Net worth grew $569 million in 1988, or 20.0%, and book value per share has compounded at 23.0% a year for 24 years. Buffett opens by explaining why neither number says much about the next 24.

Over the 24 years, intrinsic business value (the estimate of what all of Berkshire's businesses are worth) has grown somewhat faster than book value, though in 1988 book value grew the faster, by a bit. Both rates were achieved under circumstances far different from today's, and anyone ignoring the differences "makes the same mistake that a baseball manager would were he to judge the future prospects of a 42-year-old center fielder on the basis of his lifetime batting average." Four negatives follow (Exhibit 2): a less attractive stock market, higher corporate tax rates on most investment income, a far more richly priced market for buying whole businesses, and industry conditions for Cap Cities/ABC, GEICO, and The Washington Post, about half of Berkshire's net worth, that range from slightly to materially less favorable than five to ten years ago.

The major problem, though, is the growing capital base, a problem that, like age, grows in significance every year and, like age, is better kept than solved. Four years ago a 15% annual return over the decade ahead required profits of $3.9 billion. Today the same return over the next decade demands $10.3 billion (Exhibit 1). "That seems like a very big number to me and to Charlie Munger, Berkshire's Vice Chairman and my partner."

The partial offset is one Berkshire lacked 24 years ago, when all its capital was tied up in a textile business with inescapably poor economics. Today part of it sits in some really exceptional businesses. The Sainted Seven, so dubbed last year (the Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, the Scott Fetzer Manufacturing Group, See's, and World Book), came marching in: taken together with several smaller units, and with no help from leverage, the group earned about 67% on average equity capital. An exceptional franchise explains part of that in most cases, an exceptional management is vital in all of them, and "The contribution Charlie and I make is to leave these managers alone." The question mark, he says, is whether he and Charlie can put the money to good use. A step in the right direction came early in 1989 with Borsheim's (Lesson 03).

A rule change forced Berkshire to fold a savings and loan and a credit company into its main statements, which made them harder to read. Buffett's answer was to publish more, not less, and to say what a set of accounts is for.

His customary disclaimer comes first: despite the shortcomings of generally accepted accounting principles, he would hate the job of devising a better set. But the limitations need not be inhibiting. "CEOs are free to treat GAAP statements as a beginning rather than an end to their obligation to inform owners and creditors (and indeed they should)." A subsidiary manager who reported barebones GAAP numbers that left out what his boss needed would be in hot water, and the CEO's bosses are the shareholders (Exhibit 3). Many managements see GAAP as an obstacle to overcome instead, with accountants who oblige. ("How much," says the client, "is two plus two?" Replies the cooperative accountant, "What number did you have in mind?") Then there are the charlatans, few of whom are punished: "It has been far safer to steal large sums with a pen than small sums with a gun."

The 1988 change required Berkshire to consolidate Mutual Savings and Loan and Scott Fetzer Financial line by line, where before the two appeared, combined, as a single entry. The more economically diverse operations are lumped into one set of figures, the less useful the figures become, which is why the only reason Berkshire prepares consolidated statements at all is to meet outside requirements. So the report now adds four separate sets of accounts, for finance, insurance, manufacturing-publishing-retailing, and everything else (Exhibit 4). Add them up and you get the GAAP totals. The auditors in no way bless the presentation. They may be horrified. He does not want to ask.

A second change, expected in 1990, moves numbers without moving anything real. The tax Berkshire books against its insurers' unrealized stock gains is layered: 28% on the $1.2 billion built up through 1986 and 34% on the $600 million since. The new rule will apparently require the whole liability at 34%, cutting 1990 earnings, and so reported net worth, by $71 million if tax rates do not change. Neither rate precisely depicts reality, since Berkshire has no plans to sell the stocks holding the great bulk of its gains. To the uninterested he apologizes for the dissertation. Many hold Berkshire on faith, others on analysis, and in its own investing Berkshire looks for cases where both approaches give the same answer.

In 1983 Berkshire bought 80% of Nebraska Furniture Mart, and Buffett neglected to ask Mrs. B whether there were any more at home like her. There were. Early in 1989 Berkshire bought 80% of Borsheim's, the Omaha jewelry store run by her sister's family, on a one-page contract.

Mrs. B's sister Rebecca and Rebecca's husband Louis Friedman escaped Russia through Latvia in 1922, reached Omaha with no tangible assets, and in 1948 Mr. Friedman bought Borsheim's, a small Omaha jewelry store. His son Ike joined in 1950, then Ike's son Alan and sons-in-law Marvin Cohn and Donald Yale. The family brings to jewelry precisely the approach the Blumkins bring to furniture, built on Mrs. B's creed, "Sell cheap and tell the truth," and on five fundamentals (Exhibit 5): one huge store with an enormous selection, daily attention to detail by the top people, rapid turnover, shrewd buying, and incredibly low expenses. Mr. and Mrs. Friedman, 88 and 87, are in the store daily.

Most people, however sophisticated elsewhere, feel like babes in the woods buying jewelry, able to judge neither quality nor price, so only one rule makes sense: "If you don't know jewelry, know the jeweler." Berkshire took its own advice (Exhibit 6). Borsheim's had no audited statements, and Berkshire skipped the inventory count, the receivables check, and every other kind of audit. Ike simply told them what was so, they drew up a one-page contract, and they wrote a large check. Nothing changes in how the store is run. The buses after the annual meeting will stop there too. Be prepared for bargains.

The older branch keeps rolling. Mrs. B turned 95 on the eve of Hanukkah, 51 years into being the boss after starting with $500 at 44 (think what she would have done with $1,000), and Berkshire does not retire a superstar because "a cake gets crowded with candles." When Dillard's, one of the country's most successful department store operations, came to Omaha, its chairman announced that the new store would not sell furniture: "We don't want to compete with them. We think they are about the best there is." That is the most expensive compliment in retailing, a competitor deciding not to be one. Elsewhere, Stan Lipsey made Buffett's forecast of falling margins at the Buffalo News look foolish by improving them a tad, and See's earned a record 90% of its pre-tax profit in December.

Industry premiums grew an estimated 3.9% in 1988 while Buffett expects claims to grow about 10% a year, so underwriting losses are almost certain to mount, and probably to accelerate, for at least two more years. He explains why an industry that loses money gets the complaints too, and why Berkshire can sit this out.

He expects incurred losses to grow about 10% a year even when inflation runs considerably lower, so premium growth that materially lags that pace means underwriting losses, whose size the industry's habit of underreserving when business turns bad may obscure for a time. The loss grew in 1988, and the trend is almost certain to continue, and probably accelerate, for at least two more years. Then the irony (Exhibit 7). Breakfast cereal earns more than double the return on invested capital of auto insurance, which is why Kellogg and General Mills sell at five times book value while most large insurers sell close to book. Cereal makers raise prices regularly and not a peep is heard. Auto insurers raise prices by less than their costs rise, and customers are outraged. "If you want to be loved, it's clearly better to sell high-priced corn flakes than low-priced auto insurance."

The resentment has consequences. Proposition 103, a California initiative passed last fall, threatens to push auto insurance prices down sharply even though costs have been soaring. The cut is suspended while the courts review it, but the resentment is not. (Thank heavens the citizenry is not mad at bonbons: under the same rule See's would have to sell at $5.76 a pound instead of $7.60 and lose money by the bucketful.) The immediate direct effect on Berkshire is minor, since it saw few chances for profit in California's old rates. GEICO, 44% owned, gets about 10% of its premiums there and, as a low-cost producer earning high returns, has a huge amount of economic goodwill at risk if other states follow. If prices are ever held below cost, the chain runs one way (Exhibit 8): "If voters insist that auto insurance be priced below cost, it eventually must be sold by government."

Berkshire's own premium volume kept falling in 1988 and will drop a lot in 1989 for a special reason: the contract giving it 7% of Fireman's Fund's business ends and about $85 million of unearned premiums goes back, which will make one quarter look peculiar and profit look much the same. Its combined ratio, on a statutory basis and excluding structured settlements and financial reinsurance, was 104. Volume over the next few years is likely to run very low, since business with a reasonable potential for profit will almost certainly be scarce. "At Berkshire, we simply will not write policies at rates that carry the expectation of economic loss. We encounter enough troubles when we expect a gain." Low volume with an exceptional amount of float, which he expects to be at least three times the typical company's per premium dollar in 1989 and 1990, augurs well for profits (Exhibit 9). At some point, he does not know when, the deluge will come. Meanwhile: keep the talented professionals, protect the capital, and try not to make major mistakes.

The letter lists the common stocks worth over $100 million at year-end. The three permanent holdings are unchanged, and two large new positions, Coca-Cola and Freddie Mac, are expected to be held for a long time.

The insurers choose among five categories (long-term stocks, medium-term and long-term bonds, short-term cash equivalents, and short-term arbitrage), with no bias beyond the highest after-tax return by "mathematical expectation" among things Berkshire thinks it understands (Exhibit 10). The Freddie Mac shares, the maximum the law allows, sit in Mutual Savings and Loan, a non-insurance subsidiary, so they are carried at cost. The $700 million Salomon convertible preferred, a long-term investment carried at cost, is now estimated to be worth moderately more than cost. The parked money sits in about $800 million of medium-term tax-exempt bonds, almost all fully tax-exempt under the 1986 tax act, and in the WPPSS bonds, the only long-term bonds Berkshire holds, carried at $247 million and worth about $352 million. Practically all the Texaco bonds were sold during the year at a pre-tax profit of about $22 million. His aversion to long-term bonds is intact: he will warm to them when he warms to the prospects for the purchasing power of money, and that is not in the cards.

Watching the managers of the permanent holdings up close, and many other CEOs from a safe distance, leads Buffett to the supreme irony of business management: the bigger the job, the safer it can be to do it badly.

A secretary hired to type 80 words a minute who manages 50 loses her job in no time: there is a logical standard, performance is easily measured, and if you cannot make the grade you are out. New salespeople who fail to generate sufficient business quickly enough are let go, since "Excuses will not be accepted as a substitute for orders." A CEO who does not perform is frequently carried indefinitely (Exhibit 11). One reason is that performance standards for his job seldom exist, and when they do they are often fuzzy, waived, or explained away even when the shortfalls are major and repeated. At too many companies, he says, the boss shoots the arrow first and paints the bullseye around wherever it lands (Exhibit 12).

The second difference is that the CEO has no immediate superior whose own performance is being measured. A sales manager who keeps a bunch of lemons will soon be in hot water himself, so it is in his interest to weed out his hiring mistakes promptly, or be weeded out. But the CEO's boss is a board that seldom measures itself and is infrequently held to account for substandard results. If it hires wrong and perpetuates the mistake, so what? Even a takeover brought on by the mistake will probably reward the outgoing directors handsomely. And board relations are expected to be congenial, so a director who criticizes the CEO at a meeting has, in the eyes of the table, committed a breach of manners rather than performed his job.

None of this is a blanket condemnation. Most CEOs and directors are able and hard-working, and a number are truly outstanding. But the failings he and Charlie have seen make them thankful for Tom Murphy and Dan Burke at Cap Cities, Bill Snyder and Lou Simpson at GEICO, and Kay Graham and Dick Simmons at the Post: "They love their businesses, they think like owners, and they exude integrity and ability." The standard cuts the other way at home. Berkshire does not remove a superstar from its lineup for reaching the traditional 65, or the 95 Mrs. B reached in 1988, while its experience with newly minted MBAs has not been that great: terrific records, the right things to say, and too often little personal commitment or business savvy.

Berkshire bought big stakes in Coca-Cola and Freddie Mac in 1988 and expects to keep them a long time, then moved its own shares to the New York Stock Exchange with a request: trade them as little as possible, at a price that tracks the business.

When Berkshire owns part of an outstanding business run by outstanding people, he sees no reason ever to sell it. It is the opposite of those who hurry to sell and book profits when companies perform well but hang on tenaciously to businesses that disappoint, which Peter Lynch likens to cutting the flowers and watering the weeds (Exhibit 13). The investments stay concentrated in a very few companies Berkshire tries to understand well. There are only a handful of businesses about which Berkshire has strong long-term convictions, so when it finds one it wants to participate in a meaningful way. "We agree with Mae West: 'Too much of a good thing can be wonderful.'"

Berkshire's shares were listed on the New York Stock Exchange on November 29, 1988, mainly to cut transaction costs, and the spread between bid and asked prices has generally run well below the over-the-counter market's. Beyond that, the goals probably differ somewhat from most listed companies' in two respects (Exhibit 14). First, Berkshire does not want to maximize its share price. It wants the shares to trade in a narrow range centered on intrinsic business value, because both significant overvaluation and significant undervaluation give many shareholders results that differ sharply from the business's own. If the price instead consistently mirrors value, each owner's result roughly parallels Berkshire's during his holding period.

Second, it wants very little trading. Running a private business with a few passive partners, he would be disappointed if those partners and their replacements kept wanting to leave, and a public company feels no different. "At what other organization (school, club, church, etc.) do leaders cheer when members leave?" Some owners will need or want to sell, and Berkshire wants good replacements who pay them a fair price: people who understand the operations, share the time horizon, and measure the company as it measures itself. The specialist handling the stock, Henderson Brothers, is the oldest continuing specialist firm on the Exchange, and its progenitor bought his seat for $500 in 1861. Seats lately sold for about $625,000. Buffett does not say whether he considers that an adequate rate of return.

Arbitrage earned Berkshire about $78 million before tax in 1988 on about $147 million of average funds. Buffett explains how the game works with one deal that went wrong in nearly every way but the result, then turns 63 years of such returns on the professors who taught that the market cannot be beaten.

Once the word meant buying Royal Dutch in Amsterdam and selling it in New York for a tiny difference, which some might call scalping (practitioners preferred the French). Since World War I it has meant profiting from an announced event, a sale, merger, recapitalization, or liquidation. In most cases the arbitrageur expects to profit whatever the market does, and the major risk he usually faces is that the event does not happen. One offbeat case came at 24, when he worked for Graham-Newman and bought Rockwood & Co. shares to exchange each for 80 pounds of cocoa beans under a tax quirk: "The profits were good and my only expense was subway tokens." Four questions decide any such deal (Exhibit 15): how likely is the promised event, how long will the money be tied up, what chance is there of something better, and what happens if it falls through?

Arcata Corp. shows the twists (Exhibit 15). In September 1981 its directors agreed in principle to sell to KKR, a major leveraged-buyout firm, at $37 a share plus two-thirds of any additional amount the government might pay for 10,700 acres of redwoods it had taken for a national park, a claim Buffett, who cannot tell an elm from an oak, "coolly evaluated... at somewhere between zero and a whole lot." Berkshire bought over 7% of the company. The lenders then took a "second look," KKR cut its offer, and the directors accepted another group's $37.50 plus half the redwood recovery, paid in June 1982: $24.6 million on a cost of $22.9 million, a 15% annual rate he calls more than satisfactory given the trouble. The best came in 1988, when the claim settled for $519 million and Berkshire received another $29.48 a share, about $19.3 million. Berkshire's arbitrage differs from the trade's: a few, usually very large, deals a year rather than perhaps 50 or more, only publicly announced ones, no rumors. For 1989 it expects to sit out, since cash is down because long-term holdings are up and the takeover field shows extraordinary excesses. In Herb Stein's words, "If something can't go on forever, it will end."

Then the professors. Efficient market theory, almost holy scripture in academic circles during the 1970s, held that darts thrown at the stock tables pick as well as the brightest analyst, since prices already reflect everything public. "Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day." The rebuttal is 63 years of arbitrage at Graham-Newman, Buffett Partnership, and Berkshire, averaging 20% a year unleveraged from 1926 to 1956 and well over 20% since, across hundreds of securities (Exhibit 16). The market itself returned just under 10%, which turns $1,000 into $405,000. At 20% it becomes $97 million. No one, to his knowledge, has said he was wrong, and the theory remains part of the curriculum at major business schools, which suits him: in any contest "it's an enormous advantage to have opponents who have been taught that it's useless to even try." Then the warning. Arbitrage has looked easy lately, but it guarantees nothing. "An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline."