Labitan.沃伦.巴菲特文集(EN)——The_Warren_Buffett_Business_Factors

The Warren Buffett Business Factors

(Selected articles from the Letters of Warren E. Buffett

to the Shareholders of Berkshire Hathaway Inc.)

Selected and Arranged by

Cesar Labitan, Jr. MD

clabitan@

MBAE student

Purdue University – Calumet

School of Management

Hammond, Indiana

2002

Table of Contents

INTRODUCTION ................................................................................................................................................... 4

GOALS ..................................................................................................................................................................... 6

ATTITUDE AND TEMPERAMENT .................................................................................................................... 6

FRIENDS AND WONDERFUL BUSINESSES .................................................................................................... 6

HONESTY ............................................................................................................................................................... 7

CHARLIE MUNGER ............................................................................................................................................. 7

BEN GRAHAM ....................................................................................................................................................... 8

DAVE DODD ........................................................................................................................................................... 9

LORIMER DAVIDSON ......................................................................................................................................... 9

ROSE BLUMKIN .................................................................................................................................................. 10

THE WONDERFUL BUSINESS ......................................................................................................................... 11

SHUTDOWN OF TEXTILE BUSINESS ............................................................................................................ 12

CAPITAL TURNOVER AND ALLOCATION .................................................................................................. 14

A MANAGERIAL STORY .................................................................................................................................. 15

DIVIDEND POLICY ............................................................................................................................................ 16

INTELLIGENT INVESTING .............................................................................................................................. 19

MR. MARKET ...................................................................................................................................................... 25

RISK ....................................................................................................................................................................... 26

RETURN ON EQUITY CAPITAL ...................................................................................................................... 27

FINANCE ............................................................................................................................................................... 28

BOOK VALUE AND INTRINSIC VALUE ........................................................................................................ 29

INTRINSIC VALUE AND CAPITAL ALLOCATION .................................................................................... 30

ANIMAL SPIRITS AND EGO ............................................................................................................................ 30

GREED ................................................................................................................................................................... 31

ACCOUNTING ..................................................................................................................................................... 32

TAXATION AND INFLATION .......................................................................................................................... 32

"LOOK-THROUGH" EARNINGS..................................................................................................................... 34

NON-INSURANCE OPERATIONS .................................................................................................................... 35

CORPORATE GOVERNANCE .......................................................................................................................... 38

EQUITY VALUE-ADDED ................................................................................................................................... 40

EFFICIENT MARKET THEORY ...................................................................................................................... 42

EBITDA OR EBDIT ............................................................................................................................................. 43

CAPITAL STRUCTURE ..................................................................................................................................... 45

JUNK BONDS ....................................................................................................................................................... 46

SOME MISTAKES ............................................................................................................................................... 46

THE INSTITUTIONAL IMPERATIVE ............................................................................................................. 47

ARBITRAGE ......................................................................................................................................................... 49

INSURANCE OPERATIONS .............................................................................................................................. 52

MEASURING INSURANCE PERFORMANCE ............................................................................................... 54

COST AND RETURN ON CAPITAL ................................................................................................................. 55

THE MANAGER-OWNER RELATIONSHIP: ................................................................................................. 56

BONDS, VALUATION APPROACH ................................................................................................................. 58

CONVERTIBLE PREFERREDS AND STRUCTURED INVESTMENT ...................................................... 60

ZERO-COUPON SECURITIES .......................................................................................................................... 62

INVESTMENT BANKERS .................................................................................................................................. 65

ADVANTAGE IN PURCHASING ...................................................................................................................... 65

INSURANCE OPERATIONS ADVANTAGE ................................................................................................... 66

GENERAL RE ....................................................................................................................................................... 66

THE BORSHEIM ADVANTAGE ....................................................................................................................... 67

SUPER-CATS ADVANTAGE ............................................................................................................................. 67

COCA-COLA AND GILLETTE ADVANTAGES ............................................................................................ 68

CAPITAL STRENGTH ADVANTAGE ............................................................................................................. 69

ACQUISITIONS ................................................................................................................................................... 69

GEICO .................................................................................................................................................................... 71

MARKETING OF GEICO ................................................................................................................................... 71

TECH COMPANIES ............................................................................................................................................ 73

UNDERSTANDABLE BUSINESS ...................................................................................................................... 74

SUSTAINABLE COMPETITIVE ADVANTAGE ............................................................................................. 75

TRUSTWORTHY FIRST-CLASS MANAGEMENT ....................................................................................... 76

BARGAIN PRICE ................................................................................................................................................. 77

Introduction

These selected passages from the annual letters of Warren Buffett to the shareholders of Berkshire Hathaway Inc. reveal the qualitative business knowledge and wisdom a man and his friends have acquired over 50 years in the business world. All the words, sentences, and stories came from his letters and writings. Therefore, this is the business book that I imagined Warren Buffett could have organized and written.

I borrow the idea of edited selections from Professor Lawrence Cunningham’s 1997 book, “The Essays of Warren Buffett: Lessons for Corporate America”. This book differs from Professor Cunningham’s book in the manner and order the sections are presented to the reader. This book deliberately presents Mr. Buffett’s business teachers first; because I felt that this section shows the reader some of the social and emotional intelligence Mr. Buffett possesses.

The book progresses into Mr. Buffett’s documented business thoughts and ideas. Finally, this book focuses on Mr. Buffett’s writings related to his four major investment selection criteria. I also borrow the idea of dividing up sections into more easily readable independent pieces from Andrew Kilpatrick’s comprehensive and entertaining biography, “Of Permanent Value: The Story of Warren Buffett”.

I edited the passages into shorter distilled forms of qualitative and practical business ideas. Consequently, you will learn more about Mr. Buffett’s ideas on business and investing. Through his writings, you will appreciate a unique combination of character, intellect, discipline, and sociability. As you read other books about Warren Buffett, Charlie Munger, and Benjamin Graham, notice a wider circle of friends and family that have grown together. I have taken the liberty to rearrange the sections of Warren Buffett’s letters with the hope of capturing the essence of important business and investing ideas. For the reader interested in learning more about the wider circle of Berkshire’s family and friends, I would refer you to Andy’s biographical book as well as Janet Lowe’s book on Charlie Munger entitled “Damn Right!”

Thanks to Roger Lowenstein for writing the 1995 biography, “Buffett: The Making of an American Capitalist” This was the book that first captured my interest in Mr. Buffett, value investing, and efficient business thought. I have also enjoyed reading the fine books written by Robert Hagstrom, Mary Buffett, David Clark, and Timothy Vick.

Thanks to Janine Rueth for love, support, and encouragement. Thanks to Victoria Labitan, Helen Rueth, J.T. Loudermilk, Everett McDonald, Dr. Shomir Sil, and Dr. Pat Obi for your encouragement. Ultimately, the best book on Mr. Buffett’s business and investing ideas is one written by Mr. Buffett

and co-written by Mr. Munger. Therefore, I concluded that the annual letters best capture these ideas. The order or disorder in which they are presented can be blamed on me. In general, the order of presented sections goes from friends and teachers towards concepts and actions. I attempted to “trim a bit of fat” off a large fine steak.

These are minimalistic edits of selected passages from the annual letters of Warren E. Buffett to the Shareholders of Berkshire Hathaway Inc. In order to preserve Mr. Buffett’s words, I approached the material as if I were editing scripture. Therefore, there are no additions of content from me.

My editing was performed by careful surgical subtraction of less essential words. My goal was:

1.Dividing up sections into more easily readable independent pieces, 2.Clarifying ideas presented in longer sentences and 3.Enhancing clarity of thought of the reader. As a book, it is designed/divided to be an appealing bestseller by my intentional division of interesting selections into small sections/chapters. I have heard Mr. Buffett describe the process of writing the annual letters, initially dedicating them to his sisters in this way: “Dear Doris and Bertie,” Therefore, this book could also be titled: ( Dear Doris and Bertie, Here is what I learned about wonderful businesses from your brother Warren. )

_____________________________________________________________________________

August 15,2002

Dear Dr. Labitan:

I enjoyed your letter and organization of the material from the Berkshire annual

reports. However, I would not like to reissue these stories in a book. Larry

Cunningham's work was designed as a textbook, organizing various principles I'd laid

out over the years. I, therefore, okayed publication (without sharing in any way in

royalties or profits) because I felt he had developed a good way to teach my ideas to

younger audiences. I've never wanted to take other parts of the report and package them

for resale; rather I wish them to be free and available through the internet.

Sincerely,

Warren E. Buffett

_____________________________________________________________________________

Therefore, this organized collection is released freely to my friends and associates. C.L.

Goals

Our long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future - a greatly enlarged capital base will see to that. We will be disappointed if our rate does not exceed that of the average large American corporation.

Charlie Munger and I can attain our long-standing goal of increasing Berkshire's per-share intrinsic value at an average annual rate of 15%. We have not retreated from this goal. We again emphasize that the growth in our capital base makes 15% an ever-more difficult target to hit.

What we have going for us is a growing collection of good-sized operating businesses that possess economic characteristics ranging from good to terrific, run by managers whose performance ranges from terrific to terrific. You need have no worries about this group.

The capital-allocation work that Charlie and I do at the parent company, using the funds that our managers deliver to us, has a less certain outcome: It is not easy to find new businesses and managers comparable to those we have.

Attitude and Temperament

Our advantage, was attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. We do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we also are, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets. Instead, we view the company as a conduit through which our shareholders own the assets. In line with this owner-orientation, our directors are all major shareholders of Berkshire Hathaway. In the case of at least four of the five, over 50% of family net worth is represented by holdings of Berkshire. We eat our own cooking.

Friends and Wonderful Businesses

I attended Columbia University's business school in 1950-51, not because I cared about the degree it offered, but because I wanted to study under Ben Graham, then teaching there. The time I spent in Ben's classes was a personal high, and quickly induced me to learn all I could about my hero. I turned first to Who's Who in America, finding there, among other things, that Ben was Chairman of Government Employees Insurance Company, (GEICO), to me an unknown company in an unfamiliar industry. Ben wrote: “Investment is most intelligent when it is most businesslike.” This quote comes from what I think is the best book on investing ever written - “The Intelligent Investor.”

Berkshire dominates both the investment portfolios of most members of our families and of a great

many friends who belonged to partnerships that Charlie and I ran in the 1960's. We could not be more motivated to do our best.

Honesty

We feel that you, as owners, are entitled to the same sort of reporting by your manager as we feel is owed to us at Berkshire Hathaway by managers of our business units. Obviously, the degree of detail must be different, particularly where information would be useful to a business competitor or the like. But the general scope, balance, and level of candor should be similar. We don’t expect a public relations document when our operating managers tell us what is going on, and we don’t feel you should receive such a document.

We believe that our formula - the purchase at sensible prices of businesses that have good underlying economics and are run by honest and able people - is certain to produce reasonable success. We expect, therefore, to keep on doing well.

Charlie Munger

Charlie Munger and I can attain our long-standing goal of increasing Berkshire's per-share intrinsic value at an average annual rate of 15%. We have not retreated from this goal. But we again emphasize, that the growth in our capital base makes 15% an ever-more difficult target to hit. What we have going for us is a growing collection of good-sized operating businesses that possess economic characteristics ranging from good to terrific, run by managers whose performance ranges from terrific to terrific. You need have no worries about this group. The capital-allocation work that Charlie and I do at the parent company, using the funds that our managers deliver to us, has a less certain outcome: It is not easy to find new businesses and managers comparable to those we have.

My pal Charlie has always emphasized the study of mistakes rather than successes, both in business and other aspects of life. He does so in the spirit of the man who said: “All I want to know is where I’m going to die so I’ll never go there.” You’ll immediately see why we make a good team: Charlie likes to study errors and I have generated ample material for him, particularly in our textile and insurance businesses. Irrespective of titles, Charlie and I work as partners in managing all controlled companies. We enjoy our work as managing partners. And we enjoy having you as our financial partners.

Charlie is broader in his interests than I am. In Berkshire’s investments, Charlie and I have employed the principles taught by Dave Dodd and Ben Graham. Our prosperity is the fruit of their intellectual tree. At Berkshire, our managers will continue to earn extraordinary returns from what appear to be ordinary businesses. These managers look for ways to deploy their earnings advantageously in their businesses. What's left, they will send to Charlie and me. We then try to use the funds in ways that build per-share intrinsic value. Our goal is to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.

Ben Graham

Ben Graham taught me that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. The true investor welcomes volatility. Ben Graham explained this in Chapter 8 of The Intelligent Investor. There he introduced "Mr. Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That's true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.

Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed. There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

We bought all of our Washington Post Company holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory that the stock market was totally efficient. Under the EMT, calculations of business value and even thought, itself were of no importance in investment activities. We are enormously indebted to those academics: what could be more advantageous in an intellectual contest.

Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974 our WPC holding showed a loss of about 25%, with market value at $8 million against our cost of $10.6 million. What we had thought ridiculously cheap a year earlier had become cheaper as the market, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.

Berkshire will someday again have opportunities to deploy major amounts of cash in equity markets -- we are confident of that. But, as the song goes, "Who knows where or when?" Meanwhile, if anyone starts explaining to you what is going on in the truly-manic portions of this "enchanted" market, you might remember still another line of song: "Fools give you reasons, wise men never try."

Dave Dodd

Dave Dodd, my friend and teacher for 38 years, died in 1988 at age 93. Most of you don’t know of him. Yet any long-time shareholder of Berkshire is appreciably wealthier because of the indirect influence he had upon our company. Dave spent a lifetime teaching at Columbia University, and he co-authored Security Analysis with Ben Graham. From the moment I arrived at Columbia, Dave personally encouraged and educated me; one influence was as important as the other. Everything he taught me, directly or through his book, made sense. Later, through dozens of letters, he continued my education right up until his death. I have known many professors of finance and investments but I have never seen any, except for Ben Graham, who was the match of Dave. The proof of his talent is the record of his students: No other teacher of investments has sent forth so many who have achieved unusual success. When students left Dave’s classroom, they were equipped to invest intelligently for a lifetime because the principles he taught were simple, sound, useful, and enduring. Though these may appear to be unremarkable virtues, the teaching of principles embodying them has been rare. It’s particularly impressive that Dave could practice as well as preach. just as Keynes became wealthy by applying his academic ideas to a very small purse, so, too, did Dave. Indeed, his financial performance far outshone that of Keynes, who began as a market-timer (leaning on business and credit-cycle theory) and converted, after much thought, to value investing. Dave was right from the start. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success. As Ben Graham said: "In the short-run, the market is a voting machine - reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long-run, the market is a weighing machine."

In Berkshire’s investments, Charlie and I have employed the principles taught by Dave and Ben Graham. Our prosperity is the fruit of their intellectual tree. Our managers will continue to earn extraordinary returns from what appear to be ordinary businesses. As a first step, these managers will look for ways to deploy their earnings advantageously in their businesses. What's left, they will send to Charlie and me. We then try to use those funds in ways that build per-share intrinsic value. Our goal is to acquire either part or all of businesses that we believe we understand, that have good, sustainable underlying economics, and that are run by managers whom we like, admire and trust.

Lorimer Davidson

(1999) It's with sadness that I report to you that Lorimer Davidson, GEICO's former Chairman, died last November, a few days after his 97th birthday. For GEICO, Davy was a business giant who moved the company up to the big leagues. For me, he was a friend, teacher and hero. I have told you of his lifelong kindnesses to me in past reports. Clearly, my life would have developed far differently had he not been a part of it. Tony Nicely, Lou Simpson and I visited Davy in August and marveled at his mental alertness -- particularly in all matters regarding GEICO. He was the company's number one supporter right up to the end, and we will forever miss him.

On a Saturday in January, 1951, I took the train to Washington and headed for GEICO's downtown headquarters. To my dismay, the building was closed, I pounded on the door until a custodian appeared. I asked this puzzled fellow if there was anyone in the office I could talk to, and he said he'd seen one man

working on the sixth floor.

And thus, I met Lorimer Davidson, Assistant to the President, who was later to become CEO. Though my only credentials were that I was a student of Graham's, "Davy" graciously spent four hours or so showering me with both kindness and instruction. No one has ever received a better half-day course in how the insurance industry functions nor in the factors that enable one company to excel over others. As Davy made clear, GEICO's method of selling - direct marketing - gave it an enormous cost advantage over competitors that sold through agents, a form of distribution so ingrained in the business of these insurers that it was impossible for them to give it up. After my session with Davy, I was more excited about GEICO than I have ever been about a stock. Davy (Lorimer Davidson) was my friend and teacher. He was there when the company's CEOs - Jack Byrne, Bill Snyder and Tony Nicely - needed him. Our acquisition of 100% of GEICO caused Davy to incur a large tax. Characteristically, he still warmly supported the transaction. Davy has been one of my heroes for the 45 years I've known him, and he never let me down. You should understand that Berkshire would not be where it is today if Davy had not been so generous with his time on a cold Saturday in 1951.

Rose Blumkin

We now move on to the high point of 1983 - the acquisition of a majority interest in Nebraska Furniture Mart and our association with Rose Blumkin and her family. Last year, (1982), in discussing how managers with bright, but adrenalin-soaked minds scramble after foolish acquisitions, I quoted Pascal: “It has struck me that all the misfortunes of men spring from the single cause that they are unable to stay quietly in one room.”

Even Pascal would have left the room for Mrs. Blumkin. About 67 years ago, Mrs. Blumkin, then 23, talked her way past a border guard to leave Russia for America. She had no formal education, not even at the grammar school level, and knew no English. After some years in this country, she learned the language when her older daughter taught her, every evening, the words she had learned in school during the day. In 1937, after many years of selling used clothing, Mrs. Blumkin had saved $500 with which to realize her dream of opening a furniture store. Upon seeing the American Furniture Mart in Chicago - then the center of the nation’s wholesale furniture activity - she decided to christen her dream Nebraska Furniture Mart.

She met every obstacle you would expect (and a few you wouldn’t) when a business endowed with only $500 and no locational or product advantage goes up against rich, long-entrenched competition. At one early point, when her tiny resources ran out, “Mrs. B” coped in a way not taught at business schools: she simply sold the furniture and appliances from her home in order to pay creditors precisely as promised.

Omaha retailers began to recognize that Mrs. B would offer customers far better deals than they had been giving, and they pressured furniture and carpet manufacturers not to sell to her. By various strategies she obtained merchandise and cut prices sharply. Mrs. B was then hauled into court for violation of Fair Trade laws. She not only won all the cases, but received invaluable publicity. At the end of one case, after demonstrating to the court that she could profitably sell carpet at a huge discount from the prevailing price, she sold the judge $1400 worth of carpet.

Today Nebraska Furniture Mart generates over $100 million of sales annually out of one 200,000 square-foot store. No other home furnishings store in the country comes close to that volume. That single store also sells more furniture, carpets, and appliances than do all Omaha competitors combined.

One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it. I’d rather wrestle grizzlies than compete with Mrs. B and her progeny. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business - one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.

Mrs. B was wise as well as smart and, for far-sighted family reasons, was willing to sell the business. I had admired both the family and the business for decades, and a deal was quickly made. We purchased 90% of the business - leaving 10% with members of the family who are involved in management - and have optioned 10% to certain key young family managers.

And what managers they are. Geneticists should do handsprings over the Blumkin family. Louie Blumkin, Mrs. B’s son, has been President of Nebraska Furniture Mart for many years and is widely regarded as the shrewdest buyer of furniture and appliances in the country. Louie says he had the best teacher, and Mrs. B said she had the best student. They’re both right. Louie and his three sons all have the Blumkin business ability, work ethic, and, most important, character. On top of that, they are really nice people. We are delighted to be in partnership with them.

The Wonderful Business

Time is the friend of the wonderful business, the enemy of the mediocre. You might think this principle is obvious, but I had to learn it the hard way. In fact, I had to learn it several times over. Shortly after purchasing Berkshire, I acquired a Baltimore department store, Hochschild Kohn, buying through a company called Diversified Retailing that later merged with Berkshire. I bought at a substantial discount from book value, the people were first-class, and the deal included some extras - unrecorded real estate values and a significant LIFO inventory cushion. How could I miss? So-o-o - three years later I was lucky to sell the business for about what I had paid.

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

That leads right into a related lesson: Good jockeys will do well on good horses, but not on broken-down nags. Both Berkshire's textile business and Hochschild, Kohn had able and honest people running them. The same managers employed in a business with good economic characteristics would have achieved fine records. But they were never going to make any progress while running in quicksand. I've said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.

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

done better by avoiding dragons than by slaying them.

Shutdown of Textile Business

In July (1985) we decided to close our textile operation, and by yearend this unpleasant job was largely completed. The history of this business is instructive.

When Buffett Partnership, Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway, it had an accounting net worth of $22 million, all devoted to the textile business. The company’s intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value. Indeed, during the previous nine years (the period in which Berkshire and Hathaway operated as a merged company) aggregate sales of $530 million had produced an aggregate loss of $10 million. Profits had been reported from time to time but the net effect was always one step forward, two steps back.

At the time we made our purchase, southern textile plants - largely non-union - were believed to have an important competitive advantage. Most northern textile operations had closed and many people thought we would liquidate our business as well.

We felt, however, that the business would be run much better by a long-time employee whom, we immediately selected to be president, Ken Chace. In this respect we were 100% correct: Ken and his successor, Garry Morrison, have been excellent managers, every bit the equal of managers at our more profitable businesses.

In early 1967 cash generated by the textile operation was used to fund our entry into insurance via the purchase of National Indemnity Company. Some of the money came from earnings and some from reduced investment in textile inventories, receivables, and fixed assets. This pullback proved wise: although much improved by Ken’s management, the textile business never became a good earner, not even in cyclical upturns.

Further diversification for Berkshire followed, and gradually the textile operation’s depressing effect on our overall return diminished as the business became a progressively smaller portion of the corporation. We remained in the business for reasons that I stated in the 1978 annual report (and summarized at other times also): “(1) our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labor has been cooperative and understanding in facing our common problems, and (4) the business should average modest cash returns relative to investment.” I further said, “As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital.”

It turned out that I was very wrong about cash returns (4). Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.

I won’t close down businesses of sub-normal profitability merely to add a fraction of a point to our

corporate rate of return. However, I also feel it inappropriate for even an exceptionally profitable company to fund an operation once it appears to have unending losses in prospect. Adam Smith would disagree with my first proposition, and Karl Marx would disagree with my second; the middle ground is the only position that leaves me comfortable.

I should reemphasize that Ken and Garry were resourceful, energetic and imaginative in attempting to make our textile operation a success. Trying to achieve sustainable profitability, they reworked product lines, machinery configurations and distribution arrangements. We also made a major acquisition, Waumbec Mills, with the expectation of important synergy (a term widely used in business to explain an acquisition that otherwise makes no sense). In the end, nothing worked and I should be faulted for not quitting sooner. I ignored Comte’s advice - “the intellect should be the servant of the heart, but not its slave” - and believed what I preferred to believe.

The domestic textile industry operates in a commodity business, competing in a world market in which substantial excess capacity exists. Much of the trouble we experienced was attributable to competition from foreign countries whose workers are paid a small fraction of the U.S. minimum wage. But that in no way means that our labor force deserves any blame for our closing. In fact, in comparison with employees of American industry generally, our workers were poorly paid, as has been the case throughout the textile business. In contract negotiations, union leaders and members were sensitive to our disadvantageous cost position and did not push for unrealistic wage increases or unproductive work practices. To the contrary, they tried just as hard as we did to keep us competitive. Even during our liquidation period they performed superbly. (Ironically, we would have been better off financially if our union had behaved unreasonably some years ago; we then would have recognized the impossible future that we faced, promptly closed down, and avoided significant future losses.)

Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses.

The promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry wide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.

Thus, we faced a miserable choice: huge capital investment would have helped to keep our textile business alive, but would have left us with terrible returns on ever-growing amounts of capital. After the investment, moreover, the foreign competition would still have retained a major, continuing advantage in labor costs. A refusal to invest, however, would make us increasingly non-competitive, even measured against domestic textile manufacturers.

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match. Also, it had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any

other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington’s basic commitment to stay in textiles, I would also surmise that the company’s capital decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 -- on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid, but they too have shrunk significantly in purchasing power.

This devastating outcome for the shareholders indicates what can happen when much brainpower and energy are applied to a faulty premise. The situation is suggestive of Samuel Johnson’s horse: “A horse that can count to ten is a remarkable horse - not a remarkable mathematician.” Likewise, a textile company that allocates capital brilliantly within its industry is a remarkable textile company - but not a remarkable business.

My conclusion from my own experiences and from much observation of other businesses is that a good managerial record (measured by economic returns) is far more a function of what business boat you get into than it is of how effectively you row (though intelligence and effort help considerably, in any business, good or bad). Some years ago I wrote: “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.

Capital Turnover and Allocation

Textile plant and equipment were on the books for a very small fraction of what it would cost to replace such equipment. And, despite the age of the equipment, much of it was functionally similar to new equipment being installed by the industry. Despite this “bargain cost” of fixed assets, capital turnover was relatively low reflecting required high investment levels in receivables and inventory compared to sales. Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital. Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc. Our management was diligent in pursuing such objectives. The problem was that our competitors were just as diligently doing the same thing.

Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate

and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.

Capital allocation at Berkshire was tough work in 1986. We did make one business acquisition - The Fechheimer Bros. Company. Fechheimer is a company with excellent economics, run by exactly the kind of people with whom we enjoy being associated. But it is relatively small, utilizing only about 2% of Berkshire's net worth. Meanwhile, we had no new ideas in the marketable equities field, an area in which once, we could readily employ large sums in outstanding businesses at very reasonable prices. So our main capital allocation moves in 1986 were to pay off debt and stockpile funds. Neither is a fate worse than death, but they do not inspire us to do handsprings either. If Charlie and I were to draw blanks for a few years in our capital-allocation endeavors, Berkshire's rate of growth would slow significantly.

The two companies we acquired in 1998, General Re and Executive Jet, are first-class in every way. In capital allocation, my grade for 1999 most assuredly is a D. What most hurt us during the year was the inferior performance of Berkshire's equity portfolio -- and responsibility for that portfolio, leaving aside the small piece of it run by Lou Simpson of GEICO, is entirely mine. Several of our largest investees badly lagged the market in 1999 because they've had disappointing operating results. We still like these businesses and are content to have major investments in them. But their stumbles damaged our performance in 1998, and it's no sure thing that they will quickly regain their stride.

The fallout from our weak results in 1999 was a more-than-commensurate drop in our stock price. In 1998, to go back a bit, the stock outperformed the business. Last year the business did much better than the stock, a divergence that has continued to the date of this letter. Over time, the performance of the stock must roughly match the performance of the business.

Despite our poor showing last year, Charlie and I expect that the gain in Berkshire's intrinsic value over the next decade will modestly exceed the gain from owning the S&P. We can't guarantee that, of course. But we are willing to back our conviction with our own money.

Our optimism about Berkshire's performance is also tempered by the expectation that the S&P will do far less well in the next decade or two than it has done since 1982. A recent article in Fortune expressed my views as to why this is inevitable, and I'm enclosing a copy with this report.

Our goal is to run our present businesses well -- a task made easy because of the outstanding managers we have in place -- and to acquire additional businesses having economic characteristics and managers comparable to those we already own. We made important progress in this respect during 1999 by acquiring Jordan's Furniture and contracting to buy a major portion of MidAmerican Energy. Let me emphasize one point here: We bought both for cash, issuing no Berkshire shares. Deals of that kind aren't always possible, but that is the method of acquisition that Charlie and I vastly prefer.

A Managerial Story

Berkshire's collection of managers is unusual in several important ways. As one example, a very high percentage of these men and women are independently wealthy, having made fortunes in the businesses that they run. They work neither because they need the money nor because they are contractually obligated to -- we have no contracts at Berkshire. Rather, they work long and hard because they love their businesses. These managers are truly in charge. There are no show-and-tell presentations in Omaha, no budgets to be approved by headquarters, no dictums issued about capital expenditures. We simply ask our

managers to run their companies as if these are the sole asset of their families and will remain so for the next century.

Charlie and I try to behave with our managers just as we attempt to behave with Berkshire's shareholders, treating both groups as we would wish to be treated if our positions were reversed. Though "working" means nothing to me financially, I love doing it at Berkshire for some simple reasons: It gives me a sense of achievement, a freedom to act as I see fit and an opportunity to interact daily with people I like and trust. Why should our managers -- accomplished artists at what they do -- see things differently? Here's a remarkable story from last year: It's about R. C. Willey, Utah's dominant home furnishing business, which Berkshire purchased from Bill Child and his family in 1995. Bill and most of his managers are Mormons, and for this reason R. C. Willey's stores have never operated on Sunday. This is a difficult way to do business: Sunday is the favorite shopping day for many customers. Bill, nonetheless, stuck to his principles -- and while doing so built his business from $250,000 of annual sales in 1954, when he took over, to $342 million in 1999.

Bill felt that R. C. Willey could operate successfully in markets outside of Utah and in 1997 suggested that we open a store in Boise. I was highly skeptical about taking a no-Sunday policy into a new territory where we would be up against entrenched rivals open seven days a week. Nevertheless, this was Bill's business to run. So, despite my reservations, I told him to follow both his business judgment and his religious convictions.

Bill then insisted on a truly extraordinary proposition: He would personally buy the land and build the store -- for about $9 million as it turned out -- and would sell it to us at his cost if it proved to be successful. On the other hand, if sales fell short of his expectations, we could exit the business without paying Bill a cent. This outcome, of course, would leave him with a huge investment in an empty building. I told him that I appreciated his offer but felt that if Berkshire was going to get the upside it should also take the downside. Bill said nothing doing: If there was to be failure because of his religious beliefs, he wanted to take the blow personally.

The store opened last August and immediately became a huge success. Bill thereupon turned the property over to us -- including some extra land that had appreciated significantly -- and we wrote him a check for his cost. And get this: Bill refused to take a dime of interest on the capital he had tied up over the two years.

If a manager has behaved similarly at some other public corporation, I haven't heard about it. You can understand why the opportunity to partner with people like Bill Child causes me to tap dance to work every morning.

A footnote: After our "soft" opening in August, we had a grand opening of the Boise store about a month later. Naturally, I went there to cut the ribbon (your Chairman, I wish to emphasize, is good for something). In my talk I told the crowd how sales had far exceeded expectations, making us, by a considerable margin, the largest home furnishings store in Idaho. Then, as the speech progressed, my memory miraculously began to improve. By the end of my talk, it all had come back to me: Opening a store in Boise had been my idea.

Dividend Policy

Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, "Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least

equal to the rise in the CPI". And that's it - no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios - inflation causes some or all of the reported earnings to become ersatz. The ersatz portion - let's call these earnings "restricted" - cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.

Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company's stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.

Let's turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders - to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect - backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future - that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.

To illustrate, let's assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.

If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course - reinvestment of the coupon - would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.

Think about whether a company's unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment. Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.

With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO's business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% - and market rates are 10% - he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.

In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company's overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team's best-ball score will be respectable because of the dominating skills of the professional.

Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)

In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners' interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.

Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect

long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.

Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.

Intelligent Investing

On December 6, 1994, we attended a session at the New York Society of Financial Analysts entitled "A Tribute to Ben Graham". Ben Graham would have been celebrating his 100th birthday if he had been alive. Three of Graham's former students spoke at length: Warren Buffett, Irving Kahn, and Walter Schloss, all very successful investors.

"This is the 100th anniversary of Ben's birth, I believe. And on the creative side, if what I consider his three basic ideas are really ground into your intellectual framework, I don't see how you can help but do reasonably well in stocks. His three basic ideas - and none of them are complicated or require any mathematical talent or anything of the sort - are:

1. that you should look at stocks as part Ownership of a business,

2. that you should look at market fluctuations in terms of his "Mr. Market" example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,

3. the three most important words in investing are "Margin of safety" - which Ben talked about in his last chapter of The Intelligent Investor - always building a 15,000 pound bridge if you're going to be driving 10,000 pound trucks across it.

I think those three ideas 100 years from now will still be regarded as the three cornerstones of sound investment. And that's what Ben was all about. He wasn't about brilliant investing. He wasn't about fads or fashion. He was about sound investing. And what's nice is that sound investing can make you very wealthy if you're not in too big a hurry. And it never makes you poor - which is even better. So I think that it comes down to those ideas - although they sound so simple and commonplace that it kind of seems like a waste to go to school and get a Ph.D. in Economics and have it all come back to that. It's a little like spending eight years in divinity school and having somebody tell you that the ten commandments were all that counted. There is a certain natural tendency to overlook anything that simple and important. But those are the important ideas. And they will still be the important ideas 100 years from now. And we will owe them to Ben.

In Berkshire’s investments, Charlie and I have employed the principles taught by Dave Dodd and Ben Graham. I think the best book on investing ever written is “The Intelligent Investor”, by Ben Graham. Ben wrote “Investment is most intelligent when it is most businesslike.” I learned from Ben that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values. Ben identified this "margin of safety" in bargain purchasing as

the cornerstone of intelligent investing. He wrote: "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Years after reading that, I still think those are the right three words. And, the failure of investors to heed this simple message caused them staggering losses.

Our equity-investing strategy remains little changed from what it was years ago: "We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety. We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price." We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute "an attractive price" for "a very attractive price."

But how, you will ask, does one decide what's "attractive"? In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:

"value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.

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

Whether appropriate or not, the term "value investing" is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase.

Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.

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

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

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

When bonds are calculated to be the more attractive investment, they should be bought.

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

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

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

Now, we believe that it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. When buying companies or common stocks, we look for first-class businesses accompanied by first-class managements. We know that time is the friend of the wonderful business, the enemy of the mediocre.

We have a corporate policy of reinvesting earnings for growth, diversity and strength, which has the incidental effect of minimizing the current imposition of explicit taxes on our owners. However, you can be subjected to the implicit inflation tax, and when you wish to transfer your investment in Berkshire into another form of investment, or into consumption, you also will face explicit taxes. Probably no business in America changed hands in 1946 at book value that the buyer believed lacked the ability to earn more than 1% on book. But investors with bond-buying habits eagerly made economic commitments throughout the year on just that basis. Similar conditions prevailed for the next two decades as bond investors happily signed up for twenty or thirty years on terms outrageously inadequate by business standards.

An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously

exercising discipline. Investing in arbitrage situations, per se, is no better a strategy than selecting a portfolio by throwing darts.

Common stocks are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs. We often find no equities that come close to meeting our tests. We do not predict markets, we think of the business. We have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future.

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