey in Las Vegas and NFM in Kansas City, Kansas. Indeed, we believe the Kansas City store is the country’s largest-volume home-furnishings store. (Our Omaha operation, while located on a single plot of land, consists of three units.) --- Page 18 --- 19NFM was founded by Rose Blumkin (“Mrs. B”) in 1937 with $500. She worked until she was 103 (hmmm . . . not a bad idea). One piece of wisdom she imparted to the gene rations following her was, “If you have the lowest price, customers will find you at the bottom of a river.” Our store serving greater Kansas City, which is located in one of th e area’s more sparsely populated parts, has proved Mrs. B’s point. Though we have more than 25 acres of parking, the lot has at times overflowed. “Victory,” President Kennedy told us after the Bay of Pigs disaster, “has a thousand fathers, but defeat is an orphan.” At NFM, we knew we had a winner a month after the boffo opening in Kansas City, when our new store attracted an unex pected paternity claim. A speake r there, referring to the Blumkin family, asserted, “They had enough confidence and the policies of the Administration were working such that they were able to provide work for 1,000 of our fellow citizens.” The proud papa at the podium? President George W. Bush. • In flight services, FlightSafety, our training operation, experienced a drop in “normal” operating earnings from $183 million to $150 million. (The abnormals: In 2002 we had a $60 million pre-tax gain from the sale of a partnership interest to Boeing, and in 2003 we recognized a $37 million loss stemming from the premature obsolescence of simulato rs.) The corporate aviation business has slowed significantly in the past few years, and this f act has hurt FlightSafety’s results. The company continues, however, to be far and away the leader in its field. Its simulators have an original cost of $1.2 billion, which is more than triple the cost of those operated by our closest competitor. NetJets, our fractional-ownership operation lost $41 million pre-tax in 2003. The company had amodest operating profit in the U.S., but this was more than offset by a $32 million loss on aircraftinventory and by continued losses in Europe. NetJets continues to dominate the fractional-ownershi p field, and its lead is increasing: Prospects overwhelmingly turn to us rather than to our three major competitors. Last year, among the four of us, we accounted for 70% of net sales (measured by value). An example of what sets NetJets apart from co mpetitors is our Mayo Clinic Executive Travel Response program, a free benefit enjoyed by all of our owners. On land or in the air, anywhere in theworld and at any hour of any day, our owners and their families have an immediate link to Mayo. Should an emergency occur while they are traveling here or abroad, Mayo will instantly direct them to an appropriate doctor or hospital. Any baseline data about the patient that Mayo possesses issimultaneously made available to the treating physician. Many owners have already found this service invaluable, including one who needed emergency brain surgery in Eastern Europe. The $32 million inventory write-down we took in 2003 occurred because of falling prices for usedaircraft early in the year. Sp ecifically, we bought back fractions from withdrawing owners at prevailing prices, and these fell in value before we were able to remarket them. Prices are now stable. The European loss is painful. But any company that forsakes Europe, as all of our competitors havedone, is destined for second-tier status. Many of our U.S. owners fly extensively in Europe and wantthe safety and security assured by a NetJets plane and pilots. Despite a slow start, furthermore, we are now adding European customers at a good pace. During the years 20 01 through 2003, we had gains of 88%, 61% and 77% in European management-and-flying revenues. We have not, however, yetsucceeded in stemming the flow of red ink. Rich Santulli, NetJets’ extraordinar y CEO, and I expect our European loss to diminish in 2004 and also anticipate that it will be more than offset by U. S. profits. Overwhelmingly, our owners love the NetJets experience. Once a customer has tried us , going back to commercial aviation is like going back to holding hands. NetJets will become a very big business over time and will be one in which we are preeminent in both customer satisfac tion and profits. Rich will see to that. --- Page 19 --- 20Investments The table that follows shows our common stock investments. Those that had a market value of more than $500 million at the end of 2003 are itemized. 12/31/03 Shares CompanyPercentage of Company Owned Cost Market (in $ millions) 151,610,700 American Express Company ................ 11.8 $ 1,470 $ 7,312 200,000,000 The Coca-Cola Company ..................... 8.2 1,299 10,150 96,000,000 The Gillette Company .......................... 9.5 600 3,526 14,610,900 H&R Block, Inc.................................... 8.2 227 809 15,476,500 HCA Inc. .............................................. 3.1 492 665 6,708,760 M&T Bank Corporation ....................... 5.6 103 659 24,000,000 Moody’s Corporation ........................... 16.1 499 1,453 2,338,961,000 PetroChina Company Limited .............. 1.3 488 1,340 1,727,765 The Washington Post Company ........... 18.1 11 1,367 56,448,380 Wells Fargo & Company...................... 3.3 463 3,324 Others ................................................... 2,863 4,682 Total Common Stocks .......................... $ 8,515 $35,287 We bought some Wells Fargo shares last year. Otherwise, among our six largest holdings, we last changed our position in Coca-Cola in 1994, American Express in 1998, Gillette in 1989, Washington Post in 1973, and Moody’s in 2000. Brokers don’t love us. We are neither enthusiastic nor negative about th e portfolio we hold. We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current prices reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what Iwas thinking four years ago when their intrinsic valu e was lower and their prices far higher. So do I. In 2002, junk bonds became very cheap, and we purchased abou t $8 billion of these. The pendulum swung quickly though, and this sector now looks decidedly unattractive to us. Yesterday’s weeds are today being priced as flowers. We’ve repeatedly emphasized that realized gain s at Berkshire are meaningless for analytical purposes. We have a huge amount of unrealized gains on our books, and our thinking about when, and if, to cash them depends not at all on a desire to report earnings at one specific time or another. Nevertheless,to see the diversity of our investment activities, you may be interested in the following table, categorizing the gains we reported during 2003: Category Pre-Tax Gain (in $ million) Common Stocks .............................................................................................................. $ 448 U.S. Government Bonds.................................................................................................. 1,485 Junk Bonds..................................................................................................................... . 1,138 Foreign Exchange Contracts ........................................................................................... 825 Other.......................................................................................................................... ...... 233 $4,129 The common stock profits occurred around the edges of our portfolio – not, as we already mentioned, from our selling down our major positions . The profits in governments arose from our --- Page 20 --- 21liquidation of long-term strips (the most volatile of government securities) and from certain strategies I follow within our finance and financial products division. We retained most of our junk portfolio, selling only a few issues. Calls and maturing bonds accounted for the rest of the gains in the junk category. During 2002 we entered the foreign currency market for the first time in my life, and in 2003 we enlarged our position, as I became in creasingly bearish on the dollar. I should note that the cemetery for seers has a huge section set aside for macro forecasters . We have in fact made few macro forecasts at Berkshire, and we have seldom seen ot hers make them with sustained success. We have – and will continue to have – the bulk of Berkshire’s net worth in U.S. assets. But in recent years our country’s trade deficit has been fo rce-feeding huge amounts of claims on, and ownership in, America to the rest of the world. For a time, foreign appetite for these assets readily absorbed the supply. Late in 2002, however, the world started choking on this diet, and the dollar’s value began to slideagainst major currencies. Even so, prevailing exchange rates will not lead to a material letup in our trade deficit. So whether foreign investors like it or not, they will continue to be flooded with dollars. The consequences of this are anybody’s guess. They coul d, however, be troublesom e – and reach, in fact, well beyond currency markets. As an American, I hope there is a benign ending to this problem. I myself suggested one possible solution – which, incidentally, leaves Charlie cold – in a November 10, 2003 article in Fortune Magazine. Then again, perhaps the alarms I have raised will prove needless: Our country’s dynamism and resiliency have repeatedly made fools of naysayers. But Berkshire holds many billions of cash-equivalents denominated in dollars. So I feel more comfortable ow ning foreign-exchange contracts that are at least a partial offset to that position. These contracts are subject to accounting rule s that require changes in their value to be contemporaneously included in capital gains or losses, even though the contracts have not been closed. We show these changes each quarter in the Finance and Financial Products segment of our earnings statement. At yearend, our open foreign exchange contracts totale d about $12 billion at market values and were spread among five currencies. Also, when we were purchasing junk bonds in 2002, we tried when possible to buy issues denominated in Euros. Today, we own about $1 billion of these. When we can’t find anything exciting in which to invest, our “default” position is U.S. Treasuries, both bills and repos. No matter how low the yields on these instruments go, we never “reach” for a little more income by dropping our credit standards or by ex tending maturities. Charlie and I detest taking even small risks unless we feel we are being adequately co mpensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton. * * * * * * * * * * * * A 2003 book that investor s can learn much from is Bull! by Maggie Mahar. Two other books I’d recommend are The Smartest Guys in the Room by Bethany McLean and Peter Elkind, and In an Uncertain World by Bob Rubin. All three are well-reported and we ll-written. Additionally, Jason Zweig last year did a first-class job in revising The Intelligent Investor , my favorite book on investing. Designated Gifts Program From 1981 through 2002, Berkshire administered a program whereby shareholders could direct Berkshire to make gifts to their favorite charitable orga nizations. Over the years we disbursed $197 million pursuant to this program. Churches were the most frequently named designees, and many thousands ofother organizations benefited as well. We were the on ly major public company that offered such a program to shareholders, and Charlie and I were proud of it. We reluctantly terminated the program in 2003 because of controversy over the abortion issue. Over the years numerous organizations on both sides of this issue had been designated by our shareholdersto receive contributions. As a result, we regularly r eceived some objections to th e gifts designated for pro- choice operations. A few of these came from people and organizations that proceeded to boycott products --- Page 21 --- 22of our subsidiaries. That did not concern us. We refused all requests to limit the right of our owners to make whatever gifts they chose (as long as the recipients had 501(c)(3) status). In 2003, however, many independent associates of The Pampered Chef began to feel the boycotts. This development meant that people who trusted us – but who were neither employees of ours nor had a voice in Berkshire decision-making – suffered serious losses of income. For our shareholders, there was some modest tax efficiency in Berkshire doing the giving rather than their making their gifts directly. Additionally, the program was consistent with our “partnership”approach, the first principle set forth in our Owner’s Manual. But these advantages paled when they were measured against damage done loyal associates who ha d with great personal effort built businesses of their own. Indeed, Charlie and I see nothing charitable in harming decent, hard-working people just so we and other shareholders can gain some minor tax efficiencies. Berkshire now makes no contributions at the parent company level. Our various subsidiaries follow philanthropic policies consistent with their prac tices prior to their acquisition by Berkshire, except that any personal contributions that former owners had earlier made from their corporate pocketbook are now funded by them personally. The Annual Meeting Last year, I asked you to vote as to whether you wished our annual meeting to be held on Saturday or Monday. I was hoping for Monday. Saturday won by 2 to 1. It will be a while before shareholderdemocracy resurfaces at Berkshire. But you have spoken, and we will hold this year’s annual meeting on Saturday, May 1 at the new Qwest Center in downtown Omaha. The Qwest offers us 194,000 square feet for exhibition by our subsidiaries (up from 65,000 square feet last year) and much more seating capacity as well. The Qwest’s doors will open at 7 a.m., the movie will begin at 8:30, and the meeting itself will commence at 9:30. There will be a short break at noon for food. (San dwiches will be available at the Qwest’s concession stands.) That interlude aside, Charlie and I will an swer questions until 3:30. We will tell you everything we know . . . and, at least in my case, more. An attachment to the proxy material that is enclosed with this report explains how you can obtain the credential you will need for admission to the meeti ng and other events. As for plane, hotel and car reservations, we have again signed up American Express (800-799-6634) to give you special help. They do a terrific job for us each year, and I thank them for it. In our usual fashion, we will run vans from the la rger hotels to the meeti ng. Afterwards, the vans will make trips back to the hotels and to Nebraska Furniture Mart, Borsheim’s and the airport. Even so,you are likely to find a car useful. Our exhibition of Berkshire goods and services will blow you away this year. On the floor, for example, will be a 1,600 square foot Clayton home (featuring Acme brick, Shaw carpet, Johns-Manville insulation, MiTek fasteners, Carefree awnings, and out fitted with NFM furniture). You’ll find it a far cry from the mobile-home stereotype of a few decades ago. GEICO will have a booth staffed by a number of its top counselors from around the country, all of them ready to supply you with auto insurance quotes . In most cases, GEICO will be able to give you a special shareholder discount (usually 8%). This speci al offer is permitted by 41 of the 49 jurisdictions in which we operate. Bring the details of your existin g insurance and check out whether we can save you money. On Saturday, at the Omaha airport, we will ha ve the usual array of aircraft from NetJets® available for your inspection. Stop by the NetJets boo th at the Qwest to learn about viewing these planes. If you buy what we consider an appropriate number of items during the weekend, you may well need your own plane to take them home. --- Page 22 --- 23At Nebraska Furniture Mart, lo cated on a 77-acre site on 72nd Street between Dodge and Pacific, we will again be having “Berkshire Weekend” pricing, which means we will be offering our shareholders a discount that is customarily given only to employees. We initiated this special pricing at NFM seven yearsago, and sales during the “Weekend” grew from $5.3 million in 1997 to $17.3 million in 2003. Every year has set a new record. To get the discount, you must make your purchases between Thursday, April 29 and Monday, May 3 inclusive, and also present your meeting creden tial. The period’s special pricing will even apply to the products of several prestigious manufacturers that normally have ironclad rules against discounting butthat, in the spirit of our shareholder weekend, have made an exception for you. We appreciate their cooperation. NFM is open from 10 a.m. to 9 p.m. Monday through Saturday, and 10 a.m. to 6 p.m. on Sunday. On Saturday this year, from 5:30 p.m. to 8 p.m., we are having a special affair for shareholders only. I’ll be there, eating barbeque and drinking Coke. Borsheim’s ⎯ the largest jewelry store in the country except for Tiffany’s Manhattan store ⎯ will have two shareholder-only events. The first will be a co cktail reception from 6 p.m. to 10 p.m. on Friday, April 30. The second, the main gala, will be from 9 a.m. to 4 p.m. on Sunday, May 2. Ask Charlie to autograph your sales ticket . Shareholder prices will be available Thursday thro ugh Monday, so if you wish to avoid the large crowds that will assemble on Friday evening and Sund ay, come at other times and identify yourself as a shareholder. On Saturday, we will be open until 6 p.m. Borsheim’s operates on a gross margin that is fully twenty percentage points below that of its major rivals , so the more you buy, the more you save – at least that’s what my wife and daughter tell me. (Both were impressed early in life by the story of the boy who,after missing a street car, walked home and proudly announced that he had saved 5¢ by doing so. His father was irate: “Why didn’t you miss a cab and save 85¢?”) In the mall outside of Borsheim’s, we will have Bob Hamman and Sharon Osberg, two of the world’s top bridge experts, available to play with our shareholders on Sunday afternoon. Additionally, Patrick Wolff, twice U.S. chess champion, will be in the mall, taking on all comers ⎯ blindfolded! I’ve watched, and he doesn’t peek. Gorat’s ⎯ my favorite steakhouse ⎯ will again be open exclusively for Berkshire shareholders on Sunday, May 2, and will be serving from 4 p.m. until 10 p.m. Please remember that to come to Gorat’s on Sunday, you must have a reservation. To make one, call 402-551-3733 on April 1 ( but not before ). If Sunday is sold out, try Gorat’s on one of the other evenings you will be in town. Flaunt your mastery offine dining by ordering, as I do, a rare T-bone with a double order of hash browns. We will have a special reception on Saturday afte rnoon from 4:00 to 5:00 for shareholders who come from outside of North America. Every year our meeting draws many people from around the globe, and Charlie and I want to be sure we personally meet those who have come so far. Any shareholder who comes from other than the U.S. or Canada will be given special credentials and instructions for attendingthis function. Charlie and I have a great time at the annual meeting. And you will, too. So join us at the Qwest for our annual Woodstock for Capitalists. Warren E. Buffett February 27, 2004 Chairman of the Board