Letter to Shareholders

# 1979 Letter to Shareholders ## To the Shareholders of Berkshire Hathaway Inc. Inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital. It makes little difference whether you earn 12% on your equity if inflation is also 12%. In that situation, you have gained nothing in purchasing power, despite the fact that you may have paid substantial income taxes on your reported earnings. ## The Inflation Tax To illustrate the corrosive effect of inflation, consider the following example. If you have an investment that earns 12% annually and you are in a 50% tax bracket, your after-tax return is 6%. If inflation is running at 6%, you have earned nothing in real terms. If inflation is higher than 6%, you have actually lost purchasing power, even though you have paid taxes on your "gain." > "The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature." This reality has profound implications for equity investors. A company that earns a 15% return on equity may appear to be performing well. But if inflation is running at 15%, the business is not creating any real wealth for its shareholders. All of the reported earnings are merely an accounting illusion. ## The Mathematics of Inflation and ROE The relationship between return on equity and inflation determines whether a business is creating or destroying purchasing power. Consider a business with $100 million of equity capital earning a 12% return. It generates $12 million of earnings. If inflation is 12%, the business needs to retain all $12 million just to maintain its purchasing power. The equity base must grow by 12% just to stay even in real terms. But if the company pays out any dividends, it is actually distributing capital that should have been retained to maintain the business's real size. [[Charlie Munger]] and I have long focused on this dynamic. We seek businesses that can earn high returns on equity and that can reinvest those earnings at equally high rates. In an inflationary environment, only businesses with both high ROE and the ability to reinvest at high returns can build real wealth. ## Insurance Operations Our insurance operations faced significant challenges in 1979. The industry experienced severe underwriting losses as inflation drove up the cost of claims faster than premiums could be adjusted. [[GEICO]] continued to perform reasonably well, though the industry's overall struggles affected results. The key advantage GEICO maintains is its low-cost operating structure, which allows it to price more competitively than its rivals. The **insurance float** that we generate remains a valuable asset. However, the value of float is diminished when underwriting losses exceed the investment income that float generates. We must maintain underwriting discipline to ensure that float is truly a source of profit rather than a cost. ## Energy and Inflation The energy crisis of the 1970s has been a primary driver of inflation. Oil prices have increased dramatically, and these increases have rippled through the entire economy. Businesses that are energy-intensive face particularly difficult challenges. We have avoided investments in businesses that we believe will be permanently impaired by inflation. Instead, we focus on businesses with pricing power—the ability to raise prices in line with or ahead of inflation. Only such businesses can protect shareholders' purchasing power. ## Looking Forward We make no predictions about the future rate of inflation. We do know, however, that inflation is a powerful force that can destroy wealth rapidly. Our strategy is to own businesses that have the characteristics necessary to withstand inflationary pressures: 1. **Pricing power** — The ability to raise prices without losing customers 2. **Low capital intensity** — Businesses that don't require massive reinvestment to maintain their competitive position 3. **Strong market positions** — Businesses that dominate their markets and can maintain margins We believe this approach gives Berkshire the best chance of building real purchasing power for shareholders over time, regardless of what inflation does. Warren E. Buffett March 1980