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Friday, March 12, 1999

An Investment Opinion
by Dale Wettlaufer

Readers' Guide to Berkshire

As tomorrow's 8 a.m. release of Berkshire Hathaway's (NYSE: BRK.A) annual report nears, I am reviewing a few things to look for as you read it. Today's article and yesterday's introduction are not really intended to provide commentary for current shareholders. The subjects that I have and will discuss are somewhat basic and not new for current shareholders.

Yesterday I left off with the concept of "float." Float is capital the company brings in through the insurance underwriting process and gets to use for a while before paying it out for losses. Float is of central important for Berkshire Hathaway. As a source of capital, it can be better than equity and better than debt over the long term if the after-tax underwriting losses as a percentage of float are smaller than the after-tax cost of equity and debt. If you can manage to underwrite at a 100% combined ratio or less, then your after-tax cost of capital is nil or even negative. If you have quality investing opportunities available to you and a low to zero to negative cost of capital, that's pretty much corporate nirvana. For instance, you would write as much insurance possible if you knew you could write it at a 100% combined ratio or less and you could use that to acquire businesses at 1974 prices and government bonds at 1981 prices.

The problem is that those prices for financial assets don't exist right now. The prices of many large privately owned companies that meet Berkshire's acquisition criteria also are affected by lower interest rates and higher equity prices for publicly traded companies. I would pay attention to the discussion of where the company is going to allocate capital in the future. That doesn't mean you're going to hear ideas on publicly traded companies in the annual report. But you will probably get some idea of:

1. Executive Jet International

The economics of Executive Jet International, the company's fractional jet ownership company. I've heard it explained before by a very good investor who has done some investigating on it, and as I understand it, the massive liquidity the company favors Berkshire in taking advantage of growth opportunities for EJI and keeps out lesser competitors. In effect, Berkshire has the financial ability to bridge the ordering of aircraft with the sale of aircraft to fractional owners. The razor/razor blade explanation of its continuing economics also makes sense, but I am looking forward to hearing from the annual report or the shareholders' meeting exactly how Berkshire can grow this high-potential business and how it benefits from being in that business over the longer term.

2. Allocation of Capital

Remember, my remarks have to do with the allocation of capital. Raising capital is no problem for the company due to its excellent insurance ratings, debt ratings, and cash generating abilities. Just check out the company's new Berkshire Hathaway Life Insurance of Nebraska BHLN Direct website. The insurance units are able to raise very low-cost capital -- what I am most interested in is investment of that capital. GEICO is a good outlet for capital, but the company is generating capital from operations faster than it can use it, even as it pours on the marketing spending. GEICO has shown up recently among the top three television advertisers in the country and is taking market share. People pay a lot of attention to recent revelations of GEICO's acquisition of shares of Great Lakes Chemical (NYSE: GLK) and TCA Cable TV (Nasdaq: TCAT), but these are relatively small investments compared with GEICO's marketing spending.

3. The Internet

I think Warren Buffett is fascinated with the Internet and that it has invigorated his thinking on marketing. How could an aware businessperson so tuned in to the nuances of marketing and distribution not be excited by the Internet? It so obviously benefits the company's insurance units and its large equity investments in companies such as Washington Post Co. (NYSE: WPO) that I think people at Berkshire cannot avoid thinking of ways to exploit that.

4. Global Opportunities

Remember when everyone wanted to own a piece of the world in 1993 and no one wanted to own it in 1999? There are very few companies that have the array of global opportunities working to its benefit to the extent Berkshire does. Owning large stakes in multinational powerhouses such as Coca-Cola and Gillette and being the largest publicly traded global reinsurer (measured by equity capital), Berkshire's fortunes are increasingly tied to increasing standards of living across the globe. Some look at the global exposure as a handicap, but unless someone really screws up, hooking your economic wagon to the ingenuity and drive of humans across the world to improve their lots in life isn't the worst way to grow. Insurance and reinsurance are basic needs to societies that are building wealth. I would hope to see some discussion of this.

5. Further Investing Lessons

Even if you don't own Berkshire or ever plan to invest in it, pay attention to what Warren Buffett has to say about running a business. Too many people scour the letters to shareholders looking for "investing" advice and overlook the excellent discussions on running a business. The two go hand-in-hand, after all. If you're an owner of a business, whether your own enterprise or an investor in someone else's business, there are few better thinkers on the subject of business. As Buffett once said, he's a better businessman because he's an investor and a better investor because he's a businessman. Truer words were never spoken by a CEO.

The market is there as a huge laboratory for investors. If you pay attention to others' screwups and successes and learn from those, you're ahead of the game. You're like a bank's loan officer who sees tons of businesses and learns why they succeed and why they fail. Trying to divine what Warren Buffett will do next is of little value. Paying attention to why he did something is of higher value.

6. Buffett Means What He Says

Don't pay attention to the press reports that try to read into every little thing said in the report. In a recent ABC interview, Buffett said there is increased danger in securities prices today. The next day I heard TV announcers saying Buffett thinks the market will crash. Buffett's not trying to fool you or scare you. Just listen to what he has to say -- it's pretty candid without revealing everything he thinks. Looking for the hidden message in everything isn't useful.

7. Listen to the Subtext

This will sort of contradict what I just said above, but Buffett says more than the literal words on the page indicate, in my opinion. If you're familiar with the way EVA (economic value added) people talk about the way they value businesses and assess performance, you can see a lot of the same principles in Warren Buffett's writings, but they're not expressed in the vocabulary of EVA. I believe the letters try to make everything understandable for a wide audience of investors, but the more you read on business and finance theory, the more you see things crystallized in the letters to shareholders and in the transcripts of the annual meetings. Sorry to use a cliche, but still waters run deep with the Berkshire Chairman.

In conclusion, if you're reading the letter to shareholders for the first time tomorrow, have fun. And also be sure to read some of the back letters to get a perspective on things.

While I have failed to mention it directly today, my discussions above encompass in many ways General Re, the company's largest single business unit. The global growth opportunities and capital raising abilities brought to Berkshire are hugely important, as are the synergies that will arise from the combination of Berkshire and GenRe.

Finally, while I've talked about some of the big issues, don't overlook discussions of things like Nebraska Furniture Mart or any of the smaller businesses in the Berkshire fold that Warren Buffett chooses to discuss. The essence of a business's economics might be summed up very succinctly in the discussion, and that's a valuable thing. So don't pass over that lightly. In sum, go into reading the letter with an open mind. Warren Buffett is very flexible (not flabby) intellectually. Approaching the letter with an inflexible intellect won't allow you to extract all you can about Berkshire and business and investing in general.

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