2004 Annual Letter

--- Page 1 --- 2 Note: 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) 2004 .................................................. 10.5 10.9 (.4) Average Annual Gain — 1965-2004 21.9 10.4 11.5 Overall Gain — 1964-2004 286,865 5,318 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 this 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 --- BER KSHIR E HATHAWAY INC. To the Shareholders of Berkshire Hath away Inc. : Our gain in net worth du ring 2004 was $8.3 billion, which increased the per-share book value of both our Class A and Class B stock by 10.5%. Over the last 40 y ears (that is, since present manage ment took over) book value has grown from $19 t o $55,824, a rate of 21.9% c ompounded annually.* It’s pe r-share intrinsic val ue that cou nts, however, not book value. Here , the news is good: Between 196 4 and 200 4, Berk shire m orphed from a struggling north ern textile b usiness who se intrinsic value was less th an book into a diversified en terprise w orth fa r more than book. Our 40-year gain in intrinsic value has there fore s omewhat exceeded our 21.9% gain in book. (For an e xplanation of intrinsic value and the econ omic pri nciples that guide C harlie Munger, my part ner and B erkshire’s vi ce-chai rman, and me in runnin g Berkshire, please r ead our Ow ner’s Manu al, beginning on page 73.) Desp ite their sh ortco mings, yearly calcu lations of book va lue are useful at Berk shire as a sligh tly understated gauge f or measuri ng the long-term rate o f increase in our intrinsic v alue. Th e calcu lations are less rel evant, however, than they once we re in rating any single year’s performance v ersus the S&P 500 index (a c omparison we display on the faci ng page). Our equity holdings (including convertible preferreds) have fallen considerably as a p ercentage of our net wo rth, from an average of 114% in the 1980s, f or exam ple, to less than 50% i n recent years . There fore, yea rly movem ents in the stoc k market now affe ct a much smaller p ortion of ou r net worth than was once the case, a fact th at will n ormally cau se us to underperform in years when stocks rise substantially and overperform in years when they fall. Howe ver the yearly co mparisons work out, Berk shire’s long-term perform ance vers us the S&P remains all-important. Our shareholders can buy the S&P through an index fund at very low cost. Unless we ach ieve gains in per-share intrinsic value in the future that ou tdo the S&P, C harlie and I will b e adding nothing to wh at yo u can accom plish on your ow n. Last year , Berk shire’s boo k-value gain of 10.5% f ell sho rt of the index ’s 10.9% return. Our lackluster performance was n ot due t o any stumbles by the CEOs o f our operating businesses: As al ways, they pulled more than their share of th e load . My m essage to them is simple: Ru n your business as if it were t he only asset yo ur fam ily will o wn over the next hundred years. Almost invariably they do just that and, a fter ta king ca re of the needs of their business , send excess cash to Omaha for m e to de ploy. I didn’t do that job very well last year. My hope wa s to make several multi-billion dollar acquisition s that wou ld add new and significan t stream s of earn ings to the many we alread y have. But I struck out. Additionally, I found very few attractiv e securities to buy. Berkshire therefo re end ed the year with $43 billion of cash equivalen ts, not a happy position. Charlie and I will work to translate so me of th is hoard int o more interesting assets duri ng 2005, t hough we can’t prom ise success. In one res pect, 2004 was a rem arkable year fo r the stoc k market, a fact burie d in the maze of numbers on page 2. If yo u examine the 35 years sin ce th e 1960s end ed, yo u will find th at an investor’s return, including dividends, from owni ng the S&P has a veraged 11.2% annua lly (well above what we expect future returns to be). Bu t if yo u look for years wi th returns any where close t o that 11.2% – say, between 8% an d 14% – you will fin d only one before 2004 . In other words, last year ’s “normal” return is anything but. * All fi gures used in t his report ap ply to Berkshi re’s A shares, the successor to the only stock that the company had outstan ding before 1996. The B shares hav e an econ omic interest equal to 1/30th that of the A. 3 --- Page 3 --- Over the 35 ye ars, American bus iness has delivered terrific res ults. It should therefore have been easy fo r inv estors to earn juicy retu rns: All th ey h ad to do was piggyback Corporate Am erica in a diversified, low-expense way. An i ndex fund that they neve r touche d would have done the job. Instead many invest ors have had experiences ranging from mediocre to disastrous. There have been three primary causes: first, high c osts, usually because inves tors t raded excessi vely or spent far too much on invest ment management; second, portfolio deci sions based on tips and fads rather than on thou ghtful, q uantified evaluation of businesses; and third, a star t-and-stop approach to the market marked by untimely en tries (after an adva nce has been long underway ) and exits (a fter periods of stagnation or decl ine). Investors s hould remember that exci tement and expe nses a re their enemies. And if they in sist o n tryin g to time th eir participatio n in equities, th ey sho uld try to be fearfu l when others are greedy and greedy only when others are fea rful. Sector Results As managers, C harlie and I want to give our owners the financi al information and c ommentary we would wish t o receive if our roles were re verse d. To do this with both clar ity and reasona ble bre vity becom es more di fficult as B erkshire’s scope widens. Some of o ur businesses have vast ly different econom ic characteristics from others, which means that our consolidated state ments, with their jumble of figures, make usef ul analysis almost impossible. On th e following pages, therefore, we will present some balance sheet and earn ings figures from our four major categories of businesses along with commentary ab out each . We particularly wan t you to understand the li mited circum stances un der which we will u se debt, given that we ty pically sh un it. We will n ot, howev er, in undate yo u with data that has no real value in estimatin g Berk shire’s in trinsic v alue. Doing so would tend to obfuscate the facts that count. Regulated Uti lity Businesses We ha ve an 80.5% (fully diluted) interest in MidAm erican Ene rgy Holdings, which owns a wide variety o f utility o peration s. The larg est of these are (1 ) Yorkshire Electricity and Northern Electric, wh ose 3.7 million electric cu stomers m ake it t he third larg est d istribu tor of electricity in the U.K.; (2) MidAm erican Energy, whic h serves 698,000 electric customers, primarily in Iowa; an d (3) Kern River and Northern Natural pipelines, which carry 7.9% of the natural gas c onsum ed in the U.S. The remaining 19 .5% of MidAmerican i s owned by three partners of ours: Dave Sokol and Greg Abel, th e brillian t managers of these bu sinesses, an d Walter Sco tt, a long-time frien d of m ine who introdu ced m e to the company. Becau se MidAmerican is sub ject to the Pub lic Utility Ho lding Com pany Act (“PUHCA”), Berk shire’s voting interest is limited to 9.9%. Vo ting control rests with Walter. Our limited voting interest forces us to acco unt for Mi dAm erican in an abbreviated manner. Instead of our fully in corporating the company’s asse ts, liab ilities, rev enues an d expenses in to Berk shire’s statements, we m ake one-line en tries only in both our balance sheet and income account. It’s lik ely, though, t hat PUHC A will someday – perhaps soon – be repeale d or that accoun ting rules will cha nge. Berks hire’s consoli dated figures woul d then in corporate all o f Mid American , including the substan tial d ebt it utilizes (th ough this debt is not now, nor will it ev er be, an obligation of Berk shire). At yearend , $1.47 8 billion of Mid American ’s junior debt was payable to Berk shire. This debt has allowed acquisitions t o be finance d without our partners nee ding t o increase their already s ubstantial investments in MidAmerican . By ch arging 11% interest, B erkshire is co mpensated fairly for putting up the funds needed for purchases, wh ile ou r partners are sp ared dilution of th eir equ ity in terests. Becau se MidAmerican mad e no large acquisition s last year, it p aid down $100 million of what it owes us. 4 --- Page 4 --- MidAmerican also own s a significan t non-utility b usiness, Ho meServices o f America, th e second largest real est ate broker in the country. Unlike our utility o perations, this bu siness is h ighly cyclica l, but nevertheless on e we view enthusiastically. We have an exceptional manager, Ron Peltier, wh o through both his acq uisition and operatio nal skills is b uilding a brokerag e powerh ouse. HomeServices p articip ated in $59.8 billion of tran sactions in 2004, a gain of $11.2 billio n from 2003. About 24% of the increase cam e from six acqui sitions m ade during the year. Through our 17 brokerage firms – all o f which retain their lo cal id entities – we em ploy more th an 18,000 brok ers in 1 8 states. Hom eServices is alm ost certa in to grow substantially in the ne xt decade as we c ontinue t o acquire leading localized operation s. Last year Mid American wrote off a m ajor investment in a zin c reco very p roject th at was in itiated in 1998 and became operation al in 2002. Larg e quantities o f zinc are presen t in the brin e pro duced by o ur California ge otherm al operat ions, and we believed we c ould profitably extract the metal. For m any months, it appeared that commercially- viable recov eries were i mminent. Bu t in mining, just as in oil exploration, prospects have a way of “teasing” their developers, and every time one problem was s olved, another popped up. In September, we t hrew in the towel. Our fail ure here illu strates th e importance of a gu ideline – stay with simp le propositions – that we usually ap ply in investments as well as operatio ns. If only on e variable is k ey to a decision , and the variable has a 90% chance of going your way, the chan ce for a successful outcom e is obviously 90%. But if ten indepe ndent va riables need to brea k favorably for a successful result, and each has a 90% proba bility of success , the likelihood of having a winner is only 35 %. In our zinc vent ure, we solve d most of the problem s. But one prove d intractable, and t hat was one too many. Since a chai n is no stronger than its weake st link, it makes sense t o look for – if you’ll excuse an oxymoron – mono-l inked chains. A breakdown of MidA merican’s results fo llows. In 2004, th e “other” categ ory includes a $7 2.2 million profit from sale of an Enro n recei vable that was thrown in wh en we purc hased Northern Na tural two years ea rlier. Walter, Dave an d I, as nat ives o f Omaha, view th is un anticip ated gain as war rep aration s – partial co mpensation for the lo ss ou r city su ffered in 1986 when Ken Lay moved Northern to Housto n, after promising to leav e the com pany here. (F or details, see Ber kshire’s 2002 annu al report.) Here are some key fi gures on MidAm erican’s operations: Earnings (in $ millio ns) 2004 2003 U.K. utilitie s....................................................................................................... $ 326 $ 289 Iowa u tility ......................................................................................................... 268 269 Pipelines ............................................................................................................. 288 261 Hom eServices ..................................................................................................... 130 113 Othe r (net).......................................................................................................... 172 190 Loss from zinc project ........................................................................................ (579) (46) Earni ngs before corporate i nterest and ta xes...................................................... 605 1,076 Intere st, other than to Berkshi re......................................................................... (212) (225) Intere st on Be rkshire junior debt ........................................................................ (170) (184) Income tax.......................................................................................................... (53) (251) Net ear nings........................................................................................................ $ 170 $ 416 Earni ngs applicable to Be rkshire*...................................................................... $ 237 $ 429 Debt owed to others ............................................................................................ 10,528 10,296 Debt owed to Berks hire...................................................................................... 1,478 1,578 *Includes interest earne d by Berkshire (net of related income taxes) of $110 in 2004 and $118 in 2003. 5 --- Page 5 --- Insur ance Since B erkshire purchased National Indem nity (“NIC O”) in 1967, property-casual ty insurance has been our core business a nd the propellant of our growth. Insurance has provided a fountain of funds with which we’v e acq uired th e secu rities and businesses th at now give us an ever-wi dening variety of earnin gs stream s. So in this sectio n, I will b e spending a little ti me telling you how we got where we are. The s ource of our insurance funds is “float,” which is money that does n’t belong to us but that we temporarily hold. Most of our fl oat arises because (1) pre miums are pa id upfront though the servic e we provide – insurance protection – i s delivered over a pe riod that usual ly cove rs a y ear and; (2) loss events that occur toda y do not always resu lt in our immediately p aying claim s, because it sometim es takes many years for lo sses to be repo rted (asb estos lo sses wou ld be an example), negotiated and settled . Th e $20 million of float that came with our 1967 purchase has n ow increase d – bot h by way of internal growth and acquisition s – to $46.1 billion. Float is wonderful – if it doesn’t come at a high price. Its co st is d etermined by underwritin g results, m eaning how th e expen ses an d losses we will ultimatel y pay com pare with the premiums we h ave receive d. Whe n an underwriting profit is achieve d – as has been the case at Berksh ire in about half of the 38 years we have bee n in the insurance business – float is better than free. I n such years, we are act ually paid for holding other people’s m oney . For m ost insurers, however, life has been far more di fficult: In aggre gate, the property-cas ualty industry al most invariabl y operates at an underwriting loss . Whe n that loss is large, float becomes expe nsive, sometimes devast atingly so. Insurers have gene rally earned poor returns for a simple reas on: They sell a com modity-like product. Policy forms are st andard, and the product is available from many suppliers, some of whom are mutual co mpanies (“o wned” by policyho lders rath er th an stockholders) with profit g oals that are li mited. Moreover, most insureds don’t care f rom whom they buy. Customers by the millions say “I need some Gillette b lades” o r “I’ll h ave a Coke” bu t we wait in vain for “I’d like a Natio nal Indemnity policy, p lease.” Consequently, price co mpetition in insurance is u sually fierce. Th ink airline seats. So, you may ask , how do Berkshire’s insuran ce operations overc ome the dism al economics of t he industry an d achieve some measu re of enduring competitiv e advantage? We’v e attack ed th at problem in several ways. Let’s lo ok first at N ICO’s stra tegy. When we purchased the company – a sp ecialist in comme rcial au to and general liab ility insurance – it did not appear t o have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the com pany has never had an actuary), was not a low-cost operator, and sold through genera l age nts, a method m any people thou ght outdate d. Neve rtheless, for almost all o f the past 38 years, NICO h as been a star performer. Ind eed, had we not made this acq uisition, Berk shire would be lucky to be wo rth half of what it is tod ay. What we’ve had going for us is a managerial mindset that most insurers find impossi ble to replicate. Tak e a look at the facing page. Can you imagine any public com pany e mbracing a busi ness model that woul d lead t o the decl ine in revenue that we expe rienced from 198 6 through 1999? That colossal slide , it shoul d be e mphasized, di d not oc cur b ecause busi ness was unobtaina ble. Many billions o f premium dollars were readily av ailab le to NICO had we only been willing to cut prices. B ut we i nstead consisten tly priced to make a profit, no t to match our most optimistic co mpetitor. We never left cu stomers – but they left us. Most Am erican businesses harbo r an “institutional imperative” th at rej ects ex tended decreases in volume. What CEO want s to repo rt to his share holders that not only did business co ntract last year but that it will continue to drop ? In insu rance, the urge to keep writing busi ness is also intensified because the consequences of foolishly-priced p olicies may not bec ome appare nt for some time. If a n insurer is optimistic in its reserv ing, rep orted earn ings will b e overstated , and years m ay pass before true loss co sts are re veale d (a form of self-de ception that nearly destroyed GEICO in the early 19 70s). 6 --- Page 6 --- Portrait of a Discip lined Underwriter National Indemnity Company Year Written Premi um (In $ millio ns) No. of Employees at Year -End Ratio of Oper ating Expenses to Written Premi umUnderwriting Profit (Loss) as a Per - centage of Premiums (Calculated as of year e nd 2004)* 1980 ........................... $79.6 372 32.3% 8.2% 1981 ........................... 59.9 353 36.1% (.8%) 1982 ........................... 52.5 323 36.7% (15.3%) 1983 ........................... 58.2 308 35.6% (18.7%) 1984 ........................... 62.2 342 35.5% (17.0%) 1985 ........................... 160.7 380 28.0% 1.9% 1986 ........................... 366.2 403 25.9% 30.7% 1987 ........................... 232.3 368 29.5% 27.3% 1988 ........................... 139.9 347 31.7% 24.8% 1989 ........................... 98.4 320 35.9% 14.8% 1990 ........................... 87.8 289 37.4% 7.0% 1991 ........................... 88.3 284 35.7% 13.0% 1992 ........................... 82.7 277 37.9% 5.2% 1993 ........................... 86.8 279 36.1% 11.3% 1994 ........................... 85.9 263 34.6% 4.6% 1995 ........................... 78.0 258 36.6% 9.2% 1996 ........................... 74.0 243 36.5% 6.8% 1997 ........................... 65.3 240 40.4% 6.2% 1998 ........................... 56.8 231 40.4% 9.4% 1999 ........................... 54.5 222 41.2% 4.5% 2000 ........................... 68.1 230 38.4% 2.9% 2001 ........................... 161.3 254 28.8% (11.6%) 2002 ........................... 343.5 313 24.0% 16.8% 2003 ........................... 594.5 337 22.2% 18.1% 2004 ........................... 605.6 340 22.5% 5.1% *It takes a l ong time to learn the tr ue profitability of any given year. First, m any clai ms are receive d after the end of t he year, an d we must esti mate how many of these t here will b e and what they will co st. (In insurance jargon, these claim s are te rmed IB NR – incurred but not reported.) Sec ond, claims often take years, or eve n decade s, to settle, which m eans there can be many su rprises along t he way. For these reason s, the results in this column simply rep resent o ur best esti mate at the end of 2004 as to how we have don e in prior year s. Pro fit margins for the year s thro ugh 1999 are probably close to corr ect because these years are “m ature,” in the se nse that they have fe w clai ms still outstanding. The m ore recent the year, th e more guesswork is invo lved. In particular, th e resu lts sho wn for 200 3 and 2004 are apt to change sign ifican tly. 7 --- Page 7 --- Finally, there is a fear factor at work , in that a shri nking business us ually leads t o layoffs. To avoid pink slips, em ployees will ration alize in adequate pricin g, tellin g themselves th at poorly-priced business m ust be tolerated in order to keep t he organization intact and t he distribution system happy . If t his course isn’t follo wed, th ese e mployees will arg ue, the company will not particip ate in the reco very th at they inva riably feel is just around t he corner. To com bat employees’ nat ural tendency to save t heir own ski ns, we ha ve al ways prom ised NICO’s workforce that no one will be fired because of declining volu me, howeve r severe the c ontrac tion. (This is not Donald T rump’s sort of place.) NICO is not la bor-i ntensi ve, and, as t he tabl e sugge sts, ca n live with excess overhead. It can ’t live, howev er, with underpriced business a nd the breakdown in underwriting discipline t hat accom panies it. An in suranc e orga nization that doesn’t ca re deeply a bout unde rwriting at a profit this year is un likely to care next year ei ther. Naturally, a business th at fo llows a n o-layo ff policy m ust be especia lly careful to avoid overstaffing when times are go od. Th irty years ag o Tom Murphy, then CEO of Cap Cities, d rove this point home to me with a hypothetical tale about an em ployee who asked his boss for permission to hire an assistant. The employee assu med that adding $20,000 to the annual payroll would be inconsequential. But his boss told him the proposal should be evaluated as a $3 million decision, given that an additional person would probably cost at least that amount over his lifetime, fact oring in raises, be nefits and other expenses (more pe ople, more toilet paper). And unless the com pany fell on very hard times, the em ployee added would be unlikely to be dismissed, however marginal his contribution to the business. It takes re al fortitude – em bedde d deep within a company’s cul ture – to operate as NICO does. Anyone exam ining the table can sca n the years from 1986 to 1999 quickly. Bu t living day after day with dwindling volume – while co mpetitors are b oasting of growth and reaping Wall Street ’s app lause – is an experience few managers can tolerate. N ICO, how ever, has had four CEO s since its f ormatio n in 1940 an d none have bent. (It should be noted that only one of the four graduated from college. Our experience tells us that ex traord inary bu siness ab ility is largely in nate.) The cu rrent manage rial star – m ake that supe rstar – at NIC O is Do n Wu rster (y es, he’s “the graduate”), who has bee n running things since 1989. His slugging perce ntage is right up there with Barry Bonds’ because, like Barry, Don will accept a walk rathe r than swing at a bad pitch. Don has now am assed $950 million of float at NICO that over tim e is al most certain to be proved the negative-cost kind. Becau se insuran ce prices are fallin g, Don’s volume will so on decline very significantly an d, as it does, Charlie an d I will ap plaud him ever more lou dly. * * * * * * * * * * * * Another way to prosper in a commodity-type business is to be the low-cost operator. Among a uto insurers op eratin g on a broad scale, GEICO holds that ch erish ed title. For NIC O, as we have seen , an ebb- and-flow business m odel makes se nse. But a company holding a low-cost advantage m ust pursue an unrelenting foot-to-the-floor strategy. And that’s just what we do at GEICO. A ce ntury ago, when aut os first appeare d, the property- casualty in dustry operated as a cartel. Th e major com panies, most of wh ich were base d in the Nort heast, established “bureau” rat es and t hat was it. No one cut prices to attract b usiness. In stead , insurers co mpeted for str ong, well-re garded agents, a foc us that produced high commissi ons for agents and high prices for consumers. In 1922, State Farm was fo rmed by Geo rge Mech erle, a farmer fro m Mern a, Illino is, who aimed to take adva ntage of t he pri cing umbrella maintained by the high-cost giants of t he industry. St ate Farm employed a “cap tive” ag ency force, a system k eeping its acq uisition costs lo wer t han those incurred by the bureau insurers (whose “i ndependent” agent s successfully played off on e com pany against anot her). W ith its low-c ost structure, State Farm event ually capture d about 25% of the personal lines (a uto and homeowners) busi ness, far o utdistancing its once -mighty com petitors. Allstate, formed in 1931, put a similar distribution system into place a nd soon becam e the runner-up in personal lines t o State Farm . Capitalis m had wo rked its m agic, an d these low-co st op eratio ns looked unsto ppable. 8 --- Page 8 --- But a man nam ed Leo G oodwin had an i dea for an even more efficient auto ins urer and, with a skimpy $200,000, started GEICO in 1936. Goodwin’s plan was t o eliminate the agent entirely and to deal instead di rectly with the auto ow ner. Why, he as ked him self, shoul d there be any unnecessary and expe nsive links in the distribution mechani sm when t he produ ct, aut o insura nce, was both m andatory and costly. Purc hasers o f business insurance , he reas oned, might well require professional advi ce, b ut most consum ers kne w what t hey ne eded in a n auto policy. Th at was a po werful insight. Originally, GEICO m ailed its low-cost m essage to a limited audience of government employees. Later, it wi dened its horizon s and shifted its m arketing emphasis to the phone, wo rking inquiries th at ca me from broa dcast and print advertising. And today the Internet is com ing on strong. Betw een 1936 and 1975, GEICO grew from a standing sta rt to a 4% m arket sha re, becoming the country’s fo urth larg est au to insurer. Duri ng most of this period, th e company was su perbly managed, achieving both excel lent volume gains and high profits. It looke d unstoppable. B ut after my friend and hero Lorimer Davi dson retired as C EO in 1970, his suc cesso rs soon made a h uge mistake by under- reserv ing for lo sses. This produced faulty co st inform ation, which in turn produced inadequate pricing . By 1976, GEICO was on the brink of failure. Jack Byrne the n joine d GEICO as CE O and, alm ost single-handedly, save d the company by heroic efforts t hat inc luded major price incr eases . Though GEICO’s survi val required these, po licyh olders fled the com pany, and by 1980 its market share had fal len to 1.8%. Subsequently, the company embarked on some unwise diversificatio n moves. This sh ift of emphasis away from its extraordinary c ore business stunted GEIC O’s growth, and by 1993 its market share had grown only fract ionally, to 1.9%. Then Tony Nicely took c harge. And what a differen ce th at’s made: In 2005 GEIC O will p robably secu re a 6% market sh are. Better yet, To ny has matched growth with p rofitab ility. Indeed, GEIC O delivers all of its co nstituen ts major benefits: In 2004 its cu stomers sav ed $1 billion or so compared to what they wou ld otherwise have paid for coverage, its associ ates earn ed a $191 million profit-sharing bonus that averaged 24.3% of salary, and its own er – that’s us – enjo yed excellen t financial returns. There’s more good news. When Jack Byr ne was re scuing the com pany in 1976, New Je rsey refused to grant him the rat es he neede d to operate profitably. He t herefore promptly – an d properly – withdre w from the state. Subseq uently, GEICO avo ided both New Jersey an d Massachu setts, recogn izing them as two jurisdictions in which insurers were destine d to struggle. In 2003, however, New Je rsey took a new l ook at its chro nic aut o-insurance pr oblems and e nacted legislation that would curb fraud and allow insurers a fai r playing fi eld. Eve n so, one might have e xpected the state’s bureaucracy t o make change slow and di fficult. But just the opposite occurred. Holly Bakke, the New Jersey insurance commissioner, who would be a success i n any line of work, was determined to turn the law’s in tent into reality. With her staff’s cooperatio n, GEICO iro ned out the details fo r re-en tering the state and was license d last August. Since then, we’v e receiv ed a respo nse fro m New Jersey drivers that is m ultiples of m y expectatio ns. We are n ow serving 140,000 policyholders – abo ut 4% of the Ne w Je rsey market – and sa ving them subst antial sum s (as we do drivers e verywhere). Word-of-mouth recom mendations wi thin the state are causi ng inquiries to pour in. And once we hea r from a New Jersey pros pect, our closure rate – the percentage of policies issu ed to inquiries receiv ed – is far higher in th e state th an it is nationally. We m ake no claim, of co urse, that we can save every one money . Som e com panies, using rating syste ms that are differen t from o urs, will o ffer certai n classes o f drivers a lower rate than we do. Bu t we believe GE ICO offers the lowest price m ore oft en than any other nationa l company that serves all segments of the public. In a ddition, in m ost states, includi ng Ne w Jersey, Be rkshire share holders recei ve an 8% discount. So gam ble fifteen minutes of y our t ime and go to GEIC O.com – or cal l 800- 847-7536 – to see 9 --- Page 9 --- whet her y ou can save big money (whi ch you m ight want to use, of cou rse, to buy other B erkshire products). * * * * * * * * * * * * Reinsu rance – insura nce sol d to othe r ins urers who wish to lay off p art of t he risks they have assumed – shou ld not be a commo dity product. At bottom, any insurance po licy is si mply a pro mise, an d as ev eryon e knows, promises v ary eno rmously in their quality. At th e prim ary in surance lev el, nevertheless, just who makes t he promise is often of m inor importance. In personal-lines insurance , for exam ple, states levy assess ments on s olvent com panies to pay the po licyho lders of companies th at go broke. In the business-insurance fi eld, the sam e arrange ment applies to work ers’ compensatio n policies. “Protected” policies of these typ es acco unt f or about 60% of the property-casualty industry’s volume. Prude ntly-run insurers are irritated by the need to subsidize po or or reck less m anagement elsewh ere, bu t that’s the way it is. Other forms of busi ness insurance at the primary level involve promises that carry greater risks for the ins ured. Whe n Relianc e Ins urance a nd Home Insu rance we re run into the ground, for e xample, their promises prov ed to be w orthless. C onsequently, many holders o f their business policies (other than those cove ring workers’ compensat ion) suffered painful losses. The solvency risk in primary policies, however, pales in compariso n to that lurking in reinsuran ce policies. Whe n a rei nsurer goes broke, stag gering losses almost always strik e the primary companies it h as dealt with . Th is risk is far from minor: GEICO has suffered tens of millio ns in losses fro m its care less selection of reinsurers in the e arly 1980s. Were a tru e meg a-catastrop he to occur in th e next decade or two – and that’s a real possib ility – some rein surers wou ld not survive. Th e larg est in sured loss to date is th e World Trad e Cen ter disaster, which cost the insurance indu stry an estimated $35 billion . Hurrican e Andrew co st insurers abou t $15.5 billion in 1992 (th ough that loss wo uld be far h igher in today’s do llars). Bo th events rocked the insuran ce and reinsurance wo rld. But a $100 billion event, or even a larg er catastrop he, rem ains a possibility if ei ther a particula rly severe ea rthqua ke or hurrica ne hits just the wrong place. Four si gnificant hurricanes struck Florida during 2004, cau sing an aggreg ate of $25 billion or so in insured losses. Two o f these – Charley and Ivan – could have done at least three times the dam age they did had they entered the U.S . not far from their actual landing points. Many insurers regard a $100 billion industry loss as “u nthinkable” and won’t ev en plan for it. Bu t at Berkshi re, we are ful ly prepared. Our share of t he loss would probably be 3% t o 5%, and ear nings from our i nvestm ents and other businesses woul d com fortably e xceed that cost. Whe n “the day after” arrives, Berk shire’s check s will clear. Though the hurrican es hit us with a $1 .25 billion loss, ou r reinsurance operations did well last year. At Gene ral Re, Joe Bra ndon has re stored a long -admired culture of u nderwritin g discip line that, fo r a time, had l ost its way . The excellent results he realized i n 2004 on current business, however, were offset by adve rse d evelopments from the years befo re he t ook the helm . At NIC O’s rei nsurance o peration, Ajit Jain continues to succes sfully underwrite huge risks that no other reinsurer is willing or a ble to ac cept. Ajit’s v alue to Berk shire is eno rmous. * * * * * * * * * * * * Our insuran ce managers, m aximizin g the competitiv e strengths I’v e mentioned in this section , again delivered first-class un derwritin g results last year. As a c onsequence , our float was bet ter than costless. Here’s the sc orecard: 10 --- Page 10 --- (in $ millio ns) Underwriting Profit Yearend Float Insurance Ope rations 2004 2004 2003 Gene ral Re ....................... $ 3 $23,120 $23,654 B-H Rei nsurance.............. 417 15,278 13,948 GEIC O............................. 970 5,960 5,287 Othe r Primary*................. 161 1,736 1,331 Total ................................. $1,551 $46,094 $44,220 *Includes, in addition to National Indemnity, a v ariety o f other exceptional insurance businesses, run by Rod Eldred, John Kizer, Tom Nerney and Don T owle. Berk shire’s float in creased $1.9 billion in 2004, even though a few insu reds opted to commute (that is, unwind) certain reinsurance c ontracts. We agree to such commutations o nly when we believe the econ omics are favorable to us (after giving due weight to what we might earn in the future on the money we are returning). To summarize, last year we were p aid more th an $1.5 billion to hold an av erage of about $45.2 billion. In 2005 pricin g will b e less attract ive than it has been. Nevertheless, ab sent a mega-catastrop he, we have a dece nt chance of achieving no-cost float again this year. Finance and F inance Produc ts Last year in this sectio n we d iscussed a potpourri of activities. In this report, we’ll sk ip over several that are now of lesser importance: Berkadia is do wn to tag ends; Value Capital h as added other invest ors, negating o ur expectation that we wo uld nee d to consolidate its fin ancials in to ours; and th e trading operation that I run continues to shri nk. • Both of Berk shire’s leasin g operation s rebo unded last year. At CORT (office furniture), earnings remain inadeq uate, but are t rending upward. XTRA disposed of its container and intermodal businesses in order to concentrate on trailer leasin g, long its stro ng suit. Ov erhead h as been reduced, asset u tilizatio n is u p and decent profits are now b eing achieved under Bill Fran z, the company’s ne w CEO. • The wind -down of Gen Re Secu rities con tinues. We decided to exit this derivative operatio n three years ag o, but getting out is easier said th an done. Tho ugh derivative instruments are purported t o be hi ghly liquid – an d though we hav e had the benefit of a beni gn m arket while liquidating ours – we still h ad 2,8 90 contracts outstanding at yearend , down from 23,218 at th e peak. Like Hell, derivative trad ing is easy to en ter but difficult to leave. (Ot her similarities come to mind as well.) Gen Re’s derivative contracts have always been re quired to be marked to mark et, an d I believ e the company’s managem ent conscientiously tried to make rea listic “marks.” The market prices of derivatives, however, can be v ery fuzzy in a world in which settlemen t of a tran saction is sometimes d ecades away and o ften involves multiple variables as well. In the interim the marks influence t he manageri al and trading bonuses t hat are paid annually. It’s s mall wonde r that phantom profits are often recorded. Investors should und erstan d that in all types of financial institutions, rap id grow th sometimes masks m ajor u nderlying problems (and occasionally fraud). The re al test of the earning power of a derivatives operation is what it ach ieves after operating for an extended period in a no-growth mode. Y ou only learn who has bee n swimming na ked when the tide goes out. • After 40 years, we’v e finally generated a little sy nergy at B erkshire: Clayto n Ho mes is do ing well and that’s in part due to its asso ciatio n with Berkshire. The manufactured ho me industry 11 --- Page 11 --- continues to reside in the intensive care unit of Corporate America, havi ng sold less than 135,000 new ho mes last year, abou t the sam e as in 2003. Volume in these y ears was th e lowest since 1962, and it was al so only abo ut 40% of ann ual sales d uring the year s 1995-99. That era, charact erized by irresponsible financing and naïve funders, was a fool’s paradise for the industry. Because one major le nder after anot her has fle d the field, fi nancing continues t o bedevil manufact urers, retailers an d purchasers of manufact ured homes. He re Berkshire’s support has proven valuable to Clayton. We stand ready to fund whatever makes sen se, an d last year Clayton’s m anagem ent found much that qualified. As we explained in our 2003 r eport, we believe in using borrowed money to support profitable, interest-beari ng receiva bles. At the be ginning of last year, we ha d borrowed $2 billion to relend to Clayto n (at a one percentage-point markup) and by Janu ary 2005 the total was $7.35 billion. M ost of the dollars added were borrowed by us on January 4, 2005, to finance a seaso ned portfolio that Clayton purc hased on December 30, 200 4 from a bank e xiting t he business. We no w have two additional portfolio purchases in the wo rks, totaling about $1.6 billion, but it’s quite unlikely that we will secure others of a ny significa nce. There fore, C layton’s recei vables (in which originations will roughly offset p ayoffs) will probab ly ho ver arou nd $9 billion for so me time and shou ld deliver steady earn ings. This p attern will b e far differen t from that of the past, in whic h Clayton, like all major players in its i ndustry, “securitized ” its receivables , causing earni ngs to be fro nt-ended . In th e last two years, th e securitizatio n mark et has dried up. The limited funds available today com e onl y at higher cost and with harsh terms. Ha d Clayton rem ained independent in this period, it would have had mediocre ea rnings as it struggled with financing. In April, Clayto n completed the acq uisition of Oakwood Homes and is now th e industry’s larg est produce r and retailer of m anufact ured homes. We l ove putting more asse ts in the han ds of Ke vin Clayton, the company’s CEO. He is a prototype Berkshire manager. Today , Clayton has 11,837 employees, up from 7,136 when we purchased it, and Charlie and I are pleased t hat Berkshire has been usefu l in facilitatin g this growth. For sim plicity’s sak e, we include all of Clayto n’s earnings in this sector, t hough a sizabl e portion of these a re derived from areas ot her than consum er finance . (in $ millio ns) Pre-Tax E arnings Interest-Bea ring Liabilities 2004 2003 2004 2003 Tradi ng – ordinary i ncome............................ $ 264 $ 355 $5,751 $7,826 Gen Re Sec urities........................................... (44) (99) 5,437* 8,041* Life and a nnuity operation .............................. (57) 85 2,467 2,331 Value Capital.................................................. 30 31 N/A N/A Berka dia......................................................... 1 101 — 525 Leasing operations .......................................... 92 34 391 482 Manufactured housi ng fina nce (Cla yton) ....... 220 37** 3,636 2,032 Othe r............................................................... 78 75 N/A N/A Income before capital gains ............................ 584 619 Tradi ng – capit al gains ................................... 1,750 1,215 Total ............................................................... $2,334 $1,834 * Includes all liab ilities ** From date of acquisition , August 7, 2003 12 --- Page 12 --- Manufa cturing , Serv ice a nd Reta iling Opera tions Our activities in this category cover the waterfront . But let’s look at a sum mary balance sheet and earni ngs statement consolid ating the entire group. Balance Sh eet 1 2/31/04 (in $ millio ns) Assets Liabilities and Equity Cash a nd equi valents ................................. $ 899 Notes paya ble............................... $ 1,143 Accounts a nd notes receivabl e.................. 3,074 Othe r current l iabilities ................. 4,685 Inventory ................................................... 3,842 Total curre nt liabilities ................. 5,828 Othe r current a ssets ................................... 254 Total curre nt assets .................................... 8,069 Goodwill and other inta ngibles.................. 8,362 Defe rred taxes............................... 248 Fixed assets ................................................ 6,161 Term debt a nd other liabilities ...... 1,965 Othe r assets ................................................ 1,044 Equity ........................................... 15,595 $23,636 $23,636 Earnings Statemen t (in $ millio ns) 2004 2003 Revenues ................................................................................................................. $44,142 $32,106 Operating expenses (including depreci ation of $676 in 2004 and $605 in 2003) ............................................................................................. 41,604 29,885 Intere st expe nse (net)............................................................................................... 57 64 Pre-ta x earnings....................................................................................................... 2,481 2,157 Income taxes ............................................................................................................ 941 813 Net inc ome.............................................................................................................. $ 1,540 $ 1,344 This eclectic group , which sells p roducts ran ging from Dilly Bars to fractio nal interests in Boeing 737s, ea rned a very res pectabl e 21.7% on average tangible net worth last year, com pared to 20.7% in 2003. It’s noteworthy that these operations used only minor fi nanc ial leverage i n achieving these returns. Clearly, we o wn some very good businesses. We p urchase d many of them, however, at subst antial prem iums to net worth – a m atter th at is reflected in th e goodwill ite m shown on the balance sh eet – and that fact reduces the earnings on our ave rage carrying value to 9.9%. Here are t he pre-tax ea rnings for the larger categories or units. Pre-Tax E arnings (in $ millio ns) 2004 2003 Building Pr oducts .................................................................................................... $ 643 $ 559 Shaw Industri es....................................................................................................... 466 436 Appa rel & Footw ear................................................................................................ 325 289 Retailing of Je welry, Home Furnishings a nd Candy ............................................... 215 224 Flight Se rvices......................................................................................................... 191 72 McLane .................................................................................................................... 228 150* Othe r businesses...................................................................................................... 413 427 $2,481 $2,157 * From date of acquisition, May 23, 2003. • In the building-products sector and at Shaw, we’ve experie nced sta ggering cost inc reases for both raw- materials and energy. By Dece mber, for e xample, steel costs at MiTek (whose prim ary busi ness is connector s for roof trusses) were running 100% over a year earlier. And MiTek uses 665 million pounds of steel every year. Nevertheless, the company continues to be an outstanding performer. 13 --- Page 13 --- Since we purchased MiTek in 2001, Gene Toombs, its CEO, h as made some brilliant “bo lt-on ” acquisition s and is on his way to creatin g a mini-Berk shire. Shaw fielded a barrage of price increases in its main fiber materials during the year, a hit that added more th an $300 million to its co sts. (Wh en you walk on ca rpet y ou are, in effect, stepping on processe d oil.) Though we fo llowed these hi kes in costs with price increa ses of our own, there was an inevitable lag. There fore, margins narrowed as the year pr ogresse d and remain under pressure today. Despi te these roadblocks, S haw, l ed by Bob Sha w and Julian Saul , earn ed an o utstanding 25.6% on tangible equity in 2004. The com pany is a powerhouse and h as a bright future. • In apparel, Fru it of th e Loom increased un it sales b y 10 million dozen, or 14%, wit h shipments of intimate appar el for women and girls growing by 31%. Charlie, who is far more knowledgea ble than I am on this subject, ass ures me that wom en are not weari ng more underwear. With t his expe rt input , I can only conclude that our market share in the wom en’s ca tegory must be gr owing rapidly. Tha nks to John Holland , Fru it is on the move. A sm aller ope ration, Gara n, also had an excel lent year. Le d by Seymour Li chtenstein and Jerry Kam iel, this company manufactures t he popular Garanimals line for children. Next time you are in a Wal-Mart, check out this im aginative product. • Among our re tailers, Ben Bridge (jewelry) and R. C . Willey (hom e furnishi ngs) were particula r standouts last year. At Ben Bridge sam e-store sal es grew 11.4%, the best gain among t he publicly-held jewelers whose reports I have seen. Additionally, th e company’s profit marg in widened. Last year was no t a fl uke: During t he past decade , the same-store sale s gains of the com pany have a verage d 8.8%. Ed an d Jon B ridge a re fourth-generation manage rs and run the business e xactly as if it were t heir own – which it is in every res pect excep t for Berkshire’s name on the stock ce rtificates. The Bridges h ave expa nded successful ly by securing the right locations an d, more im portantly, by staffing these st ores with enthusiastic an d kno wledg eable asso ciates. We will mo ve into Minn eapolis-St. Pau l this year. At Utah -based R. C. Willey, the gains from expansion have been even more dram atic, with 41.9% of 2004 sales coming fr om out-of-state stores that didn’t exi st before 1999. The com pany also im prove d its profit margin in 200 4, propelled by its two n ew stores in Las Veg as. I would like to tell you that these sto res were my idea. In truth, I tho ught they were m istakes. I knew, of course, how b rillian tly Bill Child had run the R. C. Willey o peration in Utah , where its market share had l ong been huge. B ut I felt our cl osed-on-Sunday policy woul d prove disastrous away from hom e. Even our first out-of-state store in Boise, which was highly successf ul, left me uncon vinced. I kept asking whether Las Ve gas r esidents, conditioned t o seve n-day-a-week retailers, w ould adjust to us. Our first Las Vegas store, ope ned in 2001, answered this question in a re sounding m anner, immediately becom ing ou r number one unit. Bill and Sc ott Hym as, his successor as CEO, t hen proposed a sec ond Las Ve gas st ore, only about 20 minutes away . I fel t this expansion would canni balize the first unit, adding si gnificant cost s but only modest sales. The result? Each store is now do ing about 26% more volume th an any other store in the chain and is con sisten tly showing large year-o ver-year gains. R. C. Willey will soo n open in Reno . Befo re making this co mmitment, Bill an d Sco tt again asked for my ad vice. Initiall y, I was pretty p uffed up abo ut the fact that they were con sulting me. But then it dawned on me that the opi nion of som eone wh o is always wrong has its o wn special u tility to decisio n- makers. 14 --- Page 14 --- • Earni ngs improved in flight servi ces. At FlightSafet y, the world ’s leader in pilot trainin g, profits ro se as cor porate av iation rebound ed and our business with reg ional air lines in creased . We now operate 283 simulators with an orig inal co st of $1.2 billion. Pilo ts are train ed one at a time o n this exp ensive equipment. Thi s means t hat as much as $3 .50 of ca pital investment is requ ired to produce $1 o f annual revenue. With th is lev el of capital in tensity, Flig htSafety requi res ve ry high operating margins in order to obtain reason able ret urns on capital, wh ich means that utilizat ion rates are all-i mportant. Last year, FlightSafety’s return on tangible equity improve d to 15.1% from 8.4% in 2003. In another 2004 event, Al Ueltsch i, wh o foun ded FlightSafety in 1951 with $10,000, turned ov er th e CEO po sition to Bruce Whitman, a 43-year v eteran at th e company. (B ut Al’s not going anywhere; I won’t let h im.) Bru ce sh ares Al’s conv iction that flyin g an aircraft is a p rivilege to be exten ded only to people who re gularly receive the highest quality of traini ng and are undenia bly com petent. A few years ag o, Charlie was as ked to intervene with Al on behalf of a tycoon friend whom FlightSafet y had flunked. Al’s reply to Charlie: “Tell yo ur pal he belongs in the back of the plane, not t he cockpit.” FlightSafety’s num ber o ne customer is NetJets, ou r aircraft fract ional-ownership subsidiary. Its 2,100 pilots sp end an average of 18 days a year i n training. Additionally, th ese p ilots fly on ly one aircraft type whe reas many flight operations juggle pilots among seve ral types. Net Jets’ high st andards on both fronts are two of the reasons I signed up with the company years before Berkshire bought it. Fully as im portant in my decisions t o both use a nd buy Net Jets, ho weve r, was t he fact that the company was man aged by Rich Santulli, th e creato r of the fraction al-ownersh ip industry and a fan atic about safety and service. I vi ewed the selection of a flight provider as a kin to picking a brai n surgeon: you si mply want the best. (Let som eone el se experiment with the low bidder.) Last year NetJ ets again gaine d about 70% of the net new bu siness (measur ed by dollar value) going to the four c ompanies that dominate the ind ustry. A portion o f our growth cam e from the 25-hour card offered by Marquis Jet Partners. M arquis is not owned by NetJets, but is instead a customer that repackages the purchases it makes from us into smaller packages that it sells th rough its card. Marqu is deals ex clusively with NetJets, u tilizin g the power of our rep utation in its mark eting. Our U. S. co ntracts, including M arquis cust omers, gre w from 3,87 7 to 4,967 in 2004 ( versus approximately 1,200 contracts whe n Berkshire bought NetJets in 1998). Some clients (incl uding me) enter into m ultiple contract s because they wish to use more tha n one type of airc raft, selecting for any given trip whicheve r type best fits the mission at hand. NetJets ear ned a m odest amount in the U.S. last year. But what we ea rned domestically was l argely offset by losses in Europe. We are now, however, generating real momentum abroa d. Contracts (including 25-hour cards that we ourselves market in Europe) increase d from 364 to 693 during the year. We will ag ain have a very significant Eu ropean loss in 2005, but domestic earn ings will lik ely put us in the black ove rall. Europe has been ex pensive for NetJets – fa r more expe nsive than I ant icipated – but it is essent ial to building a fligh t operation that will fo rever be in a class by itself. Our U.S. owners alread y wan t a quality serv ice wh erever they trav el an d their wish for fligh t hours ab road is certain to grow dram atically in the decades a head. Last yea r, U.S. owners made 2,003 flights in E urope, up 22% from the pre vious year an d 137% from 2000. Ju st as im portant, our European owners m ade 1, 067 flights in the U.S., up 65% fr om 2003 and 239 % from 2000. 15 --- Page 15 --- Inves tments We sh ow below our common st ock i nvestments. Th ose that had a m arket value of more than $600 million at th e end of 2004 are itemized . 12/31/04 Percent age of Shares Company Company Owned Cost* Market (in $ millio ns) 151,610,700 American Expr ess Co mpany................... 12.1 $1,470 $ 8,546 200,000,000 The C oca-C ola Com pany........................ 8.3 1,299 8,328 96,000,000 The Gillette Com pany............................. 9.7 600 4,299 14,350, 600 H&R Bloc k, Inc....................................... 8.7 223 703 6,708,760 M&T Bank C orporation .......................... 5.8 103 723 24,000, 000 Moody’s Corporation .............................. 16.2 499 2,084 2,338,961,000 PetroChina “H” sh ares (or equivalents)... 1.3 488 1,249 1,727,765 The Washington Post Company.............. 18.1 11 1,698 56,448, 380 Wells Far go & Com pany......................... 3.3 463 3,508 1,724,200 White Mountains Insurance ..................... 16.0 369 1,114 Othe rs...................................................... 3,531 5,465 Total Com mon Stoc ks............................. $9,056 $37,717 *This is our actual purchase price and al so our tax basis; GAAP “c ost” differs in a few case s because of write-ups or write-downs that ha ve bee n require d. Some people may look at t his table and view it as a list of stocks to be bought and s old base d upon chart patterns, brokers’ opinions, or est imates of near-term earni ngs. Charlie and I ignore such distractions and i nstead view o ur holdings as fract ional owne rships in businesse s. Thi s is an impo rtant distinction. Indeed, this thinking has bee n the cor nerstone of m y investment behavi or since I was 19. At that time I read Be n Gra ham’s The Intelligent Investo r, and the scale s fell from my ey es. (P reviously, I had been entranced by the stock market, but didn’t have a cl ue about how to invest.) Let’s loo k at ho w the businesses of our “Big Four” – American Express, Co ca-Co la, Gillette an d Wells Farg o – have fared since we bo ught into these co mpanies. As the tab le shows, we in vested $3.83 billion in the four, by way o f multiple tran sactio ns between May 1 988 and Octob er 2003. On a co mposite basis, our dollar-weighted purchase dat e is July 1992. By yearend 2 004, therefore, we had held these “business in terests,” on a wei ghted basis, about 12½ years. In 2004, Be rkshire’s share of the group’s earnings am ounte d to $1.2 billion. T hese earnings might legiti mately be conside red “norm al.” True, they were swelled because Gillette and Wells Fargo omitted option c osts in their prese ntation of earnings ; but on the ot her ha nd they were re duce d because Coke had a non-recurring write-off. Our sha re of t he earni ngs of these f our com panies has grown almost every year, and n ow amounts to about 31.3% o f our cost. Th eir cash distr ibutions to us have also grown consisten tly, to taling $434 million in 2004, or about 11.3% of cost. All in all, th e Big Fou r have delivered us a satisf actory, tho ugh f ar from spectacular, business result. That’s tru e as well o f our exp erience in the market with the group . Since o ur orig inal purchases, valuation gai ns have s omewhat exceede d earni ngs growth because price/e arnings ratios have inc reased. On a year-to-year basi s, however, the business and m arket performances hav e often diverged, sometimes to an extra ordina ry degree. Duri ng The Great Bubble, market-value gains far outstripped the performance of the businesses . In the afterm ath of the Bubble, t he reverse was true. 16 --- Page 16 --- Clearly, Berkshire’s results would have be en fa r better if I had caugh t this swing of th e pendulum. That m ay see m easy to do when one look s through an always-clean, rear-view mirror. Unfort unately, however, it’s the windshield through which invest ors must peer, a nd that glass is invariably fogged. Our huge positions add to the difficulty of our nimbly danci ng in and out of holdings as valuations s wing. Nevertheless, I can prop erly b e criticized for m erely c lucking about nose-bleed valuation s during the Bubble rather t han acting on m y views. Though I said at the tim e that certain of the stocks we held were priced a head of them selves, I undere stimated just how sev ere the overvaluation was. I talk ed when I should have walked. What Charlie an d I wou ld like is a lit tle act ion now. We don’t enj oy sittin g on $43 billion of cash equivalents that are earni ng paltry returns. Instead, we yearn to buy mo re fraction al interests simila r to those we no w own or – better still – more larg e businesses outright. We will d o either, however, only wh en purchases ca n be m ade at prices that offer us the prospect of a reasonable return on our investment. * * * * * * * * * * * * We’ve re peate dly emphasized that the “rea lized” gains that we re port quarterly or annually ar e meaningless for analytical purposes. We have a huge amount of unrealized gains on our books, and our thinking about when, an d if, to cash them depends not at all on a desire to repo rt earn ings at one specific time or anot her. A f urther c omplication in our rep orted gains occ urs because G AAP requires that foreign excha nge contracts be m arked to m arket, a stipula tion that cau ses unrealized gains or losses in these holdings to flow through our published earnings as if we had sold our positions. Despi te the problems enum erated, y ou may be i nterested in a breakdown of the gains we reported in 2003 and 2004. Th e data r eflect actual sales exce pt in the cas e of cu rrency gains, which are a combination of sales and marks to market. Category Pre-Ta x Gain (in $ millio ns) 2004 2003 Com mon Stoc ks............................. $ 870 $ 448 U.S. Gover nment Bonds ................. 104 1,485 Junk B onds..................................... 730 1,138 Foreign E xchange Cont racts ........... 1,839 825 Othe r............................................... (47) 233 Total ............................................... $3,496 $4,129 The junk bond profits in clude a foreign e xchange com ponent. When we bought these bonds in 2001 and 200 2, we fo cused fi rst, of course, on the cred it quality o f the issu ers, all of which were Am erican corporations. Some of t hese com panies, however, had issued bonds denominated in foreign currencies. Because of our views on the dolla r, we favored the se for purchase whe n they were availa ble. As an e xample, we b ought €254 million of Level 3 bonds (10 ¾% of 2008) in 2001 at 51.7% of par, and s old these at 85% of par in December 2004. T his issue was tra ded in Euro s tha t cost us 88¢ at the time of purchase bu t that brou ght $1.29 when we sold. Thus, of our $163 million overall gain, abo ut $85 million cam e fro m the market’s rev ised opinion about Lev el 3’s cred it quality, with the rem aining $78 million resulting from the a ppreciati on of the Euro. (In addition, we received cash interest during our holding period that amounted to about 25% annually on our dollar cost.) * * * * * * * * * * * * The media con tinue to report th at “B uffett b uys” th is or th at sto ck. State ments lik e these are almost always base d on filings Berkshire makes wi th the SEC and are therefore wrong. As I’ ve said before , the stories shoul d say “Berkshire buys.” 17 --- Page 17 --- Portrait of a Disciplined Investor Lou Simpson Return from Year GEIC O Equities S&P Return Relative Resu lts 1980 ................................................ 23.7% 32.3% (8.6%) 1981 ................................................ 5.4% (5.0% ) 10.4% 1982 ................................................ 45.8% 21.4% 24.4% 1983 ................................................ 36.0% 22.4% 13.6% 1984 ................................................ 21.8% 6.1% 15.7% 1985 ................................................ 45.8% 31.6% 14.2% 1986 ................................................ 38.7% 18.6% 20.1% 1987 ................................................ (10.0%) 5.1% (15.1%) 1988 ................................................ 30.0% 16.6% 13.4% 1989 ................................................ 36.1% 31.7% 4.4% 1990 ................................................ (9.9% ) (3.1% ) (6.8% ) 1991 ................................................ 56.5% 30.5% 26.0% 1992 ................................................ 10.8% 7.6% 3.2% 1993 ................................................ 4.6% 10.1% (5.5% ) 1994 ................................................ 13.4% 1.3% 12.1% 1995 ................................................ 39.8% 37.6% 2.2% 1996 ................................................ 29.2% 23.0% 6.2% 1997 ................................................ 24.6% 33.4% (8.8%) 1998 ................................................ 18.6% 28.6% (10.0%) 1999 ................................................ 7.2% 21.0% (13.8%) 2000 ................................................ 20.9% (9.1% ) 30.0% 2001 ................................................ 5.2% (11.9%) 17.1% 2002 ................................................ (8.1% ) (22.1%) 14.0% 2003 ................................................ 38.3% 28.7% 9.6% 2004 ................................................ 16.9% 10.9% 6.0% Average Annual Gain 1980-2004 20.3% 13.5% 6.8% 18 --- Page 18 --- Even then, it is typically not I wh o make the buy ing decisions. Lou Si mpson manages about $2½ billion of eq uities th at are held by GEICO, and it is h is tran saction s that Berk shire is u sually rep orting. Customarily his pu rchases ar e in the $200-$300 million range a nd are i n com panies t hat are sm aller than the ones I foc us on. Ta ke a look at the fa cing page to see wh y Lo u is a cin ch to be inducted into the invest ment Hall of Fam e. You may be sur prised to learn t hat Lou does not necessa rily inform me about what he is doing. When Charlie an d I assign resp onsibility, we tru ly hand over the baton – and we give it to Lou just as we do to our operating managers. Th erefore, I typically lear n of Lou ’s transaction s about ten days af ter the end of each month. Sometimes, it should be adde d, I silently disagree with his decisions. But he’s usuall y right. Foreign Curr encies Berks hire owned about $21.4 billi on of foreign exc hange cont racts at yearend, s pread among 12 currencies. As I mentioned last year, hol dings of this kind are a deci ded cha nge for us. B efore M arch 2002, neither Berkshire nor I had ever traded in curren cies. Bu t the evidence grows th at our trade policies will p ut unremit ting pressure on the dollar for m any years to come – so since 20 02 we’v e heeded that warning in setting our investment cour se. (As W.C. Fields once sai d when asked for a ha ndout: “Sor ry, son, all m y money’s tied up in currency.”) Be clear on o ne point: In no way does our thinking about currencies rest on doubts about America. We liv e in an extraordinarily rich country, the product of a syste m that values m arket econom ics, the rule of law a nd equality of opportunity. Our econom y is far and away th e strongest in the world a nd will continue to be. We are lu cky to live here. But as I argue d in a No vember 10, 2003 art icle in Fortune, (avai lable at berkshirehathaway.com), our country’s trade practices are we ighing d own the dollar. Th e declin e in its v alue has alread y been substan tial, but is n evertheless lik ely to continue. Withou t policy ch anges, curren cy mark ets cou ld even become disorderly an d generate sp illover effects, bo th political an d financial. No one knows wh ether these problems will materialize. But such a scen ario is a far-from -remote possibility that policymakers sho uld be consideri ng now. Thei r bent, however, is to lean t oward not-so-benign neglect: A 318-page Congressional study of the consequences of un remitting trad e deficits was published in Nov ember 2000 and has been gathering dust ev er sin ce. The stu dy was o rdered after th e deficit h it a th en-alarm ing $263 billion in 1999; by last year it had risen to $61 8 billion. Charlie and I, it sh ould be emp hasized , believe that true tra de – that is, the excha nge of goods and servi ces with other countries – is enormously benefi cial for both us an d them. Last year we ha d $1.15 trillio n of such honest-to-God trad e and the more of this, th e better. Bu t, as n oted, o ur cou ntry also purchased an ad ditional $6 18 billion in g oods and serv ices fro m the rest of the world that was unreciprocate d. That is a staggeri ng figur e and one t hat has importa nt consequences . The balancing item to this one-way p seudo-trad e — in econ omics th ere is always an offset — is a transfer of wealth from the U.S. to the rest of th e world. Th e tran sfer m ay materialize in the form of IOUs our private o r governmental institutions give to foreign ers, or by way o f their assuming ownership of o ur assets, s uch as stoc ks and real estate. In e ither case, Am ericans e nd up owni ng a reduced por tion of our country wh ile non-Americans own a greate r part. This force-feedi ng of American wealth to the rest of th e world is now p roceeding at th e rate of $1 .8 billion daily, an increase of 2 0% sin ce I wrote you last year. Consequently, other cou ntries an d their citiz ens now own a net of about $3 trillio n of the U.S. A decade ago their net ownership was negl igible. The mention of trillio ns numbs most brains. A furth er source of con fusion is th at th e current account deficit (the sum of three item s, the m ost im porta nt by fa r being t he trade deficit) a nd our national budget deficit are ofte n lum ped as “twins.” T hey are any thing but. They have different cause s and different consequences. 19 --- Page 19 --- A budget deficit in no way reduces the por tion of the national pie that goes to Americans. As long as other countries and their citizens have no net ownership of the U.S ., 100% of o ur country’s output belongs to ou r citizen s under any budget scenario, even one involving a huge defi cit. As a rich “famil y” awash in goo ds, Am erican s will argu e through their leg islato rs as to how government shoul d redistribute the nat ional output – that is who pay s taxes and who rece ives governmental benefits. If “en titlement” promises fro m an earlie r day have to b e reex amined, “fam ily members” will angrily d ebate among themselves as t o who feels t he pain. Mayb e tax es will g o up; maybe pro mises will be modified; mayb e more internal debt will b e issu ed. Bu t when the figh t is fin ished, all of the fa mily’s huge pie remains available for its members, ho wever it is divided. No slice must be sent abroad. Large a nd persisting curre nt account de ficits produ ce an e ntirely differe nt result. As time passes, and a s claim s against us grow, we own less and less of what we produce. In eff ect, the rest of the world enjoys an ever-growing royalty o n Am erican output. Here, we are lik e a fam ily that co nsisten tly overspends its income. As time p asses, th e fam ily finds that it is w orking more an d more fo r the “finance company” and less for itself. Should we con tinue to run current acco unt d eficits co mparable to those now prev ailing, the net owne rship of the U.S. by other co untries a nd their citizens a decade fr om now will am ount to roughly $11 trillio n. And, if fo reign investors were to earn only 5% on that net holding, we would need to send a net o f $.55 trillio n of go ods and serv ices ab road every year merely to serv ice the U.S. inv estments then held by foreigners. At that date, a decade out, our GDP would probably total about $18 trillion (assum ing low inflation, which is far fr om a sure t hing). Therefore, our U.S . “fam ily” would then be delivering 3% of i ts annual ou tput to the rest o f the wo rld simply as tri bute for the overi ndulgences of t he past. In t his case, unlike that involving budget deficits, the son s would truly pay for the sins of th eir fat hers. This annual royalty paid the wo rld – which wo uld not disappear unless t he U.S . massively underconsumed an d began t o run co nsistent and large trade s urpluses – would undoubtedly produce significan t political u nrest in the U.S. Americans wou ld still b e living very well, in deed better th an now because of the growth i n our econom y. But they woul d chafe at the ide a of pe rpetually paying tribut e to their creditors and owners abroad. A cou ntry th at is n ow aspiring to an “Own ership Society” will n ot find happiness in – and I’ll use hyperbole here for emphasi s – a “Sha recropper’s Society.” But that’s precisely where our trade po licies, supp orted b y Repu blicans a nd De mocrats alike, are ta king us. Many prominent U.S . financial figures , both in and out of g overnment, have st ated that our current-account d eficits can not persist. For instance, the minutes of the Fed eral Reser ve Open Mar ket Committee of Jun e 29-30, 2004 say : “The s taff n oted that outsized ext ernal deficits coul d not be sust ained indefinitely.” But, despite the con stant handwring ing by luminaries, th ey offer no substan tive suggestions to tame the burgeoning imbalance. In the article I wrote for Fortune 16 months ago, I warned that “a gently decl ining dollar wo uld not provide the ans wer.” And so far it hasn’t. Yet policymakers c ontinue t o hope for a “s oft landing,” mean while cou nseling other countries t o stim ulate (read “inflate”) t heir econom ies and Americans to s ave more. In my view these admonitions miss the mark: There are deep-rooted structural p roblems that will cause Am erica to continue to run a huge curre nt-acc ount deficit unless trade poli cies either c hange materiall y or the dollar d eclines by a degree th at cou ld prove unsettlin g to financial m arkets. Proponents of the trade st atus quo are f ond of q uoting A dam Smith: “What is prudence in the conduct of eve ry fam ily can scarce be folly in that of a great kingdom. If a fo reign country can s upply us with a c ommodity cheape r than we oursel ves ca n make it, b etter bu y it o f them with so me part of the produce of our own industry, employed in a way in which we have some adva ntage.” I agree. Note , however, that M r. Smith’s s tatem ent refers to tra de of product for product, not of wealth for product as our cou ntry is d oing to the tune of $.6 trillio n annu ally. Mo reover, I am sure that he would never have suggest ed that “prudence” consisted of his “fam ily” selling off part of its farm ever y day 20 --- Page 20 --- in order to finance its ov erconsu mption. Yet th at is j ust what th e “great kingdom” called the Un ited States is do ing. If the U.S. was ru nning a $.6 trillio n curren t-acco unt surplus, commentators w orldwide wo uld violently conde mn our policy, v iewing it as an extreme form of “mercantilism ” – a long-discredited econ omic strategy under which countries fostered exports, discouraged imports, and piled up treasure. I would condemn s uch a policy as well. But, in effect if not in intent, the rest of th e world is practicing mercan tilism in resp ect to the U.S., an act made possible by our vast store of assets and our pristin e credit history. Indeed, the world would never let any other country use a credit card denominated in its own currency to t he insatiable extent we are e mploying ou rs. Prese ntly, most foreign investors a re san guine: they m ay view us as sp ending junkies, but they know we are rich junkies as well. Our spendthrift beha vior won’t, however, be tolerated indefinitely. And t hough it’s impossi ble to forecast just when a nd how t he trade proble m will be resolve d, it’s improbable that the resoluti on will foster an increase in the value of our c urrency relative to that of our trading partners. We hop e the U.S. adop ts policies th at will quickly and substantially reduce t he current-acc ount deficit. Tru e, a p rompt solution would likely cau se Berk shire to record losses on its forei gn-exchange contracts. But Berks hire’s re sources remain heavily con centrated in dollar-b ased assets, and both a stro ng dollar and a low-i nflatio n environ ment are very m uch in our in terest. If you wis h to keep abreas t of trade and curre ncy m atters, read The Financial Times. This London-based pape r has l ong been t he leading source f or daily international financi al new s and n ow has an excellen t American edition. Both its reportin g and commentary on trade are first-class. * * * * * * * * * * * * And, again, our usual caveat : macro-ec onomics is a tough game in which few pe ople, Charlie and I included, have demonstrated skill. W e may well turn out to be wrong in our currency judgm ents. (Indee d, the fact that so m any pundits now predict weak ness fo r the dollar makes us uneasy.) If so, our mistake will be very public. The i rony is that if we chos e the opposite course, leavi ng all of Berk shire’s assets in dollars ev en as th ey declin ed sign ificantly in val ue, no one woul d notice our m istake. John May nard Keynes said in his m asterful The Ge neral Theory : “Worldly wisdom teaches that it is better for re putation t o fail c onventionally than to succeed unconve ntiona lly.” (Or, to put it in less elegant terms, lemmings as a cl ass may be deri ded but neve r does an individual lemmin g get criticized .) Fro m a reputational standpoint, Ch arlie an d I run a clear risk with our foreign -exchange commitment. Bu t we believe in managing Berkshire as i f we owned 100% of it ourselve s. And, were that the case, we would not be following a dollar-on ly policy. Miscella neous • Last year I t old you about a group of University of Ten nessee fi nance s tudents who played a key role in our $1.7 billion acquisition of Clayt on Homes. Earlier, th ey had been brought to Omaha by their professor, Al Auxier – he brings a class eve ry year – to tour Nebraska Furniture Mart and Bors heim ’s, eat at Gorat’s and ha ve a Q&A session with me at Ki ewit P laza. These vi sitors, like those who come for our annual meeting, leave i mpressed by both the city and i ts friendly residents. Other colleges and universities h ave now co me calling. This scho ol year we will h ave visiting classes, ra nging in size from 30 to 100 students, from Chicago , Dartmouth (Tuck), Delaware State, Flori da State, India na, Iowa , Iowa State, Mary land, Nebras ka, Nort hwest Nazare ne, Pe nnsylva nia (Wharton), Stanford, Tennessee, Texas, Te xas A&M , Toronto (Rotman), Uni on and Utah. M ost of the stud ents are MBA cand idates, an d I’ve been impressed by their quality. Th ey are keenly interested in business a nd investments, but their quest ions indicate that they also hav e more on their minds t han simply making money . I always feel good after meeting them. 21 --- Page 21 --- At ou r sessi ons, I tell th e newcomers th e story of the Tenn essee group and its spo tting of Clayton Homes. I do this in the spirit o f the farm er wh o enters his h en house with an ostrich egg and admonishes the flo ck: “I do n’t lik e to complain, girls, bu t this is j ust a s mall sample of what the competitio n is doing.” To date, ou r new sco uts have not brought us deals. Bu t their missio n in life has been made clear to t hem. • You should be aware of an acco unting rule that mild ly distorts our financial state ments in a pain- today , gain-tomorrow manner. B erkshire purchases l ife insurance policies from individuals and corporations who would otherwise surrender them for cas h. As the new holder of the policies, we pay any prem iums that beco me due and ul timately – wh en the ori ginal holder dies – collect the face value of the policies. The orig inal po licyh older is u sually in good health when we pu rchase the p olicy. Still, th e price we p ay for it is always well ab ove its cash surrend er value (“CSV”). Sometimes th e original policyho lder has bo rrowed against the CSV to make pr emium paym ents. In that case, t he remaining CSV will b e tiny and our purchase p rice will b e a larg e multiple of what the orig inal policyholde r woul d have recei ved, had he cashed out by surrende ring it. Unde r account ing rules, we must immediately char ge as a realized capi tal loss the excess over CSV th at we pay u pon purchasin g the policy. W e also must make additional charges each year fo r the am ount by which the premium we pay to keep the policy in force e xceeds t he increase in CSV. But obviously, w e don’t think these bookkeep ing charges r epresent econ omic losses. I f we did, we wouldn’t buy the policies. During 2004, we rec orded net “losses” fr om the purc hase of policies (and from the prem ium payments req uired to maintain them) totaling $207 million, wh ich was ch arged against realized invest ment gains in our earnings statement (included in “other” in the table on page 17). When the procee ds from these policies are receive d in th e future, we will record as realized inve stment gain t he excess over the t hen-CSV. • Two post-bubble gove rnance reforms have b een pa rticularly useful at Berkshi re, an d I fa ult myself for no t putting th em in place many years a go. Th e first involves regu lar m eetings of directo rs without the C EO present. I’ve sa t on 19 boards, and on many occasions this process would have led to dub ious plans being examined more th oroughly. In a few cases, CEO changes that were neede d would also have been made more prom ptly. There i s no do wnside to this process, an d there a re many possible benefits. The sec ond reform concer ns the “w histleblower line,” an a rrangem ent through which employees can send informatio n to me and the board’s audit committe e witho ut fear o f reprisal. Berk shire’s extrem e decentralization m akes this system partic ularly va luable both to me and the committee. (In a spra wling “ci ty” of 18 0,000 – B erkshire’s cur rent employee cou nt – not every spar row that falls will be noticed at headqua rters.) Most of the com plaints we have received are of “the guy next t o me has ba d breath” variety, but on occas ion I have learne d of important probl ems at our subsidiaries that I ot herwise would have missed. The issues rai sed are usually not of a t ype discoverable by au dit, bu t relate in stead to personnel and business practices. B erkshire would be more valuable today if I had put in a wh istleblo wer lin e decades ago . • Charlie and I love the idea of shareholders thinking and behaving like owners. Sometimes that requires th em to be pro-active. And in this aren a larg e institutional owners shou ld lead the way. So far, however, the moves made by institutions have been less than awe-inspiring. Usually, they’ve focused on minutiae and igno red the three questio ns that tru ly count. First, d oes the company have the right CEO? Second, is he/she overreac hing in terms of com pensat ion? Third, are proposed acquisition s more lik ely to create o r destroy per-share value? 22 --- Page 22 --- On such questions, the interests of t he CEO m ay wel l differ from thos e of the shareholders. Director s, moreover, sometimes lack the knowledge or gumption to ov errule the CEO. Th erefore, it’s v ital th at larg e own ers focus on these three questions a nd speak up when necessa ry. Instea d many sim ply follow a “chec klist” ap proach to the issu e du jour. Last year I was on the receiving end of a judgm ent reache d in that manner. Se veral institutional share holders and their advis ors deci ded I lac ked “inde pendence” in my role as a director of Coca-C ola. One group want ed me rem oved fr om the b oard and anot her si mply want ed m e booted from the au dit committee. My first impulse was to secre tly fund the group behind the seco nd idea. Why anyone would wish to be on an audit committee is beyond me. But since directors must be assig ned to one commit tee or an other, and since no C EO want s me on hi s com pensat ion committee, it’s often bee n my lot to get an audit committee assig nment. As it turned out, the institutions that opposed me failed and I was re-elected to the aud it job. (I fought off the urg e to ask for a recount.) Some institutions questione d my “indepe ndence” b ecause, among ot her things, McLa ne and Dai ry Queen buy lots of Coke products. ( Do they want us to favor Pepsi?) Bu t independence is defined in Webst er’s as “not subject to control by others.” I’m puzzled how anyone could conclude that our Coke purchases w ould “control” my deci sion-m aking when the counterweight is the wel l- being of $8 billion o f Coke stock held by Berkshire. Assuming I’m even m arginally rational, elementary arithm etic should make it clear that my heart and m ind belong to the owners of Coke, not to its managem ent. I can ’t resist mentioning that Jesus understood the cal ibration of independence far m ore clearly than do the pro testin g institutio ns. In Matt hew 6:21 He observed: “For wh ere y our treasure is, there will yo ur heart b e also .” Ev en to an institutional investor, $8 billion should qualify as “treasure” that dwarfs any profits Berkshire might earn on its routine transactions with Coke. Measure d by the biblical sta ndard, the Berkshi re board is a model: (a ) every director is a member of a fam ily owning at least $4 million o f stock; (b) none of these s hares were ac quire d from Berk shire via options or gran ts; (c) no directors receive c ommit tee, co nsulting or board fees from the com pany that are m ore than a tiny portion of th eir annu al income; and (d) alth ough we hav e a standard corp orate ind emnity arran gement, we carry no liability in surance for directors. At Berks hire, board m embers travel the same road as s hareholders. * * * * * * * * * * * * Charlie and I have see n much be havior confirming the Bible’s “t reasure” point. In our view, based on our considerable boardroom expe rience, t he least indepe ndent directors are likely to be those who receive an im portant fra ction of their annual incom e from the fees they receive for board service (and who hope as wel l to be recom mended for election to other boards and thereby to boost th eir income further). Yet th ese are the very board m embers most ofte n classed as “independent.” Most directors of this type are decent pe ople and do a first-c lass job. But they wouldn’t be hum an if they weren’t te mpted to thwart action s that wo uld threaten their livelihood. Some may go on to succumb to such temptations. Let’s look at an example bas ed upon circumstantial evidence. I have first-hand knowledge of a recent acquisition proposal (not from Berkshire) t hat was favored by managem ent, blessed by the company’s investment banke r and sl ated to go f orward at a price above the lev el at which the stock had sold for som e years ( or now sells for). In addition, a number of directors favored the transact ion and wanted it proposed to shareholders. 23 --- Page 23 --- Seve ral of t heir brethren, howeve r, each of whom received board and committee fees totaling about $10 0,000 annu ally, scu ttled the propo sal, wh ich meant that sh areholders never learn ed of this multi-billion offer. Non-m anagement directors owned little sto ck except for sh ares th ey had receive d from the com pany. Their open-market purcha ses in rece nt years ha d meanwhile been nominal, eve n though the stock had sold far below the acquisition price proposed. In other words, these di rectors didn’t want the sha reholders to be offe red X eve n though they had consi stently declin ed th e opp ortun ity to buy sto ck for thei r own acc ount at a fracti on of X. I don’t know which directors opposed l etting shareholders see t he offe r. But I do k now that $100,000 is an important portion of the annual income of som e of those deem ed “i ndependent,” clearly meetin g the Matth ew 6:21 definition of “t reasure.” If the deal ha d gone t hrough, these fees would have ended. Neith er th e shareho lders nor I will ev er kn ow what motivated the dissenters. Indeed they themselves will n ot likely kno w, given that sel f-interest i nevitably blurs in trospection. We do know one thing, though: At the sam e meeting at whic h the deal was reje cted, the board voted itself a significant i ncrease in di rectors ’ fees. • While we are on the sub ject of self-i nterest, let’s tu rn again to the m ost important acco unting mech anism still av ailab le to CEOs who wish to overstate earni ngs: the non-expensing of stock options . The accom plices in perpetuating t his ab surdity have been m any members of Congre ss who have defied the arguments put forth by all Big Fo ur auditors, all members o f the Financial Acco unting Standa rds Board and virtually all invest ment professi onals. I’m enclosing an op-e d piece I wrote for The Was hington Post desc ribing a truly breathtaking bill that was passe d 312-111 by the House last sum mer. Than ks to Senator Richard Shelby, the Senat e didn’t ratify th e Ho use’s foo lishn ess. And , to his great cred it, Bill Do naldson, th e investor- minded Chairman of the SEC, h as stood firm against massive political p ressure, generated by the check -waving CEOs who first muscled Congress in 1993 about the issue of option acc ounting and then repeated t he tactic last year. Because t he attempts to obfuscate the st ock-optio n issue continue, it’s worth poi nting out that no one – nei ther the FA SB, nor invest ors ge nerally, nor I – are t alking about restricting the use o f options i n any way. Indee d, my successor at Berks hire may well receive m uch of his pay via options, albeit logically-stru ctured ones in resp ect to 1) an appropriate strike price, 2) a n escalation in price that reflects the retention of earnings, and 3) a ba n on his quickly disposing of any shares purchased t hrough options. We chee r arra ngem ents that motivate managers , whether these be cash bonuses or options. And if a co mpany is tru ly receiv ing value for the options it issu es, we see no reason why recording their cost should cut dow n on their use. The sim ple fact is th at certain CEOs know their own compensation would be far more ratio nally determined if options were exp ensed. Th ey also suspect that their stock w ould sell at a l ower price if realistic acc ounting were em ployed, meaning that they wou ld reap less in the market when they unloade d their personal holdings. To these CEOs such unpleasant prospects are a fate to be fought with all th e reso urces th ey have at hand – even thou gh the funds they use in t hat fight norm ally don’t belong to them, but are instead pu t up by th eir sharehold ers. Option-expensing is scheduled to become mandatory on June 15th. You ca n the refore expect intensified effo rts to stall o r emasculate th is rule between n ow and then. Let yo ur Con gressm an and Sen ators know what you think on this issu e. 24 --- Page 24 --- The Annual Meeting There are two cha nges this year concerning the annual meeting. Fi rst, we have sc heduled the meetin g for the last Satu rday in April (the 30th), rath er th an the usual first Saturd ay in May. Th is year Mother’s Day falls on May 8, and it would be unfair to ask the employees o f Borsheim’s and Gorat’s to take care of us at that special time – so we’ve m oved everything up a we ek. Ne xt year we’ll return to our regular tim ing, holding the meetin g on May 6, 2006. Additionally, we are c hanging the sequence of e vents on meeting day , April 30. Just as al ways, the doors will o pen at th e Qwest Cen ter at 7 a.m. and the movie will b e shown at 8:30. At 9:30, however, we will g o directly to the question and answer p eriod, which (allo wing for lunch at th e Qwest’s stan ds) will last u ntil 3:00. Then, after a sh ort recess, C harlie and I will convene the ann ual meetin g at 3:15. We ha ve m ade this chan ge be cause a n umber of s hareholders com plained last year about the time consumed by two speakers who advocat ed proposal s of limited interest to the majority of the audience – and who were no doubt relishing their chance to talk to a cap tive group of about 19,500. With our n ew procedure, those sha reholders who wish to hear it all can stick around for the formal meeting and those who don’t can leav e – or better yet shop. There w ill be plenty of opportun ity fo r that pastime in the vast ex hibition hall that adj oins the meeting area. Kelly Muchem ore, the Fl o Zi egfel d of B erkshire, put on a magnificent shopping extra vaganza last year, and s he says that was just a wa rm-up for this y ear. (Kelly , I am delighted to report, is getting m arried in October. I’m giving her away and s uggested that she make a li ttle history by holding the we dding at the annual m eeting. She balked, however, wh en Charlie insisted that he be the ringbea rer.) Again we will showcase a 2,1 00 square foot Cl ayton home (featu ring Ac me brick, Shaw carpet, Johns Manville insulation, MiTek fast eners, Carefree a wnings a nd NFM furniture). Take a t our through the home. Better yet, buy it. GEIC O will h ave a boo th staffed by a nu mber of its to p counselors from around the coun try, all of them read y to supply you with auto insuran ce quotes. In m ost cases, GEICO will b e able to give yo u a special shareholder discount (us ually 8%). This sp ecial offer is perm itted by 45 of the 50 jurisdictions in which we o perate. B ring the details of y our existing insurance a nd check out whet her we can sa ve you money . On Saturd ay, at the Omaha airpo rt, we will have the usual array of aircraft from NetJets® availab le for your insp ection . Stop by the NetJets boo th at the Qwest t o learn a bout view ing these planes. Come to Omaha by bus; leav e in your new plane. The B ookworm shop did a terrific business last year sel ling B erkshire-related books. Di splaying 18 titles, th ey so ld 2,920 copies fo r $61,000. Sin ce we ch arge the shop no rent (I m ust be getting soft), it gives shareho lders a 20 % discount. Th is year I’ve asked The Boo kworm to add Grah am Alliso n’s Nuclear Terrorism: The Ultimate Preventable Catastrophe , a m ust-rea d for those concer ned with the safet y of our country. In addition, the shop will p remiere Poor C harlie’s Almanack, a book compiled by Peter Kaufman. Scholars ha ve fo r too long debated whether Charlie is the rein carnation of Ben Frank lin. This book shou ld settle th e question. An attachm ent to t he proxy material that is encl osed w ith th is report explains how you can obtain the cred ential yo u will n eed for ad mission to the meeting and other events. As fo r plane, ho tel and car reser vations, we have a gain signed up American Ex press (800-799-6634) to give you special help. The y do a terrific job for us eac h year, and I tha nk the m for it. At Ne braska Furniture Mart, located on a 77-ac re site on 72nd Street between Dodge and Pacific, we will again be having “Berk shire Week end” pricing . We in itiated this special ev ent at NFM ei ght years ago, and sal es during the “Weeke nd” grew from $5.3 million in 1997 to $25.1 million in 2004 (up 45% 25 --- Page 25 --- from a year earlier). Every year has set a new record, and on Saturday of last year, we had t he largest single-day sales in NFM ’s history – $6 .1 million. To get the discount, you must make your purchases between Thursday, April 28 and Monday, May 2 inclusive, an d also present your m eeting cred ential. Th e period’s sp ecial p ricing will ev en apply to the products of several prestigious m anufact urers that normally have i ronclad rules aga inst discounting but that, in the spirit of our shareholder week end, have made an exce ption for y ou. We a ppreciate their cooperation. NFM is open from 10 a.m. to 9 p.m . Monday through S aturday, and 10 a.m. to 6 p. m. on Sunday . On Saturday this year, f rom 5:30 p.m. to 8 p.m. we are having a special affair for s hareholders only. I’ll be there, eat ing barbeque and drinking Coke. Borsheim’s – the larg est jewelry sto re in the country ex cept for Tiffan y’s Manh attan store – will have t wo sha reholder-only events. The first will be a cocktail reception from 6 p.m . to 10 p.m. on Fri day, April 2 9. The seco nd, the main gala, will b e from 9 a.m. to 4 p.m. on Sunday, May 1 . On Saturday, we will b e open until 6 p.m. We w ill have h uge crow ds at Bo rsheim’s th roughout the weekend. Fo r your con venience, therefore, sh areholder prices will b e available fro m Monday, April 25 throug h Saturday, May 7 . During that period, just identify yoursel f as a s hareholder through your m eeting c redentials or a brokerage statement. Borsheim’s operates on a gross m argin th at is fu lly twenty p ercentage points below t hat of its major rivals, even before the share holders’ discount. Last year, busines s over the weekend inc reased 73% from 2003, settin g a reco rd that will b e tough to beat. Show m e it can be done. In a ten t outside of Borsheim’s, Patrick Wolff, twice U.S. ch ess ch ampion, will tak e on all co mers in groups of six – blindfolded. Add itionally, we will h ave Bob Hamm an and Sh aron Osberg, two of th e world’s top bridge e xperts, available to play with our shareholders on Sunday afternoon. They plan to keep their eyes open – but Bob never sorts his cards, eve n when playing for a national champions hip. Gorat’s – my fav orite steak house – will again be open exclu sively for Berk shire sh areholders on Sunday, May 1, and will b e serv ing from 4 p.m. until 10 p.m. Please re member that to come to Gorat’s o n that day, you must have a reservation . To make one, call 40 2-551-3733 on April 1 ( but not before). If Sunday is so ld out, try Gorat’s o n one of th e other evenings yo u will b e in town. Enh ance you r reputation as an epicure by ordering, as I do, a rare T-bone with a double helping of hash browns. We will again have a special r eception from 4:00 to 5: 30 on Saturd ay afternoon for sha reholde rs who have come from outside of North America. E very year our meeting dra ws many people from around the globe, and Charlie and I want to be sure we pe rsonally greet those who have come so fa r. Last year we enjoyed m eeting more than 400 of you including at least 100 from Australia. Any shareholder who comes from other than the U.S. or Canada will be g iven a special cred ential an d instructions for atten ding this function. * * * * * * * * * * * * Charlie and I are lu cky. We have jobs th at we love an d are hel ped every day in a myriad of ways by talen ted and cheerfu l associates. No won der we tap-d ance to work. But nothing is more fun for us th an getting together with our shareholder-partners at Berkshire’s annual meeting. So join us on April 30th at the Qwest for our annual W oodstock for Capitalists. February 28, 2005 Warren E. Buff ett Chairm an of the Board 26