brk-painewebber

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January 1999 Alice Schroeder (212) 713-4977

BRKA0120 AS Gregory Lapin (212) 713-4980

asdProperty-Casualty InsuranceBerkshire Hathaway

The Ultimate Conglomerate Discoun


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Berkshire Hathaway:

The Ultimate Conglomerate Discount

We have initiated research coverage on Berkshire Hathaway Inc. with an Attractive rating. Berkshire Hathaway is acompany that often appears to receive the ultimate conglomerate discount: Investors overlook the companys successfuloperating businesses, valuing the company as a closed-end fund. In this report, we present three alternative ways to valueBerkshire Hathaway that suggest that a premium to book value is appropriate, as for any operating enterprise with a longhistory of consistent profitable growth. Since its early days, Berkshires first-choice use of capital has been to own 100%of an operating business it finds attractive, rather than to own only part of such a company through a public equityinvestment. Today, we view the company asprimarilyan operating company that also has a sizeable investment portfolio.

Berkshire Hathaway directly employs 45,000 people around the world, in businesses ranging from aircraft fractionalownership sales to vacuum cleaner manufacturing.

Berkshires 1997 pro forma operating revenues of $17.4 billion would rank 75th in the Fortune500. Its operating

earnings of $1.518 billion, excluding investment gains, would rank 54th.

Berkshire is primarily a property-casualty insurer. Seventy-nine percent of both its $18.6 billion total pro formarevenues and its $1.5 billion operating earnings are derived from insurance.

Berkshires insurance operations are the fourth largest in the U.S. based on premiums, the largest based on surplusand the second largest based on market capitalization. By themselves, the insurance operations would rank 100th inthe Fortune500 based on 1997 pro forma revenues and 67th based on 1997 earnings.

Berkshires noninsurance operations, by themselves, and excluding all earnings from dividends and interest, wouldrank 391st in the Fortune500 based on 1997 pro forma revenues and 243rd based on 1997 earnings.

In this report, we review Berkshires business from four different perspectivesbased on the sources of its marketcapitalization; from an operating segment perspective; as a capital allocating machine; and as an acquirer, manager and

builder of well-run businesses with a virtuous circle of competitive advantages. As a stock, BRKs performance has beensuperb. It has underperformed the S&P 500 in only four of the past 33 years. The compounding effect of thisoutperformance has been even more impressive: $10,000 invested in BRK in 1965 would have been worth $51 million onDecember 31, 1998, compared to $132,990 for the S&P.

Our valuation work reviews Berkshires valuation extensively using three methodsa float-based valuation, a bookvalue-based valuation and an earnings-based valuation. We have provided sensitivity information so that readers canadjust our assumptions if they so choose. We believe that the intrinsic value of BRK today, using conservativeassumptions, is $91,000-97,000 per share. Valuing the equity securities in Berkshires portfolio at a significant discountto their market valuations would reduce this number to $67,000-92,000 (depending on the degree of discount).Therefore, we view BRKs price as including a significant margin of safety at its current valuation.

Finally, in this report, we discuss the operating businesses of Berkshire in some detail, particularly the insurance

businesses, which we believe are more difficult for investors to understand. We also review the aviation businesses,including the recently acquired Executive Jet, which we expect will be the other key driver of Berkshires growth.


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Table of ContentsPage

Our Approach to Following the Stock............................................................................................................................ 3

What Will Berkshire Hathaway Do Next?...................................................................................................................... 3

Berkshire HathawayFrom a Market Capitalization Perspective ................................................................................... 3Berkshire HathawayFrom an Operating Segment Perspective..................................................................................... 4

Insurance Predominates ............................................................................................................................................... 5

The Investing Segment.............................................................................................................................................. 5

Manufacturing, Publishing and Retailing ..................................................................................................................... 6

The Aviation BusinessesFlying Into the Future.................................................................................................. 6

Berkshires Other Businesses.................................................................................................................................. 8

Berkshire HathawayA Capital Allocating Machine ................................................................................................... 10

Berkshire HathawayThe Virtuous Circle............................................................................................................... 12

Our ModelEarnings and Book Value Growth Assumptions ..................................................................................... 15

Concentrated Investing ................................................................................................................................................ 16The Mystery of Intrinsic Value..................................................................................................................................... 16

Our View of Intrinsic Value......................................................................................................................................... 17

Float-Based Valuation ......................................................................................................................................... 17

Book Value-Based Valuation ............................................................................................................................... 23

Earnings-Based Valuation.................................................................................................................................... 24

Look-Through Earnings ...................................................................................................................................... 25

Berkshires Insurance Operations ................................................................................................................................. 28

Why Insurance? ................................................................................................................................................... 29

Will Berkshire Buy More Insurers? ...................................................................................................................... 29

GEICOShifting Into High Gear ............................................................................................................................ 29Direct Writers: Poised for Additional Market Penetration ................................................................................... 31

GEICO: The Borsheims of the Auto Insurance Industry............................................................................................ 32

What About Homeowners Insurance?................................................................................................................. 34

GEICOs Float .................................................................................................................................................... 35

Super-Catastrophe Reinsurance.................................................................................................................................. 36

General Re: No Longer Your Fathers Reinsurance Company ................................................................................... 37

Recent Actions: D.P. Mann................................................................................................................................. 40

Why Did Berkshire Buy General Re?................................................................................................................... 41

Risk Factors of General Re .................................................................................................................................. 41

Management and Management Succession .................................................................................................................. 42Berkshire A and B Shares.............................................................................................................................................. 43

A Brief History of Berkshire Hathaway and its Management........................................................................................ 43

Risk Factors.................................................................................................................................................................. 44

Cover art: Courtesy of Berkshire Hathaway Inc.


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Overview

We have initiated research coverage on BerkshireHathaway Inc. with an Attractive rating. Berkshire is acompany that often seems to receive the ultimate con-

glomerate discount: Investors overlook the companyssuccessful operating businesses, valuing the company as aclosed-end fund. In this report, we present three alter-native ways to value BRK that suggest that a premiumto book value is appropriate, as it would be for anyoperating enterprise with a long history of consistentprofitable growth.

Our discussions with investors have convinced us thatmany people are students of (or self-appointed expertson) Berkshire Hathaway. Our goal is not to win acontest of BRK Trivial Pursuiton that, we concededefeat. Rather, we bring the perspective of an insurance

analyst to Berkshire Hathaway for the first time. If we

can help investors understand this important Americancorporation and contribute to the body of thought onBRK valuation, our purpose is served. Consider thefollowing:

Berkshire Hathaway directly employs 45,000 peoplaround the world, in businesses ranging from

aircraft fractional ownership sales to vacuum cleanemanufacturing.

Berkshires 1997 pro forma operating revenues of$17.4 billion would rank 75th in the Fortune 500.Its operating earnings of $1.518 billion, excludinginvestment gains, would rank 54th. Estimated 199cash operating earnings are $1.945 billion excludinginvestment gainssuggesting that Berkshire is oneof the largest companies in the world in terms ofeconomic earnings.

Exhibit 1

1997 Pro Forma Revenues

Fin Svc.

1.9%Manuf./Sv

18.8%

Insurance

78.8%

Non

Oper.

0.5%

Source: Company financial information and PaineWebber estimates.

Exhibit 2

1997 Pro Forma Operating EPS

Manuf./Sv

20.1%

Fin Svc.

1.1%

Insurance

78.8%

Berkshire is primarily a property-casualty insurer.Seventy-nine percent of both its total $18.6 billionpro forma revenues and its $1.5 billion pro formaoperating earnings are derived from insurance.

Berkshires insurance operations are the fourthlargest in the U.S. based on premiums, the largestbased on surplus and the second largest based onmarket capitalization. By themselves, the insuranceoperations would rank 100th in the Fortune500based on pro forma revenues and 67th based onearnings. Also, because all of its businesses havebeen acquired, on an economic earnings basis,excluding goodwill, Berkshire would rank higher.

GEICOis the seventh-largest auto insurer in theU.S. and the 18th-largest insurer overall. We expecit to grow policies in force by 20% this year, morethan quadruple the industry growth rate. GEICOalone would rank 227th in the Fortune500 based o

1997 earnings. General Reis the largest direct-writing reinsurer in

the U.S. based on premiums and surplus and thethird-largest reinsurer in the world. General Redirectly and indirectly owns approximately 82% ofCologne Re, a major European-based reinsurer, andalso has other important insurance operations, suchas General Star Indemnity, a large excess and surplulines insurer; Genesis Insurance, an alternative


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markets subsidiary; D.P. Mann, a newly acquiredLloyds managing agency; investment servicesprovider New England Asset Management; and U.S.

Aviation Underwriters, a prominent aviationunderwriting manager.

Berkshires insurance operations other than GEICOand General Re are also significant. In particular,National Indemnity, which wrote nearly $1 billionof premium in 1997 under Ajit Jains stewardship, isthe most prominent underwriter of super cat orhigh-layer excess catastrophe reinsurance products,as well as structured settlements and other productsfor which a high claims-paying rating, large amountsof capital, and a willingness to accept significantvolatility are a competitive advantage.

Berkshires noninsurance operations, by themselves,

and excluding all earnings from dividends andinterest, would rank 391st in the Fortune500 basedon 1997 revenues and 243rd based on 1997earnings.

Berkshire Hathaway was named one of Fortunemagazines 10 Most Admired Companies in theU.S. and the World in 1998.

As a stock, Berkshire Hathaways performance has beensuperb. Berkshire stock rose 52.2% in 1998, versus28.6% for the S&P, outperforming the index by 2,360basis points.

The stock has underperformed the S&P in only four ofthe past 33 years and has never had a down year. Thecompounding effect of this outperformance has beeneven more impressive: $10,000 invested in Berkshire in1965 would have been worth $51 million on December

31, 1998, compared to $132,990 if the money had beeninvested in the S&P.

Exhibit 3

BRK Outperformance vs. S&P 500

-25%

-15%

-5%

5%

15%

25%

35%

45%

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997


The reason for this relative outperformance isstraightforward: Berkshire has earned it throughexceptionally strong, consistent growth.

Exhibit 4

Compound Annual Growth Rate in:

5 Years 10 Years 20 Years 30 Years

Book Value per Share 26.9% 26.3% 27.5% 25.1%

Net Earnings per Share 34.1% 22.4% 21.9% 27.2%

Operating Earnings per Share 28.1% 20.8% 22.5% 24.2%


Because Berkshire Hathaway is an unusual company and

possibly the most-talked-about and the least-understoodcompany in the world, this report takes a differentapproach. We assume that our readers know somethingof the background of the company and are familiar with

Warren Buffett and Charlie Munger, althoughmanagements background and the history of thebusiness are discussed briefly later in this report.

We look at Berkshire Hathaway from four basic

perspectives: market capitalization; operating segments;as a capital allocating machine; and as an acquirer,manager and builder of well-run businesses with avirtuous circle of sustainable competitive advantages.But first, a couple of brief but necessary digressions.


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Our approach to following the stock

In keeping with our view that BRK is most suitable forlong-term, value-oriented investors, we are publishingvaluation information but not establishing a specific

price target on the stock. From a long-term perspective,we believe that BRK merits an Attractive rating todaybecause it is trading at less than our view of intrinsicvalue.

We will downgrade or upgrade the stock should itbecome significantly over- or undervalued versus ouropinion of intrinsic value. However, we do not plan tomake rating changes frequently absent a significantchange in valuation. We stress that our estimate ofintrinsic value has not been endorsed by anyone atBerkshire Hathaway. In fact, we hope that readers willconsider our valuation work more of a framework and

toolkit to stimulate their own thought processes,rather than an attempt to dictate how the stock shouldbe valued.

Second, we will publish annual estimates of operatingearnings (excluding realized investment gains and losses)because this is a convention followed by Wall Street.However, an important part of Berkshires insurancestrategy is to accept significant short-term earningsvolatility in exchange for superior long-term returns.Further, major changes in asset allocation may occur atany time. These changes could have a significant impacton investment income, as potential capital appreciation

is traded off against cash yield and/or operating earningsfrom acquired businesses.

Therefore, we do not consider short-term estimates ofoperating earnings to be significant (a three- to five-yearmeasurement period would be more meaningful). Wedo not plan to focus on deviations from earnings esti-mates in our research. By the same token, we are notpublishing quarterly estimates, as we believe that theyare simply not an appropriate measure of performancefor this company.

What will Berkshire Hathaway do next?

We dont know. Please dont ask. We do not planto question management on this subject, nor are wetrying to read the tea leaves from any other source.Therefore, we have absolutely no insight into what

Warren Buffett and Charlie Munger might be planningto buy or sell. When we want to know where themarket is going or what stocks are attractive, we deferto PaineWebbers own market strategist, Ed Kerschner,or its individual industry analysts. In short, we arecovering Berkshire Hathaway for its own sake, not as a

way to invest in other stocks.

Berkshire Hathawayfrom a marketcapitalization perspective

A simple way to look at Berkshire is to allocate itsmarket capitalization to two major elements of the

businessoperations and equity investmentsas shownin the following exhibit. Of Berkshires total marketcapitalization of $105.8 billion at December 31, 1998,approximately $29 billion is composed of Berkshiresmajor equity investments (net of our estimate of half thdeferred tax liability on unrealized gains1). This portionis the darker shaded area in the following exhibit. Theremaining 72.5% of the market capitalization relates tothe operating activities of the company, primarilyinsurance. Viewing Berkshire in this light, it is difficultto characterize it as a de facto closed-end fund.

This exhibit also highlights a point on BRK stocktrading patterns. In early 1998, Coca-Colas andGillettes stocks were hit hard due to concerns overslowing growth in Asia. Berkshire declined 26% fromits weekly high in July to its weekly low in September.To understand the source of the decline, we constructeda weighted index of Berkshires major equities andcompared it to BRKs trading pattern. The indexdeclined by almost 30% from its weekly high (in April)to its weekly low (in September).

However, as the following exhibit indicates, theseequities are only about one-quarter of Berkshires markevalue. Therefore, we dont believe that the stock wouldtrack the index so closely if it behaved rationally. Infact, we believe that it should be valued based on thecompanys long-term operating fundamentals.

There are other reasons that we believe Berkshire stockshould not be considered equivalent to a closed-endfund that trades in proportion to the equities it owns.

Berkshire has access to investment opportunitiesthat arent available to a fund manager. Forexample, the company can buy 100% of anotherbusiness. And, as discussed later in this report,Berkshire is the investor of first resortmany

good investment ideas go to Omaha first, beforeanyone else gets a crack at them.

Berkshire has free cash flow from its operatingbusinesses to invest, as well as the leverage of theinsurance businesses. This is an important dis-tinction between Berkshire and any other invest-ment fund, which is dependent on the publicmarkets and new capital from outside investorsfor investable funds.

1To adjust for the impact on present value of the very low turnover of

Berkshires equity portfolio.


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Berkshire is one of the few investors that would stillhave access to capital during a market decline.Others, including mutual funds, might like to takeadvantage of the same situation, but most likely

would not have access to investable capital underthese circumstances. In fact, some asset managers

would be liquidating investments to cover

withdrawals. No matter what happens to the equitymarkets, Berkshire is not subject to the liquidityissues that many fund managers face. And with itstriple-A credit rating, it can actually leverage up tomaximize its ability to invest at a very low cost of

capital. This makes the stock a hedge on a bearmarket.

Exhibit 5

Berkshire Market Cap Vs Berkshire Equity Index Value($, millions)

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

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BRK.A ($ Mill)

Equities


Berkshire Hathawayfrom an operatingsegment perspective

Investors often seemingly default to thinking ofBerkshire as a couple of really smart guys investing abunch of money in equities. The company is frequently

referred to as a proxy for a closed-end fund.

When we analyze Berkshire, we see a conglomerateacollection of wholly owned operating businesses, along

with minority positions in other well-managedcompanies.

Unlike most conglomerates, however, there is noattempt to create synergies between different pieces ofthe business. And each company that Berkshire investsin must meet stringent criteria (discussed later). The

following schematic of Berkshire is our interpretationbased on year-end 1997 numbers, pro forma for GeneralRe (dollars are in billions):

When asked which part he would keep if Berkshirewere split into two partsmarketable securities andinsurance and other private businesses: Thats aneasy question for me. Id choose the operatingbusinesses any timebecause theyre more fun.I have a good time with the investments, too. ButI like being involved with real people in the busi-nesses where theyre a cohesive unit that can growover time.

Warren Buffett, 1998 Annual ShareholdersMeeting, as quoted in Outstanding Investor Digest.


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Exhibit 6

Mfg-Publishing-Retailing

Capital $1,417.4Operating Earnings $318.9

Assets $2,375.1Return on assets 14.1%

Finance Businesses

Capital $121.7Op. Earnings $18.0

Assets $1271.0Return on assets 1.6%

BRK Insurance


Assets $12,438.5Op. ROE at cost 17.6%Total return ROE 24.5%**

Investing/AAA Capital

Equities a- tax $26,307.2Realized gains $718.5Unreal. gains $18,470.3Dividends $393.5

Corporate

Assets $4,298.3

Capital $4,530.2Net income ($673.5)

General Re


Assets $41,459.0Op. ROE at cost 17.0%*Total return ROE 23.4%*

Total Insurance

Capital $25,623.5Op. Earnings $1,662.1

Assets $53,897.5

* Historical excluding goodwill from Berkshire acquisition.

** Five-year average.

Note: Operating earnings do not sum to total because corporate net income includes corporate operating expenses.


Insurance predominates

Even before adding General Re to the mix, earnings frominsurance dominated Berkshire Hathaway. Now, 79% ofearnings (1997 pro forma) are derived from insurance,excluding realized and unrealized investment gains. Theinsurance segment also provides the investing float,

which is a form of low-cost leverage for Berkshire. Wediscuss Berkshires insurance businesses in more detaillater in this report. Note that our presentation abovepushes down insurance-related goodwill to that segment.

The investing segment

The schematic above allocates Berkshires assets,liabilities and earnings into four segments (rather thanthe three segments the company presents). We add aninvesting segment because the insurance operation isovercapitalized versus peers and its returns are difficult toascertain on a stand-alone basis. In keeping with ourconcept of virtual capital, discussed later in this report,

we have presented the assets and earnings thatwe consider to be available for underwriting but notcurrently in use as part of an investing segment. The

capital we have allocated to insurance is approximatelyequal to the fixed-income investments (which iscoincidental) and is what we believe the company wouldneed to carry if it operated as a stand-alone company (nothe maximum or optimum leverage, but what we think arating agency might be comfortable with for a companyat the A level).

Exhibit 7

Berkshire Invested Assets per Share

$0

$10,000

$20,000

$30,000

$40,000

$50,000

85 86 87 88 89 90 91 92 93 94 95 96 97 98E



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Ratings impactBy creating an investing segment we ineffect allocate the triple-A rating, along with the relatedcapital that supports the rating, to that segment. Thissuggests an interesting way to look at Berkshirenoother triple-A insurer is able to invest its face capital to

earn the returns that Berkshire does. Any other companywith a triple-A rating would have to invest primarily inhigh-grade bonds that would not earn an equity hurdlerate. This was part of the stated motivation behindGeneral Res merger with Berkshire. The ability to investthe capital required to support the triple-A rating in amanner that produces an equity return is, from ourperspective, a very important part of the underpinningsof Berkshire.

Exhibit 8

Mfg, Publishing, Retailing A-Tax Earnings 1992

$0

$20

$40

$60

$80

$100

Buffa

loNe

ws

Sees

Can

dies

Scott

Fetze

r

Shoe

Group

Home

Furnishin

gs

Finan

ceBusine

ss Othe

r


Manufacturing, Publishing and Retailing

This segment has changed significantly in the past fiveyears. In 1992, after-tax earnings from six businessesSees Candies, The Buffalo News, Scott Fetzer, homefurnishings, the finance business and the Shoe Groupin total were only about 35% greater than all of the other

wholly owned businesses combined (for which Berkshiredid not provide any specific financial information).

By 1997, Berkshire had acquired FlightSafety and theother segment had shrunk, as World Book and Kirby

were reclassified with Scott Fetzer. (As a result, thebusinesses listed separately below earn about ten timesthe amount contributed by the other wholly ownedbusinesses not listed separately.)

Total operating earnings of this segment have com-pounded by more than 62% annually in dollar terms(excluding goodwill amortization and shares issued inacquisitions). Not shown in the following exhibit,because they will not be reported until 1998 full-yearnumbers are presented in the annual report, areInternational Dairy Queen (acquired in January 1998),

which earned $56.8 million pretax in fiscal 1996, andExecutive Jet (acquired in July 1998).

Exhibit 9

Mfg, Publishing, Retailing A-Tax Earnings 1997

$0

$20

$40

$60

$80

$100

FlightS

afety

ScottF

etze

r

Sees

Can

dies

Home

Furn.

Buffa

loNe

ws

Shoe

Group

Jew

elry

Finan

ceOt

her


FlightSafety, the worlds largest aviation trainingcompany, is Berkshires biggest noninsurance business; in1998, Berkshire purchased Executive Jet, the companythat originated and dominates the fractional aircraftleasing business. Together, we believe that these aviationservices businesses will lead Berkshires noninsuranceoperations. Both Flight Safety and Executive Jet possessattributes that Berkshire finds most attractive in its

wholly owned businesses: enormous economies of scale,strong cash flow and a market dominance sooverwhelming that competitors are deterred fromentering the business.

The aviation businessesflying intothe future

When asked how best to assess intrinsic valuerelative to book value today: You should focus onour aviation businesses.

Warren Buffett, September 16, 1998, SpecialShareholders Meeting

FlightSafety. Purchased in 1997 for $1.5 billion in stockand cash, FlightSafety was Berkshires largest acquisitionbefore General Re. The company provides high-technology training to operators of aircraft and shipsusing sophisticated simulators and training devices forairlines, corporations and governmental customers. Thesingle most important individual business, other thaninsurance, in 1997, FlightSafety represented 28% ofBerkshires after-tax earnings (excluding interest andgoodwill amortization) from noninsurance businesses.Its 1997 net income of $84.4 million was comparable toFlightSafetys $84.5 million 1995 net income.


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FlightSafety was founded in 1951 by Al Ueltschi, a pilotwho mortgaged his house to start the flight trainingcompany. FlightSafety went public in 1968 and wasacquired by Berkshire through a match suggested by aBerkshire shareholder. FlightSafety operates training

programs for Airbus, Bell Helicopter, Boeing, BritishAerospace, Raytheon, Sikorsky, Learjet, Lockheed,Cessna, Gulfstream and various other types of aircraft.The company has a $200 million training venture

with Boeing.

FlightSafetys corporate objective: To satisfy themost rigorous airline training demands, and to do sofor less than the cost a carrier would incur operatingits own in-house training department. Once theyanalyze the cost-effectiveness of our service, weanticipate more new and existing carriers will invite

us to handle their training as well. We believe theoutsourcing of crew training will become standardpractice among airlines in the future

President A.L. Ueltschi, FlightSafety 1995Annual Report to Shareholders

The company has a typical Berkshire Hathawaymoatapproximately 90% market share, very longterm (e.g., ten-to 15-year) contracts with its majorcustomers, heavy capital expenditure requirements thatare a barrier to entry for start-up competitors, and the

additional barriers to entry of advanced technology andmarket reputation. FlightSafety is able to provide thebest-quality trainingsomething that aircraft fleetowners cant afford to scrimp onat a competitive pricedue to its economies of scale (including the advantage ofbuilding its own simulators and training equipment).Like Executive Jet, FlightSafetys customers oftenabandon their own training operations to buy fromFlightSafety and obtain better quality at a lower price.

Due to its 36%-plus margins, FlightSafety is a cashgenerator, notwithstanding its capital expenditures, asshown in the following exhibit. From 1992 to 1995,

FlightSafety redistributed more than $200 million toshareholders through dividends and share repurchases.FlightSafety is almost the ideal Berkshire business, givenits dominant market share, high cash flow and insulationfrom competition.

Exhibit 10

FlightSafety 1995 Operating Earnings

Training

Product sales


Exhibit 11

FlightSafety Operating Results Prior to Acquisition

($, millions) 1995 1994 199

Training revenues $307.1 $271.7 $244.% change 13.0% 11.0% 2.2

Product sales $18.7 $29.6 $52.

% change -36.6% -43.5% 34.1

Gross margin on:

Training 36.3% 37.3% 36.1

Product sales 28.5% 19.5% 24.6

Net income $84.5 $74.5 $66.

% change 13.5% 12.1% -19.3

Cash flows $140.5 $118.4 $105.

Per BRK 1996 share $116.61 $98.20 $87.4

Capital expenditures $90.0 $64.4 $64.% of cash flows 64.0% 54.4% 60.7

Share repurch./div. $45.7 $43.1 $106.

% of cash flows 50.8% 66.8% 166.6

Total 114.8% 121.3% 227.3

Equp./facilities, net $509.8 $470.1 $453.

% change 8.5% 3.7% 4.5


Executive Jet. Berkshire acquired Executive Jet inAugust 1998 for $725 million. Executive Jet has many

of the same characteristics as FlightSafety. It is theworlds leading marketer of fractional ownership inaircraft, with an approximately 75% market share.Executive Jets customers buy shares in an Executive Jet(paying in advance) and incur fees to maintain and flythe aircraft. The aircraft is sold at the same retail pricethat customers would otherwise pay, yet the customersobtain many advantages:

An Executive Jet can be reserved anywhere in thecountry on six hours notice. Customers do not havto worry about where their plane is located at anypoint in time;


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Customers only buy what they needtheres noreason to carry the cost of a whole plane if only one-quarter or one-eighth is required. They also avoidtying up capital in an aircraft. And customers canchange their ownership percentage from year to yearas their needs dictate;

Customers can trade up or down to differentmodels of aircraft as their needs change withouthaving to handle remarketing old planes; and

Customers avoid the administrative burden and costof maintenance, hiring, training and scheduling, andare assured of well-trained pilots and crew.

The fractional ownership industry was invented byExecutive Jets CEO, Richard Santulli. The valueproposition of the business is customer service (sched-uling, crew professionalism, consistently on-time service)

at an attractive value. The financial outcome of frac-tional ownership is compelling: Buying Executive Jetshares eliminates the customers remarketing risk, avoidstying up capital in an aircraft and reduces cost becausecustomers buy only the shares they need (based on thehours the customer occupiesthe plane).

Executive Jet has 140 aircraft under management cur-rently and is buying at least 45 new aircraft each year, asmany as it can get. The company had total ordersoutstanding of 129 in 1997 worth $2.6 billion, repre-senting 31% of all corporate jets ordered in the year.Since 1997, the company has significantly increased itsorders outstanding. Executive Jets sales of corporateaircraft represented 9% of all worldwide aircraft deliveriesin 1997.

Executive Jet is the largest customer for certain aircraft(for example, it is Gulfstreams largest distributor).

We expect the company to produce revenues of $1 billionor more in 1998, compared with $900 million in 1997.

Aircraft sales revenues are growing, but will graduallyrepresent a smaller share of the total as the base ofcustomers builds, because each customer provides flightrevenue (hourly flight charges and monthly maintenancefees).

In addition, existing customers buy a share in a new planeevery 3.5 years, on average, so the company would havecontinued sales even without adding new customers.Management evaluates the success of the business basedon customers added and lost. Since its inception in 1987,the company has lost only a handful of its more than1,000 customersgenerally due to the customersfinancial problems. Existing customers refer 75% of thecompanys new sales.

We believe that Executive Jet resembles Gillette. Sellingthe aircraft is like selling a razor, while the maintenance

and flight fees are the blades. The company chargesa fair price for the aircraft, but over the long term, itmakes more money selling the blades. In effect,Executive Jets business gives Berkshire an annuity-likecash flow for decades to come.

Looked at another way, EJ is yet another classic Berkshiremoat business with scale economies; the cost of startingup a new global network of leased aircraft would beprohibitive (hundreds of millions of losses incurred,according to Warren Buffett). Executive Jets onlycompetitors are two aircraft manufacturers, Raytheonand Bombardier. These manufacturers offer only onebrand of aircraft and are generally more focused onconverting fractional customers to buyers of wholeplanes, which affects their marketing and serviceapproach. Executive Jet is also the single largestnonmilitary customer of four of the five leadingcorporate jet manufacturerswhich gives it buyingpower, resulting in commensurately attractive terms,enhancing its margins.

The company differs from Berkshires other whollyowned businesses in one important respect. Executive Jetis a high-growth business. Based on annual additions tothe aircraft fleet, Executive Jet is growing in excess of30% per year. The company has begun to enter Europe,

will eventually move into Latin America and Asia, andplans to link the continents together with a network ofsupersonic aircraft. From the customers perspective, thecost advantage of fractional ownership increases with themore expensive aircraft. For example, a quarter share in asupersonic plane costs the same as a full share of aHawker, a great trade-off for corporate customers that dobusiness on many continents.

Together with GEICO, we expect Executive Jet to be themain driver of organic growth in the next few years. Themajor risk and growth constraint is building servicecapabilities to match the growth. Other risks are modest.The company is already past the point of scale where acompetitor could be a serious threat, has goodcancellation terms with its vendors, and in a recessioncould grow as owners of aircraft downsize to fractionalownership, even if its own customers reduce their shares.

Berkshires other businesses

Berkshire owns many other businesses that generally areeither the low-cost, large-scale providers in their industry(Borsheims, the Nebraska Furniture Mart), or a goodbrand with pricing power (Sees, The Buffalo News).Sees was the first business that Berkshire paid up for (atotal of $25 million), proving to Messrs. Buffett andMunger the importance of brand and pricing power. Wevisited Borsheims and the Furniture Mart, meeting


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Borsheims president, Susan Jacques, and Irv Blumkin,one of the Blumkin family members who run theFurniture Mart. The size and scope of these businessesare almost overwhelming.

Borsheims was bought by Berkshire in 1989 from amember of the Blumkin family, founders of the NebraskaFurniture Mart. The largest jewelry store in the U.S.other than Tiffanys New York store, Borsheims uses itscost advantage to discount heavily and operates throughmail order. The enormous selection, high quality anduniqueness of its products make a trip to Omaha worth-

while for anyone considering buying a serious piece ofjewelry2. For smaller items, or to make things conven-ient, Borsheims will ship a selection to you at no charge.

Just return what you dont want, and theyll bill you forwhat you keep.

The Furniture Mart is the flagship of the home furnish-ings segment, which also includes R.C. Willey HomeFurnishings and Star Furniture Co. The Furniture Martis more like a small city than a store, currently occupying72 acres and scheduled to expand. Walking through thecarpet section of the warehouse is enough exercise for anaverage person in a day. Visiting the grandfather clockdepartment is like strolling through a forest of clocks.

The Mart has extended its geographic reach to the pointthat anyone within a few hours drive of Omaha can justifya trip if they are shopping for electronics, appliances orhome furnishings. In addition to these items, you can

carpet, tile and paint your house using products from theMart. Basically, once you buy a house, almost everythingelse you need for it can be acquired at a discount fromBerkshire Hathawaytotal one-stop shopping3.

International Dairy Queen. In October 1997,Berkshire agreed to buy International Dairy Queen for$585 million. The purchase price was slightly skewed toencourage IDQ shareholders to accept cash; nevertheless,more than half of them chose BRK stock insteada wisedecision considering that the transaction closed January 7,1998. Dairy Queen is unlike McDonalds in that thecompany owns little real estate. Franchisee fees from the

companys approximately 5,800 stores are the annuity-equivalentanother cash business with a loyal customerbase. Dairy Queen had fiscal 1996 pretax income of$56.8 million, comparable in size to Sees Candies.2A personal note: Despite its unusual and beautiful array of merchandise and

our first-hand experience of Borsheims excellent service, visiting Borsheimswas the only disappointing experience we had in researching BerkshireHathaway, as I discovered how much I had overpaid for a watch my husbandreceived for Christmas last year.

3The Furniture Marts founder, Rose Blumkin, illustrated one of Messrs.Buffett and Mungers points about the need to consider even remote riskswhen she quit the company to form a competitor following a dispute over themanagement of the carpet department. By the time Ms. Blumkin returnedto Berkshire at the age of 99, the company made her sign a noncompete

clause.

Berkshires two problem businesses are World Bookand the Shoe Group4. The former isnt the business itused to be, as its home sales of new books have erodeddue to the rise of the personal computer and the Interneand the latter, despite a strong brand and a profitable

history, has seen its earnings decimated by foreigncompetition.

The Shoe Group joins a list of Berkshires occasionalmistakes, which include, according to management,1) passing up some investing opportunities that shouldhave been seized; 2) early investments in cigar buttsand such capital-intensive businesses as the BerkshireHathaway textile mill; 3) a deviation from style (e.g.,investing in US Air preferred) that did not work out; an4) Salomon Brothers, which ultimately worked out as aninvestment but which cost Warren Buffett untold timeand energy in the process.

In this report, we will not be discussing the othernoninsurance businesses, such as Sees Candies, KirbyVacuum and The Buffalo News, any further. Most ofthese excellent, profitable businesses individually justclear Berkshires minimum earnings threshold foracquisitions ($25 million). Their performance isdiscussed each year in the annual report and the onlydetailed information available beyond that is their pre-and after-tax earnings excluding goodwill amortizationand interest. In total, these businesses represent about18% of Berkshires 1997 operating earnings5, a percent-age that will decline with the purchase of General Re.

[A set of the] World Book is worth $600, exceptsomebody figured out how to do it for a quarter.

Warren Buffett, September 16, 1998

Corporate segment. We have placed the remaining asseearnings and capital in a corporate segment that is composed primarily of debt, noninsurance goodwill, nonin-surance investments, shareholder contributions andadministrative costs. The pushdown of insurance goodwand the placement of debt at the corporate level results in

minimal corporate capital. The diversity of Berkshirebusinesses does not lend itself to pushing down debt to toperating level for presentation purposes. We could addthe corporate segment to the investing segment to elimi-nate this problem, but the debt is clearly also financingother operations, and we prefer to show investmentsseparately.

4Dexter Shoe was acquired in 1993 for $420 million in stock; Berkshires

normal aversion to stock acquisitions must have been compounded by this.The company also owns H.H. Brown and Lowell Shoes.

5Without allocating goodwill amortization and interest expense.


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Berkshire Hathawaya capital allocatingmachine

Conceptually, we believe that Berkshire Hathaway is abusiness that generates and reinvests capital at a consis-

tently higher return than investors normally receive. Infact, it could be argued that Warren Buffett refined theconcept of Economic Value-Added (EVA) before SternStewart came along6.

The strange thingits a real contradictionis thatif a business is earning a given amount of moneyand everything else is equal, the less it has inassets, the more its worth. You wont get that in anaccounting book.

The really desirable business is the one thatdoesnt take any money to operate because its

already proven that money will not enable anyone toget a position within the business. Those are thegreat businesses.

You dont need any money whatsoever in afabulous business.

Warren Buffett, guest lecture at Stanford BusinessSchool (April 18, 1990)

The concept behind EVA is that an investment must becharged for the capital it uses: Mr. Buffett learned thisearly, with the Berkshire Hathaway textile mill, althoughhe continued to operate the mill for many years because

it did not consume cash, and out of respect for itsworkers, management and tradition, he rationed capitalrather than indiscriminately putting money into abusiness that could never cover its cost of capital. Sincethen, every business that Berkshire has acquired has beenrationalized from a capital standpoint and any excesscapital has been sent elsewhere where it could be moreproductive, raising returns.

Value investing and growth investing are one andthe same. Growth is part of value. Part of the sameequation. Returns on incremental capital are the

key.Warren Buffett, 1986 Annual ShareholdersMeeting, as quoted in Outstanding Investor Digest.

Today, Berkshire is a collection of many businesses thatgenerate capital at an appropriate return, such as SeesCandies, along with others that consume capital but thatare generating positive EVA (such as FlightSafety and

6For convenience, we are using the term EVA, although Berkshire manage-

ment uses its own words (which were developed many years ago) to describeits capital management approach.

Executive Jet). Capital that cannot be invested by buying100% of a business that generates positive EVA andmeets other Berkshire investing criteria is put to workelsewhere.

The business is wonderful if it gives you more andmore money every year without putting up anythingor very little. And we have some businesses likethat. A business is also wonderful if it takes money,but where the rate at which you reinvest the moneyis very satisfactory. The worst business of all is theone that grows a lot, where youre forced to growjust to stay in the game at all and where yourereinvesting the capital at a very low rate of return.And sometimes people are in those businesseswithout knowing it.

Warren Buffett, 1998 Annual Shareholders

Meeting, as quoted in Outstanding Investor Digest.

Nor is the basic concept behind EVA forgotten in thecompanys minority equity positions. We believe that itis not a coincidence that Coca-Cola, Gillette, AmericanExpress and Disney all produce sizeable positive EVA ascalculated by Stern Stewart, according to a November 9,1998, Fortunearticle. According to Stern Stewart,however, Buffetts financial services investments do notfare so well on an EVA scale7.

To illustrate the way capital is used at Berkshire, we usedBerkshires segment data to estimate the amount of earn-

ings generated by each segment that was reinvested in thebusiness. The following table shows the results. Themethod we used is very imprecise. For example, we esti-mated the amount reinvested by analyzing the change incapital excluding dividends and changes in investmentvalues; there may be other changes (e.g., related toacquisitions) for which we were unable able to account.

However, as a general guide, we think that this method isreasonable and that it shows clearly that most of thebusinesses operating earnings are not reinvested in thebusinesses but used by the parent company in other ways,contrary to most companies practice of retaining

earnings.

7However, as we have noted in previous research, we believe that Stern

Stewarts method for calculating EVA for financial services, and, in par-ticular, insurance companies, needs a substantial amount of refinementbefore it can be considered credible. Companies that are weather sensitivecannot be analyzed meaningfully using this method, and companies thatsystematically understate claim reserves and overstate book value will scorefavorably, even though economically that is the wrong answer. The methodis biased against insurers that invest for total return, as well as against com-panies that write longer-tailed lines of business and carry large loss reservepositions. Confirming these problems, unlike other industries, there is astrikingly low correlation between MVA (market value-added) and EVA inproperty-casualty insurance, even though the two should track each other.


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Berkshire Hathawaythe virtuous circle

While Berkshires track record is indisputable, whatinvestors want to know is whether and how it can besustained (note that Berkshire itself warns that historical

returns are not sustainable, but that outperformancerelative to the marketis sustainable).

The sustainability of Berkshires performance is not anacademic question because this is one of the directinputs to valuing the stock. We believe that the driversof performance can, to a large degree, be identified andevaluated; the genius of Messrs. Buffett and Munger hasbeen to design a system that continuously generatesshareholder value and institutionalizes it. In doing so,theyve created a virtuous circle in which past gooddecisions beget opportunities for future good decisions.

Ive heard Warren say since very early in his lifethat the difference between a good business and abad business is that a good business throws up oneeasy decision after another, whereas a bad busi-ness gives you horrible choicesdecisions that areextremely hard to makeOne way to determinewhich is the good business and which is the badone is to see which one is throwing managementblooperspleasant, no-brainer decisionstimeafter time after time.

Charles Munger, 1998 Annual ShareholdersMeeting, as quoted in Outstanding Investor Digest.

Weve used the concept of the virtuous circle oftenbefore because it applies so well to the insurance busi-ness: an insurance company with a cost or underwritingadvantage and good management that avoids majormistakes, which frees management and capital to captureopportunities at the appropriate point in this cyclicalindustry. This begets larger marginal gains during themore positive points in the cycle, positioning thecompany for further outperformance during morecompetitive periods.

Here are some of the performance elements that we

consider most relevant to create the virtuous circle ofBerkshire Hathaway. Some of these are unique, andtherefore, should be key investment considerations forthe stock:

Partnership. We always consider management and itsattitude the single most important attribute of investingin an insurance company. Berkshire management viewsits shareholders as partners in every sense of the word.Senior management receives only modest salaries, and byfar the bulk of its net worth is invested in the company.There are no stock option plans or other employeebenefits to dilute shareholder value. Mr. Buffett has

stated that 99% of his net worth is invested directly inthe company. Messrs. Buffett and Munger share in anylosses directly in proportion to the other shareholders.

Shareholder buy-in. Management has invested

enormous time and energy in outlining its philosophyconsistently and clearly. Further, Berkshire has honoredits commitment to shareholders by living up to theprinciples it has espoused, and management is candid inadmitting its infrequent mistakes8. As a result, thecompany has unparalleled shareholder loyalty and is ableto act in its long-termbest interests with great flexibility.

We believe that this gives Berkshire a competitiveadvantage in acquisitions because it can make long-term-oriented decisions that the companies it has acquiredcould not under the constraints of public ownership.

Clarity and focus. Every person, in every unit of

Berkshire Hathaway, is clearly focused on the single goalof increasing shareholder value. With a few notableexceptions since discarded that were lessons for man-agement, Berkshire has invested only in extremelyfocused companies that run a competitive, high-qualitybusiness. Once Berkshire acquires a company, allincentives thereafter are aligned to focus on improvingoperations and nothing else. Operating managers haveno role in Berkshires overall corporate strategy or capitalallocation; cross-unit synergies are neither required norencouraged (the Sees candy cart at the NebraskaFurniture Mart notwithstanding). There are no dis-tractions at Berkshire Hathaway. Everyone understandshis or her mission and gets on with business.

Speaking of himself as the employer of RoseBlumkin, founder of the Nebraska Furniture Mart:I mean any guy wholl have a 95-year-old womanwork for him seven days a week has no shame atall.

Warren Buffett, as quoted in Outstanding InvestorDigest, April 18, 1990

Simplicity. Over the years, management has spent

considerable time defining what it does notwant toinvest in, and the kinds of businesses it does notwant toown. Messrs. Buffett and Munger are willing to pass onpotentially great ideas that dont fit these criteria,because they are confident that there are enough greatideas within the universe of investments they are inter-ested in and able to understand. The trade-off is moretime to spend on what matters. They also dont believevery many ideas are worth acting on. This philosophy

8Buffetts genius was largely a genius of characterof patience, discipline,

and rationalityIn this sense, Buffetts character and career unfolded as asort of public tutorial on investing and on American business.RogerLowenstein, introduction to BuffettThe Making of an American Capitalist.


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reduces risk from a Berkshire shareholders standpoint aswell as raising the probability that investments Berkshiredoes make will succeed.

What we do is simple, although its not necessarilyeasy. The checklist going through our mind isntvery complicated. Knowing what you dont know isimportant. Sometimes thats not easy. Seeing thefuture is impossible in many cases, in our view, anddifficult in others. But sometimes its relativelyeasy. And those are the ones that were lookingfor.


On active, high-turnover equity investing: Extracare in thinking is not all good but also introduces

extra errormost good things have undesired sideeffects, and thinking is no exception.

Charles Munger, Speech to the FoundationFinancial Officers Group, October 14, 1998

Margin of safety. Most of the time, the margin ofsafety is described as a significant haircut on the valueof an investmenta discount that is supposed to coverthe contingency that an investors expectations aboutperformance are wrong. However, we believe thatBerkshire alsolooks at risk in another way, using prob-ability distributions. To qualify as an investment, the

probability distribution must be normal or skewed inBerkshires favor. Thus, if there is an unquantifiabletail on the negative side of the distribution, manage-ment will not take that risk, even if the positive end ofthe distributionthe potential rewardis overwhelm-inglyin its favor. Every potential loss must be quanti-fiableand understandablenot leveraged or subject tosignificant unknown exogenous events. Berkshire looksfor the earthquake risk in every business.

We believe that this is why management avoids investingbased on quantitative models, eschews hedged deriva-tives strategies, charges premium rates for its riskier

businesses such as super-catastrophe reinsurance, andputs finite limits on its aggregate exposures to eventssuch as earthquakes. Therefore, each individual businessor asset owned by Berkshire, individually, has a lowprobability of loss of principal if owned over a reason-able time period. This attribute is unusual amonginsurers, which are generally more leveraged thaninvestors realize and have difficulty earning returnscommensurate with the risk they are taking.

A small chance of distress or disgrace cannot, inour view, be offset by a large chance of extrareturns. If your actions are sensible, you arecertain to get good results; in most such cases,leverage just moves things along faster. Charlieand I have never been in a big hurry: We enjoy theprocess far more than the proceedsthough wehave lived with those also.

Warren Buffett, 1989 annual report

In addition, we believe that Berkshire considers themanagement of the businesses it owns to provide anextra margin of safety. Messrs. Buffett and Munger havcommented frequently that they only wish to invest incompanies with managements of high integrity whose

word they can believe and whose financial reports can b

relied upon to contain only inadvertent errors.Capital allocation. Every dime of capital is investedagainst a stringent set of criteria. When possible,Berkshire would prefer to buy more of what it alreadyowns at a good price. New investments require a highemargin of safety. Businesses are expected to producehigh returns and to generate excess capital for Berkshireto deploy if their cash flows cannot be redeployed in thebusiness at a high return.

Cost of capital. Berkshire not only has a triple-Arating, which reduces its cost of debt capital, and a lowcost of equity capital, but the company has access to a

substantial and increasing amount of low-cost insurancefloatfunds owed to others but invested forBerkshirethat further reduces the companys effectivcost of capital by providing an additional source of verylow-cost (actually, negative cost) leverage.

Exhibit 13

Berkshire Float History Before GEICO

($, mill ions)

$0

$750

$1,500

$2,250

$3,000

$3,750

$4,500

1967 1975 1980 1985 1990 1995


The preceding chart shows Berkshires float growthbefore it acquired GEICO. Berkshires float com-pounded at 22.5% per year from 1968 through 1997.

Following are GEICO and General Res float, overlaid


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on the previous numbers. The acquisition of GEICOalmost doubled Berkshires float at one stroke. Theacquisition of General Re will almost triple it.

Placing these large chunks of float in perspective on a

percentage basis, they raise the average growth rate overthe entire 29-year period to 33.6%. The cost of acquir-ing this float was slightly higher than the float createdinternally by Berkshire (due to the purchase premiumpaid for GEICO and General Re); these additional costsare captured in the goodwill paid for these companies.

Exhibit 14

Berkshire Float History ($, millions)

$0.0

$5,000.0

$10,000.0

$15,000.0

$20,000.0

$25,000.0

1975 1985 1995 1996 1997 1998

Berkshire GEICO General Re


Unlimited investment universe. Berkshire is the onlyinsurer with an unlimited investment universe andmaximum flexibility to allocate capital. Thanks to its

track record of superb investing and superior capitali-zation, the Nebraska insurance department, the ratingagencies and investors give Berkshire Hathaway invest-ing latitude not granted to any other insurer. Thisenables Berkshire to invest for an equity return anycapital that it is not using in the insurance business,eliminating the burden of subpar returns on excesscapital. Because no competitor has, or could develop ina reasonable time horizon, an investment record similarto Berkshires, we believe that this is an overwhelmingand practically permanent competitive advantage.

Virtual capital. Along with the unlimited investment

universe goes virtual capital. The typical insurer isrequired to support its claim reserves primarily withinvestment-grade fixed-income securities. In addition,as a practical matter, the typical insurer must maintainmore capital at any point in time than it is likely torequire for the volume of business it is writing. Needlessto say, it is difficult for an insurer to earn an equityreturn on its capital under these circumstances9.9The insurer must either underwrite at a sufficient profit (something that

rarely happens these days), or at margins that result in an economicallyattractive return measured against the average claims payout pattern of itsreserve liabilities. The industrys overall return on capital is about 7%, wellbelow the cost of capital and the level of risk assumed.

Berkshire, on the other hand, can invest all of its capitalin whatever it chooses. All of the insurance operationscapital is available to earn an equity return for BerkshireHathaway.

Investor of first resort. Berkshire has made itself theinvestor of first resort for business owners who want torun the operating side of their companies without inter-ference while freeing themselves from capital-raising,capital allocating and investor relations. Berkshire is theideal acquirer for the truly dedicated hands-on operatingmanager. As such, the company has first pick of invest-ment opportunities that are never shown to anyone else.

In addition, Berkshires ability to instantly commitcapital to ideasno committee process or elaborateprospectus requiredmeans that good investment ideasgo to Omaha first. We believe that: 1) Berkshire gen-

erally approaches businesses it wants to buy only once,and 2) no one ever gets a better price from Berkshire thesecond time around. This also gives the company astrong advantage in buying businesses.

Long-term orientation. Very few companies haveshareholders with a truly long-term orientation.Therefore, companies must manage earnings andoccasionally make uneconomic decisions to avoiddisappointing investors short-term expectations.

Berkshire is the only company we are aware of whoseshareholders have a completely long-term orientation.This gives the company flexibility that its competitorsdo not havewhich we believe is a significant advan-tage. Management itself always takes the long view,never compromising the long-term best interests ofBerkshire shareholders for short-term gains.

The super cat business is the best example of thisother participants in that business set up public com-panies whose capital was dedicated to catastrophereinsurance. This took away the ability to allocatecapital flexibly and forced these companies to diversify

when the cycle inevitably headed downward. ButBerkshire can use the capital elsewhere, and so needonly accept business on its own terms.

Investing is the greatest business in the worldbecause you never have to swing. You stand at theplate; the pitcher throws you General Motors at 47!U.S. Steel at 39! And nobody calls a strike on you.Theres no penalty except opportunity. All day youwait for the pitch you like; then, when the fieldersare asleep, you step up and hit it.

Warren Buffett quoted in Forbes, November 1,1974


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Competitive advantages. Berkshires noninsurancebusinesses are expected to have some sort of moat, orcompetitive advantage, that will sustain them againstcompetition for as long as possible. In the case of pas-sive investments, this is normally a franchise brand (e.g.,

Coca-Cola, Gillette, American Express). However,wholly owned subsidiaries also normally have some sortof overwhelming market share or cost advantage.

Making Warren proud. Warren Buffett has oftenstated that his job is to tap dance into work everymorning, allocate capital and find reasons for people

who are independently wealthy to work incredibly hardfor the shareholders of Berkshire Hathaway. How hedoes this has never been clear. We noticed, however,that every manager of every business we spoke to men-tioned, without prompting, their desire to make

Warren proudto show him that he made the rightdecision when he invested in that business or thatpersonand their pleasure in doing so. Somethingabout Warren Buffett elicits this response in people.

Our modelearnings and book valuegrowth assumptions

While we do not believe that short-term earningsestimates are meaningful for a company like BerkshireHathaway, we are projecting annual operating earnings(excluding realized investment gains and losses) forcomparative purposes and to assist in compoundingbook value per share. Using the following majorassumptions for 1999 and 2000 operating earnings, weproject short-term earnings growth of 15.6% per sharein 1999 and 24.4% per share in 2000 (compared withthe average 22% historical rate). Cash operating earn-ings per share are estimated to grow 35.2% in 1999 and19.0% in 2000.

1/20/99 price $64,500 NYSEBRK.AMarket Cap.: $97,524M 52-wk. High: $84,000Shares Out.: 1.512M 52-wk. Low: $48,000Float %: 68% Avg. Dly. Vol.: 0.571K

FY End: December 1998E 1999E 2000EFY Oper. EPS* $863.27 $997.88 $1,241.59Oper. EPS (ex gw) $949.19 $1,283.73 $1,527.44

*Operating EPS exclude realized capital gains and losses.

Noninsurance businesses grow by approximately10%;

GEICO grows premiums 18% per year with acombined ratio of 95.7% in 1999 (2.7 points higher

than the 1998 estimate) and 96.2% in 2000. Onepoint of the increase relates primarily to higheradvertising costs, while the remainder reflectsdeclining industry pricing.

We maintain our former model on General Re,except that we assume the following: 1) approxi-

mately $150 million of retrocessional premium isrecaptured annually; 2) premiums grow faster5%for the next two years, better than the industroverall due to the companys ability to accept largerand more diverse risks; 3) approximately $2 billionof General Res $5 billion equity portfolio isinvested in fixed-income securities with relativelyshort maturities (we assume that the remainder,although initially transferred to short-term fixed-income securities, will be deployed to equities fairlyquicklya more conservative assumption from anoperating earnings standpoint); 4) the effective taxrate on the investment portfolio declines, onaverage, by 100 basis points over two years as thecompany shifts into more municipal securities; and5) the loss ratio rises by one point from our previouassumption to reflect the conversion of optionincentive programs to cash programs. Of theseassumptions, the premium growth assumption hasalmost no impact on earnings, but the investing andtax assumptions have a significant impact.

Weighted-average Class A equivalent shares outstanding

of 1.5152 million.In estimating the growth of book value, we assume thatthe equity market increases in value by 5% per year,including reinvested dividends, for the next two years(consistent with the PaineWebber investment strategygroups view and as opposed to our own long-termassumption of 10% per year) and that Berkshire out-performs by 500 basis points. Adding this increment as

well as reinvested earnings and the 10% market valueincrease related to approximately $1 billion per year ofincremental float yields book value growth of 10.4% in1999 and 7.7% in 2000. Over the long term, we expec

book value to compound at approximately 15% inperiods when the equity markets grow by 10% andBerkshire Hathaway has a higher asset allocation toequities.


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Concentrated investing

The importance of concentrated equity investing toBerkshire Hathaways success as an insurance company

cannot be overstated. For example, consider thefollowing table comparing return on invested assetsand relative size for the property-casualty industry:

Exhibit 15Investment Returns and Premiums, Year-End 1997

% of Industrys Market Share, Equities/ Net Inv. Total Return

Equity Inv. NPW Surplus Yield on Inv. Assets

Berkshire Hathaway 23.4% 1.7% 85.0% 2.6% 21.8%

Top 10 Insurers 62.1% 32.0% 65.0% 5.2% 12.3%

Other 1100 Insurers 37.9% 68.0% 29.0% 6.1% 7.7%

Total Industry 100.0% 100.0% 44.0% 5.8% 9.2%

Source: A.M. Best.

Berkshire Hathaway wrote 1.7% of the industrys totalpremiums and yet owned, at year-end 1997, almost24% of the total equities held by the property-casualtyindustry. These equities represented about 85% ofBerkshires insurance subsidiaries policyholders surpluscompared to 44% for the average property-casualtyinsurer.

Because of the high concentration in equities relative tofixed-income securities, Berkshires statutory investmentyield was only 2.6% compared with 5.8% for theindustry. However, the impact on total returns morethan offset this. Berkshire achieved a total return of21.8% on its invested assets, compared with an averageof 9.2% for the industry. Further, Berkshire hasachieved similar returns throughout its historynot justduring equity bull markets.

Our experience in shifting from savings and loanoperation to ownership of Freddie Mac sharestends to confirm a long-held notion that beingprepared, on a few occasions in a lifetime, to actpromptly in scale in doing some simple and logicalthing will often dramatically improve the financialresults of that lifetime. A few major opportunities,clearly recognizable as such, will usually come toone who continuously searches and waits, with a

curious mind, loving diagnosis involving multiplevariables. And then all that is required is a willing-ness to bet heavily when the odds are extremelyfavorable, using resources available as a result ofprudence and patience in the past.

Charles Munger, Wesco Financial Corp. 1998Annual Report to Shareholders

One unusual feature of Berkshire Hathaway is thedegree of concentration in its equity portfolio. Berkshireis not the only insurer with a similar investmentapproach (Cincinnati Financial had 127% of its share-holders equity invested in a concentrated portfolio ofequities at September 30, 1998, and Reliance Group forthe past few years has compounded its tangible bookvalue at a much faster pace than the industry through asimilar strategy, which, however, is no longer beingfollowed). However, we believe that Berkshire has donethe clearest job of 1) achieving consistent returns over anextended period, and 2) obtaining shareholder, ratingagency and regulatory buy-in. We consider this buy-inan important part of Berkshires franchise, as it gives the

company unparalleled flexibility compared to otherinsurers.

Diversification serves as protection againstignorance. If you want to make sure that nothingbad happens to you relative to the market, youshould own everythingBut if you know how tovalue businesses, its crazy to own 50 stocks or 40stocks or 30 stocks, probablybecause therearent that many wonderful businesses understand-able to a single human being in all likelihood.


The mystery of intrinsic value

Investors have historically struggled to assess the intrinsicvalue of Berkshire Hathaway. Management inten-tionally does not provide a valuation, although Messrs.Buffett and Munger have provided quantitative infor-mation and have given a number of suggestions over theyears to help investors derive their own valuation.


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General Re has underwritten at a combined ratioof just over 100% consistently for the past 50 years.There is little question that General Re can bevalued using a float method. In addition, incor-porating General Re into Berkshire Hathawayessentially triples the companys float.

Accordingly, we believe that it is no longer possibleto understand and value Berkshire withoutconsidering the value of the companys float.

Before presenting our valuation of Berkshire Hathawaysfloat, a conceptual description of the underlyingfinancial concepts and mathematics may be useful.

If you could see our float for the next 20 years andyou could make an estimate as to the amount andthe cost of it, and you took the difference between

its cost and the returns available on governments,you could discount it back to a net present value.


Beginning with the simplest conceptual example, aninvestor should be willing to pay up to the risk-free rateto use float for one year. The investor would, for exam-ple, be willing to pay up to $5 to borrow $100 andinvest it at 5%.

Moving on, an investor should be willing to pay up to

the amount of the float itself for the ability to invest thefloat at the risk-free rate in perpetuity. For example, aninvestor would pay up to $100 for the right to invest$100 at the risk-free rate forever. At this breakevenpoint, the earnings foregone on the $100 paid wouldexactly offset the earnings on the borrowed amount.

Applying this from an insurance investors perspective,an insurer in effect has the ability to invest in perpe-tuityor close enough so as to be irrelevant mathemati-callyas long as the insurer does not shrink or liquidate.

Exhibit 17

Berkshires Cost of Float

-20%

-10%

0%

10%

20%

1985

1987

1989

1991

1993

1995

1997

Cost of Floa t 30-Yr Treas.


Now come the three complications. The first relates tothe cost of float. What if the investor must occasionallypay an additional fee above the risk-free rate in order touse the float? The valuation would obviously be net ofthat cost. The extra fee is the result of a higher

combined ratio that increases the cost of float above therisk-free rate, and for most insurance companies, theuncertainty of this extra fee means that a value cannotbe placed on the float. It is reasonable to value floatonly if the company has demonstrated that the cost of itfloat is predictable and lower than the amount it couldearn on the float at a risk-free rate. In the case ofBerkshire Hathaway, this test has been met. Ourvaluation formula incorporates an anticipated long-termaverage charge for the cost of float.

The second complication is the growth of float. Aninvestor would pay more for an amount of float that islikely to grow in the future because the investmentearnings would increase every year. However, estimat-ing the future growth of float can be difficult for mostcompanies in the cyclical insurance industry. Further, ia perpetuity calculation, historical growth rates will leadto an unrealistically high, if not outlandish, valuation.To address this, we have performed a three-step calcu-lation, shown in the following exhibit. For the first fiveyears, we estimate that Berkshires float will grow by15% per year. This is 75% of the rate of estimatedpremium growth, which is how GEICOs float has his-torically developed11. For the next five years, we assum

that Berkshires float will grow by 11.25%, or 75% of a15% premium growth rate. We assume that GeneralRes float will grow by 5% per year for ten years as itcaptures synergies related to Berkshire.

To test the reasonableness of the first assumption, weprojected GEICOs market share in 2008 using thesegrowth rates and assuming that the U.S. auto insurancemarket grows by 4% per year. In 2008, GEICO wouldhave a 13.5% share of the market, slightly larger than

Allstate currently and within the range we expect forGEICO over that time period. General Res float woulbe approximately two-thirds larger than it is today. Mr

Buffett has stated that he expects General Re to doublein size over ten to 15 years. We use float as a proxy forsize because we believe that Berkshire values the growthof float rather than the growth of premiums andincents management accordingly.

11We are assuming that, given its exceptional growth rate, GEICO will com

to represent the majority of Berkshires insurance operations other thanGeneral Re. However, through 1995, before it acquired GEICO,Berkshires own insurance float grew at a compounded rate of 21.0% peryear. While this historical rate is not sustainable, Berkshire should be abl

to grow its float much faster than the insurance industry overall.


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The third complication relates to taxation. In order togenerate float, Berkshire must operate through an insur-ance company, an incorporated entity that results indouble taxation on shareholders capital. Mr. Buffetthas commented that the cost of these corporate taxes to

a Berkshire holder is about 100 basis points of float. Ina valuation, this cost should be charged to the capitalthat generates the floatthe insurance operations.

Our methodology for calculating float-basedvaluation. After estimating float after ten years, wecompute minimum estimated investment income on thefloat (the risk-free rate less expected underwriting loss orcost of float) and then capitalize that income at thedifference between the risk-free rate and the expectedgrowth rate for year 11 and thereafter. After ten years,

we have assumed that GEICOs float grows at 1.0%over estimated GDP and that General Res float growsat estimated GDP of 3%.

Note that in the calculation shown below, we areassuming that General Res float costs 1% per year morethan its long-term historical average. Management hasestimated that the cost of converting General Res stockoption program to a cash program will add about onepoint to underwriting results.

In addition, we are assuming that GEICO/Berkshireunderwrites at a 100% combined ratio. Realistically,however, the auto and super-catastrophe businesses mustbe underwritten at a long-term profit.

To the value of float we add tangible book value, 50%of Berkshires estimated year-end deferred tax liability(to reflect the fact that, under the companys low-turnover policy, the time value of this liability is lessthan its nominal value) and the value of Berkshiresnoninsurance business (using a market P/E ratio of26.5x on 1999 First Call consensus earnings, asdiscussed below).

Noninsurance operations. Berkshire is involved ineverything from aviation training to furniture retailing.Some of these businesses have strong growth potential,

whereas others are high-return on equity businesses thatgenerate more cash than needed for internal growth andthrow off excess capital for Berkshire to invest. Thesebusinesses, in total, had 1997 revenues of $3,735 mil-lion. Over the past ten years, these businesses havegrown their operating earnings by 20.8% per share,excluding all income from investments. Over 20 yearsand 30 years, the performance was slightly better.Taken together, their earnings would rank 243rd in theFortune500. What would you be willing to pay for aFortune500 company whose earnings grow at a morethan 20% rate sustainably?

Applying a 20% growth rate using a dividend discountmodel results in an absurd valuation because, theo-retically, Berkshire would eventually grow to be largerthan the entire U.S. gross domestic product. If weassume that Berkshire can grow in perpetuity at 50 basis

points less than its cost of capital, we derive a value ofmore than $31 billionequivalent to a price-to-earningsratio of 100x. Obviously, the public market would notpay that (unless, perhaps, we renamed the company e-Berkshire.com).

For our comparison, we use a market multiple on 1999estimated earnings, which gives us a value of $9.0 bil-lion. However, considering that the S&P 500s earningsare growing at a much slower pace than Berkshires havehistorically, these businesses should receive a premiumto a market multiple, and so this is probably the low endof the correct valuation. Fundamentally, the highgrowth rate is because all of the businesses have a highreturn on equity, and any excess capital continues to bereinvested at a positive EVA. (Since the S&P multiple isa weighted average of all S&P index companies valua-tions, a top-tier company would usually receive a highervaluation than the average.)

Sensitivity to assumptions and what we didntassume. Some of our assumptions were conservative. Asensitivity analysis is provided so that readers can adjustthe valuation in either direction.

GEICO underwriting. GEICOs statutory combined

ratio has averaged 96.5% for the past ten years, a periodencompassing a higher interest rate environment thatincluded many years in which GEICO wrote less profit-able lines of business, such as homeowners insurance.During this time, the company was operated by differentmanagement and without the support of Berkshire. Webelieve that GEICOs results would have been better hadthe company operated under present conditions.

Nevertheless, we have used a 100% combined ratioassumption, in part because near-term auto insurancemarket conditions are becoming more competitive andin part because at GEICOs growth rate, acquisition

costs of new business burden the combined ratio as themix shifts in favor of new policies. However, over thelong term, we would be surprised if GEICO ran at acombined ratio this high. No credit for this widerspread is given in the calculation.

Other Berkshire underwriting. In general, we believethat, because Berkshires own underwriting (excludingGEICO) has historically been more profitable than weare assuming, the 100% combined ratio used in deter-mining the spread on float is conservative. Each 1%change in Berkshire Hathaways total cost of float(including GEICO) is worth $8,423 per share.


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General Re underwriting. While General Re hashistorically underwritten at a combined ratio just overbreakeven, most of the float was generated duringperiods of much higher interest rates and inflation,

which especially affect the combined ratios of long-tail

reinsurers. In todays interest rate environment (or in a6.5% rate environment), we would expect the averagecombined ratio to be lower than the historical averageratio.

We are also assuming that the combined ratio will riseby one point due to the cost of the new incentive plan,but in fact, the opposite may occur. As part ofBerkshire, General Re should gradually migrate tohigher-layer excess reinsurance transactions, whichshould carry better underwriting margins.

Each 1% change in the cost of General Res float is

worth an additional $4,562 per share, as noted below.Investing. We are not giving any credit to Berkshire forits investing skill.

Our 6.5% investment rate is the estimated long-term Treasury yield, not an equity return12.

In addition, Berkshire has traditionallyoutperformed the equity markets.

Each additional 100 basis points of spread on float isworth approximately $12,983 per Berkshire share, asnoted below.

Value of noninsurance businesses. Each additionalmultiple of estimated 1999 earnings from the nonin-surance businesses (excluding interest and dividends) is

worth $224 per Berkshire share.

Growth. Each additional percentage point of growthfor both companies combined in the first ten yearsis

worth an additional $14,201 per share.

There are some special, important considerations tochanging the growth rate of float afterthe first ten years:

The impact of a 0.5% increase in Berkshires floatgrowth rate (including GEICO, but excludingGeneral Re) after ten years to perpetuity (i.e., from1.0% over GDP to 1.5% over GDP) is $30,881 perBRK share.

12While this is higher than the current risk-free rate, we do not believe that

the current rate is representative of a long-term average expected rate. Inaddition, a compensating factor is present because the average spreadbetween the investing and the risk-free rates that we are using for bothcompanies is well below historical averages, which were developed during

periods of higher inflation and interest rates.

The impact of a 0.5% increase in General Res floatgrowth rate (i.e., from 3.0% to 3.5%) after ten yearto perpetuity is $4,561 per BRK share. A 1%increase in General Res float growth rate (to 4.0%)after ten years in perpetuity is $12,771 per BRKshare.

The formulas used to calculate these two sensitivityassumptions are nonlinear, and, therefore, the values fora 0.5% change, for example, cannot be doubled toascertain the impact of a 1% change. In addition, thecloser the growth rate comes to the risk-free rate, the lesreliable the estimate of value becomes because eachfractional variation in the rate has a huge impact on theresulting value.

As the growth rate approaches the risk-free rate, thetheoretical values approach infinitytrees cant grow

to the sky.13 Because of the basic limitations of eco-nomics, we do not recommend adding more than 0.5%to the Berkshire growth rate and 1% to the General Regrowth rate.

After ten years, the growth rates shown in our exampleare the ones with which we are the most comfortable.The main reason we are assuming that Berkshire cangrow slightly faster than the GDP, apart from theunderlying prospects of the business, is that Berkshirehas other growth alternatives if our assumptions forthose businesses prove wrong. However, the magnitudeof the difference between the value of General Res float

and the value of Berkshires float simply due to a 1%difference in the perpetuity growth rate after ten yearsshould caution investors that Berkshire is not a staticenterprisewhen one of its operating companies reacheits natural limits to growth, it continues at an appro-priate return on equity, but excess capital generated isused to invest in other businesses with better grow

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