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Rupert Hargreaves
Rupert Hargreaves
Articles (658)  | Author's Website |

Warren Buffett's Geico Adventure Part 3: The Turnaround

The 'Oracle of Omaha' made a fortune betting on the insurance company's turnaround

January 11, 2018 | About:

This is part three of a series on Warren Buffett (Trades, Portfolio)’s Geico story.

After Buffett sold his first Geico holding in 1952, he disappeared from the company for a while. Over that period, the company continued to compound wealth until the early 1970s.

Between the early 50s and 70s, Buffett’s investment would have expanded from around $10,000 to more than $1.3 million. However, everything came crashing down when, according to Buffett, “the executives running Geico made some serious errors in estimating their claims costs, a mistake that led the company to underprice its policies - and that almost caused it to go bankrupt.”

The downfall

Geico peaked in 1972, a year after Buffett joined the board after Jerry Newman, Benjamin Graham’s partner in the Graham-Newman partnership, stepped down. Graham wrote the following recommendation to the board on Buffett’s behalf:

“…I am 100 percent for that idea. I have known Buffett intimately for many years, and I must say that I have never met anyone else with his combination of high character and brilliant business qualities. His record an investment fund manager is probably unequalled. In addition, I can recommend Warren as a good-humored, easy-to-get-along-with person, who can liven up your directors meetings. He would be sure to supply more than his share of worthwhile ideas for the benefit of the GEICO companies.”

When the stock reached its zenith, one share in the Graham-Newman Corp. had grown in value from $27 to a staggering $16,349, enshrining its founders in investment history.

Unfortunately, Buffett entered the company when its explosive growth was just about to come to an end.

Fall from grace

Geico’s fall from grace was a result of years of misallocation of capital. The company, driven on by its success, decided to relax its conservative business model. After impressing regulators, Geico was allowed to increase its premium-to-surplus ratio to over 5:1, up from a more conservative 3:1. Then it expanded away from non-bureaucrats, its core customer base, to help drive growth. This was a pivotal mistake and losses ballooned. For 1969, the underestimate of reserves came to a total of $10 million, wiping out the earlier reported profit of $2.5 million. In 1970, the underestimate of reserves was $25 million -- just a taste of things to come. A new CEO tried to grow the business out of its miserable situation and over the next several years, new policy growth averaged 11%, more than 50% higher than the rate in the decade before.

In 1974, losses started to appear on Geico’s balance sheet as is break-neck growth started to catch up with it. The company reported its first underwriting loss in 1974. It lost $126 million in 1975 and $40 million during the first half of 1976.

Buffett's magic wand

By the annual shareholders meeting in 1976, Geico was on the verge of bankruptcy and the stock was down to $2 per share. Buffett, in his position as chairman, appealed to regulators to keep the lights on. They ignored his pleas.

Luckily, Buffett had a secret weapon, Kay Graham at the Washington Post, whom he had a healthy relationship with. She introduced Buffett to John Byrne, “The Babe Ruth of Insurance,” who he convinced to come aboard and help sort out the struggling Geico. In typical Buffett style, immediately after the meeting with Byrne, confident this was the man to turn the business around, he started aggressively buying Geico stock. He spent $4.1 million purchasing stock on the market at an average price of $2.55 per share, and $19 million in a Salomon Brothers-led convertible preferred stock issuance of $75 million. Berkshire Hathaway’s (NYSE:BRK.A)(NYSE:BRK.B) average all-in cost was around $1.3 per share.

Byrne instigated what has to be one of the most outstanding turnarounds of all time. He fired 4,000 of the company’s 7,000 employees, closed 100 offices and exited any unprofitable markets. He then went on to hike rates 40% and convince insurance companies to reinsure all of Geico’s existing book of business.

The success was immediate. Geico’s statutory capital by the end of 1976 was back up to $137 million, and the company’s surplus topped $250 million -- the highest level in the company’s then 43-year history. In one year, Geico shifted from being a basket case to a profitable, well-capitalized business. The dividend was restored in 1977 and by 1979 profits had hit $220 million.

None of this transformation would have been possible without the firepower of Buffett’s Berkshire, his connections at the Washington Post, Salomon Brothers and his insurance businesses, which helped reinsure Geico’s existing policies.

Disclosure: The author owns no stocks mentioned.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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