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Berkshire Annual Letter 2001 (Part 3)

Warren Buffett recommended reading Jack Welch’s book, Jack, Straight from the Gut.

In the words of Warren Buffett, Jack Welch is smart, energetic, hands-on, and expects much of both himself and his organisation.

In investing (just like insurance), you can produce outstanding long term results primarily by avoiding dumb decisions, rather than by making brilliant ones.

…Continue reading » Loss Development in Insurance Accounting

Berkshire Annual Letter 2000 (Part 3)

At Berkshire, full reporting means giving all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business.

There is neither vague accounting methodolody, nor messages prepared by the public relations department.

…Continue reading » Full and Fair Reporting

Berkshire Annual Letter 1999 (Part 2)

When an acquisition takes place, there are two generally accepted accounting principles (GAAP) methods of recording the transaction.

In the “purchase” method, a goodwill account has to be established and subsequently written off against earnings. Payment can be made in either cash or stock.

…Continue reading » Acquisition Accounting

Berkshire Annual Letter 1998 (Part 4)

Michael Kinsley has said about Washington: “The scandal isn’t in what’s done that’s illegal but rather in what’s legal.

Many CEOs have no hesistation about manipulating earnings to meet the desires of Wall Street.

Their first assumption is that their job is to encourage the highest stock price possible, something which Warren Buffett disagrees. To get a high price, operational excellence is required failing which they will resort to accounting gimmicks.

…Continue reading » Restructuring and Merger Accounting

Berkshire Annual Letter 1998 (Part 3)

Many companies ignore the cost of stock options when earnings are calculated, even though such employee’s compensation should be an expense.

Imagine that GEICO spends $190 million for advertising and pays for it all using Berkshire options. Isn’t that an expense, and should be charged accordingly to the earnings?

…Continue reading » Stock Options as Compensation

Berkshire Annual Letter 1997 (Part 4)

Unless you understand about “float” and how to measure its cost, you will never be able to make a good estimate about Berkshire’s intrinsic value.

Float is money that is held but not owned.

In the insurance industry, there is float because premiums are received before losses are paid. This time interval can sometimes extend to decades. During this time, the money can be invested by the insurer.

…Continue reading » A Discussion on Insurance Float

Accounting Rules

A major accounting change, which was to be implemented by January 1, 1993, requires that businesses recognize their present-value liability for post-retirement health benefits.

For some reason, these were not required to be recorded on the books previously even though pensions to be paid in the future (something similar) were.

By ignoring the built-up of such liabilities, some companies had left themselves vulnerable to open-ended liabilities in the future.

The result of this new rule will many companies to record a huge balance-sheet liability (and a consequent reduction in net worth).

Warren Buffett tends to avoid companies with significant post-retirement liabilities when he is making his acquisitions.

Stock Options

Despite the accounting rule change for health benefits, no such change was required for stock options.

Stocks options were still illogically treated for in the accounts.

Some people have argued that “out-of-the-money” options (those with an exercise price equal to or above the current market price) have no value when they are issued.

Others have said that options should not be viewed as a cost because they “aren’t dollars out of a company’s coffers.”

Warren Buffett sees these as flawed as they would open up possibilites for companies to instantly improve their reported profits.

For example, they could now eliminate the cost of insurance by paying with it using options.

As long as something of value changes hand (and not just when cash changes hands), there will be a cost involved.

The arguement that options should not be recognised in the accounts because it is difficult to value them is also not right.

Currently, estimates are being used in accouting anyway. Examples include depreciation of a plane, a bank’s annual loan loss charge and losses of property-casualty ompanies.

In summary,

“If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And, if expenses shouldn’t go into the calculation of earnings, where in the world should they go?”

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Berkshire Hathaway seldom issues out shares. On 1st October 1964, there were 1,137,778 shares outstanding. On March 1993, that number has increased to 1,152,547 shares.

This is due to Warren Buffett’s firm policy about issuing shares of Berkshire only when they receive as much value as they give. Bershire’s size should only be increased when doing so increases the wealth of its owners.

The long term goal of Berkshire is to increase its per-share intrinsic value at a 15% annual rate.

This objective cannot be attained in a smooth manner because a high proportion of Berkshire’s net worth is represented by common stocks. Generally accepted accounting principles(GAAP) accounting rules require that these securities be valued at their market prices (less an adjustment for tax on any net unrealized appreciation).

Frequent changes in equity prices will ensure a great deal of fluctuations in their annual results. This is especially so when you compare it to the typical industrial company.

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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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Generally Accepted Accounting Principles (GAAP)

When an investor looks at financial statements, there are a few questions that he wants to know:

(1) Approximately how much is this company worth?
(2) What is the likelihood that it can meet its future obligations?
(3) How good a job are its managers doing, given the hand they have been dealt?

In most cases, answers to one or more of these questions are difficult from the minimum GAAP presentation.

Further complicating the problem is the fact that many managements view GAAP not as a standard to be met, but as an obstacle to overcome.

Then there are managers who actively use GAAP to deceive and defraud.

I just read a book on “understanding financial statements for managers” the other day and indeed it is easy to “cook” the books as a lot of accounting is subjected to the interpretation of the accountant.

If the information presented is insufficient, it then falls on the investor to ask the management to provide data (whether GAAP, non-GAAP or extra-GAAP) that helps us to answer the three questions above.

Update on major non-insurance business operations

There follows the usual summary of the major non-insurance business operations. These included Nebraska Furniture Mart, The Buffalo News, See’s Candies, Fechheimer, World Book, Kirby, The Scott Fetzer Manufacturing Group and Borsheim’s.

A very interesting fact was that when Warren purchased Borsheim’s, they had no audited financial statement and he didn’t take inventory, verify receivables or audit the operation in any way.

A lot of it was based on trust in the Friedman family, who were siblings of Mrs Blumkins (founder of Nebraska Furniture).

And the Friedman family brings to the jewelry business precisely the same approach that the Blumkins bring to the furniture business. The cornerstone for both enterprises is Mrs. B’s creed: “Sell cheap and tell the truth.” Other fundamentals at both businesses are:

(1) Single store operations featuring huge inventories that provide customers with an enormous selection across all price ranges.
(2) Daily attention to detail by top management.
(3) Rapid turnover.
(4) Shrewd buying.
(5) Incredibly low expenses.

The combination of the last three factors lets both stores offer everyday prices that no one in the country comes close to matching.

And Warren’s major contribution? Leave them alone and let them do their job.

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