Investment PhilosophyWarren Buffett

Buffett Thoughts on GEICO in 1976

I’ve been spending the vast majority of my time working on a number of new investment ideas, but I do find time to catch up on reading the paper. Earlier this week I came across a post on one of the Wall Street Journal blogs that posted a copy of an old letter that Warren Buffett sent to George Young at National Indemnity (a Berkshire owned insurance subsidiary) regarding his thoughts on GEICO.

I’ve written a few posts on Buffett and GEICO, and his history with the company goes back to 1951 when he put 65% of his net worth (at the time around $13,000) into GEICO stock. At that time, a 21 year old Buffett saw the enormous growth potential GEICO had because of the large market it operated in and the fact that GEICO could provide car insurance at a lower cost than any of its competitors.

The two most important factors:

  1. Low cost provider of a product that competes mainly on price
  2. Huge addressable market

These two things—combined with good management—contributed to GEICO’s fabulous growth in earning power in the subsequent decades, and its stock price went up over 100 times.

As I’ve stated before, despite the frequent comparisons between Buffett and Graham in his early years, Buffett was in fact much different than Graham. Although Graham bought a controlling stake in GEICO, he rarely made investment decisions based on the factors that Buffett used to put a majority of his capital into GEICO—factors such as management, market share, cost structure, and future growth prospects. As Buffett wrote about in his 1951 writeup of the stock, these qualitative considerations were much more significant to Buffett than price (which although not a Graham asset based bargain, was still attractive at around 8 times earnings).

So the fact that he bought it at 8 times earnings certainly contributed to Buffett doubling his money in the stock in the next year and a half, but the qualitative factors Buffett pointed out were the reasons that the stock was a 100 bagger over the coming decades.

Regarding his early 1950’s purchase, Buffett wrote that he was able to “develop a depth of conviction which I have felt few times since about any security”.

“At the time I felt that GEICO possessed an extraordinary business advantage in a very large industry that was going to continue to grow. Since that time they never have lost that advantage—the ability to give the policyholder back in losses a greater percentage of the premium dollar than any other auto insurance company in the country, while still providing a profit to the company.”

But fast forward a couple decades—despite its core low cost advantage still intact—the company was struggling because of factors that often ail many insurance operations—focusing on growth more than prudent underwriting. GEICO’s management had been doing a poor job of pricing its product and they were accepting inadequately priced risk.

Buffett often talks about the dubious prospects of investing in turnarounds, but GEICO was one that he thought could in fact turn. Buffett felt that GEICO was the rare exception to his rule because it had a low cost advantage that was still intact, it was just being mitigated because of poor management.

Buffett felt that this could be corrected, and with the right manager—Jack Byrne—this proved to be true. Buffett bought a significant amount of stock in the 70’s, and then bought the rest of the company entirely in the mid 90’s.

Here is one clip from the letter I thought was worth highlighting, as it is a key advantage to consider with other businesses and investment opportunities:

“I have always been attracted to the low cost operator in any business and, when you can find a combination of i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation. That situation prevailed twenty five years ago when I first became interested in the company, and it still prevails.”

Here is the link to the entire letter that Buffett sent to National Indemnity concerning his thoughts on GEICO.

8 thoughts on “Buffett Thoughts on GEICO in 1976

  1. thanks, this is great stuff. a couple comments here
    1) I wonder why a homogenous product would be considered a positive here? isnt that more prone to being a commodity product?
    2) why is it hard to duplicate GEICO’s low cost strategy (less of a question today due to its size.. .but back then I imagine GEICO to be smaller in market share – so Buffett must have thought this through..)

    1. The point about GEICO is that it greatly reduced one of the major cost components of insurance. The combined ratio is the main ratio of insurance, made up of the expense ratio (operating expenses as a percentage of premiums) plus the loss ratio (payments on claims as a percentage of premiums). If it’s 1, or 100%, then the float or “borrowed money” of the premiums until paid out was free. If higher, the excess over 100% was the cost of the float. If lower, the insurance company was actually paid to “borrow” the money.

      What GEICO did was to eliminate agents. That eliminates the majority of the expense ratio– while insurance prices were “set” by GEICO’s competitors who still had to pay agents. Not having that expense put GEICO in the driver’s seat– able to scoop up the highest-quality insurance business (government employees) with lower rates without losing business to competitors or losing money to claims due to bad underwriting. It was a huge structural advantage.

      1. What I meant was, why back in 1976 why couldn’t other insurers erode that advantage by also cutting out the agents? Now in 2014 GEICO has scale and consumer awareness plus the glow of WEB himself, all sustainable advantages. I’m not sure that was the case in 1976 with GEICO in distress.

        Clearly this worked out very well for WEB in hindsight but I bet it wasn’t so clear cut back then..

        1. I suspect the answer is much like the comparison between GM and Tesla. GM could not ditch unprofitable dealerships when it needed to, because dealerships tend to be family-owned and politically powerful. Tesla is starting out without dealerships of any sort, and even avoiding states like NJ because they are trying to ban Tesla sales in the state as a result. Similarly, GEICO started out without any relationships to politically powerful groups (rather like unions, another group Buffett has also tried to limit his dealings with), in this case insurance agencies, which also tend to be family-owned, and whose power is augmented by the fact that insurance is even more heavily regulated by states than autos and therefore is more politically sensitive. GEICO’s insurance competitors did not enjoy that situation and could not rid themselves of the monkey on their backs.

          Why did no one spot GEICO’s profitable little move and decide to start their own insurance companies on the same model from scratch, free of agencies? I don’t know. But Buffett was still not that well-known then and insurance was thought of as a stodgy, low-growth, heavily-regulated business. But it was a much more fragmented business situation back in the 1930s when GEICO was founded, with securities analysis a nascent profession and information slow and hard-won, and it wasn’t all that much better in 1976. Graham and Buffett spotted it, sure, and Buffett saw that GEICO was still unique that way in ’76– but they were highly unusual in many, many ways.

          The really interesting question is why no one is doing it now. (The low interest rates probably contribute.)

          1. thats a great answer thanks.

            as for why new competitors can’t get traction now with the same model,
            I think the auto insurance business has consolidated so much that top players can all spend huge $$ on advertising budgets to build their brand names, but it’s hard for new entrants to compete with that.

            Progressive also has a direct business but they still have the agents system,. which I suspect can partly be attributed to legacy/vested interests like you mentioned.

  2. This is an excellent post. Thanks for the link to the WSJ article.

    In one of the WEB biographies there was a passage to the effect he met with GEICO’s management in the 1970s before the problems emerged. Apparently, WEB said to them that their loss reserving was clearly inadequate and he asked what was going on. The story goes that WEB’s enquiries were quickly dismissed because GEICO’s management refused to accept that there was a problem.

    I would be very interested to learn how it was that WEB was able to come to his initial assessment that GEICO was under-reserving. Did he do this by comparison to other auto insurers (eg, comparing the ratio of reserves to the amount of business written)? Or did WEB form his views based on footnote disclosures on the development of prior year loss reserves? Or did WEB use some other measure?

    Have you seen anything on this?

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