I wrote an article about GEICO last November (here), but I haven’t talked too much about the company since then. In that article, I discussed some of the amazing results GEICO has reported since becoming a wholly-owned subsidiary of Berkshire Hathaway (BRK.B) two decades ago. The research I completed in preparation for writing that article left me with the impression that GEICO was one of the best businesses I had ever seen. They have a sustainable competitive advantage, and the moat has widened over time.
This has allowed GEICO to slowly but surely take market share, moving from outside the top five in private passenger auto insurance in the U.S. to second over the past two decades; they’ve been wildly profitable as well, with a ~92% combined ratio (on average) over the past decade.
That article only looked forward from the acquisition (1995). In the past few weeks, I’ve been working my way through Warren Buffett (Trades, Portfolio)’s old shareholder letters; as I started reading the letters from the late seventies and early eighties, Warren began talking about GEICO in detail.
As the investment became increasingly important to Berkshire (which I’ll discuss in part two), Warren essentially presented a case study that outlines his thought process for what has become one of his best investments of all time – and quite possibly #1 overall. This article will look at what Warren was saying about GEICO in the late seventies and early eighties, in addition to looking at how he built the position; the second part (which I'll publish tomorrow) will look at how he managed the position after initially investing in GEICO in 1976.
Thoughts on GEICO
Despite a lot of activity behind the scenes (primarily an initial investment of ~$20 million in preferred stock and a few million in common), Warren didn’t mention GEICO in the 1976, 1977 or 1978 shareholder letters (besides listing it as a holding in the investments table). He mentioned the company in 1979, but only in passing: “We have a very large indirect interest in two truly outstanding management groups through our investments in SAFECO and GEICO.”
In 1980, after Warren added another ~$20 million of common stock to Berkshire’s stake in the company – the last time he would buy GEICO shares for many, many years – he began to open up and discuss the rationale for the investment. He didn’t mince his words:
“GEICO represents the best of all investment worlds - the coupling of a very important and very hard to duplicate business advantage with an extraordinary management whose skills in operations are matched by skills in capital allocation”.
By the end of 1980, Warren had acquired 7.2 million shares for Berkshire Hathaway, with a market value of $105 million; that was enough for a one-third equity interest in GEICO. Consider those figures in the context of this comment from the 1980 shareholder letter:
“We estimate our share of [GEICO’s] earning power is on the order of $20 million annually.”
In 1980, the stock was valued at roughly 5x normalized earnings. Note that the market value of the position had already more than doubled by this point from Berkshire’s cost basis (most of the position had been purchased in 1976 when GECIO was facing serious financial issues).
Warren noted that even after a solid performance for the stock in recent years, “buying a similar $20 million of earnings power in a business with first-class economic characteristics and bright prospects would cost a minimum of $200 million”. Clearly Warren thought Mr. Market was being too pessimistic with the $105 million valuation he placed on Berkshire’s stake at year end 1980. It didn’t take long for that to change: A year later, GEICO’s stock had nearly doubled.
Importantly, management realized that the valuation was attractive in the late 1970’s as well, and acted accordingly (surely Warren would’ve been happy to share his thoughts if they inquired):
“In just the last two years [1979 & 1980] GEICO, through repurchases of its own stock, has reduced the share equivalents it has outstanding from 34.2 million to 21.6 million, dramatically enhancing the interests of shareholders in a business that simply can’t be replicated. The owners could not have been better served.”
In that same letter, Warren shared his investment thesis for GEICO in detail:
“The fundamental business advantage that GEICO had enjoyed - an advantage that previously had produced staggering success - was still intact within the company, although submerged in a sea of financial and operating troubles.
GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) populated largely by companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its customers while earning unusual returns for itself. For decades it had been run in just this manner. Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage.
GEICO’s problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true “turnaround” situation in which the managers expect - and need - to pull off a corporate Pygmalion.”
The points addressed there are worth summarizing: Warren found a company that (a) had a competitive advantage in its core business (“the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company”), (b) with competitors who were unwilling or unable to address their relative shortcomings, (c) was facing temporary issues that didn’t reflect any diminution of its competitive advantage (“the company had not lost its position as a low cost operator”), (d) run by people who had the ability to address and remove those issues, and (e) once those issues were addressed, would be positioned in a large market where it could generate outsized returns for years / decades. Other important factors were specific to the industry, notably (a) the relatively homogeneous nature of the product being sold, and (b) the large gap in operating costs between the low cost operator – GEICO – and the competition.
Warren put this all succinctly in the 1981 letter to shareholders:
“GEICO is a brilliantly run implementation of a very important business idea.”
As he shared in 1983, Warren was able to look a few years out in the late 1970’s and get a pretty good idea of what laid ahead for GEICO; in other words, it essentially became a matter of time:
“Though business policies may be changed and personnel improved, a significant period must pass before the effects are seen. (This characteristic of the business enabled us to make a great deal of money in GEICO; we could picture what was likely to happen well before it actually occurred.)”
The culmination of those factors led to a once in a lifetime investment opportunity; Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) weren't going to let that opportunity pass them by. As I'll show in part two, which I'll publish tomorrow, they took a big swing when they saw a pitch they liked coming across the plate.
