Net worth grew $464 million in 1987, or 19.5%, and Buffett spends his opening pages on a claim every CEO makes and few can back: that his managers are remarkable. He proves it with one number, and it is not the earnings.

Book value per share has compounded at 23.1% a year for 23 years, and Buffett says business value has grown moderately faster, in 1987 as over the past decade, for two simple reasons: "We own some remarkable businesses and they are run by even more remarkable managers." He knows that second claim is the kind CEOs make all the time, oftentimes in a warm closing paragraph about "our most precious asset" after pages of woeful results. So he offers arithmetic. The seven units in Exhibit 1 earned $180 million before interest and taxes on equity of only $175 million, and with net interest of just $2 million, their after-tax earnings as one company would have been about $100 million, a return of about 57% on equity capital.

For scale, Fortune's 1988 Investor's Guide found that among the 500 largest industrial and 500 largest service companies, only six had averaged a return on equity over 30% during the previous decade, and the best, Commerce Clearing House, managed 40.2%. Berkshire's own return on the seven is lower, because it bought them at a substantial premium: they sit on its books about $222 million above the historical values of their assets. That is Berkshire's affair, not the managers' (Exhibit 2). "[W]hat we pay for a business does not affect the amount of capital its manager has to work with."

Three things follow: the seven are worth far more than their book value or their carrying value, they can grow while making almost all of their earnings available for new opportunities, and they are run by truly extraordinary people, who have given Berkshire far more than it deserves. (Buffett accepts the inequity in the spirit of Jack Benny receiving an acting award: "I don't deserve this, but then, I have arthritis and I don't deserve that either.") Buffett and Munger hold no corporate meetings, set no corporate budgets, and conduct no performance reviews, and he thinks it probably fair to say that if they did more, less would be accomplished. What they supply is informed applause, and for 1987 only one response is appropriate: "sustained, deafening applause."

There is not a lot new to report about Berkshire's businesses, and Buffett calls that good news. Most investors pay their highest prices for exotic companies promising feverish change. The record says the money is usually made by companies doing much what they did ten years ago.

Most investors behave as if the opposite were true, conferring the highest price-earnings ratios on exotic-sounding businesses. His verdict: "For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be." That is no argument for complacency, since businesses always have service, products, and methods to improve. But the Fortune study makes the point (Exhibit 3). Of the 1,000 largest industrial and service companies, only 25 passed two tests of economic excellence, an average return on equity over 20% from 1977 through 1986 and no year worse than 15%, and 24 of those 25 outperformed the S&P 500 over the decade.

The champions surprise in two ways (Exhibit 4). Most use very little leverage compared with their capacity to pay interest. "Really good businesses usually don't need to borrow." And apart from one high-tech company and several makers of ethical drugs, they are in businesses that, on balance, seem rather mundane, most of them selling non-sexy products much as they did ten years ago, in larger quantities, at higher prices, or both. Berkshire's managers, likewise, protect their franchises, control costs, build on existing strengths, and do not get diverted. "Our managers have produced extraordinary results by doing rather ordinary things (but doing them exceptionally well)."

The update bears it out. Nebraska Furniture Mart's sales rose 8% to $142.6 million, and Mrs. B, 94, still works seven days a week and is, Buffett says, gathering speed, so he has persuaded the board to scrap its mandatory retirement-at-100 policy. See's sold slightly under 25 million pounds, a new high, and held same-store pounds virtually unchanged for a second year after six years of decline. Fechheimer's earnings rose substantially. Scott Fetzer's pre-tax earnings rose 10% on significantly less capital, and World Book brought out its most dramatically revised edition since 1962, with 24,000 color photos in place of 14,000.

Cutting the Buffalo News's news hole from 50% to 40% would save approximately $4 million a year in newsprint. Buffett says that interests Berkshire not at all, and explains why a budget that flexes with the profit line is neither business-like nor humane.

Among dominant papers of its size or larger, the News leads the country in penetration and in news hole, and it may not be coincidence, Buffett suggests: "an exceptionally 'newsrich' product makes for broad audience appeal, which in turn leads to high penetration." The news hole was about 50% in 1987, as year after year, and a typical 40% would save approximately $4 million annually (Exhibit 5). It will not happen even if margins significantly shrink, and he says they will. For several years he has incorrectly predicted that the News's margins would fall, and this year, with newsprint costs skyrocketing, margins "will, without question, shrink in 1988 and profit may fall as well."

He and Munger do not believe in flexible operating budgets, the kind where expenses can be X if revenues are Y but must be cut if revenues fall 5% (Exhibit 6). Should the News cut its news hole, or See's its quality and service, because profits are down for a quarter? Should Berkshire add a staff economist, a corporate strategist, or an institutional advertising campaign because money is rolling in? "That kind of yo-yo approach is neither business-like nor humane." The goal is to do what makes sense for customers and employees at all times and never to add the unneeded. (Asked rudely about the corporate jet, he concedes that occasionally a man must rise above principle.)

Mrs. B runs the same policy from the other side of the counter (Exhibit 7). Nebraska Furniture Mart's customers saved about $30 million in 1987 by buying there rather than elsewhere, and an anonymous letter signed "A Competitor" arrived in August urging Buffett to raise prices, since the store was "leaving 10% to 20% on the table," some $28 million. NFM will keep following Mrs. B's maxim instead: "Sell cheap and tell the truth." At See's, when 14 of about 100 varieties were culled last spring, many hundreds of letters arrived, one wishing a pox on all involved, and Chuck Huggins brought back the two that were badly missed, with an honest explanation and a gift certificate for every writer.

The three permanent holdings were worth over $2 billion at year-end against $573 million paid, and Buffett says Berkshire would not sell them even if they became far overpriced. The year's largest investment was $700 million of Salomon preferred stock.

Cap Cities/ABC, GEICO, and The Washington Post are viewed exactly like Berkshire's controlled businesses, a permanent part of the company rather than merchandise to be sold once Mr. Market offers a high enough price, with one qualifier: the insurers hold them and would, if absolutely necessary, sell portions to pay extraordinary losses, which he intends never to be required (Exhibit 8). Berkshire's only other common stock position over $50 million was an arbitrage holding (shares of a company in an announced takeover, held for the small gap to the deal price), Allegis, at $76 million cost and $78 million market. The insurers' main parking place is around $900 million of medium-term tax-exempt bonds. The Washington Public Power Supply System bonds (WPPSS) are carried at $240 million, worth $316 million, and pay $34 million a year tax-free, and defaulted Texaco bonds bought after the bankruptcy filing are carried at $104 million and worth $119 million. The largest and most publicized investment was $700 million of Salomon Inc 9% convertible preferred, a preferred stock that can later be exchanged for common shares, from most standpoints a medium-term fixed-income commitment with an interesting conversion possibility and, in John Gutfreund, a chief executive Buffett and Munger like, admire and trust.

Ben Graham, Buffett's friend and teacher, taught him to imagine every market quotation as coming from a remarkably accommodating partner named Mr. Market. In the year the market went on a manic rampage and then had a seizure, Buffett retells the lesson.

Buffett and Munger buy stocks for the insurers as if buying into a private business, weighing the economic prospects, the people, and the price, with no time or price for sale in mind: "When investing, we view ourselves as business analysts (not as market analysts, not as macroeconomic analysts, and not even as security analysts)." Exhibit 9 draws Graham's Mr. Market. Euphoric, he names a very high price because he fears you will snap up his interest. Depressed, he names a very low one because he is terrified you will unload yours on him. Transactions are strictly at your option, so "the more manic-depressive his behavior, the better for you." The warning is Cinderella's: fall under his influence and everything turns into pumpkins and mice, and if you are not certain you can value the business far better than he can, you do not belong in the game.

The year tested the allegory. The Dow rose 2.3% in 1987 after a roller coaster: "Mr. Market was on a manic rampage until October and then experienced a sudden, massive seizure." For most of the turmoil Buffett credits the "professional" investors who manage many billions, many of whom now study what other money managers will do in the days ahead rather than what businesses will do in the years ahead. Portfolio insurance is the extreme case (Exhibit 10): a rule that sells more stock the further prices fall and buys it back once they rebound, with $60 billion to $90 billion poised on that hair trigger in mid-October, according to the Brady Report. Many commentators who say the small investor now has no chance are dead wrong: such markets are ideal for anyone who sticks to his investment knitting. Berkshire found a few stocks interesting during the October break but could not buy meaningfully before they rebounded.

It took Buffett, "always a quick study," only 20 years to learn that buying good businesses beats buying bargains. The lesson holds whether Berkshire owns all of a company or a sliver of it, and the sliver sometimes comes absurdly cheap.

Berkshire lets its stocks tell it by their operating results, not their price quotations, whether an investment is working, because, as Graham said, "In the short run, the market is a voting machine but in the long run it is a weighing machine." Holdings are sold when the market overvalues them or when the money is needed for something still cheaper, never merely because they have gone up. For the three permanent holdings even that is off the table: he would rather earn X alongside people he strongly likes and admires than 110% of X without them. He and Munger have found that "making silk purses out of silk is the best that we can do," and that with sow's ears they fail. His own education in sow's ears took 20 years and included short-line farm implement makers, third-place department stores, and New England textile mills.

Control brings two advantages. The first is capital allocation: Berkshire decides where a controlled company's earnings go, and many CEOs are not skilled at that. It is as if a gifted musician's final step were not Carnegie Hall but the chairmanship of the Federal Reserve, and after ten years a CEO retaining 10% of net worth annually has deployed more than 60% of the capital in the business. The second is taxes: a given business result can now deliver Berkshire as much as 50% more from an 80%-or-greater holding. Against that stands one huge advantage of the market (Exhibit 11): it occasionally sells non-controlling pieces of extraordinary businesses at truly ridiculous prices. Berkshire paid $5.63 a share for The Washington Post in 1973, and in 1987 the Post earned $10.30 a share after tax. GEICO cost an average of $6.67 a share in 1976, 1979 and 1980 and earned $9.01 in 1987. "In cases such as these, Mr. Market has proven to be a mighty good friend."

The accounting is schizophrenic about all this (Exhibit 12). The three permanent holdings are worth over $2 billion but produced only $11 million of reported earnings in 1987, because the rules count only the dividends they pay, while Berkshire's share of their actual earnings was well over $100 million. Yet the same rules carry them at market value on the balance sheet. Controlled companies get the reverse: full earnings in the income account, and asset values that never change however much the business has grown. Buffett ignores the GAAP figures (GAAP being the standard accounting rulebook) and keeps his own idea of business value, independent of the books and of a sometimes foolish market.

The industry's combined ratio fell to an estimated 104.7 and 1987 was a banner year, the one that strong revenue gains in 1985 through 1987 almost guaranteed. The quarterly numbers show those gains fading, and Buffett explains why Berkshire can stand aside while the crowd rushes back in.

Best's estimates the year-over-year volume gains at 12.9%, 11.1%, 5.7%, and 5.6% by quarter (Exhibit 13), against the about 10% a year Buffett believes the industry needs just to hold its own. In 1988 the revenue gain is certain to fall far below that. "Clearly, the party is over." Earnings will not sink at once, because most policies run a year and a price change takes many months to reach earnings: when the party ends and the bar closes, you are allowed to finish your drink. Most managers in commodity industries abhor the only conditions that give them good returns, and plugged this shortage as fast as they could, confirming Disraeli's observation that what we learn from history is that we do not learn from history.

Berkshire's first escape is financial strength exceeding anyone's in the industry. It means nothing in personal lines, where a failed insurer's claims get paid anyway, and often nothing in commercial lines, where in good times many big corporate buyers and their brokers pay scant attention to whether a claim can be paid five years later. But periodically buyers recall Ben Franklin's observation that it is hard for an empty sack to stand upright, and among the few insurers they can then trust, Berkshire will lead the pack, he says. The second escape is indifference to volume: Berkshire will be perfectly willing to write five times as much business in 1989 as in 1988, or one-fifth as much. Three features of insurance allow it (Exhibit 14): market share is not an important determinant of profitability, in most of the sectors Berkshire writes the distribution channels are not proprietary, and idle capacity is mostly people, so Berkshire can run at quarter-speed much of the time.

A broker who has long been a Berkshire shareholder showed the consequences in 1987 (Exhibit 15). When the market softened dramatically, he found lower prices elsewhere, placed all his business there, and bought more Berkshire stock: had Berkshire been really competitive, he said, it would have had his insurance business, and he would not have bought the stock. Berkshire's own combined ratio, on a statutory basis and excluding structured settlements and financial reinsurance, was 105, somewhat worse than 1986's 103, but profitability improved materially on far more float. He urges suspicion of every insurer's earnings, Berkshire's included: auditors certify figures they know may differ dramatically from true earnings, and he would have their opinion letter admit that they "can express no opinion about the accuracy of these figures." The tax news got worse too: the 1987 Bill cut the dividends-received credit from 80% to 70%.

Shortly after year-end Berkshire borrowed $250 million for 30 years at slightly over 10%, and is earning about 6½% on the proceeds. The gap costs about $160,000 a week, and Buffett calls it unimportant. The letter explains why Berkshire borrows before it needs to, and how much it is willing to borrow at all.

Berkshire could likely raise its return on equity with a much higher, though still conventional, ratio of debt to business value. But they do not wish it to be only likely that Berkshire can meet its obligations. They wish it to be certain. The policies are set for acceptable results under extraordinarily adverse conditions rather than optimal results under normal ones, and the welfare of innocent bystanders such as policyholders and employees is part of what must not be risked. Nor is it a phobia: Berkshire is willing to borrow an amount it believes, on a worst-case basis, poses no threat to its well-being, and its diverse businesses, their small need for capital, and its large liquid holdings mean it could carry more debt than it does.

The timing rule is the interesting part (Exhibit 16). The chances to act well on the two sides of the balance sheet rarely coincide: tight money, which makes borrowing dear, brings the best acquisition opportunities, and cheap money bids assets to the sky. So action on the liability side should sometimes be taken independent of the asset side. Since Buffett cannot forecast interest rates and, in his usual open-minded spirit, believes no one else can, Berkshire simply borrows when conditions seem non-oppressive and waits. "Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun." The $250 million raised at 10% now earns about 6½% (Exhibit 17), a negative spread of about $160,000 a week that will not push Berkshire into a hasty acquisition or higher-yielding short-term paper. If the right business elephant appears within five years or so, the wait will have been worthwhile.

The ad runs again: at least $10 million of after-tax earnings, consistent earning power, good returns on little or no debt, management in place, a simple business, and a price named up front, with an answer customarily within five minutes. Berkshire would also like large but non-controlling blocks of stock like those in Cap Cities and Salomon. And a bit of deja vu: in 1962 Charlie pointed Buffett to Harry Bottle, who had Dempster Mill's problems disappearing within a week, and 24 years later Charlie called him himself, at 68, for K&W Products, where 1987 profits set a record, up more than 300%, with receivables and inventories down 20%. If a managerial problem turns up in ten or twenty years, you know whose phone will ring.