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BERKSHIRE HATHAWAY’S KEY INVESTING QUOTES
Contents
Investing ................................................................................................... 2
Insight Development .................................................................................................................... 2
Temperament/Discipline .............................................................................................................. 7
Learning ...................................................................................................................................... 19
Stock Selection ....................................................................................... 23
Comprehension .......................................................................................................................... 23
Moat ........................................................................................................................................... 31
Reinvestment/Growth ................................................................................................................ 39
Management .............................................................................................................................. 45
Financial Strength ....................................................................................................................... 66
Valuation .................................................................................................................................... 72
Inflation ...................................................................................................................................... 83
Risk ............................................................................................................................................. 86
Industry .................................................................................................. 88
Banking ....................................................................................................................................... 88
Insurance .................................................................................................................................. 112
Life Insurance ........................................................................................................................... 126
Money Management ................................................................................................................ 127
Portfolio Management ......................................................................... 128
Source: 1970‐2010 BRK shareholder Letters, 1983‐2010 WSC Investor Letters, BRK/WSC Meeting Transcripts 1986‐2011,
Poor Charlie’s Almanac 3, Select Presentation Transcripts 1991‐, Buffett Partnership Letters 1956‐1970.
Investing
Insight Development
“Severe change and exceptional returns usually don't mix.”
- BRK 1987 Letter
“Last year MidAmerican wrote off a major investment in a zinc recovery project that was initiated in 1998 and became
operational in 2002. Large quantities of zinc are present in the brine produced by our California geothermal operations,
and we believed we could profitably extract the metal. For many months, it appeared that commercially‐viable
recoveries were imminent. But in mining, just as in oil exploration, prospects have a way of “teasing” their developers,
and every time one problem was solved, another popped up. In September, we threw in the towel.
Our failure here illustrates the importance of a guideline – stay with simple propositions – that we usually apply in
investments as well as operations. If only one variable is key to a decision, and the variable has a 90% chance of going
your way, the chance for a successful outcome is obviously 90%. But if ten independent variables need to break
favorably for a successful result, and each has a 90% probability of success, the likelihood of having a winner is only 35%.
In our zinc venture, we solved most of the problems. But one proved intractable, and that was one too many. Since a
chain is no stronger than its weakest link, it makes sense to look for – if you’ll excuse an oxymoron – mono‐linked
chains.”
- BRK 2004 Letter
“[On pharmaceuticals] Buffett responded that ‘we generally look at businesses with the belief that change is going to
work against us. We try to find businesses where the basic demand for business is going to be the same, year after year.
Look at Gillette: they dominate their business so much that if they bring out a new product, men will automatically give
it a try. We think we know, in a general way, what the See’s, Coca‐Colas, and Gillette’s of the world will look like in ten or
twenty years.’ ‘Wall Street tells you that change will present you with opportunity. Frankly, that scares the hell out of us.
Why try betting on things we don’t know when we can bet on things we do know?’”
- Buffett, 1996 BRK Meeting
“I've heard Warren say since very early in his life that the difference between a good business and a bad one is that a
good business throws up one easy decision after another. whereas a bad one gives you horrible choices ‐ decisions that
are extremely hard to make: "Can it work?" "Is it worth the money?"
One way to determine which is the good business and which is the bad one is to see which one is throwing
management bloopers ‐ pleasant, no‐brainer decisions ‐ time after time after time. For example. it's not hard for us to
decide whether or not we want to open a See's store in a new shopping center in California. It's going to succeed. That's
a blooper.”
- Munger, 1998 BRK Meeting
“Shareholder: My question involves what Phil Fisher referred to as "scuttlebutt". When you identify a business you
believe warrants further investigation, how much time do you typically spend on it ‐ both in terms of total hours and in
terms of weeks or months during which time you perform your investigation?
“There’s no substitute for devoting a lot of time to thinking.
Now, it’s better for the rest of us that many of the people who are too busy to think are that busy. They don’t do
that much thinking anyway – and you get more output out of them than if they’re thinking.
But if your ambition is to be a person of good general cognition so you’re likely to be reasonably wise compared
to other people under various tough situations, I don’t think there’s any substitute for devoting a lot of time to your
thinking…
One lesson we learned was to be very selective. I don’t think we’ve ever regretted not making a lot of easy money when
we declined to do it because we felt it was beneath us.”
- Munger, 2008 WSC Meeting
“In the great majority of cases the lack of performance exceeding or even matching an unmanaged index in no way
reflects lack of either intellectual capacity or integrity. I think it much more the product of: (1) group decisions – my
perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of
any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the
portfolios of other large well‐regarded organizations; (3) an institutional framework whereby average is “safe” and the
personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4)
an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”
- “Observations on Performance,” From a letter to the Buffett Partnership, Omaha, Nebraska, Jan 1965
“…over the years, and in the aggregate, the return on (S&P500) book value tends to keep coming back to a level around
12 percent.”
- “How Inflation Swindles the Equity Investor,” Fortune, May 1977
Temperament/Discipline
“A further related lesson: Easy does it. After 25 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.”
- BRK 1989 Letter
“Granting the presence of perverse incentives, what are the operating mechanics that cause widespread bad loans
(where the higher interest rates do not adequately cover increased risk of loss) under our present system? After all, the
bad lending, while it has a surface plausibility to bankers under cost pressure, is, by definition, not rational, at least for
the lending banks and the wider civilization. How then does bad lending occur so often?
It occurs (partly) because there are predictable irrationalities among people as social animals. It is now pretty clear (in
experimental social psychology) that people on the horns of a dilemma, which is where our system has placed our
bankers, are extra likely to react unwisely to the example of other peoples' conduct, now widely called "social proof". So,
once some banker has apparently (but not really) solved his cost‐pressure problem by unwise lending, a considerable
amount of imitative "crowd folly", relying on the "social proof", is the natural consequence. Additional massive irrational
lending is caused by "reinforcement" of foolish behavior, caused by unwise accounting convention in a manner
discussed later in this letter. It is hard to be wise when the messages which drive you are wrong messages provided by a
mal‐designed system.”
- WSC 1990 Letter
“This brings to mind Ben Graham's paradoxical observation that good ideas cause more investment mischief than bad
ideas. He had it right. It is so easy for us all to push a really good idea to wretched excess, as in the case of the Florida
land bubble or the "nifty fifty" corporate stocks. Then mix in a little "social proof" (from other experts), and brains
(including ours) often turn to mush. It would be nice if great old models never tricked us, but, alas, "some dreams are
not to be." Even Einstein got tricked in his later years.”
- WSC 1990 Letter
“Under prevailing accounting, banks now ordinarily report increases in both earnings and equity capital during any
transition they make toward less conservative lending. And then, if more lending of that type is done, and is
accompanied by growth in institutional size, good reported figures will continue for an additional period. If an increase
in institutional size is deemed necessary, it is, of course, assured by the bank's access to the government's credit through
deposit insurance.
Of course, a large minority, even a majority, of bankers will remain sound, despite the temptations. But this outcome is
not sufficient to protect the deposit insurer from unacceptable ultimate losses. In due course, given present conditions,
the deposit insurer will suffer from what some wag called the problem of there being so many more banks than
bankers.”
- WSC 1990 Letter
“Though we are delighted with what we own, we are not pleased with our prospects for committing incoming funds.
Prices are high for both businesses and stocks. That does not mean that the prices of either will fall ‐‐ we have absolutely
no view on that matter ‐‐ but it does mean that we get relatively little in prospective earnings when we commit fresh
money.
Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted
explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his "best" cell,
he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone,
would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging
indiscriminately would mean a ticket to the minors.
If they are in the strike zone at all, the business "pitches" we now see are just catching the lower outside corner. If we
swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next
ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices
of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just
standing there, day after day, with my bat on my shoulder is not my idea of fun.”
- BRK 1997 Letter
“We made few portfolio changes in 1999. As I mentioned earlier, several of the companies in which we have large
investments had disappointing business results last year. Nevertheless, we believe these companies have important
competitive advantages that will endure over time. This attribute, which makes for good long‐term investment results, is
one Charlie and I occasionally believe we can identify. More often, however, we can't ‐‐ not at least with a high degree
of conviction. This explains, by the way, why we don't own stocks of tech companies, even though we share the general
view that our society will be transformed by their products and services. Our problem ‐‐ which we can't solve by
studying up ‐‐ is that we have no insights into which participants in the tech field possess a truly durable competitive
advantage.
Our lack of tech insights, we should add, does not distress us. After all, there are a great many business areas in which
Charlie and I have no special capital‐allocation expertise. For instance, we bring nothing to the table when it comes to
evaluating patents, manufacturing processes or geological prospects. So we simply don't get into judgments in those
fields.
If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are
approaching the perimeter. Predicting the long‐term economics of companies that operate in fast‐changing industries is
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simply far beyond our perimeter. If others claim predictive skill in those industries ‐‐ and seem to have their claims
validated by the behavior of the stock market ‐‐ we neither envy nor emulate them. Instead, we just stick with what we
understand. If we stray, we will have done so inadvertently, not because we got restless and substituted hope for
rationality. Fortunately, it's almost certain there will be opportunities from time to time for Berkshire to do well within
the circle we've staked out.”
- BRK 1999 Letter
“Now, speculation ¾ in which the focus is not on what an asset will produce but rather on what the next fellow will pay
for it ¾ is neither illegal, immoral nor un‐American. But it is not a game in which Charlie and I wish to play. We bring
nothing to the party, so why should we expect to take anything home?
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most
market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money.
After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball.
They know that overstaying the festivities ¾ that is, continuing to speculate in companies that have gigantic valuations
relative to the cash they are likely to generate in the future ¾ will eventually bring on pumpkins and mice. But they
nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave
just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.
Last year, we commented on the exuberance ¾ and, yes, it was irrational ¾ that prevailed, noting that investor
expectations had grown to be several multiples of probable returns. One piece of evidence came from a Paine Webber‐
Gallup survey of investors conducted in December 1999, in which the participants were asked their opinion about the
annual returns investors could expect to realize over the decade ahead. Their answers averaged 19%. That, for sure, was
an irrational expectation: For American business as a whole, there couldn’t possibly be enough birds in the 2009 bush to
deliver such a return.
Far more irrational still were the huge valuations that market participants were then putting on businesses almost
certain to end up being of modest or no value. Yet investors, mesmerized by soaring stock prices and ignoring all else,
piled into these enterprises. It was as if some virus, racing wildly among investment professionals as well as amateurs,
induced hallucinations in which the values of stocks in certain sectors became decoupled from the values of the
businesses that underlay them.
This surreal scene was accompanied by much loose talk about "value creation." We readily acknowledge that there has
been a huge amount of true value created in the past decade by new or young businesses, and that there is much more
to come. But value is destroyed, not created, by any business that loses money over its lifetime, no matter how high its
interim valuation may get.
What actually occurs in these cases is wealth transfer, often on a massive scale. By shamelessly merchandising birdless
bushes, promoters have in recent years moved billions of dollars from the pockets of the public to their own purses (and
to those of their friends and associates). The fact is that a bubble market has allowed the creation of bubble companies,
entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits,
was the primary goal of a company’s promoters. At bottom, the "business model" for these companies has been the old‐
fashioned chain letter, for which many fee‐hungry investment bankers acted as eager postmen.
But a pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old
lessons: First, many in Wall Street ¾ a community in which quality control is not prized ¾ will sell investors anything they
will buy. Second, speculation is most dangerous when it looks easiest.
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At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises.
We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600‐year‐old equation to
opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge
(a formulation that my grandsons would probably update to "A girl in a convertible is worth five in the phonebook.").
Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try,
therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak
havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future
economics of trading stamps, textiles, shoes and second‐tier department stores.”
- BRK 2000 Letter
“And now it’s confession time: I’m sure I could have saved you $100 million or so, pre‐tax, if I had acted more promptly
to shut down Gen Re Securities. Both Charlie and I knew at the time of the General Reinsurance merger that its
derivatives business was unattractive.
Reported profits struck us as illusory, and we felt that the business carried sizable risks that could not effectively be
measured or limited. Moreover, we knew that any major problems the operation might experience would likely
correlate with troubles in the financial or insurance world that would affect Berkshire elsewhere. In other words, if the
derivatives business were ever to need shoring up, it would commandeer the capital and credit of Berkshire at just the
time we could otherwise deploy those resources to huge advantage. (A historical note: We had just such an experience
in 1974 when we were the victim of a major insurance fraud. We could not determine for some time how much the
fraud would ultimately cost us and therefore kept more funds in cash‐equivalents than we normally would have.
Absent this precaution, we would have made larger purchases of stocks that were then extraordinarily cheap.)
Charlie would have moved swiftly to close down Gen Re Securities – no question about that. I, however, dithered. As a
consequence, our shareholders are paying a far higher price than was necessary to exit this business.”
- BRK 2003 Letter
“Banking's a little like investing. You have to avoid folly.
Buffett: There's no magic to it. You just have to avoid doing something foolish. It's a little like investing. You don't have
to do anything very smart. You just have to avoid doing things that are ungodly dumb when looked at about a year later
‐ airlines and that sort of thing. That's the trick.
It is not some great crystal ball game where you look into the future and see all these things other people can't. After
all, what's complicated about Coca‐Cola or Gillette ‐ or Wells Fargo for that matter?
On the record, I'd say that Wells has done an exceptionally good job running its bank compared to other big banks.
And those two operations put together will be run a whole lot more efficiently than if First Interstate had been run on its
own.
So you really ought to invest with the idea that if you were going to take a trip for 20 years, you wouldn't feel bad
leaving the money with the company ‐ with no orders with your broker, no power of attorney or anything ‐ and you
knew that when you came back that it would still be a terribly strong company.”
- Buffett, 1996 BRK Meeting
“I said, ‘We know the edge of our competency better than most.’ That’s a very worthwhile thing. It’s not a competency if
you don’t know the edge of it.”
- Munger, 2005 BRK Meeting
“We’ve never eliminated the difficulty of that problem. And ninety‐eight percent of the time, our attitude toward the
market is… [that] we’re agnostics. We don’t know. Is GM valued properly vis‐à‐vis Ford? We don’t know.
We’re always looking for something where we think we have an insight which gives us a big statistical advantage. And
sometimes it comes from psychology, but often it comes from something else. And we only find a few – maybe one or
two a year. We have no system for having automatic good judgment on all investment decisions that can be made. Ours
is a totally different system.”
“We just look for no‐brainer decisions. As Buffett and I say over and over again, we don’t leap seven‐foot fences.
Instead, we look for one‐foot fences with big rewards on the other side. So we’ve succeeded by making the world easy
for ourselves, not by solving hard problems.
Q. Based on statistical analysis and insight?
Well, certainly when we do make a decision, we think that we have an insight advantage. And it’s true that some of the
insight is statistical in nature. However, again, we find only a few of those.”
“It doesn’t help us merely for favorable odds to exist. They have to be in a place where we can recognize them. So it
takes a mispriced opportunity that we’re smart enough to recognize. And that combination doesn’t occur often.”
‐A Lesson on Elementary, Worldly Wisdom, Revisited – Stanford Law School, 4/19/1996
As Jessie Livermore said, ‘ The big money is not in the buying and selling…but in the waiting” – Poor Charlie’s Almanac 3
P 60
“It’s not the bad ideas that do you in, it’s the good ideas. And you may say, that’s paradoxical. What Graham meant was
that if a thing was a bad idea, it’s hard to overdo. But where there is a good idea with a core of essential and important
truth, you can’t ignore it. And then its so easy to overdo it. So the good ideas are a wonderful way o suffer terribly if you
overdo them.”
‐Poor Charlie’s Almanac 3 P63.
“If we have a strength, it is in recognizing when we are operating well within our circle of competence and when we are
approaching the perimeter.”
‐WEB, Poor Charlie’s Almanac 3 P65
“I feel I’m not entitled to have an opinion unless I can state the arguments against my position better than the people
who are in opposition.”
– PCA3, p430.
“You will not be right simply because a large number of people momentarily agree with you. You will not be right simply
because important people agree with you. In many quarters the simultaneous occurrence of the two above factors is
enough to make a course of action meet the test of conservatism.
You will be right, over the course of many transactions, if your hypotheses correct, your facts are correct, and your
reasoning is correct. True conservatism is only possible through knowledge and reason.”
- Buffett Partnership Letter, January 24, 1962
“Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may
lead to conventional acts, but there have been many times when they have led to unorthodoxy.”
- Buffett Partnership Letter, January 18, 1985
“if you have a 150 IQ and you think it is 160, you are a complete disaster!”
- Munger, 2009 BRK Meeting
“It is a mistake to believe that rationality is going to be perfect, even in very capable people.”
- Munger, 2011 BRK Meeting
Learning
“Outside science, it is amazing how little impact there can be from a powerful idea, published in a prominent place (such
as the Journal). Everyone's experience is that you teach only what a reader almost knows, and that seldom.
- WSC 1990 Letter
“Well, that’s a perfectly good question. But I can’t tell you when to buy some pork company. And it’s not because I know
and I’m holding back from you.
If you’re going to be an investor, you’re going to make some investments before you’ve learned the game as
well as you may eventually learn it. And if you just keep trying to get a little better all the time, it’s been my experience
that in due course, you start making some investments where you’re practically sure that the odds are overwhelmingly
in your favor. You get justified confidence through work, discipline and practice – ending with powerful habits.
There’s no shorthand way to get it by going to the master and whispering in his ear fro the solution. [Chuckling]
It’s like learning to play good golf. You’ve got to have some aptitude – and then work at it.”
- Munger, 2002 WSC Meeting
“Cigar Butts vs. Quality Businesses; Learning from Constructive Criticism
Munger: If See’s Candy had asked $100,000 more [in the purchase price; Buffett chimed in, “$10,000 more”], Warren
and I would have walked ‐‐ that’s how dumb we were.
Ira Marshall said you guys are crazy ‐‐ there are some things you should pay up for, like quality businesses and people.
You are underestimating quality. We listened to the criticism and changed our mind. This is a good lesson for anyone:
the ability to take criticism constructively and learn from it. If you take the indirect lessons we learned from See’s, you
could say Berkshire was built on constructive criticism. Now we don’t want any more today.
Buffett: The qualitative [evaluating management, competitive advantage, etc.] is harder to teach and understand, so
why not just focus on the quantitative [e.g., cigar butt investing]? Charlie emphasized quality [of a business] much more
than I did initially. He had a different background.
It makes more sense to buy a wonderful business at a fair price. We’ve changed over the years in this direction. It’s not
hard to watch businesses over 50 years and learn where the big money can be made.”
- 2003 BRK Meeting
“Keys to Investment Success
Partly its temperament – most people are too fretful, they worry to much. Success means being very patient, but
aggressive when it’s time. And the more hard lessons you can learn vicariously rather than through your own hard
experience, the better.
I don’t know anyone who [learned to be a great investor] with great rapidity. Warren has gotten to be one hell of a lot
better investor over the period I’ve known him, so have I. So the game is to keep learning. You gotta like the learning
process.”
‐ Munger, 2004 WSC Meeting
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“All you have to do is keep trying to learn at the temple of rationality and do things [when it makes sense]. I’m quite
prosperous even though I didn’t invest in K‐Mart’s bankruptcy. You can miss a lot. We bought 4% of Freddie Mac [many
years ago] yet none of Fannie Mae. How could the same mind have done that?! It wasn’t very smart.
But despite the many cognitive mistakes [we’ve made], we’re a lot richer now than we were then. I think you need to
constantly remember the mistakes of omission. We’re very good at this. Nobody remembers them – nobody thinks less
of me for missing K‐Mart – but I think about it every day. It’s a very [useful discipline to have].
Chris Davis [of Davis Advisors], who’s not here, has a temple of shame for mistakes. [It’s a wall in his office in which he
hangs stock certificates of the worst stocks he’s ever invested in.] But this is inadequate. You need the temple of shame
squared – great things you almost did and, had you been a little more rational, should have invested in. You’ll be a lot
better investor if you do this. You ought to remember boners of both kinds. Reality doesn’t distinguish – either way, in
10 years, you’re poorer. So why not celebrate your mistakes in both categories?”
- Munger, 2006 WSC Meeting
“The ability to destroy your ideas rapidly instead of slowly when the occasion is right is one of the most valuable things.
You have to work hard on it. Ask yourself what are the arguments on the other side. It’s bad to have an opinion you’re
proud of if you can’t state the arguments for the other side better than your opponents. This is a great mental
discipline.”
- Munger, 2006 WSC Meeting
“What explains the extraordinary success of Berkshire Hathaway?
You won’t have anything like the past to look forward to. Berkshire’s results have been so extreme that it’s hard to think
of a precedent in the history of the world. The balance sheet is gross considering the small beginnings of the place.
What has caused this extreme record to go on for such a long time? I would argue that it started with a young man
reading everything when he was 10 years old, becoming a learning machine. He started this long run early. Had he not
been learning all this time, our record would be a mere shadow of what it is. And he’s actually improved since he passed
the age at which most other people retire. Most people don’t even try this – it takes practice.
So it’s been a long run, with extraordinarily concentrated power by a man who is a ferocious learner. Our system ought
to be more copied than it is. The system of passing power from one old codger to another is not necessarily the right
system at all.”
‐ Munger, 2007 BRK Meeting
“I don’t have a simple checklist. You have to work at it a long long time. I still do dumb things after years of hard work.
The more big ideas you have the easier. We exclude a whole lot of things because they are in the too tough pile. If you
exclude, you do better.
“The second factor, obviously, was that Warren has been extremely interested in the subject at which he has achieved
so much. Peter Kaufman quotes Sir William Osler as saying, “It’s very hard to succeed in something unless you take the
Stock Selection
Comprehension
“Few, if any, investors have ever prospered mightily from investing in convertible preferred stocks of leading
corporations.”
- WSC 1989 Letter
“As we select mortgage‐backed securities, we will probably not be buying any complex instruments. Despite our love of
comedy, we are going to avoid the newest form of ‘Jump Z tranches in REMICS.’ This refers to a particular contractual
fraction ‐‐ the ‘Z Form’ ‐‐ of a pool of mortgages, now subdivided by obliging issuers, advised by obliging investment
bankers, into two new contractual fractions: (1) the ‘Sticky Jump Z.’ At this rate, subdivision will soon get down to
quarks.
We are deterred from buying such securities partly by our hatred of complexity. We also dread the prospect of state and
federal examiners, none of whom has a Ph.D. in physics, reviewing, one after the other, our choices for soundness and
billing us on cost‐plus basis to reflect value thus added. Some of the wonders of modern finance go on without us as we
yearn for a lost age when most reasonable people could, with effort, understood what was going on.”
- WSC 1990 Letter
“In studying the investments we have made in both subsidiary companies and common stocks, you will see that we
favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type
of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive
strength ten or twenty years from now. A fast‐changing industry environment may offer the chance for huge wins, but it
precludes the certainty we seek.”
- BRK 1996 Letter
“If our derivatives experience – and the Freddie Mac shenanigans of mind‐blowing size and audacity that were revealed
last year – makes you suspicious of accounting in this arena, consider yourself wised up. No matter how financially
sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives‐intensive
company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can
learn from the disclosures normally proffered you. In Darwin’s words, ‘Ignorance more frequently begets confidence
than does knowledge.’”
- BRK 2003 Letter
“Investors should understand that in all types of financial institutions, rapid growth sometimes masks major underlying
problems (and occasionally fraud). The real test of the earning power of a derivatives operation is what it achieves after
operating for an extended period in a no‐growth mode. You only learn who has been swimming naked when the tide
goes out.”
- BRK 2004 Letter
Moat
“We continue to feel that the ratio of operating earnings (before securities gains or losses) to shareholders’ equity with
all securities valued at cost is the most appropriate way to measure any single year’s operating performance.”
- BRK 1979 Letter
“You'll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage. Here's
a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and
500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade. The
best performer among the 1000 was Commerce Clearing House at 40.2%. “
- BRK 1987 Letter
“Experience, however, indicates that the best business returns are usually achieved by companies that are doing
something quite similar today to what they were doing five or ten years ago. That is no argument for managerial
complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and
the like, and obviously these opportunities should be seized. But a business that constantly encounters major change
also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground
on which it is difficult to build a fortress‐like business franchise. Such a franchise is usually the key to sustained high
returns.
The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic
excellence ‐ an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%.
These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P
500.
The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest‐
paying capacity. Really good businesses usually don't need to borrow. Second, except for one company that is "high‐
tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather
mundane. Most sell non‐sexy products or services in much the same manner as they did ten years ago (though in larger
quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an
already strong business franchise, or concentrating on a single winning business theme, is what usually produces
exceptional economics.“
- BRK 1987 Letter
“The property‐casualty insurance industry is not only subnormally profitable, it is subnormally popular. (As Sam Goldwyn
philosophized: “In life, one must learn to take the
bitter with the sour.”) One of the ironies of business is that many relatively‐unprofitable industries that are plagued by
inadequate prices habitually find themselves beat upon by irate customers even while other, hugely profitable industries
are spared complaints, no matter how high their prices.
Take the breakfast cereal industry, whose return on invested capital is more than double that of the auto insurance
industry (which is why companies like Kellogg and General Mills sell at five times book value and most large insurers sell
close to book). The cereal companies regularly impose price increases, few of them related to a significant jump in their
costs. Yet not a peep is heard from consumers. But when auto insurers raise prices by amounts that do not even match
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cost increases, customers are outraged. If you want to be loved, it’s clearly better to sell high‐priced corn flakes than
low‐priced auto
insurance.”
- BRK 1988 Letter
“Some historical explanation for the current situation should be repeated here. When Wesco's parent corporation
acquired control, Wesco∙s activities were almost entirely limited to holding (1) some surplus cash, plus (2) a multi‐branch
savings and loan association which had many very long‐term, fixed‐rate mortgage, offset by interest‐bearing demand
deposits. The acquisition of this intrinsically disadvantageous position was unwisely made, alternative opportunities
considered, because the acquirer (including the signer of this letter) was overly influenced by a price considered to be
moderately below liquidating value. Under such circumstances, acquisitions have a way of producing, on average, for
acquirers who are not quick‐turn operators, low to moderate long‐term results. This happens because any advantage
from a starting ‘bargain’ gets swamped by effects from change‐resistant mediocrity in the purchased business. Such
normal effects have not been completely avoided at Wesco, despite some successful activities, including a large gain in
1985 from an investment in General Foods.”
- WSC 1988 Letter
“We attract business nationwide because we have several advantages that competitors can't match. The most
important item in the equation is our operating costs, which run about 18% of sales compared to 40% or so at the typical
competitor. (Included in the 18% are occupancy and buying costs, which some public companies include in "cost of
goods sold.") Just as Wal‐Mart, with its 15% operating costs, sells at prices that high‐cost competitors can't touch and
thereby constantly increases its market share, so does Borsheim's. What works with diapers works with diamonds.
Our low prices create huge volume that in turn allows us to carry an extraordinarily broad inventory of goods, running
ten or more times the size of that at the typical fine‐jewelry store. Couple our breadth of selection and low prices with
superb service and you can understand how Ike and his family have built a national jewelry phenomenon from an
Omaha location.”
- BRK 1990 Letter
“The simple, low‐cost(*), cream‐the‐market approach thus taken (or stumbled into) often works well in business. For
instance, look at (1) GEICO, a hugely successful auto insurer almost 50% owned by Wesco's parent corporation or (2)
various membership warehouse clubs, in the form invented by Sol Price, which are now clobbering retailing competitors
as they get total "markup" under 10%. And this approach, as would be expected, is working like gangbusters for the
money‐market funds, as you see in the graph from The Economist.”
- WSC 1990 Letter
“The fact is that newspaper, television, and magazine properties have begun to resemble businesses more than
franchises in their economic behavior. Let's take a quick look at the characteristics separating these two classes of
enterprise, keeping in mind, however, that many operations fall in some middle ground and can best be described as
weak franchises or strong businesses.
An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to
have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be
demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates
Reinvestment/Growth
“Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation
intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their
existing physical volume of business. There is a certain mirage‐like quality to such operations. However attractive the
earnings numbers, we remain leery of businesses that never seem able to convert such pretty numbers into no‐strings‐
attached cash.”
- BRK 1980 Letter
“Last year in this section I ran a small ad to encourage acquisition candidates. In our communications businesses we tell
our advertisers that repetition is a key to results (which it is), so we will again repeat our acquisition criteria.
We prefer:
(1) large purchases (at least $5 million of after‐tax earnings),
(2) demonstrated consistent earning power (future projections are of little interest to
us, nor are “turn‐around” situations),
(3) businesses earning good returns on equity while employing little or no debt,
(4) management in place (we can’t supply it),
(5) simple businesses (if there’s lots of technology, we won’t understand it),
(6) an offering price (we don’t want to waste our time or that of the seller by talking,
even preliminarily, about a transaction when price is unknown).”
- BRK 1983 Letter
“Obviously, the future results of a business earning 23% annually and retaining it all are far more affected by today’s
capital allocations than are the results of a business earning 10% and distributing half of that to shareholders.
“In a company adding only, say, 5% to net worth annually, capital‐allocation decisions, though still important, will
change the company’s economics far more slowly.”
- BRK 1986 Letter
“I've told you that over time look‐through earnings must increase at about 15% annually if our intrinsic business value is
to grow at that rate. Our look‐through earnings in 1992 were $604 million, and they will need to grow to more than
$1.8 billion by the year 2000 if we are to meet that 15% goal. For us to get there, our operating subsidiaries and
investees must deliver excellent performances, and we must exercise some skill in capital allocation as well.
We cannot promise to achieve the $1.8 billion target. Indeed, we may not even come close to it. But it does guide our
decision‐making: When we allocate capital today, we are thinking about what will maximize look‐through earnings in
2000.
We do not, however, see this long‐term focus as eliminating the need for us to achieve decent short‐term results as
well. After all, we were thinking long‐range thoughts five or ten years ago, and the moves we made then should now be
paying off. If plantings made confidently are repeatedly followed by disappointing harvests, something is wrong with
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the farmer. (Or perhaps with the farm: Investors should understand that for certain companies, and even for some
industries, there simply is no good long‐term strategy.) Just as you should be suspicious of managers who pump up
short‐term earnings by accounting maneuvers, asset sales and the like, so also should you be suspicious of those
managers who fail to deliver for extended periods and blame it on their long‐term focus.”
- BRK 1992 Letter
“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.”
- BRK 1992 Letter
“Earlier I mentioned the financial results that could have been achieved by investing $40 in The Coca‐Cola Co. in 1919.
In 1938, more than 50 years after the introduction of Coke, and long after the drink was firmly established as an
American icon, Fortune did an excellent story on the company. In the second paragraph the writer reported: "Several
times every year a weighty and serious investor looks long and with profound respect at Coca‐Cola's record, but comes
regretfully to the conclusion that he is looking too late. The specters of saturation and competition rise before him."
Yes, competition there was in 1938 and in 1993 as well. But it's worth noting that in 1938 The Coca‐Cola Co. sold 207
million cases of soft drinks (if its gallonage then is converted into the 192‐ounce cases used for measurement today) and
in 1993 it sold about 10.7 billion cases, a 50‐fold increase in physical volume from a company that in 1938 was already
dominant in its very major industry. Nor was the party over in 1938 for an investor: Though the $40 invested in 1919 in
one share had (with dividends reinvested) turned into $3,277 by the end of 1938, a fresh $40 then invested in Coca‐Cola
stock would have grown to $25,000 by yearend 1993.
I can't resist one more quote from that 1938 Fortune story: "It would be hard to name any company comparable in size
to Coca‐Cola and selling, as Coca‐Cola does, an unchanged product that can point to a ten‐year record anything like
Coca‐Cola's." In the 55 years that have since passed, Coke's product line has broadened somewhat, but it's remarkable
how well that description still fits.”
‐ BRK 1993 Letter
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily‐understandable
business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time,
you will find only a few companies that meet these standards ‐ so when you see one that qualifies, you should buy a
meaningful amount of stock. You must also resist the temptation to stray from your guidelines: If you aren't willing to
own a stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of companies
whose aggregate earnings march upward over the years, and so also will the portfolio's market value.”
- BRK 1996 Letter
“Let’s look at the prototype of a dream business, our own See’s Candy. The boxed‐chocolates industry in which it
operates is unexciting: Per‐capita consumption in the U.S. is extremely low and doesn’t grow. Many once‐important
brands have disappeared, and only three companies have earned more than token profits over the last forty years.
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Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of
the entire industry’s earnings.
At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie
and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a
growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50‐year period,
and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.
We bought See’s for $25 million when its sales were $30 million and pre‐tax earnings were less than $5 million. The
capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months
each year.) Consequently, the company was earning 60% pre‐tax on invested capital. Two factors helped to minimize the
funds required for operations. First, the product was
sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which
minimized inventories.
Last year See’s sales were $383 million, and pre‐tax profits were $82 million. The capital now required to run the
business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical
growth – and somewhat immodest financial growth – of the business. In the meantime pre‐tax earnings have totaled
$1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After
paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve
kick‐started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The
biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)
There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82
million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses
have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset
investments.
A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment.
There is, to follow through on our example, nothing shabby about earning $82 million pre‐tax on $400 million of net
tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an
ever‐increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.
One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers
benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable
competitive advantage: Going to any other flight‐training provider than the best is like taking the low bid on a surgical
procedure.
Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased
FlightSafety in 1996, its pre‐tax operating earnings were $111 million, and its net investment in fixed assets was $570
million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled
$1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A
simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now
amount to $1.079 billion. Pre‐tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That
gain gave us a good, but far from See’s‐like, return on our incremental investment of $509 million.
Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put‐
up‐more‐to‐earn‐more experience is that faced by most corporations. For example, our large investment in regulated
Management
“As we have noted, we evaluate single‐year corporate performance by comparing operating earnings to shareholders’
equity with securities valued at cost. Our long‐term yardstick of performance, however, includes all capital gains or
losses, realized or unrealized. We continue to achieve a long‐term return on equity that considerably exceeds the
average of our yearly returns. The major factor causing this pleasant result is a simple one: the retained earnings of
those non‐controlled holdings we discussed earlier have been translated into gains in market value.”
- BRK 1980 Letter
“In fairness, we should acknowledge that some acquisition records have been dazzling. Two major categories stand out.
The first involves companies that, through design or accident, have purchased only businesses that are particularly well
adapted to an inflationary environment. Such favored business must have two characteristics: (1) an ability to increase
prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of
either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often
produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary
ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades.
However, very few enterprises possess both characteristics, and competition to buy those that do has now become
fierce to the point of being self‐defeating.
The second category involves the managerial superstars ‐ men who can recognize that rare prince who is disguised as a
toad, and who have managerial abilities that enable them to peel away the disguise. We salute such managers as Ben
Heineman at Northwest Industries, Henry Singleton at Teledyne, Erwin Zaban at National Service Industries, and
especially Tom Murphy at Capital Cities Communications (a real managerial “twofer”, whose acquisition efforts have
been properly focused in Category 1 and whose operating talents also make him a leader of Category 2). From both
direct and vicarious experience, we recognize the difficulty and rarity of these executives’ achievements. (So do they;
these champs have made very few deals in recent years, and often have found repurchase of their own shares to be the
most sensible employment of corporate capital.)”
- BRK 1981 Letter
“Currently, we find values most easily obtained through the open‐market purchase of fractional positions in companies
with excellent business franchises and competent, honest managements. We never expect to run these companies, but
we do expect to profit from them.
We expect that undistributed earnings from such companies will produce full value (subject to tax when realized) for
Berkshire and its shareholders. If they don’t, we have made mistakes as to either: (1) the management we have elected
to join; (2) the future economics of the business; or (3) the price we have paid.
We have made plenty of such mistakes ‐ both in the purchase of non‐controlling and controlling interests in businesses.
Category (2) miscalculations are the most common.”
- BRK 1981 Letter
“The banking business is no favorite of ours. When assets are twenty times equity ‐ a common ratio in this industry ‐
mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the
rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last
year when discussing the "institutional imperative:" the tendency of executives to mindlessly imitate the behavior of
their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow‐the‐leader with
lemming‐like zeal; now they are experiencing a lemming‐like fate.
Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in
purchasing shares of a poorly‐managed bank at a "cheap" price. Instead, our only interest is in buying into well‐managed
banks at fair prices.”
- BRK 1990 Letter
“Despite Freddie Mac's strong competitive position, its stock declined in market value by 27% in 1990 (from $67.12 per
share to $48.75 per share, in trading on the New York Stock Exchange). One reason for the decline was unanticipated
losses from apartment house loans, particularly in New York and Atlanta. As a result, Freddie Mac wisely discontinued
the most obviously dangerous part of its apartment house loan buying program. But it remains the guarantor or owner
of some old loans (fortunately a small portion of total apartment house loans and a really tiny portion of total loans) that
will create misery for years. It was probably ill‐advised for Freddie Mac, given its position and financial leverage and the
nation's needs, (1) ever to finance anything except owner‐occupied, single‐family, non‐vacation houses, for which
substantial down payments had been made by credit‐worthy people, and (2) ever to deal with anyone other than
mortgage originators and services of obvious integrity and competence. Just as it is unwise for an individual to risk losing
what he has and needs in an effort to gain what he doesn't have and doesn't need, it seems unwise for Freddie Mac to
stretch its leveraged resources beyond purchase from obviously responsible people of carefully selected first mortgages
on individual houses. Each lender, including the one writing this letter, seems destined to learn through painful, personal
experience two obvious lessons from the past:
(1) The first chance you have to avoid a loss from a foolish loan is by refusing to make it; there is no second chance.
(2) As you occupy some high‐profit niche in a competitive order, you must know how much of your present prosperity is
caused by talents and momentum assuring success in new activities, and how much merely reflects the good fortune of
being in your present niche.
In common experience, including ours, lesson (1) is eventually learned, but lessons (2) resists learning, despite high pain
inflicted by multiple reverses.
As nearly as we can foretell, Freddie Mac's troubles with apartment house loans are endurable in scale and will no more
significantly impair its long‐term prospects than the salad oil swindle of 1963 impaired the long‐term prospects of
American Express. Moreover, the present managers and directors of Freddie Mac all seem to have absorbed a catechism
appropriate for Freddie Mac and to be willing to endure political friction burns as necessary to keep operations sound.
We like our large position.”
- WSC 1990 Letter
“Corporate Governance
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At our annual meetings, someone usually asks "What happens to this place if you get hit by a truck?" I'm glad they
are still asking the question in this form. It won't be too long before the query becomes: "What happens to this place if
you don't get hit by a truck?"
Such questions, in any event, raise a reason for me to discuss corporate governance, a hot topic during the past year.
In general, I believe that directors have stiffened their spines recently and that shareholders are now being treated
somewhat more like true owners than was the case not long ago. Commentators on corporate governance, however,
seldom make any distinction among three fundamentally different manager/owner situations that exist in publicly‐held
companies. Though the legal responsibility of directors is identical throughout, their ability to effect change differs in
each of the cases. Attention usually falls on the first case, because it prevails on the corporate scene. Since Berkshire
falls into the second category, however, and will someday fall into the third, we will discuss all three variations.
The first, and by far most common, board situation is one in which a corporation has no controlling shareholder. In that
case, I believe directors should behave as if there is a single absentee owner, whose long‐term interest they should try
to further in all proper ways. Unfortunately, "long‐term" gives directors a lot of wiggle room. If they lack either integrity
or the ability to think independently, directors can do great violence to shareholders while still claiming to be acting in
their long‐term interest. But assume the board is functioning well and must deal with a management that is mediocre
or worse. Directors then have the responsibility for changing that management, just as an intelligent owner would do if
he were present. And if able but greedy managers over‐reach and try to dip too deeply into the shareholders' pockets,
directors must slap their hands.
In this plain‐vanilla case, a director who sees something he doesn't like should attempt to persuade the other directors
of his views. If he is successful, the board will have the muscle to make the appropriate change. Suppose, though, that
the unhappy director can't get other directors to agree with him. He should then feel free to make his views known to
the absentee owners. Directors seldom do that, of course. The temperament of many directors would in fact be
incompatible with critical behavior of that sort. But I see nothing improper in such actions, assuming the issues are
serious. Naturally, the complaining director can expect a vigorous rebuttal from the unpersuaded directors, a prospect
that should discourage the dissenter from pursuing trivial or non‐rational causes.
For the boards just discussed, I believe the directors ought to be relatively few in number ‐ say, ten or less ‐ and ought to
come mostly from the outside. The outside board members should establish standards for the CEO's performance and
should also periodically meet, without his being present, to evaluate his performance against those standards.
The requisites for board membership should be business savvy, interest in the job, and owner‐orientation. Too often,
directors are selected simply because they are prominent or add diversity to the board. That practice is a mistake.
Furthermore, mistakes in selecting directors are particularly serious because appointments are so hard to undo: The
pleasant but vacuous director need never worry about job security.
The second case is that existing at Berkshire, where the controlling owner is also the manager. At some companies, this
arrangement is facilitated by the existence of two classes of stock endowed with disproportionate voting power. In
these situations, it's obvious that the board does not act as an agent between owners and management and that the
directors cannot effect change except through persuasion. Therefore, if the owner/manager is mediocre or worse ‐ or is
over‐reaching ‐ there is little a director can do about it except object. If the directors having no connections to the
owner/manager make a unified argument, it may well have some effect. More likely it will not.
If change does not come, and the matter is sufficiently serious, the outside directors should resign. Their resignation will
signal their doubts about management, and it will emphasize that no outsider is in a position to correct the
owner/manager's shortcomings.
Financial Strength
“Our consistently‐conservative financial policies may appear to have been a mistake, but in my view were not. In
retrospect, it is clear that significantly higher, though still conventional, leverage ratios at Berkshire would have
produced considerably better returns on equity than the 23.8% we have actually averaged. Even in 1965, perhaps we
could have judged there to be a 99% probability that higher leverage would lead to nothing but good. Correspondingly,
we might have seen only a 1% chance that some shock factor, external or internal, would cause a conventional debt
ratio to produce a result falling somewhere between temporary anguish and default.
We wouldn't have liked those 99:1 odds ‐ and never will. A small chance of distress or disgrace cannot, in our view, be
offset by a large chance of extra returns. If your actions are sensible, you are certain to get good results; in most such
cases, leverage just moves things along faster. Charlie and I have never been in a big hurry: We enjoy the process far
more than the proceeds ‐ though we have learned to live with those also.”
- BRK 1989 Letter
“Wesco's practice has been to do a certain amount of long‐term borrowing in advance of specific need, in order to have
maximum financial flexibility to face both hazards and opportunities.”
- WSC 1983 Letter
“Any company's level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost;
and (3) its utilization of "leverage" ‐ that is, the degree to which its assets are funded by liabilities rather than by equity.
Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted
greatly ‐ to a degree that is not generally well‐understood ‐ because our liabilities have cost us very little. An important
reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many
other property and casualty insurers, who may generate plenty of float, but at a cost that exceeds what the funds are
worth to them. In those circumstances, leverage becomes a disadvantage.
- BRK 1995 Letter
“Derivatives
Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view
them as time bombs, both for the parties that deal in them and the economic system.
Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation
must be general because the word covers an extraordinarily wide range of financial contracts. Essentially, these
instruments call for money to change hands at some future date, with the amount to be determined by one or more
reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an
S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from
movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and
their value is often tied to several variables.
“You need – if you run an institution with enormous leverage, you need somebody with a fiduciary gene running it.”
- From a CNBC interview with Buffett, Aug 22, 2008
“We will never become dependent on the kindness of strangers. Too‐big‐to‐fail is not a fallback position at Berkshire.
Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed
by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and
diverse businesses.”
- BRK 2009 Letter
“There are three factors to measure and price risk whether it be an insurance policy or derivative contract or options; 1.)
do you understand the risk, 2.) do you get a premium or rate greater than the probability of loss, and 3.) make sure you
do not take on too much aggregated loss events. The way our derivative contracts are set up is fundamentally the same
business as insurance. We assess the risk and if we feel that we are being adequately compensated we will write the
contract, whether it is insurance or a derivative. Where people have a hard time is understanding why the accounting
for derivatives is completely different causing wide volatility in financial statements but not in cash transactions. If they
are mis‐priced and good for Berkshire shareholders they’ll continue to write the business. We never have too much
exposure and are careful to avoid correlation with other risks we have underwritten. Even though we have taken
advantage of the ability to write derivative contracts we would vote against their use if asked because of their general
misuse.”
- 2009 BRK Press Conference
“You can get in a lot of trouble with leverage. If you go 20‐1 levered, you better be right.”
- Buffett, 2009 BRK Meeting
“The fundamental principle of auto racing is that to finish first, you must first finish. That dictum is equally applicable to
business and guides our every action at Berkshire.”
- BRK 2010 Letter
“any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero.
History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.
Valuation
“Book value tells you what has been put in; intrinsic business value estimates what can be taken out.”
- BRK 1983 Letter
“Appendix
Goodwill and its Amortization: The Rules and The Realities
This appendix deals only with economic and accounting Goodwill – not the goodwill of everyday usage. For example, a
business may be well liked, even loved, by most of its customers but possess no economic goodwill. (AT&T, before the
breakup, was generally well thought of, but possessed not a dime of economic Goodwill.) And, regrettably, a business
may be disliked by its customers but possess substantial, and growing, economic Goodwill. So, just for the moment,
forget emotions and focus only on economics and accounting.
When a business is purchased, accounting principles require that the purchase price first be assigned to the fair value of
the identifiable assets that are acquired. Frequently the sum of the fair values put on the assets (after the deduction of
liabilities) is less than the total purchase price of the business. In that case, the difference is assigned to an asset account
entitled "excess of cost over equity in net assets acquired". To avoid constant repetition of this mouthful, we will
substitute "Goodwill".
Accounting Goodwill arising from businesses purchased before November 1970 has a special standing. Except under rare
circumstances, it can remain an asset on the balance sheet as long as the business bought is retained. That means no
amortization charges to gradually extinguish that asset need be made against earnings.
Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about $8 million of net tangible
assets. (Throughout this discussion, accounts receivable will be classified as tangible assets, a definition proper for
business analysis.) This level of tangible assets was adequate to conduct the business without use of debt, except for
short periods seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed
conservatively representative of future earning power in constant 1972 dollars.
Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to
produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess
return is economic Goodwill.
In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after tax on net tangible
assets that was earned by See’s – doing it, furthermore, with conservative accounting and no financial leverage. It was
not the fair market value of the inventories, receivables or fixed assets that produced the premium rates of return.
Rather it was a combination of intangible assets, particularly a pervasive favorable reputation with consumers based
upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the purchaser, rather than its
production cost, to be the major determinant of selling price. Consumer franchises are a prime source of economic
Goodwill. Other sources include governmental franchises not subject to profit regulation, such as television stations, and
an enduring position as the low cost producer in an industry.
Let’s return to the accounting in the See’s example. Blue Chip’s purchase of See’s at $17 million over net tangible assets
required that a Goodwill account of this amount be established as an asset on Blue Chip’s books and that $425,000 be
charged to income annually for 40 years to amortize that asset. By 1983, after 11 years of such charges, the $17 million
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had been reduced to about $12.5 million. Berkshire, meanwhile, owned 60% of Blue Chip and, therefore, also 60% of
See’s. This ownership meant that Berkshire’s balance sheet reflected 60% of See’s Goodwill, or about $7.5 million.
In 1983 Berkshire acquired the rest of Blue Chip in a merger that required purchase accounting as contrasted to the
"pooling" treatment allowed for some mergers. Under purchase accounting, the "fair value" of the shares we gave to (or
"paid") Blue Chip holders had to be spread over the net assets acquired from Blue Chip. This "fair value" was measured,
as it almost always is when public companies use their shares to make acquisitions, by the market value of the shares
given up.
The assets "purchased" consisted of 40% of everything owned by Blue Chip (as noted, Berkshire already owned the
other 60%). What Berkshire "paid" was more than the net identifiable assets we received by $51.7 million, and was
assigned to two pieces of Goodwill: $28.4 million to See’s and $23.3 million to Buffalo Evening News.
After the merger, therefore, Berkshire was left with a Goodwill asset for See’s that had two components: the $7.5
million remaining from the 1971 purchase, and $28.4 million newly created by the 40% "purchased" in 1983. Our
amortization charge now will be about $1.0 million for the next 28 years, and $.7 million for the following 12 years, 2002
through 2013.
In other words, different purchase dates and prices have given us vastly different asset values and amortization charges
for two pieces of the same asset. (We repeat our usual disclaimer: we have no better accounting system to suggest. The
problems to be dealt with are mind boggling and require arbitrary rules.)
Another reality is that annual amortization charges in the future will not correspond to economic costs. It is possible, of
course, that See’s economic Goodwill will disappear. But it won’t shrink in even decrements or anything remotely
resembling them. What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because
of inflation.
That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation. To
illustrate how this works, let’s contrast a See’s kind of business with a more mundane business. When we purchased
See’s in 1972, it will be recalled, it was earning about $2 million on $8 million of net tangible assets. Let us assume that
our hypothetical mundane business then had $2 million of earnings also, but needed $18 million in net tangible assets
for normal operations. Earning only 11% on required tangible assets, that mundane business would possess little or no
economic Goodwill.
A business like that, therefore, might well have sold for the value of its net tangible assets, or for $18 million. In contrast,
we paid $25 million for See’s, even though it had no more in earnings and less than half as much in "honest‐to‐God"
assets. Could less really have been more, as our purchase price implied? The answer is "yes" – even if both businesses
were expected to have flat unit volume – as long as you anticipated, as we did in 1972, a world of continuous inflation.
To understand why, imagine the effect that a doubling of the price level would subsequently have on the two
businesses. Both would need to double their nominal earnings to $4 million to keep themselves even with inflation. This
would seem to be no great trick: just sell the same number of units at double earlier prices and, assuming profit margins
remain unchanged, profits also must double.
But, crucially, to bring that about, both businesses probably would have to double their nominal investment in net
tangible assets, since that is the kind of economic requirement that inflation usually imposes on businesses, both good
and bad. A doubling of dollar sales means correspondingly more dollars must be employed immediately in receivables
and inventories. Dollars employed in fixed assets will respond more slowly to inflation, but probably just as surely. And
1. In analysis of operating results – that is, in evaluating the underlying economics of a business unit – amortization
charges should be ignored. What a business can be expected to earn on unleveraged net tangible assets,
excluding any charges against earnings for amortization of Goodwill, is the best guide to the economic
attractiveness of the operation. It is also the best guide to the current value of the operation’s economic
Goodwill.
Operations that appear to be winners based upon perspective
1. may pale when viewed from perspective
2. A good business is not always a good purchase – although it’s a good place to look for one.”
- BRK 1983 Letter
“As we discussed last year, the gain in per‐share intrinsic business value is the economic measurement that really
counts.”
- BRK 1984 Letter
“Some historical explanation for the current situation becomes appropriate here. When Wesco’s parent corporation
acquired control, Wesco’s activities were almost entirely limited to holding (1) some surplus cash, plus (2) a multi‐branch
savings and loan association which had many very long‐term, fixed‐rate mortgages, offset by interest‐bearing demand
deposits. The acquisition of this intrinsically disadvantageous position was unwisely made, alternative opportunities
considered, because the acquirer was overly influenced by a price considered to be moderately below liquidating value.
Under such circumstances, acquisitions have a way of producing on average, for acquirers who are not quick‐turn
operators, low to moderate long‐term results. This happens because any advantage from a starting ‘bargain’ gets
swamped by effects from change‐resistant mediocrity in the purchased business swamped by effects from change‐
resistant mediocrity in the purchased business. Such normal effects have not completely avoided at Wesco, despite
some successful activities, including recent investment in General Foods.”
- WSC 1987 Letter
“We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business
whose long‐term future is predictable, because of short‐term worries about an economy or a stock market that we know
to be unpredictable. Why scrap an informed decision because of an uninformed guess?”
- BRK 1995 Letter
“Though we are delighted with what we own, we are not pleased with our prospects for committing incoming funds.
Prices are high for both businesses and stocks. That does not mean that the prices of either will fall ‐‐ we have absolutely
no view on that matter ‐‐ but it does mean that we get relatively little in prospective earnings when we commit fresh
money.
Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book The Science of Hitting, Ted
explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his "best" cell,
he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone,
Inflation
“High rates of inflation create a tax on capital that makes much corporate investment unwise ‐ at least if measured by
the criterion of a positive real investment return to owners. This “hurdle rate” the return on equity that must be
achieved by a corporation in order to produce any real return for its individual owners ‐ has increased dramatically in
recent years. The average tax‐paying investor is now running up a down escalator whose pace has accelerated to the
point where his upward progress is nil.
For example, in a world of 12% inflation a business earning 20% on equity (which very few manage consistently to do)
and distributing it all to individuals in the 50% bracket is chewing up their real capital, not enhancing it. (Half of the 20%
will go for income tax; the remaining 10% leaves the owners of the business with only 98% of the purchasing power they
possessed at the start of the year ‐ even though they have not spent a penny of their “earnings”). The investors in this
bracket would actually be better off with a combination of stable prices and corporate earnings on equity capital of only
a few per cent.
Explicit income taxes alone, unaccompanied by any implicit inflation tax, never can turn a positive corporate return into
a negative owner return. (Even if there were 90% personal income tax rates on both dividends and capital gains, some
real income would be left for the owner at a zero inflation rate.) But the inflation tax is not limited by reported income.
Inflation rates not far from those recently experienced can turn the level of positive returns achieved by a majority of
corporations into negative returns for all owners, including those not required to pay explicit taxes. (For example, if
inflation reached 16%, owners of the 60% plus of corporate America earning less than this rate of return would be
realizing a negative real return ‐ even if income taxes on dividends and capital gains were
eliminated.)
Of course, the two forms of taxation co‐exist and interact since explicit taxes are levied on nominal, not real, income.
Thus you pay income taxes on what would be deficits if returns to stockholders were measured in constant dollars.”
- BRK 1980 Letter
“Equity Value‐Added
An additional factor should further subdue any residual enthusiasm you may retain regarding our long‐term rate of
return. The economic case justifying equity investment is that, in aggregate, additional earnings above passive
investment returns ‐ interest on fixed‐income securities ‐ will be derived through the employment of managerial and
entrepreneurial skills in conjunction with that equity capital. Furthermore, the case says that since the equity capital
position is associated with greater risk than passive forms of investment, it is “entitled” to higher returns. A “value‐
added” bonus from equity capital seems natural and certain.
But is it? Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a “good”
business ‐ i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at
more than one hundred cents. For, with long‐term taxable bonds yielding 5% and long‐term tax‐exempt bonds 3%, a
business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity
capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce
the 10% earned by the corporation to perhaps 6%‐8% in the hands of the individual investor.
Risk
“Any minority‐position investment with such extreme financial leverage (in effect buying with a 2% down payment),
involving a troubled company in a demanding environment, can fairly be called a venture‐capital type investment for
Wesco. In our judgment, the prospect for gain justified the risk of loss. The investment involves a small portion (about
5%) of Wesco’s consolidated net worth. We consider it financially conservative to risk 3½% of Wesco’s net worth, which
is roughly the after‐tax exposure involved, if we believe a hundred similar bets would, in aggregate, be almost sure to
work out successfully.”
- WSC 1985 Letter
“The ratio of Wesco’s annual reported consolidated net income to reported consolidated sahreholders’ equity, about
21% in 1983‐85, was dependent to a very large extent on securities gains, irregular by nature. The recent ratio is almost
certain to decline, quite probably very sharply. Neither possible future acquisitions of other businesses nor possible
future securities gains appear likely to cause the recent ratio to continue. The business acquisition game is now crowded
with optimistic players who usually force prices for low‐leverage acquirers like Wesco to levels where return‐on‐
investment prospects are modest. And, as discussed earlier, the great contribution of 1985 securities gains to Wesco’s
recent return on shareholders’ equity contained a big fluke element. Such fluke gain, rare in any event, tends to come to
an investor like Wesco mostly as an unanticipated by‐product of an obviously sound i8nvestment which does not require
any fluke to work out well. Because securities generally traded lower several years ago than they do now, relative to the
intrinsic values of the businesses represented by the securities, creating more obviously sound investment then than
now, and because prospects for above‐average returns tend to go down as assets managed go up, it is now easy to
predict less desirable future results. It is also easy for any sophisticated Wesco shareholder, reviewing Wesco
marketable securities disclosed in the 1985 Annual Report, to diagnose (correctly) that the decision‐makers are dry of
good investment ideas.”
- WSC 1985 Letter
“I wish I knew where I was going to die, and then I’d never go there.”
‐Harvard School Commencement Speech – June 13, 1986
“Mutual Savings’ ‘normal’ net operating income of $2,895,000 in 1987 represented an increase of 34% from the
$2,159,000 figure the previous year.
However, this ‘normal’ figure of $2,895,000 for Mutual Savings’ 1987 earnings is created by ignoring as abnormal an
after‐tax charge of $1,935,000 from writeoff of prepayments of deposit‐insurance premiums. The premiums had been
prepaid in the previous years to FSLIC, the U.S. agency which insures accounts in savings and loan associations. Since
FSLIC has been grievously impaired by widespread failure of insured associations and continues to be insolvent, and
since its long‐term source of support is collection of premiums which the savings and loan industry is compelled to pay, it
may well be questioned whether FSLIC‐related charges far in excess of past experience should on that account now be
excluded from the ‘normal’ as we do in this explanatory letter. Mutual Savings’ position, relative to FSLIC, is like that of
the owner of a concrete pier, mostly underwater, compelled to buy fire insurance on a pooled‐rate basis with a group of
oily‐rag collectors, many of whom have already had but not reported their fires, with the result that no provision for
such fires has yet been made in pooled‐basis premium rates. Such an owner probably has not yet had his last unpleasant
Industry
Banking
“The savings and loan association described in the foregoing paragraphs, quite different form most other associations
for a long time, added a significant new abnormality during 1988. Mutual Savings increased its position in preferred
stock of Federal Home Loan Mortgage Corporation (widely known as ‘Freddie Mac’) to 2,400,000 when‐issued shares.
This is 4% of the total shares outstanding, the legal limit for any one holder. As this letter is written, all of these
2,400,000 have been issued and paid for. Mutual Savings’ average cost is $29.89 per share, compared to a price of
$50.50 per share in trading on the New York Stock Exchange at the end of 1988. Thus, based on 1988 yearend trading
prices, Mutual Savings had an unrealized pre‐tax profit in Freddie Mac shares of about $49.5 million. At current tax rates
the potential after‐tax profit is about $29.2 million, or $4.10 per Wesco share outstanding.
Freddie Mac is a hybrid, run by a federal agency (the Federal Home Loan Bank Board), but now owned privately, largely
by institutional investors. Freddie Mac supports housing primarily by purchasing housing mortgage loans for immediate
transmutation into mortgage‐backed securities that it guarantees and promptly sells. In the process Freddie Mac earns
fee, and 'spreads’ while avoiding most interest rate‐change risk. This is a much better business, than that carried on by
most (or indeed most of the top 10% of) savings and loan associations, as demonstrated by Freddie Mac's remarkable
percentage returns earned on equity capital in recent years.
At Freddie Mac's current dividend rate ($1.60 per annum per share), Mutual
Savings' pre‐tax yield is only 5.35% on its $29.89 average cost per share. Post‐tax, the dividend yield is only 4.4%. But
Freddie Mac has a very creditable history of raising it, earnings and dividend rate, thus contributing to increases in the
market price of its stock. The market price increases because Freddie Mac's ‘preferred’ stock in substance is equivalent
to common stock. Here are figures for 1985‐1939:
Freddie Mac’s
Year‐End Return Earned
Earnings Dividends Market Price on all
Year Ended 12/31 per Share per Share per Share Average Equity
1985 ……………………………………. $2.98 $.53 $9.19 30.0%
1986 ……………………………………. 3.72 1.13 15.17 28.5
1987 ……………………………………. 4.53 1.10 12.13 28.2
1988 ……………………………………. 5.73 1.25 50.50 27.5
1989 ……………………………………. ? 1.60 ? ?
The above numbers are unusually good for a stock selling at only $50.00 per share at the end of 1988. We think the
probably cause of substandard investor response is some combination of (1) lack of familiarity with Freddie Mac among
investors and (2) fear that the federal officials who control Freddie Mac will mismanage it or not deal fairly with Freddie
Mac's private owners, perhaps under pressure from Congress.
There is, of course, ,one risk that Freddie Mac will ruin its remarkable business by fiduciary duties to new private
owners, or reducing credit standards, or making bets on the future course of interest rates, But we consider such
outcomes unlikely. The tendency to consider them likely rests largely in those who think ill of federal officials because of
the dramatic, multi‐billion‐dollar insolvency of FSLIC (the U.S. agency which insures depositor accounts in savings and
loan associations). This reaction is natural as it becomes ever more clear that the final FSLIC insolvency was augmented
by regulatory failure to intervene early to solve easily diagnosed problems which were getting worse at a rapid rate.
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But FSLIC and Freddie Mac are two separate entities, and the circumstances affecting the business of each are radically
different. As the world changed, the troubles of FSLIC had roughly the following history and causes:
(1) In its early decades, the savings and loan industry lived under a system ordained by legislation in the 1930s.
Interest rates paid by both banks and associations were fixed by law at low levels, but with (i) a deposit‐attracting
advantage of ¼% more per annum which could be paid by associations and (ii) tax advantages for associations,
compared with banks. The interest rate controls were created to dampen competition in an effort to prevent recurrence
of the widespread failure of deposit‐taking institutions which had followed the aggressive banking practices of the
1920s. In return for the cartel‐like advantages granted and federal deposit insurance, associations were required to
concentrate assets in home lending and to be conservative in risking losses from non‐repayment of loans. The standard
practice of associations was then to borrow short (by taking demand deposits) and to lend long (by making long‐term
mortgage loans at fixed rates). Associations lived on an approximate two‐percentage‐point ‘spread’ between the
mortgage interest rate and the mandated low interest rate on deposits.
(2) This system always had a built‐in risk that interest rates would generally and sharply rise, in which case the
government would be forced to raise interest rates on deposits in order to enable associations to hold deposits. Then
associations would be squeezed into losses because they were hooked by contract to fixed interest rates on old
mortgages. But associations accommodated this risk, during periods of low inflation and slowly rising, government‐fixed
interest rates on deposits, by continuously ‘growing their way’ out of profit‐margin trouble.
Associations simply ‘averaged up’ the rate of interest on the whole mortgage portfolio by making ever larger amounts of
new mortgage loans at higher interest rates. The necessary continuous growth, despite mandated low interest rates for
savers, was made possible, of course, by the ¼% per annum deposit‐attracting rate advantage possessed by associations.
The system contained much wise and constructive cynicism, akin to that of the country's founding fathers. The system's
creators wanted associations not to cause losses to FSLIC, the federal deposit‐insurer, while helping the citizenry by
favoring housing. So, knowing like Ben Franklin that ‘it is hard for an empty sack to stand upright,’ the creators simply
gave associations significant competitive and tax advantage that made it easy for executives to do well while doing right.
Also, because the creator, admired ‘cooperative,’ workers'‐self‐help models and, looking back at the excesses of the
1920s, feared losses from capitalistic ambition more than they feared inefficiency from a more socialized process, all
federally‐chartered and most state‐chartered associations were ‘mutual’ institutions. Such institutions are ‘owned’ by
depositors and are therefore not capable of making any shareholder rich. In the early decades, this system, relying on
carrot as well as stick, was, like the FHA, one of the most successful systems in U.S. history. It did a world of good at a
trifling cost.
(3) Naturally, the few state‐chartered, shareholder‐owned associations (including Mutual Savings, which was
"mutual" in name only) in due course became more aggressive than their "mutual" brethren and used their government‐
mandated competitive advantage to make their shareholders rich. This process was aided by their emphasizing high‐
yielding tract‐housing loans in the faster‐growing parts of the country during a long boom. And envy plus logic then
caused many ‘conversions’ of formerly ‘mutual’ associations to shareholder ownership, which, featuring different
incentives, increased managements’ proclivity to endure risk in the hope of above‐normal reward. The heavy‐risk‐taking‐
attitude finally spread throughout a large percentage of the savings and loan industry, including formerly conservative
‘mutual’ institutions that remained ‘mutual’ institutions.
(4) But, eventually, the tendencies of government to escalate currency debasement and of interest rates to rise
sharply with sharp inflation combined to reduce the prosperity of the savings and loan industry, now structured more to
produce extra profit when much went wrong. As interest rose, even associations holding only high‐grade, long‐term,
fixed‐rate mortgages suffered large losses. Most gamier associations became hopelessly insolvent.
“The present situation, with its many insolvent and almost‐insolvent institutions, is such a mess that further legislation
seems inevitable. We can predict neither the changes, nor whether the changes will make matters better or worse. But
we do have some opinions. These opinions are almost totally out of step with current thinking in academia, among
government officials, among banking executives and, most of all, among banking lobbyists. Despite this
unconventionality, our opinions are now given to Wesco shareholders because they may provide some insight into our
institutional nature and likely future action. We also hope, but only slightly, that the opinions, set forth below, will have
a wider, civic utility.
First, let us turn to banking, after which we will consider the savings and loan business.
The sum of all deposit‐insurance losses in banking will probably be much lower than the $200 billion or so recently
caused by savings and loan associations. But there are a lot of very sick banks, and deposit‐insurance losses are sure to
be large. Moreover, even if there had been no such losses, there would be much to regret in the nature of our modern
banks as they have increasingly emphasized lending for consumption (even lending at 20% for vacations in Tahiti) and
lending to financial promoters and real estate developers. We have come a long way from an ideal emphasizing the
banker's provision, to both big and small businesses, of what Pierre DuPont provided to General Motors. Plainly, we
have a two‐forked banking problem, with a questionable shift in priorities accompanying rising insolvencies.
Let us attempt to diagnose the causes of our problem. By and large, our problem did not come because banks couldn't
branch across state lines, sell insurance, or underwrite corporate securities. Instead, it came because banks "reached"
for higher yields on assets as they faced higher interest costs that came from (1) decontrol of interest rates paid by
insured institutions plus (2) pressure from new competitors, including money‐market funds possessing a large
competitive edge.
(1) kept its assets in liquid short‐term obligations of the U.S. government and other creditworthy entities;
(2) furnished efficient checkwriting privileges and wire transfer service to its depositors;
(3) kept its total operating costs under two‐tenths of 1% of deposits per annum as it avoided costs of maintaining branch
offices, deposit insurance, etc.;
(4) furnished no capital of its own as a cushion supporting promises to depositors; and
(5) paid very competitive rates on its interest‐bearing accounts, as a result of which it grew 27% in size.
This example demonstrates the raw competitive power of keeping things simple. Indeed, in this example all costs
combined have been controlled so as to be roughly equal to what the average local bank pays for federal deposit
insurance alone. We are not dealing with some minor competitive advantage. The new competition is a juggernaut.
How important has the new competitor become? Naturally, the competitor has taken a huge bite out of the market
formerly served by banks (and savings and loan associations) burdened by much higher costs. How could it be
otherwise? Here is a dramatic graph reprinted from what is surely among the best magazines in the world, England's The
Economist:
[GRAPH OMITTED: "From nowhere, Amounts outstanding, December, Source: Federal Reserve"]
The money‐market funds are, in substance, "non‐bank" banks, furnishing interest‐bearing savings and checking
accounts. And, by an odd stroke of good fortune, their light regulation by an overburdened SEC has turned out to be
more advantageous than no regulation at all. The rules of the SEC force investment largely confined to reasonably safe
and liquid categories. This has spawned simple operations with very low costs.
The simple, low‐cost(*), cream‐the‐market approach thus taken (or stumbled into) often works well in business. For
instance, look at (1) GEICO, a hugely successful auto insurer almost 50% owned by Wesco's parent corporation or (2)
various membership warehouse clubs, in the form invented by Sol Price, which are now clobbering retailing competitors
as they get total "markup" under 10%. And this approach, as would be expected, is working like gangbusters for the
money‐market funds, as you see in the graph from The Economist.
What were the effects on banks as these new and successful, low‐cost competitors took more and more of the market
while, at the same time, each bank's banking competitors could bid as they wished for funds, using the government's
credit? Well, naturally, almost every bank, being inherently saddled with much higher costs, and not wanting to go out
of business, tried to get higher contractual interest rates on its loans. And this caused greater emphasis on loans for
consumption and loans to financial promoters and real estate developers. Indeed, many of our most decisive bankers,
quite logically, stopped trying to make loans to their most creditworthy customers, accepting the disappearance of any
important linkage between our best banks and our best businesses. The banks had been forced into an entirely different
market niche (which already had some occupants): high‐interest‐rate lending.
We are not alone in our diagnosis. Here is an excerpt from a recent Wall Street Journal editorial: "When more efficient,
uninsured and less regulated financial institutions creamed off profitable lines of business, the [Bank of New England]
was left concentrated in commercial real estate. This artificially diverted money into Boston's building boom, which
inevitably became a bust."
(*) Total costs are low, even though they include fees containing a substantial profit element that are paid by the "non‐
bank" banks to the "non‐independent" independent managing companies employed in conformity with mutual fund
practice. While Lewis Carroll might have liked the consistency of the nomenclature just used, it is not clear that it befits a
banking system. "Pretending" under misleading labels is not a good idea in banks. All "pretending" habits tend to spread.
Granting the presence of perverse incentives, what are the operating mechanics that cause widespread bad loans
(where the higher interest rates do not adequately cover increased risk of loss) under our present system? After all, the
bad lending, while it has a surface plausibility to bankers under cost pressure, is, by definition, not rational, at least for
the lending banks and the wider civilization. How then does bad lending occur so often?
It occurs (partly) because there are predictable irrationalities among people as social animals. It is now pretty clear (in
experimental social psychology) that people on the horns of a dilemma, which is where our system has placed our
bankers, are extra likely to react unwisely to the example of other peoples' conduct, now widely called "social proof". So,
once some banker has apparently (but not really) solved his cost‐pressure problem by unwise lending, a considerable
amount of imitative "crowd folly", relying on the "social proof", is the natural consequence. Additional massive irrational
lending is caused by "reinforcement" of foolish behavior, caused by unwise accounting convention in a manner
discussed later in this letter. It is hard to be wise when the messages which drive you are wrong messages provided by a
mal‐designed system.
In chemistry, if you mix items that explode in combination, you always get in trouble until you learn not to allow the
mixture. So also, in the American banking system. To us, a lot of foolish, unproductive lending and many bank
insolvencies are the natural consequences, given existing American banking culture, of the combination of the following
two elements alone:
(1) virtually unlimited deposit insurance; and
(2) uncontrolled interest rates on insured deposits.
These two elements combine to create a Gresham's law effect, in which "bad lending tends to drive out good." Then, if
factor (3) below is added to an already unsound combination, we think deposit‐insurance troubles are sure to be further
expanded ‐‐ and not by a small amount:
Moreover, when the government starts suffering big deposit‐insurance losses, if it continuously responds (in a natural,
unthinking reaction) by raising deposit‐insurance prices, we think it creates a "runaway‐feedback" mode and makes its
problems worse. This happens because the government, by adding even more cost pressure on banks, increases the
cause of the troubles it is trying to cure. The price‐raising "cure" is the equivalent of trying to extinguish a fire with
kerosene.
Many eminent "experts" would not agree with our notions about systemic irresponsibility from combining (1) "free‐
market" pricing of interest rates with (2) government guarantees of payment. If many eminent "experts" are wrong, how
could this happen? Our explanation is that the "experts" are over‐charmed with an admirable, powerful, predictive
model, coming down from Adam Smith. Those discretionary interest rates on deposits have a "free‐market" image,
making it easy to conclude, automatically, that the discretionary rates, like other freemarket processes, must be good.
Indeed, they are appraised as remaining good even when combined with governmental deposit insurance, a radical non‐
free‐market element.
Such illogical thinking, displays the standard folly bedeviling the "expert" role in any soft science: one tends to use only
models from one's own segment of a discipline, ignoring or underweighing others. Furthermore, the more powerful and
useful is any model, the more error it tends to produce through overconfident misuse.
This brings to mind Ben Graham's paradoxical observation that good ideas cause more investment mischief than bad
ideas. He had it right. It is so easy for us all to push a really good idea to wretched excess, as in the case of the Florida
land bubble or the "nifty fifty" corporate stocks. Then mix in a little "social proof" (from other experts), and brains
(including ours) often turn to mush. It would be nice if great old models never tricked us, but, alas, "some dreams are
not to be." Even Einstein got tricked in his later years.
We may be right or wrong. But, if we are right, if there are deep, structural faults in the American banking system, it
follows that merely giving banks the right to branch across state lines, to sell insurance, or to enter investment banking
(or all of the above) is not going to end our troubles.
Instead, a good long‐term fix can come only after the government considers more extreme modifications in the system,
each of which has powerful, vocal opponents. What are the more extreme modifications to consider? We think the list
includes:
(1) greatly reducing deposit insurance;
(2) eliminating money‐market funds;
(3) bringing back some form of controls on interest paid on insured deposits;
(4) intensifying regulatory control of bank lending in an attempt to reduce loan losses;
(5) forcing more conservative accounting covering bank lending;
(6) forcing weak banks into other hands before the weak banks become insolvent; and
(7) forcing insolvent banks into competing local banks, or entirely out of business, instead of into strong, out‐of‐state
banks.
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Let us next attempt a brief discussion of the merits and/or political prospects of each of these seven government
options.
Option (1): greatly reducing deposit insurance:
To many people, remembering former banking panics, this option, adopted fully, seems like trying to solve the
overcrowding problem by bringing back cholera. Accordingly, proponents of this option typically would limit its effects
by (1) bringing back bank "runs" only for small banks (big banks, regardless of law, are "too big to fail" in all advanced
countries) and (2) bringing back deposit losses only to some rich depositors. Because voters don't like bank "runs" of any
size, and small banks don't like discrimination, it seems unlikely that reductions in deposit insurance are going to be
made on a scale that solves the structural defect problem. Conceivably, "brokered" deposits could be removed from
insurance coverage, in a move driven by legislative remembrance of many abuses involving stockbroker‐assisted
financing of despicable insured institutions. (Many stockbrokers could easily see that the insured certificates of deposit
they were paid to sell were issued by institutions managed by knaves and fools, presiding over piles of junk loans and
junk securities. The stockbrokers thus knew, or should have known, that their government was being robbed. To sell
certificates under such conditions was a lot like finding currency in a post office bag and deciding it was ethical to keep
it.)
Option (2): eliminating the money‐market funds:
This option is almost never discussed. This seems peculiar. The money‐market funds came into being without public
policy input when some clever person combined (1) mutual fund status under the S.E.C. with (2) purchase, under
subcontract, of services from a bank. What was created was, in essence, a virtually unregulated, uninsured bank
furnishing interest‐bearing savings and checking accounts. The creation of such entities would probably not have been
authorized if new legislation had been necessary. Where else do we have virtually identical regulated and unregulated
entities operating on the same scale, side by side? If new legislation had been needed, the following questions might
have been raised:
(1) What do money‐market funds do for "community" lending, lifetime services to the elderly, etc.?
(2) Are they fair to existing institutions?
(3) Won't the new "non‐bank" banks make it harder for the Federal Reserve System to render constructive economic
service?
(4) Since the public is already on the hook as guarantor of solvency of existing institutions, is it wise for the guarantor to
risk losses from allowing uninsured, cream‐the‐market, more efficient operators to add to the competition? (This
question would not be hard to answer in a private setting. If you were guarantor of all obligations of your brother‐in‐
law's hamburger joint, you would consider it very foolish to allow McDonald's to commence operations by his side when
you possessed the ability to prevent it.)
(5) Considering all of the above (and more), are the money‐market funds in the long‐term interest of the soundness and
service of the total banking system?
These questions are still good questions. But possession is strength under law. The money‐market genie is now out of
the bottle. And, considering his size, it would be hard to put him back. The prospects of rebottling are plainly remote.
Option (3): bringing back some form of controls on interest paid on insured deposits:
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This option, too, is now seldom discussed. Again, this seems peculiar. It is among the first things you or I would consider
if we had to guarantee all obligations of that hamburger joint owned by a brother‐in‐law. We would no more guarantee
an 11% obligation for him, when we could easily borrow at 8%, than we would burn currency in the fireplace. In fact, we
would suspect dishonorable "monkey business" if an 11% transaction occurred.
One reason for present lack of legislative interest in interest‐rate controls lies in the knowledge that a former version of
such controls constricted housing credit when interest rates rose to high levels. No one now seems interested in trying
to develop new controls, more flexible in form and practice that would avoid former defects. Nor is anyone much
interested in the success the Japanese (or the United States) had during a long period of control of interest rates paid by
banks. The interest‐rate‐control option, at the moment, seems dead.
Option (4): intensifying regulatory control of bank lending in an attempt to reduce loan losses:
This option is already being exercised ‐‐ erratically ‐‐ with effects both good and bad. It certainly has successful
counterparts in non‐banking businesses. For instance, take McDonald's franchised restaurants. If you want to use the
McDonald's authenticating name and arches on your restaurant, you have to operate in a very limited, foolproof way.
Moreover, the McDonald's approach once worked in banking. When deposit insurance first came in, and long thereafter,
most insured banks operated in simple, sound fashion, often through ill‐paid employees. But, based on all recent
precedents, the government won't now act like McDonald's, or itself in a former era. (If it wished to do that, it might
now give deposit insurance to all the simple, sound money‐market funds, lending to big business through purchases of
commercial paper, and take deposit insurance away from all the banks and savings and loan associations) Government,
instead, will probably take the more limited approach of concurrently: (1) leaving banking over‐stressed by competition,
(2) leaving banking very complicated, (3) trying to prevent problems by writing massive, hard‐to‐understand regulations
that create more work for lawyers, and then (4) monitoring bank operations through overburdened civil servants. These
limited remedies may be better than nothing, but their prospects for causing a real banking fix seem poor. It is almost a
general rule of American life that, when incentives are all wrong, controls (even criminal‐law controls) can't fix our
troubles. We can expect limited good effects from Option 4 and the continuation of important, basic problems.
Option (5): forcing more conservative accounting covering bank lending:
Bank accounting is a hot current topic, but conservatism is not the goal. Everyone is wondering how much to delay loan
write‐offs, when loans go sour, so as not to over‐correct weak banks. We are not going to enter the lists on that
problem.
The almost‐never‐discussed problem that interests us is that presented by newly made loans, bearing high interest
rates, that under current bank accounting tend to be treated as "born good." The result is that all interest accrued, and
sometimes some up‐front fees, are treated as fully earned, even though the final outcome of the whole loan transaction
is far from clear. To us, this is counterproductive accounting, even though we use it ourselves when pushed by
convention.
We think current accounting for many high‐interest‐rate loans has terrible consequences in the banking system. In
essence, it "front ends" into reported income revenues that would have been deferred until much later, after risky bets
were more clearly won, if more conservative accounting had been employed. This practice turns many a banker into a
human version of one of B.F. Skinner's pigeons, since he is "reinforced" into continuing and expanding bad lending
through the pleasure of seeing good figures in the short term. The good figures substitute nicely in the mind for
nonexistent underlying institutional good, partly through the process, originally demonstrated by Pavlov, wherein we
respond to a mere association because it has usually portended a reality that would make the response correct.
We think acculturated corporate nature, in American financial institutions, simply cannot, on average, handle
temptations implicit in this sort of accounting. Indeed, the succumbing to the temptations, in a manner not consistent
with long‐term institutional interest, often occurs through a subconscious process. The subconscious process includes
bad effects from both (1) "social proof", and (2) a "reality‐denial" mode that creates bias in people stimulated, honored
and paid in proportion to institutional size. Under our present system a Columbia Savings, and many less obscene
versions of its model, are almost inevitable.
Of course, a large minority, even a majority, of bankers will remain sound, despite the temptations. But this outcome is
not sufficient to protect the deposit insurer from unacceptable ultimate losses. In due course, given present conditions,
the deposit insurer will suffer from what some wag called the problem of there being so many more banks than bankers.
What should now be considered are mandatory accounting changes, including changes in accounting to shareholders,
designed to force "back‐ending" into reported income of revenue from various types of gamy lending (and letters of
credit), in lieu of allowing "front‐ending" to continue. The changes would cause American bank accounting, by fiat, to
imitate what some of the best European bankers have long done by choice. Eventually, credibility might be returned to
banks' audited financial statements, now often regarded as fairy tales.
Despite the obvious (to us) accounting defects that bedevil our system, we don't think any wise and important
accounting changes will be made. Typical bank reaction to such proposals is, at best, that of the man who asked, well
before his ultimate sainthhood: "God, give me chastity, but not yet." Also, time periods for accomplishing even the
simplest, "no‐brainer" changes in accounting convention tend to stretch into years.
Option (6): forcing weak banks into other hands before the weak banks become insolvent:
This option is also a hot topic. Usual governmental practice at the moment is to force merger only when all shareholders'
equity is gone and the deposit insurer has a large loss. This is "bonkers," due process gone mad. It seems entirely logical
now to commence the forced merger or closure of many of the nation's 13,000 banks and to do it in many cases before
a weak bank is insolvent. Because the need is so obvious, laws and customs may possibly change to cause more of this to
happen. And interstate branching may be allowed in order to enlarge the number of potential bank buyers.
While these steps seem helpful, they won't fix the problem of deep structural fault in the system ‐‐ at least within any
acceptable time period. Look at the present carnage in airlines. Even when we are down to fewer than a dozen
significant operators, messy airline failures continue. If we wait for an airline‐style solution in banking, we will have to
endure years, maybe decades, of suffering.
Option (7): forcing insolvent banks into competing local banks, or entirely out of business, instead of into strong out‐of‐
state banks:
According to Martin Mayer, writing recently in The Wall Street Journal, the FDIC now typically deals with an insolvent
bank by choosing between two options:
(2) first, replacing all the insolvent bank's bad assets with good assets, and, second, selling it to some skillfull out‐of‐state
buyer, after which process the new bank can help clobber the remaining also‐weak‐and‐also‐insured banks in the area.
Mayer believes it was "insane" for the FDIC to do as it did in many instances, which was to select option (2). Accordingly
to Mayer, the FDIC thus arranged that "overcapacity was rigorously maintained." Mayer raises an interesting question.
Coming back to the analogy earlier used, if you or I were really unlucky and were guarantor for seven local brothers‐in‐
law, each with a troubled hamburger joint, what would we do when the first one went broke? We would surely reject
the idea, of, first, fixing up the defunct joint so that it was better than the others, and, second, guaranteeing the
obligations of a new and more skillfull out‐of‐state operator who wanted to enter the market by taking over the
improved facility.
Mayer is right insofar as he implies that there are too many banks and bank branches, just as there were formerly too
many filing stations, sometimes three or four at an intersection. The departed filling stations "never will be missed," so
perhaps the FDIC should "have a little list," like the bloodthirsty figure in the Mikado.
Beyond that, we are not certain that Mayer's conclusions will always prove right. The basic banking system is right out of
Alice in Wonderland, so maybe it's like non‐Euclidean geometry and only Alice‐in‐Wonderland‐type cures really fit in.
After all, the scenario which troubles Mayer has a perverse beauty, at least to a government. The bank failures cascade,
on and on, refreshed by new governmental acts, so that the FDIC can be saving a large part of the banking system each
year for a long time.
And we must admit that, if we were the FDIC and were thus forced to participate heavily in our present banking system,
like it or not, we would occasionally do what Mayer finds objectionable, in those rare cases when we saw a chance for
greatly improving banking culture in some community. We would, for instance, occasionally sell a sick bank to John
McCoy (of Banc One), even when this brought a new bank to a state full of troubled banks, if every in‐state bank seemed
too weak or foolish to be selected as an alternative buyer. We would figure that (1) some subsequent insolvencies of
other local banks were in our long‐term interest, (2) we were supporting a sound model, and (3) eventually, as the
example spread, our troubles as deposit‐insurer of a silly system would be reduced. We would then have a pleasant lull
before the silly system caused new troubles to pop up, maybe even under McCoy's successors at Banc One.
While Mayer's subject is interesting, we probably don't have to worry much about worldly consequences. Outside
science, it is amazing how little impact there can be from a powerful idea, published in a prominent place (such as the
Journal). Everyone's experience is that you teach only what a reader almost knows, and that seldom.
If our foregoing comments about systemic irresponsibility and chances for a rational cure are right, or substantially right,
it is hard to be optimistic about coming legislative "reform" of banking. Perhaps the best we can hope for is Menckenian
reform where old error is replaced, not by truth, but by new error. It is also possible that we will see exactly the same
old systemic error repeated, but bearing bells and whistles in the form of new bank powers. This outcome is roughly
what is recommended by the banking lobby, which has evidently learned nothing from the history of the savings and
loan laws.
Let us next turn to the savings and loan field. Here, faced with a more disastrous mess, the legislators were so outraged
that they attempted what they thought was extreme reform: FIRREA. This legislation took a "back‐to‐basics" approach
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and has since been interpreted by regulators who seem to believe, understandably, that they must act as though they
were tough "bouncers," given the job of bringing order to a drunken brawl (a description that understates what the
regulators faced).
This regulatory approach is now squeezing out (1) much folly, and (2) some non‐folly needed to keep institutions
healthy. Most executives we know at other associations concentrate only on the negative side and are outraged at
instances of regulatory elimination of non‐folly.
They tend to construe present FIRREA enforcement as the equivalent of Mark Twain's prescription for preventing
children's stuttering: "Remove the lower jaw."
Our view is different, even though we are much harmed by FIRREA. We think the system needed new rules, interpreted
by tough "bouncers," and that the "bouncing" process, done with sufficient vigor, inevitably involves some lumps for the
undeserving. There may even be some deaths from "friendly fire." Nonetheless, the process must go on.
What concerns us is the most important question of all. Did our legislators, through FIRREA, even with their "never
again" mindset, fix the most important systemic error in the savings and loan industry? We think not.
As the dust has cleared, the best savings and loan associations are clearly worse businesses than the best banks (which
themselves have plenty of troubles). This conclusion is supported by both (1) stock market prices and (2) action of
governmental liquidators in response to market conditions. Stocks of the best associations now sell at much lower
price/book‐value ratios than stocks of the best banks. And governmental liquidators are constantly selling association
branches to banks while almost never selling bank branches to associations. FIRREA has not made associations, on
average, as desirable for owners as banks. The two institutional types remain different and unequal, while quite
comparable in essential residual function, now that Fannie Mae and Freddie Mac exist to perform a lion's share of the
finance function supporting housing.
The savings and loan system, in a modern era in which the government is always a large net borrower, still tries to use
short‐term savings accounts to finance long‐term housing lending. This is, in essence, a very bad idea, violating the logic
of an elementary prescription: "If a thing isn't worth doing at all, it isn't worth doing well."
To be sure, some fix of systemic maturity‐mismatch risk is now attempted, through encouragement of variable‐rate
loans. But the variable‐rate loans typically "cap" interest rate escalation at a few percentage points, which must be done
for moderate‐income borrowers to prevent both (1) unacceptable hardship and (2) sudden falls in non‐housing
spending. This compromise is like having building codes in California protect only up to 5 points on the Richter
earthquake scale. The compromise is almost sure to bring back, probably at a remote date, another horrible collapse of
the savings and loan system.
As we say this, we are not critical of the best California associations, such as Home Savings, Great Western Savings and
World Savings. These people have logical operations bearing one big systemic risk that cannot be avoided by permanent
players. If we had to play forever under current rules, we would try to imitate them. But we would have a big
disadvantage: "we don't know how to get there from here," because they have such momentum in systems, particularly
in loan origination. Fortunately, no one is sentencing us to play forever in a game with a systemic risk we don't like and
in which we are at a big disadvantage. Instead, we have temporized with a different, acceptable "there" in a form
combining (1) a big holding of Freddie Mac, with (2) financial flexibility to adapt as we choose to new conditions.
(1) Because we have a help‐housing bias, we would keep government‐assisted housing finance for low‐to‐moderate‐
income people. We would do this by forcing pension funds to maintain a significant portion of their assets in housing‐
related assets in the form of Freddie Mac and Fannie Mae mortgage‐backed securities representing interests in fixed‐
rate mortgages. This requirement strikes us as fair, given the tax exemption possessed by the pension funds. And the
pension funds are the logical suppliers of housing finance because they by nature have (a) massive assets, and (b)
liabilities with maturities matching homeowners' needs for long‐term, fixed‐rate credit. Our reason for specifying
Freddie Mac and Fannie Mae securities as a conduit for housing assistance is our belief that these entities would assure
loan quality better and more cheaply than would any government bureaucracy. In quantitative terms, we would leave
housing finance more assisted than it is now, particularly for first‐time home buyers who have won their spurs.
(2) We would merge the banks, money‐market funds and savings and loan associations into one banking system, with
insured deposits. The new banking system would be separate from both (a) industry and (b) the part of investment
banking likely to disappoint investors. It would have the following characteristics:
(i) There would be one federal regulator that also served as deposit‐insurer, in lieu of the truly crazy, inefficient
Balkanization of our present regulatory and insurance apparatus. (Eliminating Balkanization would do more than reduce
costs, delays, confusion and competition in laxity. There is a system‐design advantage in making the deposit‐insurance
loss payer and the bank‐controlling loss preventer one and the same. The system then becomes more "responsible" in
the Frankelian sense, requiring that systems be organized, to the extent feasible, so that decision‐makers, not others,
bear consequences of decisions.)
(ii) There would be no bank‐holding companies, but the new banks would have a monopoly in offering check‐writing
privileges, debit cards and credit cards, except for credit cards offered on behalf of a single vendor. (The new law would
permit tax‐free spinoffs of existing banks, newly organized banks, and non‐banks to help existing corporations come into
compliance. Spun‐off non‐banks could include specialists in high‐interest‐rate lending to businesses.)
(iii) Flexible, government‐regulatory‐run controls would set a ceiling on interest that could be paid on bank accounts. (If
you are going to guarantee the credit of an entire industry, there is a limit to the competition that is desirable. Besides,
many banks will behave badly in their important function when they are under the extreme cost pressure, not normal in
business, that occurs when one's competitors are all financed without limit by the government, through deposit
insurance.)
(iv) All capital satisfying regulatory requirements would have to be in the form of stock, either common or preferred,
except for "grandfathered" debt. (v) Stockbrokers (and others) could buy for customers all the insured certificates of
deposit they wished, but they could not, in exchange, receive commissions or other advantages from the banks issuing
the certificates. ("Abuse it and lose it," is our motto.)
(vi) The federal regulator would have clear power, exercisable without an excess of "due process" or "second guessing,"
to close out or force sale or merger of weak banks well before they became insolvent. Banks could ordinarily avoid such
calamities, after a first warning, by raising new capital through "rights" issues, or in some other way. (There is nothing
novel in such a system. Close‐out orders, issued well short of insolvency, have long been standard practice under
regulatory practice governing securities and currency traders.)
Income tax would be deferred on the deferred revenues required by this new conservatism in accounting. (It is a terrible
mistake, a novice's mistake to try to control important behavior with an all‐stick‐and‐no‐carrot approach. Therefore, the
carrot‐providing tax deferment would be wise.)
(viii) There would be no 2,000‐page mass of government regulations. But there would be some rule for business and real
estate loans such as: loan as you wish, but no new loans count as bank assets unless supported by substantial equity, a
stipulation that would create a large margin of safety.
(ix) Deposit‐insurance rates would promptly be lowered from present levels, but under a new system so tough that risk
of loss to the deposit insurer would be reduced, even after taking into account the effects from lower rates.
(x) The whole system would be designed to have the best businesses small and large, again become intimate with the
best banks. The banks would again concentrate on being (1) relatively low‐interest‐rate lenders to high‐quality
businesses, and (2) lenders to consumers who are not "fiscaholics". High‐interest‐rate lending, to people with weak
credit, would be forced into non‐banking systems retaining no common‐management or common‐premises links with
banking.
There is, no doubt, much wrong with our recommendations. But there is also much wrong with our present system,
which has helped cause a questionable shift in banking priorities and a big mess, with every prospect for more of the
same. In contrast, there is little in history to suggest that our recommendations would be as bad. And even if the new
system had serious faults, it would probably be a better way station on the path to a banking system befitting a great
country.
In recent years the government has tried to maintain a useful, relatively trouble‐free banking system by making the
banking business bear increased competitive burdens, and, when the system has responded by working worse, the
government has increased both the burdens and the permitted scope of banks' activities. After such revisions the
system has again worked worse. Surely it is time to reverse our approach. We should act like the artillery officer who,
when he has put one shell over the target, next tries to put a shell clearly short, expecting to get the desired result in
due course.
Some people might worry that banking would get too profitable under the system we recommend. To this worry there
are three answers:
(1) The prospect of better profits, with less risk, would tend to (a) reduce governmental losses as many billions of dollars
worth of foreclosed thrift and bank assets are sold off by the FDIC, and (b) enable the government, through tough capital
standards, to cause eager private augmentation of banking capital by shareholders, precisely what is needed.
(2) Based on past experience, the nation's bankers (including us) may, on average, be up to the challenge of not earning
excessive profits, even in an easier system.
(3) If excessive profits came, they could easily be reduced in due course by a new governmental tax, charge or burden.
We now quitclaim legislative reform to those who make it their business. We also assure Wesco shareholders that this
reform‐minded section of our letter to shareholders is an unlikely‐to‐be‐repeated aberration. It was caused, in part, by a
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combination of (1) overwhelming disgust with the present scene, and (2) long association by the writer with an eccentric
fellow who may not share all the notions herein expressed but who encourages this kind of writing.
This eccentric, who heads Berkshire Hathaway, Wesco's parent corporation, believes for some reason that accumulated
wealth should never be spent on oneself or one's family, but instead should merely serve, before it is given to charity, as
an example of a certain approach to life and as a didactic platform. These uses, plus use in building the platform higher,
are considered the only honorable ones not only during life but also after death. Shareholders who continue in such
peculiar company are hereby warned by our example in writing this section: some of the eccentricities of this fellow are
contagious, at least if association is long continued.”
- WSC 1990 Letter
Insurance
“Insurance companies offer standardized policies which can be copied by anyone. Their only products are promises. It
is not difficult to be licensed, and rates are an open book. There are no important advantages from trademarks, patents,
location, corporate longevity, raw material sources, etc., and very little consumer differentiation to produce insulation
from competition. It is commonplace, in corporate annual reports, to stress the difference that people make.
Sometimes this is true and sometimes it isn’t. But there is no question that the nature of the insurance business
magnifies the effect which individual managers have on company performance. We are very fortunate to have the
group of managers that are associated with us.”
- BRK 1977 Letter
“GEICO was designed to be the low‐cost operation in an enormous marketplace (auto insurance) populated largely by
companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its
customers while earning unusual returns for itself.
“The insurance industry’s underwriting picture continues to unfold about as we anticipated, with the combined ratio
(see definition on page 37) rising from 100.6 in 1979 to an estimated 103.5 in 1980. It is virtually certain that this trend
will continue and that industry underwriting losses will mount, significantly and progressively, in 1981 and 1982. To
understand why, we recommend that you read the excellent analysis of property‐casualty competitive dynamics done
by Barbara Stewart of Chubb Corp. in an October 1980 paper. (Chubb’s annual report consistently presents the most
insightful, candid and well‐written discussion of industry conditions; you should get on the company’s mailing list.) Mrs.
Stewart’s analysis may not be cheerful, but we think it is very likely to be accurate.
And, unfortunately, a largely unreported but particularly pernicious problem may well prolong and intensify the coming
industry agony. It is not only likely to keep many insurers scrambling for business when underwriting losses hit record
levels ‐ it is likely to cause them at such a time to redouble their efforts.
This problem arises from the decline in bond prices and the insurance accounting convention that allows companies to
carry bonds at amortized cost, regardless of market value. Many insurers own long‐term bonds that, at amortized cost,
amount to two to three times net worth. If the level is three times, of course, a one‐third shrink from cost in bond prices
‐ if it were to be recognized on the books ‐ would wipe out net worth. And shrink they have. Some of the largest and
best known property‐casualty companies currently find themselves with nominal, or even negative, net worth when
bond holdings are valued at market.
Of course their bonds could rise in price, thereby partially, or conceivably even fully, restoring the integrity of stated net
worth. Or they could fall further. (We believe that short‐term forecasts of stock or bond prices are useless. The
forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.)
It might strike some as strange that an insurance company’s survival is threatened when its stock portfolio falls
sufficiently in price to reduce net worth significantly, but that an even greater decline in bond prices produces no
reaction at all. The industry would respond by pointing out that, no matter what the current price, the bonds will be
paid in full at maturity, thereby eventually eliminating any interim price decline. It may take twenty, thirty, or even forty
years, this argument says, but, as long as the bonds don’t have to be sold, in the end they’ll all be worth face value. Of
course, if they are sold even if they are replaced with similar bonds offering better relative value ‐ the loss must be
booked immediately.
And, just as promptly, published net worth must be adjusted downward by the amount of the loss.
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Under such circumstances, a great many investment options disappear, perhaps for decades. For example, when large
underwriting losses are in prospect, it may make excellent business logic for some insurers to shift from tax‐exempt
bonds into taxable bonds. Unwillingness to recognize major bond losses may be the sole factor that prevents such a
sensible move.
But the full implications flowing from massive unrealized bond losses are far more serious than just the immobilization
of investment intellect. For the source of funds to purchase and hold those bonds is a pool of money derived from
policyholders and claimants (with changing faces) ‐ money which, in effect, is temporarily on deposit with the insurer.
As long as this pool retains its size, no bonds must be sold. If the pool of funds shrinks ‐ which it will if the volume of
business declines significantly ‐ assets must be sold to pay off the liabilities. And if those assets consist of bonds with big
unrealized losses, such losses will rapidly become realized, decimating net worth in the process.
Thus, an insurance company with a bond market value shrinkage approaching stated net worth (of which there are now
many) and also faced with inadequate rate levels that are sure to deteriorate further has two options. One option for
management is to tell the underwriters to keep pricing according to the exposure involved ‐ “be sure to get a dollar of
premium for every dollar of expense cost plus expectable loss cost”.
The consequences of this directive are predictable: (a) with most business both price sensitive and renewable annually,
many policies presently on the books will be lost to competitors in rather short order; (b) as premium volume shrinks
significantly, there will be a lagged but corresponding decrease in liabilities (unearned premiums and claims payable); (c)
assets (bonds) must be sold to match the decrease in liabilities; and (d) the formerly unrecognized disappearance of net
worth will become partially recognized (depending upon the extent of such sales) in the insurer’s published financial
statements.
Variations of this depressing sequence involve a smaller penalty to stated net worth. The reaction of some companies at
(c) would be to sell either stocks that are already carried at market values or recently purchased bonds involving less
severe losses. This ostrich‐like behavior ‐ selling the better assets and keeping the biggest losers ‐ while less painful in
the short term, is unlikely to be a winner in the long term.
The second option is much simpler: just keep writing business regardless of rate levels and whopping prospective
underwriting losses, thereby maintaining the present levels of premiums, assets and liabilities ‐ and then pray for a
better day, either for underwriting or for bond prices. There is much criticism in the trade press of “cash flow”
underwriting; i.e., writing business regardless of prospective underwriting losses in order to obtain funds to invest at
current high interest rates. This second option might properly be termed “asset maintenance” underwriting ‐ the
acceptance of terrible business just to keep the assets you now have.
Of course you know which option will be selected. And it also is clear that as long as many large insurers feel compelled
to choose that second option, there will be no better day for underwriting. For if much of the industry feels it must
maintain premium volume levels regardless of price adequacy, all insurers will have to come close to meeting those
prices. Right behind having financial problems yourself, the next worst plight is to have a large group of competitors
with financial problems that they can defer by a “sell‐at‐any‐price” policy.
We mentioned earlier that companies that were unwilling ‐ for any of a number of reasons, including public reaction,
institutional pride, or protection of stated net worth ‐ to sell bonds at price levels forcing recognition of major losses
might find themselves frozen in investment posture for a decade or longer. But, as noted, that’s only half of the
problem.
Life Insurance
“We have no particular bias against the life insurance business; in fact, we’re in it through General Re. The problem with
it is that it’s not terribly profitable, and you wind up basically managing equities for other people [so there is a sum
certain at death]. We don’t want to wear two hats, just one for Berkshire Hathaway. We want to put our best equity
ideas into Berkshire Hathaway and it wouldn’t be fair to other investor/policy holders out of the picture.”
- Buffett, 1999 BRK Meeting
Money Management
“…you can make way more money in money mgmt than insurance business. There are few businesses as good as money
management. Average returns in insurance property and casualty have been pretty pathetic. Once you have enough
money you stop accepting compensation and just manage money ‐‐ it is more manly. At least 95% of the insurance
businesses in the world are worse than ours.”
- Munger, 2008 WSC Meeting
Portfolio Management
“Management’s objective is to achieve a return on capital over the long term which averages somewhat higher than that
of American industry generally – while utilizing sound accounting and debt policies.”
- BRK 1973 Letter
“You will notice that our major equity holdings are relatively few. We select such investments on a long‐term basis,
weighing the same factors as would be involved in the purchase of 100% of an operating business: (1) favorable long‐
term economic characteristics; (2) competent and honest management; (3) purchase price attractive when measured
against a yardstick of value to a private owner; and (4) an industry with which we are familiar and whose long‐term
business characteristics we feel competent to judge. It is difficult to find investments meeting such a test, and that is one
reason for our concentration of holdings. We simply can’t find one hundred different securities that conform to our
investment requirements. However, we feel quite comfortable concentrating our holdings in the much smaller number
that we do identify as attractive.”
- BRK 1976 Letter
“Both our operating and investment experience cause us to conclude that “turnarounds” seldom turn, and that the
same energies and talent are much better employed in a good business purchased at a fair price than in a poor business
purchased at a bargain price. Although a mistake, the Waumbec acquisition has not been a disaster. Certain portions of
the operation are proving to be valuable additions to our decorator line (our strongest franchise) at New Bedford, and
it’s possible that we may be able to run profitably on a considerably reduced scale at Manchester. However, our original
rationale did not prove out.”
- BRK 1979 Letter
“One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as “marketability” and
“liquidity”, sing the praises of companies with high share
turnover (those who cannot fill your pocket will confidently fill your ear). But investors should understand that what is
good for the croupier is not good for the customer. A hyperactive stock market is the pickpocket of enterprise.
For example, consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of
100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on
low‐priced stocks) and if the stock trades at book value, the owners of our hypothetical company will pay, in aggregate,
2% of the company’s net worth annually for the privilege of transferring ownership.
This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through
the “frictional” cost of transfer. (And this calculation does not count option trading, which would increase frictional costs
still further.)
All that makes for a rather expensive game of musical chairs. Can you imagine the agonized cry that would arise if a
governmental unit were to impose a new 16 2/3% tax on earnings of corporations or investors? By market activity,
investors can impose upon themselves the equivalent of such a tax.”
- BRK 1983 Letter