On August 25, 1995, Warren Buffett, the CEO of Berkshire Hathaway, announced that his firm would acquire the 49. 6 percent of GEICO Corporation that it did not already own. The $2. 3 billion deal would give GEICO shareholders $70. 00 per share, up from the $55. 75 per share market price before the announcement.
Observers were astonished at the 26 percent premium that Berkshire Hathaway would pay, particularly since Buffett proposed to change nothing about GEICO, and there were no apparent synergies in the combination of the two firms. At the announcement, Berkshire Hathaway’s shares closed up 2. 4 percent for the day, for a gain in market value of $718 million.
That day, the Standard & Poor’s 500 index closed up 0. 5 percent. The acquisition of GEICO renewed public interest in its architect, Warren Buffett. In many ways he was an anomaly. One of the richest individuals in the world (with an estimated net worth of about $7 billion), he was also respected and even beloved. Though he had accumulated perhaps the best investment record in history (a compound annual increase in wealth of 28 percent from 1965 to 1994), Berkshire Hathaway paid him only $100,000 per year to serve as its CEO. Buffett and other insiders controlled 47. 9 percent of the company, yet Buffett ran the company in the interests of all shareholders. He was the subject of numerous laudatory articles and three biographies,yet he remained an intensely private individual.
Though acclaimed by many as an intellectual genius, he shunned the company of intellectuals and preferred to affect the manner of a down-home Nebraskan (he lived in Omaha), and a tough-minded investor. In contrast to other investment ‘stars,’ Buffett acknowledged his investment failures quickly and publicly. Though he held an MBA from Columbia University and credited his mentor, Professor Benjamin Graham, with developing the philosophy of value-based investing that guided Buffett to his success, he chided business schools for the irrelevance of their theories of finance and investing.
Numerous writers sought to distill the essence of Buffett’s success. What were the key principles that guided Buffett? Could these be applied broadly in the late 1990s and into the 21st century, or were they unique to Buffett and his time? From an understanding of these principles, analysts hoped to illuminate Berkshire Hathaway’s acquisition of GEICO. Under what assumptions would this acquisition make sense? What were Buffett’s probable motives in the acquisition? Would the acquisition of GEICO prove to be a success?
How would it compare to the firm’s other recent investments in Salomon Brothers, USAir, and Champion International? Berkshire Hathaway, Inc. The company was incorporated in 1889 as Berkshire Cotton Manufacturing, and eventually grew to become one of New England’s biggest textile producers, accounting for 25 percent of the country’s cotton textile production. In 1955, Berkshire merged with Hathaway Manufacturing and began a secular decline due to inflation, technological change, and intensifying competition from foreign competitors.
In 1965 Buffett and some partners acquired control of Berkshire Hathaway, believing that the decline could be reversed. Over the next 20 years it became apparent that large capital investments would be required to remain competitive and that even then the financial returns would be mediocre. In 1985, Berkshire Hathaway exited the textile business. Fortunately, the textile group generated enough cash in the initial years to permit the firm to purchase two insurance companies headquartered in Omaha: National Indemnity Company and National Fire & Marine Insurance Company.
Acquisitions of other businesses followed in the 1970s and 1980s. The investment performance of a share in Berkshire Hathaway had astonished most observers. In 1977 the firm’s year-end closing share price was $89. On August 25, 1995, the firm’s closing share price was $25,400. In comparison, the annual average total return on all large stocks from 1977 to the end of 1994 was 14. 3 percent. 4 Over the same period, the Standard & Poor’s 500 index grew from 107 to 560. Some observers called for Buffett to split the firm’s share price, to make it more accessible to the individual investor.
The managers of Scott & Fetzer had attempted a leveraged buyout of the company in the face of rumored hostile takeover attempt. When the Labor Department objected to the company’s use of an employee stock ownership plan to assist in the financing, the deal fell apart. Soon the company attracted unsolicited proposals to purchase the company, including one from Ivan F. Boesky, the arbitrageur. Buffett offered to buy the company for $315 million (which compared to its book value of $172. 6 million). Following the acquisition, Scott & Fetzer paid Berkshire Hathaway dividends of $125 million, even though it earned only $40. million that year.
In addition, Scott & Fetzer was conservatively financed, going from modest debt at the acquisition to virtually no debt by 1994. Buffett noted that in terms of return on book value of equity, Scott & Fetzer would have easily beaten the Fortune 500 firms. The annual average total return on large company stocks from 1986 to 1994 was 12. 6 percent. Buffett’s Investment Philosophy Warren Buffett was first exposed to formal training in investing at Columbia University, where he studied under Professor Benjamin Graham.
The coauthor of a classic text, Security Analysis, Graham developed a method of identifying undervalued stocks (i. e. , stocks whose price was less than ‘intrinsic value’). This became the cornerstone of the modern approach of ‘value investing. ’ Graham’s approach was to focus on the value of assets such as cash, net working capital, and physical assets. Eventually, Buffett modified that approach to focus also on valuable franchises that were not recognized by the market. Over the years, Buffett had expounded his philosophy of investing in his CEO’s letter to shareholders in Berkshire Hathaway’s annual report.
By 1995, these lengthy letters had accumulated a broad following because of their wisdom and their humorous, self-deprecating tone. Economic reality, not accounting reality. Financial statements prepared by accountants conformed to rules that might not adequately represent the economic reality of a business. Buffett wrote: Because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers …
Accounting consequences do not influence our operating or capital-allocation process. Accounting reality was conservative, backward-looking, and governed by generally accepted accounting principles (GAAP). Investment decisions, on the other hand, should be based on the economic reality of a business. In economic reality, intangible assets such as patents, trademarks, special managerial know-how, and reputation might be very valuable, yet under GAAP they would be carried at little or no value. GAAP measured results in terms of net profit; in economic reality, the results of a business were its flows of cash.
A key feature of Buffett’s approach defined economic reality at the level of the business itself, not the market, the economy, or the security—he was a fundamental analyst of a business. His analysis sought to judge the simplicity of the business, the consistency of its operating history, the attractiveness of its long-term prospects, the quality of management, and the firm’s capacity to create value.
The cost of the lost opportunity. Buffett compared an investment opportunity against the next best alternative, the so-called lost opportunity. In his business decisions, he demonstrated a tendency to frame his choices as ‘either/or’ decisions rather than ‘yes/no’ decisions. Thus, an important standard of comparison in testing the attractiveness of an acquisition was the potential rate of return from investing in common stocks of other companies. Buffett held that were was no fundamental difference between buying a business outright and buying a few shares of that business in the equity market. Thus, for him, the comparison of an investment against other returns available in the market was an important benchmark of performance.
Value creation: time is money. Buffett assessed intrinsic value as the present value of future expected performance. [All other methods fall short in determining whether] an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value for his investments … Irrespective of whether a business grows or doesn’t, displays volatility or smoothness in earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase.
Enlarging on his discussion of ‘intrinsic value,’ Buffett used an educational example: We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
To see how historical input (book value) and future output (intrinsic value) can diverge, let’s look at another form of investment, a college education. Think of the education’s cost as its ‘book value. ’ If it is to be accurate, the cost should include the earnings that were foregone by the student because he chose college rather than a job. For this exercise, we will ignore the important non-economic benefits of an education and focus strictly on its economic value.
First, we must estimate the earnings that the graduate will receive over his lifetime and subtract from that figure an estimate of what he would have earned had he lacked his education. That gives us an excess earnings figure, which must then be discounted, at an appropriate interest rate, back to graduation day. The dollar result equals the intrinsic economic value of the education. Some graduates will find that the book value of their education exceeds its intrinsic value, which means that whoever paid for the education didn’t get his money’s worth.
In other cases, the intrinsic value of an education will far exceed its book value, a result that proves capital was wisely deployed. In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value. To illustrate the mechanics of this example, consider the hypothetical case presented in Exhibit 6. Suppose an individual has the opportunity to invest $50 million in a business—this is its ‘cost’ or ‘book value. ’ This business will throw off cash at the rate of 20 percent of its investment base each year.
Suppose that instead of receiving any dividends, the owner decides to reinvest all cash flow back into the business—at this rate the book value of the business will grow at 20 percent per year. Suppose that the investor plans to sell the business for its book value at the end of the fifth year. Does this investment create value for the individual? One determines this by discounting the future cash flows to the present at a cost of equity of 15 percent—suppose that this is the investor’s opportunity cost, the required return that could have been earned elsewhere at comparable risk.
The gain in intrinsic value could be modeled as the value added by a business above and beyond a charge for the use of capital in that business. The gain in intrinsic value was analogous to ‘economic profit’ and ‘market value added,’ measures used by analysts in leading corporations to assess financial performance. Those measures focus on the ability to earn returns in excess of the cost of capital.
Risk and discount rates. Conventional academic and practitioner thinking held that the more risk one took, the more one should get paid. Thus, discount rates used in determining intrinsic values should be determined by the risk of the cash flows being valued. The conventional model for estimating discount rates was the capital asset pricing model (CAPM), which added a risk premium to the long-term risk-free rate of return (such as the U. S. Treasury bond yield). Buffett departed from conventional thinking, by using the rate of return on the long-term (e. . , 30-year) U. S. Treasury bond to discount cash flows.
Defending this practice, Buffett argued that he avoided risk, and therefore should use a ‘risk-free’ discount rate. His firm used almost no debt financing. He focused on companies with predictable and stable earnings. He or his vice chairman, Charlie Munger, sat on the boards of directors where they obtained a candid, inside view of the company and could intervene in decisions of management if necessary. Buffett wrote: I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing.
We define risk, using dictionary terms, as ‘the possibility of loss or injury. ’ Academics, however, like to define ‘risk’ differently, averring that it is the relative volatility of a stock or a portfolio of stocks—that is, the volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the ‘beta’ of a stock—its relative volatility in the past—and then build arcane investment and capital allocation theories around this calculation.
In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong. Buffett was fond of repeating a parable told him by Benjamin Graham: There was a small private business and one of the owners was a man named Market. Every day Mr. Market had a new opinion of what the business was worth, and at that price stood ready to buy your interest or sell you his.
As excitable as he was opinionated, Mr. Market presented a constant distraction to his fellow owners. ‘What does he know? ’ they would wonder, as he bid them an extraordinarily high price or a depressingly low one. Actually, the gentleman knew little or nothing. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
Buffett used this allegory to illustrate the irrationality of stock prices as compared to true intrinsic value. Graham believed that an investor’s worst enemy was not the stock market, but oneself. Superior training could not compensate for the absence of the requisite temperament for investing. Over the long term, stock prices should have a strong relationship with the economic progress of the business. But daily market quotations were heavily influenced by momentary greed or fear and were an unreliable measure of intrinsic value. Buffett said, As far as I am concerned the stock market doesn’t exist.
It is there only as a reference to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses. You simply have to behave according to what is rational rather than according to what is fashionable. Accordingly, Buffett did not try to ‘time the market’ (i. e. , trade stocks based on expectations of changes in the market cycle)—his was a strategy of patient, long-term investing. As if in contrast to ‘Mr. Market,’ Buffett expressed more contrarian goals: ‘We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
Buffett also said, ‘Lethargy bordering on sloth remains the cornerstone of our investment style,’ and, ‘The market, like the Lord, helps those who help themselves. But unlike the Lord the market does not forgive those who know not what they do. Buffett scorned the academic theory of capital market efficiency. The efficient markets hypothesis (EMH) held that publicly known information was rapidly impounded into share prices, and that as a result, stock prices were ‘fair’ in reflecting what was known about a company. Under EMH, there were no bargains to be had and trying to outperform the market would be futile. It has been helpful to me to have tens of thousands turned out of business schools taught that it didn’t do any good to think,’ Buffett said.
I think it’s fascinating how the ruling orthodoxy can cause a lot of people to think the earth is flat. Investing in a market where people believe in efficiency is like playing bridge with someone who’s been told it doesn’t do any good to look at the cards. Alignment of agents and owners. Explaining his significant ownership interest in Berkshire Hathaway, Buffett said, ‘I am a better businessman because I am an investor. And I am a better investor because I am a businessman. ’
As if to illustrate this sentiment, he said, A managerial ‘wish list’ will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market. For four of Berkshire’s six directors, over 50 percent of their family net worth was represented by shares in Berkshire Hathaway.
The senior managers of Berkshire Hathaway subsidiaries held shares in the company, or were compensated under incentive plans that imitated the potential returns from an equity interest in their business unit, or both. GEICO Corporation Berkshire Hathaway began purchasing shares in GEICO in 1976, and by 1980 had accumulated a 33 percent interest (34. 25 million shares) for $45. 7 million. During the period from 1976 to 1980, GEICO’s share price had been hammered by double-digit inflation, higher accident rates, and high damage awards that raised the costs of its business more rapidly than premiums could be increased.
At the same time, these managers wish to remain significant owners who continue to run their companies just as they have in the past. We think we offer a particularly good fit for owners with such objectives and we invite potential sellers to check us out by contacting people with whom we have done business in the past. Charlie and I frequently get approached about acquisitions that don’t come close to meeting our tests: We’ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker paniels.
A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: ‘When the phone don’t ring, you’ll know it’s me’. Besides being interested in the purchase of businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Capital Cities, Salomon, Gillette, USAir, and Champion. We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.
Total dividends to Berkshire were estimated by multiplying the per share dividend times 34. 25 million shares, Berkshire’s holdings in GEICO. This presentation assumes that all of Berkshire’s shares in GEICO were acquired in 1976. Source of annual dividends per share: Value Line Investment Survey.
Source
- Bruner, R. F. , Case Studies in Finance: Managing for Corporate Value Creation, 3rd edn, Irwin McGraw-Hill, Boston, 1999, pp. 2–17.
