Warren Buffett on Dividend Policy

CEO Mike Wirth opened the Q4 2023 review against the backdrop of the October announcement of the all-stock acquisition of Hess Corporation, including the Hess interest in the Guyana Stabroek block co-owned with ExxonMobil. Management told the call that the Company had returned a record $26.3 billion to shareholders during the year, including $16.3 billion of share repurchases and approximately $10 billion of dividends, and that the Board had authorized a $75 billion increase to the share repurchase program, with the intent to execute the program at the top of the targeted $20 billion annual range through 2024. CFO Pierre Breber walked analysts through the Hess transaction framework, indicating that the deal would close in the first half of 2024 subject to regulatory clearances, that the structure was all-stock to preserve the balance sheet and the capital return trajectory and that the synergy opportunities were concentrated in the Permian and the Bakken portfolios. He flagged that the Guyana Stabroek interest being acquired was the strategic centrepiece of the transaction, with a multi-decade production growth profile from the resource base already discovered. On the Q&A, analysts pressed on whether the all-stock structure implied that the Company viewed its own shares as overvalued. Wirth responded that the all-stock structure reflected the Company's preference for preserving the balance sheet capacity to fund the long-cycle project portfolio and the capital return trajectory simultaneously, and that the share repurchase pace would be maintained through the closing of the transaction. He also pushed back on the framing of the deal as a bet on crude prices, arguing that the Guyana resource base had been de-risked through the exploration and appraisal program and that the unit economics of the Stabroek block were among the most attractive in the global upstream portfolio. The call closed with management reaffirming the long-term framework of three percent annual production growth through 2027, anchored on the Permian unconventional, the Gulf of Mexico deepwater and the Guyana interest, and with the Company committing to maintain the multi-decade trajectory of dividend growth and to continue the share repurchase pace through the cycle.

Our goal is realistic. Berkshire’s strength comes from its Niagara of diverse earnings delivered after interest costs, taxes and substantial charges for depreciation and amortization (“EBITDA” is a banned measurement at Berkshire). We also operate with minimal requirements for cash, even if the country encounters a prolonged period of global economic weakness, fear and near-paralysis. Berkshire does not currently pay dividends, and its share repurchases are 100% discretionary. Annual debt maturities are never material. Your company also holds a cash and U.S. Treasury bill position far in excess of what conventional wisdom deems necessary. During the 2008 panic, Berkshire generated cash from operations and did not rely in any manner on commercial paper, bank lines or debt markets. We did not predict the time of an economic paralysis but we were always prepared for one. Extreme fiscal conservatism is a corporate pledge we make to those who have joined us in ownership of Berkshire. In most years – indeed in most decades – our caution will likely prove to be unneeded behavior – akin to an insurance policy on a fortress-like building thought to be fireproof. But Berkshire does not want to inflict permanent financial damage – quotational shrinkage for extended periods can’t be avoided – on Bertie or any of the individuals who have trusted us with their savings. Berkshire is built to last.

But he had one nagging worry, heightened because he had recently witnessed a friend’s early death and the disastrous results that followed for that man’s family and business. What, Paul asked himself in 2006, would happen to the many people depending on him if he should unexpectedly die? For a year, Paul wrestled with his options. Sell to a competitor? From a strictly economic viewpoint, that course made the most sense. After all, competitors could envision lucrative “synergies” – savings that would be achieved as the acquiror slashed duplicated functions at TTI. But . . . Such a purchaser would most certainly also retain its CFO, its legal counsel, its HR unit. Their TTI counterparts would therefore be sent packing. And ugh! If a new distribution center were to be needed, the acquirer’s home city would certainly be favored over Fort Worth.

CEO Michael Wirth opened the Q2 2020 review against the backdrop of the COVID-driven collapse in global oil demand during the second quarter, when WTI crude briefly traded at negative $37 per barrel in April. Management told the call that the Company had cut the 2020 capital program by approximately twenty percent to roughly $14 billion and that the operating expense run-rate had been reduced by approximately $1.4 billion on an annualised basis, while the common dividend had been raised for the thirty-third consecutive year. CFO Pierre Breber walked analysts through the capital allocation framework, indicating that the Company intended to defend the dividend through the downturn without issuing equity, fund the reduced capital program from operating cash flow and the balance sheet, and use the asset divestiture program to bridge the gap. He flagged that the Company's balance sheet had been built deliberately for environments like the COVID-driven collapse, with net debt at the bottom of the peer group range coming into the downturn. On the Q&A, analysts pressed on whether the Company would consider cutting the dividend as several peers had signalled. Wirth responded that the Company had committed to the dividend through the cycle and that the long-cycle project portfolio entering service through 2021 and 2022, especially the Permian unconventional and the Gulf of Mexico deepwater projects, would provide the cash flow growth to support the trajectory of dividend growth. He also pushed back on the suggestion that the Permian unconventional growth ambition should be moderated, arguing that the Company's position in the basin was the structural driver of long-term production growth. The call closed with management reaffirming the long-term framework of between three and four percent annual production growth into the mid-decade, anchored on the Permian unconventional, the Gulf of Mexico deepwater and the recently acquired Noble Energy portfolio in the Eastern Mediterranean, and committing to return essentially all of the operating cash flow net of capex to shareholders through the cycle once the price environment normalised.

My only disposal of Berkshire shares, aside from charitable donations and minor personal gifts, took place in 1980, when I, along with other Berkshire stockholders who elected to participate, exchanged some of our Berkshire shares for the shares of an Illinois bank that Berkshire had purchased in 1969 and that, in 1980, needed to be offloaded because of changes in the bank holding company law. Today, my will specifically directs its executors – as well as the trustees who will succeed them in administering my estate after the will is closed – not to sell any Berkshire shares. My will also absolves both the executors and the trustees from liability for maintaining what obviously will be an extreme concentration of assets. The will goes on to instruct the executors – and, in time, the trustees – to each year convert a portion of my A shares into B shares and then distribute the Bs to various foundations. Those foundations will be required to deploy their grants promptly. In all, I estimate that it will take 12 to 15 years for the entirety of the Berkshire shares I hold at my death to move into the market. Absent my will’s directive that all my Berkshire shares should be held until their scheduled distribution dates, the “safe” course for both my executors and trustees would be to sell the Berkshire shares under their temporary control and reinvest the proceeds in U.S. Treasury bonds with maturities matching the scheduled dates for distributions.

It’s true, of course, that American owners of homes, autos and other assets have often borrowed heavily to finance their purchases. If an owner defaults, however, his or her asset does not disappear or lose its usefulness. Rather, ownership customarily passes to an American lending institution that then disposes of it to an American buyer. Our nation’s wealth remains intact. As Gertrude Stein put it, “Money is always there, but the pockets change.” Above all, it’s our market system – an economic traffic cop ably directing capital, brains and labor – that has created America’s abundance. This system has also been the primary factor in allocating rewards. Governmental redirection, through federal, state and local taxation, has in addition determined the distribution of a significant portion of the bounty. America has, for example, decided that those citizens in their productive years should help both the old and the young. Such forms of aid – sometimes enshrined as “entitlements” – are generally thought of as applying to the aged. But don’t forget that four million American babies are born each year with an entitlement to a public education. That societal commitment, largely financed at the local level, costs about $150,000 per baby. The annual cost totals more than $600 billion, which is about 3 1⁄2 % of GDP. However our wealth may be divided, the mind-boggling amounts you see around you belong almost exclusively to Americans.

The company cut commissions and expenses – moves that permitted lower prices – and soon became a powerhouse. For many decades, State Farm has been the runaway volume leader in both auto and homeowner’s insurance. Allstate, which also operated with a direct distribution model, was long the runner-up. Both State Farm and Allstate have had underwriting expenses of about 25%. In the early 1930s, another contender, United Services Auto Association (“USAA”), a mutual-like company, was writing auto insurance for military officers on a direct-to-the-customer basis. This marketing innovation rose from a need that military personnel had to buy insurance that would stay with them as they moved from base to base. That was business of little interest to local insurance agencies, which wanted the steady renewals that came from permanent residents. The direct distribution method of USAA, as it happened, incurred lower costs than those enjoyed by State Farm and Allstate and therefore delivered an even greater bargain to customers. That made Leo and Lillian Goodwin, employees of USAA, dream of broadening the target market for its direct distribution model beyond military officers. In 1936, starting with $100,000 of capital, they incorporated Government Employees Insurance Co. (later compressing this mouthful to GEICO). Their fledgling did $238,000 of auto insurance business in 1937, its first full year. Last year GEICO did $22.6 billion, more than double the volume of USAA.

Chairman and CEO John Watson opened the Q4 2014 review against the backdrop of a more than fifty percent collapse in crude prices during the second half of 2014. Management told the call that the Company was entering 2015 with the largest long-cycle project portfolio in its history, anchored on the Gorgon LNG project in Australia, the Wheatstone LNG project, the Jack/St. Malo deepwater project in the Gulf of Mexico and the Big Foot tension-leg platform, with aggregate capital commitments that would peak at approximately $35 billion during 2015 before tapering sharply through 2016 and 2017. CFO Pat Yarrington walked analysts through the capital allocation framework, indicating that the Company would fund the peak capex year from operating cash flow and the balance sheet, with the asset divestiture program contributing additional funding. She flagged that the dividend had been increased for the twenty-seventh consecutive year, that the Company intended to continue the multi-decade trajectory of dividend growth through the downturn and that share buybacks were not part of the framework given the long-cycle investment pipeline. On the Q&A, analysts pressed on whether the dividend was safe given the crude price environment and the capex burden. Watson responded that the Company had stress-tested the dividend through a $50 per barrel environment and that the balance sheet and the asset divestiture program provided the bridge through the downturn. He also argued that the long-cycle projects entering service during 2015 and 2016 were the structural drivers of cash flow growth through the back half of the decade and that pulling back on the final completion capex would have been the wrong decision under any plausible price scenario. The call closed with management reiterating the long-term objective of upstream production growth toward 3.1 million barrels of oil equivalent per day by 2017 and a return on capital employed above the peer group average through the cycle, and committing to defend the dividend through the downturn even if doing so required incremental balance-sheet leverage.

(viii) He would also spend much time in enthusiastically admiring what others were accomplishing. (7) New subsidiaries would usually be bought with cash, not newly issued stock. (8) Berkshire would not pay dividends so long as more than one dollar of market value for shareholders was being created by each dollar of retained earnings. (9) In buying a new subsidiary, Berkshire would seek to pay a fair price for a good business that the Chairman could pretty well understand. Berkshire would also want a good CEO in place, one expected to remain for a long time and to manage well without need for help from headquarters. (10) In choosing CEOs of subsidiaries, Berkshire would try to secure trustworthiness, skill, energy, and love for the business and circumstances the CEO was in. (11) As an important matter of preferred conduct, Berkshire would almost never sell a subsidiary. (12) Berkshire would almost never transfer a subsidiary’s CEO to another unrelated subsidiary. (13) Berkshire would never force the CEO of a subsidiary to retire on account of mere age. (14) Berkshire would have little debt outstanding as it tried to maintain (i) virtually perfect creditworthiness under all conditions and (ii) easy availability of cash and credit for deployment in times presenting unusual opportunities. (15) Berkshire would always be user-friendly to a prospective seller of a large business. An offer of such a business would get prompt attention.

Moreover, your annual cash receipts from the sell-off policy would now be running 4% more than you would have received under the dividend scenario. Voila! – you would have both more cash to spend annually and more capital value. This calculation, of course, assumes that our hypothetical company can earn an average of 12% annually on net worth and that its shareholders can sell their shares for an average of 125% of book value. To that point, the S&P 500 earns considerably more than 12% on net worth and sells at a price far above 125% of that net worth. Both assumptions also seem reasonable for Berkshire, though certainly not assured. Moreover, on the plus side, there also is a possibility that the assumptions will be exceeded. If they are, the argument for the sell-off policy becomes even stronger. Over Berkshire’s history – admittedly one that won’t come close to being repeated – the sell-off policy would have produced results for shareholders dramatically superior to the dividend policy. Aside from the favorable math, there are two further – and important – arguments for a sell-off policy. First, dividends impose a specific cash-out policy upon all shareholders. If, say, 40% of earnings is the policy, those who wish 30% or 50% will be thwarted. Our 600,000 shareholders cover the waterfront in their desires for cash. It is safe to say, however, that a great many of them – perhaps even most of them – are in a net-savings mode and logically should prefer no payment at all.

Clearly my ownership percentage of the company has significantly decreased. Yet my investment in the business has actually increased: The book value of my current interest in Berkshire considerably exceeds the book value attributable to my holdings of seven years ago. (The actual figures are $28.2 billion for 2005 and $40.2 billion for 2012.) In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased. It’s also true that my share of both Berkshire’s intrinsic business value and the company’s normal earning power is far greater than it was in 2005. Over time, I expect this accretion of value to continue – albeit in a decidedly irregular fashion – even as I now annually give away more than 4 1⁄2% of my shares (the increase having occurred because I’ve recently doubled my lifetime pledges to certain foundations). * * * * * * * * * * * * Above all, dividend policy should always be clear, consistent and rational. A capricious policy will confuse owners and drive away would-be investors. Phil Fisher put it wonderfully 54 years ago in Chapter 7 of his Common Stocks and Uncommon Profits, a book that ranks behind only The Intelligent Investor and the 1940 edition of Security Analysis in the all-time-best list for the serious investor. Phil explained that you can successfully run a restaurant that serves hamburgers or, alternatively, one that features Chinese food.

Its sales growth and overall performance are unique in its industry. Iscar’s managers – Eitan Wertheimer, Jacob Harpaz and Danny Goldman – are brilliant strategists and operators. When the economic world was cratering in November 2008, they stepped up to buy Tungaloy, a leading Japanese cutting-tool manufacturer. Tungaloy suffered significant damage when the tsunami hit north of Tokyo last spring. But you wouldn’t know that now: Tungaloy went on to set a sales record in 2011. I visited the Iwaki plant in November and was inspired by the dedication and enthusiasm of Tungaloy’s management, as well as its staff. They are a wonderful group and deserve your admiration and thanks. • McLane, our huge distribution company that is run by Grady Rosier, added important new customers in 2011 and set a pre-tax earnings record of $370 million. Since its purchase in 2003 for $1.5 billion, the company has had pre-tax earnings of $2.4 billion and also increased its LIFO reserve by $230 million because the prices of the retail products it distributes (candy, gum, cigarettes, etc.) have risen. Grady runs a logistical machine second to none. You can look for bolt-ons at McLane, particularly in our new wine-and-spirits distribution business.

Next to Marmon, the two largest earners in this sector are Iscar and McLane. Both had excellent years. In 2010, Grady Rosier’s McLane entered the wine and spirits distribution business to supplement its $32 billion operation as a distributor of food products, cigarettes, candy and sundries. In purchasing Empire Distributors, an operator in Georgia and North Carolina, we teamed up with David Kahn, the company’s dynamic CEO. David is leading our efforts to expand geographically. By yearend he had already made his first acquisition, Horizon Wine and Spirits in Tennessee. At Iscar, profits were up 159% in 2010, and we may well surpass pre-recession levels in 2011. Sales are improving throughout the world, particularly in Asia. Credit Eitan Wertheimer, Jacob Harpaz and Danny Goldman for an exceptional performance, one far superior to that of Iscar’s main competitors. All that is good news. Our businesses related to home construction, however, continue to struggle. Johns Manville, MiTek, Shaw and Acme Brick have maintained their competitive positions, but their profits are far below the levels of a few years ago. Combined, these operations earned $362 million pre-tax in 2010 compared to $1.3 billion in 2006, and their employment has fallen by about 9,400. A housing recovery will probably begin within a year or so. In any event, it is certain to occur at some point.

(We don’t fault the Fed: For various reasons, an across-the-board freeze made sense during the crisis and its immediate aftermath.) At some point, probably soon, the Fed’s restrictions will cease. Wells Fargo can then reinstate the rational dividend policy that its owners deserve. At that time, we would expect our annual dividends from just this one security to increase by several hundreds of millions of dollars annually. Other companies we hold are likely to increase their dividends as well. Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business. Overall, I believe our “normal” investment income will at least equal what we realized in 2010, though the redemptions I described will cut our take in 2011 and perhaps 2012 as well. * * * * * * * * * * * * Last summer, Lou Simpson told me he wished to retire. Since Lou was a mere 74 – an age Charlie and I regard as appropriate only for trainees at Berkshire – his call was a surprise. Lou joined GEICO as its investment manager in 1979, and his service to that company has been invaluable.

Almost all of the many and widely-diverse operations in this sector suffered to one degree or another from 2009’s severe recession. The major exception was McLane, our distributor of groceries, confections and non-food items to thousands of retail outlets, the largest by far Wal-Mart. Grady Rosier led McLane to record pre-tax earnings of $344 million, which even so amounted to only slightly more than one cent per dollar on its huge sales of $31.2 billion. McLane employs a vast array of physical assets – practically all of which it owns – including 3,242 trailers, 2,309 tractors and 55 distribution centers with 15.2 million square feet of space. McLane’s prime asset, however, is Grady. We had a number of companies at which profits improved even as sales contracted, always an exceptional managerial achievement. Here are the CEOs who made it happen: COMPANY CEO Benjamin Moore (paint) Denis Abrams Borsheims (jewelry retailing) Susan Jacques H. H. Brown (manufacturing and retailing of shoes) Jim Issler CTB (agricultural equipment) Vic Mancinelli Dairy Queen John Gainor Nebraska Furniture Mart (furniture retailing) Ron and Irv Blumkin Pampered Chef (direct sales of kitchen tools) Marla Gottschalk See’s (manufacturing and retailing of candy) Brad Kinstler Star Furniture (furniture retailing) Bill Kimbrell Among the businesses we own that have major exposure to the depressed industrial sector, both Marmon and Iscar turned in relatively strong performances.

Chairman Dave O'Reilly opened the Q4 2008 review against the exceptional backdrop of a year in which crude oil had spiked above $145 in July and then collapsed below $35 by December. Management told the call that the full-year earnings would set a record for Chevron, with the upstream earnings benefiting from the first-half spike and the downstream refining business having produced record margins in the first half before swinging to losses in the fourth quarter as demand collapsed. CFO Steve Crow walked analysts through the capital program, indicating that the Company had actually increased the capital budget during the year to $22.9 billion to advance the Gorgon LNG project in Australia, the Tahiti deepwater project in the Gulf of Mexico and the Chuandongbei sour-gas project in China. He flagged that the Company had bought back approximately $3.5 billion of common stock during the year, that the dividend had been increased for the twenty-first consecutive year and that the balance sheet was positioned to support the long-cycle capital program through any plausible near-term price environment. On the Q&A, analysts pressed on whether the collapse in crude prices would force a rethink of the long-cycle capital allocation framework. O'Reilly responded that the Company had built the project portfolio specifically to deliver returns through the cycle and that the deepwater and LNG projects in the pipeline were expected to earn double-digit returns even at substantially lower long-run crude prices than the 2008 average. He also defended the buyback pace, arguing that the Company's strong operating cash flow permitted both the long-cycle investment and the shareholder returns. The call closed with management reaffirming the long-term framework of organic production growth of one to two percent per year through the next decade, anchored on the deepwater and LNG portfolio, and with the Company committing to continue the multi-decade trajectory of annual dividend increases even in a low-price environment.

5 billion, and the price of our later purchases will be based on a formula tied to earnings. Prior to our entry into the picture, the Pritzker family received substantial consideration from Marmon’s distribution of cash, investments and certain businesses. This deal was done in the way Jay would have liked. We arrived at a price using only Marmon’s financial statements, employing no advisors and engaging in no nit-picking. I knew that the business would be exactly as the Pritzkers represented, and they knew that we would close on the dot, however chaotic financial markets might be. During the past year, many large deals have been renegotiated or killed entirely. With the Pritzkers, as with Berkshire, a deal is a deal. Marmon’s CEO, Frank Ptak, works closely with a long-time associate, John Nichols. John was formerly the highly successful CEO of Illinois Tool Works (ITW), where he teamed with Frank to run a mix of industrial businesses. Take a look at their ITW record; you’ll be impressed.

Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire. We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories. Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us.

A “normal” dividend policy, of course – one-third of earnings paid out, for example – produces 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 outstanding options. I’ve never, however, seen this manager-owner conflict referenced in proxy materials that request approval of a fixed-priced option plan. Though CEOs invariably preach internally that capital comes at a cost, they somehow 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 value that occurs when earnings are retained. But – surprise, 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 earns in a lifetime of cleaning 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.

Finally, there is a fear factor at work, in that a shrinking business usually leads to layoffs. To avoid pink slips, employees will rationalize inadequate pricing, telling themselves that poorly-priced business must be tolerated in order to keep the organization intact and the distribution system happy. If this course isn’t followed, these employees will argue, the company will not participate in the recovery that they invariably feel is just around the corner. To combat employees’ natural tendency to save their own skins, we have always promised NICO’s workforce that no one will be fired because of declining volume, however severe the contraction. (This is not Donald Trump’s sort of place.) NICO is not labor-intensive, and, as the table suggests, can live with excess overhead. It can’t live, however, with underpriced business and the breakdown in underwriting discipline that accompanies it. An insurance organization that doesn’t care deeply about underwriting at a profit this year is unlikely to care next year either. Naturally, a business that follows a no-layoff policy must be especially careful to avoid overstaffing when times are good. Thirty years ago Tom Murphy, then CEO of Cap Cities, drove this point home to me with a hypothetical tale about an employee who asked his boss for permission to hire an assistant. The employee assumed that adding $20,000 to the annual payroll would be inconsequential.

With its low-cost structure, State Farm eventually captured about 25% of the personal lines (auto and homeowners) business, far outdistancing its once-mighty competitors. Allstate, formed in 1931, put a similar distribution system into place and soon became the runner-up in personal lines to State Farm. Capitalism had worked its magic, and these low-cost operations looked unstoppable.

But a man named Leo Goodwin had an idea for an even more efficient auto insurer and, with a skimpy $200,000, started GEICO in 1936. Goodwin’s plan was to eliminate the agent entirely and to deal instead directly with the auto owner. Why, he asked himself, should there be any unnecessary and expensive links in the distribution mechanism when the product, auto insurance, was both mandatory and costly. Purchasers of business insurance, he reasoned, might well require professional advice, but most consumers knew what they needed in an auto policy. That was a powerful insight. Originally, GEICO mailed its low-cost message to a limited audience of government employees. Later, it widened its horizons and shifted its marketing emphasis to the phone, working inquiries that came from broadcast and print advertising. And today the Internet is coming on strong. Between 1936 and 1975, GEICO grew from a standing start to a 4% market share, becoming the country’s fourth largest auto insurer. During most of this period, the company was superbly managed, achieving both excellent volume gains and high profits. It looked unstoppable. But after my friend and hero Lorimer Davidson retired as CEO in 1970, his successors soon made a huge mistake by under- reserving for losses. This produced faulty cost information, which in turn produced inadequate pricing. By 1976, GEICO was on the brink of failure.

Chairman Ken Derr opened the Q4 1998 review against the backdrop of an oil price that had collapsed below $12 per barrel during the Asian financial crisis and that was pressuring the entire integrated peer group. Management told the call that Chevron had responded to the downturn by accelerating the cost-reduction program announced in 1997, taking a further $250 million of operating expense out of the run-rate during 1998 and pushing the upstream unit operating cost trajectory toward the lower end of the peer group range. CFO Mike Smith walked analysts through the upstream production trajectory, indicating that the company was tracking toward approximately 1.55 million barrels of oil equivalent per day for the year, with the deepwater Gulf of Mexico portfolio ramping through 1999. He flagged that the downstream business had absorbed the worst refining margin environment in a decade, with the benchmark West Coast crack spread compressing by roughly thirty percent year over year. On the Q&A, analysts pressed on whether the downturn would force a rethink of the long-term capital allocation framework. Derr responded that the Company's capital spending would actually be increased modestly into 1999, anchored on the deepwater portfolio and on international upstream projects in Kazakhstan and West Africa, and that the operating expense reduction was being executed without compromising the long-cycle upstream project pipeline. The call closed with management reiterating the long-term framework of between two and three percent annual production growth, competitive returns on capital employed through the cycle, and a commitment to defend the common dividend through downturns rather than to cut it, citing the multi-decade track record of dividend growth as the most important signal of the franchise's quality.

Here's a story illustrating what Melvyn and Shirley are like: When they told their associates of the sale, they also announced that Star would make large, special payments to those who had helped them succeed -- and then defined that group as everyone in the business. Under the terms of our deal, it was Melvyn and Shirley's money, not ours, that funded this distribution. Charlie and I love it when we become partners with people who behave like that.

World Book, however, did not find it easy: Despite the operation's new status as the only direct-seller of encyclopedias in the country (Encyclopedia Britannica exited the field last year), its unit volume fell. Additionally, World Book spent heavily on a new CD-ROM product that began to take in revenues only in early 1997, when it was launched in association with IBM. In the face of these factors, earnings would have evaporated had World Book not revamped distribution methods and cut overhead at headquarters, thereby dramatically reducing its fixed costs. Overall, the company has gone a long way toward assuring its long-term viability in both the print and electronic marketplaces.

Obviously all businesses change to some extent. Today, See's is different in many ways from what it was in 1972 when we bought it: It offers a different assortment of candy, employs different machinery and sells through different distribution channels. But the reasons why people today buy boxed chocolates, and why they buy them from us rather than from someone else, are virtually unchanged from what they were in the 1920s when the See family was building the business. Moreover, these motivations are not likely to change over the next 20 years, or even 50.

I can't resist one more Candler quote: "Beginning this year about March 1st . . . we employed ten traveling salesmen by means of which, with systematic correspondence from the office, we covered almost the territory of the Union." That's my kind of sales force. Companies such as Coca-Cola and Gillette might well be labeled "The Inevitables." Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation. In the end, however, no sensible observer - not even these companies' most vigorous competitors, assuming they are assessing the matter honestly - questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen. Both companies have significantly expanded their already huge shares of market during the past ten years, and all signs point to their repeating that performance in the next decade.

At some point, we may stop mailing our quarterly reports and simply post these on the Internet. This move would eliminate significant costs. Also, we have a large number of "street name" holders and have found that the distribution of our quarterlies to them is highly erratic: Some holders receive their mailings weeks later than others. The drawback to Internet-only distribution is that many of our shareholders lack computers. Most of these holders, however, could easily obtain printouts at work or through friends. Please let me know if you prefer that we continue mailing quarterlies. We want your input - starting with whether you even read these reports - and at a minimum will make no change in 1997. Also, we will definitely keep delivering the annual report in its present form in addition to publishing it on the Internet.

And thus I met Lorimer Davidson, Assistant to the President, who was later to become CEO. Though my only credentials were that I was a student of Graham's, "Davy" graciously spent four hours or so showering me with both kindness and instruction. No one has ever received a better half-day course in how the insurance industry functions nor in the factors that enable one company to excel over others. As Davy made clear, GEICO's method of selling - direct marketing - gave it an enormous cost advantage over competitors that sold through agents, a form of distribution so ingrained in the business of these insurers that it was impossible for them to give it up. After my session with Davy, I was more excited about GEICO than I have ever been about a stock.

Moreover, both Coke and Gillette have actually increased their worldwide shares of market in recent years. The might of their brand names, the attributes of their products, and the strength of their distribution systems give them an enormous competitive advantage, setting up a protective moat around their economic castles. The average company, in contrast, does battle daily without any such means of protection. As Peter Lynch says, stocks of companies selling commodity-like products should come with a warning label: "Competition may prove hazardous to human wealth."

Berkshire's acquisition criteria are described on page 23. Beyond purchases made by the parent company, however, our subsidiaries sometimes make small "add-on" acquisitions that extend their product lines or distribution capabilities. In this manner, we enlarge the domain of managers we already know to be outstanding - and that's a low-risk and high-return proposition. We made five acquisitions of this type in 1992, and one was not so small: At yearend, H. H. Brown purchased Lowell Shoe Company, a business with $90 million in sales that makes Nursemates, a leading line of shoes for nurses, and other kinds of shoes as well. Our operating managers will continue to look for add-on opportunities, and we would expect these to contribute modestly to Berkshire's value in the future.

When this kind of gain is made - and when a paper attains an unequaled degree of acceptance in its home town - someone is doing something right. In this case major credit clearly belongs to Murray Light, our long-time editor who daily creates an informative, useful, and interesting product. Credit should go also to the Circulation and Production Departments: A paper that is frequently late, because of production problems or distribution weaknesses, will lose customers, no matter how strong its editorial content.

Three conditions that prevail in insurance, but not in most businesses, allow us our flexibility. First, market share is not an important determinant of profitability: In this business, in contrast to the newspaper or grocery businesses, the economic rule is not survival of the fattest. Second, in many sectors of insurance, including most of those in which we operate, distribution channels are not proprietary and can be easily entered: Small volume this year does not preclude huge volume next year. Third, idle capacity - which in this industry largely means people - does not result in intolerable costs. In a way that industries such as printing or steel cannot, we can operate at quarter-speed much of the time and still enjoy long-term prosperity.

And now a bit of deja vu. Most of Berkshire's major stockholders received their shares at yearend 1969 in a liquidating distribution from Buffett Partnership, Ltd. Some of these former partners will remember that in 1962 I encountered severe managerial problems at Dempster Mill Manufacturing Co., a pump and farm implement manufacturing company that BPL controlled.

See’s has a one-of-a-kind product "personality" produced by a combination of its candy’s delicious taste and moderate price, the company’s total control of the distribution process, and the exceptional service provided by store employees. Chuck rightfully measures his success by the satisfaction of our customers, and his attitude permeates the organization. Few major retailing companies have been able to sustain such a customer-oriented spirit, and we owe Chuck a great deal for keeping it alive and well at See’s.

He filled me in on a little history: Fechheimer, a uniform manufacturing and distribution business, began operations in 1842. Warren Heldman, Bob’s father, became involved in the business in 1941 and his sons, Bob and George (now President), along with their sons, subsequently joined the company. Under the Heldmans’ management, the business was highly successful.

I should reemphasize that Ken and Garry have been resourceful, energetic and imaginative in attempting to make our textile operation a success. Trying to achieve sustainable profitability, they reworked product lines, machinery configurations and distribution arrangements. We also made a major acquisition, Waumbec Mills, with the expectation of important synergy (a term widely used in business to explain an acquisition that otherwise makes no sense). But in the end nothing worked and I should be faulted for not quitting sooner. A recent Business Week article stated that 250 textile mills have closed since 1980. Their owners were not privy to any information that was unknown to me; they simply processed it more objectively. I ignored Comte's advice - 'the intellect should be the servant of the heart, but not its slave' - and believed what I preferred to believe.

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

In dividend policy also, the option holders' interests are best served by a policy that may ill serve the owner. Think back to the savings account example. The trustee, holding his option, would benefit from a no-dividend policy. Conversely, the owner of the account should lean to a total payout so that he can prevent the option-holding manager from sharing in the account's retained earnings.

About 96.8% of all eligible shares participated in Berkshire's 1985 shareholder-designated contributions program. Total contributions made through the program were $4 million, and 1,724 charities were recipients. We conducted a plebiscite last year in order to get your views about this program, as well as about our dividend policy. (Recognizing that it's possible to influence the answers to a question by the framing of it, we attempted to make the wording of ours as neutral as possible.) We present the ballot and the results in the Appendix on page 69. I think it's fair to summarize your response as highly supportive of present policies and your group preference - allowing for the tendency of people to vote for the status quo - to be for increasing the annual charitable commitment as our asset values build.

Using my academic voice, I have told you in the past of the drag that a mushrooming capital base exerts upon rates of return. Unfortunately, my academic voice is now giving way to a reportorial voice. Our historical 22% rate is just that - history. To earn even 15% annually over the next decade (assuming we continue to follow our present dividend policy, about which more will be said later in this letter) we would need profits aggregating about $3.9 billion. Accomplishing this will require a few big ideas - small ones just won't do. Charlie Munger, my partner in general management, and I do not have any such ideas at present, but our experience has been that they pop up occasionally. (How's that for a strategic plan?)

Sharp-eyed shareholders will notice that the amount of the special GEICO distribution and its location in the table have been changed from the presentation of last year. Though they reclassify and reduce 'accounting' earnings, the changes are entirely of form, not of substance. The story behind the changes, however, is interesting. As reported last year: (1) in mid-1983 GEICO made a tender offer to buy its own shares; (2) at the same time, we agreed by written contract to sell GEICO an amount of its shares that would be proportionately related to the aggregate number of shares GEICO repurchased via the tender from all other shareholders; (3) at completion of the tender, we delivered 350,000 shares to GEICO, received $21 million cash, and were left owning exactly the same percentage of GEICO that we owned before the tender; (4) GEICO's transaction with us amounted to a proportionate redemption, an opinion rendered us, without qualification, by a leading law firm; (5) the Tax Code logically regards such proportionate redemptions as substantially equivalent to dividends and, therefore, the $21 million we received was taxed at only the 6.9% inter-corporate dividend rate; (6) importantly, that $21 million was far less than the previously-undistributed earnings that had inured to our ownership in GEICO and, thus, from the standpoint of economic substance, was in our view equivalent to a dividend.

Because it was material and unusual, we highlighted the GEICO distribution last year to you, both in the applicable quarterly report and in this section of the annual report. Additionally, we emphasized the transaction to our auditors, Peat, Marwick, Mitchell & Co. Both the Omaha office of Peat Marwick and the reviewing Chicago partner, without objection, concurred with our dividend presentation.

Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, 'Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI'. And that's it - no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.

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

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

Let's now turn to Berkshire Hathaway and examine how these dividend principles apply to it. Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.

The special GEICO distribution reported in the table arose when that company made a tender offer for a portion of its stock, buying both from us and other shareholders. At GEICO's request, we tendered a quantity of shares that kept our ownership percentage the same after the transaction as before. The proportional nature of our sale permitted us to treat the proceeds as a dividend. Unlike individuals, corporations net considerably more when earnings are derived from dividends rather than from capital gains, since the effective Federal income tax rate on dividends is 6.9% versus 28% on capital gains.

The other problem we face, as the table suggests, is our recent inability to achieve meaningful gains in pounds sold. The industry has the same problem. But for many years we outperformed the industry in this respect and now we are not. 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). Of course, dollar volume has increased because we have raised prices significantly. But we regard the most important measure of retail trends to be units sold per store rather than dollar volume. On a same-store basis (counting only shops open throughout both years) with all figures adjusted to a 52-week year, poundage was down .8 of 1% during 1983. This small decline was our best same-store performance since 1979; the cumulative decline since then has been about 8%. Quantity-order volume, about 25% of our total, has plateaued in recent years following very large poundage gains throughout the 1970s.

And that fact, of course, has been hard for many people to grasp. For years the traditional wisdom ' long on tradition, short on wisdom ' held that inflation protection was best provided by businesses laden with natural resources, plants and machinery, or other tangible assets ("In Goods We Trust"). It doesn't work that way. Asset-heavy businesses generally earn low rates of return ' rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses.

If, however, costs and prices are determined by full-bore competition, 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. They may well be disastrous. Hence the constant struggle of every vendor to establish and emphasize special qualities of product or service. This works with candy bars (customers buy by brand name, not by asking for a 'two-ounce candy bar') but doesn't work with sugar (how often do you hear, 'I'll have a cup of coffee with cream and C & H sugar, please').

Why, then, was underwriting, despite the existence of cycles, generally profitable over many decades? (From 1950 through 1970, the industry combined ratio averaged 99.0. allowing all investment income plus 1% of premiums to flow through to profits.) The answer lies primarily in the historic methods of regulation and distribution. For much of this century, a large portion of the industry worked, in effect, within a legal quasi-administered pricing system fostered by insurance regulators. While price competition existed, it was not pervasive among the larger companies. The main competition was for agents, who were courted via various non-price-related strategies.

That day is gone. Although parts of the old structure remain, far more than enough new capacity exists outside of that structure to force all parties, old and new, to respond. The new capacity uses various methods of distribution and is not reluctant to use price as a prime competitive weapon. Indeed, it relishes that use. In the process, customers have learned that insurance is no longer a one-price business. They won't forget.

When supply ultimately contracts, large amounts of business will be available for the few with large capital capacity, a willingness to commit it, and an in-place distribution system. We would expect great opportunities for our insurance subsidiaries at such a time. During 1982, our insurance underwriting deteriorated far more than did the industry's. From a profit position well above average, we, slipped to a performance modestly below average. The biggest swing was in National Indemnity's traditional coverages. Lines that have been highly profitable for us in the past are now priced at levels that guarantee underwriting losses. In 1983 we expect our insurance group to record an average performance in an industry in which average is very poor.

During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor.

Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or 'real' dividends. The tapeworm of inflation simply cleans the plate. (The low-return company's inability to pay dividends, understandably, is often disguised. Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of 'dividends' that can be paid out only if someone promises to replace the capital distributed.)

Our remaining textile operation, still sizable, has been divided into a manufacturing and a sales division, each free to do business independent of the other. Thus, distribution strengths and mill capabilities will not be wedded to each other. We have more than doubled capacity in our most profitable textile segment through a recent purchase of used 130-inch Saurer looms. Current conditions indicate another tough year in textiles, but with substantially less capital employed in the operation.

On this basis, we had a reasonably good operating performance in 1979 - but not quite as good as that of 1978 - with operating earnings amounting to 18.6% of beginning net worth. Earnings per share, of course, increased somewhat (about 20%) but we regard this as an improper figure upon which to focus. We had substantially more capital to work with in 1979 than in 1978, and our performance in utilizing that capital fell short of the earlier year, even though per-share earnings rose. 'Earnings per share' will rise constantly on a dormant savings account or on a U.S. Savings Bond bearing a fixed rate of return simply because 'earnings' (the stated interest rate) are continuously plowed back and added to the capital base. Thus, even a 'stopped clock' can look like a growth stock if the dividend payout ratio is low.