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The Science of Hitting
The Science of Hitting
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Berkshire Hathaway Meeting: 1996 Morning Session

Highlights from the morning session of the 1996 shareholder meeting

June 14, 2020 | About:

In 2018, CNBC launched the Warren Buffett (Trades, Portfolio) Archive, “the digital home to the world’s largest video collection of Warren Buffett (Trades, Portfolio).” The website includes complete video footage from every Berkshire Hathaway (BRK.A, BRK.B) shareholder meeting since 1994, along with video clips from Warren Buffett’s appearances on CNBC dating back 15 years (to 2005).

As discussed previously, my goal in this series is to share key takeaways from the shareholder meetings. I will select a handful of quotes from each section that I think are most insightful for investors. With that, let’s take a look at the 1996 morning session.

Class B Issuance

At the beginning of the session, Buffett discussed a proposal related to the issuance of Berkshire Hathaway Class B common stock, along with the course of events that led the board to that decision:

“Over the years, we’ve had probably half a dozen people propose the creation of an all-Berkshire investment company or unit trust. In other words, an entity that would hold nothing but Berkshire stock, and then would parcel out its own shares in smaller denomination pieces to the public. And we have generally discouraged that because we felt that there was considerable potential for abuse in such an arrangement. And our discouragement has been successful up until last fall, when there were two proposals that went as far as submission to the SEC for clearance that involved unit trusts. And these unit trusts would’ve owned nothing but Berkshire shares and then been sold to the public in small denominations, probably with a minimum investment of around $1,000 or so. And holders of those trusts would’ve bought into an entity that had a defined life, but that had considerable costs and some tax consequences that they might not anticipate when they came in. Charlie and I were worried that a combination of Berkshire’s past record - which cannot be repeated - and high sales commissions, and a low denomination, and a lot of publicity about Berkshire… a great many people would end up buying these unit trust holdings without any idea, really, of what they were buying, and with unrealistic expectations as to the future. And that would, in turn, create a considerable demand - because these unit trusts would go out and buy Berkshire shares - that would create a considerable demand against a fixed supply, much of which is almost unavailable because people have a low tax basis and are reluctant to sell... And that the very action of the creation of these, and that push on the demand, might very well create some speculative spurt in the stock, which in turn, would induce people who had been approached about the trust to feel they were missing even more of a good thing by rushing in. Rising prices in certain kinds of markets create their own kind of demand. It’s not a sustained demand. And it’s a demand that the reversal of which, later on, when people become disillusioned, can cause a lot of problems.”

Buffett and Munger had long avoided a stock split for commendable reasons. They believed dicing the ownership of Berkshire into smaller and smaller pieces could incentivize activity among market participants that they did not want to encourage, i.e. trading the stock as opposed to owning the business. When they were backed into a corner and faced with the prospect of individual investors getting the short end of the stick – with Berkshire likely to share in the blame if there was an adverse outcome – they acted. I highlight this decision because I think it speaks to the pragmatic decision-making of Buffett and Munger. They did something that they didn’t want to do because it was ultimately in the best interest of their shareholders and Berkshire Hathaway.

Float & Low-Cost Capital

Later in the meeting, Buffett and Munger were asked about valuing Berkshire Hathaway. Buffett used the question as an opportunity to discuss the problem associated with using book value as a proxy for intrinsic value, most notably as it related to National Indemnity (which was acquired in 1967):

I think people, to the extent they’ve made a mistake in the past in valuing Berkshire - and they have made this mistake over time - is to look at it as simply a breakup value to our businesses… That has tended to be the case with many people looking at Berkshire, looking at it on a static basis. And that is not the way that Charlie and I have looked at it over time. It lends itself a little more to that kind of analysis because we have a lot of money in marketable securities. But we have a lot of money in other things, too… The value of our insurance business, for example, if you go back 29 years since we bought it from Jack Ringwalt, we paid $8.7 million, I believe, for two companies Jack controlled. If you had the foresight at that time - I didn’t – but if you had the foresight at that time to see what would develop out of that insurance business, you would’ve come to the conclusion that their value to us was going to be far, far greater than the value at which they were then carried on our balance sheet. They were part of a business which had enormous potential. And that’s been, probably, the most significant asset developed at Berkshire. But right now, we have over $7 billion of float that’s been developed from our insurance business. We couldn’t foresee that 25 or 30 years ago. But it would’ve been a big mistake to think in terms of the book value of that business being representative of its actual value to us over time, if it was run right. And that situation probably prevails today. So, Berkshire is a group of, on balance, very fine businesses to which we hope to add. The intrinsic value will be affected by the job we do in allocating capital. It’ll be affected by the job our managers do in running their businesses. It’ll be affected by some items that we don’t foresee now and, perhaps, have no control over. But it is not measured, essentially, by what we could sell each separate business for and pay the tax on now. We haven’t run it that way. We’ve run it so that we get the use of a lot of capital at very low cost. Between deferred taxes and our insurance float, we have some $12 billion or so on the liability side that we think will be a very low cost. And that doesn’t show as an asset, but it can be quite valuable.

With hindsight, we can see that this was a prescient call by Buffett. In the first quarter of 2020, Berkshire’s insurance float was at $130 billion – nearly 20 times larger than the $7 billion in float that Berkshire had in 1995. This, among other considerations, has led to a continued divergence between Berkshire’s book value and its per share intrinsic value over the past two decades.

GEICO

Towards the end of the session, Buffett discussed Berkshire’s recent (at the time) acquisition of GEICO. He explained why he thought the auto insurer was a great addition for Berkshire:

“GEICO is a huge plus to Berkshire. Now, we owned 50% of it before. We’ve benefitted from our GEICO investment in a big way, ever since 1976. So, it’s not entirely a new benefit that’s coming in. We paid a good price for GEICO, but it is a terrific company. It has outstanding management. It has a low-cost method of distribution, which is very difficult for people to [compete with]. Everybody wants to have that, but very few come close to it. The management is focused on bringing costs down even further and widening that competitive moat. I personally think that, just from what I see, GEICO’s growth rate is likely to be greater in the future over where it has been in the past. But it’s been perfectly satisfactory in the past. I think there are some advantages to it being part of Berkshire, in that there are costs attached to bringing new business on the books. And we care not at all about reported quarterly earnings. GEICO was relatively insensitive to those before. And that’s a compliment when I say that. But they had some more pressure on them in respect to reported earnings than they will have as part of Berkshire. And I think there’s some really big opportunities, in terms of what can be done with GEICO as part of Berkshire. So, I think five years from now, you’ll be very happy that we own 100% of GEICO. And I think you will see that as marvelous a company as GEICO was as an independent company, it will flourish maybe even a bit more as being part of Berkshire. Not because we bring anything to the party. The management will continue to run it autonomously. But there are some advantages for it in being part of a larger enterprise.”

When he spoke about the advantages associated with being a subsidiary of Berkshire, he was alluding to the fact that GEICO, as a public company, had to worry about short-term results. Attracting and signing new policyholders is expensive; profits are only generated through long-term customer retention.I heard Tom Russo (Trades, Portfolio) speak a few years ago, and he estimated that new policies at GEICO in the 1990’s came with a year-one operating loss of roughly $250, but that each of those policies had a net present value to GEICO of roughly $2,000 over the life of the customer. He argued GEICO was not in a financial position at that time to sustain that $250 per policy hit in large numbers, a constraint that limited growth and market share gains. Adding 200,000 customers new customers would result in a year one operating loss of roughly $50 million at a time when the firm was generating $200 million to $300 million a year in net income.

But those concerns became irrelevant when GEICO joined Berkshire. The company now had the financial ability and the willingness of its owners to add as many new policies as possible. This change in perspective showed up in a meaningful way in the company’s marketing spend, which increased from $33 million in 1995 to $143 million in 1998 (as discussed in the 1998 shareholder letter). This proved effective: GEICO added more than 1.5 million net new customers in its first two years as part of Berkshire (1996 and 1997) – nearly double the customer additions reported on average in its final three years as a public company (1993-1995). Today, GEICO is the 2nd largest private passenger auto insurer in the United States, compared to being the 7th largest in 1995 (and with much better underwriting results than industry leader State Farm). The acquisition has proven to be quite beneficial to GEICO's business - and a valuable addition for Berkshire shareholders.

Disclosure: Long BRK.B

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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