Berkshire Hathaway Letters to Shareholders, 2016
Berkshire Hathaway Letters to Shareholders, 2016

Berkshire Hathaway Letters to Shareholders, 2016

Our investment in the insurance companies reflects a first major step in our efforts to achieve a more diversified base of earning power. (Location 323)

Our present liquid resources held in readily marketable common stocks are available for either acquisition of new businesses or for application toward greater profit opportunities in our present operations. (Location 330)

we will not hesitate to borrow money to take advantage of attractive opportunities. (Location 332)

operating earnings in 1971, excluding capital gains, amounted to more than 14% of beginning shareholders’ equity. (Location 440)

redeployment of capital inaugurated five years ago. It will continue to be the objective of management to improve return on total capitalization (long term debt plus equity), as well as the return on equity capital. (Location 442)

Our objective is a conservatively financed and highly liquid business—possessing extra margins of balance sheet strength consistent with the fiduciary obligations inherent in the banking and insurance industries—which (Location 876)

(1) favorable long-term economic characteristics; (2) competent and honest management; (3) purchase price attractive when measured against the 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. (Location 954)

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.  In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure. (Location 1446)

We have achieved this result while utilizing a low amount of leverage (both financial leverage measured by debt to equity, (Location 1461)

Year after year, he produces very large earnings relative to capital employed—realized in cash and not in increased receivables and inventories as in many other retail businesses—in a segment of the market with little growth and unexciting demographics. (Location 1584)

In some businesses—a network TV station, for example—it is virtually impossible to avoid earning extraordinary returns on tangible capital employed in the business. (Location 1589)

improve but return on equity to decrease. (Location 1795)

but return on beginning equity capital (with securities valued at cost) fell to 17.8% from 18.6%. (Location 1811)

For capital to be truly indexed, return on equity must rise, i.e., business earnings consistently must increase in proportion to the increase in the price level without any need for the business to add to capital—including working capital—employed.  (Increased earnings produced by increased investment don’t count.) Only a few businesses come close to exhibiting this ability.  And Berkshire Hathaway isn’t one of them. (Location 1913)

Companies that have made extensive commitments to long-term bonds may have lost, for a considerable period of time, not only many of their investment options, but many of their underwriting options as well. (Location 2166)

The magnetic lure of such cash-generating characteristics, currently enhanced by the presence of high interest rates, is transforming the reinsurance market into “amateur night”. (Location 2185)

Results, with investment income included, have been reasonably profitable.  We will retain an active reinsurance presence but, for the foreseeable future, we expect no premium growth from this activity. (Location 2189)

Rather, we borrowed because we think that, over a period far shorter than the life of the loan, we will have many opportunities to put the money to good use. (Location 2228)

Our acquisition preferences run toward businesses that generate cash, not those that consume it. (Location 2231)

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. (Location 2231)

You learn a great deal about a person when you purchase a business from him and he then stays on to run it as an employee rather than as an owner. (Location 2240)

At the outset of negotiations, he laid all negative factors face up on the table; on the other hand, for years after the transaction was completed he would tell me periodically of some previously undiscussed items of value that had come with our purchase. (Location 2245)

(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. (Location 2299)

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. (Location 2328)

What makes sense for the bondholder makes sense for the shareholder.  Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. (Location 2409)

To understand the change, we need to look at some major factors that affect levels of corporate profitability generally. Businesses in industries with both substantial over-capacity and a “commodity” product (undifferentiated in any customer-important way by factors such as performance, appearance, service support, etc.) are prime candidates for profit troubles. (Location 2966)

there is more than ample capacity, and the buyer cares little about whose product or distribution services he uses, industry economics are almost certain to be unexciting. (Location 2973)

disaster—the insurance industry operates under the competitive sword of substantial overcapacity. (Location 2990)

Managers and directors might sharpen their thinking by asking themselves if they would sell 100% of their business on the same basis they are being asked to sell part of (Location 3105)

We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely. (Location 3189)

And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (Location 3197)

Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in it. (Location 3200)

During 1983 our book value increased from $737.43 per share to $975.83 per share, or by 32%. (Location 3240)

We never take the one-year figure very seriously. (Location 3240)

Instead, we recommend not less than a five-year test as a rough yardstick of economic performance. (Location 3242)

We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value—the measurement that really counts. (Location 3247)

Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out. (Location 3251)

My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission. (Location 3268)

That problem concerns costs, except those for raw materials. We have enjoyed a break on raw material costs in recent years though so, of course, have our competitors. (Location 3492)

The poundage volume in our retail stores has been virtually unchanged each year for the past four, despite small increases every year in the number of shops (and in distribution expense as well). (Location 3547)

For example, consider a typical company earning, say, 12% on equity. (Location 3659)

But calculations of intrinsic business value are subjective. In our case, book value serves as a useful, although somewhat understated, proxy. In my judgment, intrinsic business value and book value increased during 1984 at about the same rate. (Location 3828)

Once dominant, the newspaper itself, not the marketplace, determines just how good or how bad the paper will be. Good or bad, it will prosper. (Location 4176)

In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) might command a price of $250—$300 million (or sometimes far more). For a business we understand well and strongly like, we will gladly pay that much. (Location 4358)

But it is double the price we paid to realize the same earnings from WPPSS bonds. (Location 4360)

It should be realized, however, that the great majority of operating businesses have a limited upside potential also unless more capital is continuously invested in them. That is so because most businesses are unable to significantly improve their average returns on equity—even under inflationary conditions, though these were once thought to automatically raise returns. (Let’s push our bond-as-a-business example one notch further: if you elect to “retain” the annual earnings of a 12% bond by using the proceeds from coupons to buy more bonds, earnings of that bond “business” will grow at a rate comparable to that of most operating businesses that similarly reinvest all earnings. In the first instance, a 30-year, zero-coupon, 12% bond purchased today for $10 million will be worth $300 million in 2015. In the second, a $10 million business that regularly earns 12% on equity and retains all earnings to grow, will also end up with $300 million of capital in 2015. Both the business and the bond will earn over $32 million in the final year.) Our approach to bond investment—treating it as an (Location 4364)

In many businesses particularly those that have high asset/profit ratios—inflation causes some or all of the reported earnings to become ersatz. (Location 4425)

No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused. (Location 4429)

This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors. (Location 4443)

We expect to continue to diversify while also supporting the growth of current operations though, as we’ve pointed out, our returns from these efforts will surely be below our historical returns. (Location 4499)

Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks. (Location 4779)

is—you (Location 4799)

You must first make sure that earnings were not severely depressed in the base year. (Location 4800)

If they were instead substantial in relation to capital employed, (Location 4800)

an even more important point must be examined: (Location 4801)

how much additional capital was required to produce the additional earnings? (Location 4801)

The average American business has required about $5 of additional capital to generate an additional $1 of annual pre-tax earnings. (Location 4808)

When returns on capital are ordinary, an earn-more-by-putting-up-more record is no great managerial achievement. (Location 4810)

Yet, retirement announcements regularly sing the praises of CEOs who have, say, quadrupled earnings of their widget company during their reign—with no one examining whether this gain was attributable simply to many years of retained earnings and the workings of compound interest. (Location 4812)

the widget company consistently earned a superior return on capital throughout the period, or if capital employed only doubled during the CEO’s reign, the praise for him may be well deserved. (Location 4814)

And, finally, your “dividends” would have increased commensurately, rising regularly from $2,000 in the first year to $3,378 in the tenth (Location 4825)

expense—just from having held on to most of your earnings. If he were both Machiavellian and a bit of a mathematician, your manager might also have cut the pay-out ratio once he was firmly entrenched. (Location 4830)

Managers regularly engineer ten-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value and, second, ignore the carrying cost of capital. (Location 4838)

At Berkshire, however, we use an incentive compensation system that rewards key managers for meeting targets in their own bailiwicks. (Location 4874)

“Performance”, furthermore, is defined in different ways depending upon the underlying economics of the business: in some our managers enjoy tailwinds not of their own making, in others they fight unavoidable headwinds. (Location 4878)

Obviously, all Berkshire managers can use their bonus money (or other funds, including borrowed money) to buy our stock in the market. (Location 4884)

industry trends are not good, and we continue to experience slippage in poundage sales on a same-store basis. (Location 4893)

The combined ratio represents total insurance costs (losses incurred plus expenses) compared to revenue from premiums: a ratio below 100 indicates an underwriting profit, and one above 100 indicates a loss. (Location 4926)

Two economic principles will see to that. First, commodity businesses achieve good levels of profitability only when prices are fixed in some manner or when capacity is short. Second, managers quickly add to capacity when prospects start to improve and capital is available. (Location 4943)

I have told you that Berkshire’s strong capital position—the best in the industry—should one day allow us to claim a distinct competitive advantage in the insurance market. (Location 4958)

Berkshire’s financial strength (and our record of maintaining unusual strength through thick and thin) is now a major asset for us in securing good business. (Location 4960)

Unfortunately, the lamp of experience has always provided imperfect illumination for reinsurers because so much of their business is “long-tail”, meaning it takes many years before they know what their losses are. (Location 4977)

At Berkshire we have never played the lay-it-off-at-a-profit game and, until recently, that put us at a severe disadvantage in certain lines. (Location 5002)

For instance, we are perfectly willing to risk losing $10 million of our own money on a single event, as long as we believe that the price is right and that the risk of loss is not significantly correlated with other risks we are insuring. (Location 5005)

Last year I told you of the major mistakes I had made in loss-reserving, and promised I would update you annually on loss-development figures. (Location 5016)

has changed from one in which great businesses were totally unappreciated to one in which they are appropriately recognized. (Location 5084)