1987 Letter to Shareholders

The 1987 Letter is a masterpiece on psychological discipline. Written in the immediate aftermath of the Black Monday crash (October 1987), it serves as a tutorial on how an investor should maintain emotional distance from market volatility using the Mr. Market allegory. Financially, Berkshire pivoted toward large-scale corporate rescues with a $700 million investment in Salomon Inc. convertible preferred stock.

Historical Stats

Net Worth Gain: $464 million (19.5%)
Compounded Annual Growth Rate (23 years): 23.1% (per-share book value grew from $19.46 to $2,477.47)
Sainted Seven Pre-Tax Equity Return: 57% ($178 million pre-tax earnings on a $175 million historical-cost equity base)
Salomon Inc. Investment: $700 million in 9% convertible preferred stock (valued at 98% of par at yearend)
WPPSS Bond Holdings: Amortized cost of $240 million; market value of $316 million ($34 million annual tax-exempt income)
Traditional Insurance Combined Ratio: 105% (statutory basis, excluding structured settlements; up from 103% in 1986)
Arbitrage Returns: Historical pre-tax average of at least 25% (Allegis was the main 1987 position: $76M cost, $78M market value)
Texaco Bankrupt Bonds: Bought for $104 million; market value of $119 million

🏢 Corporate Performance & Operations

The Sainted Seven: The seven non-financial units (Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing, See's Candies, and World Book) generated $180 million pre-tax operating earnings on just $175 million in historical-cost equity (nearly debt-free).
Nebraska Furniture Mart: Sales grew 8% to $142.6 million. Rose Blumkin ("Mrs. B") at 94 continues to outsell competitors, leading Berkshire to officially scrap its mandatory retirement-at-100 policy. Her team (Louie, Ron, Irv, Steve) saved customers an estimated $30 million relative to competitor prices.
The Buffalo News: Stan Lipsey achieved excellent profit growth despite flat revenues. The paper maintained its 50% news hole and top weekday/Sunday penetration rates. Buffett predicts margins will shrink in 1988 due to rising newsprint costs.
See's Candies: Volume reached a record 24.9 million pounds. Same-store poundage stabilized (flat for two years, after six years of declines). Christmas concentration increased further, with 85% of annual profits earned in December under Chuck Huggins.
Scott Fetzer Co.: Under Ralph Schey, pre-tax earnings rose 10% while capital employed declined. World Book introduced its most major revision since 1962, adding 10,000 color photos and growing U.S. unit sales for the fifth straight year.
Insurance Group: Under Mike Goldberg, underwriting results were excellent (statutory combined ratio of 105), generating massive investable float. Buffett cautions that industry combined ratios will climb in 1988/1989 due to excess capacity ("less corn, not more statesmen").
GEICO: 41% owned. Bill Snyder reduced the expense ratio to 23.5% (down from 24.1%), while Lou Simpson's equity portfolio continued its stellar outperformance.
K & W Products: Small automotive subsidiary turnaround. Under 68-year-old manager Harry Bottle (recruited by Charlie Munger), profits grew 300% while capital employed fell 20%.

Core Themes & Insights

🎭 Market Psychology & The 1987 Crash

Buffett uses the 1987 crash to re-introduce Ben Graham's Mr. Market, adding a layer of contemporary warning. He argues that the stock market is there to serve the investor, not to guide them.

The Philosophy: An investor should only interact with the market when price deviates significantly from business value.
The Lesson: Buffett famously analogizes the late stages of a bull market to Cinderella at the ball. Everyone knows the coach will turn back into a pumpkin at midnight, but everyone thinks they can stay until 11:59 and still exit.
Modern Relevance: He critiques Portfolio Insurance as an "Alice-in-Wonderland" practice where mechanical selling at 9:31 AM triggers more selling, a phenomenon that remains highly relevant in today's High-Frequency Trading (HFT) and algorithmic liquidity cascades.

🏛️ Corporate Governance: The Sainted Seven

Buffett identifies seven non-financial units—The Sainted Seven—that achieved a combined 57% ROE.

The Insight: This performance highlights the scarcity of high-yield, low-capital businesses. Buffett uses this to bridge into a discussion on Capital Allocation vs Management. He argues that most CEOs are "musicians" (experts in marketing or ops) who are suddenly asked to lead the "Federal Reserve" (capital allocation) without training.
The Strategy: Berkshire’s structure solves this by leaving "World-Class Musicians" (the managers) to play their game while Buffett and Munger focus exclusively on the allocation of the resulting cash.

💹 Arbitrage & Salomon Brothers

The year saw a major shift with the $700 million investment in Salomon Inc. convertible preferred stock.

The Logic: While investment banking is unpredictable, the investment was a bet on the integrity of John Gutfreund, whom Buffett trusted due to his role in the 1976 GEICO rescue.
Arbitrage Mastery: Buffett reports a multi-decade average return of 25% on Berkshire’s Work-outs (arbitrage). He notes the 1987 position in Allegis as a prime example of finding value in corporate breakups while others were panicked by the crash.

⚠️ Analysis of Mistakes & Warnings

While 1987 was profitable, Buffett warns against the "Patsy" syndrome: "If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy." He admits that Berkshire's inability to deploy its large cash pile during the brief October dip was a lost opportunity for "rare, fast-moving elephants."

💰 1987 Shareholder Letter: The Weighing Machine and the October Panic

"In the short run, the market is a voting machine but in the long run it is a weighing machine." — Benjamin Graham (quoted by Warren Buffett)

🎭 The Narrative Context

The 1987 letter is written in the shadow of Black Monday (October 19, 1987), when the Dow Jones Industrial Average fell 22.6% in a single day, sending shockwaves through global finance. Rather than panic, Buffett uses this historic volatility to deliver a timeless lecture on investor psychology. In a year where professional money managers engaged in mechanical hedging schemes like "portfolio insurance" (which exacerbated the crash), Berkshire remained rock-solid. Buffett's primary frustration was not the price drop—which he welcomed—but Berkshire's inability to deploy its cash pile into cheap businesses before they rapidly rebounded. The letter is a calm, analytical defense of business reality over market noise.

💡 Philosophical Gems

The Philosophy: Mr. Market and the Illusion of Volatility

Buffett resurrects Benjamin Graham's Mr. Market allegory to explain the relationship between price fluctuations and business value.

The Logic: Price volatility is not risk; it is a source of opportunity. Mr. Market is a manic-depressive partner whose daily price quotes should be taken as options, never as guides to business health.
The Mechanism: The professional money managers who treat volatility (Beta) as risk are acting irrationally, selling assets simply because prices are falling. For a long-term business owner, a lower price represents an opportunity to buy more, not a reason to liquidate.
The Quote: "Volatility caused by money managers who speculate irrationally with huge sums will offer the true investor more chances to make intelligent investment moves. He can be hurt by such volatility only if he is forced, by either financial or psychological pressures, to sell at untoward times."

The Strategy: The Federal Reserve Musician (Capital Allocation)

Buffett argues that capital allocation is a distinct and rare skill that is completely separate from operating a business, yet traditional corporate structures ignore this difference.

The Thesis: Most CEOs are promoted because they are excellent "musicians" (specialists in marketing, engineering, or operations). Once they reach the top, they are suddenly expected to act as the "Chairman of the Federal Reserve," allocating capital without any prior training.
The Lesson: Because bad capital allocation can destroy a company's economics over a ten-year period, Berkshire separates the two functions: managers run the businesses, while Buffett and Munger allocate the cash.
The Quote: "The lack of skill that many CEOs have at capital allocation is no small matter: After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business."

The Discipline: The loaded gun of Financing

Buffett explains why Berkshire raised $250 million in debt at 10% despite having substantial cash, and despite the near-term penalty on earnings (as they only earned 6.5% on T-bills).

The Logic: Cheap money bidding up assets is the worst time to buy. Conversely, tight money environments create the best opportunities to acquire assets at bargain prices. Therefore, liabilities should be structured before assets are purchased.
The Insight: To buy "rare, fast-moving elephants," you must carry a loaded gun. Waiting to raise capital during a crisis is a recipe for failure.
The Quote: "Our basic principle is that if you want to shoot rare, fast-moving elephants, you should always carry a loaded gun."

The Culture: Audits of Reserve Integrity

Buffett calls out the property-casualty insurance industry for using reserving errors to manipulate earnings, pointing out the limitations of traditional audits.

The Critique: Auditors confidently certify reserving figures that they have no capacity to evaluate, giving dishonest managers a pen-stroke tool to create paper profits in long-tail lines.
The Lesson: True auditing of insurance liabilities requires admitting the inherent uncertainty of long-tail claims.
The Quote: "Where 'earnings' can be created by the stroke of a pen, the dishonest will gather. For them, long-tail insurance is heaven."

🗣️ Verbatim Masterclass

"If you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game. As they say in poker, 'If you’ve been in the game 30 minutes and you don’t know who the patsy is, you’re the patsy.'"
"What we learn from history is that we do not learn from history."
"Develop your eccentricities while you are young. That way, when you get old, people won’t think you’re going ga-ga."
"Charlie and I have found that making silk purses out of silk is the best that we can do; with sow’s ears, we fail."
"When A takes money from B to give to C and A is a legislator, the process is called taxation. But when A is an officer or director of a corporation, it is called philanthropy."

🔗 Evolutionary Links

Entities: Salomon Inc., John Gutfreund, The Sainted Seven, Nebraska Furniture Mart, See's Candies, The Buffalo News, Scott Fetzer Co., GEICO, Lou Simpson, Harry Bottle
Concepts: Mr. Market, Volatility vs Risk, Capital Allocation vs Management, Insurance Float, Arbitrage, Portfolio Insurance, Patsy Syndrome, Deferred Tax Liability

[!CAUTION] Investor Takeaway: Do not let price volatility dictate your emotional state or business decisions. The stock market exists to serve you by presenting mispriced opportunities, not to guide you. True investment risk is the permanent loss of purchasing power, not the daily fluctuation of stock prices. Maintain a loaded gun (capital liquidity) to act decisively when Mr. Market panics.

Preceded by: 1986 Letter
Followed by: 1988 Letter
Index: index