TO THE shareholders of Berkshire Hathaway Inc: Our decrease in net worth during 2008 was US$11.5bil, which reduced the per-share book value of both our Class A and Class B stock by 9.6%. Over the last 44 years (that is, since present management took over), book value has grown from US$19 to US$70,530, a rate of 20.3% compounded annually. The table recording both the 44-year performance of Berkshire’s book value and the S&P 500 index, shows that 2008 was the worst year for each. The watchword throughout the country became the creed I saw on restaurant walls when I was young: “In God we trust; all others pay cash.” By the fourth quarter, the credit crisis, coupled with tumbling home and stock prices, had produced a paralysing fear that engulfed the country. A freefall in business activity ensued, accelerating at a pace that I have never before witnessed. This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation. Moreover, major industries have become dependent on federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat. Amid this bad news, however, never forget that our country has faced far worse travails in the past. In the 20th Century alone, we dealt with two great wars (one of which we initially appeared to be losing); a dozen or so panics and recessions; virulent inflation that led to a 21½% prime rate in 1980; and the Great Depression of the 1930s, when unemployment ranged between 15% and 25% for many years. America has had no shortage of challenges. Without fail, however, we’ve overcome them. In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead. In 75% of the last 44 years, the S&P stocks recorded a gain. I would guess that a roughly similar percentage of years will be positive in the next 44. As predicted in last year’s report, the exceptional underwriting profits that our insurance businesses realised in 2007 were not repeated in 2008. Nevertheless, the insurance group delivered an underwriting gain for the sixth consecutive year. This means that our US$58.5bil of insurance “float” – money that doesn’t belong to us but that we hold and invest for our own benefit – cost us less than zero. In fact, we were paid US$2.8bil to hold our float during 2008. Charlie and I find this enjoyable. Our insurance operation, the core business of Berkshire, is an economic powerhouse. The market value of the bonds and stocks that we continue to hold suffered a significant decline along with the general market. This does not bother Charlie and me. Indeed, we enjoy such price declines if we have funds available to increase our positions. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down. In 2008, our investments fell from US$90,343 per share of Berkshire (after minority interest) to US$77,793, a decrease that was caused by a decline in market prices, not by net sales of stocks or bonds. Our second segment of value fell from pre-tax earnings of US$4,093 per Berkshire share to US$3,921 (again after minority interest). Both of these performances are unsatisfactory. Over time, we need to make decent gains in each area if we are to increase Berkshire’s intrinsic value at an acceptable rate. Going forward, however, our focus will be on the earnings segment, just as it has been for several decades. We like buying underpriced securities, but we like buying fairly-priced operating businesses even more. Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. Private equity Some years back our competitors were known as “leveraged-buyout operators (LBO).” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage. Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below US70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private. Derivatives Our put contracts total US$37.1bil (at current exchange rates) and are spread among four major indices: the S&P 500 in the US, the FTSE 100 in Britain, the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on Sept 9, 2019 and our last on Jan 24, 2028. We have received premiums of US$4.9bil, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black-Scholes valuation methods to record a year-end liability of US$10bil, an amount that will change on every reporting date. The two financial items – this estimated loss of US$10bil minus the US$4.9bil in premiums we have received – means that we have so far reported a mark-to-market loss of US$5.1bil from these contracts. We endorse mark-to-market accounting. I will explain later, however, why I believe the Black-Scholes formula, even though it is the standard for establishing the dollar liability for options, produces strange results when the long-term variety are being valued. One point about our contracts that is sometimes not understood: For us to lose the full $37.1bil we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends. If the formula is applied to extended time periods, however, it can produce absurd results. I Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted their own valuations for esoteric financial instruments have seldom erred on the side of conservatism. That club of optimists is one that Charlie and I have no desire to join.
