Thursday, November 13, 2008

The Warren Buffett Way: Chp 5 Part 5: Permanent Holdings

The Government Employees Insurance Company Corporation (Geico Corp.), is engaged through its affiliates, in the multiple line property and casualty insurance business. The company was founded in 1936 by Leo Goodwin, an insurance accountant. Leo had the idea to market insurance directly to customers. By doing so, Geico could save between 15% to 25% per collected insurance premium dollar by eliminating the need for a conventional insurance sales force. Geico could then pass on the savings to its customers and become the low cost provider of insurance policies. Leo also had the idea to insure only government employees, since statistically speaking, they were less risky policy holders to insure.

Geico was quite successful for a number of years, but they lost their way starting in the late 1960s. During that time, Geico had pushed ahead to expand their business and started writing money losing insurance policies to higher claim risk customers. There problems seemed to start as they moved away from their successful business model.

Buffett started buying shares in Geico in 1976, when the company was close to bankruptcy. At that time, a new manager, John Byrne took over at Geico. His plan to rescue the company included focusing on their previously successful business model, raising capital and cutting costs. He named the rescue plan, "Operation Bootstrap".

Its curious that Buffett invested in Geico in 1976, since he is not a strong in corporate turnarounds and typically does not invest in commodity businesses. However, Buffett commented that even in 1976, "the Geico franchise was still intact". Buffett said that the company was still the low cost provider of insurance and that even a commodity business can make a lot of money, provided they are the low cost producer. Buffett felt that since the business model was still direct to customers, Geico could improve their profitability by increasing premiums, cutting costs and only insuring low claim risk customers. That is precisely what happened under the leadership of John Byrne.

John Byrne led Geico to a dramatic recovery, largely due to his cost cutting discipline and willingness to forgo growth for profitability. As Geico adjusted the pricing on policies, they lost 1.3 million policy holders (almost half their total number of policy holders at the time). However, within one year, Byrne's actions led to restored profitability at Geico.

Starting in 1976, Berkshire Hathaway purchased a 33% stake in Geico for an average price of $6.67 per share. Buffett had purchased both common stock and preferred convertibles that were later converted into common shares. In 1980, just 4 years later, Berskhire's $47 million investment in Geico was worth $105 million.

Since 1982, Geico's return on equity has averaged 21.2%, which is roughly twice the industry's average. From 1980 to 1992, every dollar retained by Geico resulted in $3.12 of market value. From 1980 to 1992, not including the impact of dividends, Geico's share price has risen at a compounded annual rate of 29.2%.

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