In 1951, Warren Buffett wrote an article about the Government Employees Insurance Company (GEICO) in the local newspaper entitled, “The Security I Like Best”. The article is instructive because it clearly shows the factors that Buffett used to analyze and value a stock. The story of how Buffett came to own it provides a model of how to find and research a stock.
Buffett was first attracted to GEICO in the 50’s when he learned that his idol, Ben Graham, was chairman of the board and an owner. He thoroughly researched the company and invested three-quarters of his portfolio in the stock. Although he eventually sold his original position, in the late 70’s, he again, through Berkshire Hathaway, made a major investment in GEICO, when its share price tumbled as a result of underpricing its insurance risk. Finally, in 1996, Berkshire Hathaway purchased the balance of the company, and GEICO became a wholly owned subsidiary of Berkshire Hathaway. Today, GEICO continues to thrive and take market share under its low-cost model.
Here are some of the lessons we can take away from Buffett’s early purchase of GEICO.
1. Use public disclosures as a way to generate ideas. Buffett closely followed the investments of Benjamin Graham’s investment company, Graham-Newman Corp. As a result, he invested in Marshall Wells and Timely Clothes. He became interested in Geico, when he learned that Graham was the chairman and an owner. A great way to generate ideas today are Form 13Fs, which disclose the equity holdings of large institutional investment managers. They are available for free at the SEC website and available from a number of free and paid service providers such as Gurufocus, Portfolio Reports, The Manual of Ideas, and SuperInvestor Insight. Caution! These ideas are a starting point and you should always do your own research to understand the company and why its stock may be undervalued.
2. Do thorough research. It was not enough for Buffett to know that Graham was chairman of Geico. He wanted to understand the company for himself. On a Saturday in 1951, Buffett took a train from New York to Washington and went to Geico’s office in downtown Washington. Since it was closed, he had to bang on the door until the janitor finally let him in to see an executive, Lorimar Davidson, who happened to be working. Buffett ended up spending four hours with Davidson. Lowenstein tells us in his biography of Buffett that, “He asked searching and highly intelligent questions. What was Geico? What was its method of doing business, its outlook, its growth potential? He asked the types of questions that a good security analyst would ask. I was the financial vice president. He was trying to find out what I knew.”
3. Invest based on the facts and have confidence in your own judgment. Ben Graham would say, “You are neither right not wrong because the crowd disagrees with you.” After Buffett returned from Washington, he was excited about what he had learned about Geico. He did additional research and found out that Geico’s profit margins were five times higher than those of its competitors and that their premium volume was growing at a fast clip. However, when he visited a number of insurance experts of the day to get their take, they told him that the stock was overvalued. In the end, Buffett proceeded to invest based on his own work, putting three-quarters of his portfolio into the stock.
4. Make meaningful investments. It is difficult to find a great company at a great price. If you do, you should commit enough capital to make a difference in your results. A 1% position in a great company, with a clear competitive advantage, that you understand, with great management, available at a significant discount, does not make a lot of sense. Think how a private investor would approach it, if he had a chance to invest a portion of his capital in the best company in town at a fair price.
5. Look for good economics with a competitive advantage. Capitalism breeds intense competition. As Bruce Greenwald wryly put it, “In the long run, everything is a toaster”. Buffett recognized this and that GEICO was special. First, GEICO had great economics: its profit margin on underwriting was 27.5% vs. an industry average of 6.7%. Better yet, it appeared sustainable. Buffett identified that GEICO had a cost advantage over its competitors because it sold policies directly and therefore did not have to pay the industry-norm agent commissions. Moreover, this advantage was sustainable because the large established companies would not risk alienating their agents by providing an alternate direct channel. GEICO further reduced costs by focusing on lower-risk customers such as government employees, military personnel, and educators. Finally, Buffett liked the fact that most people have to purchase auto insurance and that, since premiums are paid in before claims are paid out, an insurance company gets to invest and benefit from the float.
6. If growth is part of your valuation, make sure its potential is grounded in reality. In spite of its rapid growth, GEICO had, until 1950, been licensed in only 13 states, plus Hawaii and the District of Columbia, and had a miniscule market share. Its growth potential was enormous. During periods of recession, Buffett recognized that GEICO would take share as consumers focused on reducing costs. GEICO continues to take share today for precisely the same reason.
7. Purchase shares at attractive prices. Buffett paid about eight times what he viewed as poor earnings, meaning he paid more like seven times normalized earnings.