Days when the market trades 100 million shares (and that
kind of volume, when over-the-counter trading is included, is
today abnormally low) are a curse for owners, not a blessing -
for they mean that owners are paying twice as much to change
chairs as they are on a 50-million-share day. If 100 millionshare
days persist for a year and the average cost on each
purchase and sale is 15 cents a share, the chair-changing tax for
investors in aggregate would total about $7.5 billion - an amount
roughly equal to the combined 1982 profits of Exxon, General
Motors, Mobil and Texaco, the four largest companies in the
Fortune 500.
These companies had a combined net worth of $75 billion at
yearend 1982 and accounted for over 12% of both net worth and net
income of the entire Fortune 500 list. Under our assumption
investors, in aggregate, every year forfeit all earnings from
this staggering sum of capital merely to satisfy their penchant
for financial flip-flopping? In addition, investment
management fees of over $2 billion annually - sums paid for
chair-changing advice - require the forfeiture by investors of
all earnings of the five largest banking organizations (Citicorp,
Bank America, Chase Manhattan, Manufacturers Hanover and J. P.
Morgan). These expensive activities may decide who eats the pie,
but they don’t enlarge it.
(We are aware of the pie-expanding argument that says that
such activities improve the rationality of the capital allocation
process. We think that this argument is specious and that, on
balance, hyperactive equity markets subvert rational capital
allocation and act as pie shrinkers. Adam Smith felt that all
noncollusive acts in a free market were guided by an invisible
hand that led an economy to maximum progress; our view is that
casino-type markets and hair-trigger investment management act as
an invisible foot that trips up and slows down a forward-moving
economy.)
Contrast the hyperactive stock with Berkshire. The bid-andask
spread in our stock currently is about 30 points, or a little
over 2%. Depending on the size of the transaction, the
difference between proceeds received by the seller of Berkshire
and cost to the buyer may range downward from 4% (in trading
involving only a few shares) to perhaps 1 1/2% (in large trades
where negotiation can reduce both the market-maker’s spread and
the broker’s commission). Because most Berkshire shares are
traded in fairly large transactions, the spread on all trading
probably does not average more than 2%.
Meanwhile, true turnover in Berkshire stock (excluding
inter-dealer transactions, gifts and bequests) probably runs 3%
per year. Thus our owners, in aggregate, are paying perhaps
6/100 of 1% of Berkshire’s market value annually for transfer
privileges. By this very rough estimate, that’s $900,000 - not a
small cost, but far less than average. Splitting the stock would
increase that cost, downgrade the quality of our shareholder
population, and encourage a market price less consistently
related to intrinsic business value. We see no offsetting
advantages.
Miscellaneous
Last year in this section I ran a small ad to encourage
acquisition candidates. In our communications businesses we tell
our advertisers that repetition is a key to results (which it
is), so we will again repeat our acquisition criteria.
We prefer:
(1) large purchases (at least $5 million of after-tax
earnings),
(2) demonstrated consistent earning power (future
projections are of little interest to us, nor are
turn-around?situations),
(3) businesses earning good returns on equity while
employing little or no debt,
(4) management in place (we can’t supply it),
(5) simple businesses (if there’s lots of technology, we
won’t understand it),
(6) an offering price (we don’t want to waste our time or
that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
We will not engage in unfriendly takeovers. We can promise
complete confidentiality and a very fast answer - customarily
within five minutes - as to whether we’re interested. We prefer
to buy for cash, but will consider issuance of stock when we
receive as much in intrinsic business value as we give. We
invite potential sellers to check us out by contacting people
with whom we have done business in the past. For the right
business - and the right people - we can provide a good home.
* * * * *
About 96.4% of all eligible shares participated in our 1983
shareholder-designated contributions program. The total
contributions made pursuant to this program - disbursed in the
early days of 1984 but fully expensed in 1983 - were $3,066,501,
and 1353 charities were recipients. Although the response
measured by the percentage of shares participating was
extraordinarily good, the response measured by the percentage of
holders participating was not as good. The reason may well be
the large number of new shareholders acquired through the merger
and their lack of familiarity with the program. We urge new
shareholders to read the description of the program on pages 52-
53.
If you wish to participate in future programs, we strongly
urge that you immediately make sure that your shares are
registered in the actual owner’s name, not in street?or nominee
name. Shares not so registered on September 28, 1984 will not be
eligible for any 1984 program.
* * * * *
The Blue Chip/Berkshire merger went off without a hitch.
Less than one-tenth of 1% of the shares of each company voted
against the merger, and no requests for appraisal were made. In
1983, we gained some tax efficiency from the merger and we expect
to gain more in the future.
One interesting sidelight to the merger: Berkshire now has
1,146,909 shares outstanding compared to 1,137,778 shares at the
beginning of fiscal 1965, the year present management assumed
responsibility. For every 1% of the company you owned at that
time, you now would own .99%. Thus, all of today’s assets - the
News, See’s, Nebraska Furniture Mart, the Insurance Group, $1.3
billion in marketable stocks, etc. - have been added to the
original textile assets with virtually no net dilution to the
original owners.
We are delighted to have the former Blue Chip shareholders
join us. To aid in your understanding of Berkshire Hathaway, we
will be glad to send you the Compendium of Letters from the
Annual Reports of 1977-1981, and/or the 1982 Annual report.
Direct your request to the Company at 1440 Kiewit Plaza, Omaha,
Nebraska 68131.
Warren E. Buffett
March 14, 1984 Chairman of the Board
Appendix
BERKSHIRE HATHAWAY INC.
Goodwill and its Amortization: The Rules and The Realities
This appendix deals only with economic and accounting Goodwill ?not the goodwill of
everyday usage. For example, a business may be well liked, even loved, by most of its customers
but possess no economic goodwill. (AT&T, before the breakup, was generally well thought of,
but possessed not a dime of economic Goodwill.) And, regrettably, a business may be disliked
by its customers but possess substantial, and growing, economic Goodwill. So, just for the
moment, forget emotions and focus only on economics and accounting.
When a business is purchased, accounting principles require that the purchase price first be
assigned to the fair value of the identifiable assets that are acquired. Frequently the sum of the
fair values put on the assets (after the deduction of liabilities) is less than the total purchase
price of the business. In that case, the difference is assigned to an asset account entitled
"excess of cost over equity in net assets acquired". To avoid constant repetition of this
mouthful, we will substitute "Goodwill".
Accounting Goodwill arising from businesses purchased before November 1970 has a special
standing. Except under rare circumstances, it can remain an asset on the balance sheet as long
as the business bought is retained. That means no amortization charges to gradually extinguish
that asset need be made against earnings.
The case is different, however, with purchases made from November 1970 on. When these create
Goodwill, it must be amortized over not more than 40 years through charges ?of equal amount in
every year ?to the earnings account. Since 40 years is the maximum period allowed, 40 years is
what managements (including us) usually elect. This annual charge to earnings is not allowed as
a tax deduction and, thus, has an effect on after-tax income that is roughly double that of most
other expenses.
That’s how accounting Goodwill works. To see how it differs from economic reality, let’s
look at an example close at hand. We’ll round some figures, and greatly oversimplify, to make
the example easier to follow. We’ll also mention some implications for investors and managers.
Blue Chip Stamps bought See’s early in 1972 for $25 million, at which time See’s had about
$8 million of net tangible assets. (Throughout this discussion, accounts receivable will be
classified as tangible assets, a definition proper for business analysis.) This level of tangible
assets was adequate to conduct the business without use of debt, except for short periods
seasonally. See’s was earning about $2 million after tax at the time, and such earnings seemed
conservatively representative of future earning power in constant 1972 dollars.
Thus our first lesson: businesses logically are worth far more than net tangible assets when
they can be expected to produce earnings on such assets considerably in excess of market rates
of return. The capitalized value of this excess return is economic Goodwill.
In 1972 (and now) relatively few businesses could be expected to consistently earn the 25% after
tax on net tangible assets that was earned by See’s ?doing it, furthermore, with conservative
accounting and no financial leverage. It was not the fair market value of the inventories,
receivables or fixed assets that produced the premium rates of return. Rather it was a
combination of intangible assets, particularly a pervasive favorable reputation with consumers
based upon countless pleasant experiences they have had with both product and personnel.
Such a reputation creates a consumer franchise that allows the value of the product to the
purchaser, rather than its production cost, to be the major determinant of selling price.
Consumer franchises are a prime source of economic Goodwill. Other sources include
governmental franchises not subject to profit regulation, such as television stations, and an
enduring position as the low cost producer in an industry.
Let’s return to the accounting in the See’s example. Blue Chip’s purchase of See’s at $17
million over net tangible assets required that a Goodwill account of this amount be established
as an asset on Blue Chip’s books and that $425,000 be charged to income annually for 40 years
to amortize that asset. By 1983, after 11 years of such charges, the $17 million had been reduced
to about $12.5 million. Berkshire, meanwhile, owned 60% of Blue Chip and, therefore, also 60%
of See’s. This ownership meant that Berkshire’s balance sheet reflected 60% of See’s
Goodwill, or about $7.5 million.
In 1983 Berkshire acquired the rest of Blue Chip in a merger that required purchase accounting
as contrasted to the "pooling" treatment allowed for some mergers. Under purchase accounting,
the "fair value" of the shares we gave to (or "paid") Blue Chip holders had to be spread over the
net assets acquired from Blue Chip. This "fair value" was measured, as it almost always is when
public companies use their shares to make acquisitions, by the market value of the shares given
up.
The assets "purchased" consisted of 40% of everything owned by Blue Chip (as noted, Berkshire
already owned the other 60%). What Berkshire "paid" was more than the net identifiable assets
we received by $51.7 million, and was assigned to two pieces of Goodwill: $28.4 million to
See’s and $23.3 million to Buffalo Evening News.
After the merger, therefore, Berkshire was left with a Goodwill asset for See’s that had two
components: the $7.5 million remaining from the 1971 purchase, and $28.4 million newly created
by the 40% "purchased" in 1983. Our amortization charge now will be about $1.0 million for the
next 28 years, and $.7 million for the following 12 years, 2002 through 2013.
In other words, different purchase dates and prices have given us vastly different asset values
and amortization charges for two pieces of the same asset. (We repeat our usual disclaimer: we
have no better accounting system to suggest. The problems to be dealt with are mind boggling
and require arbitrary rules.)
But what are the economic realities? One reality is that the amortization charges that have been
deducted as costs in the earnings statement each year since acquisition of See’s were not true
economic costs. We know that because See’s last year earned $13 million after taxes on about
$20 million of net tangible assets ?a performance indicating the existence of economic Goodwill
far larger than the total original cost of our accounting Goodwill. In other words, while
accounting Goodwill regularly decreased from the moment of purchase, economic Goodwill
increased in irregular but very substantial fashion.
Another reality is that annual amortization charges in the future will not correspond to
economic costs. It is possible, of course, that See’s economic Goodwill will disappear. But it
won’t shrink in even decrements or anything remotely resembling them. What is more likely is
that the Goodwill will increase ?in current, if not in constant, dollars ?because of inflation.
That probability exists because true economic Goodwill tends to rise in nominal value
proportionally with inflation. To illustrate how this works, let’s contrast a See’s kind of
business with a more mundane business. When we purchased See’s in 1972, it will be recalled,
