GEICO

As you are aware, the funds are allowed to employ leverage. PIFI can leverage upto 30% and the other funds can go upto 50%. When Buffett ran his partnerships in the 1950s and 60s, he almost always had more ideas than money and the funds were nearly fully leveraged (50%) during most of the period. Buffett’s use of leverage was focused on workout and special situation investments. Today Buffett’s vehicle for leverage is insurance float – which is simply brilliant since that float is subdivided into a myriad of risk classes being covered that are very very unlikely to have any sort of aggregation ever. As an example, after 9/11, some of Berkshire’s Insurance units saw big claims, but its GEICO auto insurance unit with about 15% of the float was untouched by the events of 9/11. Many partners and potential partners have voiced concerns about the use of leverage in the funds to me from time to time. I have always been very careful with leverage – only using it for special situations. However, after a great deal of reflection, I have come to the conclusion that there are really no limits to the short-term irrationality of markets. I don’t believe 1929 represents the extreme to which markets can go. If fact, until 1987 common wisdom was that big market drops were a thing of the past. So while we are probably protected against a 50 or 100 year flood, I don’t think we’re protected against a 1000 year flood.

If the answer is no, the business is simply skipped over. 2. Is this a great and predictable business? The definition of a great business would mean a business that has some of the following characteristics: • Recurring Revenue Streams (e.g. GEICO) • Ability to raise prices ahead of inflation (e.g. The Washington Post) • Some sort of Monopoly or Oligopy type market positioning (e.g. American Express) • Strong franchise/brand that gives it insulation from most competitors (e.g. Coca Cola) Most businesses do not have ANY of the above characteristics and some may just have one of the above. A business that has more than one of the above characteristics is, by definition, rare. If I find a great business then I ask the third, and more difficult, question: 3. Is it on sale at a price well below its Intrinsic Value(IV)?3

The combination of a great business and it being on sale is, by definition, an anomaly. I look for these anomalies. When they occur, after rigorous analysis, I’ll either take a pass or backup the truck. There are two types of great business that are of interest to the fund: 1. Great, compelling companies trading at very low valuations relative to their expected value in a private sale. These companies may have little to no annual growth, but tend to have a solid cash flow engines that are highly predictable and are trading at very low multiples to earnings, cash flow and/or other metrics of value. 2. Growth at Reasonable Price (GARP) Companies. These companies, in high- growth markets, have shown a history of growing fast and are expected to continue to do so. I usually prefer GARP companies to straight value companies. I think the best returns will come from great, high growth companies that are available well below IV. I believe most of Buffett’s success has come from GARP-type businesses (Coca Cola, American Express, GEICO, The Washington Post etc.) So value businesses remain in the portfolio till either: 1. They reach IV and are sold. 2. A better value business comes along. 3. A better GARP business comes along. GARP businesses remain in the portfolio till: 1. They go well beyond IV. I hate to sell a good GARP business unless its well beyond IV. 2. A better GARP business comes along.

Buffett described insurance float — the money an insurer holds between collecting premiums and paying claims — as the central economic engine of Berkshire. He wrote that if underwriting is profitable over time, float is effectively a form of capital the insurer is paid to hold, and that the test of a great insurer is whether the long-run cost of float is negative. GEICO, he wrote, met that test because its low-cost distribution model produced sustained underwriting profits.

On the economics of float and the full GEICO acquisition.

Buffett cautioned that float is only valuable when the insurer resists the temptation to write business at an underwriting loss in order to grow investable assets. He wrote that the insurance industry's periodic price wars destroy the economics of float, and that Berkshire's discipline was to let volume fall when prices were inadequate rather than write unprofitable business to employ the float.

On the discipline that makes float valuable.

Graham narrates the GEICO investment in his memoirs as a near-accidental encounter. The founder of Government Employees Insurance Company had approached Graham-Newman seeking capital; the partnership negotiated the purchase of approximately half the company for around seven hundred thousand dollars. Graham writes that the deal was an unusual step for the partnership, which had historically preferred workouts, arbitrages, and liquid-asset plays rather than building a new insurance franchise. The transaction immediately created a regulatory problem. The Securities and Exchange Commission informed Graham-Newman that an investment fund was not permitted to hold more than a small percentage of an insurance company, and the partnership was required to distribute most of the GEICO stake to its own shareholders. Graham writes that the forced distribution turned out to be one of the most valuable involuntary decisions the partnership ever made, because the recipients held on through the post-war growth years and the position multiplied hundreds of times in value over the following decades. Graham treats GEICO as both a triumph and a paradox. He had paid a price that turned out to be a tiny fraction of what the company would be worth; the analytical framework had identified the underlying low-cost-operator advantage of GEICO's direct-selling model. But he also notes that the magnitude of the gain was not in any sense forecast by the partnership at the time of purchase. The lesson Graham draws is that the analyst can be right about the business and still badly wrong about the size of the payoff.

Buffett wrote that he and Charlie Munger had never made an investment decision based on a forecast of the economy or of interest rates, and that such forecasts would not have helped them if they had tried. He argued that the work of investing is to judge the long-term economics of individual businesses, and that macro forecasting is a distraction that produces activity without judgment.

On the irrelevance of macro forecasting to business-quality investing.

Buffett wrote that Berkshire's policy was to hold a small set of businesses it understood and admired, and that the test for inclusion was not whether a position had risen in price but whether the underlying business still met the original standard. He compared the portfolio to a group of permanent holdings — the kind of business one would be content to own if the stock market closed for a decade — and warned that the temptation to trade in and out of such businesses was the chief way owners harm themselves.

On the 'permanent holdings' framing and the futility of trading wonderful businesses.

Our largest non-controlled holding is 7.2 million shares of GEICO Corp., equal to about a 33% equity interest. Normally, an interest of this magnitude (over 20%) would qualify as an 'investee' holding and would require us to reflect a proportionate share of GEICO's earnings in our own. However, we purchased our GEICO stock pursuant to special orders of the District of Columbia and New York Insurance Departments, which required that the right to vote the stock be placed with an independent party. Absent the vote, our 33% interest does not qualify for investee treatment. (Pinkerton's is a similar situation.)

Of course, whether or not the undistributed earnings of GEICO are picked up annually in our operating earnings figure has nothing to do with their economic value to us, or to you as owners of Berkshire. The value of these retained earnings will be determined by the skill with which they are put to use by GEICO management. On this score, we simply couldn't feel better. GEICO represents the best of all investment worlds - the coupling of a very important and very hard to duplicate business advantage with an extraordinary management whose skills in operations are matched by skills in capital allocation.

As you can see, our holdings cost us $47 million, with about half of this amount invested in 1976 and most of the remainder invested in 1980. At the present dividend rate, our reported earnings from GEICO amount to a little over $3 million annually. But we estimate our share of its earning power is on the order of $20 million annually. Thus, undistributed earnings applicable to this holding alone may amount to 40% of total reported operating earnings of Berkshire.

We should emphasize that we feel as comfortable with GEICO management retaining an estimated $17 million of earnings applicable to our ownership as we would if that sum were in our own hands. In just the last two years GEICO, through repurchases of its own stock, has reduced the share equivalents it has outstanding from 34.2 million to 21.6 million, dramatically enhancing the interests of shareholders in a business that simply can't be replicated. The owners could not have been better served.

GEICO may appear to be an exception, having been turned around from the very edge of bankruptcy in 1976. It certainly is true that managerial brilliance was needed for its resuscitation, and that Jack Byrne, upon arrival in that year, supplied that ingredient in abundance. But it also is true that the fundamental business advantage that GEICO had enjoyed - an advantage that previously had produced staggering success - was still intact within the company, although submerged in a sea of financial and operating troubles.

GEICO was designed to be the low-cost operation in an enormous marketplace (auto insurance) populated largely by companies whose marketing structures restricted adaptation. Run as designed, it could offer unusual value to its customers while earning unusual returns for itself. For decades it had been run in just this manner. Its troubles in the mid-70s were not produced by any diminution or disappearance of this essential economic advantage.

GEICO's problems at that time put it in a position analogous to that of American Express in 1964 following the salad oil scandal. Both were one-of-a-kind companies, temporarily reeling from the effects of a fiscal blow that did not destroy their exceptional underlying economics. The GEICO and American Express situations, extraordinary business franchises with a localized excisable cancer (needing, to be sure, a skilled surgeon), should be distinguished from the true 'turnaround' situation in which the managers expect - and need - to pull off a corporate Pygmalion.

Whatever the appellation, we are delighted with our GEICO holding which, as noted, cost us $47 million. To buy a similar $20 million of earning power in a business with first-class economic characteristics and bright prospects would cost a minimum of $200 million (much more in some industries) if it had to be accomplished through negotiated purchase of an entire company. A 100% interest of that kind gives the owner the options of leveraging the purchase, changing managements, directing cash flow, and selling the business. It may also provide some excitement around corporate headquarters (less frequently mentioned).

Our forecast is for an average combined ratio for the industry in the 105 area over the next five years. While we have a high degree of confidence that certain of our operations will do considerably better than average, it will be a challenge to us to operate below the industry figure. You can get a lot of surprises in insurance. Nevertheless, we believe that insurance can be a very good business. It tends to magnify, to an unusual degree, human managerial talent - or the lack of it. We have a number of managers whose talent is both proven and growing. (And, in addition, we have a very large indirect interest in two truly outstanding management groups through our investments in SAFECO and GEICO.) Thus we expect to do well in insurance over a period of years. However, the business has the potential for really terrible results in a single specific year. If accident frequency should turn around quickly in the auto field, we, along with others, are likely to experience such a year.

The two lists of special situations in the 1940 edition of Security Analysis advanced an average of 252 percent in the following eight years, as compared with a 33 percent advance for the Standard & Poor's Industrials. THE GEICO STORY In 1948, a Washington lawyer and a bond salesman from Baltimore called at the Graham-Newman Corporation office with a special situation for sale. After negotiations, the fund bought a half-interest in the company offered for sale, Government Employees Insurance Company. The cost was $720,000, or nearly one-quarter of the Graham-Newman assets. It was necessary to spin off 1.08 shares of GEICO for each share of Graham-Newman Corp. because, under the Investment Company Act, it was not permissible to own more than 10 percent of an insurance company. The market value at that time (July 2, 1948) was $27 for the 1.08 shares. This eventually grew to $16,349 at the peak in 1972 and still stood at $2,407 at the close of 1976--nearly 90 times the starting point. GEICO had been founded in 1936 in Texas by Leo Goodwin, who had a 25 percent interest, with the balance owned by a Fort Worth banker who was the anxious seller to the Graham-Newman Corporation.be

sold by direct mail to the consumer at a reduced rate, as no commissions had to be paid to insurance agents. The policies were available only to government employees, a group that fortunately averaged fewer claims than most. The company had exceptional growth during its first dozen years and this continued after the Graham-Newman purchase. In 1958, it was decided to offer insurance to professional, managerial, technical and administrative workers, as well as government employees. This broadened the market from 15 percent of car owners to 50 percent. Again, these new policyholders also turned out to be preferred risks. In the following years, growth and profitability continued at an exceptional pace until GEICO became the nation's fifth largest automobile insurer. However, the days of 15 percent underwriting profit margins were over; GEICO was now so large that insurance commissioners would grant rates aimed at producing only a five percent underwriting margin, the same rates granted to other large insurance companies. Starting in 1974 costs rose as inflation accelerated. Adding in the problems of no-fault insurance and low rates, losses skyrocketed and GEICO's net worth dropped from $144 million at the start of 1975 to $37 million at the end of the year. A great many changes have been made and it is expected that 1977 will see GEICO return to profitability.

GEICO continues to have one of the lowest cost distribution systems in the industry, with expense ratios at 14 percent as compared with the industry's 28 percent ratio. The long-term future of the company still has to be determined, but for Graham-Newman investors it has been most profitable with very substantial dividends over the years plus interests in three GEICO affiliates (Government Employees Life Insurance Company, Government Employees Financial Corp., and Criterion Insurance). Ben summed up the fact that the decision to buy the half-interest in GEICO brought in vastly more profits than all of his other investments combined as follows: "An obvious (moral) is that there are several different ways to make and keep money in Wall Street." FAREWELL TO NEW YORK Ben's personality required a stream of new challenges. The Graham-Newman Corporation continued to prosper, essentially repeating the same processes for selecting undervalued securities. The fabulous success of the Government Employees Insurance Co. investment also blunted much of his never very great desire for financial success.had

The results of an investment in 100 shares of Graham-Newman Corporation common at 1-31-48, costing $11,413, compared with an equivalent investment in the Standard & Poor's 500, are presented below. Neither series has been adjusted for dividends, but the proceeds from the 1956 liquidation of Graham-Newman were assumed to have been reinvested in the S&P 500. These results certainly speak for themselves. 1-31-48 8-20-56 1972 Peak 12-31-76 1948-76 Appreciation Graham-N ewman and GEICO $ 11,413 70,413 1,658,989 262,490 11.4% per year S&P 500 $11,413 30,968 93,181 84,060 7.1% per year

Graham's 1976 La Jolla interview, conducted by Hartman L. Butler Jr. about a year before Graham's death, is the document in which Graham reflected most candidly on his career, his analytical method, and the changes he had made to his method in the light of the experience of the postwar decades. Graham tells Butler that he had, by 1976, simplified his analytical method substantially, and that the simplified method rested on the acquisition of a diversified portfolio of undervalued common stocks selected by a small number of quantitative screens. Graham's instruction is that the simplified method had produced returns at least as good as the more elaborate method he had applied through the Graham-Newman years, and that the individual investor who applied the simplified method would, over a long horizon, do at least as well as the more elaborate method had done for the partnership. Graham's discussion of the GEICO position is the interview's most instructive passage. Graham tells Butler that the partnership had bought half of GEICO in 1948 for about seven hundred and twenty thousand dollars, that the SEC had forced the partnership to distribute the stake, and that the distributed stake had subsequently been worth over a billion dollars in the public market. Graham is candid that the magnitude of the GEICO re-rating exceeded even the partnership's analytical expectations, and that the partnership had not, at the time of purchase, fully appreciated the operating leverage of the insurance-underwriting model that GEICO's direct-to-consumer distribution had produced. The interview's instruction is that the GEICO position was, in retrospect, the partnership's most consequential single investment, and that the partnership's analytical method had been sufficient to identify the position's margin of safety at the time of purchase, even though the subsequent re-rating had exceeded the analytical forecast. Graham's discussion of the 1929 crash is the interview's other instructive passage. Graham tells Butler that he had been running an investment account with margin leverage when the crash began, and that the wipeout had been severe even though Graham had been cautious about speculation by the standards of the era. Graham's instruction is that the experience of 1929 through 1932 had been the formative financial event of his life, and that the experience had taught him the discipline of avoiding leverage and the discipline of buying only with a margin of safety. The 1976 interview is, in this sense, the document in which Graham's most candid reflection on his career is recorded, and it is the document on which subsequent generations of value analysts have drawn for Graham's most direct statements on the lessons of his own experience. The interview is also the document in which Graham's revised view on the simplification of his analytical method is most directly recorded, and it is the document that grounds the simplified quantitative methods later generations of value analysts have applied.

AN HOUR WITH MR. GRAHAM by Hartman L. Butler, Jr., C.F.A. La Jolla, California March 6, 1976 lIB: Mr. Graham, I do appreciate so much being able to come and visit with you this afternoon. When Bob Milne learned that Mrs. Butler and I would be in La Jolla, he suggested that I not only visit with you but also bring along my cassette tape recorder. We have much I would like to cover. First, could we start with a topical question-Government Employees Insurance Company-with GEICO being very much in the headlines. Graham: Yes, what happened was the team came into our office and after some negotiating, we bought half the company for $720,000. It turned out later that we were worth-the whole company--over a billion dollars in the stock market. This was a very extraordinary thing. But we were forced by the SEC to distribute the stock among our stockholders because, according to a technicality in the law, an investment fund was not allowed more than 10 percent of an insurance company. Jerry Newman and I became active in the conduct of GEICO, although we both retired a number of years ago. I am glad I am not connected with it now because of the terrific losses. lIB: Do you think GEICO will survive? Graham: Yes, I think it will survive. There is no basic reason why it won't survive, but naturally I ask myself whether the company did expand much too fast without taking into account the possibilities of these big losses.

The letters record that Graham-Newman's GEICO holding, although reduced by the SEC-mandated distribution, remained a meaningful position and a focus of the partnership's attention. Graham and Newman took board seats and involved themselves in the company's underwriting and finance. The letters describe GEICO's growth in premium volume and policyholder count, and note that the company's direct-to-consumer model was producing underwriting profits that other insurers could not match. The letters are explicit that Graham-Newman did not forecast GEICO's later dominance. The partnership's analytical case at the time of the 1948 investment was that the company was a low-cost operator with disciplined underwriting, in an industry where most operators were neither. The letters do not project the twenty-five-year outcome; they project a sound business bought cheaply. The lesson the partnership drew, in retrospect, was that soundness and price were sufficient and the growth bonus was a free rider. Graham-Newman's letters also disclose the moment in the early 1970s when GEICO's underwriting discipline broke and the company nearly collapsed. Graham writes, in later correspondence, that he had been retired from Graham-Newman by then and was not involved in the rescue, but that the episode confirmed his view that even a low-cost operator can be ruined by underwriting for growth rather than for profit.

The 1948 report discloses that the partnership held a meaningful concentration in a small number of securities. The audited balance sheet shows that the largest positions, including GEICO, made up a substantial portion of net asset value. The concentration is a function of Graham-Newman's analytical discipline: the partnership bought only when the analytical case was strong, and the result was that a small number of positions carried the partnership's returns. Graham-Newman's working view, recorded across the letters, was that concentration was acceptable when each position had a margin of safety and when the analyst's conviction was grounded in financial-statement analysis rather than narrative. The partnership did not diversify for its own sake; it diversified to the extent that the analytical screen produced a list of qualifying positions, and concentrated when the screen produced a short list. The 1948 report is also notable for the disclosure of the GEICO position. Graham-Newman had purchased its stake in 1948, and the audited balance sheet records the holding at cost. The report's auditors confirmed the partnership's valuation of the position, but the report did not yet reflect the later SEC-mandated distribution of the GEICO stake. The 1948 report is therefore a snapshot of the partnership at the moment the GEICO position entered the portfolio, before the regulatory process that would turn the holding into one of the most successful investments in the partnership's history.