To the Shareholders of Berkshire Hathaway

# 1985 Letter to Shareholders ## To the Shareholders of Berkshire Hathaway Inc. Our operating earnings in 1985 were $161.9 million, or $137.81 per share—a new record. This performance occurred against a backdrop of a lackluster year for the overall market, but it reflects the earnings power of businesses we own rather than market movements. ## The Capital Allocation Imperative One of the most important responsibilities of corporate management—particularly the CEO of a company with significant cash flow—is **capital allocation**. This is the process of determining where to invest the company's resources to maximize long-term value for shareholders. Poor capital allocation can destroy even an excellent underlying business. Conversely, superior capital allocation skills can generate enormous value over time. > "The heads of many companies are not paid to allocate capital, but they should be. A CEO who makes poor capital allocation decisions may be paid well for the short-term earnings he reports, but he is actually stealing value from shareholders." ## Owner Earnings: The True Measure In last year's letter, I introduced the concept of "owner earnings." This year, I want to elaborate on why I believe it is the most accurate measure of Berkshire's true earnings power. **The formula is simple:** Owner Earnings = Reported Earnings + Depreciation/Amortization/Depletion − Required Capex This differs from GAAP earnings because accounting cannot perfectly capture the economic reality of businesses that require ongoing capital investment to maintain their competitive position. For a business like See's Candies, the required capex to maintain the business is modest relative to reported earnings, so owner earnings are close to reported earnings. For a business requiring massive ongoing reinvestment (think commodity businesses), owner earnings can be far below reported earnings. ## Share Repurchases: When They Make Sense One of the most underused capital allocation tools is the share repurchase. If a company's shares trade consistently below intrinsic value, repurchasing them is the most efficient use of capital. At Berkshire, we have repurchased shares when they have traded at prices we believed were significantly below intrinsic value. Each share repurchased increases the ownership stake of remaining shareholders. > "Buy a dollar of earnings for 80 cents. If you do this repeatedly, you will become rich." ## The Munger Framework [[Charlie Munger]] has been a thought partner in developing these ideas. He has emphasized that the key to compounding is not to do many things well, but to do a few exceptional things. This is the framework that guides our acquisition strategy. When we bought See's Candies in 1972, we paid $25 million for a business earning $4.2 million after tax. We have since earned over $180 million from this business without any significant additional capital investment. This is the power of acquiring businesses with genuine economic goodwill. The lesson: the best capital allocation decision is often to pay a fair price for an excellent business rather than a bargain price for a mediocre one. ## Conclusion Our job is to allocate capital where it will earn the highest returns over the long run. When we cannot find attractive reinvestment opportunities, we will return capital to shareholders through dividends or repurchases. When we find businesses of exceptional quality at reasonable prices, we will invest heavily. Warren E. Buffett March 1986