To Our Shareholders:
Consolidated "normal" operating income (i.e., before all unusual operating income and all net gains from sales of securities) for the caiendar year 1985- decreased to $8,347,000 ($1.17 per share) from $10,060,000 ($1.42 per share) in the previous year.
Consolidated net income (i.e., after unusual operating income and all net gains from sales of securities) increased to $51,541,000 ($7.24 per share) from $23,656,000 ($3.32 per share) in the previous year.
A highly unusual capital gain, of a not-likely-to-recur type, from disposition of General Foods stock caused most of the net income in 1985. The table below gives particulars.
Wesco has. three major subsidiaries, Mutual Savings, in Pasadena, Precision Steel, headquartered in Chicago and engaged in the steeI warehousing and specialty metal products businesses, and Wesco-Financial Insurance Company, headquartered in Omaha and currently engaged in the reinsurance husiness.
This supplementary breakdown of earnings differs somewhat from that used in audited financial statements, which follow standard accounting convention as interpreted from time to time by Wesco's outside auditor. The supplementary breakdown is furnished because it is considered useful to shareholders.
Mutual Savings
Mutual Savings' "normal" net operating income of $3,342,000 in 1985 represented a decrease of 4% from the $3,476,000 figure the previous year.
Separate balance sheets of Mutual Savings at yearend 1984 and 1985 are set forth at the end of this annual report. They show (1) total savings accounts rising to $269 million from $228 million the year before, (2) a very high ratio of shareholders' equity to savings account liabilities (probably the highest for any mature U.S. savings and loan association), (3) a substantial portion of savings account liabilities offset by cash equivalents and marketable securities, (4) a loan portfolio (mostly real estate mortgages) of about $83 million at the end of 1985, down 12% from the $95 million at the end of 1984, and (5) favorable effects of securities gains and other onusual gains and fluctuations, which caused net worth to decline only $4 million in 1985 despite payment of a dividend of $14 million to the parent corporation.
The loan portfolio at the end of 1985, although containing almost no risk of loss from defaults, bore a fixed average interest rate of only 7.60%, probably the lowest for any U.S. savings and loan assodation and far below the average interest rate which now must be paid to hold savings accounts. However, as the loan payoff pace intensified and interest rates declined sharply in 1985, the unrealized depreciation in the loan portfolio became approximately offset by unrealized appreciation in Mutual Savings' interest-bearing securities and preferred stocks.
As pointed out in footnote 13 to the accompanying financial statements, the book value of Wesco's equity in Mutual Savings ($57.6 million at December 31, 1985) overstates the amount realizable, after taxes, from sale or liquidation at book value. If all Mutual Savings' assets, net of liabilities, were to be sold, even pursuant to a plan of complete liquidation, for the $57.6 million in book value reported under applicable accounting convention, the parent corpuration would receive much less than $57.6 million aftertaxes, from sale or liquidation at book value. If all Mutual Savings' assets, net of liabilities, were to be sold, even pursuant to a plan of complete liquidation, for the $57.6 million in book value reported under applicable accounting convention, the parent corpuration would receive much less than $57.6 million after substantial income taxation imposed because about $47 million of what is designated shareholders' equity for accounting purposes is considered bad debt reserves for most tax purposes.
There is, however, a buried plus value in Mutual Savings. The foreclosed property on hand (mostly 22 largely oceanfront acres in Santa Barbara) has become worth over a long holding period much more than its $1.5 million balance, sheet carrying cost. Reasonable, community-sensitive development of this property has been delayed over 10 years in the course of administratior of land-use laws. But we are optimistic that an end to the delay is near and that the Santa Barbara and Montecito communities will be very pleased with the development now likely to go forward. This development will contain 32 houses interspersed with large open areas. Mutual Savings plans to make the development first rate in every respect and unique in the quality of its landscaping.
Balancing all merits and demerits, Mutual Savings, as it has been managed under present conditions by the writer and others, is no jewel of a business icon from the shareholders' point of view. Mutual Savings' good points are: (1) high asset quality and sound balance sheet; (2) a maturity match of interest-bearing assets and liabilities which makes risk of insolvency near zero, whatt·ver happens to interest rates; and (3) a deserved reputation for high quality service to account holders, achieved at below-average cost to the institution in an efficient one-large office operation, as distinguished from a many-small-branch-offices operation. Mutual Savings' bad points ere (1) all recent growth in savings accounts, considered on an incremental effects basis, has been loss business because interest and other costs incurred exceed income obtained by employing proceeds in short-term interest-bearing assets; (2) a burdensome position under the FSLIC account-insurance system causes payments of ever-higher amounts into the system to help bail out more venturesome savings and loan associations which become insolvent, with the payments being required despite the fact that Mutual Savings imposes almost no risk on FSLIC; (3) "normal" net operating income is below an acceptable rate of return on present book value of shareholders' equity, with such return reaching an acceptable level over recent years only with help from securities gains and other unusual items; (4) it would not be easy to leave the savings and loan business, should this course of action ever be desired, without a large income tax burden of a type not applied to corporations other than savings and loan associations; (5) the regulatory structure of the savings and loan business creates a competitive situation in which it is hard to make respectable profits·through careful operations; and (6) management has not yet found an acceptable remedy for any of the previously stated bad points, despite years of trying.
Moreover, comparisons of post-1984 financial results for Mutual Savings with results for many other and more typical savings and loan associations in California leave Mutual Savings looking inferior, to put it mildly. As interest rates went down these other associations, which have greater financial leverage and operated less fearfully than Mutual Savings during former high-interest periods, came to have loan and investment portfolios which (1) now are worth more on average than book value and (2) now produce a high return on book value of shareholders' equity, after deduction of operating expenses and interest to account holders at presen: rates Any Wesco shareholder who thinks Mutual Savings has any expertise in predicting and profiting from interest rate changes can look at the 1985 record and despair.
Despite the fact that some other savings and loan associations did much better after 1984 than Mutual Savings, and are now much better poised to report good figures for 1986, we plan to continue operating only in ways acceptable in our own judgment, anticipating as a consequence widely fluctuating and sometimes inadequate returns. In the future, however, Mutual Savings will make and purchase more loans. Now that Mutual Savings' old mortgage loans have declined in amount and increased in market value (the market value increase being caused both by a decline in generally prevailing interest rates and by a shortening of remainint, loan life), new loans will be added as seems wise, with a target that 60% of assets be in housing-related loans. The first new direct loan in some time, an adjustable rate mortgage with no cap on future interest rate changes but with an extremely low "spread" for the lender, will shortly be closed. We are not at all excited by our prospects as we now make housing loans of this type, but we wish to get some renewal of direct mortgage lending under way.
With assets not employed in direct real-estate planning, Mutual Savings continues not only to make payments to FSLIC far in excess of fair charges for risks imposed on FSLIC but also to employ a large part of total assets in short-term loans to the Federal Home Loan Bank. These practices are pro-social but will continue to increase profits.
Mutual Savings also continues to support the Federal Home Loan Bank Board in efforts to change the present rules of the savings and loan business to augment average soundness of FSLIC-Insured associations. We retain our opinion thot the present rules, despite some improvement in 1985 through wise efforts of the Federal Home Loan Bank Board, are unsound, from the country's point of view. Too much latitude is allowed financial "swingers" to grow as they gamble, through use of account guarantees from FSLIC, an agency of the U.S. Government, while they offer whatever it takes in interest rdtes to attract more accounts.
With money being the ultimate fungible commodity, it seems to us that the rules create a super-competitive, commodity-type business, in which (1) economic law probably destines most careful associations, like other fungible-commodity dealers, to realize very modest returns on shareholders' equity over extended time periods, yet (2) good financial results can nonetheless usually be reported in each near-term period by managers-in-charge through aggressive deposit-expanding, lending and investing measures which increase risk, while (3) the importance and rewards of managers, who mually have little downside risk as owners, are tied mostly to imtitutional size and recently reported numbers. With managers mostly being non-owners, a sort of Cresham's law of competitive-yet-deposit-insured banking, "bad loans drive out good" tends to work with extra force as managers fear being left out of whatever activity allows computing managers to report high profits while bidding hlgh for deposits. We see no reason for assuming that ethical, intelligent managers in the savings and loan industry are immune from effects similar to those which caused similar managers of all major U.S. banks to place significant portions of assets in now-regretted foreign loans, rather than stand apart from the crowd. If our diagnosis is correct, a sort of serious trouble lies ahead (perhaps far ahead) for U.S. savings and loan associations.
While present rules and practices have a positive side in causing satisfaction of almost 100% of demand for those housing loans which are sound at the prevailinis interest rule, this accomplishiment is accompanied by much unsound housing and other lending and by much unsound investment in "junk bonds" and other assets unsuitable for highly leveraged, federally insured, deposit-taking institutions. The system design in place would probably be a flunking design in an engineering course, where the emphasis would be on preserving the integrity of an essential system by a margin of safety, by being content with rules which (1) caused satisfaction of, say, only 95% of requests for sound credit extension and (2) forced more conservative conduct on banks and savings and loan associations.
The present design, we think, would probably also be a flunking design in a surgery course, where the wise practice is to remove some healthy cells along with cancerous cells, based on margin-of-safety principles, We hope we are wrong about the present design of the savings and loan system, but we fear increased, widespread adversity, ultimately reaching housing borrowers and would-be housing borrowers , whose interests we consider important. Any such adversity would probably be followed by changes in therules. No doubt, our judgment is to the probable temporary nature of present savings and loan industry structure, and practices has helped deter us from direct lending of a conventional sort which otherwise would have occured. Our attitude, right or wrong, during recent tumultuous changes in the savings and loan industry, has been roughly that of the French grandfather who replied when asked what he did in the great revolution: "I got through." 'We also think something good could eventually happen to Mutual Savings, because future trouble in the savings and loan industry may create opportunities worth seizing.
Precision Steel
Wesco's Precision Steel subsidiary, located in the outskirts of Chicago at Franklin Park, Illinois, was acquired for approximately $15 million on February 28, 1979. The price was roughly book value for a company which earned its inventories on a conservative LIFO accounting basis and which contained significant cash balances. More important, the company had reached its position from a modest beginning through maintenance of sound, customer-oriented business values inculcated over a long time by a gifted founder and his successors. Precision Steel owns a well-established steel service center business and a subsidiary engaged in the manufacture and distribution of tool room supplies and other soecialty metal pmducts.
Precision Steel's businesses contributed $2,010,000 to "normal" net operating income in 1985, down 1% compared with $2,034,000 in 1984. Such a modest decrease in 1985 profit was achieved in spite of decreased sales (down 7% to $51,124,000).
Under the skilled leadership of David Hillstrom, Precision Steel's businesses are now quite satisfactory, taking into account the financial leverage put into Wesco's consolidated picture incident to their acquisition.
Shortly after Wesco's purchase of Precision Steel, a substantial physical expansion of steel warehousing facilities was authorized, involving a new building in Charlotte, North Carolina. The new bullding and the whole North Carolina operation are now very successful contributing $9,140,000 to 1985 sales at a profit margin higher than has prevailed in the long-established Chicago headquarters facility.
Precision Steel's businesses, despite their mundane nomenclature, are steps advanced on the quality scale from mere commodity-type businesses. Many customers of Precision Steel, needing dependable supply on short notice of specialized grades of high-quality, cold-rolled strip steel, reasonable prices, technical excellence in cutting to order, and rememberance when supplies are short, rightly believe they have no fully comparable alternative in Precision Steel's market area. Indeed, many customers at locations remote from Chicago and Charlotte (for instance, Los Angeles) seek out Precision Steel's service.
Wesco remains interested in logical expansion of Precision Steel's businesses, using available liquid assets.
Wesco Financial Isurance Company
A new business was added to the Wesco group in 1985, in-coventure with Wesco's 80% owner and ultimate profit corporaition, Berkshire Hathaway.
With the enthusiastic approval of all Wesco's directors, including substantial Wesco shareholders in the Peters and Caspers families, without whose approval such action would not have been taken, Wesco invested $45 million in cash and cash equivalents in a newly organized, wholly owned, Nebraska-chartered insurance company, Wesco Financial Isurance Company (Wes-FIC).
The new subsidiary, Wes-FIC, then reinsured through another Berkshire Hathaway insurance company subsidiary as intermidinary without profit 2% of the entire book of insurance business of the long-established Fireman's Fund Corp listed on the NYSE.
Wes-FIC thereby assumed the benefits and burdens of Fireman's Fund's prices, costs and losses under a contract covering all insurance premiums earned by Fireman's Fund during a four-year period commencing September 1, 1985. The arrangement puts Wes-FIC in almost exactly the position it would have been in if it, instead of Fireman's Fund, had directly written 2% of the business. Differences in results should occur only from the investment side of insurance, as Wes-FIC, instead of Fireman's Fund, invests funds from "float" generated. Wes-FIC's share of premiums earned in 1986 ls expected to be over $60 million.
Wes-FIC's separate financial statements, covering the brief period of its existence, September 1, 1985, to December 31, 1985, are included on pages 29 and 30 of this Annual Report, and show that Wes-FIC experienced a small 1985 reduction in net worth, from $45,000,000 to $44,676,000.
We do not consider this four-month result to have significant predictive value with respect to the future. The price of insurance is rising, with price increases not yet fully reflected in 1985 numbers. Moreover, the financial statements are of questionable accuracy and could be wrong in either direction. It is in the nature of even the finest casualty insurance businesses that in keeping their accounts they must estimate and deduct all future costs and losses from premiums already earned. Uncertainties inherent in this undertaking make financial staterrnmts more mere "best honest guesses" than is typically the case with accounts of non-insurance-writing corporations. And this reinsurance portion of the casualty insurance business, because it contains one or more extra links in the loss-reporting chain, usually creates more accounting uncertainty than the non-reinsurance portion. Finally, Wes-FIC's initial financial statements have a disadvantage in that the period covered is short, making any use of the reported past cost-price ratio extra dubious as an indicator of any probable future cost-price ratio, due to the small size of the sample forming a base for projection.
It is entirely too soon to forecast future results, for Wes-FIC but Wesco hopes for: (1) a reasonable return on its investment over the four years of the Fireman's Fund reinsurance contract and (2) possible future reinsurance contracts with other insurers.
Wesco has high regard for John Byrne, newly appointed CEO and also a large shareholder and stock-option holder of Fireman's Fund. Mr. Byrne was an outstanding insurance company manager in his previous position as CEO of Geico Corporation (38% owned, but not controlled, by Berkshire Hathaway), which improved enormously during his stewardship. Fireman's Fund's insurance business is intrinsically more cyclical and less-advantaged than Geico's business, which has lower distribution costs from a different "direct-writing" distribution system. Thus, Fireman's Fund's business will almost surely be much more difficult to improve permanently than what was the case of Geico. However, Mr. Byrne and other Fireman's Fund's executives know all this very well, and with emprovment less spectacular than previous improvments at Geico. Fireman's Fund and Wes-FIC could both prosper.
lndustry-wide conditions, as well as management excellence, affect Wes-FIC's prospects under the reinsurance contract with Fireman's Fund. Large premium increases now going into effect throughout the casualty insurance business could provide some welcome tailwind effects instead of the headwind effects of the period just ended, which was one of the worst in history.
We are pleased with our relationship with Fireman's Fund, which has a long and distinguished record, going all the way back to superb performance after the great San Francisco earthquake and fire, and which is affiliated with the even longer established American Express Company, one of the premier corporations in the United States,
However, Wesco's optimism about quality of Fireman's Fund, quality of this reinsurance contract, and possible short-term, industry-wide cyclical improvement, is tempered by a larger and longer view of the rehisurance business. That business has the defect of being too attractive-looking to new entrants for its own good and therefore will always tend to be more or less the opposite of, say, the old business of gathering and rendering dead horses, which tended to contain few and prosperous participants,
Troubles, losses, and insolvencies can come fast as the apparent attraction, of the reinsurance business, including its seductive receive-pay-in-advance aspects, lure new entrants and encourage expansions by old occupants, The business was a disaster area in recent years, adversely affected by prices which would hive been too low in a stable world, plus inflation, new judicial notion, tending to augment insurance coverage beyond limits contemplated when policies were issued, and not-minor degradation of commercial behavior.
No doubt recent commercial behavior degradation, particularly noticeable in the reinsurance business on both sides of the purchase counter, was accelerated by general hardship, demonstrating once again the wisdom of Poor Richard's Almanac: "It is hard for an empty sack to stand upright."
lnsurance company subsidiaries of Wesco's parent corporation, Berkshire Hathaway, Iong active in reinsurance, did continue proper commercial behavior during the recent period of industry-wide problems, but financial results from reinsurance were terrible. Thus Wesco shareholders are being led not only into an extra -hazardous place but also by people who met severe reverses on the last trip.
Is there any reasonable hope for Wesco shareholders that its reinsurance business, whatever its short-term merits, will provide an advantageous long-term journey? Yes, one reason for long-term optimism is present. With recent defaults by reinsurers causing everyone to worry more about quality in promisors, Wes-FIC and Berkshire Hathaway expect that their old-fashioned enginerring-type attitudes and financial practices will help create for Wes-FIC an unusual, commercially-useful reputation for issuing trustworthy promises in one or more markets or submarkets wherein most buyers will accept nothing less. Thus, the absence of federal insurance for reinsurance liabilities may create for Wes-FIC a reputation based competitive advantage which is denied to Mutual Savings by FSLIC's support of Mutual Savings' competitors through insuring their accounts.
All Other "Normal" Net Operating Income
All other "normal" net operating income, net of interest paid and general corporate expenses, decreased to $3,354,000 in 1985 from $4,550,000 in 1984. Sources were (1) rents of $2.219 million gross, excluding rent from Mutual Savings from Wesco's Pasadena office building block predominently leased to outsiders although Mutual Savings is the ground floor tenant and (2) interest and dividends from cash equivalents from marketable securities held by Precision Steel and its subsidiaries and at the parent company level.
Net Gains on Sale of Securities
Wesco's aggregate net gains on sales of securities, combined, after income taxes, increased to $41,523,000 in 1985 from $13,138,000 in 1984.
The 1985 figure includes a big after-tax gain ($34,363,000) from sale of General Foods stock to Philip Morris Company. This gain contained a large amount of windfall profit. When Wesco made its investment in General Foods stock several years ago, because General Foods' executives seemed sensible and the stock was available in the market at a conservative price relative to its value as a share of ownership in a presumably ever-continuing independent entity, it was unprecedented and virtually inconceivable that a corporation the size of General Foods wouid ever be "bear-hugged" into selling out at an immense premium over the then prevailing market price for its stock. But that is what happened, wholly unpredicted by Wesco, in 1985 as old taboos eroded and the great American takeover game swept into new areas.
Bowery Savings Bank
In 1985 Wesco, in another co-venture with its parent corporation, approved by Wesco's directors in the same manner as the Wes-FIC co-venture, joined a group which invested $100,000,000 cash in a newly organized, New York-chartered savings bank. The new bank then took over the name, assets and liabilities of the insolvent Bowery Savings Bank in the city of New York. The takeover received (1) much needed assistance from FDIC, the federal agency, akin to FSLIC, which insures deposits in banks, and (2) the blessing of New York bank regulators. Wesco invested $9 million, other Berkshire subsidiaries invested $12,384,000, and other unrelated investors invested the balance of the $100 million.
The terms of the FDIC assistance which includes income assistance payments over many years to the newly organized bank are extremely complex but can be fairly summarized as far from adequate to assure that the investors will make a profit. This is as it should be when $100 million buy a highly-leveraged residual position in a $5 billion bank, albeit one with many such assets.
Consolidated Balance Sheet and Related Discussion
As indicated in Note 3 to the accompanying financial statements, the aggregate market value of Wesco's marketable equiry securities was higher· than their aggregate cost at December 31, 1985 by about $5 million, down sharply from about $13 million one year earlier.
Wesco's Pasadena real estate, a full block (containing (1) about 125,000 first class net rentable square feet, including Mutual Savings' space, in a moden office building, plus (2) an additional net rentable 34,000 square feet of economically marginal space in an old building requiring expensive improvement), has a market value substantially in excess of carryrng value, demonstrated by (1) mortgage debt ($5,023,000 at 9.25% fixed) against this real estate now exceeding its depreciated carrying value of $3,158,000) in Wesco's balance sheet at December 31, 1985, and (2) substantial current net cash flow (about $1 million per year) to Wesco after debt service on the mortgage. The modern office building is 96% rented, despite a glut of vacant office space in Pasadena. We charge just-below-standard rents and run the building as a sort of first-class club for tenants we admire. With these practices, a prime location and superior parking facilities, we anticipate future increases in cash flow, but at no better rate than the rate of inflation.
Wesco remains in a prudent position when total debt is compared to total shareholders' equity and total liquid assets. Wesco's practice has been to do a certain amount of long-term borrowing in advance of specific needs, in order to have maximum financial flexibility to face both hazards and opportunities.
It is expected that the balance sheet strength of the consolidated enterprise will in due course be used in one or more business extensions. The extension activity, however, requires some patience, as suitable opportunities are not always present.
As indicated in Schedule I accompanying Wesco's financial statements, investments, both those in the savings and loan ratio of Wesco's annual reported consolidated net income to reported consolidated shareholders' equity, about 21% in 1983-85, was dependent to a very large extent on securities gains, irregular by nature. The recent ratio is almost certain to decline, quite probably very sharply. Neither posible future acquisitions of other businesses nor possible future securities gains appear likely to cause the present ratio to continue. The business acquisition game is now crowded with optimistic players who usually force prices for low-leverage acquirers, like Wesco to levels where return-on-investment prospects are modest. And, as discussed earlier, the great contribution of 1985 securities gains to Wesco's recent return on shareholder's equity containd a big fluke element. Such fluke gain, rare in any event, tends to come to an investor like Wesco mostly as an unanticipated by-product of an obviously sound investment which does not require any fluke to work out well. Because securities generally traded lower several years ago than they do now, relative to the intrinsic values of the businesses represented by the securities, creating more obviously sound investments then than now, and because prospects for above-average returns tend to go down as assets managed go up, it is now easy to predict less desirable future results. It is also easy for any sophisticated Wesco shareholder, reviewing Wesco marketable securities disclosed in the 1985 Annual Report, to diagnose (correctly) that the decision-makers are dry of good investment ideas.
Wesco is trying more to profit from always remembering the obvious than from grasping the esoteric (including much modern "strategic planning" and "portfolio theory"). Such an approach, while it has worked fairly well on average in the past and will probably work fairly well over the long-term future, is bound to encounter periods of dullness and disadvantage as it limits action. Moreover, the approach is being applied to no great base position. Wesco is sort of scrambling through the years without owning a single business, even a small one, with enough commercial advantage in place to pretty well assure high future returns on its capital. In contrast, Berkshire Hathaway, Wesco's parent corporation, owns three such high-return businesses.
On January 25, 1986, Wesco increased its regular quarterly dividend from 15½ cents per share to 16½ cents per share, payable March 6, 1986, to shareholders of record as of the close of business on February 1986.
This annual report contains Form 10-K, a report filed with the Securities and Exchange Commission, and includes detailed information about Wesco and its subsidiaries as well as audited financial statements bearing extensive footnotes. As usual, your careful attention is sought with respect to these items.
Charles Munger
Chairman of the Board
February 13, 1986
