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The amount of federal income tax that Berkshire pays (either directly or indirectly) is about 0.5% of the total paid by all American corporations. Their 1993 direct federal income tax comes up to $390 million, about $200 million from operating earnings and $190 million from realized capital gains.

Another $400 million of federal and foreign income tax is contributed by their investees, a figure that can’t be seen on Berkshire’s financial statements.

Warren Buffett and Charlie Munger prefer having a buy-and-hold policy. This is the soundest way to invest and taxes are due only when gains are realized.

Imagine you take a dollar, invest it in company A and it doubles in value after one year. Now, you sell the investment, invest it in company B and it doubles again. Repeat for 20 years and your investment will become $1,048,576. If a capital gains tax of 35% has to be paid every year, the amount will only have increased to $22,370 after 20 years. Another 7.5 years would be needed for it to exceed a million dollars.

On the other hand, if you hold on to a single investment and let it double by itself every year, you will end up with about $200 million pretax after 27.5 years. After paying a tax of $70 million, you will still be left with about $130 million.

You will realize a far, far greater sum from a single investment that compounds internally at a given rate than from a succession of investments compounding at the same rate.

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High Growth Rate

If the base from which the growth is measured is small, it may still last a long time. But once it becomes big, it will eventually stop.

This phenomenal is aptly described by Carl Sagan, refering to the destiny of bacteria that reproduce by dividing into two every 15 minutes. Says Sagan:

That means four doublings an hour, and 96 doublings a day. Although a bacterium weighs only about a trillionth of a gram, its descendants, after a day of wild asexual abandon, will collectively weigh as much as a mountain…in two days, more than the sun – and before very long, everything in the universe will be made of bacteria.

Not to worry, says Sagan: Some obstacle always impedes this kind of exponential growth. “The bugs run out of food, or they poison each other, or they are shy about reproducing in public.

From Berkshire’s base of $4.9 billion in net worth, it will be much more difficult to average 15% annual growth in book value than they did to average 23.8% from the $22 million they began with.


A new accounting rule likely to be adopted will require companies to reserve against all gains at the current tax rate, whatever it may be.

In economic terms, the liability, equivalent to a transfer tax, resembles an interest-free loan from the U.S. Treasury that comes due only when the asset is sold.

Because of the way the tax law works, the Rip Van Winkle style of investing that Buffett favours, is much favourable than a short holding period of securities.

Suppose there is an investment that is bought at $1 and doubles in value. Each year, it is sold and the proceeds used to purchase another security which then doubles in value after another year.

At the end of 20 years, the 34% capital gains tax that is paid on the profits from each sale would have delivered about $13,000 to the government and $25,250 to the investor.

However, if there is a fantastic investment that itself doubled 20 times during the 20 years, its final value would grow to $1,048,576. If it were then sold, there would be a 34% tax of roughly $356,500 and the investor would be left with about $692,000.

The sole reason for this difference in results would be the timing of tax payments. Deferred taxaxtion is great!

Undistributed Earnings

In 1989 Berkshire recieved about $45 million, after taxes in dividends from their five major investees. However, their share of the retained earnings of these investees totaled about $212 million, not counting large capital gains realized by GEICO and Coca-Cola.

Are these undistributed earnings as important as those that were reported?

Buffett believes so. His reasoning is that earnings retained by these investees will be deployed by talented, owner-oriented managers who sometimes have better uses for these funds in their own businesses than in Berkshire.

Thus, a better gauge of Berkshire’s fundamental earning power is by using a “look-through” approach, in which the share of the operating earnings retained by Berkshire’s investees are appended to their own reported operating earnings, excluding capital gains in both instances.


There is a story related by Buffett about Ike Friedman. It has nothing to do with investments but it’s so humourous that I’m reproducing it below for your reading pleasure:

A story will illustrate why I enjoy Ike so much: Every two years I’m part of an informal group that gathers to have fun and explore a few subjects. Last September, meeting at Bishop’s Lodge in Santa Fe, we asked Ike, his wife Roz, and his son Alan to come by and educate us on jewels and the jewelry business.

Ike decided to dazzle the group, so he brought from Omaha about $20 million of particularly fancy merchandise. I was somewhat apprehensive – Bishop’s Lodge is no Fort Knox – and I mentioned my concern to Ike at our opening party the evening before his presentation. Ike took me aside. “See that safe?” he said. “This afternoon we changed the combination and now even the hotel management doesn’t know what it is.” I breathed easier. Ike went on: “See those two big fellows with guns on their hips? They’ll be guarding the safe all night.” I now was ready to rejoin the party. But Ike leaned closer: “And besides, Warren,” he confided, “the jewels aren’t in the safe.”

Buffett offers the following insights for the continued success of Borsheim and Nebraska Furniture Mart:

(1) unparalleled depth and breadth of merchandise at one location
(2) the lowest operating costs in the business
(3) the shrewdest of buying, made possible in part by the huge volumes purchased
(4) gross margins, and therefore prices, far below competitors
(5) friendly personalized service with family members on hand at all times

These are useful factors to consider when evaluating investments in retail businesses.

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Of Corporate Taxes

In my earlier post, I asked a question on the effects of raised corporate taxes. Will it flow through to the consumers in the form of increased prices?

There are some advocates who insist that any forms of increased in corporate taxes will only lead to higher prices to offset the increase for the corporation. Does this mean that if there is a corporate tax decrease, it will lead to reduced prices for consumers?

On the other hand, there are some who think that corporates will absorb any increase in taxes (as well as enjoy the benefits when taxes are reduced).

Buffett’s view is that it really depends on the strength of the business franchise and regulations.

1) When the franchise is strong and after-tax profits is precisely regulated (eg. utilities), the prices will usually adjust to reflect the change in corporate tax rate.

2) When the business franchise is weak but the industry is price competitive, market forces will usually help to regulate the price.

3) In the case of an unregulated business with a strong franchise, it is usually the corporation that benefits from tax changes. They will increase prices when taxes are increased; and enjoy increased profits (with no reduction in prices) when taxes are reduced.

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The Job of Warren Buffett

Warren Buffett really has only two jobs. One is attracting and keeping outstanding managers to run the various operations. This he has no problems doing as one of the criteria that he uses for buying any business is an outstanding management team.

And he never gets in the way of these managerial stars. They got to where they were because they knew what they were doing. If you were managing a top soccer team and had world class players, would you be teaching them technical skills like how to kick a ball?

Rather, the value a soccer manager bring to the team lies in team selection and formulation of tactics. This is what Buffett’s second job is. The task of capital allocation. This is a challenge as Berkshire generates a lot of capital.

A business earning 23% annually and retaining it all will be far more affected by today’s capital allocations than a business earning 10% and distributing half of that to shareholders.

As far as Buffett is concerned, there are five options to deploy the capital: (1) long-term common stock investments; (2) long-term fixed-income securities; (3) medium-term fixed-income securities; (4) short-term cash equivalents; and (5) short-term arbitrage commitments.

Of these, he likes common stocks the most but in times of greed where stock prices are gloriously uncoupled from the underlying business itself, he would rather not take part in such foolishness. After all, stocks can’t outperform businesses indefinitely.

To have a material difference in the performance of Berkshire, any business acquisition would have to be of a significant amount. And as Berkshire gets larger, any returns are almost certain to drop.

News Hole in Newspapers

In any newspaper, there is an important statistic known as the news hole. This is the portion of the total space in the paper that is devoted to news. A typical newspaper has a news hole of about 40% compared to 50% for “The Buffalo News”.

While 10% might not sound like a lot, it is the reason why “The Buffalo New” has a much greater readership compared to it’s rivals.

A paper with 30 pages of advertisements and a 40% news hole delivers 20 pages of news a day, whereas another paper with a 50% news hole matches 30 pages of ads with 30 pages of news. For the same amount of ads, the latter has 50% more news content!

The Fechheimer Bros. Co

There was a purchase of a company called Fechheimer in the past year. It’s basically a uniform manufacturing and distribution business. The interesting point about this acquisition is that neither Buffett nor Charlie Munger went to Cincinnati, headquarters for Fechheimer, to see their operation.

This is actually Buffett’s usual practice. He does not rely on insights obtained from plant inspections to decide whether or not to purchase a company. Rather, he considers the economics of the business as well as the quality of the people running the show.


I will leave you with a question. If corporate taxes are increased, does it really affect the corporations? Do they pass on the increased taxes to the consumers by increasing prices? Or do they simply absorb the increased taxes?

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