The Warren Buffett Way
Buffett's Investments: GEICO Corporation
Government Employees Insurance Company (GEICO) was a special type of insurance company that used to sell motor insurance to government employees. The founder of the company had discovered that government employees are safe drivers and hence its profitable to sell insurance to them as the claims are lower. Additionally, GEICO used to sell insurance directly to customers, thus eliminating middle men. This helped the company save 10-25% of the cost compared to other insurance companies that sold policies through agents.
GEICO was running profitably; however, post the management change it faced a lot of difficulties specially related to underfunded balance sheets. This means that the company had lower assets than the claims it needed to settle. Thus, the share price which had hit a high of $61 in 1972, stood at $2 in 1976. Buffett invested $4.1mn into the stock at an average price of $3.18 when it was close to bankruptcy. Let us find out what made Buffett buy such a loss-making company.
Simple and understandable
Buffett was fond of insurance companies and held insurers such as Kansas City Life, Massachusetts Indemnity and Life Insurance Company and National Indemnity in Berkshire’s portfolio. The CEO of National Indemnity educated Buffett on how an insurance company is run. Thus, despite GEICO’s shaky financials, Buffett was able to invest in the company because he knew the business well.
Consistent operating history
Although, 1975-1976, GEICO performed poorly, but the understanding of the economics of the insurance business made Buffett conclude that the company was just wounded and could turnaround. The low-cost operations of the company achieved through selling insurance directly to the customers created a moat and hence was a special business to own.
Favorable long-term prospects
Although, insurance is a commodity business, with no price differentiation. However, Buffett has always believed that low-cost is a moat and hence for a commodity business, having a low-cost operation is a must.
When the company was facing financial losses, the CEO at that time, Jack Byrne, made a tough decision to slow down the growth and work on profitability first. The efforts paid off.
In 1976, when the company was facing financial difficulties and required money for operations, it stopped dividends. Next, in 1983, the company was not able to invest the surplus cash at higher returns. It increased the dividends and returned the money to shareholders by way of buybacks.
Return on Equity
In 1980, the ROE was 30.8%, twice as high than its peers.
Determining the value
In 1980, Buffett owned a third of GEICO. It earned a net profit of $60 million. So, Berkshire’s share in the earning would be 60/3 = $20 million. Buffett was of the view that to buy a $20 million earning business with similar quality, one was ready to pay $200 million. And do you know at what price Buffet acquired 1/3 of GEICO or at what price Buffett acquired the business giving him $20 million annually? It was at just $47 million. That is a huge margin of safety.
The One-Dollar Premise
Between 1980 to 1992, GEICO’s market cap rose from $296 million to $4.3 billion. During these 13 years, it retained $1.4 billion. Hence it created a value of $3.12 for every dollar retained.