One quick qualification before you decide I should be covered in tar then rolled me in feathers; I believe that most investors should follow Graham's value approach as laid out in "Security Analysis" and "The Intelligent Investor." The reason is simple — the average investor is much better served by using assets to ascertain a sufficient "margin of safety" rather than attempting to assess a durable competitive advantage which affords a growth stock a sizable moat. Now back to the story of GEICO.
Graham and GEICO
The story of Graham-Newman and their investment in the Government Employees Insurance Company (GEICO) is described in the Postscript of the "Intelligent Investor." It is also recalled in Buffett's autobiography, "The Snowball.” The details are slightly different so I am going quote Graham's version.
In 1948, Graham-Newman invested about $712,000 of their investment fund (approximately 25% of their total funds) in acquiring a 50% ownership of GEICO. The investment firm held the shares until they were forced by the SEC to distribute the shares to individual shareholders in 1972. One hundred shares of GEICO purchased in 1948 for a sum of $11,413 were worth a total of $1.66 million when the shares were distributed in 1972. The gain in GEICO represented a much larger percentage of the firm's profits than its other investments combined.
Graham-Newman's outstanding 20% per annum rate of return was largely a function of one brilliant investment. The firm held the stock as sort of a "family investment,” long after it was deemed as too expensive by Graham's own valuation metrics. In essence, Graham-Newman had followed the exact investment philosophy which would be documented a decade late by Phillip Fisher in his investment classic "Common Stocks and Uncommon Gains.” Graham had identified an outstanding business and allowed "the stock to run.”
Buffett and GEICO
Ironically, Warren Buffett stumbled upon GEICO early in his college career when he had become enamored with Ben Graham after reading "Security Analysis.” Young Buffett had discovered that Graham was a member of the Board for GEICO and his firm held a large interest in the security.
Buffett at the time knew little about GEICO or the insurance industry per se; on a lark he took off one Saturday morning, riding a train to Washington D.C. in hopes of speaking with GEICO management.
Buffett was extremely lucky that day. After explaining to a guard that he was one of Graham's students he was allowed to speak with Lorimar Davidson who was GEICO's vice president in charge of investments. Davidson became fascinated with Buffett's intellect and his quick grasp of the insurance business after speaking with him for a few minutes, and the conversation ended up lasting four hours.
When the conversation with Davidson was finished Buffett had acquired a profound appreciation for the business of insurance, and that appreciation would translate into billions of dollars of profits decades later. He subsequently sold most of his stock holdings and sunk 75% of his investment portfolio into GEICO. He also submitted a detailed investment report to his father's investment firm recommending a buy on the company. While the business traded at a reasonable price of eight times its trailing profits, the thesis of his investment recommendation was the companies' rapid rate of growth.
Consensus opinion at that time was that tiny insurance companies, which did business without enlisting the support of trained sales agents, would be trampled by established businesses which possessed greater financial resources. As is frequently the case, consensus opinion was dead wrong. Incidentally, Dell Computer (DELL) employed a similar business model decades later to revolutionize the method by which desk top computers were sold.
GEICO utilized a unique business model; they sold insurance without the aid of sales agents. Instead they targeted government employees as their prospective clientele, utilizing direct marketing techniques while contacting them through the mail. The business model was borrowed from another insurance company USAA, who sold directly to military officers noting that such clients were more responsible than average drivers. Fewer claims meant larger profits and few expenses gave GEICO a competitive advantage in the form of lower premiums. The management of GEICO correctly accessed that a similar business model would work if they targeted government employees.
The story rekindled in 1976 when GEICO stock plunged to low single digits following a massive loss of $126 million. It seems the company had lost its underwriting discipline and had severely under-reserved for future claims. Buffett became interested in the company following a visit with its newly appointed CEO J.J. Byrnes. The meeting was arranged by Buffett's close friend Katherine Graham of Washington Post fame.
Buffett was still confident in the business model of the company and his discussion with Byrnes was followed by a purchase of 500,000 shares of GEICO stock. Later, Buffett teamed up with Lehman Brothers in a large purchase of preferred shares using his influence with government regulators to ensure that GEICO was able to maintain its licenses.
Buffett continued to add to his GEICO position for years to come whenever the stock dropped to a sufficient level. The story culminated in 1994 when Buffett purchased the remaining shares for a sum of $2.3 billion. Since that time GEICO has become a major supplier of earnings for Berkshire Hathaway (BRK.A)(BRK.B) while supplying a continual mammoth-sized float which Buffett has converted into an additional ongoing stream of profits.
Properties of GEICO Which Promoted its Growth
Geico possessed several qualities which allowed it to become an excellent long term buy and hold investment. However, it should be noted that poor management, shoddy underwriting practices, and poor accounting practices brought the company to the edge of bankruptcy before Buffett interceded. Those developments threatened nearly every bit of capital that long-term shareholders held in the company. Such developments can happen in any company, particularly in the insurance sector; therefore it behooves investors to limit the percentage of any individual holding in their portfolio to a reasonable figure.
All that said, the reason that GEICO compounded its intrinsic value over the decades was two-fold:
1) GEICO's unique business model which created a durable competitive advantage.
2) The business model of insurance companies which utilize the earnings power of prepaid premiums (float).
The ongoing competitive advantage of GEICO lies in its ability to maintain its status as one of the low cost producers of automobile insurance. However, competition entered the fray long ago and the original competitive advantage which GEICO held by eliminating the commission of agents and using direct mail is now largely invalid. Indeed the cost of maintaining the franchise is now expensive. The key cost and metric for evaluating GEICO can now be described as its advertising efficiency. Exactly the same is true for its arch rival Progressive. The moat has receded and the cost of defending its moat has increased as well.
Automobile insurance is not cyclical in the sense that drivers are mandated by law to purchase insurance if they wish to own a vehicle. That is a characteristic of insurance stocks which is particularly appealing. Unlike most industries, insurance is a grudge purchase and the expenditure must be must be paid for in advance. Those two features facilitate growth in insurance stocks; adding new customers compounds growth rates by increasing the float of the company while existing customers continually result in residual sales.
The power of float in the correct hands is consummate to receiving a positive rate of interest for receiving a loan. In what other industry does one possess the ability to borrow money (in the form of prepaid premiums) and then pay back the loan at a discounted rate (so long as the insurance is properly underwritten)? For investors, it is literally the best of both worlds so long as they do not overpay for the right to hold insurance shares.
The Demise of Insurance Companies
The near demise of GEICO in the mid 1970s exemplifies the two main perils which insurance companies and their investors face. Specifically, underwriting policies which are not actuarially sound, and secondly, inadequately reserving for future liabilities which result from poor underwriting practices.
In other words, during periods of severe competition investors must be certain that the company they hold is not writing polices which are consistently resulting in more payouts than premiums received. Additionally, investors must understand that poorly written policies frequently result in future liabilities which will not turn up on their income statements until future periods. Those two conditions nearly resulted in the collapse of GEICO in 1976. The biggest moat in the world can not save an insurance company from itself.
Current Opportunity in Insurance Stocks
I have begun investing significant money in insurance companies in the last few months, specifically in property and casualty companies. I believe that the sector now possesses favorable valuation metrics in the form of historically low price to book ratios, and rate increases are now springing up virtually across the board. The main threat to valuing P&C and insurance companies in general, is assessing the likelihood that management under-reserved their losses in prior years. Those losses may begin turning up in future earnings reports which could result in higher provisions for losses and higher combined ratios which could pressure forward earnings.
The other factor currently pressuring P&C companies is declining interest yields in the fixed income investment portfolios where they invest their float. Declining yields tend to put pressure on investment income.