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Warren Buffett and GEICO Case Study

1. 1. Security Analysis Case Study Warren E. Buffett, 1995 UCLA Extension X433.02 Summer
2015 Presented by: John Yannone September 10, 2015
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3. 3. 3 Table of Contents Foreword and Introduction
............................................................................................................. 4
..... 5 Warren Buffett & Berkshire Hathaway Early
History.................................................................... 7 Warren Buffett as Student of Value
Investing............................................................................ 7 Berkshire Hathaway as a Holding
Company.............................................................................. 9 Warren Buffett’s Investor/CEO
Principles of Investment........................................................ 10 Berkshire Hathaway’s Goals
& Acquisition Criteria................................................................ 17 Government Employees
Insurance Company (GEICO)............................................................... 19 Warren Buffett &
GEICO......................................................................................................... 19 GEICO’s
Competitive Advantage ............................................................................................ 20
GEICO’s Business Principles ...................................................................................................
22 Lou Simpson - GEICO’s Superinvestor
................................................................................... 22 Lou Simpson’s 5 Principles of
Investment ............................................................................... 24 Financial Analysis of
GEICO Acquisition ................................................................................... 25 Acquisition
Announcement ...................................................................................................... 25 Analysis
of Value Line Forecast Using CAPM........................................................................ 26 How
Warren Buffett May Have Analyzed the Same Value Line Data .................................... 28
Other Items Warren Buffett May Have Considered .................................................................
... 31
.... 33
34 Exhibits
......................................................................................................................................... 35
Exhibit 1....................................................................................................................................
35 Exhibit
2.................................................................................................................................... 36
Exhibit 3....................................................................................................................................
37 Exhibit
4.................................................................................................................................... 38
Exhibit 5....................................................................................................................................
39 Exhibit
6.................................................................................................................................... 40
Exhibit 7....................................................................................................................................
41 Exhibit
8.................................................................................................................................... 42
Exhibit 9....................................................................................................................................
43 Exhibit
10.................................................................................................................................. 44
4. 4. 4 Foreword and Introduction In August of 1995, Warren Buffett, CEO of holding company
Berkshire Hathaway which owned approximately 50% of GEICO, announced a $2.3 billion
deal to acquire the remaining publicly traded stock. GEICO shareholders were offered $70
per share, a 25.6% premium, over the $55.75 per share market price before the
announcement. Buffett proposed to change nothing about GEICO, and there were no
apparent synergies (e.g. reduction in fixed costs) in the combination of the two firms. After
the announcement, Berkshire Hathaway’s shares closed up for the day with a $718 million
gain in market value (after adjusting for the S&P 500’s increase of 0.5% for the day). In the
same year as the acquisition (1996), University of Virginia Professor Robert F. Bruner wrote
a case study about Warren Buffett. The acquisition of GEICO renewed public interest in its
architect, Warren E. Buffett. In many ways, he was an anomaly. One of the richest
individuals in the world with an estimated net worth of about $7 billion, he was also respected
and even beloved. Although he had accumulated perhaps the best investment record in
history (a compound annual increase in wealth of 28% from 1965 to 1994), Berkshire
Hathaway paid him only $100,000 per year to serve as its CEO. Buffett and other insiders
controlled 47.9% of the company, yet he ran the company in the interests of all shareholders.
He was the subject of numerous laudatory articles and three biographies, yet he remained
an intensely private individual. Though acclaimed by many as an intellectual genius, he
shunned the company of intellectuals and preferred to affect the manner of a down-home
Nebraskan (he lived in Omaha), and a tough-minded investor. In contrast to investing’s other
“stars,” Buffett acknowledged his investment failures both quickly and publicly. He held an
MBA from Columbia University and credited his mentor, Professor Benjamin Graham, with
developing the philosophy of value-based investing that guided him to his success. Buffett
chided business schools for the irrelevance of their finance and investing theories. This
paper looks at various aspects of Warren Buffett, Berkshire Hathaway and GEICO and will
answer the questions posed at the end of the case:  Would the GEICO acquisition serve the
long-term goals of Berkshire Hathaway?  Was the bid price appropriate?  What might
account for the share price increase for Berkshire Hathaway at the announcement?
5. 5. 5 History Although a history lesson is not the main intent of this case study, the following
table demonstrates the histories of Warren Buffett and GEICO were intertwined for 25 years
before the full acquisition. Note: Reference for this timeline will be listed below Date Event
Reference 1888 Hathaway Manufacturing founded 3 1889 Berkshire Cotton Manufacturing
founded 1 1929 Several textile operations (one of which was founded ~1806) merged with
Berkshire Cotton Manufacturing and renamed Berkshire Fine Spinning Associates 3 1936
Government Employees Insurance Company (GEICO) founded 2 1948 Benjamin Graham’s
firm (Graham-Newman) buys 50% of GEICO Graham-Newman paid $0.7362 million on
7/6/1948 2 1949 Graham becomes member of GEICO Board of Directors 2 1951 Buffett
meets Lorimer Davidson (a future CEO) at GEICO Headquarters 4 1951 Buffett graduates
from Columbia Business School; starts career as a stock broker working for his father’s firm
4 1951 Buffett writes an article on GEICO (“The Security I like Best”) Article 1952 Buffett
sells GEICO shares for $15,259.00 4 1953 New England textiles industry starts facing
depressed conditions and a rising cost of cotton 3 1954 Buffett joins Graham-Newman as an
analyst 3 1955 Berkshire Fine Spinning Associates (cotton based business) merged with
Hathaway Manufacturing (synthetics based business). Name changed to Berkshire
Hathaway (diversified business) FY ending 9/30/1955 balance sheet book value = $51.4
million 3 1956 Graham dissolves Graham-Newman; Buffett moves back to Nebraska 4 1957
Buffett creates Buffett Partners Limited (BPL) 3 1959 Buffett is introduced to Charlie Munger
3 1962 BPL start purchasing shares in Berkshire Hathaway (initially at $7.60 per share) 3
1964 Berkshire Hathaway 10/3/1964 adjusted balance sheet book value = $35.2 million
(shareholder equity $22.1 million +$13 million in share repurchases) a significant decline
from 1955 3 1965 Warren Buffett and partners acquire controlling interest in Berkshire
Hathaway and Buffett was elected as a Director of the corporation 1 1967 Berkshire
Hathaway enters insurance business by acquiring National Indemnity Company and National
Fire and Marine Insurance Company 3 1969 Buffett closes Buffett Partnership 5
6. 6. 6 1970 Warren Buffett elected Chairman of the Board of Berkshire Hathaway 3 1976
Berkshire Hathaway begins purchasing GEICO as share price drops to multi-decade low of
$2 per share (near bankruptcy and share price down from $60 3 years earlier) 2 1979 Lou
Simpson hired by GEICO with endorsement by Buffett 6 1980 Berkshire Hathaway increases
stake in GEICO to 7.2 million shares representing 33% of the equity Total invested was $47
million 4 1985 Berkshire Hathaway shuts down textile business 1 1988 Berkshire Hathaway
purchases General Re for $22 billion 3 1988 Berkshire Hathaway listed on New York Stock
Exchange 3 1993 Tony Nicely and Lou Simpson become co-CEOs of GEICO 7 1995 Buffett
announces Berkshire Hathaway to acquire balance of GEICO Value of GEICO before the
announcement was $3.695 billion Value of GEICO based on the announcement was $4.637
billion 1 1996 Berkshire Hathaway issues 450 thousand shares of Class B Common Stock.
Warren Buffett states Berkshire Hathaway is overvalued in the Prospectus. 3 1996 Berkshire
Hathaway becomes 100% owner of GEICO [adds ~$1.5 billion of goodwill to balance sheet]
4 2015 Berkshire Hathaway A Shares (never split since acquired) trade for over $200,000 for
the first time 3 References 1. Case Study 2. The Einstein of Money: The Life and Timeless
Financial Wisdom of Benjamin Graham 3. Berkshire Hathaway Inc.: Celebrating 50 Years of
a Profitable Partnership 4. Buffett Beyond Value 5. Superinvestors of Graham-and-
Doddsville 6. Washington Post 7. Warren Buffett Wealth
7. 7. 7 Warren Buffett & Berkshire Hathaway Early History “Should you find yourself in a
chronically-leaking boat, energy devoted to changing vessels is likely to be more productive
than energy devoted to patching leaks” –Warren E. Buffett Berkshire Hathaway was once
New England’s largest textile producers and held a 25% share of the US fine cotton textile
production market. It survived the Great Depression (partially by cutting preferred dividends
between 1930 and 1936 and by refurbishing used equipment to make it more efficient) and
then prospered during and after the Second World War. A recession in the industry and a
troubled executive team (members of the executive team and board of directors disliked
each other) ultimately led to Berkshire Hathaway selling well below net working capital
(current assets less current liabilities) in the late 1950’s and early 1960’s. Professor Bruner’s
case provides a concise description of the economics affecting Berkshire Hathaway in the
decade prior to Warren Buffett and his partner’s acquisition of control in early May 1965 and
troubles encountered in the decades afterwards (primarily increasing competition from non-
union textile plants in southern states and abroad, where there were several economic
advantages). [Berkshire Hathaway] began a secular decline due to inflation, technological
change, and intensifying competition from foreign competitors. In 1965, Buffett and some
partners acquired control of Berkshire Hathaway, believing that the decline could be
reversed. Over the next 20 years, it became apparent that large capital investments would
be required to remain competitive and that even then the financial returns would be
mediocre. Fortunately, the textile group generated enough cash in the initial years to permit
the firm to purchase two insurance companies headquartered in Omaha: National Indemnity
Company and National Fire & Marine Insurance Company. Acquisitions of other businesses
followed throughout the 1970s and 1980s. Warren Buffett as Student of Value Investing
“Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.” –Warren E. Buffett
Professor Bruner’s case describes Warren Buffett’s introduction to the teachings of Benjamin
Graham: Warren Buffett was first exposed to formal training in investing at Columbia
University in New York, where he studied under Professor Benjamin Graham. The coauthor
of a classic text, Security Analysis, Graham developed a method for identifying undervalued
stocks (i.e., stocks whose price was less than their intrinsic value). This became the
cornerstone of the modern approach of value investing. Graham’s approach was to focus on
the value of assets, such as cash, net working capital, and physical assets. Eventually,
Buffett modified that approach to focus also on valuable franchises that were not recognized
by the market. From 1957 through 1969, the Buffett Partnership achieved extraordinary
results by beating the Dow every year without using leverage (see Exhibit 1). Buffett used
the deep value approach (short to mid-range focus) he learned from Graham, while a student
at Columbia. By the mid- 1960s he made two investments, American Express and Disney,
which were a departure from Graham’s teachings and the beginnings of a reorientation of his
investment philosophy toward higher-quality companies with durable competitive advantages
(and a longer term focus).
8. 8. 8 In a letter to the shareholders of Berkshire Hathaway titled “Berkshire – Past, Present
and Future”, Buffett indicates Charlie Munger’s influence was largely responsible for his
change in philosophy: From My perspective, though, Charlie’s most important architectural
feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget about
what you know about buying fair businesses at wonderful prices; instead, buy wonderful
businesses at fair prices On May 17, 1984, Warren Buffett gave a speech at Columbia
Business School that was later published as “The Superinvestors of Graham-and-
Doddsville”, where he discussed a group of investors who were all taught by Graham and
later consistently beat the Standard & Poor’s 500 stock index (S&P500). They all “search[ed]
for discrepancies between the value of a business and the price of small pieces of that
business in the market” and did “not discuss beta, the capital asset pricing model, or
covariance in returns among securities”. “The investors simply focus[ed] on two variables:
price and value.” The following table includes the “superinvestors” Buffett described that had
been taught by Graham. After introducing these “superinvestors” (and 5 others that were not
students or employees of Graham) Buffett starts discussing risk and his disdain for the
CAPM… It's very important to understand that this group has assumed far less risk than
average; note their record in years when the general market was weak. While they differ
greatly in style, these investors are, mentally, always buying the business, not buying the
stock. A few of them sometimes buy whole businesses. Far more often they simply buy small
pieces of businesses. Their attitude, whether buying all or a tiny piece of a business, is the
same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful.
But all exploit the difference between the market price of a business and its intrinsic value.
Superinvestor Years Annual Compound Rate Comments Walter J Schloss Partnership 1956
– Q1 1984 16.1% vs. 8.4% for S&P500 Took a class from Graham; worked for Graham-
Newman  Over 100 stocks  High aversion to loss  Margin of Safety Tom Knap of Tweedy,
Browne Inc. Q2 1968 – 1983 16.0% vs. 7.0% for S&P500 Took classes from Graham and
Dodd; worked for Graham-Newman  Wide diversification Warren Buffett Partnership 1957 -
1969 23.8% vs. 7.4% for the Dow Took classes from Graham; worked for Graham-Newman
 Closed partnership in 1969 since could not find investments with sufficient margin of safety
Sequoia Fund 3Q 1970 – 1Q 1984 17.2% vs. 10% for S&P500 Took classes from Graham;
worked for Graham-Newman
9. 9. 9 I'm convinced that there is much inefficiency in the market. These Graham-and-
Doddsville investors have successfully exploited gaps between price and value. When the
price of a stock can be influenced by a "herd" on Wall Street with prices set at the margin by
the most emotional person, or the greediest person, or the most depressed person, it is hard
to argue that the market always prices rationally. In fact, market prices are frequently
nonsensical. I would like to say one important thing about risk and reward. Sometimes risk
and reward are correlated in a positive fashion… The exact opposite is true with value
investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40
cents, but the expectation of reward is greater in the latter case. The greater the potential for
reward in the value portfolio, the less risk there is. He continues with a quick example that
illustrates the essence of value investing and in particular how Buffett thinks about investing:
The Washington Post Company in 1973 was selling for $80 million in the market. At the time,
that day, you could have sold the assets to any one of ten buyers for not less than $400
million, probably appreciably more. The company owned the Post, Newsweek, plus several
television stations in major markets. Those same properties are worth $2 billion now, so the
person who would have paid $400 million would not have been crazy. Now, if the stock had
declined even further to a price that made the valuation $40 million instead of $80 million, its
beta would have been greater. And to people that think beta measures risk, the cheaper
price would have made it look riskier. This is truly Alice in Wonderland. I have never been
able to figure out why it's riskier to buy $400 million worth of properties for $40 million than
$80 million. And, as a matter of fact, if you buy a group of such securities and you know
anything at all about business valuation, there is essentially no risk in buying $400 million for
$80 million, particularly if you do it by buying ten $40 million piles of $8 million each. Since
you don't have your hands on the $400 million, you want to be sure you are in with honest
and reasonably competent people, but that's not a difficult job. You also have to have the
knowledge to enable you to make a very general estimate about the value of the underlying
businesses. But you do not cut it close. That is what Ben Graham meant by having a margin
of safety. You don't try and buy businesses worth $83 million for $80 million. You leave
yourself an enormous margin. When you build a bridge, you insist it can carry 30,000
pounds, but you only drive 10,000 pound trucks across it. And that same principle works in
investing. Berkshire Hathaway as a Holding Company In 1967 Buffett started investing in
insurance companies because they could generate float, cash premium income in advance
of losses and expenses (which could be viewed as an interest free loan). He would then
invest the float very selectively, buying both publicly traded securities and wholly owned
businesses under opportune circumstances. A viewing of share price performance of
Berkshire Hathaway from 1976 (same year as initial purchase of GEICO shares) to present
(Exhibit 2) shows an incredible performance compared to the S&P 500. By 1995, Berkshire
Hathaway was engaged in several diverse operating business segments and also held a
concentrated portfolio of equity securities (which included ~50% of GEICO).
10. 10. 10 Exhibit 3 shows the insurance segment made up ~40% of revenues (and almost 90%
of pretax operating profits). These were property and casualty insurance operations (on both
a direct and reinsurance basis) that held meaningful equity interests in 10 other publicly
traded companies. Exhibit 4 is a copy of the “Common Stock Investments Table from
Berkshire Hathaway’s 1994 Annual Report which lists these equities. GEICO was the second
to lowest cost, but was the 4th largest holding based on year end 1994 market price. Exhibit
5 shows financial performance for equity interests disclosed by Berkshire Hathaway Key
metrics include  Berkshire Hathaway’s approximate ownership  Berkshire Hathaway’s
share of undistributed operating earnings Berkshire Hathaway also owned several
convertible preferred stocks (preferred stocks that could be viewed as a hybrid between a
bond like preferred stock and a call option). These gave Berkshire Hathaway the right to
exchange them for common stock and several had very favorable terms because they were
negotiated purchases when the companies involved were takeover targets and in need of a
white knight. Fast forward to today (August 2015) and Berkshire Hathaway can best be
described as a hybrid between an operating conglomerate and a holding company; it is one
of the largest companies in the world with a market capitalization of ~$350 billion and annual
sales ~$200 billion (price to sales ~1.75). The bulk of sales comes from wholly owned
operating subsidiaries (like GEICO) and its stock portfolio had a market value of $115 billion
(end of 2014). Warren Buffett’s Investor/CEO Principles of Investment “Long ago, Ben
Graham taught me that ‘Price is what you pay; value is what you get.’ Whether were talking
about socks or stocks, I like buying quality merchandise when it is marked down.” –Warren
E. Buffett The following table is from the “Buffett’s Investment Philosophy” section of
Professor Bruner’s case and includes several of Warren Buffett’s principles of investment
that were compiled by reading the Chairman Letters included in Berkshire Hathaway annual
reports. Principles that were part of Buffett’s Investment Philosophy in 1995 as listed in
Professor Bruner’s case 1. Economic reality, not accounting reality. Financial statements
prepared by accountants conformed to rules that might not adequately represent the
economic reality of a business. Buffett wrote:
11. 11. 11 …because of the limitations of conventional accounting, consolidated reported
earnings may reveal relatively little about our true economic performance. Charlie and I, both
as owners and managers, virtually ignore such consolidated numbers.… Accounting
consequences do not influence our operating or capital allocation process. [Berkshire
Hathaway, Inc., 1994 Annual Report, 2.] Accounting reality was conservative, backward-
looking, and governed by GAAP. Investment decisions, on the other hand, should be based
on the economic reality of a business. In economic reality, intangible assets such as patents,
trademarks, special managerial expertise, and reputation might be very valuable, yet under
GAAP, they would be carried at little or no value. GAAP measured results in terms of net
profit; in economic reality, the results of a business were its flows of cash. A key feature of
Buffett’s approach defined economic reality at the level of the business itself, not the market,
the economy, or the security—he was a fundamental analyst of a business. His analysis
sought to judge the simplicity of the business, the consistency of its operating history, the
attractiveness of its long-term prospects, the quality of management, and the firm’s capacity
to create value. Comments The above quote is also from two of Buffett’s “OWNER-
RELATED BUSINESS PRINCIPLES”, #5 and #6. #5 is a statement that Berkshire Hathaway
will report important information to investors beyond what is required by accounting
principles, and #6 argues more earnings is better than less earnings regardless of its
reportability. The result of using economic reality is that they have made investments in
companies that “have garnered far more than a dollar of value for each dollar they have
retained”. In other words the return on retained earnings was greater than cost of capital and
that they used numbers based on economic reality (not accounting reality) when doing
discounted cash flow analysis. As Professor Bruner indicated, these are key principles, but
they are also timeless. By using one’s knowledge of a business and its economics, it is
possible to arrive at an intrinsic value that is different from that obtained using certified
accounting numbers. 2. The cost of the lost opportunity. Buffett compared an investment
opportunity against the next best alternative, the so-called “lost opportunity.” In his business
decisions, he demonstrated a tendency to frame his choices as “either/or” decisions rather
than “yes/no” decisions. Thus, an important standard of comparison in testing the
attractiveness of an acquisition was the potential rate of return from investing in the common
stocks of other companies. Buffett held that there was no fundamental difference between
buying a business outright, and buying a few shares of that business in the equity market.
Thus, for him, the comparison of an investment against other returns available in the market
was an important benchmark of performance. Comments Opportunity cost is associated with
the fundamental economic problem: scarcity and choice. This is another timeless principle
and it also helps concentrate a portfolio when it is used in conjunction with Buffett’s other
principles. By incorporating opportunity cost into the decision
12. 12. 12 making process, it forces an investor to only invest in the best opportunities. Over
time the quality of the portfolio should improve because new acquisitions must be better than
all alternatives available at the time. 3. Value creation: time is money. Buffett assessed
intrinsic value as the present value of future expected performance. [All other methods fall
short in determining whether] an investor is indeed buying something for what it is worth and
is therefore truly operating on the principle of obtaining value for his investments.…
Irrespective of whether a business grows or doesn’t, displays volatility or smoothness in
earnings, or carries a high price or low in relation to its current earnings and book value, the
investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one
that the investor should purchase. [Berkshire Hathaway, Inc., 1992 Annual Report, 14]
Expanding his discussion of intrinsic value, Buffett used an educational example: We define
intrinsic value as the discounted value of the cash that can be taken out of a business during
its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly
subjective figure that will change both as estimates of future cash flows are revised and as
interest rates move. Despite its fuzziness, however, intrinsic value is all important and is the
only logical way to evaluate the relative attractiveness of investments and businesses. To
see how historical input (book value) and future output (intrinsic value) can diverge, let us
look at another form of investment, a college education. Think of the education’s cost as its
book value. If it is to be accurate, the cost should include the earnings that were foregone by
the student because he chose college rather than a job. For this exercise, we will ignore the
important noneconomic benefits of an education and focus strictly on its economic value.
First, we must estimate the earnings that the graduate will receive over his lifetime and
subtract from that figure an estimate of what he would have earned had he lacked his
education. That gives us an excess earnings figure, which must then be discounted, at an
appropriate interest rate, back to graduation day. The dollar result equals the intrinsic
economic value of the education. Some graduates will find that the book value of their
education exceeds its intrinsic value, which means that whoever paid for the education didn’t
get his money’s worth. In other cases, the intrinsic value of an education will far exceed its
book value, a result that proves capital was wisely deployed. In all cases, what is clear is that
book value is meaningless as an indicator of intrinsic value. [Berkshire Hathaway, Inc., 1994
Annual Report, 7] To illustrate the mechanics of this example, consider the hypothetical case
presented in Exhibit 6 [of the case]. Suppose an individual has the opportunity to invest $50
million in a business—this is its cost, or book value. This business will throw off cash at the
rate of 20% of its investment base each year. Suppose that instead of receiving any
dividends, the owner decides to reinvest all cash flow back into the business—at this rate,
the book value of the business will grow at 20% per year. Suppose that the investor plans to
sell the business for its book value at the end of the fifth year. Does this investment create
value for the individual? One determines this by discounting the future cash flows to the
present at a cost of equity of 15%— suppose that this is the investor’s opportunity cost, the
required return that could have been earned elsewhere at comparable risk. Dividing the
present value of future cash flows (i.e., Buffett’s intrinsic value) by the cost of the investment
(i.e., Buffett’s book value) indicates that every dollar invested buys securities worth $1.23.
Thus, value has been created. Consider an opposing case, summarized in Exhibit 7 [of the
case]. The example is similar in all respects except for one key difference: the annual return
on the investment is 10%. The result is
13. 13. 13 that every dollar invested buys securities worth $0.80. Thus, value has been
destroyed. Comparing the two cases in Exhibits 6 and 7 [of the case], the difference between
value creation and destruction is driven entirely by the relationship between the expected
returns and the discount rate: in the first case, the spread is positive; in the second case, it is
negative. Only in the instance where expected returns equal the discount rate will book value
equal intrinsic value. In short, book value or the investment outlay may not reflect economic
reality: one needs to focus on the prospective rates of return, and how they compare to the
required rate of return. Comments Buffett’s definition of intrinsic value [“It is the discounted
value of the cash that can be taken out of a business during its remaining life”] clearly
suggests the present intrinsic value is a function of  Future cash flows (which are a function
of expected rates of return)  Discount rate  Timing of cash flows Professor Bruner’s
hypothetical examples demonstrate that for a firm with no debt, value is created when the
cost of equity is less than the return on equity and if the security is fairly valued, the book
value will be greater than 1 (present value > invested capital). Buffett uses intrinsic value as
a way to weigh relative attractiveness of investment options; this is a timeless principle and is
based on one of the fundamental finance equations (series of present values). 4. Measure
performance by gain in intrinsic value, not by accounting profit. Buffett wrote: Our long-term
economic goal … is to maximize the average annual rate of gain in intrinsic business value
on a per-share basis. We do not measure the economic significance or performance of
Berkshire by its size; we measure by per-share progress [Berkshire Hathaway, Inc., 1994
Annual Report, 2] The gain in intrinsic value could be modeled as the value added by a
business above and beyond a charge for the use of capital in that business. The gain in
intrinsic value was analogous to economic profit and market value added, measures used by
analysts at leading corporations to assess financial performance. Those measures focus on
the ability to earn returns in excess of the cost of capital. Comments The above quote is also
from Buffett’s “OWNER-RELATED BUSINESS PRINCIPLES”, #3. This is the intrinsic value
concept, which was described in the previous principle, applied to Berkshire Hathaway. As
an aside, by “analogous to economic profit and market value added”, Professor Bruner is
referring to the Economic Value Added (EVA) measure of profitability and Market Value
14. 14. 14 measure of wealth creation developed Stern Stewart. EVA = NOPAT – WACC x TC 
NOPAT = Net operating profit after taxes  WACC = Weighted Average Cost of Capital  TC
= Total Capital MVA = Market Value – Total Capital As another aside, Buffett makes an
important cautionary statement in #3: We are certain that the rate of per-share progress will
diminish in the future – a greatly enlarged capital base will see to that. But we will be
disappointed if our rate does not exceed that of the average large American corporation. 5.
Risk and discount rates. Conventional scholarly and practitioner thinking held that the more
risk one took, the more one should get paid. Thus, discount rates used in determining
intrinsic values should be determined by the risk of the cash flows being valued. The
conventional model for estimating discount rates was the capital asset pricing model
(CAPM), which added a risk premium to the long-term risk- free rate of return (such as the
U.S. Treasury bond yield). Buffett departed from conventional thinking by using the rate of
return on the long-term (such as a 30-year) U.S. Treasury bond to discount cash flows.
Defending this practice, Buffett argued that he avoided risk, and therefore should use a risk-
free discount rate. His firm used almost no debt financing. He focused on companies with
predictable and stable earnings. He, or his vice chair Charlie Munger, sat on the boards of
directors where they obtained a candid, inside view of the company and could intervene in
managements’ decisions, if necessary. Buffett wrote: I put a heavy weight on certainty. If you
do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not
knowing what you’re doing. [Quoted in Jim Rasmussen, “Buffett Talks Strategy with
Students,” Omaha World-Herald, 2 January 1994, 26] We define risk, using dictionary terms,
as “the possibility of loss or injury.” Academics, however, like to define risk differently,
averring that it is the relative volatility of a stock or a portfolio of stocks—that is, the volatility
as compared to that of a large universe of stocks. Employing databases and statistical skills,
these academics compute with precision the beta of a stock—its relative volatility in the
past—and then build arcane investment and capital allocation theories around this
calculation. In their hunger for a single statistic to measure risk, however, they forget a
fundamental principle: it is better to be approximately right than precisely wrong. [Berkshire
Hathaway, Inc., 1993 Annual Report, and republished in Andrew Kilpatrick, Of Permanent
Value: The Story of Warren Buffett (Birmingham, Ala.: AKPE, 1994), 574] Comments
Buffett’s “OWNER-RELATED BUSINESS PRINCIPLES”, #7 indicate Berkshire Hathaway
“use[s] debt sparingly and, when [they] do borrow, [they] attempt to structure [their] loans on
a long-term fixed-rate basis.
15. 15. 15 A real example of how Buffett evaluates a company (Washington Post) was given in
the “Warren Buffett as Student of Value Investing” section of this paper. This is another
timeless and very important principle, since the discount rate is used for discounted cash
flow calculations to assess intrinsic value. This principle, however, would not be applicable to
investors buying index funds or assuming additional risks (e.g. using debt for the
investment). Professor Bruner’s discussion on use of CAPM to determine discount rate from
risk can be summarized with the following two equations: E(rD ) = rf + βD x (Market Risk
Premium)  E(rD ) = expected rate of return of an asset  rf = risk-free-rate  βD = asset’s
systematic risk measure, which is called beta Market Risk Premium = E(rM ) - rf  E(rM ) =
expected rate of return of the market 6. Diversification. Buffett disagreed with conventional
wisdom that investors should hold a broad portfolio of stocks in order to shed company-
specific risk. In his view, investors typically purchased far too many stocks rather than
waiting for the one exceptional company. Buffett said: Figure businesses out that you
understand, and concentrate. Diversification is protection against ignorance, but if you don’t
feel ignorant, the need for it goes down drastically. [Quoted in Forbes (October 19, 1993),
and republished in Andrew Kilpatrick, Of Permanent Value, 574] Comments As can be seen
in Exhibit 4, Berkshire Hathaway has a concentrated stock portfolio (the majority of funds are
invested in 4 firms: Coca-Cola, Gillette, Capital Cities/ABC and GEICO). This is not a key
principle, but is a natural result of the other principles in action. Furthermore, this principle
would not be applicable to most non-professional investors or anyone using passive
investment strategies. 7. Investing behavior should be driven by information, analysis, and
self-discipline, not by emotion or hunch. Buffett repeatedly emphasized awareness and
information as the foundation for investing. He believed that “anyone not aware of the fool in
the market probably is the fool in the market.” [Quoted in Michael Lewis, Liar’s Poker (New
York, NY: Norton, 1989), 35] Buffett was fond of repeating a parable told him by Benjamin
Graham: There was a small private business and one of the owners was a man named
Market. Every day Market had a new opinion of what the business was worth, and at that
price stood ready to buy your interest or sell you his. As excitable as he was opinionated,
Market presented a constant distraction to his fellow owners. “What does he know?” they
would wonder, as he bid them an extraordinarily high price or a depressingly low one.
Actually, the gentleman knew little or nothing. You may be happy to sell out to him when he
quotes you a ridiculously high price, and equally happy to buy from him when his price is low.
But the rest of the time you will be wiser to form your own ideas of the value of your holdings,
based on full reports from the company about its operation and financial position. [Originally
published in Berkshire Hathaway, Inc., 1987 Annual Report. This quotation was paraphrased
from James Grant, Minding Mr. Market (New York, NY: Times Books, 1993), xxi]
16. 16. 16 Buffett used this allegory to illustrate the irrationality of stock prices as compared to
true intrinsic value. Graham believed that an investor’s worst enemy was not the stock
market, but oneself. Superior training could not compensate for the absence of the requisite
temperament for investing. Over the long term, stock prices should have a strong
relationship with the economic progress of the business. But daily market quotations were
heavily influenced by momentary greed or fear, and were an unreliable measure of intrinsic
value. Buffett said, As far as I am concerned, the stock market doesn’t exist. It is there only
as a reference to see if anybody is offering to do anything foolish. When we invest in stocks,
we invest in businesses. You simply have to behave according to what is rational rather than
according to what is fashionable. [Peter Lynch, One up on Wall Street, (New York, NY:
Penguin Books, 1990), 78] Accordingly, Buffett did not try to time the market (i.e., trade
stocks based on expectations of changes in the market cycle)—his was a strategy of patient,
long-term investing. As if in contrast to Market, Buffett expressed more contrarian goals: “We
simply attempt to be fearful when others are greedy and to be greedy only when others are
fearful.” [Berkshire Hathaway, Inc., 1986 Annual Report, 16] Buffett also said, “Lethargy
bordering on sloth remains the cornerstone of our investment style,” [Berkshire Hathaway,
Inc., 1990 Annual Report, 15] and “The market, like the Lord, helps those who help
themselves. But unlike the Lord, the market does not forgive those who know not what they
do. [Berkshire Hathaway, Inc., Letters to Shareholders, 1977–1983, 53] Buffett scorned the
academic theory of capital market efficiency. The efficient markets’ hypothesis (EMH) held
that publicly known information was rapidly impounded into share prices, and that as a result,
stock prices were fair in reflecting what was known about a company. Under EMH, there
were no bargains to be had and trying to outperform the market was futile. “It has been
helpful to me to have tens of thousands turned out of business schools taught that it didn’t do
any good to think,” Buffett said. [Quoted in Andrew Kilpatrick, Of Permanent Value, 353] I
think it’s fascinating how the ruling orthodoxy can cause a lot of people to think the earth is
flat. Investing in a market where people believe in efficiency is like playing bridge with
someone who’s been told it doesn’t do any good to look at the cards. [Quoted in L. J. Davis,
“Buffett Takes Stock,” New York Times, 1 April 1990, 16] Comments Buffett also stated the
following in his Superinvestors paper: I'm convinced that there is much inefficiency in the
market. These Graham-and-Doddsville investors have successfully exploited gaps between
price and value. When the price of a stock can be influenced by a "herd" on Wall Street with
prices set at the margin by the most emotional person, or the greediest person, or the most
depressed person, it is hard to argue that the market always prices rationally. In fact, market
prices are frequently nonsensical. This is another very important principle with timeless
applicability for value investors. 8. Alignment of agents and owners. Explaining his significant
ownership interest in Berkshire Hathaway, Buffett said, “I am a better
17. 17. 17 businessman because I am an investor. And I am a better investor because I am a
businessman.” [Quoted in Forbes (19 October 1993), and republished in Andrew Kilpatrick,
Of Permanent Value, 574] As if to illustrate this sentiment, he further stated: A managerial
wish list will not be filled at shareholder expense. We will not diversify by purchasing entire
businesses at control prices that ignore long-term economic consequences to our
shareholders. We will only do with your money what we would do with our own, weighing
fully the values you can obtain by diversifying your own portfolios through direct purchases in
the stock market. [“Owner-Related Business Principles” in Berkshire Hathaway’s 1994
Annual Report, 3] For four of Berkshire’s six directors, over 50% of their families’ net worth
was represented by shares in Berkshire Hathaway. The senior managers of Berkshire
Hathaway subsidiaries held shares in the company, or were compensated under incentive
plans that imitated the potential returns from an equity interest in their business unit or both.
Comments The above quote is also from Buffett’s “OWNER-RELATED BUSINESS
PRINCIPLES”, #3. The “principal-agent problem” (microeconomics) can be a source of
source of market failure (e.g. inefficient operations; in extreme cases fraud). Agents (e.g.
corporate management) are hired to run a business on behalf of the principals
(shareholders). The primary goal of a publicly owned firm interested in serving its
stockholders should be to maximize shareholder equity (or wealth). Problems occur when
there is poor alignment between these two groups and the agents pursue self-interests.
While this principle describes management philosophy at Berkshire Hathaway, it can also be
used by investors to seek better investments (ones with alignment between agents and
principals) and is certainly one of the things Warren Buffett looks for when analyzing
businesses. While Professor Bruner has done an excellent job of compiling these principles,
it is not an all- inclusive-list and some are presented out of context. Investors who want a
fuller understanding of Warren Buffett’s principles, should read his OWNER-RELATED
BUSINESS PRINCIPLES easily accessible from the Berkshire Hathaway website. Berkshire
Hathaway’s Goals & Acquisition Criteria (Buffett’s Investing Principles in Action) The case
indicated “the GEICO announcement renewed general interest in Buffett’s approach to
acquisitions” and that the acquisition policy was a “tightly disciplined strategy”. The following
is Berkshire Hathaway’s Acquisition Policy (from the case, but originally from Berkshire
Hathaway’s 1994 Annual Report) and comments about GEICO
18. 18. 18 Berkshire Hathaway Acquisition Policy Comments about the GEICO Acquisition 1.
Large purchases of at least $10 million in after-tax earnings GEICO met this criteria 2.
Demonstrated consistent earning power Note that future projections are of no interest to us,
nor are turnaround situations. GEICO met this criteria 3. Businesses earning good returns on
equity, while employing little to no debt GEICO met this criteria 4. Management in place. We
cannot supply it GEICO met this criteria 5. Simple businesses only: if there is a lot of
technology, we will not understand it GEICO met this criteria 6. An offering price. We do not
want to waste our time or that of the seller by talking, even preliminarily, about a transaction
when the price is unknown N/A, since the acquisition was initiated by Berkshire Hathaway To
be considered, a company had to meet all of the acquisition criteria GEICO met all of the
applicable criteria The larger the company, the greater will be our interest: we would like to
make an acquisition in the $2 billion to $3 billion range. The GEICO acquisition was in this
range We will not engage in unfriendly takeovers The GEICO acquisition does not appear to
have been unfriendly As commented above, GEICO met all of Berkshire Hathaway’s
acquisition criteria. As Professor Bruner mentions in the case, Buffett had “stated that it was
the firm’s goal to meet a 15% annual growth rate in intrinsic value.” Buffett’s “OWNER-
RELATED BUSINESS PRINCIPLES” #3 gives Berkshire Hathaway’s goals: Our long-term
economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s
average annual rate of gain in intrinsic business value on a per-share basis. We do not
measure the economic significance or performance of Berkshire by its size; we measure by
per-share progress. We are certain that the rate of per-share progress will diminish in the
future – a greatly enlarged capital base will see to that. But we will be disappointed if our rate
does not exceed that of the average large American corporation. And, a way of tracking
intrinsic value: Inadequate though they are in telling the story, we give you Berkshire’s book-
value figures because they today serve as a rough, albeit significantly understated, tracking
measure for Berkshire’s intrinsic value. The following are figures provided by GEICO in their
1994 Annual Report:
19. 19. 19 1990 1991 1992 1993 1994 Book Value/sh $13.06 $16.67 $18.16 $21.66 $21.17
Common shares outstanding 74.253 M 71.047 M 71.184 M 70.834 M 68.291 M ROE 27.8%
24.6% 19.4% 18.7% 16.4% Using a financial calculator, we can see GEICO grew its proxy
for intrinsic value at 18.3% per year from 1990 to 1993. 1994 was not used for this
calculation since it saw a series of catastrophic losses: While the overall underwriting results
were satisfactory, 1994 was impacted significantly by a series of catastrophic losses
including winter freezing in the northeast and the Northridge, California earthquake. Based
on this calculation and Berkshire Hathaway’s experience with insurance, the GEICO
acquisition should serve the long-term goals of Berkshire Hathaway. Government Employees
Insurance Company (GEICO) As will be seen in the next sections, Warren Buffett had a
deep understanding of the insurance industry at the time of the acquisition and had been
following GEICO for a long time. Warren Buffett & GEICO “When I count my blessings, I
count GEICO twice.” –Warren E. Buffett William Thorndike’s book The Outsiders: Eight
Unconventional CEOs and Their Radically Rational Blueprint for Success gives a concise
description of Warren Buffett’s early interactions with GEICO: After graduation in 195[1],
Buffett asked Graham for a job at his investment firm, but was turned down and returned to
Omaha, where he took a job as a broker. The first company he recommended to clients was
GEICO, a car insurance company that sold policies directly to government employees. The
company had initially attracted Buffett’s attention because Graham was its chairman, but the
more he studied it, the more he realized GEICO had both important competitive advantages
and a margin of safety, Graham’s term for a price well below intrinsic value (the price a fully
informed, sophisticated buyer would pay for the company). He invested the majority of his
net worth in the company and attempted to interest his firm’s clients in the stock. He found
this a hard sell, however, and more generally found the brokerage business to be far
removed from the investment research he had come to love. An article Buffett wrote in 1951
(Exhibit 6) demonstrated his understanding of the economics associated with the automobile
insurance industry and the competitive advantage and good business foundation GEICO
held in the marketplace:
20. 20. 20  Auto insurance is regarded as a necessity by the majority of purchasers.  Other
industry advantages include lack of inventory collection, labor and raw material problems.
The hazard of product obsolescence and related equipment is also absent.  The company
has no agents or branch offices. As a result, policyholders receive standard auto-insurance
policies at premium discounts running as high as 30% off manual rates.  Probably the
biggest attraction of GEICO is the profit margin advantage it enjoys. The ratio of underwriting
profit to premiums earned in 1949 was 27.5% for GEICO as compared to 6.7% for the 135
stock casualty and surety companies summarized by Best’s.  At the end of 1950, the 10
members of the Board of Directors owned approximately one- third of the outstanding stock.
Some of the attributes associated with insurance companies can be discerned from Exhibit 1
of Professor Bruner’s Case, which shows the business segments of Berkshire Hathaway.
Inspection of the 1994 data reveals the following from the insurance segment:  Compared
to pretax operating profit, there is little capital expenditures  Compared to identifiable
assets, there is little depreciation  Compared to revenues, pretax operating profits are high
GEICO’s Competitive Advantage "I am perfectly willing to spend whatever it takes to get
everyone in the country to check our price” –Warren E. Buffett In the 1986 Chairman’s Letter,
Buffett states the following: The difference between GEICO’s costs and those of its
competitors is a kind of moat that protects a valuable and much-sought-after business castle.
No one understands this moat-around-the-castle concept better than Bill Snyder, Chairman
of GEICO. He continually widens the moat by driving down costs still more, thereby
defending and strengthening the economic franchise. Between 1985 and 1986, GEICO’s
total expense ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s
leadership, the ratio is almost certain to drop further. If it does - and if GEICO maintains its
service and underwriting standards - the company’s future will be brilliant indeed… In sum,
GEICO is an exceptional business run by exceptional managers. We are fortunate to be
associated with them. A recent Wall St Journal Article recently added: The architect of
Geico's strategy, ironically, is a publicity-shy chief executive who rarely gives interviews.
Tony Nicely, who started as a Geico clerk, initiated the ad push, with Mr. Buffett's
encouragement, soon after he took the top job in 1993. Mr. Nicely has long been one of Mr.
Buffett's top lieutenants.
21. 21. 21 Since 1995, Geico's market share of the U.S. personal auto-insurance market has
jumped to about 10% from 2.5%. Last year [2013], Geico became the second-largest U.S.
auto insurer by premiums, behind State Farm and ahead of Allstate Corp. and Progressive
Corp. One reason advertising is so important to Geico is that the firm doesn't use insurance
agents, which keeps its costs low. It instead offers policies directly to customers over the
Web or phone. In the 1993 Chairman letter, Buffett wrote: When I was first introduced to
GEICO in January 1951, I was blown away by the huge cost advantage the company
enjoyed compared to the expenses borne by the giants of the industry. That operational
efficiency continues today and is an all-important asset. No one likes to buy auto insurance.
But almost everyone likes to drive. The insurance needed is a major expenditure for most
families. Savings matter to them – and only a low-cost operation can deliver these. GEICO’s
cost advantage is the factor that has enabled the company to gobble up market share year
after year. Its low costs create a moat – an enduring one – that competitors are unable to
cross. Meanwhile, our little gecko continues to tell Americans how GEICO can save them
important money. With our latest reduction in operating costs, his story has become even
more compelling. The following table from GEICO’s 1994 Annual Report shows GEICO had
better underwriting ratios, a key metric used by insurance companies as a measure of
profitability of operations (lower numbers are better; values above 100% indicate the firm is
not making a profit), than the industry: Note: Hurricane Andrew caused the profitability
measures to suffer in 1992. Lastly, Exhibit 7, a historical record of GEICO’s share price (prior
to stock splits) shows GEICO significantly outperformed both its industry and the market.
22. 22. 22 GEICO’s Business Principles GEICO’s 1994 Annual Report contains a list of five
business operating principles at GEICO: In our 1986 Annual Report we discussed our five
operating principles. To remind you, those principles are:  Be fanatics for good service 
Achieve an underwriting profit  Be the low-cost provider  Maintain a disciplined balance
sheet  Invest for total return As we have said many times, we think that over time,
shareholder value is most enhanced by investing for long-term total returns. We feel this
approach helps keep us from making poor short-term decisions when it comes to sector
allocation or investing in the latest Wall Street craze. Over the years, the superior
performance of your common stock portfolio segment in particular has added much value to
the Corporation. In the selection of common stocks, we continue to be guided by the same
five criteria that we detailed in our 1986 Annual Report:  Think independently  Invest in
high-return businesses run for the shareholders  Pay only a reasonable price, even for an
excellent business  Invest for the long term  Do not diversify excessively Since we last
mentioned these principles in 1986, the Corporation has seen its ups and downs, but mostly
ups. In reviewing this history, management asks itself what we could have done better. As
the expression goes, hindsight is always 20-20, and we would possibly have done certain
things differently. We can assure you, however, that we would not have changed any of our
five operating principles or our dedication to them. They have served us well in the past and
we expect to be guided by them in the future. We intend to continue to focus our
concentration on profitably growing our core personal lines automobile business, through
concentrating on providing superior customer service and achieving greater operating
efficiencies. By 1995, Warren Buffett would have been intimately aware of the job Nicely and
Simpson were doing living up to these principles. Lou Simpson - GEICO’s Superinvestor
“The second stage of the GEICO rocket is fueled by Lou Simpson, Vice Chairman, who has
run the company’s investments since late 1979.” –Warren E. Buffett
23. 23. 23 Prior to 1979, Lou Simpson was unknown by Warren Buffett. By 2004, Simpson was
managing ~$2.5 billion of equities held by GEICO and Buffett had this to say: You may be
surprised to learn that Lou does not necessarily inform me about what he is doing. When
Charlie and I assign responsibility, we truly hand over the baton – and we give it to Lou just
as we do to our operating managers. Therefore, I typically learn of Lou’s transactions about
ten days after the end of each month. Sometimes, it should be added, I silently disagree with
his decisions. But he’s usually right. Exhibit 8 from Berkshire Hathaway’s 2004 chairman
letter shows that Simpson had compounded investment returns at 20.3% annually from
1980-2004 vs. 13.5% for the S&P 500 A Washington Post article provides more insight into
Lou Simpsons Investing Principles and it is no wonder Warren Buffett took a liking to him
when they met in 1979. According to the article: In 1960, he completed a master's degree in
economics at Princeton University. Simpson considered a career teaching economics, but
soon abandoned that in favor of a job with a Chicago investment firm. The deciding factor, he
said, was that the Chicago job offered greater financial rewards. Before Buffett and former
Geico chairman Jack Byrne persuaded him to join Geico in 1979, Simpson worked about 10
years as a money manager and in other capacities for Western Asset Management Inc. in
California. Simpson says there is no mystery to his stock market magic. A voracious reader,
the 50- year-old vice chairman of Geico searches daily newspapers, magazines, annual
reports and newsletters for clues that might spark investment ideas. His four-member
investment team uses computer screens to identify stocks that, on the basis of financial data,
appear to be bargains. "One of the things I have learned over the years is how important
management is in building or subtracting from value. We will try to see a senior person and
prefer to visit a company at their office, almost like kicking the tires. You can have all the
written information in the world, but I think it is important to figure out how senior people in a
company think." "Indeed, it's a little embarrassing for me, the fellow responsible for
investments at Berkshire, to chronicle Lou's performance at Geico," Buffett wrote. "Only my
ownership of a controlling block of Berkshire stock makes me secure enough to give you the
following figures. These are not only terrific figures, but, fully as important, they have been
achieved in the right way. Lou has consistently invested in undervalued common stocks that,
individually, were unlikely to present him with a permanent loss and that, collectively, were
close to risk-free." Buffett said he talks to Simpson about once a week. "Lou has made me a
lot of money," Buffett said. "Under today's circumstances, he is the best I know. He has done
a lot better than I have done in the last few years. He has seen opportunities I have missed.
We have $700 million of our own net worth of $2.4 billion invested in Geico's operations, and
I have no say whatsoever in how Lou manages the investments. He sticks to his principles.
Most people on Wall Street don't have principles to begin with. And if they have them, they
don't stick to them."
24. 24. 24 Lou Simpson’s 5 Principles of Investment 1. Think Independently "We try to be
skeptical of conventional wisdom and try to avoid the waves of irrational behavior and
emotion that periodically engulf Wall Street. We don't ignore unpopular companies. On the
contrary, such situations often present the greatest opportunities." Comments This principle
is similar to Buffett’s: Investing behavior should be driven by information, analysis, and self-
discipline, not by emotion or hunch. 2. Invest in High-Return Businesses Run for the
Shareholders "Over the long run appreciation in share prices is most directly related to the
return the company earns on its shareholders' investment. Cash flow, which is more difficult
to manipulate than reported earnings, is a useful additional yardstick. "We ask the following
questions in evaluating management:  Does management have a substantial stake in the
stock of the company?  Is management straightforward in dealings with the owners?  Is
management willing to divest unprofitable operations?  Does management use excess cash
to repurchase shares? The last may be the most important. Managers who run a profitable
business often use excess cash to expand into less profitable endeavors. Repurchase of
shares is in many cases a much more advantageous use of surplus resources." Comments
This principle contains elements from four of Buffetts’ principles:  Economic reality, not
accounting reality  Value creation: time is money  Measure performance by gain in intrinsic
value, not by accounting profit  Alignment of agents and owners 3. Pay only a reasonable
price, even for an excellent business "We try to be disciplined in the price we pay for
ownership even in a demonstrably superior business. Even the world's greatest business is
not a good investment if the price is too high. The ratio of price to earnings and its inverse,
the earnings yield, are useful gauges in valuing a company, as is the ratio of price to free
cash flow. A helpful comparison is the earnings yield of a company versus the return on a
risk-free long- term United States Government obligation." Comments This is related to
Buffett’s value creation: time is money principle and the value investing margin of safety
25. 25. 25 Invest for the long-term. "Attempting to guess short-term swings in individual stocks,
the stock market or the economy is not likely to produce consistently good results. Short-
term developments are too unpredictable. On the other hand, shares of quality companies
run for the shareholders stand an excellent chance of providing above-average returns to
investors over the long term. Furthermore, moving in and out of stocks frequently has two
major disadvantages that will substantially diminish results: transaction costs and taxes.
Capital will grow more rapidly if earnings compound with as few interruptions for
commissions and tax bites as possible.” Comments This is an element of Buffett’s investing
behavior should be driven by information, analysis, and self-discipline, not by emotion or
hunch principle. Both of these very successful investors have a long-term investment
horizon. Do not diversify excessively "An investor is not likely to obtain superior results by
buying a broad cross-section of the market. The more diversification, the more performance
is likely to be average, at best. We concentrate our holdings in a few companies that meet
our investment criteria. Good investment ideas-that is, companies that meet our criteria-are
difficult to find. When we think we have found one, we make a large commitment.” “The five
largest holdings at Geico account for more than 50 percent of the stock portfolio." "One
lesson I have learned is to make fewer decisions. Sometimes the best thing to do is to do
nothing. The hardest thing to do is to sit with cash. It is very boring." Comments This
principle contains elements from two of Buffetts’ principles:  Diversification  The cost of the
lost opportunity Both of these very successful investors have similar view about
diversification and concentrating a portfolio to the best ideas. Like all of Warren Buffett’s
principles’, these are timeless advice for value investors but not always applicable (e.g.
portfolio concentration) to all investors. Financial Analysis of GEICO Acquisition Acquisition
Announcement Although Professor Bruner did an excellent job describing the Acquisition
Announcement, additional information is available in the Exhibits.
26. 26. 26 Exhibit 9 is the joint press release issued by Berkshire Hathaway and GEICO on
August 25, 1996. As a result of the transaction GEICO will become a subsidiary of Berkshire
Hathaway. Olza M. (Tony) Nicely and Louis A. Simpson will continue as Co-Presidents and
Co- Chief Executives of GEICO. They noted that, since GEICO will continue to be run by its
present management team as a separate business operation, they and Warren E. Buffett,
the Chairman of Berkshire Hathaway, do not expect any reduction in staff at GEICO as a
result of the merger. Exhibit 10 is a New York Times Article describing the offer from Buffett
the following day. Analysis of Value Line Forecast Using CAPM Columbia Business School
Professor Noron Nissim wrote and excellent paper on the analysis and valuation of
insurance companies. While free cash flow valuation is the primary fundamental valuation
approach used to value non-financial companies, it is rarely used to value financial service
companies. This is due to the differences between financial and non-financial companies
discussed at the beginning of Section 3.7. Instead, financial service companies are typically
valued by discounting expected cash flows or earnings that flow to or accrue to equity-
holders. Three types of models are used: (a) discounted dividend per share, (b) discounted
net equity flows, and (c) the residual income model. Although these models are analytically
equivalent, in practice their implementation involves different assumptions and hence results
in different value estimates. Since we have dividend data for GEICO, we can use the
discounted dividend per share method. Professor Bruner’s case provides the following key
data and forecast data from Value Line:
27. 27. 27 Note: The relevancy of the Capital Cities/ABC deal is that it would provide the cash
Buffett needed to close the deal with GEICO. Using CAPM, we can calculate the required
return: GEICO's Beta β = 0.75 Equity market risk premium E(rM ) - rf = 5.50% 30-year
Treasury Yield rf = 6.86% Discount Rate K = rf + β x ( E(rM ) - rf ) = 10.985% The following
tables use this discount rate with the Value Line forecast to calculate present values for
GEICO. Cash Flows Year 1995 1996 1997 1998 1999 2000 Low Forecast Cash Flows N/A $
1.16 $ 1.25 $ 1.34 $ 1.44 $ 91.55 Present Value for 1995 N/A $1.05 $1.01 $0.98 $0.95
$54.37 Low Estimate of Value for 1995 $58.36 The low estimate of present value is slightly
above the $55.75 market price before the announcement was made.
28. 28. 28 Cash Flows Year 1995 1996 1997 1998 1999 2000 High Forecast Cash Flows N/A $
1.16 $ 1.34 $ 1.55 $ 1.79 $ 127.07 Present Value for 1995 N/A $1.05 $1.09 $1.13 $1.18
$75.46 High Estimate of Value for 1995 $79.91 The high estimate of present value is almost
$10 higher than the $70 offer price. If we assume either outcome has a 50% chance, we can
come up with a value very close to the offer price: 50% x $58.36 + 50% x $79.91 = $69.14
So using CAPM and assuming Value Line’s security analysts represent a typical security
analyst following GEICO, it appears the offer was a fair one (and proof was in its
acceptance). We will revisit this in the next section. How Warren Buffett May Have Analyzed
the Same Value Line Data “GEICO’s sustainable cost advantage is what attracted me to the
company way back in 1951, when the entire business was valued at $7 million. It is also why
I felt Berkshire should pay $2.3 billion last year [1996] for the 49% of the company that we
didn’t then own” –Warren E. Buffett From Professor Bruner’s case, we know Buffett would
use a risk free rate (e.g. rate of return on the long-term 30-year U.S. Treasury bond) to
discount future cash flows to the present. The case also provided the following data: Yield of
30-year U.S. Treasury bond on August 25, 1995 was 6.86% If Buffett used this risk-free rate
as the discount rate along with the low forecast from Value Line (which would be required as
a conservative investor attempting to determine the more certain outcome), Buffett would
have calculated an intrinsic value of ~$70.00, which is the offer price
29. 29. 29 Cash Flows Year 1995 1996 1997 1998 1999 2000 Low Forecast Cash Flows N/A $
1.16 $ 1.25 $ 1.34 $ 1.44 $ 91.55 Present Value for 1995 N/A $1.09 $1.09 $1.10 $1.10
$65.70 Low Estimate of Value for 1995 $70.09 This discounted cash flow analysis using
conservative estimates and a risk free discount rate suggests that the bid price was
appropriate, but did not appear to have a margin of safety. As we will see in the next section,
the acquisition had hidden benefits that would allow the acquisition to make sense to an
investor like Buffett. Other Items Warren Buffett May Have Considered This section will
explore some things that Buffett may have considered and were probable motives for making
an offer close to the probable intrinsic value calculation from the last section. Professor
Nissim’s paper also discusses taxation of insurance companies. With Berkshire Hathaway
owning 50.4% of GEICO’s 67,889,574 shares outstanding (approximately 34.2 million
shares), Berkshire Hathaway would have an effective tax rate (TR) (20% x 35%) + (15% x
80% x 35%) = 11.2% on dividend income from GEICO (although footnote 6 of the case
indicated Berkshire Hathaway paid 14% tax rate on dividends, we will use the calculated rate
of 11.2% below). With a forecast dividend for 1996 of $1.16, Berkshire Hathaway would earn
~$39.7 million in dividend income from GEICO and pay ~$4.45 million in taxes. However, by
fully acquiring GEICO, this effective tax rate would drop to 0% on dividends. Assuming
GEICO’s dividend grows 7.5%/year (growth rate found using financial calculator and Value
Line’s low forecasts), we can use the constant growth Dividend Discount Model to determine
how much Berkshire Hathaway would save in taxes after the acquisition.
30. 30. 30 TR = 11.2% T1 = TR * D1 = 11.2% * $39.7 million = $4.446 million G = 7.5% To be
conservative, we will use GEICO’s cost of equity, so K = 11% (Value Line) Present value of
all future taxes on dividends: PV = T1 / (K – G) = $4.446 million / (11% - 7.5%) = $127 million
It should be noted that GEICO’s cost of equity could be significantly lower post acquisition
(Berkshire Hathaway had a beta closer to one, meaning the typical security analyst would
view Berkshire Hathaway less risky). It was also likely Buffett would cancel the “dividends”
altogether and allow Simpson to invest all of the earnings. Buffett may have also considered:
Berkshire Hathaway paid ~$50 million for its state in GEICO At preannouncement market
price, Berkshire Hathaway’s stake in GEICO was $1.825 billion. By purchasing GEICO,
Berkshire Hathaway would never have to pay capital gains tax on the original investment! A
tax liability of 35% x $1,825 million = $638.75 million If we add the tax savings on dividends
($127 million) and the thwarted capital gain tax ($638.75 million), Berkshire Hathaway is
saving ~$765 million by buying GEICO. This is the most likely reason Berkshire Hathaway’s
share price increased in value on the same day as the announcement. Although Berkshire
Hathaway owned more than 50% of GEICO, it was not a controlling interest (had it been, the
acquisition price would have been a lot lower). By making the deal, Berkshire Hathaway
would assume full control. The 1980 Chairman Letter states:
31. 31. 31 The deal would also add more float and an executive (Lou Simpson) who could fill
Buffett’s position as chief investment officer if something were to happen to Buffett
(something that investors were worried about due to Buffett’s age). Note: Buffett was 65
years old in 1996. The 2014 Annual Report provides a good introduction to float at Berkshire
Hathaway: Conclusions This paper looked at various aspects of Warren Buffett, Berkshire
Hathaway and GEICO and answered the questions posed at the end of the Professor
Bruner’s case:  Would the GEICO acquisition serve the long-term goals of Berkshire
Hathaway? Yes; GEICO met all of Berkshire Hathaway’s acquisition criteria and would serve
the long-term goals of Berkshire Hathaway to outperform the average large American
corporation. Note: See the section of this paper titled Berkshire Hathaway’s Goals &
Acquisition Criteria for the full details.  Was the bid price appropriate? Yes; a conservative
calculation of GEICO’s intrinsic value was in line with the offer price. By factoring in other
items including tax savings, bringing another superinvestor on board and corporate control,
there was also a margin of safety. Note: See the sections of this paper titled Analysis of
Value Line Forecast Using CAPM and How Warren Buffett May Have Analyzed the Same
Value Line Data for the full details.
32. 32. 32  What might account for the share price increase for Berkshire Hathaway at the
announcement? In buying GEICO, Berkshire Hathaway would never have to pay capital
gains tax on gain of the first half of the company they already owned and would no longer
have to pay tax on the dividends. Note: See the section of this paper titled How Warren
Buffett May Have Analyzed the Same Value Line Data for the full details. In closing, we all
owe a debt of gratitude to Benjamin Graham, Warren Buffett, Lou Simpson and others who
have candidly shared their value investing philosophies and principles over the years.
33. 33. 33 References Publications Case Study: Professor Robert F. Bruner (1996), “Warren E.
Buffett, 1995”, Darden Business Publishing (UV0006 V1.7) 1995 Annual Report (10K) –
GEICO 1996 Annual Report – Berkshire Hathaway 2004 Annual Report – Berkshire
Hathaway Berkshire Hathaway Inc.: Celebrating 50 Years of a Profitable Partnership, 2014
Buffett, Warren E., “The Security I like Best”, The Commercial and Financial Chronicle,
December 6, 1951 Buffett, Warren E., "The Superinvestors of Graham-and-Doddsville",
Hermes, Columbia Business School Magazine, Fall 1984 Joe Carlen, The Einstein of Money:
The Life and Timeless Financial Wisdom of Benjamin Graham, Amherst, New York,
Prometheus Books, 2012 Anupreeta Das, “Berkshire Sees Green With Geico”, Wall Street
Journal, Aug. 24, 2014 Easton P., Wild J., Halsey R. & McAnally M., 2013, Financial
Accounting for MBAs, 5th ed., Cambridge Business Publishers, Westmont, Illinois Prem C.
Jain, Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management When
Investing, Hoboken, NJ, John Wiley & Sons, 2010 Koller T., Goedhart M. & Wessels D.
2010, Valuation: Measuring and Managing the Value Companies, 5th ed., John Wiley &
Sons, Hoboken, New Jersey Ehrbar, Al, EVA: The Real Key to Creating Wealth, New York,
NY: John Wiley & Sons, 1998 Robert G. Hagstrom Jr., The Warren Buffett Way: Investment
Strategies of the World’s Greatest Investor, New York, NY, John Wiley & Sons, 1994 Andrew
Kilpatrick, Of Permanent Value: The Story of Warren Buffett, Birmingham, AL, AKPE, 1994
Robert P. Miles, Warren Buffett Wealth: Principles and Practical Methods Used by the
World’s Greatest Investor, Hoboken, NJ, John Wiley & Sons, 2004 Doron Nissim, “Analysis
and Valuation of Insurance Companies”, Columbia Business School, November 2010
34. 34. 34 Sharpe, Alexander & Bailey, Investments, 6th Edition, Upper Saddle River, NJ:
Prentice Hall, 1995, p228 William Thorndike, The Outsiders: Eight Unconventional CEOs
and Their Radically Rational Blueprint for Success, Boston, MA, Harvard Business School
Publishing, 2012 David A. Vise, “Geico's Top Market Strategist Churning Out Profits; Lou
Simpson’s Stock Rises on His Successful Ideas”, The Washington Post, 11 May 1987
Websites Berkshire Hathaway share prices:
Information on the insurance industry:
35. 35. 35 Exhibits Exhibit 1 From 1957 through 1969, the Buffett Partnership achieved
extraordinary results by beating the Dow every year. Source: The Outsiders: Eight
Unconventional CEOs and Their Radically Rational Blueprint for Success, P171
36. 36. 36 Exhibit 2 Share price performance of Berkshire Hathaway from 1976 compared to
S&P 500 Source:
37. 37. 37 Exhibit 3 Dollar amounts in $ millions
38. 38. 38 Exhibit 4 Source: Berkshire Hathaway 1994 Annual Report
39. 39. 39 Exhibit 5 Source: Berkshire Hathaway 1994 Annual Report
40. 40. 40 Exhibit 6
41. 41. 41 Exhibit 7 Source: The Warren Buffet Way, 1st Ed., P129
42. 42. 42 Exhibit 8 Source: Berkshire Hathaway 2004 Annual Report
43. 43. 43 Exhibit 9 Source:
44. 44. 44 Exhibit 10 Buffett Moves To Acquire All of Geico By MICHAEL QUINT Published:
August 26, 1995 Warren E. Buffett is returning his focus to one of his earliest successes.
Berkshire Hathaway Inc., which he controls, announced a $2.3 billion cash offer yesterday to
buy the 49 percent of the Geico Corporation it does not already own. Geico, the country's
sixth-largest car insurer, has been a solidly profitable company in recent years with a good
record for low losses and low expenses in comparison with others in its business. These
results have been possible because the company bypasses agents, selling directly to the
consumer, concentrating on low-risk drivers. For Mr. Buffett, the renowned investor, the cash
offer was for the company that caught his eye more than four decades ago. "In 1951, when I
was 20, I invested well over half of my net worth in Geico," Mr. Buffett said. In the mid-
1970's, when Geico was reeling from heavy losses, Mr. Buffett sharply increased his
investment, which rose in value many-fold as the company recovered. In yesterday's
announcement, Mr. Buffett did not elaborate on his views of Geico or the auto insurance
business in general, except to say that he was happy with the old investment and "equally
comfortable" with the new purchase. Ira Zuckerman, an insurance analyst at UBS Securities,
said the Geico investment could be an indirect result of the Walt Disney Company's $19
billion bid to acquire Capital Cities/ABC Inc., in which Berkshire Hathaway owns 20 million
shares. That stake would be worth $1.5 billion if all the shares were sold to Disney. "There is
a big chunk of cash coming in from the Cap Cities/ABC shares that has to be redeployed,"
Mr. Zuckerman said, "and I think that he looked around and decided he did not see anything
that was more attractive than the Geico business, which he already knows." The Berkshire
Hathaway offer of $70 a share was 26 percent higher than Thursday's closing price for Geico
of $55.75. Geico stock closed yesterday at $68.625. A rise in the stock of many automobile
and property insurers followed the Berkshire Hathaway announcement, as investors and
traders tried to imitate Mr. Buffett's decision, and as insurance investors bought shares in
other companies to replace their Geico holdings. Shares of the Allstate Corporation of
Northbrook, Ill., the second-largest seller of personal auto insurance behind the
45. 45. 45 State Farm Mutual Automobile Insurance Company of Bloomington, Ill., rose 75 cents,
to $32.50, while the Progressive Corporation of Mayfield Village, Ohio, rose $1.125, to
$42.50, and 20th Century Industries rose 62.5 cents, to $14.75. Rising bond prices also
helped lift prices of insurance stocks yesterday. Auto insurance for individuals, a business
that collects more than $90 billion of premiums a year, has been more profitable for insurers
than many kinds of property and liability insurance. Members of the baby boom generation
have become safer drivers and the number of claims has decreased with tougher penalties
for drunken driving and more safety features on cars. Unlike most auto insurers, Geico sells
policies directly to consumers using the mail and cable television, and quoting its prices by
telephone. That approach saves paying commissions to sales agents, who typically collect
10 percent or more. As a result, the company can offer lower prices to the customers it wants
-- primarily the lowest-risk, safest drivers. "I think the auto insurance business, like property
insurance in general, is undervalued in the market," Mr. Zuckerman said. Part of the
problem, he said, is that too many investors allow their judgment to be colored by their own
unpleasant experiences with insurers, and overlook favorable trends in growth and profits.
The Geico strategy has also attracted Maurice Greenberg, chairman of the American
International Group, an insurance company that last year invested more than $200 million in
20th Century Industries, an auto insurer based in Woodland Hills, Calif., with a strategy
similar to Geico's. The company was profitable until the Northridge earthquake in 1994
caused losses on homeowners' policies, threatening to put the company out of business.
Besides restoring 20th Century's financial strength, American International has helped the
company to expand its business into other states. Geico, which is based in Washington,
does business in every state except New Jersey and Massachusetts. And like 20th Century,
Geico has recently announced plans to leave the homeowners' market. Source: