In 1997, Warren Buffett (Trades, Portfolio) in Berkshire Hathaway's (BRK.A, Financial),(BRK.B, Financial) annual report disclosed to shareholders that he invested in silver. Buffett is known for his belief that gold and silver are unproductive investments because they never produce anything. It was an unconvential investment made by legendary investor Warren Buffett (Trades, Portfolio). Reading the 1997 letter to shareholders is a must for value investors wondering if it is ever productive to invest in commodities.
Berkshire Hathaway's annual letter
To the Shareholders of Berkshire Hathaway Inc.:
Our gain in net worth during 1997 was $8.0 billion, which increased the per-share book value of both our Class A and Class B stock by 34.1%. Over the last 33 years (that is, since present management took over) per-share book value has grown from $19 to $25,488, a rate of 24.1% compounded annually.
Given our gain of 34.1%, it is tempting to declare victory and move on. But last year's performance was no great triumph: Any investor can chalk up large returns when stocks soar, as they did in 1997. In a bull market, one must avoid the error of the preening duck that quacks boastfully after a torrential rainstorm, thinking that its paddling skills have caused it to rise in the world. A right-thinking duck would instead compare its position after the downpour to that of the other ducks on the pond.
So what's our duck rating for 1997? The table on the facing page shows that though we paddled furiously last year, passive ducks that simply invested in the S&P Index rose almost as fast as we did. Our appraisal of 1997's performance, then: Quack.
When the market booms, we tend to suffer in comparison with the S&P Index. The Index bears no tax costs, nor do mutual funds, since they pass through all tax liabilities to their owners. Last year, on the other hand, Berkshire paid or accrued $4.2 billion for federal income tax, or about 18% of our beginning net worth.
Berkshire will always have corporate taxes to pay, which means it needs to overcome their drag in order to justify its existence. Obviously, Charlie Munger (Trades, Portfolio), Berkshire's vice chairman and my partner, and I won't be able to lick that handicap every year. But we expect over time to maintain a modest advantage over the Index, and that is the yardstick against which you should measure us. We will not ask you to adopt the philosophy of the Chicago Cubs fan who reacted to a string of lackluster seasons by saying, "Why get upset? Everyone has a bad century now and then."
Gains in book value are, of course, not the bottom line at Berkshire. What truly counts are gains in per-share intrinsic business value. Ordinarily, though, the two measures tend to move roughly in tandem, and in 1997 that was the case: Led by a blowout performance at GEICO, Berkshire's intrinsic value (which far exceeds book value) grew at nearly the same pace as book value.
For more explanation of the term intrinsic value, you may wish to refer to our owner's manual, reprinted on pages 62 to 71. This manual sets forth our owner-related business principles, information that is important to all of Berkshire's shareholders.
In our last two annual reports, we furnished you a table that Charlie and I believe is central to estimating Berkshire's intrinsic value. In the updated version of that table, which follows, we trace our two key components of value. The first column lists our per-share ownership of investments (including cash and equivalents) and the second column shows our per-share earnings from Berkshire's operating businesses before taxes and purchase-accounting adjustments (discussed on pages 69 and 70), but after all interest and corporate expenses. The second column excludes all dividends, interest and capital gains that we realized from the investments presented in the first column. In effect, the columns show what Berkshire would look like were it split into two parts, with one entity holding our investments and the other operating all of our businesses and bearing all corporate costs.
Pre-tax Earnings Per Share Investments Excluding All Income from Year Per Share Investments 1967 $ 41 $ 1.09 1977 372 12.44 1987 3,910 108.14 1997 38,043 717.82
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Pundits who ignore what our 38,000 employees contribute to the company and instead simply view Berkshire as a de facto investment company should study the figures in the second column. We made our first business acquisition in 1967, and since then our pretax operating earnings have grown from $1 million to $888 million. Furthermore, as noted, in this exercise we have assigned all of Berkshire's corporate expenses βΓ overhead of $6.6 million, interest of $66.9 million and shareholder contributions of $15.4 million βΓ to our business operations, even though a portion of these could just as well have been assigned to the investment side.
Here are the growth rates of the two segments by decade:
Pre-tax Earnings Per Share Investments Excluding All Income from Decade Ending Per Share Investments 1977 24.6% 27.6% 1987 26.5% 24.1% 1997 25.5% 20.8% Annual Growth Rate, 1967-1997 25.6% 24.2%
During 1997, both parts of our business grew at a satisfactory rate, with investments increasing by $9,543 per share, or 33.5%, and operating earnings growing by $296.43 per share, or 70.3%. One important caveat: Because we were lucky in our super-cat insurance business (to be discussed later) and because GEICO's underwriting gain was well above what we can expect in most years, our 1997 operating earnings were much better than we anticipated and also more than we expect for 1998.
Our rate of progress in both investments and operations is certain to fall in the future. For anyone deploying capital, nothing recedes like success. My own history makes the point: Back in 1951, when I was attending Ben Graham's class at Columbia, an idea giving me a $10,000 gain improved my investment performance for the year by a full 100 percentage points. Today, an idea producing a $500 million pretax profit for Berkshire adds one percentage point to our performance. It's no wonder that my annual results in the 1950s were better by nearly 30 percentage points than my annual gains in any subsequent decade. Charlie's experience was similar. We weren't smarter then, just smaller. At our present size, any performance superiority we achieve will be minor.
We will be helped, however, by the fact that the businesses to which we have already allocated capital βΓ both operating subsidiaries and companies in which we are passive investors βΓ have splendid long-term prospects. We are also blessed with a managerial corps that is unsurpassed in ability and focus. Most of these executives are wealthy and do not need the pay they receive from Berkshire to maintain their way of life. They are motivated by the joy of accomplishment, not by fame or fortune.
Though we are delighted with what we own, we are not pleased with our prospects for committing incoming funds. Prices are high for both businesses and stocks. That does not mean that the prices of either will fall βΓ we have absolutely no view on that matter βΓ but it does mean that we get relatively little in prospective earnings when we commit fresh money.
Under these circumstances, we try to exert a Ted Williams kind of discipline. In his book "The Science of Hitting," Ted explains that he carved the strike zone into 77 cells, each the size of a baseball. Swinging only at balls in his "best" cell, he knew, would allow him to bat .400; reaching for balls in his "worst" spot, the low outside corner of the strike zone, would reduce him to .230. In other words, waiting for the fat pitch would mean a trip to the Hall of Fame; swinging indiscriminately would mean a ticket to the minors.
If they are in the strike zone at all, the business "pitches" we now see are just catching the lower outside corner. If we swing, we will be locked into low returns. But if we let all of today's balls go by, there can be no assurance that the next ones we see will be more to our liking. Perhaps the attractive prices of the past were the aberrations, not the full prices of today. Unlike Ted, we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun.
Unconventional commitments
When we can't find our favorite commitment βΓ a well-run and sensibly priced business with fine economics βΓ we usually opt to put new money into very short-term instruments of the highest quality. Sometimes, however, we venture elsewhere. Obviously we believe that the alternative commitments we make are more likely to result in profit than loss. But we also realize that they do not offer the certainty of profit that exists in a wonderful business secured at an attractive price. Finding that kind of opportunity, we know that we are going to make money βΓ the only question being when. With alternative investments, we think that we are going to make money. But we also recognize that we will sometimes realize losses, occasionally of substantial size.
We had three nontraditional positions at year end. The first was derivative contracts for 14.0 million barrels of oil, that being what was then left of a 45.7 million barrel position we established in 1994-95. Contracts for 31.7 million barrels were settled in 1995-97, and these supplied us with a pretax gain of about $61.9 million. Our remaining contracts expire during 1998 and 1999. In these, we had an unrealized gain of $11.6 million at year end. Accounting rules require that commodity positions be carried at market value. Therefore, both our annual and quarterly financial statements reflect any unrealized gain or loss in these contracts. When we established our contracts, oil for future delivery seemed modestly underpriced. Today, though, we have no opinion as to its attractiveness.
Our second nontraditional commitment is in silver. Last year, we purchased 111.2 million ounces. Marked to market, that position produced a pretax gain of $97.4 million for us in 1997. In a way, this is a return to the past for me: Thirty years ago, I bought silver because I anticipated its demonetization by the U.S. government. Ever since, I have followed the metal's fundamentals but not owned it. In recent years, bullion inventories have fallen materially, and last summer Charlie and I concluded that a higher price would be needed to establish equilibrium between supply and demand. Inflation expectations, it should be noted, play no part in our calculation of silver's value.
Finally, our largest nontraditional position at year end was $4.6 billion, at amortized cost, of long-term zero-coupon obligations of the U.S. Treasury. These securities pay no interest. Instead, they provide their holders a return by way of the discount at which they are purchased, a characteristic that makes their market prices move rapidly when interest rates change. If rates rise, you lose heavily with zeros, and if rates fall, you make outsized gains. Since rates fell in 1997, we ended the year with an unrealized pretax gain of $598.8 million in our zeros. Because we carry the securities at market value, that gain is reflected in year-end book value.
In purchasing zeros, rather than staying with cash equivalents, we risk looking very foolish: A macro-based commitment such as this never has anything close to a 100% probability of being successful. However, you pay Charlie and me to use our best judgment βΓ not to avoid embarrassment βΓ and we will occasionally make an unconventional move when we believe the odds favor it. Try to think kindly of us when we blow one. Along with President Clinton, we will be feeling your pain: The Munger family has more than 90% of its net worth in Berkshire and the Buffetts more than 99%.
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