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<TITLE>Chairman's Letter - 1988</TITLE>

<P ALIGN=CENTER>

<B>BERKSHIRE HATHAWAY INC.</B>

<B>To the Shareholders of Berkshire Hathaway Inc.:</B>

Our gain in net worth during 1988 was $569 million, or

20.0%. Over the last 24 years (that is, since present management

took over), our per-share book value has grown from $19.46 to

$2,974.52, or at a rate of 23.0% compounded annually.

We’ve emphasized in past reports that what counts, however,

is intrinsic business value - the figure, necessarily an

estimate, indicating what all of our constituent businesses are

worth. By our calculations, Berkshire’s intrinsic business value

significantly exceeds its book value. Over the 24 years,

business value has grown somewhat faster than book value; in

1988, however, book value grew the faster, by a bit.

Berkshire’s past rates of gain in both book value and

business value were achieved under circumstances far different

from those that now exist. Anyone ignoring these differences

makes the same mistake that a baseball manager would were he to

judge the future prospects of a 42-year-old center fielder on the

basis of his lifetime batting average.

Important negatives affecting our prospects today are: (1) a

less attractive stock market than generally existed over the past

24 years; (2) higher corporate tax rates on most forms of

investment income; (3) a far more richly-priced market for the

acquisition of businesses; and (4) industry conditions for

Capital Cities/ABC, Inc., GEICO Corporation, and The Washington

Post Company - Berkshire’s three permanent investments,

constituting about one-half of our net worth - that range from

slightly to materially less favorable than those existing five to

ten years ago. All of these companies have superb management and

strong properties. But, at current prices, their upside

potential looks considerably less exciting to us today than it

did some years ago.

The major problem we face, however, is a growing capital

base. You’ve heard that from us before, but this problem, like

age, grows in significance each year. (And also, just as with

age, it’s better to have this problem continue to grow rather

than to have it “solved.”)

Four years ago I told you that we needed profits of $3.9

billion to achieve a 15% annual return over the decade then

ahead. Today, for the next decade, a 15% return demands profits

of $10.3 billion. That seems like a very big number to me and to

Charlie Munger, Berkshire’s Vice Chairman and my partner. (Should

that number indeed prove too big, Charlie will find himself, in

future reports, retrospectively identified as the senior

partner.)

As a partial offset to the drag that our growing capital

base exerts upon returns, we have a very important advantage now

that we lacked 24 years ago. Then, all our capital was tied up

in a textile business with inescapably poor economic

characteristics. Today part of our capital is invested in some

really exceptional businesses.

Last year we dubbed these operations the Sainted Seven:

Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott

Fetzer Manufacturing Group, See’s, and World Book. In 1988 the

Saints came marching in. You can see just how extraordinary

their returns on capital were by examining the historical-cost

financial statements on page 45, which combine the figures of the

Sainted Seven with those of several smaller units. With no

benefit from financial leverage, this group earned about 67% on

average equity capital.

In most cases the remarkable performance of these units

arises partially from an exceptional business franchise; in all

cases an exceptional management is a vital factor. The

contribution Charlie and I make is to leave these managers alone.

In my judgment, these businesses, in aggregate, will

continue to produce superb returns. We’ll need these: Without

this help Berkshire would not have a chance of achieving our 15%

goal. You can be sure that our operating managers will deliver;

the question mark in our future is whether Charlie and I can

effectively employ the funds that they generate.

In that respect, we took a step in the right direction early

in 1989 when we purchased an 80% interest in Borsheim’s, a

jewelry business in Omaha. This purchase, described later in

this letter, delivers exactly what we look for: an outstanding

business run by people we like, admire, and trust. It’s a great

way to start the year.

<B>Accounting Changes</B>

We have made a significant accounting change that was

mandated for 1988, and likely will have another to make in 1990.

When we move figures around from year to year, without any change

in economic reality, one of our always-thrilling discussions of

accounting is necessary.

First, I’ll offer my customary disclaimer: Despite the

shortcomings of generally accepted accounting principles (GAAP),

I would hate to have the job of devising a better set of rules.

The limitations of the existing set, however, need not be

inhibiting: CEOs are free to treat GAAP statements as a beginning

rather than an end to their obligation to inform owners and

creditors - and indeed they should. After all, any manager of a

subsidiary company would find himself in hot water if he reported

barebones GAAP numbers that omitted key information needed by his

boss, the parent corporation’s CEO. Why, then, should the CEO

himself withhold information vitally useful to <I>his</I> bosses - the

shareholder-owners of the corporation?

What needs to be reported is data - whether GAAP, non-GAAP,

or extra-GAAP - that helps financially-literate readers answer

three key questions: (1) Approximately how much is this company

worth? (2) What is the likelihood that it can meet its future

obligations? and (3) How good a job are its managers doing, given

the hand they have been dealt?

In most cases, answers to one or more of these questions are

somewhere between difficult and impossible to glean from the

minimum GAAP presentation. The business world is simply too

complex for a single set of rules to effectively describe

economic reality for all enterprises, particularly those

operating in a wide variety of businesses, such as Berkshire.

Further complicating the problem is the fact that many

managements view GAAP not as a standard to be met, but as an

obstacle to overcome. Too often their accountants willingly

assist them. (“How much,” says the client, “is two plus two?”

Replies the cooperative accountant, “What number did you have in

mind?”) Even honest and well-intentioned managements sometimes

stretch GAAP a bit in order to present figures they think will

more appropriately describe their performance. Both the

smoothing of earnings and the “big bath” quarter are “white lie”

techniques employed by otherwise upright managements.

Then there are managers who actively use GAAP to deceive and

defraud. They know that many investors and creditors accept GAAP

results as gospel. So these charlatans interpret the rules

“imaginatively” and record business transactions in ways that

technically comply with GAAP but actually display an economic

illusion to the world.

As long as investors - including supposedly sophisticated

institutions - place fancy valuations on reported “earnings” that

march steadily upward, you can be sure that some managers and

promoters will exploit GAAP to produce such numbers, no matter

what the truth may be. Over the years, Charlie and I have

observed many accounting-based frauds of staggering size. Few of

the perpetrators have been punished; many have not even been

censured. It has been far safer to steal large sums with a pen

than small sums with a gun.

Under one major change mandated by GAAP for 1988, we have

been required to fully consolidate all our subsidiaries in our

balance sheet and earnings statement. In the past, Mutual

Savings and Loan, and Scott Fetzer Financial (a credit company

that primarily finances installment sales of World Book and Kirby

products) were consolidated on a “one-line” basis. That meant we

(1) showed our equity in their combined net worths as a single-

entry asset on Berkshire’s consolidated balance sheet and (2)

included our equity in their combined annual earnings as a

single-line income entry in our consolidated statement of

earnings. Now the rules require that we consolidate each asset

and liability of these companies in our balance sheet and each

item of their income and expense in our earnings statement.

This change underscores the need for companies also to

report segmented data: The greater the number of economically

diverse business operations lumped together in conventional

financial statements, the less useful those presentations are and

the less able investors are to answer the three questions posed

earlier. Indeed, the only reason we ever prepare consolidated

figures at Berkshire is to meet outside requirements. On the

other hand, Charlie and I constantly study our segment data.

Now that we are required to bundle more numbers in our GAAP

statements, we have decided to publish additional supplementary

information that we think will help you measure both business

value and managerial performance. (Berkshire’s ability to

discharge its obligations to creditors - the third question we

listed - should be obvious, whatever statements you examine.) In

these supplementary presentations, we will not necessarily follow

GAAP procedures, or even corporate structure. Rather, we will

attempt to lump major business activities in ways that aid

analysis but do not swamp you with detail. Our goal is to give

you important information in a form that we would wish to get it

if our roles were reversed.

On pages 41-47 we show separate combined balance sheets and

earnings statements for: (1) our subsidiaries engaged in finance-

type operations, which are Mutual Savings and Scott Fetzer

Financial; (2) our insurance operations, with their major

investment positions itemized; (3) our manufacturing, publishing

and retailing businesses, leaving aside certain non-operating

assets and purchase-price accounting adjustments; and (4) an all-

other category that includes the non-operating assets (primarily

marketable securities) held by the companies in (3) as well as

various assets and debts of the Wesco and Berkshire parent

companies.

If you combine the earnings and the net worths of these four

segments, you will derive totals matching those shown on our GAAP

statements. However, we want to emphasize that our new

presentation does not fall within the purview of our auditors,

who in no way bless it. (In fact, they may be horrified; I don’t

want to ask.)

I referred earlier to a major change in GAAP that is

expected in 1990. This change relates to the calculation of

deferred taxes, and is both complicated and controversial - so

much so that its imposition, originally scheduled for 1989, was

postponed for a year.

When implemented, the new rule will affect us in various

ways. Most important, we will be required to change the way we

calculate our liability for deferred taxes on the unrealized

appreciation of stocks held by our insurance companies.

Right now, our liability is layered. For the unrealized

appreciation that dates back to 1986 and earlier years, $1.2

billion, we have booked a 28% tax liability. For the unrealized

appreciation built up since, $600 million, the tax liability has

been booked at 34%. The difference reflects the increase in tax

rates that went into effect in 1987.

It now appears, however, that the new accounting rule will

require us to establish the entire liability at 34% in 1990,

taking the charge against our earnings. Assuming no change in

tax rates by 1990, this step will reduce our earnings in that

year (and thereby our reported net worth) by $71 million. The

proposed rule will also affect other items on our balance sheet,

but these changes will have only a minor impact on earnings and

net worth.

We have no strong views about the desirability of this

change in calculation of deferred taxes. We should point out,

however, that neither a 28% nor a 34% tax liability precisely

depicts economic reality at Berkshire since we have no plans to

sell the stocks in which we have the great bulk of our gains.

To those of you who are uninterested in accounting, I

apologize for this dissertation. I realize that many of you do

not pore over our figures, but instead hold Berkshire primarily

because you know that: (1) Charlie and I have the bulk of our

money in Berkshire; (2) we intend to run things so that your

gains or losses are in direct proportion to ours; and (3) the

record has so far been satisfactory. There is nothing

necessarily wrong with this kind of “faith” approach to

investing. Other shareholders, however, prefer an “analysis”

approach and we want to supply the information they need. In our

own investing, we search for situations in which both approaches

give us the same answer.

<B>Sources of Reported Earnings</B>

In addition to supplying you with our new four-sector

accounting material, we will continue to list the major sources

of Berkshire’s reported earnings just as we have in the past.

In the following table, amortization of Goodwill and other

major purchase-price accounting adjustments are not charged

against the specific businesses to which they apply but are

instead aggregated and shown separately. This procedure lets you

view the earnings of our businesses as they would have been

reported had we not purchased them. I’ve explained in past

reports why this form of presentation seems to us to be more

useful to investors and managers than the standard GAAP

presentation, which makes purchase-price adjustments on a

business-by-business basis. The total net earnings we show in

the table are, of course, identical to the GAAP total in our

audited financial statements.

Further information about these businesses is given in the

Business Segment section on pages 32-34, and in the Management’s

Discussion section on pages 36-40. In these sections you also

will find our segment earnings reported on a GAAP basis. For

information on Wesco’s businesses, I urge you to read Charlie

Munger’s letter, which starts on page 52. It contains the best

description I have seen of the events that produced the present

savings-and-loan crisis. Also, take special note of Dave

Hillstrom’s performance at Precision Steel Warehouse, a Wesco

subsidiary. Precision operates in an extremely competitive

industry, yet Dave consistently achieves good returns on invested

capital. Though data is lacking to prove the point, I think it

is likely that his performance, both in 1988 and years past,

would rank him number one among his peers.

(000s omitted)

------------------------------------------

Berkshire's Share

of Net Earnings

(after taxes and

Pre-Tax Earnings minority interests)

------------------- -------------------

1988 1987 1988 1987 </I>

-------- -------- -------- --------

Operating Earnings:

Insurance Group:

Underwriting ............... $(11,081) $(55,429) $ (1,045) $(20,696)

Net Investment Income ...... 231,250 152,483 197,779 136,658

Buffalo News ................. 42,429 39,410 25,462 21,304

Fechheimer ................... 14,152 13,332 7,720 6,580

Kirby ........................ 26,891 22,408 17,842 12,891

Nebraska Furniture Mart ...... 18,439 16,837 9,099 7,554

Scott Fetzer

Manufacturing Group ....... 28,542 30,591 17,640 17,555

See’s Candies ................ 32,473 31,693 19,671 17,363

Wesco - other than Insurance 16,133 6,209 10,650 4,978

World Book ................... 27,890 25,745 18,021 15,136

Amortization of Goodwill ..... (2,806) (2,862) (2,806) (2,862)

Other Purchase-Price

Accounting Charges ........ (6,342) (5,546) (7,340) (6,544)

Interest on Debt* ............ (35,613) (11,474) (23,212) (5,905)

Shareholder-Designated

Contributions ............. (4,966) (4,938) (3,217) (2,963)

Other ........................ 41,059 23,217 27,177 13,697

-------- -------- -------- --------

Operating Earnings ............. 418,450 281,676 313,441 214,746

Sales of Securities ............ 131,671 28,838 85,829 19,806

-------- -------- -------- --------

Total Earnings - All Entities .. $550,121 $310,514 $399,270 $234,552

<I>*Excludes interest expense of Scott Fetzer Financial Group.</I>

The earnings achieved by our operating businesses are

superb, whether measured on an absolute basis or against those of

their competitors. For that we thank our operating managers: You

and I are fortunate to be associated with them.

At Berkshire, associations like these last a long time. We

do not remove superstars from our lineup merely because they have

attained a specified age - whether the traditional 65, or the 95

reached by Mrs. B on the eve of Hanukkah in 1988. Superb

managers are too scarce a resource to be discarded simply because

a cake gets crowded with candles. Moreover, our experience with

newly-minted MBAs has not been that great. Their academic

records always look terrific and the candidates always know just

what to say; but too often they are short on personal commitment

to the company and general business savvy. It’s difficult to

teach a new dog old tricks.

Here’s an update on our major non-insurance operations:

<B>o</B> At Nebraska Furniture Mart, Mrs. B (Rose Blumkin) and her

cart roll on and on. She’s been the boss for 51 years, having

started the business at 44 with $500. (Think what she would have

done with $1,000!) With Mrs. B, old age will always be ten years

away.

The Mart, long the largest home furnishings store in the

country, continues to grow. In the fall, the store opened a

detached 20,000 square foot Clearance Center, which expands our

ability to offer bargains in all price ranges.

Recently Dillard’s, one of the most successful department

store operations in the country, entered the Omaha market. In

many of its stores, Dillard’s runs a full furniture department,

undoubtedly doing well in this line. Shortly before opening in

Omaha, however, William Dillard, chairman of the company,

announced that his new store would not sell furniture. Said he,

referring to NFM: “We don’t want to compete with them. We think

they are about the best there is.”

At the Buffalo News we extol the value of advertising, and

our policies at NFM prove that we practice what we preach. Over

the past three years NFM has been the largest ROP advertiser in

the Omaha World-Herald. (ROP advertising is the kind printed in

the paper, as contrasted to the preprinted-insert kind.) In no

other major market, to my knowledge, is a home furnishings

operation the leading customer of the newspaper. At times, we

also run large ads in papers as far away as Des Moines, Sioux

City and Kansas City - always with good results. It truly does

pay to advertise, as long as you have something worthwhile to

offer.

Mrs. B’s son, Louie, and his boys, Ron and Irv, complete the

winning Blumkin team. It’s a joy to work with this family. All

its members have character that matches their extraordinary

abilities.

<B>o</B> Last year I stated unequivocally that pre-tax margins at

The Buffalo News would fall in 1988. That forecast would have

proved correct at almost any other newspaper our size or larger.

But Stan Lipsey - bless him - has managed to make me look

foolish.

Though we increased our prices a bit less than the industry

average last year, and though our newsprint costs and wage rates

rose in line with industry norms, Stan actually improved margins

a tad. No one in the newspaper business has a better managerial

record. He has achieved it, furthermore, while running a paper

that gives readers an extraordinary amount of news. We believe

that our “newshole” percentage - the portion of the paper devoted

to news - is bigger than that of any other dominant paper of our

size or larger. The percentage was 49.5% in 1988 versus 49.8% in

1987. We are committed to keeping it around 50%, whatever the

level or trend of profit margins.

Charlie and I have loved the newspaper business since we

were youngsters, and we have had great fun with the News in the

12 years since we purchased it. We were fortunate to find Murray

Light, a top-flight editor, on the scene when we arrived and he

has made us proud of the paper ever since.

<B>o</B> See’s Candies sold a record 25.1 million pounds in 1988.

Prospects did not look good at the end of October, but excellent

Christmas volume, considerably better than the record set in

1987, turned the tide.

As we’ve told you before, See’s business continues to become

more Christmas-concentrated. In 1988, the Company earned a

record 90% of its full-year profits in December: $29 million out

of $32.5 million before tax. (It’s enough to make you believe in

Santa Claus.) December’s deluge of business produces a modest

seasonal bulge in Berkshire’s corporate earnings. Another small

bulge occurs in the first quarter, when most World Book annuals

are sold.

Charlie and I put Chuck Huggins in charge of See’s about

five minutes after we bought the company. Upon reviewing his

record, you may wonder what took us so long.

<B>o</B> At Fechheimer, the Heldmans - Bob, George, Gary, Roger and

Fred - are the Cincinnati counterparts of the Blumkins. Neither

furniture retailing nor uniform manufacturing has inherently

attractive economics. In these businesses, only exceptional

managements can deliver high returns on invested capital. And

that’s exactly what the five Heldmans do. (As Mets announcer

Ralph Kiner once said when comparing pitcher Steve Trout to his

father, Dizzy Trout, the famous Detroit Tigers pitcher: “There’s

a lot of heredity in that family.”)

Fechheimer made a fairly good-sized acquisition in 1988.

Charlie and I have such confidence in the business savvy of the

Heldman family that we okayed the deal without even looking at

it. There are very few managements anywhere - including those

running the top tier companies of the <U>Fortune 500</U> - in which we

would exhibit similar confidence.

Because of both this acquisition and some internal growth,

sales at Fechheimer should be up significantly in 1989.

<B>o</B> All of the operations managed by Ralph Schey - World Book,

Kirby, and The Scott Fetzer Manufacturing Group - performed

splendidly in 1988. Returns on the capital entrusted to Ralph

continue to be exceptional.

Within the Scott Fetzer Manufacturing Group, particularly

fine progress was recorded at its largest unit, Campbell

Hausfeld. This company, the country’s leading producer of small

and medium-sized air compressors, has more than doubled earnings

since 1986.

Unit sales at both Kirby and World Book were up

significantly in 1988, with export business particularly strong.

World Book became available in the Soviet Union in September,

when that country’s largest American book store opened in Moscow.

Ours is the only general encyclopedia offered at the store.

Ralph’s personal productivity is amazing: In addition to

running 19 businesses in superb fashion, he is active at The

Cleveland Clinic, Ohio University, Case Western Reserve, and a

venture capital operation that has spawned sixteen Ohio-based

companies and resurrected many others. Both Ohio and Berkshire

are fortunate to have Ralph on their side.

<B>Borsheim’s</B>

It was in 1983 that Berkshire purchased an 80% interest in

The Nebraska Furniture Mart. Your Chairman blundered then by

neglecting to ask Mrs. B a question any schoolboy would have

thought of: “Are there any more at home like you?” Last month I

corrected the error: We are now 80% partners with another branch

of the family.

After Mrs. B came over from Russia in 1917, her parents and

five siblings followed. (Her two other siblings had preceded

her.) Among the sisters was Rebecca Friedman who, with her

husband, Louis, escaped in 1922 to the west through Latvia in a

journey as perilous as Mrs. B’s earlier odyssey to the east

through Manchuria. When the family members reunited in Omaha

they had no tangible assets. However, they came equipped with an

extraordinary combination of brains, integrity, and enthusiasm

for work - and that’s all they needed. They have since proved

themselves invincible.

In 1948 Mr. Friedman purchased Borsheim’s, a small Omaha

jewelry store. He was joined in the business by his son, Ike, in

1950 and, as the years went by, Ike’s son, Alan, and his sons-in-

law, Marvin Cohn and Donald Yale, came in also.

You won’t be surprised to learn that this family brings to

the jewelry business precisely the same approach that the

Blumkins bring to the furniture business. The cornerstone for

both enterprises is Mrs. B’s creed: “Sell cheap and tell the

truth.” Other fundamentals at both businesses are: (1) single

store operations featuring huge inventories that provide

customers with an enormous selection across all price ranges, (2)

daily attention to detail by top management, (3) rapid turnover,

(4) shrewd buying, and (5) incredibly low expenses. The

combination of the last three factors lets both stores offer

everyday prices that no one in the country comes close to

matching.

Most people, no matter how sophisticated they are in other

matters, feel like babes in the woods when purchasing jewelry.

They can judge neither quality nor price. For them only one rule

makes sense: If you don’t know jewelry, know the jeweler.

I can assure you that those who put their trust in Ike

Friedman and his family will never be disappointed. The way in

which we purchased our interest in their business is the ultimate

testimonial. Borsheim’s had no audited financial statements;

nevertheless, we didn’t take inventory, verify receivables or

audit the operation in any way. Ike simply told us what was so -

- and on that basis we drew up a one-page contract and wrote a

large check.

Business at Borsheim’s has mushroomed in recent years as the

reputation of the Friedman family has spread. Customers now come

to the store from all over the country. Among them have been

some friends of mine from both coasts who thanked me later for

getting them there.

Borsheim’s new links to Berkshire will change nothing in the

way this business is run. All members of the Friedman family

will continue to operate just as they have before; Charlie and I

will stay on the sidelines where we belong. And when we say “all

members,” the words have real meaning. Mr. and Mrs. Friedman, at

88 and 87, respectively, are in the store daily. The wives of

Ike, Alan, Marvin and Donald all pitch in at busy times, and a

fourth generation is beginning to learn the ropes.

It is great fun to be in business with people you have long

admired. The Friedmans, like the Blumkins, have achieved success

because they have deserved success. Both families focus on

what’s right for the customer and that, inevitably, works out

well for them, also. We couldn’t have better partners.

<B>Insurance Operations</B>

Shown below is an updated version of our usual table

presenting key figures for the insurance industry:

Statutory

Yearly Change Combined Ratio Yearly Change Inflation Rate

in Premiums After Policyholder in Incurred Measured by

Written (%) Dividends Losses (%) GNP Deflator (%)</I>

------------- ------------------ ------------- ----------------

1981 ..... 3.8 106.0 6.5 9.6

1982 ..... 3.7 109.6 8.4 6.4

1983 ..... 5.0 112.0 6.8 3.8

1984 ..... 8.5 118.0 16.9 3.7

1985 ..... 22.1 116.3 16.1 3.2

1986 ..... 22.2 108.0 13.5 2.7

1987 ..... 9.4 104.6 7.8 3.3

1988 (Est.) 3.9 105.4 4.2 3.6

Source: A.M. Best Co.

The combined ratio represents total insurance costs (losses

incurred plus expenses) compared to revenue from premiums: A

ratio below 100 indicates an underwriting profit, and one above

100 indicates a loss. When the investment income that an insurer

earns from holding on to policyholders’ funds (“the float”) is

taken into account, a combined ratio in the 107-111 range

typically produces an overall break-even result, exclusive of

earnings on the funds provided by shareholders.

For the reasons laid out in previous reports, we expect the

industry’s incurred losses to grow by about 10% annually, even in

years when general inflation runs considerably lower. If premium

growth meanwhile materially lags that 10% rate, underwriting

losses will mount, though the industry’s tendency to underreserve

when business turns bad may obscure their size for a time. As

the table shows, the industry’s underwriting loss grew in 1988.

This trend is almost certain to continue - and probably will

accelerate - for at least two more years.

The property-casualty insurance industry is not only

subnormally profitable, it is subnormally popular. (As Sam

Goldwyn philosophized: “In life, one must learn to take the

bitter with the sour.”) One of the ironies of business is that

many relatively-unprofitable industries that are plagued by

inadequate prices habitually find themselves beat upon by irate

customers even while other, hugely profitable industries are

spared complaints, no matter how high their prices.

Take the breakfast cereal industry, whose return on invested

capital is more than double that of the auto insurance industry

(which is why companies like Kellogg and General Mills sell at

five times book value and most large insurers sell close to

book). The cereal companies regularly impose price increases,

few of them related to a significant jump in their costs. Yet

not a peep is heard from consumers. But when auto insurers raise

prices by amounts that do not even match cost increases,

customers are outraged. If you want to be loved, it’s clearly

better to sell high-priced corn flakes than low-priced auto

insurance.

The antagonism that the public feels toward the industry can

have serious consequences: Proposition 103, a California

initiative passed last fall, threatens to push auto insurance

prices down sharply, even though costs have been soaring. The

price cut has been suspended while the courts review the

initiative, but the resentment that brought on the vote has not

been suspended: Even if the initiative is overturned, insurers

are likely to find it tough to operate profitably in California.

(Thank heavens the citizenry isn’t mad at bonbons: If Proposition

103 applied to candy as well as insurance, See’s would be forced

to sell its product for $5.76 per pound. rather than the $7.60 we

charge - and would be losing money by the bucketful.)

The immediate direct effects on Berkshire from the

initiative are minor, since we saw few opportunities for profit

in the rate structure that existed in California prior to the

vote. However, the forcing down of prices would seriously affect

GEICO, our 44%-owned investee, which gets about 10% of its

premium volume from California. Even more threatening to GEICO

is the possibility that similar pricing actions will be taken in

other states, through either initiatives or legislation.

If voters insist that auto insurance be priced below cost,

it eventually must be sold by government. Stockholders can

subsidize policyholders for a short period, but only taxpayers

can subsidize them over the long term. At most property-casualty

companies, socialized auto insurance would be no disaster for

shareholders. Because of the commodity characteristics of the

industry, most insurers earn mediocre returns and therefore have

little or no economic goodwill to lose if they are forced by

government to leave the auto insurance business. But GEICO,

because it is a low-cost producer able to earn high returns on

equity, has a huge amount of economic goodwill at risk. In turn,

so do we.

At Berkshire, in 1988, our premium volume continued to fall,

and in 1989 we will experience a large decrease for a special

reason: The contract through which we receive 7% of the business

of Fireman’s Fund expires on August 31. At that time, we will

return to Fireman’s Fund the unearned premiums we hold that

relate to the contract. This transfer of funds will show up in

our “premiums written” account as a negative $85 million or so

and will make our third-quarter figures look rather peculiar.

However, the termination of this contract will not have a

significant effect on profits.

Berkshire’s underwriting results continued to be excellent

in 1988. Our combined ratio (on a statutory basis and excluding

structured settlements and financial reinsurance) was 104.

Reserve development was favorable for the second year in a row,

after a string of years in which it was very unsatisfactory.

Details on both underwriting and reserve development appear on

pages 36-38.

Our insurance volume over the next few years is likely to

run very low, since business with a reasonable potential for

profit will almost certainly be scarce. So be it. At Berkshire,

we simply will not write policies at rates that carry the

expectation of economic loss. We encounter enough troubles when

we expect a gain.

Despite - or perhaps because of - low volume, our profit

picture during the next few years is apt to be considerably

brighter than the industry’s. We are sure to have an exceptional

amount of float compared to premium volume, and that augurs well

for profits. In 1989 and 1990 we expect our float/premiums

ratio to be at least three times that of the typical

property/casualty company. Mike Goldberg, with special help from

Ajit Jain, Dinos Iordanou, and the National Indemnity managerial

team, has positioned us well in that respect.

At some point - we don’t know when - we will be deluged with

insurance business. The cause will probably be some major

physical or financial catastrophe. But we could also experience

an explosion in business, as we did in 1985, because large and

increasing underwriting losses at other companies coincide with

their recognition that they are far underreserved. in the

meantime, we will retain our talented professionals, protect our

capital, and try not to make major mistakes.

<B>Marketable Securities</B>

In selecting marketable securities for our insurance

companies, we can choose among five major categories: (1) long-

term common stock investments, (2) medium-term fixed-income

securities, (3) long-term fixed-income securities, (4) short-term

cash equivalents, and (5) short-term arbitrage commitments.

We have no particular bias when it comes to choosing from

these categories. We just continuously search among them for the

highest after-tax returns as measured by “mathematical

expectation,” limiting ourselves always to investment

alternatives we think we understand. Our criteria have nothing

to do with maximizing immediately reportable earnings; our goal,

rather, is to maximize eventual net worth.

<B>o</B> Below we list our common stock holdings having a value over

$100 million, not including arbitrage commitments, which will be

discussed later. A small portion of these investments belongs to

subsidiaries of which Berkshire owns less than 100%.

Shares Company Cost Market

------ ------- ---------- ----------

(000s omitted) </I>

3,000,000 Capital Cities/ABC, Inc. .............. $517,500 $1,086,750

14,172,500 The Coca-Cola Company ................. 592,540 632,448

2,400,000 Federal Home Loan Mortgage

Corporation Preferred* ............. 71,729 121,200

6,850,000 GEICO Corporation ..................... 45,713 849,400

1,727,765 The Washington Post Company ........... 9,731 364,126

<I>*Although nominally a preferred stock, this security is

financially equivalent to a common stock.</I>

Our permanent holdings - Capital Cities/ABC, Inc., GEICO

Corporation, and The Washington Post Company - remain unchanged.

Also unchanged is our unqualified admiration of their

managements: Tom Murphy and Dan Burke at Cap Cities, Bill Snyder

and Lou Simpson at GEICO, and Kay Graham and Dick Simmons at The

Washington Post. Charlie and I appreciate enormously the talent

and integrity these managers bring to their businesses.

Their performance, which we have observed at close range,

contrasts vividly with that of many CEOs, which we have

fortunately observed from a safe distance. Sometimes these CEOs

clearly do not belong in their jobs; their positions,

nevertheless, are usually secure. The supreme irony of business

management is that it is far easier for an inadequate CEO to keep

his job than it is for an inadequate subordinate.

If a secretary, say, is hired for a job that requires typing

ability of at least 80 words a minute and turns out to be capable

of only 50 words a minute, she will lose her job in no time.

There is a logical standard for this job; performance is easily

measured; and if you can’t make the grade, you’re out.

Similarly, if new sales people fail to generate sufficient

business quickly enough, they will be let go. Excuses will not

be accepted as a substitute for orders.

However, a CEO who doesn’t perform is frequently carried

indefinitely. One reason is that performance standards for his

job seldom exist. When they do, they are often fuzzy or they may

be waived or explained away, even when the performance shortfalls

are major and repeated. At too many companies, the boss shoots

the arrow of managerial performance and then hastily paints the

bullseye around the spot where it lands.

Another important, but seldom recognized, distinction

between the boss and the foot soldier is that the CEO has no

immediate superior whose performance is itself getting measured.

The sales manager who retains a bunch of lemons in his sales

force will soon be in hot water himself. It is in his immediate

self-interest to promptly weed out his hiring mistakes.

Otherwise, he himself may be weeded out. An office manager who

has hired inept secretaries faces the same imperative.

But the CEO’s boss is a Board of Directors that seldom

measures itself and is infrequently held to account for

substandard corporate performance. If the Board makes a mistake

in hiring, and perpetuates that mistake, so what? Even if the

company is taken over because of the mistake, the deal will

probably bestow substantial benefits on the outgoing Board

members. (The bigger they are, the softer they fall.)

Finally, relations between the Board and the CEO are

expected to be congenial. At board meetings, criticism of the

CEO’s performance is often viewed as the social equivalent of

belching. No such inhibitions restrain the office manager from

critically evaluating the substandard typist.

These points should not be interpreted as a blanket

condemnation of CEOs or Boards of Directors: Most are able and

hard-working, and a number are truly outstanding. But the

management failings that Charlie and I have seen make us thankful

that we are linked with the managers of our three permanent

holdings. They love their businesses, they think like owners,

and they exude integrity and ability.

<B>o</B> In 1988 we made major purchases of Federal Home Loan

Mortgage Pfd. (“Freddie Mac”) and Coca Cola. We expect to hold

these securities for a long time. In fact, when we own portions

of outstanding businesses with outstanding managements, our

favorite holding period is forever. We are just the opposite of

those who hurry to sell and book profits when companies perform

well but who tenaciously hang on to businesses that disappoint.

Peter Lynch aptly likens such behavior to cutting the flowers and

watering the weeds. Our holdings of Freddie Mac are the maximum

allowed by law, and are extensively described by Charlie in his

letter. In our consolidated balance sheet these shares are

carried at cost rather than market, since they are owned by

Mutual Savings and Loan, a non-insurance subsidiary.

We continue to concentrate our investments in a very few

companies that we try to understand well. There are only a

handful of businesses about which we have strong long-term

convictions. Therefore, when we find such a business, we want to

participate in a meaningful way. We agree with Mae West: “Too

much of a good thing can be wonderful.”

<B>o</B> We reduced our holdings of medium-term tax-exempt bonds by

about $100 million last year. All of the bonds sold were

acquired after August 7, 1986. When such bonds are held by

property-casualty insurance companies, 15% of the “tax-exempt”

interest earned is subject to tax.

The $800 million position we still hold consists almost

entirely of bonds “grandfathered” under the Tax Reform Act of

1986, which means they are entirely tax-exempt. Our sales

produced a small profit and our remaining bonds, which have an

average maturity of about six years, are worth modestly more than

carrying value.

Last year we described our holdings of short-term and

intermediate-term bonds of Texaco, which was then in bankruptcy.

During 1988, we sold practically all of these bonds at a pre-tax

profit of about $22 million. This sale explains close to $100

million of the reduction in fixed-income securities on our

balance sheet.

We also told you last year about our holdings of another

security whose predominant characteristics are those of an

intermediate fixed-income issue: our $700 million position in

Salomon Inc 9% convertible preferred. This preferred has a

sinking fund that will retire it in equal annual installments

from 1995 to 1999. Berkshire carries this holding at cost. For

reasons discussed by Charlie on page 69, the estimated market

value of our holding has improved from moderately under cost at

the end of last year to moderately over cost at 1988 year end.

The close association we have had with John Gutfreund, CEO

of Salomon, during the past year has reinforced our admiration

for him. But we continue to have no great insights about the

near, intermediate or long-term economics of the investment

banking business: This is not an industry in which it is easy to

forecast future levels of profitability. We continue to believe

that our conversion privilege could well have important value

over the life of our preferred. However, the overwhelming

portion of the preferred’s value resides in its fixed-income

characteristics, not its equity characteristics.

<B>o</B> We have not lost our aversion to long-term bonds. We will

become enthused about such securities only when we become

enthused about prospects for long-term stability in the

purchasing power of money. And that kind of stability isn’t in

the cards: Both society and elected officials simply have too

many higher-ranking priorities that conflict with purchasing-

power stability. The only long-term bonds we hold are those of

Washington Public Power Supply Systems (WPPSS). A few of our

WPPSS bonds have short maturities and many others, because of

their high coupons, are likely to be refunded and paid off in a

few years. Overall, our WPPSS holdings are carried on our

balance sheet at $247 million and have a market value of about

$352 million.

We explained the reasons for our WPPSS purchases in the 1983

annual report, and are pleased to tell you that this commitment

has worked out about as expected. At the time of purchase, most

of our bonds were yielding around 17% after taxes and carried no

ratings, which had been suspended. Recently, the bonds were

rated AA- by Standard & Poor’s. They now sell at levels only

slightly below those enjoyed by top-grade credits.

In the 1983 report, we compared the economics of our WPPSS

purchase to those involved in buying a business. As it turned

out, this purchase actually worked out better than did the

general run of business acquisitions made in 1983, assuming both

are measured on the basis of unleveraged, after tax returns

achieved through 1988.

Our WPPSS experience, though pleasant, does nothing to alter

our negative opinion about long-term bonds. It only makes us

hope that we run into some other large stigmatized issue, whose

troubles have caused it to be significantly misappraised by the

market.

<B>Arbitrage</B>

In past reports we have told you that our insurance

subsidiaries sometimes engage in arbitrage as an alternative to

holding short-term cash equivalents. We prefer, of course, to

make major long-term commitments, but we often have more cash

than good ideas. At such times, arbitrage sometimes promises

much greater returns than Treasury Bills and, equally important,

cools any temptation we may have to relax our standards for long-

term investments. (Charlie’s sign off after we’ve talked about

an arbitrage commitment is usually: “Okay, at least it will keep

you out of bars.”)

During 1988 we made unusually large profits from arbitrage,

measured both by absolute dollars and rate of return. Our pre-

tax gain was about $78 million on average invested funds of about

$147 million.

This level of activity makes some detailed discussion of

arbitrage and our approach to it appropriate. Once, the word

applied only to the simultaneous purchase and sale of securities

or foreign exchange in two different markets. The goal was to

exploit tiny price differentials that might exist between, say,

Royal Dutch stock trading in guilders in Amsterdam, pounds in

London, and dollars in New York. Some people might call this

scalping; it won’t surprise you that practitioners opted for the

French term, arbitrage.

Since World War I the definition of arbitrage - or “risk

arbitrage,” as it is now sometimes called - has expanded to

include the pursuit of profits from an announced corporate event

such as sale of the company, merger, recapitalization,

reorganization, liquidation, self-tender, etc. In most cases the

arbitrageur expects to profit regardless of the behavior of the

stock market. The major risk he usually faces instead is that

the announced event won’t happen.

Some offbeat opportunities occasionally arise in the

arbitrage field. I participated in one of these when I was 24

and working in New York for Graham-Newman Corp. Rockwood & Co.,

a Brooklyn based chocolate products company of limited

profitability, had adopted LIFO inventory valuation in 1941

when cocoa was selling for 5&cent per pound. In 1954 a

temporary shortage of cocoa caused the price to soar to over

60&cent. Consequently Rockwood wished to unload its valuable

inventory - quickly, before the price dropped. But if the cocoa

had simply been sold off, the company would have owed close to

a 50% tax on the proceeds.

The 1954 Tax Code came to the rescue. It contained an

arcane provision that eliminated the tax otherwise due on LIFO

profits if inventory was distributed to shareholders as part of a

plan reducing the scope of a corporation’s business. Rockwood

decided to terminate one of its businesses, the sale of cocoa

butter, and said 13 million pounds of its cocoa bean inventory

was attributable to that activity. Accordingly, the company

offered to repurchase its stock in exchange for the cocoa beans

it no longer needed, paying 80 pounds of beans for each share.

For several weeks I busily bought shares, sold beans, and

made periodic stops at Schroeder Trust to exchange stock

certificates for warehouse receipts. The profits were good and

my only expense was subway tokens.

The architect of Rockwood’s restructuring was an unknown,

but brilliant Chicagoan, Jay Pritzker, then 32. If you’re

familiar with Jay’s subsequent record, you won’t be surprised to

hear the action worked out rather well for Rockwood’s continuing

shareholders also. From shortly before the tender until shortly

after it, Rockwood stock appreciated from 15 to 100, even though

the company was experiencing large operating losses. Sometimes

there is more to stock valuation than price-earnings ratios.

In recent years, most arbitrage operations have involved

takeovers, friendly and unfriendly. With acquisition fever

rampant, with anti-trust challenges almost non-existent, and with

bids often ratcheting upward, arbitrageurs have prospered

mightily. They have not needed special talents to do well; the

trick, a la Peter Sellers in the movie, has simply been “Being

There.” In Wall Street the old proverb has been reworded: “Give a

man a fish and you feed him for a day. Teach him how to

arbitrage and you feed him forever.” (If, however, he studied at

the Ivan Boesky School of Arbitrage, it may be a state

institution that supplies his meals.)

To evaluate arbitrage situations you must answer four

questions: (1) How likely is it that the promised event will

indeed occur? (2) How long will your money be tied up? (3) What

chance is there that something still better will transpire - a

competing takeover bid, for example? and (4) What will happen if

the event does not take place because of anti-trust action,

financing glitches, etc.?

Arcata Corp., one of our more serendipitous arbitrage

experiences, illustrates the twists and turns of the business.

On September 28, 1981 the directors of Arcata agreed in principle

to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR),

then and now a major leveraged-buy out firm. Arcata was in the

printing and forest products businesses and had one other thing

going for it: In 1978 the U.S. Government had taken title to

10,700 acres of Arcata timber, primarily old-growth redwood, to

expand Redwood National Park. The government had paid $97.9

million, in several installments, for this acreage, a sum Arcata

was contesting as grossly inadequate. The parties also disputed

the interest rate that should apply to the period between the

taking of the property and final payment for it. The enabling