Note: The following table appears in the printed Annual Report on the facing page of the Chairman's Letter 2 Berkshire’s Corporate Performance vs. the S&P 500 Annual Percentage Change in Per-Share in S&P 500 Book Value of with Dividends Relative Berkshire Included Results Year (1) (2) (1)-(2) 1965 .................................................. 23.8 10.0 13.8 1966 .................................................. 20.3 (11.7) 32.0 1967 .................................................. 11.0 30.9 (19.9) 1968 .................................................. 19.0 11.0 8.0 1969 .................................................. 16.2 (8.4) 24.6 1970 .................................................. 12.0 3.9 8.1 1971 .................................................. 16.4 14.6 1.8 1972 .................................................. 21.7 18.9 2.8 1973 .................................................. 4.7 (14.8) 19.5 1974 .................................................. 5.5 (26.4) 31.9 1975 .................................................. 21.9 37.2 (15.3) 1976 .................................................. 59.3 23.6 35.7 1977 .................................................. 31.9 (7.4) 39.3 1978 .................................................. 24.0 6.4 17.6 1979 .................................................. 35.7 18.2 17.5 1980 .................................................. 19.3 32.3 (13.0) 1981 .................................................. 31.4 (5.0) 36.4 1982 .................................................. 40.0 21.4 18.6 1983 .................................................. 32.3 22.4 9.9 1984 .................................................. 13.6 6.1 7.5 1985 .................................................. 48.2 31.6 16.6 1986 .................................................. 26.1 18.6 7.5 1987 .................................................. 19.5 5.1 14.4 1988 .................................................. 20.1 16.6 3.5 1989 .................................................. 44.4 31.7 12.7 1990 .................................................. 7.4 (3.1) 10.5 1991 .................................................. 39.6 30.5 9.1 1992 .................................................. 20.3 7.6 12.7 1993 .................................................. 14.3 10.1 4.2 1994 .................................................. 13.9 1.3 12.6 1995 .................................................. 43.1 37.6 5.5 1996 .................................................. 31.8 23.0 8.8 1997 .................................................. 34.1 33.4 .7 1998 .................................................. 48.3 28.6 19.7 1999 .................................................. .5 21.0 (20.5) 2000 .................................................. 6.5 (9.1) 15.6 2001 .................................................. (6.2) (11.9) 5.7 2002 .................................................. 10.0 (22.1) 32.1 2003 .................................................. 21.0 28.7 (7.7) 2004 .................................................. 10.5 10.9 (.4) 2005 .................................................. 6.4 4.9 1.5 Average Annual Gain — 1965-2005 21.5 10.3 11.2 Overall Gain — 1964-2005 305,134 5,583 Notes: Data are for calendar years with these exceptions: 1965 and 1966, year ended 9/30; 1967, 15 months ended 12/31. Starting in 1979, accounting rules required insurance companie s to value the equity securities they hold at market rather than at the lower of cost or market, which was prev iously the requirement. In this table, Berkshire’s results through 1978 have been restated to conform to the changed rule s. In all other respects, the results are calculated using the numbers originally reported. The S&P 500 numbers are pre-tax whereas the Berkshire numbers are after-tax. If a corporation such as Berkshire were simply to have owned the S&P 500 and accrued the appr opriate taxes, its results would have lagged the S&P 500 in years when that index showed a positive return, but would have exceeded the S&P 500 in years when the index showed a negative return. Over the years, the tax costs would have caused the aggregate lag to be substantial.
BERKSHIRE HATHAWAY INC. To the Shareholders of Berkshire Hathaway Inc.: Our gain in net worth during 2005 was $5.6 billion, which increased the per-share book value of both our Class A an d Class B stock by 6.4%. O ver the last 41 y ears (that is, since present management took over) book value has grown from $19 to $59,377, a rate of 21.5% compounded annually.* Berkshire had a decent year in 2005. We initiated five acquisitions (two of which have yet to close) and most of ou r operating subsidiaries prospered. Even o ur insurance business in its entirety did well, though Hurricane Katrina inflicted record losses on both Berkshire and the industry. We estimate our loss from Katrina at $2.5 billion – and her ugly sisters, Rita and Wilma, cost us an additional $.9 billion. Credit GEICO – and its brilliant CEO, Tony Nicely – for our stellar insurance results in a disaster- ridden year. One statistic stan ds out: In just two years, GEICO im proved its p roductivity b y 32%. Remarkably, employment fel l by 4% eve n as pol icy co unt grew by 26% – an d more gai ns are i n store. When we dri ve un it co sts d own in such a dram atic manner, we can offer ever-greater value to our customers. The payoff: La st y ear, GEICO gained m arket-share, e arned c ommendable profits an d strengthened its brand. If you have a new son or grandson in 2006, name him Tony. * * * * * * * * * * * * My g oal in writin g th is report is to g ive yo u th e info rmation yo u need to esti mate Berkshire’s intrinsic value. I say “estimate” because calculations of int rinsic value, t hough all-im portant, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is th at the calculation will b e wildly off-base. (Fo r an explanation of intrinsic value, see pages 77 – 78.) Here B erkshire has some advantages: a wide variety of relatively-stable earnings streams, combined with great liquidity and minimum debt. These factors mean that Berkshire’s intrinsic value can be more precisely calculated than can the intrinsic value of most companies. Yet i f precision i s ai ded by Berkshire’s fi nancial ch aracteristics, the job o f calcu lating intrinsic value has been made more complex by the mere presence of s o many earnings streams. Back in 1965, when we owned only a small textile operation, the task of calculating intrinsic value was a snap. Now we own 68 distinct bu sinesses with widely di sparate operating an d financial charact eristics. T his a rray of unrelated enterprises, coupled with our massive investment holdings, makes it impossible for you to simply examine our consolidated financial statements and arrive at an informed estimate of intrinsic value.
We have attempted to ease this problem by clustering our businesses into four logical groups, each of which we discuss later in this report. In th ese discussions, we will provide the key figures for both the group and its important components. Of course, the value of B erkshire may be ei ther greater or less than the sum of these four parts. The outcome depends on whether our many units function better or worse by being part of a larger enterprise and whether capital allocation improves or deteriorates when it is under the direction of a holding company. In other words, does Berkshire ownership bring anything to the party, or would our shareholders be better off if they directly owned shares in each of our 68 businesses? These are important questions but ones that you will have to answer for yourself. Before we look at our individual businesses, however, let’s review two sets of figures that show where we’ve come from and where we are now. The first set is the amount of investments (including cash and cash-equivalents) we o wn on a per-share basis. In making this calculation, we excl ude investments held in our finance operation because these are largely offset by borrowings: * All figures used in this report apply to Berkshire’s A shares, the successor to the only stock that the company had outstanding before 1996. The B shares have an economic interest equal to 1/30th that of the A. 3 Year Per-Share Investments* 1965 ..................................................................... $ 4 1975 ..................................................................... 159 1985 ..................................................................... 2,407 1995 ..................................................................... 21,817 2005 ..................................................................... $74,129 Compound Growth Rate 1965-2005.................... 28.0% Compound Growth Rate 1995-2005.................... 13.0% * Net of minority interests In addition to th ese marketable securities, which with minor exceptions are held in our insurance companies, w e o wn a w ide v ariety o f non- insurance bu sinesses. Belo w, w e sh ow th e p re-tax earn ings (excluding goodwill amortization) of these businesses, again on a per-share basis: Year Per-Share Earnings* 1965 ..................................................................... $ 4 1975 ..................................................................... 4 1985 ..................................................................... 52 1995 ..................................................................... 175 2005 ..................................................................... $2,441 Compound Growth Rate 1965-2005.................... 17.2% Compound Growth Rate 1995-2005.................... 30.2% *Pre-tax and net of minority interests
When growth rates are under discussion, it will pay you to be suspicious as to why the beginning and terminal years have been selected. If eith er year was aberrational, any calculation of growth will be distorted. In part icular, a base y ear i n whi ch ear nings were poor can produce a breat htaking, but meaningless, growth rat e. In t he t able ab ove, however, t he base y ear o f 1965 was ab normally good; Berkshire earned more money in that year than it did in all but one of the previous ten. As you can see f rom the two tables, the comparative growth rates of Berkshire’s two elements of value have change d i n the last decade, a result re flecting our e ver-increasing em phasis on business acquisitions. Nev ertheless, Ch arlie Mu nger, Berk shire’s Vice Ch airman and my p artner, and I wan t to increase the figures in both tables. In this ambition, we hope – metaphorically – t o avoid the fate of the elderly couple who had been romantically challenged for some time. As they finished dinner on their 50th anniversary, however, the wife – stimulated by soft music, wine and candlelight – felt a long-absent tickle and demurely suggested to her husband that they go u pstairs and m ake love. He ag onized for a m oment and then replied, “I can do one or the other, but not both.” Acquisitions Over the years, our current businesses, in aggregate, should deliver modest growth in operating earnings. But they will not in themselves produce truly satisfactory gains. We will need major acquisitions to get that job done. In this quest, 2005 was encouraging. We agreed to five purchases: two that were co mpleted last year, one that closed after yearend and two others that we expect to close soon. None of the deals involve the issuance of Berkshire shares. That ’s a c rucial, but often ignored, point: When a management proudly acquires another company for stock, the shareholders of the acquirer are concurrently selling part of their interest in everything they own. I’ve made this kind of deal a few times myse lf – a nd, on balance, my actions have cost you money. 4 Here are last year’s purchases: • On June 3 0 we bo ught Medical Protective Company (“MedPro”), a 106-year-old m edical malpractice insurer based in Fort Wayne. Malp ractice insurance is tough to underwri te and has proved to be a graveyard for many insurers. MedPro nevertheless should do well. It will have the attitudinal advantage that all Berkshire insurers share, wherein underwriting discipline trumps all other goals. Additionally, as part of Berkshire, MedPro has financial strength far exceeding that of its competitors, a quality assuring doctors that long-to-settle claims will not end up back on their doorstep because their ins urer failed. Fi nally, the company has a sm art and energetic CEO, Tim Kenesey, who instinctively thinks like a Berkshire manager.
• Forest River, our second acquisition, closed on August 31. A co uple of months earlier, on June 21, I recei ved a two-page fax telling me – point by point – why Forest River m et the ac quisition criteria we set fort h o n pa ge 25 o f t his r eport. I ha d not be fore he ard of t he co mpany, a recreational v ehicle manufacturer with $ 1.6 billion of sal es, nor of Pete Lieg l, its owner an d manager. But the fax made sense, and I immediately asked for more figures. These came the next morning, and that afternoon I made Pete an offer. On June 28, we shook hands on a deal. Pete is a remarkable entrepreneur. So me years back, he sold his business, then far smaller than today, to a n LBO operator who promptly began telling him how to run th e place. Before long, Pete left, and the business soon sunk into bankruptcy. Pete then repurchased it. You can be sure that I won’t be telling Pete how to manage his operation. Forest River has 60 plants, 5,400 employees and has consistently gained share in the RV business, while also expanding into other areas such as boats. Pete is 61 – and definitely in an acceleration mode. Read the piece from RV Business that accompanies this report, and you’ll see why Pete and Berkshire are made for each other. • On November 12, 2005, an article ran in The Wall Street Journal dealing with Berkshire’s unusual acquisition and managerial practices. In it Pete declared, “It was easier to sell my business than to renew my driver’s license.” In New York, Cathy Baron Tamraz read the article, and it struck a chord. On Novem ber 21, she sent m e a letter that be gan, “As president of Business Wire, I’d lik e to i ntroduce you to m y company, as I believe it fits the profile of Berkshire Hathaway subsidiary companies as detailed in a recent Wall Street Journal article.” By the time I finished Cathy’s two-page letter, I felt Business Wire and Berkshire were a fit. I particularly liked her penultimate paragraph: “We run a tight ship and keep unnecessary spending under wraps. No secretaries or m anagement layers here. Yet we’ll invest big dollars to gain a technological advantage and move the business forward.” I prom ptly gave Cathy a call, and before l ong Berks hire had reached agreement with Busi ness Wire’s controlling s hareholder, L orry Lokey, who founded t he company in 1961 (and who had just made Cathy CEO). I love success stories like Lorry’s. Today 78, he has built a company that disseminates inf ormation i n 15 0 co untries for 25,000 cl ients. Hi s st ory, l ike t hose of m any entrepreneurs who have selected Berkshire as a hom e for their life’s work, is an example of what can happen when a good idea, a talented individual and hard work converge.
• In December we agreed to buy 81% of Applied Underwriters, a company that offers a combination of pay roll se rvices a nd w orkers’ c ompensation i nsurance t o sm all bu sinesses. A majority o f Applied’s customers are located in California. 5 In 1998, t hough, w hen t he company had 12 em ployees, i t acqui red a n Om aha-based o peration with 24 employees that offered a somewhat-similar service. Sid Ferenc and Steve Menzies, who have built App lied’s remarkable bu siness, co ncluded that O maha h ad many ad vantages as an operational b ase – a brilliant in sight, I might add – and tod ay 400 of t he co mpany’s 479 employees are located here. Less than a year ago, Appl ied entere d into a large rein surance con tract with Aj it Jain , th e extraordinary manager of National Indemnity’s reinsurance division. Ajit was im pressed by Sid and Steve, and they liked Berkshire’s method of operation. So we decided to join forces. We are pleased that Sid and Steve retain 19% of Applied. They started on a shoestring only 12 years ago, and it will be fun to see what they can accomplish with Berkshire’s backing. • Last spri ng, MidAmerican Ener gy, our 80.5% owned s ubsidiary, a greed t o buy Pa cifiCorp, a major electric u tility serv ing si x Western states. An acquisition of th is so rt requires m any regulatory ap provals, bu t w e’ve now ob tained t hese and expect to close this tran saction soon . Berkshire will then buy $3.4 billion of MidAmerican’s common stock, which MidAmerican will supplement with $1.7 billion of borrowing to complete the purchase. You can’t ex pect to earn outsized profits in regulated utilities, but the industry offers owners the opportunity to deploy large sums at fair returns – and therefore, it makes good sense for Berkshire. A few years back, I said that we hoped to make some very large purchases in the utility field. No te the plural – we’ll b e looking for more. In addition to buying these new op erations, we co ntinue to make “bolt-on” acquisitions. So me aren’t so sm all: Sh aw, our car pet operation, sp ent abou t $5 50 m illion last year on t wo pu rchases that furthered its vertical integration and should improve its profit m argin in th e future. XTRA and Clayton Homes also made value-enhancing acquisitions. Unlike many business buyers, Berkshire has no “exit strategy.” We buy to keep. We do, though, have an entrance strategy, looking for businesses in this country or abroad that meet our six criteria and are available at a p rice that will produce a reasonable return. If you have a business that fits, g ive me a call. Like a hopeful teenage girl, I’ll be waiting by the phone.
Insurance Let’s now talk abo ut our four sectors and start with insurance, our core business. What counts here is the amount of “float” and its cost over time. For new rea ders, let m e e xplain. “Floa t” is money t hat do esn’t belo ng to us bu t th at we temporarily hold. Most of our fl oat arises because (1) pre miums are pa id upfront though the servic e we provide – insurance protection – i s delivered over a pe riod that usually covers a y ear and; (2) loss events that occur today do not always resu lt in our immediately paying claims, because it sometim es takes many years for lo sses to b e repo rted (asb estos lo sses wou ld b e an ex ample), negotiated and settled . Th e $20 million of float that came with our 1967 entry into insurance has now increased – both by way of internal growth and acquisitions – to $49 billion. Float i s w onderful – if it d oesn’t co me at a h igh price. Its co st is d etermined b y un derwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an insurer earns an underwriting profit – as has been the case at Berkshire in about half of the 39 y ears we ha ve bee n i n t he i nsurance b usiness – float is b etter th an free. In su ch years, we are actually pai d fo r h olding ot her people’s money. Fo r m ost insurers, ho wever, life has bee n far more difficult: In aggre gate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so. 6 In 2004 our float cost us less than nothing, and I told you that we had a chance – absent a mega- catastrophe – of n o-cost fl oat i n 200 5. B ut we had the mega-cat, and as a specialis t in that coverage, Berkshire suffered hurricane losses of $3.4 billion. Nevertheless, our float was costless in 2005 because of the superb results we had in our other insurance activities, particularly at GEICO. * * * * * * * * * * * * Auto policies in force grew by 12.1% at GEICO, a gain increasing its market share of U.S. private passenger auto business from about 5.6% to about 6.1%. Aut o insurance is a bi g business: Each s hare- point equates to $1.6 billion in sales. While our brand strength is not quantifiable, I believe it also grew significantly. When Berkshire acquired control of GEICO in 1996, its annual advertising expenditures were $31 million. Last year we were up to $502 million. And I can’t wait to spend more.
Our adve rtising works because we ha ve a great story to tell: More pe ople can sa ve money by insuring with us th an is th e case with an y o ther n ational carrier offering po licies to a ll co mers. (So me specialized aut o insure rs do particularly well for a pplicants fitting i nto their niches; also, because our national competitors use rating systems that differ from ours, they will sometimes beat our price.) Last year, we ac hieved by far the highest conversion rate – t he percentage of internet and phone quotes turned into sales – in ou r h istory. This is po werful ev idence that our prices a re more attractive relative to the competition than ever before. Test us by going to GEICO.com or by calling 800-847-7536. Be su re to indicate you are a shareholder because that fact will often qualify you for a discount. I told you last year about GEICO’s entry into New Jersey in August, 2004. Drivers in that state love us. Our retention rate there for new policyholders is running higher than in any other state, and by sometime in 20 07, GEIC O i s lik ely to become th e th ird largest au to insu rer i n New Jersey. Th ere, as elsewhere, our low costs allow low prices that lead to steady gains in profitable business. That si mple form ula im mediately im pressed m e 55 y ears ag o when I first di scovered GEICO. Indeed, at age 21, I wrote an article about the company – it’s reproduced on page 24 – when its market value was $7 million. As you can see, I called GEICO “The Security I Like Best.” And that’s what I still call it. * * * * * * * * * * * * We have major reinsurance operations at General Re and National Indemnity. The fo rmer is run by Joe Brandon and Tad Montross, the latter by Ajit Jain. Both units performed well in 2005 considering the extraordinary hurricane losses that battered the industry. It’s a n open question whether atm ospheric, ocea nic or o ther causal fa ctors ha ve dra matically changed the frequency or intensity of hurricanes. Recent experience is worrisome. We know, for instance, that in th e 100 year s b efore 2 004, abou t 5 9 hurricanes o f Catego ry 3 str ength, or gr eater, hit th e Southeastern and Gulf Coast states, and that only three of these were Category 5s. We further know that in 2004 there were three Category 3 st orms that hammered those areas and that these were followed by four more in 2005, one of them, Katrina, the most destructive hurricane in industry history. Mor eover, there were three Category 5s near the coast last year that fortunately weakened before landfall.
Was t his on slaught of m ore frequ ent and more in tense sto rms merely an an omaly? Or was it caused by changes in climate, water temperature or other variables we don’t fully understand? And could these factors be developing in a manner that will soon produce disasters dwarfing Katrina? Joe, Ajit and I don’t know the answer to these all-important questions. What we do k now is that our ign orance means we must fo llow th e co urse prescrib ed b y Pascal in h is fam ous wag er abou t th e existence o f God. As y ou may recal l, he concl uded t hat si nce he di dn’t know the answer, his per sonal gain/loss ratio dictated an affirmative conclusion. 7 So guided, we’ve concluded that we should now write mega-cat policies only at prices far higher than prevailed last year – and then only with an aggregate exposure that would not cause us distress if shifts in some important variable produce far m ore costly storms in the near future. To a lesser d egree, we felt this way after 2004 – and cut back our writings when prices didn’t move. Now our caution has intensified. If prices seem appropriate, however, we continue to have both the ability and the appetite to be the largest writer of mega-cat coverage in the world. * * * * * * * * * * * * Our smaller insurers, with MedPro added to the fold, delivered truly outstanding results last year. However, what you see in the table below does not do full justice to their performance. That’s because we increased the loss reserves of MedPro by about $125 million immediately after our purchase. No one knows with any precision what amount will be required to pay the claims we in herited. Medical malpractice insurance is a “long-tail” line, meaning that claims often take many years to settle. In addition, there are other losses that have occurred, but that we won’t even hear about for some time. One thing, though, we have learned – the hard way – after many years in the business: Surprises in insurance are far from symmetrical. Y ou are lucky if yo u get one that is p leasant for every ten th at go the other way. Too often, however, insurers react to looming loss problems with optimism. They behave like the fellow in a switchblade fight who, after his opponent has taken a mighty swipe at his throat, exclaimed, “You never touched me.” His adversary’s reply: “Just wait until you try to shake your head.” Excluding the reserves we added for prior periods, MedPro wrote at an underwriting profit. And our other primary companies, in aggregate, had an underwriting profit of $324 million on $1,270 million of volume. Th is is an ex traordinary r esult, and ou r th anks go to R od Eldred of Berk shire Hathaway Homestate Companies, John Kizer of Central States Indemnity, Tom Nerney of U. S. Liability, Don Towle of Kansas Bankers Surety and Don Wurster of National Indemnity.
Here’s the overall tally on our underwriting and float for each major sector of insurance: (in $ millions) Underwriting Profit (Loss) Yearend Float Insurance Operations 2005 2004 2005 2004 General Re ....................... $( 334) $ 3 $22,920 $23,120 B-H Reinsurance.............. (1,069) 417 16,233 15,278 GEICO ............................. 1,221 970 6,692 5,960 Other Primary................... 235* 161 3,442 1,736 Total................................. $ 53 $1,551 $49,287 $46,094 *Includes MedPro from June 30, 2005. Regulated Utility Business We have an 80.5% (fully diluted) interest in MidAmerican Energy Holdings, which owns a wide variety of utility operations. The largest of these are (1) Yorkshire Electricity and Northern Electric, whose 3.7 m illion electric cu stomers m ake it t he th ird larg est d istributor of electricity in th e U.K.; (2) MidAmerican Energy, which serves 706,000 electric customers, primarily in Iowa; and (3) Kern River and Northern Natural pipelines, which carry 7.8% of the natural gas consumed in the U.S. When our PacifiCorp acquisition closes, we will add 1.6 million electric customers in six Western states, with Oregon and Utah providing us the most business. This transaction will increase MidAmerican’s revenues by $3.3 billion and its assets by $14.1 billion. 8 The Pub lic Utili ty Ho lding Co mpany Act (“PUHC A”) was rep ealed o n Aug ust 8, 2 005, a milestone that allowed Berkshire to convert its MidAmerican preferred stock into voting common shares on February 9, 2 006. Thi s c onversion en ded a con voluted corporate arrangem ent that PUHC A ha d forced upon us. Now we have 83.4% of both the common stock and the votes at MidAmerican, which allows us to cons olidate the com pany’s inc ome for fina ncial accounting a nd t ax purposes . Our true ec onomic interest, howe ver, is the aforem entioned 80.5%, since t here are options outstanding that are sure t o be exercised within a few years and that upon exercise will dilute our ownership. Though our voting power has increased dramatically, the dynamics of our four-party ownership have not changed at all. We view MidAmerican as a partnership among Berkshire, Walter Scott, and two terrific managers, Dave Sokol and Greg Abel. It’s unimportant how many votes each party has; we will make major moves only when we are unanimous in thinking them wise. Five years of working with Dave, Greg and Walter have underscored my original belief: Berkshire couldn’t have better partners.
You will notice that this year we have provided you with two balance sheets, one representing our actual figures per GAAP on Decem ber 31, 2005 (which does not consolidate MidAmerican) and one that reflects the subsequent conversion of our preferred. All fu ture financial reports of Berkshire will in clude MidAmerican’s figures. Somewhat incongruously, MidAmerican owns the second largest real estate brokerage firm in the U.S. And it’s a gem . The parent company’s name is HomeServices of America, but our 19,200 agents operate through 18 locally-branded firms. Aided by three small acquisitions, we participated in $64 billion of transactions last year, up 6.5% from 2004. Currently, the white-hot market in residential real estate of recent years is cooling down, and that should lead to ad ditional acquisition possibilities for us. Both we and Ron Peltier, t he company’s CEO, expect HomeServices to be far larger a decade from now. Here are some key figures on MidAmerican’s operations: Earnings (in $ millions) 2005 2004 U.K. utilities ....................................................................................................... $ 308 $ 326 Iowa utility ......................................................................................................... 288 268 Pipelines ............................................................................................................. 309 288 HomeServices..................................................................................................... 148 130 Other (net) .......................................................................................................... 107 172 Income (loss) from discontinued zinc project .................................................... 8 (579) Earnings before corporate interest and taxes ...................................................... 1,168 605 Interest, other than to Berkshire ......................................................................... (200) (212) Interest on Berkshire junior debt ........................................................................ (157) (170) Income tax .......................................................................................................... (248) (53) Net earnings........................................................................................................ $ 563 $ 170 Earnings applicable to Berkshire*...................................................................... $ 523 $ 237 Debt owed to others............................................................................................ 10,296 10,528 Debt owed to Berkshire...................................................................................... 1,289 1,478
*Includes interest earned by Berkshire (net of related income taxes) of $102 in 2005 and $110 in 2004. 9 Finance and Financial Products The star of our finance sector is Clayton Homes, masterfully run by Kevin Clayton. He does not owe his brilliant record to a rising tide: The manufactured-housing business has been disappointing since Berkshire purchased Clayton in 2003. Industry sales have stagnated at 40-year lows, and the recent uptick from Katrina-related dem and will alm ost certainly be short-live d. In rece nt years, m any industry participants have suffered losses, and only Clayton has earned significant money. In this brutal environment Clayton has bought a large amount of manufactured-housing loans from major banks t hat fo und t hem unp rofitable and difficult t o servi ce. C layton’s operating ex pertise and Berkshire’s fi nancial res ources have m ade t his an exce llent busi ness fo r us a nd one i n whi ch w e are preeminent. We presently service $17 billion of loans, compared to $5.4 billon at the time of our purchase. Moreover, Clayton now owns $9.6 billion of its servicing portfolio, a position built up almost entirely since Berkshire entered the picture. To finance this portfolio, Clayton borrows money from Berkshire, which in turn borrows the same amount publicly. For the use of its credit, Berkshire charges Clayton a one percentage-point markup on its borrowing cos t. In 2 005, t he cost t o C layton f or t his arrangement was $ 83 m illion. That am ount i s included in “Other” income in the table on the facing page, and Clayton’s earnings of $416 million are after deducting this payment. On the manufacturing side, Clayton has also been active. To its original base of twenty plants, it first added twelve more in 2004 by way of the bankruptcy purchase of O akwood, which just a few years earlier was one of the largest companies in the business. Then in 2005 Clayton purchased Karsten, a four- plant operation that greatly strengthens Clayton’s position on the West Coast. * * * * * * * * * * * * Long ago, Mark Twain said: “A m an who tries to carry a cat home by its tail will lear n a lesso n that can be learned in no other way.” If Twain were around now, he might try winding up a der ivatives business. After a few days, he would opt for cats. We lo st $1 04 million p re-tax last year in o ur con tinuing atte mpt to e xit Gen Re’s derivative operation. Our aggregate losses since we began this endeavor total $404 million.
Originally we had 23,218 con tracts outstanding. By th e start o f 2005 we w ere dow n to 2 ,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above. Remember th at th e rationale fo r estab lishing th is un it in 19 90 was Gen Re’s wish to m eet th e needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a t erm of 1 00 years! It ’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation- conscious trader to h ave a lon g-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the m ost difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimatin g their value. Small wonder that traders promote them. A business i n which huge a mounts o f c ompensation flow from assum ed numbers i s o bviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction fa voring higher earnings at each firm. It’s a st range world in which two pa rties can carry out a paper transaction that each can promptly report as profitable. I dwell on our expe rience in derivative s each year for two reas ons. One is pe rsonal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down 10 Gen Re’s trad ing operation. Both Charlie and I knew at the time of the Gen Re pu rchase that it was a problem and told its management that we wan ted to exit the business. It was my resp onsibility to make sure that happened. R ather than address the situation head on, however, I wast ed several years while we attempted t o sel l t he operat ion. That was a doom ed en deavor beca use no real istic sol ution co uld have extricated us fro m th e m aze of liab ilities th at was go ing to ex ist fo r d ecades. Our obligations were particularly worrisom e because thei r pote ntial to explode could not be measured. Moreover, if s evere trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.
So I failed i n my atte mpt to ex it painlessly, and i n th e meantime more trad es were put on t he books. Fau lt me fo r d ithering. (Charlie calls it thumb-sucking.) Wh en a pr oblem exists, whet her in personnel or in business operations, the time to act is now. The seco nd reason I reg ularly d escribe our prob lems in th is area lies in th e ho pe th at o ur experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a son g of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and i s now a m ultiple of wh at existed in 1998, the last time that financial chaos erupted. Our experience should be particularly sobering because we we re a better-than-average candidate to exit gracefully. Ge n Re was a relatively minor operator in t he derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures t hat m ight ha ve f orced i t t o c onduct t he l iquidation i n a l ess-than-efficient m anner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved. It co uld be a d ifferent sto ry fo r o thers in the future. Imag ine, if yo u will, o ne o r more fir ms (troubles o ften spread) with p ositions that are many multiples of ours atte mpting to li quidate in ch aotic markets and under extreme, and well-publicized, press ures. Th is is a s cenario to wh ich much atten tion should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina. When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.” * * * * * * * * * * * * Below are the results of our various finance and financial products activities: (in $ millions) Pre-Tax Earnings Interest-Bearing Liabilities 2005 2004 2005 2004 Trading – ordinary income ............................ $ 200 $ 264 $1,061 $5,751 Gen Re Securities (loss) ................................. (104) (44) 2,617* 5,437* Life and annuity operation ............................. 11 (57) 2,461 2,467 Value Capital (loss) ....................................... (33) 30 N/A N/A Leasing operations ......................................... 173 92 370 391 Manufactured-housing finance (Clayton)....... 416 192 9,299 3,636 Other............................................................... 159 107 N/A N/A Income before capital gains............................ 822 584 Trading – capital gains (losses) ..................... (234) 1,750 Total .............................................................. $ 588 $2,334
*Includes all liabilities 11 Manufacturing, Service and Retailing Operations Our activities in th is p art of Berk shire cover th e waterfront. Let’s look , tho ugh, at a su mmary balance sheet and earnings statement for the entire group. Balance Sheet 12/31/05 (in $ millions) Assets Liabilities and Equity Cash and equivalents .............................. $ 1,004 Notes payable ............................ $ 1,469 Accounts and notes receivable ............... 3,287 Other current liabilities.............. 5,371 Inventory ................................................ 4,143 Total current liabilities .............. 6,840 Other current assets ................................ 342 Total current assets................................. 8,776 Goodwill and other intangibles............... 9,260 Deferred taxes............................ 338 Fixed assets............................................. 7,148 Term debt and other liabilities... 2,188 Other assets............................................. 1,021 Equity ........................................ 16,839 $26,205 $26,205 Earnings Statement (in $ millions) 2005 2004 2003 Revenues .................................................................................... $46,896 $44,142 $32,106 Operating expenses (including depreciation of $699 in 2005, $676 in 2004 and $605 in 2003).......................................... 44,190 41,604 29,885 Interest expense (net).................................................................. 83 57 64 Pre-tax earnings.......................................................................... 2,623 2,481 2,157 Income taxes............................................................................... 977 941 813 Net income ................................................................................. $ 1,646 $ 1,540 $ 1,344 This eclectic co llection, which sells produ cts ra nging from Dilly Bars to fraction al i nterests in Boeing 737s, earned a very respectable 22.2% on average tangible net worth last year. It’s noteworthy also that these operations used only minor financial leverage in achieving that return. C learly, we o wn some terrific businesses. We purchased many of them, however, at substantial premiums to net worth – a p oint reflected in the g oodwill ite m sh own on th e b alance sheet – an d th at fact red uces th e earn ings on ou r average carrying value to 10.1%.
Here are the pre-tax earnings for the larger categories or units. Pre-Tax Earnings (in $ millions) 2005 2004 Building Products .................................................................................................... $ 751 $ 643 Shaw Industries ....................................................................................................... 485 466 Apparel & Footwear................................................................................................ 348 325 Retailing of Jewelry, Home Furnishings and Candy ............................................... 257 215 Flight Services......................................................................................................... 120 191 McLane.................................................................................................................... 217 228 Other businesses ...................................................................................................... 445 413 $2,623 $2,481 12 • In both our building-products companies and at Shaw, we continue to be hit by rising costs for raw materials and energy. M ost of t hese operations are significant users of oil (or more specifically, petrochemicals) and natural gas. And prices for these commodities have soared. We, likewise, have raised prices on m any products, but there are often l ags before increases be- come effective. Nevertheless, both our building-products operations and Shaw delivered respect- able results in 2005, a fact attributable to their strong business franchises and able managements. • In apparel, our largest unit, Fruit of the Loom, again incre ased earnings and m arket-share. You know, of course, of our leadersh ip position in men’s and boys’ underwear, in which we account for about 48.7% of the sales recorded by mass-marketers (Wal-Mart, Target, etc.). That’s up from 44.2% in 2002, when we ac quired the company. O perating from a sm aller base, we have made still g reater g ains in in timate ap parel fo r women an d girls th at is so ld by th e m ass-marketers, climbing from 13.7% of their sales in 2002 to 24.7% in 2005. A gain like that in a major category doesn’t come easy. Thank John Holland, Fruit’s extraordinary CEO, for making this happen. • I told you last year that Ben Bridge (jewelry) and R. C. Willey (home furnishings) had same-store sales gains far above the average of their industries. You might think that blow-out figures in one year wo uld mak e co mparisons difficult in the fo llowing year. Bu t Ed and Jon B ridge at th eir operation and Scott Hymas at R. C. Willey were more than up to this challenge. Ben Bridge had a 6.6% same-store gain in 2005, and R. C. Willey came in at 9.9%.
Our never-on-Sunday approach at R. C. Willey continues to overwhelm seven-day competitors as we roll out stores in new markets. The Boise store, about which I was such a skeptic a few years back, had a 21% gain in 2005, coming off a 10% gain in 2004. Our new Reno store, opened in November, broke out of the gate fast with sales that exc eeded Boise’s early pace, a nd we will begin business in Sacramento in June. If this store succeeds as I expect it to, Californians will see many more R. C. Willey stores in the years to come. • In flight services, earnings improved at FlightSafety as c orporate aviation continued its rebound. To support growth, we invest heavily in new simulators. Our m ost recent expansion, bringing us to 42 trai ning cen ters, is a major facility at Farn borough, Eng land t hat o pened in September. When it is fully built out in 2007, we will have invested more than $100 million in the building and its 15 simulators. Bru ce Whitman, FlightSafety’s able CEO, m akes sure that no competitor comes close to offering the breadth and depth of services that we do. Operating results at NetJets were a di fferent story. I sai d last year th at this business would earn money in 2005 – and I was dead wrong. Our Eu ropean operat ion, i t sho uld be not ed, sh owed both excel lent gr owth an d a reduce d l oss. Customer contracts there inc reased by 37%. We are t he only fractional-ownership operation of any size in Europe, and our now-pervasive presence there is a key factor i n making NetJets the worldwide leader in this industry. Despite a la rge increase in c ustomers, however, our U.S. operation dipped far into the red. Its efficiency fell, and costs soared. We believe that our three la rgest competitors suffered similar problems, but each is owned by aircraft manufacturers that may think differently than we do about the necessi ty of m aking ade quate p rofits. The combined val ue of t he fl eets managed by t hese three competitors, in any case, continues to be less valuable than the fleet that we operate. Rich Santulli, one of the most dynamic managers I’ve ever m et, will so lve our revenue/expense problem. He won’t do it, however, in a manner that impairs the quality of the NetJets experience. Both he and I are committed to a lev el of service, security and safety t hat can’t be matched by others. 13 • Our retailing category includes See’s Candies, a company we bought early in 1972 (a date making it ou r ol dest non-insurance b usiness). At t hat t ime, C harlie and I i mmediately deci ded t o p ut Chuck Huggins, th en 46, in charge. Thoug h w e were new at th e game o f selectin g managers, Charlie and I hit a home run with this appointment. Chuck’s love for the customer and the brand permeated the organization, which in his 34-year tenure produced a more-than-tenfold increase in profits. Th is gain was ach ieved in an indu stry growing at b est slowly an d perhaps no t at all. (Volume figures in this industry are hard to pin down.)
At yeare nd, C huck t urned the reins at See ’s over to B rad K instler, who pr eviously had ser ved Berkshire well while running Cypress Insurance and Fechheimer’s. It’s unusual for us to move managers around, but Brad’s record made him an obvious choice for the See’s job. I hope Chuck and his wife, Donna, are at the annual m eeting. If they are, sha reholders can join Charlie and me in giving America’s number one candy maker a richly-deserved round of applause. * * * * * * * * * * * * Every day, i n countless ways, th e co mpetitive po sition of each of our businesses grows eith er weaker o r st ronger. I f we a re del ighting customers, el iminating u nnecessary cost s and i mproving ou r products and services, we gain strength. B ut if we t reat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous. When our l ong-term com petitive position improves as a result of t hese al most unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence. If a management makes bad d ecisions i n order t o hit sho rt-term earni ngs t argets, an d co nsequently get s behind the eight-ball in terms of cost s, customer satisfaction or brand strength, no am ount of s ubsequent brilliance will overcome the damage that has b een inflicted. Take a l ook at th e dilemmas of managers in the au to an d airline in dustries to day as th ey strugg le with th e hug e p roblems h anded th em b y th eir predecessors. Charlie is fond of quoting Ben Franklin’s “An ounce of preventi on is worth a pound of cure.” But sometimes no amount of cure will overcome the mistakes of the past. Our managers focus on moat-widening – and are brilliant at it. Quite simply, they are passionate about their businesses. Usually, they were ru nning those long before we cam e along; our only function since has bee n to stay out of the way. If y ou see t hese heroes – an d our four heroines as wel l – at the annual meeting, thank them for the job they do for you. * * * * * * * * * * * * The attitude of our managers vividly contrasts with that of the young man who married a tycoon’s only child, a decidedly homely and dul l lass. R elieved, the father called in his new son-in-law after th e wedding and began to discuss the future: “Son, you’re the boy I always wanted and n ever had. H ere’s a stoc k certificate for 50% of the company. You’re my equal partner from now on.” “Thanks, dad.” “Now, what would you like to run? How about sales?” “I’m afraid I couldn’t sell water to a man crawling in the Sahara.” “Well then, how about heading human relations?” “I really don’t care for people.” “No problem, we have lots of other spots in the business. What would you like to do?” “Actually, nothing appeals to me. Why don’t you just buy me out?”
14 Investments We show below our common stock investments. Those that had a market value of more than $700 million at the end of 2005 are itemized. 12/31/05 Percentage of Shares Company Company Owned Cost* Market (in $ millions) 151,610,700 American Express Company ................... 12.2 $1,287 $ 7,802 30,322,137 Ameriprise Financial, Inc..................... 12.1 183 1,243 43,854,200 Anheuser-Busch Cos., Inc.................... 5.6 2,133 1,884 200,000,000 The Coca-Cola Company ........................ 8.4 1,299 8,062 6,708,760 M&T Bank Corporation .......................... 6.0 103 732 48,000,000 Moody’s Corporation .............................. 16.2 499 2,948 2,338,961,000 PetroChina “H” shares (or equivalents)... 1.3 488 1,915 100,000,000 The Procter & Gamble Company .......... 3.0 940 5,788 19,944,300 Wal-Mart Stores, Inc. ......................... 0.5 944 933 1,727,765 The Washington Post Company .............. 18.0 11 1,322 95,092,200 Wells Fargo & Company......................... 5.7 2,754 5,975 1,724,200 White Mountains Insurance..................... 16.0 369 963 Others ...................................................... 4,937 7,154 Total Common Stocks ............................. $15,947 $46,721 *This i s o ur a ctual pu rchase pri ce a nd al so o ur t ax basis; GA AP “c ost” di ffers i n a few case s because of write-ups or write-downs that have been required. A couple of last year’s changes in our portfolio occurred because of corporate events: Gillette was merged into Procter & Gamble, and American Express spun off Ameriprise. In addition, we substantially increased our holdings in Wells Fargo, a co mpany that Dick Kovacevich runs brilliantly, and established positions in Anheuser-Busch and Wal-Mart. Expect n o miracles fr om our equi ty p ortfolio. T hough we ow n major i nterests i n a n umber of strong, highly-profitable businesses, they are not selling at anything like bargain prices. As a g roup, they may double in value in ten years. The likelihood is that their per-share earnings, in aggregate, will grow 6- 8% p er year o ver th e d ecade and th at their sto ck prices will more o r less match t hat g rowth. (Th eir managers, of course, think my expectations are too modest – and I hope they’re right.) * * * * * * * * * * * * The P&G-Gillette merger, closing in the fourth qu arter of 2005, required Berkshire to record a $5.0 billion pre-tax cap ital g ain. Th is bookkeeping entry, d ictated b y GAAP, is mean ingless from an economic standpoint, and you should ignore it when you are evaluating Berkshire’s 2005 earnings. We didn’t intend to sell our Gillette shares before the merger; we don’t intend to sell our P&G shares now; and we incurred no tax when the merger took place.
It’s hard to overemphasize the importance of who is CEO of a company. Before Jim Kilts arrived at Gillette in 2001, th e com pany was strugg ling, h aving p articularly suffered from cap ital-allocation blunders. In the m ajor exa mple, Gillette’ s acquisiti on of Duracell cost Gillette sharehol ders billions of dollars, a loss never m ade visible by conventional accounting. Quite simply, what Gillette received in business value i n t his ac quisition was n ot equi valent t o w hat i t ga ve u p. ( Amazingly, t his most fundamental o f y ardsticks i s alm ost al ways i gnored by b oth m anagements an d t heir i nvestment bankers when acquisitions are under discussion.) 15 Upon tak ing office at Gillett e, Ji m q uickly in stilled fiscal d iscipline, tig htened operations an d energized m arketing, m oves th at d ramatically in creased th e in trinsic v alue of t he co mpany. Gillette’s merger with P&G then expanded the potential of bot h companies. For his accom plishments, Jim was paid very well – but he earned e very penny. (This is no acade mic evaluation: As a 9.7% owner of Gillette, Berkshire in effect paid th at propo rtion of h is compensation.) Indeed, it’s difficult to overpay th e truly extraordinary CEO of a giant enterprise. But this species is rare. Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The u pshot i s t hat a mediocre-or-worse CEO – ai ded by hi s ha ndpicked VP of human rel ations and a consultant from the ever-acc ommodating firm of Ratchet, Ratchet and B ingo – all too often receives gobs of money from an ill-designed compensation arrangement. Take, fo r in stance, ten year, fixed-price options (an d who wo uldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these – let’s say enough to give him an option on 1% of the company – his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock. Let’s assume that under Fre d’s leadership Stagnant lives up to its n ame. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on t he 100 m illion sha res t hen o utstanding. Fred esc hews di vidends and regularly uses al l earni ngs t o repurchase sh ares. If th e stock co nstantly sells at ten times earn ings per sh are, it will h ave app reciated 158% by t he end of t he option period. T hat’s because repurchases would reduce the number of s hares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings f rom ow ners, Fre d get s very ri ch, m aking a cool $ 158 m illion, des pite t he b usiness i tself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.
Fred can also get a splendid result for himself by paying no dividends and deploying the earnings he withholds from share holders i nto a va riety of disappointing p rojects an d ac quisitions. E ven i f t hese initiatives deliver a paltry 5% return, Fred will still make a bundle. Specifically – with Stagnant’s p/e ratio remaining unchanged at ten – Fred’s option will deliver him $63 million. Meanwhile, his shareholders will wonder what happened to the “alignment of interests” that was s upposed to occur when Fred was issued options. A “normal” dividend policy, of co urse – one-third of earnings paid out, for e xample – pro duces less extreme results but still can provide lush rewards for managers who achieve nothing. CEOs understand this math and know that every dime paid out in dividends reduces the value of all out standing options. I’ve never, however, seen t his m anager-owner c onflict refe renced i n proxy materials that request a pproval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they so mehow forget to tell shareholders that fixed-price options give them capital that is free. It doesn’t have to be this way: It’s child’s play for a board to design options that give effect to the automatic build-up in valu e that occurs when earnings are retained. B ut – s urprise, surprise – options of that kind are almost never issued. Indeed, the very thought of options with strike prices that are adjusted for retained earnings seems foreign to compensation “experts,” who are nevertheless encyclopedic about every management-friendly plan that exists. (“Whose bread I eat, his song I sing.”) Getting fired can produce a particularly bountiful payday for a CEO. Indeed, he can “earn” more in that single day, while cleaning out his desk, than an American worker ea rns in a lifetim e of cle aning toilets. Forget the old maxim about nothing succeeding like success: Today, in the executive suite, the all- too-prevalent rule is that nothing succeeds like failure. 16 Huge s everance pay ments, l avish pe rks a nd outsized payments fo r ho-hum perf ormance often occur because comp committees have become slaves to comparative data. The drill is simple: Three or so directors – not chose n by c hance – are bombarded f or a few hours b efore a b oard meeting wi th pay statistics that perpetually ratchet upwards. Additionally, the committee is told about new perks that other managers are receiving. In this manner, outlandish “goodies” are showered upon CEOs simply because of a corporate version of the argument we al l used when children: “But, Mom, all the other kids have one.” When comp committees follow this “logic,” yesterday’s most egregious excess becomes today’s baseline.
Comp committees should adopt the attitude of Hank Greenberg, the Detroit slugger and a boyhood hero o f m ine. H ank’s s on, S teve, a t o ne t ime w as a player’s a gent. Repr esenting an outfielder i n negotiations with a major league club, Steve sounded out his dad about the size of t he signing bonus he should ask for. Hank, a true pay-for-performance guy, got straight to the point, “What did he hit last year?” When Steve answered “.246,” Hank’s comeback was immediate: “Ask for a uniform.” (Let me pause for a brief con fession: In criticizing comp committee behavior, I do n’t speak as a true insider. Though I have served as a director of twenty public companies, only one CEO has put me on his comp committee. Hmmmm . . .) * * * * * * * * * * * * My views on America’s long-term problem in respect to trade imbalances, which I have laid out in previous reports, remain unchanged. My conviction, however, cost Berkshire $955 million pre-tax in 2005. That amount is included in our earnings statement, a fact that illustrates the differing ways in which GAAP treats gains and losses. When we have a lo ng-term position in stocks or bonds, year-to-year changes in value are reflected in our balance sheet but, as long as the asset is not sold, are rarely reflected in earnings. For example, our Coca-Cola holdings went from $1 billion in value early o n to $13.4 billion at yearen d 1998 and have since declined to $8.1 billion – with none of these moves affecting our earnings statement. Long-term cu rrency positions, however, are d aily m arked to m arket an d th erefore hav e an effect on earnings i n e very rep orting period. F rom t he dat e we fi rst ent ered i nto cu rrency c ontracts, we are $2 .0 billion in the black. We re duced our direct position in c urrencies so mewhat d uring 200 5. We p artially o ffset th is change, however, by purchasing equities whose prices are denominated in a variety of foreign currencies and that earn a large part of their profits internationally. Charlie and I prefer this method of acquiring non- dollar exposure. T hat’s largely because of cha nges in interest rates: As U.S. rates ha ve risen relative to those of the rest of the world, holding most foreign currencies now involves a significant negative “carry.” The carry aspect of our direct currency position indeed cost us money in 2005 and is likely to do so again in 2006. In contrast, the ownership of foreign equities is likely, over time, to create a positive carry – perhaps a substantial one.
The underlying factors affecting the U.S. current account deficit continue to worsen, and no letup is in sight. Not only did our trade deficit – the largest and most familiar item in the current account – hit an all-time high in 2005, but we also can expect a second item – the balance of investment income – to soon turn negative. As f oreigners increase their ownership of U.S. assets (or of claim s against us) relative to U.S. investments abroad, th ese investors will b egin earning more on their ho ldings than we do on ours. Finally, the third component of the current account, unilateral transfers, is always negative. The U.S., it should be emphasized, is extraordinarily rich and will get richer. As a result, the huge imbalances in its curre nt account may continue for a long time without their ha ving noticeable deleterious effects on the U.S. economy or on markets. I doubt, however, that the situation will forever remain benign. Either Americans address the p roblem soon in a way we select, o r at so me point the problem will likely address us in an unpleasant way of its own. 17 How to Minimize Investment Returns It’s been an easy matter for Berkshire and other owners of American equities to prosper over the years. Between December 31, 1899 and December 31, 1999, to give a really long-term example, the Dow rose from 66 to 11,497. (Guess wh at annual g rowth rate is required to produce this result; the surprising answer i s at t he e nd of t his sect ion.) T his h uge rise ca me about for a simple reason: Over the century American businesses did extraordinarily well and i nvestors rode the wave of t heir prosperity. B usinesses continue to do well. Bu t now shareholders, through a series o f self-inflicted wounds, are in a m ajor way cutting the returns they will realize from their investments. The exp lanation of how th is is h appening b egins with a fu ndamental tru th: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.
Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being inc urred in amounts that will cause share holders to earn far less than they historically have. To understand how this toll has ballooned, imagine for a moment that all Am erican corporations are, and always will b e, owned by a sin gle family. We’ll call them the Gotrocks. After p aying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. B ut the portion it sav es steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious. But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on. After a while, most of the family members realize that they are not doing so well at this new “beat- my-brother” g ame. Ent er a nother set of Helpers. T hese ne wcomers explain t o ea ch m ember of the Gotrocks cl an that by himself he’ll never outsmart t he re st o f t he fam ily. T he suggested c ure: “ Hire a manager – y es, us – an d get t he jo b d one professionally.” Th ese manager-Helpers co ntinue to use th e broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers. The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course.
It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks o n s electing m anager-Helpers. The be fuddled fam ily wel comes t his assi stance. B y no w i ts members know they ca n pick neither the right st ocks nor t he ri ght st ock-pickers. Why, o ne might ask , should th ey ex pect su ccess in p icking th e righ t con sultant? Bu t th is q uestion does no t o ccur t o th e Gotrocks, and the consultant-Helpers certainly don’t suggest it to them. 18 The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appea rs. T hese friendly fol k explain t o the Gotrocks that their unsatisfactory re sults are occurring because the existing Helpers – brokers , managers , c onsultants – are not s ufficiently motivated and a re simply going through the motions. “ What,” the new Helpers ask, “can you expect from such a b unch of zombies?” The new arrivals offer a breath takingly simple solution: Pay more money. Brimmin g with self- confidence, the hyper-Hel pers assert that huge c ontingent payments – in addition to s tiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives. The mo re observant me mbers of t he f amily s ee t hat some o f t he hyper-Helpers are really ju st manager-Helpers weari ng n ew uni forms, bearing sewn-on sexy nam es like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, ass ure t he Gotrocks t hat t his c hange of cl othing i s al l-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up. And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if t hey all j ust stayed in th eir rocking ch airs – is no w going to a swelling arm y o f Hel pers. Particularly expensive is the recent pa ndemic of profit arrangem ents under whic h Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all o f the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A su fficient number of arran gements lik e this – heads, the Helper takes much of the winn ings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In ot her words, the burden of paying Helpers may cause Am erican equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Four th Law of Motion: For i nvestors as a whole, returns decrease as motion increases. * * * * * * * * * * * * Here’s the answer to the question posed at the beginning of this section: To get very specific, the Dow i ncreased f rom 65. 73 t o 11,497.12 i n t he 20th cent ury, a nd t hat am ounts t o a gain of 5.3% compounded annually. (Investors would also have received dividends, of course.) To achieve an equal rate of gain in the 21st century, the Dow will have to rise by December 31, 2099 to – brace yourself – precisely 2,011,011.23. But I’m willing to settle for 2,000,000; six years into this century, the Dow has gained not at all. Debt and Risk As we consolidate MidAmerican, our new balance sheet may suggest that Berkshire has expanded its tolerance for borrowing. But that’s not so. Except for token amounts, we shun debt, turning to it for only three purposes: 1) We occasionally use re pos a s a part of ce rtain s hort-term investing st rategies that incorporate ownership of U.S. government (or ag ency) secu rities. Pu rchases o f th is kind are highly opportunistic and i nvolve only the most liquid of sec urities. A f ew y ears ag o, we entered i nto several interesting transactions that have since been unwound or are running off. The offsetting debt has likewise been cut substantially and before long may be gone. 19 2) We borrow money against portfolios of interest-bearing receivables whose risk characteristics we understand. We did this in 2001 when we guaranteed $5.6 billion of bank debt to take over, in partnership with Leucadia, a bankr upt Finova (which held a broa d range of receiva bles). All of that debt has been repaid. More rece ntly, we ha ve b orrowed t o finance a wi dely-diversified, predictably-performing portfolio of m anufactured-home receiva bles m anaged by Clayton. Alternatively, we could “securitize” – that is, sell – these receivables, but re tain the servicing of them. If we fo llowed this procedure, which is co mmon in the industry, we wou ld not show the debt that we do on our balance sheet, and we would also accelerate the earnings we report. In the end, h owever, we w ould ea rn l ess m oney. Were market variables t o change s o as to fa vor securitization (an unlikely event), we could sell part of our portfolio and eliminate the related debt. Until then, we prefer better profits to better cosmetics.
3) At MidAmerican, we have substantial debt, but it is th at company’s obligation only. Tho ugh it will appear on our consolidated balance sheet, Berkshire does not guarantee it. Even so, this debt is unquestionably secure because it is serviced by MidAmerican’s diversified stream of highly-stable utility earnings. If t here were to be some bolt from the blue that hurt one of MidAmerican’s utility properties, earnings from the others would still b e more than ample to cover al l debt req uirements. M oreover, MidAmerican retain s all of its earn ings, an eq uity- building practice that is rare in the utility field. From a risk standpoint, it is far safer to have earnings from ten diverse and uncorrelated utility operations that cover interest charges by, say, a 2: 1 ratio than it is to have far greater coverage provided by a single utility. A catastrop hic event can render a si ngle utility insolvent – witness what Katrina did to the local electric utility in New Orleans – no matter how conservative its debt policy. A ge ographical di saster – say , an e arthquake i n a West ern st ate – can’t have the same effect on MidAm erican. And e ven a worrier lik e Ch arlie can ’t th ink o f an ev ent th at wou ld systemically decrease utility ear nings in any major way. Because of MidAm erican’s e ver- widening diversity of regulated earnings, it will always utilize major amounts of debt. And t hat’s abo ut it. We are no t in terested i n in curring an y si gnificant debt at Berk shire for acquisitions o r operating pu rposes. Conventional bu siness wisd om, of cou rse, would argu e t hat we are being too conservative and that there are added profits that could be safely earned if we injected moderate leverage into our balance sheet. Maybe so. B ut many of B erkshire’s hundreds of thousands of investors have a l arge portion of their net worth in our st ock (among them, it should be em phasized, a l arge number of ou r board and key managers) and a disaster for the company would be a disaster for them . Moreove r, there are pe ople who have been pe rmanently i njured t o w hom we o we i nsurance pay ments t hat st retch o ut for fi fty y ears or more. To these and other constituencies we have promised total security, whatever comes: financial panics, stock-exchange closures (a n extended one occurre d in 1914) or e ven dom estic nuclear, chem ical or biological attacks.
We are quite willing to accept huge risks. Indeed, more than any other insurer, we write high-limit policies that are tied to single catastrophic events. We also own a large investment portfolio whose market value cou ld fall d ramatically an d qu ickly u nder certain conditions (as h appened on October 19, 19 87). Whatever occurs, tho ugh, B erkshire will h ave t he n et worth, th e earn ings stream s an d t he liq uidity to handle the problem with ease. Any other approach is dangerous. Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always eq uals zero. That is not a n eq uation w hose ef fects I wo uld l ike t o ex perience pers onally, and I w ould l ike eve n l ess t o be responsible for imposing its penalties upon others. 20 Management Succession As owners, you are naturally concerned about whether I will insist on continuing as C EO after I begin to fade and, if so, how the board will handle that problem. You also want to know what happens if I should die tonight. That second question is eas y to ans wer. M ost o f o ur many busi nesses ha ve st rong m arket positions, significant momentum, and terrific managers. The special Berkshire culture is deeply ingrained throughout our subsidiaries, and these operations won’t miss a beat when I die. Moreover, we have three managers at Berkshire who are reasonably young and fully capable of being CEO. Any of the three would be much better at certain management aspects of my job t han I. On the minus side, none has my crossover experience that allows me to be comfortable making decisions in either the business arena or in investments. Th at problem will b e solved by having another person in the organization handle marketable securities. Th at’s an interesting job at Berkshire, and th e new CEO wil l have no problem in hiring a talented individual to do it. Indeed, that’s what we have done at GEICO for 26 years, and our results have been terrific. Berkshire’s b oard has fully di scussed eac h of t he t hree CEO can didates an d ha s u nanimously agreed on the person who s hould s ucceed me if a repl acement were needed toda y. The directors stay updated on this su bject and could al ter t heir vi ew as ci rcumstances cha nge – new managerial st ars may emerge and present ones will ag e. Th e important point is th at the directors know now – and will always know in the future – exactly what they will do when the need arises.
The other question that must be addressed is whether the Board will be prepared to make a change if that need should arise not from my death but rathe r from my decay, particularly if this decay is accompanied by my delusionally thi nking that I am reac hing ne w peaks of m anagerial brilliance. That problem woul d n ot be uni que t o m e. Charl ie an d I have faced th is situ ation from t ime to ti me at Berkshire’s subsidiaries. Humans age at greatly varyi ng rates – b ut sooner or later their talents and vigor decline. Some managers remain effectiv e well in to their 8 0s – C harlie i s a wo nder at 82 – a nd others noticeably fade in their 60s. When their abilities ebb, so usually do their powers of self-assessm ent. Someone else often needs to blow the whistle. When th at time co mes fo r me, o ur bo ard will h ave to step up to t he j ob. From a fin ancial standpoint, its members are unusually motivated to do so. I know of no other board in the country in which the financial interests of directors are so completely aligned with those of shareholders. Few b oards even come close. On a personal level, however, it is e xtraordinarily difficult for most people to tell so meone, particularly a friend, that he or she is no longer capable. If I b ecome a can didate fo r th at message, h owever, ou r b oard will be d oing m e a favo r by delivering it. Every share of Berkshire that I own is destined to go to philanthropies, and I want society to reap the maximum good from these gifts and bequests. It would be a tragedy if the philanthropic potential of m y h oldings was d iminished because my asso ciates shirked th eir respo nsibility t o (tend erly, I hope) show me the door. But don’t worry about this. We have an outstanding group of directors, and they will always do what’s right for shareholders. And while we are on the subject, I feel terrific. The Annual Meeting Our meeting this year will b e on Saturday, May 6 . As always, th e doors will o pen at th e Qwest Center at 7 a.m., and the latest Berkshire movie will be shown at 8:30. At 9 :30 we will go directly to the question-and-answer period, which (with a break for lunch at the Qwest’s stands) will last until 3:00. Then, after a short recess, Charlie and I will convene the annual meeting at 3:15. This schedule worked well last year, because it let those who wanted to attend the formal session to do so, while freeing others to shop.
21 You certainly did your share in this respect last year. Th e 194,300 square foot hall adjoining the meeting area was filled with the products of Berkshire subsidiaries, and the 21,000 people who came to the meeting allowed every location to rack up sales records. Kelly Broz (neé Muchemore), the Flo Ziegfeld of Berkshire, orchestrates both this magnificent shopping extravaganza and the meeting itself. The exhibitors love her, and so do I. Kelly got married in October, and I gave her away. She asked me how I wanted to be listed in the wedding program. I replied “envious of the groom,” and that’s the way it went to press. This year we will showcase two Clayto n ho mes (featuring Acm e brick, Sh aw carpet, Johns Manville in sulation, MiTek fasteners, Carefree awnings an d NFM furnitu re). You will find that these homes, priced at $79,000 and $89,000, deliver excellent value. In fact, three shareholders came so fi rmly to that conclusion last year that they bought the $119,000 model we then showcased. Flanking the Clayton homes on the exhibition floor will be RVs from Forest River. GEICO will have a booth staffed by a number of its top counselors from around the country, all of them ready to supply you with auto insurance quotes. In m ost cases, GEICO will b e able to give you a special shareholder discount (us ually 8%). This special offer is permitted by 45 of t he 50 jurisdictions in which we operate. (One supplemental point: The discount is not additive if you qualify for another, such as that given certain groups.) Bring the details of your existing insurance and check out whether we can save you money. For at least 50% of you, I believe we can. And while you’re at it, sign up for the new GEICO credit card. It’s the one I now use. On Saturd ay, at the Omaha airport, we will have t he u sual array of aircraft from NetJets® available for your inspection. Stop by the NetJets booth at the Qwest t o learn about viewing these planes. Come to Omaha by bus; leave in your new plane. The Bookworm boutique at the Qwest broke all rec ords last year selling Berk shire-related books. An amazing 3,500 of these were Poor C harlie’s Al manack, t he c ollected wi sdom of my part ner. This means that a copy was sold every 9 seconds. And for good reason: You will never find a book with more useful ideas. Word-of-mouth recommendations have caused Charlie’s first printing of 20,500 copies to sell out, and we will therefore have a revised and expanded edition on sale at our meeting. Among the other 22 titles an d DVDs av ailable last year at t he Book worm, 4 ,597 cop ies were so ld fo r $84,746. Our shareholders are a bookseller’s dream.
An attachment to the proxy material that is enclosed with this report explains how you can obtain the credential you will n eed for ad mission to the meeting and other events. As fo r plane, hotel and car reservations, we have a gain signed up American Express (800-799-6634) to give you special help. C arol Pedersen, who handles these matters, does a terrific job for us each year, and I thank her for it. At Nebraska Furniture Mart, located on a 77-acre site on 72nd Street between Dodge and Pacific, we will again be having “Berkshire Weekend” pricing. We in itiated this special event at NFM n ine years ago, and sales during the “Weekend” grew from $5.3 million in 1997 to $27.4 million in 2005 (up 9% from a year earlier). I get goose bumps just thinking about this volume. To obtain the discount, you must make your purchases between Thursday, May 4 and Mo nday, May 8 inclusive, and also present your meeting credential. The period’s special pricing will even apply to the products of several prestigious manufacturers that normally have ironclad rules against discounting but that, i n t he s pirit of our s hareholder weekend, have m ade a n exce ption for y ou. We a ppreciate their cooperation. NFM is open from 10 a.m. to 9 p.m . Monday through Saturday, and 10 a.m. to 6 p. m. on Sunday. On Saturday this year, from 5:30 p.m. to 8 p.m., we a re having a speci al affair for shareholders only. I’ll be there, eating barbeque, drinking Coke, and counting sales. Borsheim’s again will have t wo shareholder-only events. The first will be a coc ktail reception from 6 p.m. to 10 p.m. on Friday, May 5 . Th e second, the main gala, will b e from 9 a.m. to 4 p.m. on Sunday, May 7. On Saturday, we will be open until 6 p.m. 22 We w ill h ave h uge crow ds at Bo rsheim’s th roughout th e w eekend. Fo r your con venience, therefore, shareholder prices will be available from Monday, May 1 through Saturday, May 1 3. During that pe riod, j ust i dentify y ourself as a s hareholder t hrough y our m eeting c redentials o r a b rokerage statement. Borsheim’s operates on a gross margin that, even before the shareholders’ discount, is fully twenty percentage points below that of its major rivals. Last year, our shareholder-period business increased 9% from 2004, which came on t op of a 73% gain the year before. T he store sold 5,000 Berkshire Monopoly games – and then ran out. We’ve learned: Plenty will be in stock this year.
In a tent outside of Borsheim’s, Patrick Wolff, twice U.S. chess champion, will take on all comers in groups of six – blindfolded. Additionally, we will have Bob Hamman and Sharon Osberg, two of th e world’s top bridge experts, available to play with our shareholders on Sunday afternoon. They plan to keep their eyes open – but Bob never sorts his cards, even when playing for a national championship. Gorat’s – my fav orite steakhouse – will again be open exclusively for Berk shire shareholders on Sunday, May 7, and will be serving from 4 p.m. until 10 p.m. Please remember that to come to Gorat’s on that day, you must have a reservation. To make one, call 402-551-3733 on April 1 (but not before). In this school year, about 35 university classes will co me to Omaha for sessions with me. I tak e almost all – in aggregate, perhaps 2,000 students – to lunch at Gorat’s. And they love it. To learn why, come join us on Sunday. We will again have a special r eception from 4:00 to 5: 30 on Saturday afternoon for shareholders who have come from outside of North America. Every year our meeting draws many people from around the globe, and Charlie and I want to be sure we personally greet those who have come so far. Last year we enjoyed meeting more than 400 of you from many dozens of countries. Any shareholder who comes from other than the U.S. or Canada will be given a special credential and instructions for attending this function. * * * * * * * * * * * * Charlie and I are extraordinarily lucky. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene t hat al lows us t o p rosper i n a m anner h ugely di sproportionate t o ot her people w ho contribute as much or more to our society’s well-being. Moreover, we have long had jobs that we love, in which we are helped every day in countless ways by talented and cheerful associates. No wonder we tap- dance t o w ork. B ut n othing i s more fu n for us t han getting t ogether with o ur sha reholder-partners at Berkshire’s annual meeting. So join us on May 6th at the Qwest for our annual Woodstock for Capitalists. We’ll see you there. February 28, 2006 Warren E. Buffett Chairm an of the Board 23