Friday, 15 March 2013 00:00

GEICO: An Investment Lesson

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I wrote the following article thinking that it would be part one of a larger piece on examining Mr. Buffett's early investments by paying particular attention to what was known at the time and also to see what lessons focus investors could learn from them. With the sad passing of Mr. Bynre I thought readers might enjoy this article since it deals with GEICO, which he was instrumental in saving.

GEICO: An Investment Lesson

Mr. Buffett discovered GEICO while researching his teacher at Columbia, Benjamin Graham. After learning Graham was on the board of the company he went to its office, on a weekend, and was lucky enough to find a key executive willing to educate him on the company and the insurance industry. After this education and his own further research it became clear to him that the company enjoyed a unique distribution method, direct sales to its customers, which allowed them to enjoy a cost advantage by having lower expenses than the typical agent method of distribution. He became so enamored with the company and its business model that he recommend the company to his clients while working as a broker in Omaha.

He continued to watch the company during the following decades despite having sold his stake in the 1950s. He was finally able to make a major investment in the company when the company almost derailed into bankruptcy as a result of poor underwriting and other factors in the mid 70s. This brings up a principle that I have mentioned before in my book, a key principle of focus investing: take the time to understand exceptional companies because when they hit a rough patch and the market sends the stock price into a tail spin you can quickly examine the issues and see if they are long-term or short-term in nature and act accordingly. Let's now look an overview of the history of the company and then look at Mr. Buffett's GEICO investment history to see what lessons we can take away from it to apply in our own investment operations.

The history of the company is briefly described here from the company's internet site:

"The 1960s proved to be similarly successful. GEICO experienced virtually unbroken growth, passing the 1 million policyholder mark in 1964. Insurance premiums reached $150 million in 1965. Net earnings doubled to $13 million in 1966. GEICO opened a number of sales and service offices for walk-in customers and its first drive-in claims office in 1965.

The 1970s, however, were not nearly as good to the company. At the beginning of the decade, both Leo and Lillian Goodwin passed away, and the loss of the company's founders (I would also include the passing of the leadership reins by Mr. Lorimer Davidson in 1970 when he retired as Chairman), seemed to usher in difficult times for GEICO. By the mid-70s, the years of aggressive expansion were starting to show some weaknesses in the company's loss reserves (NOTE: Unspoken here is that poor policy pricing and a declining stock market really hurt the company. In Snowball, the book by Alice Schroeder (page 889), she writes that "...the devastating stock market of 1973-74 had wiped out so much value from GEICO's stock portfolio that for every share of stock, investments that had once been worth $3.90 were now worth a dime a share". This on top of a increase in auto accident claim costs and high inflation levels pressuring their bond portfolio are just several of the challenges that combined to make it a difficult period for the company.)"

The investment story starts in 1975 when Mr. Buffett (p. 430, Snowball) stated that "I looked again at GEICO and was startled by what I saw after a few rule-of-thumb calculations about loss reserves." This was important for a simple reason, GEICO was in growth mode and had expanded from its original mandate to only insure government workers because the founders discovered that they had a lower loss rate than the general population. When in growth mode you take on lots of new customers and to get these new customers you may have to price more aggressively. Another factor to consider is that GEICO likely had no cost/lose history on these new customer lines so a natural consequence was that they would experience more losses and hence would need to keep a close eye on their reserves going forward.

Mr. Buffett continued "It was clear in a sixty-second examination that the company was far underreserved and the situation as getting worse. I went in to see [the CEO] Norm Gidden on one of my Washington Post trips. He was friendly, but he had no interest at all in listening to my comments. They were in deep denial. He really sort of hustled me out of the office and would not respond on the subject."

It didn't take long before the company had to face reality though as in early 1976 they announced a $190 million loss and to make matters worse from the viewpoint of the investment community they also announced a suspension to their dividend payments. GEICO was soon forced to seek new management and chose Jack Byrne, an insurance executive that had recently left Travelers when wasn't picked to be their next CEO.

The situation was so serious that Jack knew he would need the help of regulators so he had a meeting with Max Wallach, the District of Columbia Insurance Superintendent. After many additional meetings Mr. Wallach decided not to shut down the company but insisted that conduct a reinsurance agreement with other companies in the business and also required them to raise a slug of capital so that they could pay their claims as they came due. This was a actually a favorable result as Mr. Wallach could have chosen to shut down the company completely! Jack wasted no time in implementing his rescue plan, Operation Bootstrap, which included closing offices, slimming down the size of the work force, and exiting unprofitable markets.
Warren watched all these events transpiring and saw the stock price go into free fall. He know the company so well and for so long he thought GEICO possessed a cost advantage rarely found in an insurance company and thought that advantage would continue if the company survived. After thinking on the situation he knew that Jack Bryne had to possess a combination of gifts if he was going to succeed in his quest to right the ship. If he was going to invest in GEICO now he had to meet with him and determine if he possessed those characteristics. Warren was looking for someone who was (page 433, Snowball) "...cool, unflappable, and professional." and who knew the insurance business inside and out. After meeting with Bryne he decided that he was the right person and started buying large amounts of GEICO common stock.

All these actions sound perfectly natural looking back on them with the advantage of time having passed and the eventual outcome being known but let's examine at what was being reported on in the news and see if you think you could have had the courage to invest then. Here is one article dated July 16, 1976 which was titled, Insurance: GEICO at the Brink[1][1]:

"Once upon a quite recent time, the staid insurance industry had a Cinderella firm called Government Employees Insurance Co. (GEICO). By charging low premium rates, GEICO skipped past older firms to become the fifth largest auto insurer in the land. Investors from far and wide flocked to buy a piece of GEICO, bidding its stock up to more than $60 a share. Then Cinderella turned into a pumpkin.

Today GEICO stock is selling at about $2.50 and the company is on the brink of bankruptcy. A GEICO crash would be costly to the company's 2.8 million policyholders in 25 states, who would lose some of the $660 million a year they have been paying GEICO in premiums, and to other insurers, who would have to take over payment of claims against GEICO. The company has lost $150 million since the start of 1975. Worse, Maximilian Wallach, Superintendent of Insurance in Washington, D.C., where GEICO is headquartered, seems to be failing in a rescue attempt.

Costly Pullout. For weeks Wallach has been phoning executives of other insurance companies to persuade them to reinsure 40% of GEICO'S policies and pay GEICO $26 million in cash commissions in return for a share of future premium income. He also sought their agreement to buy whatever part of a planned $75 million offering of GEICO convertible preferred stock the company's present shareholders do not purchase (shareholders must approve the offering at a meeting next week). By late June, Wallach had rounded up enough pledges to put off a deadline he had once set for moving to have GEICO declared bankrupt.

But last week State Farm Mutual Automobile Insurance Co., the nation's largest auto insurer, withdrew its offer to reinsure 6% of GEICO's policies. State Farm had warned Wallach that it would carry out the agreement only if other insurers agreed to reinsure 34% of GEICO's policies by June 30. With State Farm out, it is now doubtful that other insurers can be persuaded to pump enough cash into GEICO to keep the company alive. GEICO directors are planning to offer 300,000 shares of senior preferred stock (which would have first priority on any future dividends) in case the $75 million convertible preferred issue does not sell, but who might want to buy the senior preferred—and why—is open to question."

So when did Mr. Buffett make his first investment? According to Roger Lowenstein in his book, Buffett The Making of an American Capitalist, he first bought "...500,000 shares at 2 1/8 (which only a few years earlier was trading in the low 40s) and left a standing order in the multimillions" after an extensive meeting with Jack Byrne in July 1976. So at this point he thought the company had the right CEO but the insurance commissioner still needed to be convinced not to take over the company and the reinsurance program and equity raise mentioned earlier needed to be worked out.

I think he made the investment, and was comfortable with his decision, because he knew that Max Wallach, by insisting that the company coordinate a reinsurance program with other insurance companies, didn't seem to want to kill the company. He also knew that he would be willing to contribute to the reinsurance program required by the insurance commissioner (Later he did participate in the reinsurance program and during an subsequent equity raise, he advised the investment banker he would be willing to serve as the sole provider of the capital if he was forced to). In short he had a unique perspective and an in-depth knowledge of the insurance industry that many investors would not have had the benefit of when they tried to determine if the company would make a good investment. Investing during these periods is not easy as is evident in a comment Mr. Buffett made a comment at a Washington Post board meeting: "I've just invested in something that might go under. I could lose the entire investment next week". (page 198, Buffett: The Making of an American Capitalist)

How did the investment situation work out? No more than two months after Mr. Buffett made his initial investment the company completed its preferred stock offering with Mr. Buffett purchasing a large chunk of it. This offering essentially meant that the company was certain to survive its troubles. The common stock responded to the change in the situation by jumping to 8 1/8. Mr. Buffett kept investing and over the next couple of years he doubled his stake in the company.

I think focus investors, though unlikely to have been able to invest as early as Mr. Buffett due to his unique understanding and access to the company, would have been able make a profitable investment even after the clouds had cleared over the company. Learn to take the long-term view, avoid rear-view mirror investing, and if the underlying business are intact you can make very profitable investments even after the clouds have cleared because the investment community at large will take time to believe the company turnaround is real.

[1] Link: http://www.time.com/time/magazine/article/0,9171,914339,00.html

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