“The Bear” on Business

It is true. Warren Buffett does not invest in technology companies. He sat on the sidelines during the entire telecom and .com boom. He was questioned as becoming obsolete; the times were passing him by. Even after several straight years of observing Internet stocks soaring, he didn’t flinch. Then the crash came. If he hadn’t already earned the nickname “Oracle of Omaha”, he would have in 2002. His portfolio held up fairly while during the dramatic crash.

Buffett doesn’t apply his principles to tech. Why should we? To answer this, let’s first understand why Buffett avoids Internet and Telecom stocks.

Core to Buffett’s principles is to invest only in industies you understand and, as importantly, only in businesses that you can confidently project future cash flows. The second test is actually more important than the first.

The first test suggests that a person should be very up to speed on an industry before electing to invest in it. Buffett certainly believes this. Buffett might not be an Internet guru, but he could, if he choose to, get sufficiently up to speed on the sector. However, we can safely assume he chooses not to because he is convinced the second test cannot be satisfied–either by him or anyone else. That is, technology is changing both rapidly and unpredictably such that the notion that anyone can confidently predict future cash flows is naive. Moreover, he doesn’t see this changing in the near term.

In my next entry, I will dive deeper into this topic–desribing the differince between “investing” and “speculating”. I will use Google as an example. However, before diving deep into this topic, I want to make a couple of points.

First, most of Buffett’s principles are relevant even for companies that don’t meet his criteria for a potential investment. In fact, it is arguably more important for new and unpredictable companies to be built on a solid business foundation. Therefore, it does not matter whether or not an industry is ready for Buffett-style investing to apply his learnings.

Second, certain areas of technology, are maturing to the point where Buffett principles can be used to make good investment decisions. This is likely especially true for parts of telecom. My guess is that Berkshire might be slow to consider the telecom sector as it is a complex industry for outsiders. However, others (e.g., Longleaf Partners) who are more comfortable with the industry, will increasingly have the ability to confidently predict future cash flows. As a result, these investors will discover situations where the there is a large gap between value and price.

As recently as 2005, the telecom industry was a complete mess. We, as managers in the industry, must acknowledge responsibility. I personally witnessed countless situations where behavior was completely inappropriate. In many cases, management should have simply known better. However, in the majority of cases (and with the benefit of hindsight) management was trying to do the “right thing”; the problem was not
ethics, it was competence. I beleive Buffett’s principles–if fully understood and applied–would have provided a sorely needed a moral and business compass for our industry.

Telecom is enjoying an exciting resurgence. We get a do-over. This time, without doubt, the winners will be determined by those who are competent and responsible managers, not those who take the most risk and happen to be the more lucky than others. I believe this. And I believe the Oracle of Omaha is relevant to the challenges we face.

Warren Buffett is either the 1st or 2nd richest person in the world. His friend, Bill Gates, is the other. Gates entire net worth is due to Microsoft. I am not taking anything away from him–let’s face it, he was a genius on how he created and positioned DOS, Windows, Internet Explorer, and Microsoft Office. However, his entire genius was wrapped up in his ability to exploit the PC and (to a lesser extent) Internet world when they were in their infancy.

Buffett’s accomplishment, in my mind, is much more special. Buffett has accumulated his net worth through an entity called Berkshire Hathaway. Berkshire has been a NYSE public company since 1965. It’s book value per share has increased from $19/share to $70,281, a stunning 21.4% compound annual return. Buffett’s entire net worth of approximately $50B was created through Berkshire’s performance.

Berkshire is a holding company that invests in many different industries. For the most part, he purchases 100% (or close to 100%) of private companies. Among the recognizable names in his holding company are GEICO insurance, Russell sports wear, and Clayton Homes. Buffett, who is known as the Oracle of Omaha, outshines Gates because he was mind-boggling successful in many industries over a period of decades. His accomplishment is nothing short of amazing.

“The Bear” is my nickname. I am, as you can tell, an avid fan of the Omaha Oracle. My grandpa made a killer barbeque sauce but he would never tell us how he made it. Buffett, however, shares his secret sauce quite openly. Through his annual reports, he presents his approach in clear and understandable narrative. In fact, it is even fun to read. I believe strongly in his approach and, in this blog, you will see me refer to Buffett over and over again. It is for good reason–we all can learn a lot from him.

Think back to the year 2000. Were you in the middle of the big Internet and Telecom Boom? The pace was frenzied. The money being raised was staggering. Start-ups with barely defined business plans had little trouble getting funding. Companies went public while losing large sums of money and their strock prices rose in step functions. Brings back the lyrics of an old song “Those were the days my friend. I thought they’d never end.”

How young were you? How experienced were you relative to the job you had? What about your boss? Your boss’ boss? Your CEO? How many people were really qualified for the job they had?

And the investors: what did they know? They were raising money without bounds. The quicker they put it to work, the more they could raise. Just like management, the ones who knew the Internet were not all that experienced in investing.

Fast forward two years. It’s now 2002. Enron. Worldcom Global Crossing. Pets.com. The medival ages lasted for 1,000 years. The aftermath of the tech meltdown seemed to last even longer. But as bleak as the sector looked in early 2005, the renaissance was right around the corner.

Now it is almost 2008. Even the meltdown seems like a distant memory. Internet stocks are booming again. Infrastructure–fiber, wireless, content distribution networks–is in incredible demand. If you are in telecom or Internet, the future looks just fine and dandy.

Perhaps never before in American business has a large group of very young entreprenuers, management and investors experienced a dramatic boom, an equally dramatic bust, and a very strong resurgence in the span of less than 10 years. This group of professionals will be entering the prime of their careers with all the experience of this complete cycle. Wow, and the strong resurrgence is probably only in its infancy.

The question is: “What have we learned?” Certainly we have had the benefit of a lot of mistakes. Are we taking full advantage of this benefit? Or, now that we have the opportunity, will we repeat the same mistakes of the late 1990’s.

I continue to be amazed at how many in our industry blame everyone but themselves for what happened during the boom. It was Bernie Ebbers fault. Jeff Skilling poisened the industry. Joe Nacchio was a crook. Blame the bankers: Jack Grubman, Frank Quattrone, Mary Meeker and Henry Blodget.

Certainly all these folks shoulder a huge burden. But for every one of them, there are thousands of the rest of us. And most of us would do well to reflect on our own actions and behavior. This blog will be about applying better fundamental business practices to the tech industry.

I am committed to the highest level of management ethics. I would rather see the company fail financially than compromise ethics. With this in mind, below are four ethics principles that I believe capture the responsibilities management has with its investors.

1. Treat shareholders as long term business partners; and view management as managing partners. An enterprise must be managed with the perspective that investors (not management) own the assets contained within the company. It is management’s responsibility to ensure all executive compensation and perks are clearly understood and approved by its investors.
2. Be clear, open and honest in our communications with investors. Management is responsible for making it easy for investors to understand what is happening in the business. This should be the case whether the news is good, neutral, or bad.

Warren Buffet writes “Elsewhere, triumphs are trumpeted, but dumb decisions either get no follow-up or are rationalized.” This behavior finds its way into the culture and operations of a company. High risk business decisions are encouraged because if they pay off, the rewards are high and if they don’t, the ramifications are less than they should be. Though human nature might resist, management must be candid in its self-assessment, even when it comes up short.

As part of effective communication, management must strive to measuring and reporting financial performance in a clear and unbiased way. As part of this, management should seek to understand and clearly articulate the risk profile inherent in the businesses decisions being made.

3. Understand the meaning of “Intrinsic Value” and make maximizing Intrinsic Value the basis for business decisions. Warren Buffett refers to intrinsic value as an all important concept. He defines it as the discounted value of the cash that can be taken out of a business during its remaining life. Maximizing intrinsic value needs the guide for all business decision making.

Note: this point sometimes causes conflict with the notion that the CEO’s job is “maximize stock price”. Inappropriate behavior—such as hyping exciting developments or masking unfavorable results—could result from defining the goal as “Maximize Stock Price” instead of “Maximize Intrinsic Value”.

Buffett says: “If Intrinsic Value increases, the stock price will eventually follow.”

4. Investors should be informed of the company’s true Intrinsic Value, not more and not less. Buffett points out that Intrinsic Value is easier to define than to accurately calculate. Management’s goal should be to help investors gain an accurate understanding (to the best of management’s ability) of the Intrinsic Value.

Note: this point causes a further conflict with the common-held belief that a CEO’s goal is to “maximize stock price”. If a stock price reflects an enterprise value that differs from Intrinsic Value, the result is one class of shareholder will benefit at the expense of another class. For example, if the valuation implied by the stock price exceeds the Intrinsic Value, new shareholders will be overpaying exiting shareholders.

The ethics goal is to be fair to all shareholders. To accomplish this, management must strive to ensure their investors’ perceived value of the firm (whether the entity is a public or private company) is in line with management’s estimation of Intrinsic Value.

This is a growing collection of quotes from Buffett which point to his wisdom both in business and in life.

1. Price is what you pay. Value is what you get.
2. If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.
3. Of one thing be certain: if a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisors will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked.
4. It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.
5. I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.
6. Risk comes from not knowing what you’re doing.
7. The most important quality for an investor is temperament, not intellect… You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.
8. Asking an investment banker if you need to do a merger or acquisition is much like asking an interior designer if you need a $50,000 throw rug.
9. If Intrinsic Value increases, the stock price will eventually follow.
10. The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.
11. Our favorite holding period is forever.
12. If you don’t know jewelry, know the jeweler.

1 In June 1996, Berkshire’s Chairman, Warren E. Buffett, issued a booklet entitled “An Owner’s Manual” to Berkshire’s Class A and Class B shareholders. The purpose of the manual was to explain Berkshire’s broad economic principles of operation. An updated version is reproduced on this and the following four pages.
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OWNER-RELATED BUSINESS PRINCIPLES

At the time of the Blue Chip merger in 1983, I set down 13 owner-related business principles that I thought would help new shareholders understand our managerial approach. As is appropriate for “principles,” all 13 remain alive and well today, and they are stated here in italics.

1. Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.

Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family. For our part, we do not view Berkshire shareholders as faceless members of an ever-shifting crowd, but rather as co-venturers who have entrusted their funds to us for what may well turn out to be the remainder of their lives.

The evidence suggests that most Berkshire shareholders have indeed embraced this long-term partnership concept. The annual percentage turnover in Berkshire’s shares is a small fraction of that occurring in the stocks of other major American corporations, even when the shares I own are excluded from the calculation.

In effect, our shareholders behave in respect to their Berkshire stock much as Berkshire itself behaves in respect to companies in which it has an investment. As owners of, say, Coca-Cola or American Express shares, we think of Berkshire as being a non-managing partner in two extraordinary businesses, in which we measure our success by the long-term progress of the companies rather than by the month-to-month movements of their stocks. In fact, we would not care in the least if several years went by in which there was no trading, or quotation of prices, in the stocks of those companies. If we have good long-term expectations, short-term price changes are meaningless for us except to the extent they offer us an opportunity to increase our ownership at an attractive price.

2. In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.

Charlie’s family has 90% or more of its net worth in Berkshire shares; I have about 99%. In addition, many of my relatives — my sisters and cousins, for example — keep a huge portion of their net worth in Berkshire stock.

Charlie and I feel totally comfortable with this eggs-in-one-basket situation because Berkshire itself owns a wide variety of truly extraordinary businesses. Indeed, we believe that Berkshire is close to being unique in the quality and diversity of the businesses in which it owns either a controlling interest or a minority interest of significance.

Charlie and I cannot promise you results. But we can guarantee that your financial fortunes will move in lockstep with ours for whatever period of time you elect to be our partner. We have no interest in large salaries or options or other means of gaining an “edge” over you. We want to make money only when our partners do and in exactly the same proportion. Moreover, when I do something dumb, I want you to be able to derive some solace from the fact that my financial suffering is proportional to yours.

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

4. Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.

In recent yeas we have made a number of acquisitions. Though there will be dry years, we expect to make many more in the decades to come, and our hope is that they will be large. If these purchases approach the quality of those we have made in the past, Berkshire will be well served.

The challenge for us is to generate ideas as rapidly as we generate cash. In this respect, a depressed stock market is likely to present us with significant advantages. For one thing, it tends to reduce the prices at which entire companies become available for purchase. Second, a depressed market makes it easier for our insurance companies to buy small pieces of wonderful businesses – including additional pieces of businesses we already own – at attractive prices. And third, some of those same wonderful businesses, such as Coca-Cola, are consistent buyers of their own shares, which means that they, and we, gain from the cheaper prices at which they can buy.

Overall, Berkshire and its long-term shareholders benefit from a sinking stock market much as a regular purchaser of food benefits from declining food prices. So when the market plummets – as it will from time to time – neither panic nor mourn. It’s good news for Berkshire.

5. Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.

To state things simply, we try to give you in the annual report the numbers and other information that really matter. Charlie and I pay a great deal of attention to how well our businesses are doing, and we also work to understand the environment in which each business is operating. For example, is one of our businesses enjoying an industry tailwind or is it facing a headwind? Charlie and I need to know exactly which situation prevails and to adjust our expectations accordingly. We will also pass along our conclusions to you.

Over time, the large majority of our businesses have exceeded our expectations. But sometimes we have disappointments, and we will try to be as candid in informing you about those as we are in describing the happier experiences. When we use unconventional measures to chart our progress — for instance, you will be reading in our annual reports about insurance “float” — we will try to explain these concepts and why we regard them as important. In other words, we believe in telling you how we think so that you can evaluate not only Berkshire’s businesses but also assess our approach to management and capital allocation.

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

We have found over time that the undistributed earnings of our investees, in aggregate, have been fully as beneficial to Berkshire as if they had been distributed to us (and therefore had been included in the earnings we officially report). This pleasant result has occurred because most of our investees are engaged in truly outstanding businesses that can often employ incremental capital to great advantage, either by putting it to work in their businesses or by repurchasing their shares. Obviously, every capital decision that our investees have made has not benefitted us as shareholders, but overall we have garnered far more than a dollar of value for each dollar they have retained. We consequently regard look-through earnings as realistically portraying our yearly gain from operations.

7. We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. (As one of the Indianapolis “500” winners said: “To finish first, you must first finish.”)

The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return. I’ve never believed in risking what my family and friends have and need in order to pursue what they don’t have and don’t need.

Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $69 billion.

Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of the debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.

Of course, there is no guarantee that we can obtain our float in the future at no cost. But we feel our chances of attaining that goal are as good as those of anyone in the insurance business. Not only have we reached the goal in the past (despite a number of important mistakes by your Chairman), our 1996 acquisition of GEICO, materially improved our prospects for getting there in the future.

8. A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.

Charlie and I are interested only in acquisitions that we believe will raise the per-share intrinsic value of Berkshire’s stock. The size of our paychecks or our offices will never be related to the size of Berkshire’s balance sheet.

9. We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

We continue to pass the test, but the challenges of doing so have grown more difficult. If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.

10. We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance — not only mergers or public stock offerings, but stock-for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company — and that is what the issuance of shares amounts to — on a basis inconsistent with the value of the entire enterprise.

When we sold the Class B shares in 1996, we stated that Berkshire stock was not undervalued — and some people found that shocking. That reaction was not well-founded. Shock should have registered instead had we issued shares when our stock was undervalued. Managements that say or imply during a public offering that their stock is undervalued are usually being economical with the truth or uneconomical with their existing shareholders’ money: Owners unfairly lose if their managers deliberately sell assets for 80¢ that in fact are worth $1. We didn’t commit that kind of crime in our offering of Class B shares and we never will. (We did not, however, say at the time of the sale that our stock was overvalued, though many media have reported that we did.)

11. You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.

We continue to avoid gin rummy behavior. True, we closed our textile business in the mid-1980’s after 20 years of struggling with it, but only because we felt it was doomed to run never-ending operating losses. We have not, however, given thought to selling operations that would command very fancy prices nor have we dumped our laggards, though we focus hard on curing the problems that cause them to lag.

12. We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private.

At Berkshire you will find no “big bath” accounting maneuvers or restructurings nor any “smoothing” of quarterly or annual results. We will always tell you how many strokes we have taken on each hole and never play around with the scorecard. When the numbers are a very rough “guesstimate,” as they necessarily must be in insurance reserving, we will try to be both consistent and conservative in our approach.

We will be communicating with you in several ways. Through the annual report, I try to give all shareholders as much value-defining information as can be conveyed in a document kept to reasonable length. We also try to convey a liberal quantity of condensed but important information in t he quarterly reports we post on the internet, though I don’t write those (one recital a year is enough). Still another important occasion for communication is our Annual Meeting, at which Charlie and I are delighted to spend five hours or more answering questions about Berkshire. But there is one way we can’t communicate: on a one-on-one basis. That isn’t feasible given Berkshire’s many thousands of owners.

13. Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say “no comment” on other occasions, the no-comments become confirmation.

Though we continue to be unwilling to talk about specific stocks, we freely discuss our business and investment philosophy. I benefitted enormously from the intellectual generosity of Ben Graham, the greatest teacher in the history of finance, and I believe it appropriate to pass along what I learned from him, even if that creates new and able investment competitors for Berkshire just as Ben’s teachings did for him.

TWO ADDED PRINCIPLES

14. To the extent possible, we would like each Berkshire shareholder to record a gain or loss in market value during his period of ownership that is proportional to the gain or loss in per-share intrinsic value recorded by the company during that holding period. For this to come about, the relationship between the intrinsic value and the market price of a Berkshire share would need to remain constant, and by our preferences at 1-to-1. As that implies, we would rather see Berkshire’s stock price at a fair level than a high level. Obviously, Charlie and I can’t control Berkshire’s price. But by our policies and communications, we can encourage informed, rational behavior by owners that, in turn, will tend to produce a stock price that is also rational. Our it’s-as-bad-to-be-overvalued-as-to-be-undervalued approach may disappoint some shareholders. We believe, however, that it affords Berkshire the best prospect of attracting long-term investors who seek to profit from the progress of the company rather than from the investment mistakes of their partners.

15. We regularly compare the gain in Berkshire’s per-share book value to the performance of the S&P 500. Over time, we hope to outpace this yardstick. Otherwise, why do our investors need us? The measurement, however, has certain shortcomings that are described in the next section. Moreover, it now is less meaningful on a year-to-year basis than was formerly the case. That is because our equity holdings, whose value tends to move with the S&P 500, are a far smaller portion of our net worth than they were in earlier years. Additionally, gains in the S&P stocks are counted in full in calculating that index, whereas gains in Berkshire’s equity holdings are counted at 65% because of the federal tax we incur. We, therefore, expect to outperform the S&P in lackluster years for the stock market and underperform when the market has a strong year.

BERKSHIRE HATHAWAY INC. 2006 Annual Report

To the Shareholders of Berkshire Hathaway Inc.:

Our gain in net worth during 2006 was $16.9 billion, which increased the per-share book value of both our Class A and Class B stock by 18.4%. Over the last 42 years (that is, since present management took over) book value has grown from $19 to $70,281, a rate of 21.4% compounded annually.*

We believe that $16.9 billion is a record for a one-year gain in net worth – more than has ever been booked by any American business, leaving aside boosts that have occurred because of mergers (e.g., AOL’s purchase of Time Warner). Of course, Exxon Mobil and other companies earn far more than Berkshire, but their earnings largely go to dividends and/or repurchases, rather than to building net worth.

All that said, a confession about our 2006 gain is in order. Our most important business, insurance, benefited from a large dose of luck: Mother Nature, bless her heart, went on vacation. After hammering us with hurricanes in 2004 and 2005 – storms that caused us to lose a bundle on super-cat insurance – she just vanished. Last year, the red ink from this activity turned black – very black.

In addition, the great majority of our 73 businesses did outstandingly well in 2006. Let me focus for a moment on one of our largest operations, GEICO. What management accomplished there was simply extraordinary.

As I’ve told you before, Tony Nicely, GEICO’s CEO, went to work at the company 45 years ago, two months after turning 18. He became CEO in 1992, and from then on the company’s growth exploded. In addition, Tony has delivered staggering productivity gains in recent years. Between year-end 2003 and year-end 2006, the number of GEICO policies increased from 5.7 million to 8.1 million, a jump of 42%. Yet during that same period, the company’s employees (measured on a fulltime-equivalent basis) fell 3.5%. So productivity grew 47%. And GEICO didn’t start fat.

That remarkable gain has allowed GEICO to maintain its all-important position as a low-cost producer, even though it has dramatically increased advertising expenditures. Last year GEICO spent $631 million on ads, up from $238 million in 2003 (and up from $31 million in 1995, when Berkshire took control). Today, GEICO spends far more on ads than any of its competitors, even those much larger. We will continue to raise the bar.

Last year I told you that if you had a new son or grandson to be sure to name him Tony. But Don Keough, a Berkshire director, recently had a better idea. After reviewing GEICO’s performance in 2006, he wrote me, “Forget births. Tell the shareholders to immediately change the names of their present children to Tony or Antoinette.” Don signed his letter “Tony”.

* * * * * * * * * * * *
Charlie Munger – my partner and Berkshire’s vice chairman – and I run what has turned out to be a big business, one with 217,000 employees and annual revenues approaching $100 billion. We certainly didn’t plan it that way. Charlie began as a lawyer, and I thought of myself as a security analyst. Sitting in those seats, we both grew skeptical about the ability of big entities of any type to function well. Size seems to make many organizations slow-thinking, resistant to change and smug. In Churchill’s words: “We shape our buildings, and afterwards our buildings shape us.” Here’s a telling fact: Of the ten non-oil companies having the largest market capitalization in 1965 – titans such as General Motors, Sears, DuPont and Eastman Kodak – only one made the 2006 list.
In fairness, we’ve seen plenty of successes as well, some truly outstanding. There are many giant company managers whom I greatly admire; Ken Chenault of American Express, Jeff Immelt of G.E. and Dick Kovacevich of Wells Fargo come quickly to mind. But I don’t think I could do the management job they do. And I know I wouldn’t enjoy many of the duties that come with their positions – meetings, speeches, foreign travel, the charity circuit and governmental relations. For me, Ronald Reagan had it right: “It’s probably true that hard work never killed anyone – but why take the chance?”

So I’ve taken the easy route, just sitting back and working through great managers who run their own shows. My only tasks are to cheer them on, sculpt and harden our corporate culture, and make major capital-allocation decisions. Our managers have returned this trust by working hard and effectively.

For their performance over the last 42 years – and particularly for 2006 – Charlie and I thank
them.

Yardsticks

Charlie and I measure Berkshire’s progress and evaluate its intrinsic value in a number of ways. No single criterion is effective in doing these jobs, and even an avalanche of statistics will not capture some factors that are important. For example, it’s essential that we have managers much younger than I available to succeed me. Berkshire has never been in better shape in this regard – but I can’t prove it to you with numbers.

There are two statistics, however, that are of real importance. The first is the amount of investments (including cash and cash-equivalents) that we own on a per-share basis. Arriving at this figure, we exclude investments held in our finance operation because these are largely offset by borrowings.

Here’s the record since present management acquired control of Berkshire:
Year Per-Share Investments*
1965 …………………………………………………………… $ 4
1975 …………………………………………………………… 159
1985 …………………………………………………………… 2,407
1995 …………………………………………………………… 21,817
2006 …………………………………………………………… $80,636
Compound Growth Rate 1965-2006……………….. 27.5%
Compound Growth Rate 1995-2006……………….. 12.6%
*Net of minority interests

In our early years we put most of our retained earnings and insurance float into investments in marketable securities. Because of this emphasis, and because the securities we purchased generally did well, our growth rate in investments was for a long time quite high.

Over the years, however, we have focused more and more on the acquisition of operating businesses. Using our funds for these purchases has both slowed our growth in investments and accelerated our gains in pre-tax earnings from non-insurance businesses, the second yardstick we use. Here’s how those earnings have looked:

Year Pre-Tax Earnings Per Share*
1965 …………………………………………………………… $ 4
1975 …………………………………………………………… 4
1985 …………………………………………………………… 52
1995 …………………………………………………………… 175
2006 …………………………………………………………… $3,625
Compound Growth Rate 1965-2006 ……………….. 17.9%
Compound Growth Rate 1995-2006 ……………….. 31.7%
*Excluding purchase-accounting adjustments and net of minority interests

Last year we had a good increase in non-insurance earnings – 38%. Large gains from here on in, though, will come only if we are able to make major, and sensible, acquisitions. That will not be easy. We do, however, have one advantage: More and more, Berkshire has become “the buyer of choice” for business owners and managers. Initially, we were viewed that way only in the U.S. (and more often than not by private companies). We’ve long wanted, nonetheless, to extend Berkshire’s appeal beyond U.S. borders. And last year, our globe-trotting finally got underway.

Acquisitions

We began 2006 by completing the three acquisitions pending at yearend 2005, spending about $6 billion for PacifiCorp, Business Wire and Applied Underwriters. All are performing very well.

The highlight of the year, however, was our July 5th acquisition of most of ISCAR, an Israeli company, and our new association with its chairman, Eitan Wertheimer, and CEO, Jacob Harpaz. The story here began on October 25, 2005, when I received a 1¼-page letter from Eitan, of whom I then knew nothing. The letter began, “I am writing to introduce you to ISCAR,” and proceeded to describe a cutting tool business carried on in 61 countries. Then Eitan wrote, “We have for some time considered the issues of generational transfer and ownership that are typical for large family enterprises, and have given much thought to ISCAR’s future. Our conclusion is that Berkshire Hathaway would be the ideal home for
ISCAR. We believe that ISCAR would continue to thrive as a part of your portfolio of businesses.”

Overall, Eitan’s letter made the quality of the company and the character of its management leap off the page. It also made me want to learn more, and in November, Eitan, Jacob and ISCAR’s CFO, Danny Goldman, came to Omaha. A few hours with them convinced me that if we were to make a deal, we would be teaming up with extraordinarily talented managers who could be trusted to run the business after a sale with all of the energy and dedication that they had exhibited previously. However, having never bought a business based outside of the U.S. (though I had bought a number of foreign stocks), I needed to get educated on some tax and jurisdictional matters. With that task completed, Berkshire purchased 80% of ISCAR for $4 billion. The remaining 20% stays in the hands of the Wertheimer family, making it our valued partner.

ISCAR’s products are small, consumable cutting tools that are used in conjunction with large and expensive machine tools. It’s a business without magic except for that imparted by the people who run it. But Eitan, Jacob and their associates are true managerial magicians who constantly develop tools that make their customers’ machines more productive. The result: ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success.

In September, Charlie and I, along with five Berkshire associates, visited ISCAR in Israel. We – and I mean every one of us – have never been more impressed with any operation. At ISCAR, as throughout Israel, brains and energy are ubiquitous. Berkshire shareholders are lucky to have joined with Eitan, Jacob, Danny and their talented associates.
* * * * * * * * * * * *
A few months later, Berkshire again became “the buyer of choice” in a deal brought to us by my friend, John Roach, of Fort Worth. John, many of you will remember, was Chairman of Justin Industries, which we bought in 2000. At that time John was helping John Justin, who was terminally ill, find a permanent home for his company. John Justin died soon after we bought Justin Industries, but it has since been run exactly as we promised him it would be.

Visiting me in November, John Roach brought along Paul Andrews, Jr., owner of about 80% of TTI, a Fort Worth distributor of electronic components. Over a 35-year period, Paul built TTI from $112,000 of sales to $1.3 billion. He is a remarkable entrepreneur and operator.

Paul, 64, loves running his business. But not long ago he happened to witness how disruptive the death of a founder can be both to a private company’s employees and the owner’s family. What starts out as disruptive, furthermore, often evolves into destructive. About a year ago, therefore, Paul began to think about selling TTI. His goal was to put his business in the hands of an owner he had carefully chosen, rather than allowing a trust officer or lawyer to conduct an auction after his death.

Paul rejected the idea of a “strategic” buyer, knowing that in the pursuit of “synergies,” an owner of that type would be apt to dismantle what he had so carefully built, a move that would uproot hundreds of his associates (and perhaps wound TTI’s business in the process). He also ruled out a private equity firm, which would very likely load the company with debt and then flip it as soon as possible.

That left Berkshire. Paul and I met on the morning of November 15th and made a deal before lunch. Later he wrote me: “After our meeting, I am confident that Berkshire is the right owner for TTI . . . I am proud of our past and excited about our future.” And so are Charlie and I.
* * * * * * * * * * * *
We also made some “tuck-in” acquisitions during 2006 at Fruit of the Loom (“Fruit”), MiTek, CTB, Shaw and Clayton. Fruit made the largest purchases. First, it bought Russell Corp., a leading producer of athletic apparel and uniforms for about $1.2 billion (including assumed debt) and in December it agreed to buy the intimate apparel business of VF Corp. Together, these acquisitions add about $2.2 billion to Fruit’s sales and bring with them about 23,000 employees.

Charlie and I love it when we can acquire businesses that can be placed under managers, such as John Holland at Fruit, who have already shown their stuff at Berkshire. MiTek, for example, has made 14 acquisitions since we purchased it in 2001, and Gene Toombs has delivered results from these deals far in excess of what he had predicted. In effect, we leverage the managerial talent already with us by these tuckin deals. We will make many more.
* * * * * * * * * * * *
We continue, however, to need “elephants” in order for us to use Berkshire’s flood of incoming cash. Charlie and I must therefore ignore the pursuit of mice and focus our acquisition efforts on much bigger game.

Our exemplar is the older man who crashed his grocery cart into that of a much younger fellow while both were shopping. The elderly man explained apologetically that he had lost track of his wife and was preoccupied searching for her. His new acquaintance said that by coincidence his wife had also wandered off and suggested that it might be more efficient if they jointly looked for the two women. Agreeing, the older man asked his new companion what his wife looked like. “She’s a gorgeous blonde,” the fellow answered, “with a body that would cause a bishop to go through a stained glass window, and
she’s wearing tight white shorts. How about yours?” The senior citizen wasted no words: “Forget her, we’ll look for yours.”

What we are looking for is described on page 25. If you have an acquisition candidate that fits, call me – day or night. And then watch me shatter a stained glass window.
* * * * * * * * * * * *
Now, let’s examine the four major operating sectors of Berkshire. Lumping their financial figures together impedes analysis. So we’ll look at them as four separate businesses, starting with the all–important insurance group.

Insurance

Next month marks the 40th anniversary of our entrance into the insurance business. It was on March 9, 1967, that Berkshire purchased National Indemnity and its companion company, National Fire & Marine, from Jack Ringwalt for $8.6 million.

Jack was a long-time friend of mine and an excellent, but somewhat eccentric, businessman. For about ten minutes every year he would get the urge to sell his company. But those moods – perhaps brought on by a tiff with regulators or an unfavorable jury verdict – quickly vanished. In the mid-1960s, I asked investment banker Charlie Heider, a mutual friend of mine and Jack’s, to alert me the next time Jack was “in heat.” When Charlie’s call came, I sped to meet Jack. We made a
deal in a few minutes, with me waiving an audit, “due diligence” or anything else that would give Jack an opportunity to reconsider. We just shook hands, and that was that.

When we were due to close the purchase at Charlie’s office, Jack was late. Finally arriving, he explained that he had been driving around looking for a parking meter with some unexpired time. That was a magic moment for me. I knew then that Jack was going to be my kind of manager.

When Berkshire purchased Jack’s two insurers, they had “float” of $17 million. We’ve regularly offered a long explanation of float in earlier reports, which you can read on our website. Simply put, float is money we hold that is not ours but which we get to invest.

At the end of 2006, our float had grown to $50.9 billion, and we have since written a huge retroactive reinsurance contract with Equitas – which I will describe in the next section – that boosts float by another $7 billion. Much of the gain we’ve made has come through our acquisition of other insurers, but we’ve also had outstanding internal growth, particularly at Ajit Jain’s amazing reinsurance operation. Naturally, I had no notion in 1967 that our float would develop as it has. There’s much to be said for just putting one foot in front of the other every day.

The float from retroactive reinsurance contracts, of which we have many, automatically drifts down over time. Therefore, it will be difficult for us to increase float in the future unless we make new acquisitions in the insurance field. Whatever its size, however, the all-important cost of Berkshire’s float over time is likely to be significantly below that of the industry, perhaps even falling to less than zero. Note the words “over time.” There will be bad years periodically. You can be sure of that.

In 2006, though, everything went right in insurance – really right. Our managers – Tony Nicely (GEICO), Ajit Jain (B-H Reinsurance), Joe Brandon and Tad Montross (General Re), Don Wurster (National Indemnity Primary), Tom Nerney (U.S. Liability), Tim Kenesey (Medical Protective), Rod Eldred (Homestate Companies and Cypress), Sid Ferenc and Steve Menzies (Applied Underwriters), John Kizer (Central States) and Don Towle (Kansas Bankers Surety) – simply shot the lights out. When I recite their names, I feel as if I’m at Cooperstown, reading from the Hall of Fame roster. Of course, the overall insurance industry also had a terrific year in 2006. But our managers delivered results generally superior to
those of their competitors.

Below is the tally on our underwriting and float for each major sector of insurance. Enjoy the view, because you won’t soon see another like it.
(in $ millions)
Underwriting Profit (Loss) Yearend Float
Insurance Operations 2006 2005 2006 2005
General Re ………………….. $ 526 $( 334) $22,827 $22,920
B-H Reinsurance………….. 1,658 (1,069) 16,860 16,233
GEICO ……………………….. 1,314 1,221 7,171 6,692
Other Primary………………. 340** 235* 4,029 3,442
Total …………………………… $3,838 $ 53 $50,887 $49,287
* Includes MedPro from June 30, 2005.
** Includes Applied Underwriters from May 19, 2006.
* * * * * * * * * * * *
In 2007, our results from the bread-and-butter lines of insurance will deteriorate, though I think they will remain satisfactory. The big unknown is super-cat insurance. Were the terrible hurricane seasons of 2004-05 aberrations? Or were they our planet’s first warning that the climate of the 21st Century will differ materially from what we’ve seen in the past? If the answer to the second question is yes, 2006 will soon be perceived as a misleading period of calm preceding a series of devastating storms. These could rock the insurance industry. It’s naïve to think of Katrina as anything close to a worst-case event.

Neither Ajit Jain, who manages our super-cat operation, nor I know what lies ahead. We do know that it would be a huge mistake to bet that evolving atmospheric changes are benign in their implications for insurers.

Don’t think, however, that we have lost our taste for risk. We remain prepared to lose $6 billion in a single event, if we have been paid appropriately for assuming that risk. We are not willing, though, to take on even very small exposures at prices that don’t reflect our evaluation of loss probabilities.

Appropriate prices don’t guarantee profits in any given year, but inappropriate prices most certainly guarantee eventual losses. Rates have recently fallen because a flood of capital has entered the super-cat field. We have therefore sharply reduced our wind exposures. Our behavior here parallels that which we employ in financial markets: Be fearful when others are greedy, and be greedy when others are fearful.

Lloyd’s, Equitas and Retroactive Reinsurance

Last year – we are getting now to Equitas – Berkshire agreed to enter into a huge retroactive reinsurance contract, a policy that protects an insurer against losses that have already happened, but whose cost is not yet known. I’ll give you details of the agreement shortly. But let’s first take a journey through insurance history, following the route that led to our deal.

Our tale begins around 1688, when Edward Lloyd opened a small coffee house in London. Though no Starbucks, his shop was destined to achieve worldwide fame because of the commercial activities of its clientele – shipowners, merchants and venturesome British capitalists. As these parties sipped Edward’s brew, they began to write contracts transferring the risk of a disaster at sea from the owners of ships and their cargo to the capitalists, who wagered that a given voyage would be completed without incident. These capitalists eventually became known as “underwriters at Lloyd’s.”

Though many people believe Lloyd’s to be an insurance company, that is not the case. It is instead a place where many member-insurers transact business, just as they did centuries ago.

Over time, the underwriters solicited passive investors to join in syndicates. Additionally, the business broadened beyond marine risks into every imaginable form of insurance, including exotic coverages that spread the fame of Lloyd’s far and wide. The underwriters left the coffee house, found grander quarters and formalized some rules of association. And those persons who passively backed the underwriters became known as “names.”

Eventually, the names came to include many thousands of people from around the world, who joined expecting to pick up some extra change without effort or serious risk. True, prospective names were always solemnly told that they would have unlimited and everlasting liability for the consequences of their syndicate’s underwriting – “down to the last cufflink,” as the quaint description went. But that warning came to be viewed as perfunctory. Three hundred years of retained cufflinks acted as a powerful sedative to the names poised to sign up.

Then came asbestos. When its prospective costs were added to the tidal wave of environmental and product claims that surfaced in the 1980s, Lloyd’s began to implode. Policies written decades earlier – and largely forgotten about – were developing huge losses. No one could intelligently estimate their total, but it was certain to be many tens of billions of dollars. The specter of unending and unlimited losses terrified existing names and scared away prospects. Many names opted for bankruptcy; some even chose suicide.

From these shambles, there came a desperate effort to resuscitate Lloyd’s. In 1996, the powers that be at the institution allotted £11.1 billion to a new company, Equitas, and made it responsible for paying all claims on policies written before 1993. In effect, this plan pooled the misery of the many syndicates in trouble. Of course, the money allotted could prove to be insufficient – and if that happened, the names remained liable for the shortfall.

But the new plan, by concentrating all of the liabilities in one place, had the advantage of eliminating much of the costly intramural squabbling that went on among syndicates. Moreover, the pooling allowed claims evaluation, negotiation and litigation to be handled more intelligently than had been the case previously. Equitas embraced Ben Franklin’s thinking: “We must all hang together, or assuredly we shall hang separately.”

From the start, many people predicted Equitas would eventually fail. But as Ajit and I reviewed the facts in the spring of 2006 – 13 years after the last exposed policy had been written and after the payment of £11.3 billion in claims – we concluded that the patient was likely to survive. And so we decided to offer a huge reinsurance policy to Equitas.

Because plenty of imponderables continue to exist, Berkshire could not provide Equitas, and its 27,972 names, unlimited protection. But we said – and I’m simplifying – that if Equitas would give us $7.12 billion in cash and securities (this is the float I spoke about), we would pay all of its future claims and expenses up to $13.9 billion. That amount was $5.7 billion above what Equitas had recently guessed its ultimate liabilities to be. Thus the names received a huge – and almost certainly sufficient – amount of future protection against unpleasant surprises. Indeed the protection is so large that Equitas plans a cash payment to its thousands of names, an event few of them had ever dreamed possible.

And how will Berkshire fare? That depends on how much “known” claims will end up costing us, how many yet-to-be-presented claims will surface and what they will cost, how soon claim payments will be made and how much we earn on the cash we receive before it must be paid out. Ajit and I think the odds are in our favor. And should we be wrong, Berkshire can handle it.

Scott Moser, the CEO of Equitas, summarized the transaction neatly: “Names wanted to sleep easy at night, and we think we’ve just bought them the world’s best mattress.”
* * * * * * * * * * *
Warning: It’s time to eat your broccoli – I am now going to talk about accounting matters. I owe this to those Berkshire shareholders who love reading about debits and credits. I hope both of you find this discussion helpful. All others can skip this section; there will be no quiz.

Berkshire has done many retroactive transactions – in both number and amount a multiple of such policies entered into by any other insurer. We are the reinsurer of choice for these coverages because the obligations that are transferred to us – for example, lifetime indemnity and medical payments to be made to injured workers – may not be fully satisfied for 50 years or more. No other company can offer the certainty that Berkshire can, in terms of guaranteeing the full and fair settlement of these obligations. This fact is important to the original insurer, policyholders and regulators.

The accounting procedure for retroactive transactions is neither well known nor intuitive. The best way for shareholders to understand it, therefore, is for us to simply lay out the debits and credits. Charlie and I would like to see this done more often. We sometimes encounter accounting footnotes about important transactions that leave us baffled, and we go away suspicious that the reporting company wished it that way. (For example, try comprehending transactions “described” in the old 10-Ks of Enron, even after you know how the movie ended.)

So let us summarize our accounting for the Equitas transaction. The major debits will be to Cash and Investments, Reinsurance Recoverable, and Deferred Charges for Reinsurance Assumed (“DCRA”). The major credit will be to Reserve for Losses and Loss Adjustment Expense. No profit or loss will be recorded at the inception of the transaction, but underwriting losses will thereafter be incurred annually as the DCRA asset is amortized downward. The amount of the annual amortization charge will be primarily determined by how our end-of-the-year estimates as to the timing and amount of future loss payments compare to the estimates made at the beginning of the year. Eventually, when the last claim has been paid, the DCRA account will be reduced to zero. That day is 50 years or more away.

What’s important to remember is that retroactive insurance contracts always produce underwriting losses for us. Whether these losses are worth experiencing depends on whether the cash we have received produces investment income that exceeds the losses. Recently our DCRA charges have annually delivered $300 million or so of underwriting losses, which have been more than offset by the income we have realized through use of the cash we received as a premium. Absent new retroactive contracts, the amount of the annual charge would normally decline over time. After the Equitas transaction, however, the annual DCRA cost will initially increase to about $450 million a year. This means that our other insurance
operations must generate at least that much underwriting gain for our overall float to be cost-free. That amount is quite a hurdle but one that I believe we will clear in many, if not most, years. Aren’t you glad that I promised you there would be no quiz?

Manufacturing, Service and Retailing Operations

Our activities in this part of Berkshire cover the waterfront. Let’s look, though, at a summary balance sheet and earnings statement for the entire group.

Balance Sheet 12/31/06 (in millions)
Assets Liabilities and Equity
Cash and equivalents ………………………… $ 1,543 Notes payable ………………………. $ 1,468
Accounts and notes receivable …………… 3,793 Other current liabilities………….. 6,635
Inventory ………………………………………… 5,257 Total current liabilities ………….. 8,103
Other current assets ………………………….. 363
Total current assets…………………………… 10,956

Goodwill and other intangibles…………… 13,314 Deferred taxes………………………. 540
Fixed assets……………………………………… 8,934 Term debt and other liabilities… 3,014
Other assets……………………………………… 1,168 Equity …………………………………. 22,715
$34,372 $34,372
Earnings Statement (in millions)
2006 2005 2004
Revenues ……………………………………………………………………… $52,660 $46,896 $44,142
Operating expenses (including depreciation of $823 in 2006,
$699 in 2005 and $676 in 2004)………………………………… 49,002 44,190 41,604
Interest expense …………………………………………………………….. 132 83 57
Pre-tax earnings…………………………………………………………….. 3,526* 2,623* 2,481*
Income taxes and minority interests …………………………………. 1,395 977 941
Net income …………………………………………………………………… $ 2,131 $ 1,646 $ 1,540
*Does not include purchase-accounting adjustments.

This motley group, which sells products ranging from lollipops to motor homes, earned a pleasing 25% on average tangible net worth last year. It’s noteworthy also that these operations used only minor financial leverage in achieving that return. Clearly we own some terrific businesses. We purchased many of them, however, at large premiums to net worth – a point reflected in the goodwill item shown on the balance sheet – and that fact reduces the earnings on our average carrying value to 10.8%.

Here are a few newsworthy items about companies in this sector:

• Bob Shaw, a remarkable entrepreneur who from a standing start built Shaw Industries into the country’s largest carpet producer, elected last year, at age 75, to retire. To succeed him, Bob recommended Vance Bell, a 31-year veteran at Shaw, and Bob, as usual, made the right call. Weakness in housing has caused the carpet business to slow. Shaw, however, remains a powerhouse and a major contributor to Berkshire’s earnings.

• MiTek, a manufacturer of connectors for roof trusses at the time we purchased it in 2001, is developing into a mini-conglomerate. At the rate it is growing, in fact, “mini” may soon be inappropriate. In purchasing MiTek for $420 million, we lent the company $200 million at 9% and bought $198 million of stock, priced at $10,000 per share. Additionally, 55 employees bought 2,200 shares for $22 million. Each employee paid exactly the same price that we did, in most cases borrowing money to do so.

And are they ever glad they did! Five years later, MiTek’s sales have tripled and the stock is valued at $71,699 per share. Despite its making 14 acquisitions, at a cost of $291 million, MiTek has paid off its debt to Berkshire and holds $35 million of cash. We celebrated the fifth anniversary of our purchase with a party in July. I told the group that it would be embarrassing if MiTek’s stock price soared beyond that of Berkshire “A” shares. Don’t be surprised, however, if
that happens (though Charlie and I will try to make our shares a moving target).

• Not all of our businesses are destined to increase profits. When an industry’s underlying economics are crumbling, talented management may slow the rate of decline. Eventually, though, eroding fundamentals will overwhelm managerial brilliance. (As a wise friend told me long ago, “If you want to get a reputation as a good businessman, be sure to get into a good business.”) And fundamentals are definitely eroding in the newspaper industry, a trend that has caused the profits of our Buffalo News to decline. The skid will almost certainly continue.

When Charlie and I were young, the newspaper business was as easy a way to make huge returns as existed in America. As one not-too-bright publisher famously said, “I owe my fortune to two great American institutions: monopoly and nepotism.” No paper in a one-paper city, however bad the product or however inept the management, could avoid gushing profits.

The industry’s staggering returns could be simply explained. For most of the 20th Century, newspapers were the primary source of information for the American public. Whether the subject was sports, finance, or politics, newspapers reigned supreme. Just as important, their ads were the easiest way to find job opportunities or to learn the price of groceries at your town’s supermarkets.

The great majority of families therefore felt the need for a paper every day, but understandably most didn’t wish to pay for two. Advertisers preferred the paper with the most circulation, and readers tended to want the paper with the most ads and news pages. This circularity led to a law of the newspaper jungle: Survival of the Fattest.

Thus, when two or more papers existed in a major city (which was almost universally the case a century ago), the one that pulled ahead usually emerged as the stand-alone winner. After competition disappeared, the paper’s pricing power in both advertising and circulation was unleashed. Typically, rates for both advertisers and readers would be raised annually – and the profits rolled in. For owners this was economic heaven. (Interestingly, though papers regularly –
and often in a disapproving way – reported on the profitability of, say, the auto or steel industries, they never enlightened readers about their own Midas-like situation. Hmmm . . .)

As long ago as my 1991 letter to shareholders, I nonetheless asserted that this insulated world was
changing, writing that “the media businesses . . . will prove considerably less marvelous than I, the
industry, or lenders thought would be the case only a few years ago.” Some publishers took
umbrage at both this remark and other warnings from me that followed. Newspaper properties,
moreover, continued to sell as if they were indestructible slot machines. In fact, many intelligent
newspaper executives who regularly chronicled and analyzed important worldwide events were
either blind or indifferent to what was going on under their noses.

Now, however, almost all newspaper owners realize that they are constantly losing ground in the
battle for eyeballs. Simply put, if cable and satellite broadcasting, as well as the internet, had
come along first, newspapers as we know them probably would never have existed.

In Berkshire’s world, Stan Lipsey does a terrific job running the Buffalo News, and I am
enormously proud of its editor, Margaret Sullivan. The News’ penetration of its market is the
highest among that of this country’s large newspapers. We also do better financially than most
metropolitan newspapers, even though Buffalo’s population and business trends are not good. Nevertheless, this operation faces unrelenting pressures that will cause profit margins to slide.

True, we have the leading online news operation in Buffalo, and it will continue to attract more
viewers and ads. However, the economic potential of a newspaper internet site – given the many
alternative sources of information and entertainment that are free and only a click away – is at best
a small fraction of that existing in the past for a print newspaper facing no competition.

For a local resident, ownership of a city’s paper, like ownership of a sports team, still produces
instant prominence. With it typically comes power and influence. These are ruboffs that appeal to
many people with money. Beyond that, civic-minded, wealthy individuals may feel that local
ownership will serve their community well. That’s why Peter Kiewit bought the Omaha paper
more than 40 years ago.

We are likely therefore to see non-economic individual buyers of newspapers emerge, just as we
have seen such buyers acquire major sports franchises. Aspiring press lords should be careful,
however: There’s no rule that says a newspaper’s revenues can’t fall below its expenses and that
losses can’t mushroom. Fixed costs are high in the newspaper business, and that’s bad news when
unit volume heads south. As the importance of newspapers diminishes, moreover, the “psychic”
value of possessing one will wane, whereas owning a sports franchise will likely retain its cachet.

Unless we face an irreversible cash drain, we will stick with the News, just as we’ve said that we
would. (Read economic principle 11, on page 76.) Charlie and I love newspapers – we each read
five a day – and believe that a free and energetic press is a key ingredient for maintaining a great
democracy. We hope that some combination of print and online will ward off economic
doomsday for newspapers, and we will work hard in Buffalo to develop a sustainable business
model. I think we will be successful. But the days of lush profits from our newspaper are over.
• A much improved situation is emerging at NetJets, which sells and manages fractionally-owned aircraft. This company has never had a problem growing: Revenues from flight operations have increased 596% since our purchase in 1998. But profits had been erratic.

Our move to Europe, which began in 1996, was particularly expensive. After five years of
operation there, we had acquired only 80 customers. And by mid-year 2006 our cumulative pretax
loss had risen to $212 million. But European demand has now exploded, with a net of 589
customers having been added in 2005-2006. Under Mark Booth’s brilliant leadership, NetJets is
now operating profitably in Europe, and we expect the positive trend to continue.

Our U.S. operation also had a good year in 2006, which led to worldwide pre-tax earnings of $143
million at NetJets last year. We made this profit even though we suffered a loss of $19 million in
the first quarter.

Credit Rich Santulli, along with Mark, for this turnaround. Rich, like many of our managers, has
no financial need to work. But you’d never know it. He’s absolutely tireless – monitoring
operations, making sales, and traveling the globe to constantly widen the already-enormous lead
that NetJets enjoys over its competitors. Today, the value of the fleet we manage is far greater
than that managed by our three largest competitors combined.

There’s a reason NetJets is the runaway leader: It offers the ultimate in safety and service. At
Berkshire, and at a number of our subsidiaries, NetJets aircraft are an indispensable business tool.
I also have a contract for personal use with NetJets and so do members of my family and most
Berkshire directors. (None of us, I should add, gets a discount.) Once you’ve flown NetJets,
returning to commercial flights is like going back to holding hands.

Regulated Utility Business

Berkshire has an 86.6% (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 million electric customers make it the third largest distributor of electricity in the U.K.; (2)
MidAmerican Energy, which serves 706,000 electric customers, primarily in Iowa; (3) Pacific Power and
Rocky Mountain Power, serving about 1.7 million electric customers in six western states; and (4) Kern
River and Northern Natural pipelines, which carry about 8% of the natural gas consumed in the U.S.

Our partners in ownership of MidAmerican are Walter Scott, and its 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. Six years of working with Dave, Greg and Walter have
underscored my original belief: Berkshire couldn’t have better partners.

Somewhat incongruously, MidAmerican owns the second largest real estate brokerage firm in the
U.S., HomeServices of America. This company operates through 20 locally-branded firms with 20,300
agents. Despite HomeServices’ purchase of two operations last year, the company’s overall volume fell
9% to $58 billion, and profits fell 50%.

The slowdown in residential real estate activity stems in part from the weakened lending practices
of recent years. The “optional” contracts and “teaser” rates that have been popular have allowed borrowers
to make payments in the early years of their mortgages that fall far short of covering normal interest costs.
Naturally, there are few defaults when virtually nothing is required of a borrower. As a cynic has said, “A
rolling loan gathers no loss.” But payments not made add to principal, a