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Berkshire Hathaway
Goodbye, Scott Fetzer

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By EliasFardo
March 15, 2004

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Goodbye, Scott Fetzer

The reporting format does not change without a reason. When the Page 3 information, used for computing intrinsic value, was discontinued, it was for a purpose. The change in layout of the financial information in the body of the shareholders' letter would seem to represent another change; only the least of which is the loss of specific information for Scott Fetzer.

The manufacturing and retaining group was reported only in aggregate in the body of the letter. So, what groups did get broken out? Insurance, MidAmerica and Financial Products. If we look at manufacturing and retailing as one group ( M&R ) and everything else as another group ( EE ), what are the two major differences in these groups? In 2003, M&R earned, after tax, 5.8% on ending assets, while EE earned only 2.2%: that is one. The other, is that the EE group had substantial amounts of leverage, both on the balance sheet � float in the insurance group and debt in the financial products group - and off the balance sheet, in MidAmerica and Value Capital; while M&R held only small amounts of debt.

Speaking of the manufacturing and retailing group, which contained Scott Fetzer, for 2003, Buffett writes: This eclectic group, which sells products ranging from Dilly Bars to B-737s, earned a hefty 20.7% on average tangible net worth last year. In 1991, the first year for which the grey pages were provided, the manufacturing and retailing operations of Berkshire earned approximated 67% on average tangible net worth. This is quite a comedown for this group: from 67% to 21%. But this is what happens when extraordinary companies such as See's, the Buffalo News and Scott Fetzer represent a smaller and smaller portion of the whole. It was also inevitable.

I don't expect this trend to reverse itself. The return on assets may not fall much below 21%, but only the maddest optimism could forecast a return to the levels experienced 13 and more years ago. While 21% is still very respectable, the decrease in returns indicates that the more recent, larger acquisitions are diluting the overall returns of M&R. And EE, the area that has seen, investment wise, the largest attention over the last five years, has even lower returns on assets than M&R.

The lower returns of EE is only as it should be. It is not reasonable to expect the bonds held by the insurance companies, or the electrical generating plants owned by MidAmerica, to produce the same return on invested assets as, say, a pilot training machine. But, it leads me to one conclusion: that the assets we are currently purchasing - and will be purchasing in the future - in both EE and M&R, will enjoy lower returns than the average assets owned by Berkshire just a few short years ago. To mitigate this, Berkshire has been, and will continue, to employ larger amounts of leverage. If your assets don't earn as much, you must buy more of them.

To my eyes anyway, it is not hard to see this already. GeneralRe is not a GEICO or a Berkshire Hathaway Reinsurance Group. MidAmerica is not a Scott Fetzer. McLane, which uses another type of leverage, volume, and Clayton, which uses significant financial leverage, are neither a Nebraska Furniture Mart nor a See's.

It is not just that acquisitions that fit Buffett's criteria are hard to find, it is that the ones he does find are held further down in the barrel. Compared to the "wonderful" companies bought yesterday, the companies Berkshire are buying today are "great," or maybe just "very good." There is nothing-in-itself wrong with that. But, those are the facts.

So, this is not your father's Berkshire Hathaway. This is a company that will be experiencing lower returns on assets and sales. If it is to continue to grow earnings at anything at all like 15%, it will only be allowed to do so with larger and larger amounts of leverage.

Even for someone with Buffett's skills, the task is daunting. In 2003, operating earnings after tax were $5,422 million. If such earnings grew by just 10% a year for the next ten years, another $95 billion will be accrued over that period. ( Earnings over the last five years have grown at a 28.2% rate. If earnings grew at that rate over the next ten years, Berkshire would have accumulated another $270 billion, $65 billion alone in 2003. ) . And this $95 billion is just from operating earnings. This does not include funds from the growth in float, or from realized capital gains in the equity portfolio. So, don't even ask for another $95 billion of "wonderful" companies; getting "great" ones will be challenging enough. How deep into the barrel are you willing to dig? "Very good?" "Good?"

All I know is that the perfect company gets very high returns on assets, very high margins on sales, and uses very little debt. And the number of those companies available to Berkshire at � most importantly - prices Buffett is willing to pay, is very small. Is Buffett going to buy all of Moody's?

In my opinion, Berkshire is quickly reaching a flection point. A juicy bear market will allow most of its current idle assets to be placed. But, in such a market, would not Berkshire's own stock also be attractive? At some point, the question becomes: do we buy more "very good" companies, or just increase our shareholders' holdings in the "wonderful" companies we already own? Or some combination of the two?

It appears to me, that the very profits success that Berkshire is currently enjoying will only hasten the day when Buffett will be faced with that question. I am in no way badmouthing the Berkshire of today, or even of tomorrow. I just find it hard to imagine how even Buffett can find attractive places to invest the huge cash flow of Berkshire.


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