The following is the English version of the 2003 Letter to Berkshire Shareholders:
To the Shareholders
To the shareholders of Berkshire Hathaway Inc.:
Our net worth increased by $13.6 billion in 2003, raising the per - share book value of both our Class A and Class B stock by 21%. Since present management took over 39 years ago, per - share book value has grown from $19 to $50,498, a rate of 22.2% compounded annually.
It's per - share intrinsic value that counts, however. Here, the news is good: Between 1964 and 2003, Berkshire morphed from a struggling northern textile business whose intrinsic value was less than book into a widely diversified enterprise worth far more than book. Our 39 - year gain in intrinsic value has therefore somewhat exceeded our 22.2% gain in book. (For a better understanding of intrinsic value and the economic principles that guide Charlie Munger, my partner and Berkshire's vice - chairman, and me in running Berkshire, please read our Owner's Manual, beginning on page 69.)
Operating Earnings
Despite their shortcomings, book value calculations are useful at Berkshire as a slightly understated gauge for measuring the long - term rate of increase in our intrinsic value. The calculation is less relevant, however, than it once was in rating any single year's performance versus the S & P 500 index (a comparison we display on the facing page). Our equity holdings, including convertible preferreds, have fallen considerably as a percentage of our net worth, from an average of 114% in the 1980s, for example, to an average of 50% in 2000 - 03. Therefore, yearly movements in the stock market now affect a much smaller portion of our net worth than was once the case.
Nonetheless, Berkshire's long - term performance versus the S & P remains all - important. Our shareholders can buy the S & P through an index fund at very low cost. Unless we achieve gains in per - share intrinsic value in the future that outdo the S & P's performance, Charlie and I will be adding nothing to what you can accomplish on your own.
If we fail, we will have no excuses. Charlie and I operate in an ideal environment. To begin with, we are supported by an incredible group of men and women who run our operating units. If there were a Corporate Cooperstown, its roster would surely include many of our CEOs. Any shortfall in Berkshire's results will not be caused by our managers.
Additionally, we enjoy a rare sort of managerial freedom. Most companies are saddled with institutional constraints. A company's history, for example, may commit it to an industry that now offers limited opportunity. A more common problem is a shareholder constituency that pressures its manager to dance to Wall Street's tune. Many CEOs resist, but others give in and adopt operating and capital - allocation policies far different from those they would choose if left to themselves.
At Berkshire, neither history nor the demands of owners impede intelligent decision - making. When Charlie and I make mistakes, they are -- in tennis parlance -- unforced errors.
Taxes
On May 20, 2003, The Washington Post ran an op - ed piece by me that was critical of the Bush tax proposals. Thirteen days later, Pamela Olson, Assistant Secretary for Tax Policy at the U.S. Treasury, delivered a speech about the new tax legislation saying, "That means a certain midwestern oracle, who, it must be noted, has played the tax code like a fiddle, is still safe retaining all his earnings." I think she was talking about me.
Alas, my "fiddle playing" will not get me to Carnegie Hall -- or even to a high school recital. Berkshire, on your behalf and mine, will send the Treasury $3.3 billion for tax on its 2003 income, a sum equaling 2.5% of the total income tax paid by all U.S. corporations in fiscal 2003. (In contrast, Berkshire's market valuation is about 1% of the value of all American corporations.) Our payment will almost certainly place us among our country's top ten taxpayers. Indeed, if only 540 taxpayers paid the amount Berkshire will pay, no other individual or corporation would have to pay anything to Uncle Sam. That's right: 290 million Americans and all other businesses would not have to pay a dime in income, social security, excise or estate taxes to the federal government.
Berkshire Governance
In judging whether Corporate America is serious about reforming itself, CEO pay remains the acid test. To date, the results aren't encouraging. A few CEOs, such as Jeff Immelt of General Electric, have led the way in initiating programs that are fair to managers and shareholders alike. Generally, however, his example has been more admired than followed.
It's understandable how pay got out of hand. When management hires employees, or when companies bargain with a vendor, the intensity of interest is equal on both sides of the table. One party's gain is the other party's loss, and the money involved has real meaning to both. The result is an honest - to - God negotiation.
But when CEOs (or their representatives) have met with compensation committees, too often one side -- the CEO's -- has cared far more than the other about what bargain is struck. A CEO, for example, will always regard the difference between receiving options for 100,000 shares or for 500,000 as monumental. To a comp committee, however, the difference may seem unimportant -- particularly if, as has been the case at most companies, neither grant will have any effect on reported earnings. Under these conditions, the negotiation often has a "play - money" quality.
Overreaching by CEOs greatly accelerated in the 1990s as compensation packages gained by the most avaricious -- a title for which there was vigorous competition -- were promptly replicated elsewhere. The couriers for this epidemic of greed were usually consultants and human relations departments, which had no trouble perceiving who buttered their bread. As one compensation consultant commented: "There are two classes of clients you don't want to offend -- actual and potential."
In proposals for reforming this malfunctioning system, the cry has been for "independent" directors. But the question of what truly motivates independence has largely been neglected.
In last year's report, I took a look at how "independent" directors -- as defined by statute -- had performed in the mutual fund field. The Investment Company Act of 1940 mandated such directors, and that means we've had an extended test of what statutory standards produce. In our examination last year, we looked at the record of fund directors in respect to the two key tasks board members should perform -- whether at a mutual fund business or any other. These two all - important functions are, first, to obtain (or retain) an able and honest manager and then to compensate that manager fairly.
Our survey was not encouraging. Year after year, at literally thousands of funds, directors had routinely rehired the incumbent management company, however pathetic its performance had been. Just as routinely, the directors had mindlessly approved fees that in many cases far exceeded those that could have been negotiated. Then, when a management company was sold -- invariably at a huge price relative to tangible assets -- the directors experienced a "counter - revelation" and immediately signed on with the new manager and accepted its fee schedule. In effect, the directors decided that whoever would pay the most for the old management company was the party that should manage the shareholders' money in the future.
Despite the lapdog behavior of independent fund directors, we did not conclude that they are bad people. They're not. But sadly, "boardroom atmosphere" almost invariably sedates their fiduciary genes.
On May 22, 2003, not long after Berkshire's report appeared, the Chairman of the Investment Company Institute addressed its membership about "The State of our Industry." Responding to those who have "weighed in about our perceived failings," he mused, "It makes me wonder what life would be like if we'd actually done something wrong."
Be careful what you wish for.
Within a few months, the world began to learn that many fund - management companies had followed policies that hurt the owners of the funds they managed, while simultaneously boosting the fees of the managers. Prior to their transgressions, it should be noted, these management companies were earning profit margins and returns on tangible equity that were the envy of Corporate America. Yet to swell profits further, they trampled on the interests of fund shareholders in an appalling manner.
So what are the directors of these looted funds doing? As I write this, I have seen none that have terminated the contract of the offending management company (though naturally that entity has often fired some of its employees). Can you imagine directors who had been personally defrauded taking such a boys - will - be - boys attitude?
To top it all off, at least one miscreant management company has put itself up for sale, undoubtedly hoping to receive a huge sum for "delivering" the mutual funds it has managed to the highest bidder among other managers. This is a travesty. Why in the world don't the directors of those funds simply select whomever they think is best among the bidding organizations and sign up with that party directly? The winner would consequently be spared a huge "payoff" to the former manager who, having flouted the principles of stewardship, deserves not a dime. Not having to bear that acquisition cost, the winner could surely manage the funds in question for a far lower ongoing fee than would otherwise have been the case. Any truly independent director should insist on this approach to obtaining a new manager.
The reality is that neither the decades - old rules regulating investment company directors nor the new rules bearing down on Corporate America foster the election of truly independent directors. In both instances, an individual who is receiving 100% of his income from director fees -- and who may wish to enhance his income through election to other boards -- is deemed independent. That is nonsense. The same rules say that Berkshire director and lawyer Ron Olson, who receives from us perhaps 3% of his very large income, does not qualify as independent because that 3% comes from legal fees Berkshire pays his firm rather than from fees he earns as a Berkshire director. Rest assured, 3% from any source would not torpedo Ron's independence. But getting 20%, 30% or 50% of their income from director fees might well temper the independence of many individuals, particularly if their overall income is not large. Indeed, I think it's clear that at mutual funds, it has.
Let me make a small suggestion to "independent" mutual fund directors. Why not simply affirm in each annual report that "(1) We have looked at other management companies and believe the one we have retained for the upcoming year is among the better operations in the field; and (2) we have negotiated a fee with our managers comparable to what other clients with equivalent funds would negotiate."
It does not seem unreasonable for shareholders to expect fund directors -- who are often receiving fees that exceed $100,000 annually -- to declare themselves on these points. Certainly these directors would satisfy themselves on both matters were they handing over a large chunk of their own money to the manager. If directors are unwilling to make these two declarations, shareholders should heed the maxim "If you don't know whose side someone is on, he's probably not on yours."
Finally, a disclaimer. A great many funds have been run well and conscientiously despite the opportunities for malfeasance that exist. The shareholders of these funds have benefited, and their managers have earned their pay. Indeed, if I were a director of certain funds, including some that charge above - average fees, I would enthusiastically make the two declarations I have suggested. Additionally, those index funds that are very low - cost (such as Vanguard's) are investor - friendly by definition and are the best selection for most of those who wish to own equities.
I am on my soapbox now only because the blatant wrongdoing that has occurred has betrayed the trust of so many millions of shareholders. Hundreds of industry insiders had to know what was going on, yet none publicly said a word. It took Eliot Spitzer, and the whistleblowers who aided him, to initiate a housecleaning. We urge fund directors to continue the job. Like directors throughout Corporate America, these fiduciaries must now decide whether their job is to work for owners or for managers.
Financial and Financial Products
This sector includes a wide - ranging group of activities. Here's some commentary on the most important.
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I manage a few opportunistic strategies in AAA fixed - income securities that have been quite profitable in the last few years. These opportunities come and go -- and at present, they are going. We sped their departure somewhat last year, thereby realizing 24% of the capital gains we show in the table that follows.
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A far less pleasant unwinding operation is taking place at Gen Re Securities, the trading and derivatives operation we inherited when we purchased General Reinsurance.
When we began to liquidate Gen Re Securities in early 2002, it had 23,218 outstanding tickets with 884 counterparties (some having names I couldn't pronounce, much less creditworthiness I could evaluate). Since then, the unit's managers have been skillful and diligent in unwinding positions. Yet, at yearend -- nearly two years later -- we still had 7,580 tickets outstanding with 453 counterparties. (As the country song laments, "How can I miss you if you won't go away?")
The shrinking of this business has been costly. We've had pre - tax losses of $173 million in 2002 and $99 million in 2003. These losses, it should be noted, came from a portfolio of contracts that -- in full compliance with GAAP -- had been regularly marked - to - market with standard allowances for future credit - loss and administrative costs. Moreover, our liquidation has taken place both in a benign market -- we've had no credit losses of significance -- and in an orderly manner. This is just the opposite of what might be expected if a financial crisis forced a number of derivatives dealers to cease operations simultaneously.
And now it's confession time: I'm sure I could have saved you $100 million or so, pre - tax, if I had acted more promptly to shut down Gen Re Securities. Both Charlie and I knew at the time of the General Reinsurance merger that its derivatives business was unattractive. Reported profits struck us as illusory, and we felt that the business carried sizable risks that could not effectively be measured or limited. Moreover, we knew that any major problems the operation might experience would likely correlate with troubles in the financial or insurance world that would affect Berkshire elsewhere. In other words, if the derivatives business were ever to need shoring up, it would commandeer the capital and credit of Berkshire at just the time we could otherwise deploy those resources to huge advantage.
Charlie would have moved swiftly to close down Gen Re Securities -- no question about that. I, however, dithered. As a consequence, our shareholders are paying a far higher price than was necessary to exit this business.
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Though we include Gen Re's sizable life and health reinsurance business in the "insurance" sector, we show the results for Ajit Jain's life and annuity business in this section. That's because this business, in large part, involves arbitraging money. Our annuities range from a retail product sold directly on the Internet to structured settlements that require us to make payments for 70 years or more to people severely injured in accidents.
We've realized some extra income in this business because of accelerated principal payments we received from certain fixed - income securities we had purchased at discounts. This phenomenon has ended, and earnings are therefore likely to be lower in this segment during the next few years.
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We have a $604 million investment in Value Capital, a partnership run by Mark Byrne, a member of a family that has helped Berkshire over the years in many ways. Berkshire is a limited partner in, and has no say in the management of, Mark's enterprise, which specializes in highly - hedged fixed - income opportunities. Mark is smart and honest and, along with his family, has a significant investment in Value.
Because of accounting abuses at Enron and elsewhere, rules will soon be instituted that are likely to require that Value's assets and liabilities be consolidated on Berkshire's balance sheet. We regard this requirement as inappropriate, given that Value's liabilities -- which usually are above $20 billion -- are in no way ours. Over time, other investors will join us as partners in Value. When enough do, the need for us to consolidate Value will disappear.
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We have told you in the past about Berkadia, the partnership we formed three years ago with Leucadia to finance and manage the wind - down of Finova, a bankrupt lending operation. The plan was that we would supply most of the capital and Leucadia would supply most of the brains. And that's the way it has worked. Indeed, Joe Steinberg and Ian Cumming, who together run Leucadia, have done such a fine job in liquidating Finova's portfolio that the $5.6 billion guarantee we took on in connection with the transaction has been extinguished. The unfortunate byproduct of this fast payoff is that our future income will be much reduced. Overall, Berkadia has made excellent money for us, and Joe and Ian have been terrific partners.
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Our leasing businesses are XTRA (transportation equipment) and CORT (office furniture). Both operations have had poor earnings during the past two years as the recession caused demand to drop considerably more than was anticipated. They remain leaders in their fields, and I expect at least a modest improvement in their earnings this year.
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Through our Clayton purchase, we acquired a significant manufactured - housing finance operation. Clayton, like others in this business, had traditionally securitized the loans it originated. The practice relieved stress on Clayton's balance sheet, but a by - product was the "front - ending" of income (a result dictated by GAAP).
We are in no hurry to record income, have enormous balance - sheet strength, and believe that over the long - term the economics of holding our consumer paper are superior to what we can now realize through securitization. So Clayton has begun to retain its loans.
We believe it's appropriate to finance a soundly - selected book of interest - bearing receivables almost entirely with debt (just as a bank would). Therefore, Berkshire will borrow money to finance Clayton's portfolio and re - lend these funds to Clayton at our cost plus one percentage point. This markup fairly compensates Berkshire for putting its exceptional creditworthiness to work, but it still delivers money to Clayton at an attractive price.
In 2003, Berkshire did $2 billion of such borrowing and re - lending, with Clayton using much of this money to fund several large purchases of portfolios from lenders exiting the business. A portion of our loans to Clayton also provided "catch - up" funding for paper it had generated earlier in the year from its own operation and had found difficult to securitize.
You may wonder why we borrow money while sitting on a mountain of cash. It's because of our "every tub on its own bottom" philosophy. We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent. Otherwise, having a rich daddy can lead to sloppy decisions. Meanwhile, the cash we accumulate at Berkshire is destined for business acquisitions or for the purchase of securities that offer opportunities for significant profit. Clayton's loan portfolio will likely grow to at least $5 billion in not too many years and, with sensible credit standards in place, should deliver significant earnings.
For simplicity's sake, we include all of Clayton's earnings in this sector, though a sizable portion is derived from areas other than consumer finance.
For simplicity's sake, we include all of Clayton's earnings in this sector, though a sizable portion is derived from areas other than consumer finance.
Manufacturing, Service and Retailing Operations
Our activities in this category cover the waterfront. But let's look at a simplified balance sheet and earnings statement consolidating the entire group.
Balance Sheet 12/31/03
Assets
Cash and equivalents $ 1,250
Accounts and notes receivable 2,796
Inventory 3,656
Other current assets 262
Total current assets 7,964
Goodwill and other intangibles 8,351
Fixed assets 5,898
Other assets 1,054
Total $ 23,267
Liabilities and Equity
Notes payable $ 1,593
Other current liabilities 4,300
Total current liabilities 5,893
Deferred taxes 105
Term debt and other liabilities 1,890
Equity 15,379
Total $ 23,267
Earnings Statement
Item 2003 2002
Revenues 32,106 16,970
Operating expenses (including depreciation of $605 in 2003 and $477 in 2002) 29,885 14,921
Interest expense (net) 64 108
Pre - tax income 2,157 1,941
Income taxes 813 743
Net income 1,344 1,198
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. However, we purchased these businesses at substantial premiums to net worth -- that fact is reflected in the goodwill item shown on the balance sheet -- and that reduces the earnings on our average carrying value to 9.2%.
Here are the pre - tax earnings for the larger categories or units.
Item 2003 2002
Building Products 559 516
Shaw Industries 436 424
Apparel 289 229
Retail Operations 224 219
Flight Services 72 225
McLane* 150 --
Other businesses 427 328
Total 2,157 1,941
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From date of acquisition, May 23, 2003.
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Within the apparel group, Fruit of the Loom is our largest operation. Fruit has three major assets: a 148 - year - old universally - recognized brand, a low - cost manufacturing operation, and John Holland, its CEO. In 2003, Fruit accounted for 42.3% of the men's and boys' underwear that was sold by mass marketers (Wal - Mart, Target, K - Mart, etc.) and increased its share of the women's and girls' business in that channel to 13.9%, up from 11.3% in 2002.
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In retailing, our furniture group earned $106 million pre - tax, our jewelers $59 million and See's, which is both a manufacturer and retailer, $59 million.
Both R.C. Willey and Nebraska Furniture Mart ("NFM") opened hugely successful stores last year, Willey in Las Vegas and NFM in Kansas City, Kansas. Indeed, we believe the Kansas City store is the country's largest - volume home - furnishings store. (Our Omaha operation, while located on a single plot of land, consists of three units.)
NFM was founded by Rose Blumkin ("Mrs. B") in 1937 with $500. She worked until she was 103 (hmmm... not a bad idea). One piece of wisdom she imparted to the generations following her was, "If you have the lowest price, customers will find you at the bottom of a river." Our store serving greater Kansas City, which is located in one of the area's more sparsely populated parts, has proved Mrs. B's point. Though we have more than 25 acres of parking, the lot has at times overflowed.
"Victory," President Kennedy told us after the Bay of Pigs disaster, "has a thousand fathers, but defeat is an orphan." At NFM, we knew we had a winner a month after the boffo opening in Kansas City, when our new store attracted an unexpected paternity claim. A speaker there, referring to the Blumkin family, asserted, "They had enough confidence and the policies of the Administration were working such that they were able to provide work for 1,000 of our fellow citizens." The proud papa at the podium? President George W. Bush.
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In flight services, FlightSafety, our training operation, experienced a drop in "normal" operating earnings from $183 million to $150 million. (The abnormals: In 2002 we had a $60 million pre - tax gain from the sale of a partnership interest to Boeing, and in 2003 we recognized a $37 million loss stemming from the premature obsolescence of simulators.) The corporate aviation business has slowed significantly in the past few years, and this fact has hurt FlightSafety's results. The company continues, however, to be far and away the leader in its field. Its simulators have an original cost of $1.2 billion, which is more than triple the cost of those operated by our closest competitor.
NetJets, our fractional - ownership operation, lost $41 million pre - tax in 2003. The company had a modest operating profit in the U.S., but this was more than offset by a $32 million loss on aircraft inventory and by continued losses in Europe.
NetJets continues to dominate the fractional - ownership field, and its lead is increasing: Prospects overwhelmingly turn to us rather than to our three major competitors. Last year, among the four of us, we accounted for 70% of net sales (measured by value).
An example of what sets NetJets apart from competitors is our Mayo Clinic Executive Travel Response program, a free benefit enjoyed by all of our owners. On land or in the air, anywhere in the world and at any hour of any day, our owners and their families have an immediate link to Mayo. Should an emergency occur while they are traveling here or abroad, Mayo will instantly direct them to an appropriate doctor or hospital. Any baseline data about the patient that Mayo possesses is simultaneously made available to the treating physician. Many owners have already found this service invaluable, including one who needed emergency brain surgery in Eastern Europe.
The $32 million inventory write - down we took in 2003 occurred because of falling prices for used aircraft early in the year. Specifically, we bought back fractions from withdrawing owners at prevailing prices, and these fell in value before we were able to remarket them. Prices are now stable.
The European loss is painful. But any company that forsakes Europe, as all of our competitors have done, is destined for second - tier status. Many of our U.S. owners fly extensively in Europe and want the safety and security assured by a NetJets plane and pilots. Despite a slow start, furthermore, we are now adding European customers at a good pace. During the years 2001 through 2003, we had gains of 88%, 61% and 77% in European management - and - flying revenues. We have not, however, yet succeeded in stemming the flow of red ink.
Rich Santulli, NetJets' extraordinary CEO, and I expect our European loss to diminish in 2004 and also anticipate that it will be more than offset by U.S. profits. Overwhelmingly, our owners love the NetJets experience. Once a customer has tried us, going back to commercial aviation is like going back to holding hands. NetJets will become a very big business over time and will be one in which we are preeminent in both customer satisfaction and profits. Rich will see to that.
