To the Shareholders of Berkshire Hathaway Inc.

# 1978 Letter to Shareholders ## To the Shareholders of Berkshire Hathaway Inc. First, a few words about accounting. The merger with Diversified Retailing Company (DRC), completed in late 1976, and the resulting ownership in Blue Chip Stamps, now requires some explanation of how these transactions affect our reported results. In 1978, we fully consolidated the results of Blue Chip Stamps for the first time, which affects the comparability of our financial statements with prior years. Rather than treating Blue Chip as an equity investment, we now present it as a wholly-owned subsidiary. This changes the face of our financial statements but not our underlying economic reality. ## Operating Performance Operating earnings in 1978 were $21.90 million, or $22.54 per share, a moderate improvement from the previous year. Return on equity reached 19.8%—our best performance since 1972 and well above the average for American industry. The improvement was led by outstanding performance at [[GEICO]], where [[John Byrne]]'s management team continued to restore the company's fortunes. Insurance operations company-wide produced excellent results, with the cost discipline instilled by [[Phil Liesche]]'s group yielding superior underwriting profits. ## The Economics of Insurance The insurance business has one characteristic that makes it unique among all businesses: **float**. Float is the money we hold that belongs to others. Premiums are collected upfront; claims are paid later. During the interval, we invest this money for our benefit. If our float costs us nothing—if we break even on underwriting—we effectively have a zero-cost source of investment capital. In 1978, our total insurance float grew to approximately $76 million. The cost of this float was approximately zero, meaning we earned investment income on capital that did not require us to pay interest or dilutive share issuance. > "The insurance business is ideally suited to our investment philosophy. We collect money today, invest it wisely, and pay claims later. If we do this well, the float becomes a source of zero-cost capital that compounds over time." Our goal in insurance is simple: earn an underwriting profit while growing our float. Both objectives require discipline. Underwriting profit requires us to reject business that does not meet our standards. Float growth requires us to maintain financial strength so that we can write more premium when competitors become weak. ## GEICO: The Moat Confirmed [[GEICO]]'s recovery accelerated in 1978. The company earned underwriting profits for the first time since the crisis of 1975, and its investment portfolio continued to grow. What makes GEICO extraordinary is not any particular management decision—it is the company's **structural competitive advantage**. GEICO sells directly to consumers, eliminating the agent commission that represents 10-30% of premium at traditional companies. This gives GEICO a durable cost advantage that competitors cannot easily replicate. [[John Byrne]] recognized that this advantage must be protected above all else. He turned down opportunities to grow premium volume through agents or through partnerships with other insurers—opportunities that would have generated short-term revenue but eroded the direct-marketing model that is GEICO's foundation. > "GEICO's competitive position is the strongest I have seen in any property-casualty insurer. The direct-marketing system, the low-cost structure, the brand recognition among federal employees—these are advantages that compound over time. We intend to protect and extend them." ## Owner Earnings vs. Reported Earnings I want to explain an important distinction that affects how you should evaluate our results: the difference between **owner earnings** and reported accounting earnings. Reported accounting earnings are determined by rules—generally accepted accounting principles—that were designed for a different purpose: to make it difficult for companies to mislead creditors and investors. They are not designed to measure the actual economic value created or destroyed by a business. Owner earnings represent: 1. Reported earnings 2. Plus depreciation, depletion, amortization, and certain other non-cash charges 3. Less the average annual amount of capital expenditures required to maintain the long-term competitive position and unit volume of the business This last item—the capital maintenance charge—is the crucial one. A business that requires large ongoing capital investments to maintain its position is worth less than a business that can generate the same earnings with minimal reinvestment. > "The true earnings of a business are what can be taken out of it while maintaining its long-term competitive position. A business that requires constant capital infusion to stand still is not really earning what it appears to earn." By this measure, our businesses perform well. Insurance operations require minimal capital to maintain their competitive positions. Our retailing businesses generate substantial cash relative to their reported earnings. And [[GEICO]], once its turnaround is complete, will be an extraordinary cash-generating machine. ## Blue Chip Stamps and Diversified Retailing The merger with DRC and the consolidation of Blue Chip Stamps simplified our corporate structure. [[Charlie Munger]]'s retailing businesses—Sunbeam, The Buffalo News, and other well-known brands—now operate under the Berkshire umbrella, with management that shares our philosophy. Sunbeam faced challenges in 1978 as the appliance industry dealt with competitive pressures. But the underlying businesses—strong brands, nationwide distribution, experienced management—remain valuable. We will manage them patiently, extracting cash when possible and making capital investments only where returns are adequate. ## The Textile Question I continue to be candid about our textile business: it is a difficult industry with poor long-term economics. We manage it as well as possible, extracting cash and avoiding major capital investments that cannot earn adequate returns. Some observers suggest that I should close the textile operations entirely. This would be the "rational" decision if we were only considering financial returns. But the textile operations employ many people in New England communities that have few other employment options. We will continue to operate them as long as they generate positive cash flow, while being honest about the returns they produce. This is one of those cases where the economically "correct" decision conflicts with broader responsibilities. I have chosen to operate the business while honestly reporting its economics. ## Looking Forward 1979 should bring continued improvement in our financial results. Insurance operations should maintain their strength, [[GEICO]] should continue to recover, and our diversified retailing businesses should contribute meaningfully. The key to Berkshire's long-term success is the same as always: we will allocate capital to the businesses and investments that offer the highest return on invested capital, measured on an owner-earnings basis. Where we cannot find attractive opportunities, we will hold cash and wait. [[Charlie Munger]] continues to be my essential partner. His intellectual influence shapes every aspect of how we think about businesses, investments, and organizational culture. What we are building together will outlast us both. Warren E. Buffett March 1979