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John Emerson
John Emerson
Articles (106) 

Graham, Buffett, GEICO and Growth Investing

September 06, 2011 | About:

At the risk of committing value investing heresy, I submit to you that Benjamin Graham was much more successful at growth investing than value investing. Further, I am going to suggest that Graham's investment portfolio which earned an average of over 20% per annum for its duration was largely due to the fact that he unwittingly followed the strategy of Phillip Fisher.

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.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 3.8/5 (17 votes)


Mcwillia - 6 years ago    Report SPAM
Aflac is now as deep a value as GEICO once was.

Aflac is a monopolistic compounding-machine in Japan. Yet, its shares have plummeted nearly 40% recently over its portfolio concerns, which is 30% in financials and 8% in perpetuals. Euro-periphery holdings are a source of significant downward pressure at the moment. Still, if all the euro-zone exposure were 'salad oil' and disappeared, Aflac's RBC ratio, presently over 400%, would nevertheless be adequate and it would still earn its stellar returns year after year into the foreseeable future. According to the most recent quarterly report, 2011 operating earnings are estimated at $6.20 or so for a stock that trades at $36, and that's with an 80yen/dollar exchange rate...and the yen has since strengthened to 77/dollar.

Aflac has some unbelievable "moat" statistics. It:

  • Consistently makes an Underwriting profit of over 15%, and has for over a decade, year in, year out. Currently it is about 18%. The company could put the float in its mattress and still do well...
  • Is by far the low-cost operator in Japan, being free from its competitors' costs of in-house and inefficient Japanese sales forces.
  • Writes cancer and health insurance in a country full of the healthiest, longest lived people
  • Pays claims in a country where fraud is lower than any other major insurance market.
  • Faces competitors who are systemically inefficient, questionably capitalized and still badly damaged from the bubble burst and Asian financial crisis of the late 90's
  • Has a monopoly on sales through the best sales channel, the Japan Post
  • Has the number one brand in the most brand conscious society on earth.
  • Has a persistency rate of nearly 95% in Japan
  • Has grown its float every year for decades, at over 10% avg. per year.
  • Has a 75% (that's right) market share of in-force cancer insurance, its core business.
  • Is the number one insurer in Japan by number of policies issued.
  • Has bought back shares nearly every year for a decade.
  • Has a portfolio exclusively filled with bonds...no real estate or equities.
  • Earns money in Yen, a currency whose value is forced up by perpetual trade surpluses, positive capital inflows, and a net-saver electorate.
  • Reports its earnings in dollars, whose value is likely to fall, as it is a net debtor nation with intractable trade, current account and government deficits.
  • Can use windfall profits from Japan to underprice its competitors in the US.
  • Has a grandfathered and cozy relationship with regulators in Japan, who are not likely to change much, considering the annual collapse of the Japanese cabinet and 'twisted' Diet.
  • Prices its policies in an old-school cartel-type system, long gone in the States
  • Has only one set of insurance regulators to worry about in Japan, instead of 50 in the U.S.
  • Stands to gain policy holders as Japan's indebted government trims coverage under its National Health Insurance.
  • Has no inflation risk in its policies, as they are defined payout policies and shift all inflation risk to the policy holders. (I love this one, personally)
  • Has evolved one of the most highly recognized trademarks in Japan, the maneki-neko duck.
  • Holds over 30% of its portfolio in Japan Gov't Bonds, which it must in order to match its liabilities, the yield on which is likely to rise in the future.
  • Operates in a short-tail environment with little re-insurance makes it far more likely that the company is pricing its policies right and reserving adequately.
  • Has operating costs in a deflationary environment, where deflation lowers its effective costs of doing business, while the same deflation depletes the reserve ratios of its competitors, who have Japanese equities and (ugh! real estate!) in their investment portfolios.

I could go on (and on) but this is a wonderful compounding machine which has a monopolistic lock on possibly the best insurance market in the world. And anyone can buy it right now for a 5.3 multiple on Valueline's next-year estimated EPS. That works out to just under 20% earnings yield. And mind you, that yield has historically grown at 14% measured over the past decade.

So here's a Buffett stock. It yields 20% now and stands to grow at 14% annually, and maintains a best-in-breed near-monopoly. That is what GEICO was back in the day. It's why I'm long the company too.
Josh Zachariah
Josh Zachariah - 6 years ago    Report SPAM
  • "Holds over 30% of its portfolio in Japan Gov't Bonds, which it must in order to match its liabilities, the yield on which is likely to rise in the future."

Wouldnt that leave them exposed to interest rate rises? If rates go up bonds earning 0% aren't going to be worth a lot

Josh Zachariah
Mcwillia - 6 years ago    Report SPAM
Yes, that's a good point. Luckily, these bonds are held to maturity and not in the held-for-sale account, therefore their decrease in value while waiting for maturity is not counted against their value as RBC assets. They will mature, on average, in conjunction with the yen based payout obligations of the policies. On the other hand, renewal policies (95 percent of them) result in Aflac receiving more fresh funds and needing to buy more of these bonds, which will enhance the profitability of the portfolio in a rising rate environment, which Shirakawa seems to think will actually happen. Thus, if rates in Japan rise, it is to Aflac's benefit, on balance. This improvement in the investment income is welcome, although with an 18% underwriting profit it is not strictly necessary, don't you agree?

If the JGB's were downgraded to below investment grade, that could theoretically force AFL under present regulations to put them into the held-for-sale account and book the loss, with the concomitant reduction of RBC capital, but in reality, Japan's Financial Services Agency, would never rate its own sovereign debt so low or require its corporate elite to recognize losses on it. The minister of finance would be dismissed and probably lose his seat in parliament as well, and the bureaucrats would be destroying the source of their own funding, hence their jobs too, if they did it. So a JGB will never get a junk rating in Japan, to my thinking. What do you think?
Rajeev_agr - 6 years ago    Report SPAM

Given that AFL writes cancer insurance, how do you get comfortable that they will not have increased liability because of the recent nuclear radiation crisis in Japan?

You mention that they hold 30% of their portfolio in JGB. What are the other portfolio holdings? If their portfolio is primarily fixed income, how do you get comfortable that as the interest rates increase they won't have big losses in their portfolio?

I have looked at AFL in the past because of some of the things you mention about their lock on the Japanese market but had always found them quite expensive. Event at today's price they are selling at 1.4x book. Given that other insurance stocks are significantly cheaper how do you rate AFL vs other insurance stocks?

Mcwillia - 6 years ago    Report SPAM
Hi Rajeev;

Yes, Cancer risks are heightened after the Fukushima irradiation. Four factors reduce this risk. First, selling cancer insurance during a time of cancer-panic is actually extremely good business and will increase Alfac's float and its profits, making it easier to handle a future increase in claims. Second, development of cancer from Fukushima will occur several years, if not decades, in the future, during which time Aflac will have earned and reserved enough to cover the claims. Third, Alfac will have the right of subrogation to sue the parties responsible for causing the losses, in this case, Tokyo Electric Power Co., who were negligent. Fourth, Aflac can now consider adding exclusions or premium adjustments for high-risk regions and persons, and Aflac can consider pre-existing condition exclusions for new policy holders. Therefore, the risk is negated, all in all. And yet, the fear factor has reduced Aflac's share price considerably.

As for bond losses, these don't matter if the bonds are in the hold-to-maturity account, and new purchases will be at better and better rates as new money comes in from renewals and new sales.

As for share price, Aflac may or may not be cheap if one is simply looking at acquiring a bond portfolio. There are, after all, insurers selling at less than book, allowing value investors to buy a dollar for less than a dollar, a more Ben Graham approach. And this is why the stock is cheap. Investors are valuing it at the moment as if it were shaky bond portfolio with some largely irrelevant earnings. If you simply value its forward earnings stream and ignore the bond portfolio, one realizes that the earnings stream alone is an obvious bargain at present. You can own the income stream for a p/e of around six, and have all the bonds FOR FREE.

Alfac is estimating 2011 operating earnings at over $6/share. On a $35 stock, who cares if they even have a bond portfolio, so long as they can keep on earning 6$ (or more with growth) per share. The bond porfolio MUST be viewed as their "factory". Just like plant and equipment, assume the bond portfolio is merely the tool they use to earn that $6/share. As long as the bond portfolio keeps doing its job, it does not matter that it must be written down now and then, just like a factory or tangible infrastructure at an industrial company. If the portfolio falls too far, Aflac will have to dilute shareholders, raise equity or eventually go out of business, but that would only happen if the bond portfolio truly died, and such is simply not in the cards, even if the Euro zone collapses. Aflac will still be able to earn its $6. After all, during the 2008-2009 financial crisis, it did not need to raise capital or even cut its dividend.

It is interesting that when valuing industrial companies, some investors back out the cash to see what the real p/e would be, like when they say the stock is at 8$ per share but 2$ of that is cash, so it really is like 6$/share, when one backs out the cash. Well, if Aflac's net liquid securities are $25/share, this is much like cash to Aflac. If you 'back out the cash', Aflac's $35 share price is actually about $10. So you are paying $10 for the right to earn 6$ per year with growth. It works out to a p/e of about 1.7, which for some reason I find very desirable.

So Aflac is cheap because it is a non-U.S. insurer with monopolistic earnings power, being valued as if it were a U.S. insurance asset play in a commodity business. It is not an asset play. Rather, it is an earnings-power play.
Rajeev_agr - 6 years ago    Report SPAM
Thx Mcwilia. I also agree that Aflac is cheaper now then it has been in a few years. A few additional questions:

  • How much is the float that is currently on Aflac book? i.e. premium that has been paid but where the service will be rendered many years in the future. I am assuming we will have to back those out from the bond holdings to understand the true value of the portfolio.
  • What are some of the other insurance companies that you are comparing Aflac to determine whether Aflac is a good investment. Since the money is fungible I am assuming you are looking at all companies in the sector to say where you should be investing.
  • Lastly, any good source/book to learn more about insurance industry and what are the key things to be mindful of?

Thanks a lot.
Mcwillia - 6 years ago    Report SPAM
Hi Rajeev;

The source materials I use most are Warren Buffett's writings about insurance and inflation. Many compendiums are floating around the internet. I also have an ancient dusty book called Valuation of Insurance Company Portfolios. Thrilling page-burner, that one. In a '50's article, Buffet claimed that he thumbnailed the value of insurance companies by summing their premium income and book value, guessing that they already had the latter, and would eventually earn all of the former. By that measure, Aflac is valued at about $70/share. This is too rough an estimate to be reliable, but it is a way to ballpark the value of Aflac's float.

Insurance companies are each very different, depending on what risks they insure and how. I divide them roughly into long and short tail, then into prop/cat, life/health, and reinsurance. But I do not focus on the industry itself, rather I screen the entire market for companies where I can compound owners' profits at very high rates of return for many years reliably. When one of these becomes cheap, whatever the sector, I then look deeper. Many companies do not have a good long term outlook simply because they are in short term businesses and need to constantly re-invent their business or disappear, like many tech and software companies, auto makers, etc. Many more fail because they must reinvest too much of their earnings and the owners really never see any. Others are poor because their business depends on a single or government customer or is vulnerable to inflation. But when I find the perfect one, which has a high return of owner's earnings on equity and assets, is in a business unlikely to ever change much, has a monopoly of some sort, and is selling cheap, I do the kind of research like Aflac now deserves.

For really on-point comparisons though, I look at Japanese insurers and Prudential. The Japanese insurers, except for Yasuda, are poorly capitalized and hamstrung by their inefficient labor structures and keiretsu affiliation obligations. Many have horribly negative obligation spreads since they have policy dividend obligations from years ago at 5 and 6% but can earn no more than 3% on their portfolios. They offer Aflac no dangerous competition and cannot aggressively write insurance because of RBC constraints. There is no proper U.S. insurance company comparison, but Progressive is now trying to make a move in Japan...

But Progressive just committed the ultimate blunder in Japan, buying up the assets of the recent bankrupt Yamato insurance book and some AIG Japan assets. Branding and reputation is far more important in Japan than in America. Japanese intrinsically distrust and despise bankrupt brands, companies, and other unreliable franchises. Prudential picked up these garbage assets in an attempt to grow their Japanese business and compete against Aflac. There is no way, however, these trash acquisitions can compete with a pristine brand like Aflac. Not in Japan, where brand is everything. Sales agents will be reluctant to even mention these offerings to their customers. It would be too shameful and disgraceful. Damaged goods may be worth something in America, but they are worth less than zero in Japan.

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