The 1978 merger forced Berkshire to add a pile of very different businesses (textiles, insurance, candy, newspapers, trading stamps) into one giant set of figures. Buffett's first move is to warn you that the giant figure, on its own, tells you almost nothing.

The accounting rules now made Berkshire lump everything together as if it were a single company. Buffett found that unhelpful, even misleading: a blended total of a candy maker, a textile mill, a bank, and an insurer describes none of them. The rules require him to print that combined figure. They stop short of requiring anyone to believe it. So instead he breaks the year into pieces and reports each business separately, the way he actually watches them.

He keeps two scoreboards. The first asks how well the businesses ran this year: in 1978 they earned about 19 cents for every dollar of the owners' money, almost exactly last year's pace and within a whisker of Berkshire's record. The second, slower scoreboard adds in the gains and losses on its investments, which swing with the market and belong to the long story, not a single year. Together the two had nearly doubled the worth of each slice of Berkshire in three years. Buffett's reaction is not to celebrate but to say, plainly, that neither pace can last.

Textiles, Berkshire's original business, did better in 1978 than the year before, earning about $1.3 million after tax. But it sat on $17 million of capital, so the return was thin. Buffett uses it to explain why some businesses are simply hard, no matter how good the managers are.

A year ago Buffett sorted his businesses into headwinds and tailwinds and filed cloth firmly among the headwinds. Here he says plainly what makes this wind blow so hard. Cloth is a commodity: one company's is much like another's, so buyers chase the lowest price. Whenever there is plenty to go around, prices sink until they barely cover the day-to-day cost of making it, leaving almost nothing to reward the money locked up in the factory. Buffett's managers chase every sensible fix: better products, cheaper production, smarter use of people. The trouble, he notes drily, is that the competitors are just as diligently doing the same thing.

He keeps the mills running anyway, and is honest about why: they are important employers in their towns, the managers report problems straight, the workers cooperate, and the business should at least throw off modest cash. But he does not dress it up. He hopes, he says, not to buy many more businesses with economics this tough.

Insurance was Berkshire's biggest moneymaker in 1978, and its best unit turned in the kind of underwriting profit the industry rarely sees. Buffett's response is not a victory lap. He warns that the good times are already ending.

1978 was a fine year mostly because the whole industry was flying, and that rarely lasts. He sounded this very warning a year ago, at the top of the boom. Now he can see the downturn arriving. Buffett does the arithmetic that matters. Heading into 1979, car-insurance prices were rising only about 3% a year, while the costs insurers must pay (car repairs and medical care) were climbing more than 9%. When costs rise faster than prices, the profit gets squeezed out. He expects results to worsen, and points out that every insurer thinks it will beat the others, so someone is bound to be disappointed. His caution is constitutional: he even tells shareholders that his own plans to expand insurance should be met with something less than "unrestrained joy," since a few earlier attempts turned into "expensive failures."

Two years earlier the picture had been the reverse: prices had jumped far ahead of costs, and that favorable gap was what kept the industry flying into 1978. Now it had flipped the other way.

Berkshire's insurers held a growing pile of cash, and Buffett spent the late 1970s putting it into shares of outstanding companies. The thing he kept marveling at: the stock market would sell him a small piece of a superb business for less than buyers were paying to own ordinary businesses whole.

Good prices are rare, so Buffett waits. But the mid-1970s were unusually kind to a patient buyer. As the overall market drifted sideways for three years (the Dow actually slipped a little), he quietly loaded up, multiplying the insurers' stock holdings more than fivefold.

His favorite example was SAFECO, in his view the best-run large home-and-car insurer in the country: better than Berkshire's own insurance arm, better than anything he could build or buy outright. Yet he bought his shares for less than the company's net worth per share, under 100 cents on the dollar, while buyers elsewhere were paying far more than that for plainly mediocre companies.

Here is what Berkshire paid for its largest shareholdings, several of them familiar from last year's letter, beside what they were worth at the end of 1978.

Owning a sliver of SAFECO meant Buffett had no say in running it. He did not mind in the least. The people there did the job better than he could, so the only thing he gave up by sitting back was the excitement and prestige of being in charge. It was the same case he made a year earlier for buying a piece of Capital Cities rather than the whole of it: when the managers are first-rate, the smart move is to stay out of their way.

Here Buffett makes a subtle point that most investors miss. When a company you partly own keeps its profits instead of mailing them to you, that money has not vanished. If the company reinvests it well, your slice is quietly worth more.

Take SAFECO again. Of Berkshire's slice of its 1978 profit, only the small part paid out as dividends showed up in Berkshire's reported earnings. The far larger rest stayed inside SAFECO to be put back to work. Buffett counts that kept-back share as every bit as real as cash in hand, because a well-run company can often turn a retained dollar into more than a dollar of future worth. He feels the same about the businesses he owns outright: he is glad for them to keep every cent, so long as they can use it well.

The rule cuts both ways, he warns. If a business has no good use for the cash, or a manager keeps pouring it into low-return projects, then the profit should be paid out or used to buy back shares. Keeping money is only a virtue when the company can make it grow, a test more managers claim to pass than actually do.

Running through the whole letter is Buffett's affection for a certain kind of manager: the sort who treats the business as if every dollar were their own. In 1978 his favorites were, to put it kindly, experienced.

Gene Abegg, 81, had opened the Illinois National Bank back in 1931 and still ran it. One of last year's quiet winners, it earned roughly three times what the big banks managed on each dollar of assets, while taking less risk. Ben Rosner, 75, had run Associated Retail Stores since 1931, when he and a partner opened a single Chicago shop with $3,200, and still wrung fat returns from it. Louie Vincenti, 73, ran Wesco. Buffett notes, deadpan, that to a stranger this lineup might look less like a management team and more like a quiet protest against the rules on age discrimination.

It is the same lesson hiding behind SAFECO. When the people in charge are excellent, owning a piece and leaving them to it beats taking over and meddling. What Buffett prizes is not control but managers who think like owners by instinct. He also mentions, almost in passing, that Berkshire would have to give up the bank by the end of 1980 (the law required it), most likely by handing it straight to shareholders.