To the Stockholders of Berkshire Hathaway Inc.:
After two dismal years, operating results in 1976 improved significantly. Last year we said the degree of progress in insurance underwriting would determine whether our gain in earnings would be "moderate" or "major." As it turned out, earnings exceeded even the high end of our expectations. In large part, this was due to the outstanding efforts of Phil Liesche's managerial group at National Indemnity Company.
In dollar terms, operating earnings came to $16,073,000, or $16.47 per share. While this is a record figure, we consider return on shareholders' equity to be a much more significant yardstick of economic performance. Here our result was 17.3%, moderately above our long-term average and even further above the average of American industry, but well below our record level of 19.8% achieved in 1972.
Our present estimate, subject to all the caveats implicit in forecasting, is that dollar operating earnings are likely to improve somewhat in 1977, but that return on equity capital may decline a bit from the 1976 figure.
### Textile Operations
Our textile division was a significant disappointment during 1976. Earnings, measured either by return on sales or by return on capital employed, were inadequate. In part, this was due to industry conditions which did not measure up to expectations of a year ago. But equally important were our own shortcomings. Marketing efforts and mill capabilities were not properly matched in our new launbe operation. Unfavorable manufacturing cost variances were produced by improper evaluation of machinery and personnel capabilities. Ken Chace, as always, has been candid in reporting problems and has worked diligently to correct them. He is a pleasure to work with-even under difficult operating conditions.
While the first quarter outlook is for red ink, our quite tentative belief is that textile earnings in 1977 will equal, or exceed modestly, those of 1976. Despite disappointing current results, we continue to look for ways to build our textile operation and presently have one moderate-size acquisition under consideration. It should be recognized that the textile business does not offer the expectation of high returns on investment. Nevertheless, we maintain a commitment to this division-a very important source of employment in New Bedford and Manchester-and believe reasonable returns on average are possible.
### Insurance Underwriting
The property and casualty insurance industry had its worst year in history during 1975. We did our share-unfortunately, even somewhat more. Really disastrous results were concentrated in auto and long-tail lines.
This time, inflation has caused human and property damage costs to far exceed the general level of inflation, resulting in our final cost losses exceeding the increase in premium revenue in another cost environment. "Social" inflation has led to the scope of compensation expanding far beyond the original actual rate ceiling, increasing insurance items beyond our compensation range.
Such social inflation has significantly increased the likelihood of complaints and the payment of huge jury bonuses (originally not included in the statistics). In addition, the losses of the insured (due to the insolvency of an increasing number of companies that have not responded sensitively to the above issues) will be borne by guarantee funds and the remaining solvent insurance companies. This pessimistic situation will continue, and any optimism (now proven to be sharply increasing) should be restrained. There has been some success now.
Berkshire's insurance subsidiaries have deviated from the correct product lines, leading to the worst underwriting results in history for 1975. These product lines generate exceptional investment income and are particularly attractive to us under previous underwriting conditions. However, our "portfolio" has been in a disadvantageous position for the past two years and will continue to be positioned in the most challenging areas of the insurance sector during future inflationary periods.
The only noteworthy aspect of the insurance business in 1975 was the continued progress of the local business under the leadership of John Ringwalt. Despite significant underwriting losses, the combined ratio was higher than in 1974. Adjustments for underwriting excess costs are in the early stages, but underwriting performance remains satisfactory. Texas United Insurance Company, which was once a thorny problem a few years ago, has made excellent progress under George Billing's leadership. With almost entirely new institutional strength, Texas United Insurance Company was the champion of the "Chairman's Cup" as it had the lowest loss ratio among these local companies. Cornhusker Casualty Company, the oldest and largest local company, continues to generate significant premium revenue with its excellent operational capabilities, with a combined ratio slightly below 100. Premium income for the local business is expected to increase substantially in 1976, but the key to success lies in achieving a lower combined ratio.
Our traditional business at National Indemnity Company, which usually performs well and accounts for more than half of total insurance premiums, had poor underwriting results in 1975. Despite frequent and significant rate increases, they continued to operate at a loss for the entire year. Several special projects established in the early 1970s have generated significant losses and consumed a large amount of our management time and energy. Current indications suggest that premium turnover will increase in 1976, and we hope underwriting performance will improve.
Reinsurance business in 1975, as we expected, faced the same challenges. The same remedial actions have been taken. Since reinsurance contracts are settled later than direct business contracts, any improvement in direct insurance business will precede the reinsurance business department.
Our Home & Auto Insurance subsidiary now only underwrites automobile insurance in Cook County, Illinois. Its performance in 1975 continued to deteriorate, leading to a management change in October. At that time, John Seward was appointed Chairman and has been working hard and creatively to improve the underwriting approach.
Overall, our insurance premium revenue will increase significantly in 1976. This is due to rate increases rather than policy changes. Under normal circumstances, such revenue would be welcome, but our current mood is mixed. Insurance underwriting performance still needs improvement, and we hope so, but our confidence is lacking. Although we will strive to bring the combined ratio below 100, this is almost impossible in 1976.
### Insurance Investments
Last year we stated that we expected 1976 to be a year of realized capital gains and, indeed, gains of $9,962,000 before tax, primarily from stocks, were realized during the year. It currently appears that 1977 also will be a year of net realized capital gains. We now have a substantial unrealized gain in our stock portfolio as compared to a substantial unrealized loss several years ago. Here again we consider such market fluctuations from year to year relatively unimportant; unrealized appreciation in our equity holdings, which amounted to $45.7 million at yearend, has declined by about $5 million as this is written on March 21st.
However, we consider the yearly business progress of the companies in which we own stocks to be very important. And here, we have been delighted by the 1976 business performance achieved by most of our portfolio companies. If the business results continue excellent over a period of years, we are certain eventually to achieve good financial results from our stock holdings, regardless of wide year-to-year fluctuations in market values.
### Banking Operations
The Illinois National Bank & Trust Co. of Rockford again had a record year in 1976. Average deposits were approximately $130 million, of which approximately 60% were time deposits. Interest rates were increased substantially in the important consumer savings area when regulatory maximums were raised at mid-year. Despite this mix heavily weighted toward interest-bearing deposits, our operating earnings after taxes (including a new Illinois state income tax) were again over 2.1% of average deposits. We continue to be the largest bank in Rockford. We continue to maintain unusual liquidity. We continue to meet the increasing loan demands of our customers. And we continue to maintain our unusual profitability. This is a direct tribute to the abilities of Gene Abegg, Chairman, who has been running the Bank since it opened its doors in 1931, and Bob Kline, our President.
### Blue Chip Stamps
During 1976 we increased our interest in Blue Chip Stamps, and by yearend we held about 33% of that company's outstanding shares. Our interest in Blue Chip Stamps is of growing importance to us. Summary financial reports of Blue Chip Stamps are contained in the footnotes to our attached financial statements. Moreover, shareholders of Berkshire Hathaway Inc. are urged to obtain the current and subsequent annual reports of Blue Chip Stamps by requesting them from Mr. Robert H. Bird, Secretary, Blue Chip Stamps, 5801 South Eastern Avenue, Los Angeles, California 90040.
### Miscellaneous
K & W Products has performed well in its first year as a subsidiary of Berkshire Hathaway Inc. Both sales and earnings were up moderately over 1975.
We have less than four years remaining to comply with requirement that our bank be divested by December 31, 1980. We intend to accomplish such a divestiture in a manner that minimizes disruption to the bank and produces good results for our shareholders. Most probably this will involve a spin-off of bank shares in 1980.
We also hope at some point to merge with Diversified Retailing Company, Inc. Both corporate simplification and enhanced ownership position in Blue Chip Stamps would be benefits of such a merger. However, it is unlikely that anything will be proposed in this regard during 1977.
Warren E. Buffett, Chairman
March 21, 1977
