In August 25, 1995, Warren Buffet, COE of Berkshire Hathaway announced that his company would acquire the rest of the GEICO Corporation. In doing so, this would the GEICO shareholders a 26% premium per share market price, $55.75 per share to $70 per share. Buffet did not propose to change anything about GEICO, which astonished the observer since there wasn't any synergy between the two companies.
At the end of the day, Berkshire Hathaway's shares were at 2.4%, a gain in market value of $718 million and the S&P500 Index was 0.05%. (Warren E. Buffet, 1995 (VA: Darden Business Publishing) pg 2 of case study.)
Warren Buffet is considered to be an anomaly, one of the wealthiest people in the world as well as respected and loved. Warren Buffet may have the best investment record in history (a compound annual increase in wealth of 28% from 1965 to 1994); (Warren E. Buffet, 1995 (VA: Darden Business Publishing) pg 2 of case study.) Berkshire Hathaway only paid him $100,000 per year as the CEO of the company.
Even though Buffet and other insiders controlled 47.9% of the company, he ran the company in the interests of all the shareholders. He remained a private individual even when he was featured in many laudatory articles and three biographies. (Warren E. Buffet, 1995 (VA: Darden Business Publishing) pg 2 of case study.)
Many writers want to extract the essential elements of Buffet's success, hoping to expose or reveal why Berkshire's acquisition of GEICO. The questions they hoped to have answered: "What are the key principles that guided Buffet? Could these be applied broadly in the late 1990s and into the 21st century, or were they unique to Buffet and his time? Under what assumptions would this acquisition make sense?
What were Buffet's probable motives in the acquisition? Would the acquisition off GEICO prove to be a success? How would it compare to the firm's other recent investments in Salomon Brothers, USAir, and Champion International?" (Warren E. Buffet, 1995 (VA: Darden Business Publishing) pg 2 of case study.)
Berkshire Hathaway, Inc.
The company was incorporate as Berkshire Cotton Manufacturing in 1889. Berkshire Cotton Manufacturing expanded to New England's largest textile producers, 25% of the country's cotton textile production company. "In 1955, Berkshire merged with Hathaway Manufacturing and began a secular decline due to inflation, technological change, and intensifying competition from foreign competitors."
Buffet and his partners eventually acquired control of Berkshire Hathaway with the knowledge that over the next 20 years, that the large capital investments would be required to remain competitive and that the financial returns would be small. In 1985, Berkshire left the textile business to purchase two insurance companies' headquarters in Omaha, NE: National Indemnity Company and National Fire & Marine Insurance Company.
In 1977, Berkshire Hathaway had the year-end closing share price of $89.00 and on August 25, 1995, the price was $25,400.00; in comparison to the annual average total return on all large stocks from 1977 to the end of 1994 was at 14.3%. The standard & Poor's 500 Index grew from 107 to 560. Buffet refused to split the firm's share price to make it more accessible to the individual investor.
In 1994, Berkshire was described as "holding company owning subsidiaries engaged in a number of diverse business actives." (Warren E. Buffet, 1995 (VA: Darden Business Publishing) pg 3 of case study. Berkshire Hathaway, Inc., 1994 Annual Report.) In 1994, Berkshire's portfolio included: Insurance group, Buffalo News, Fechheimer, Kirby, Nebraska Furniture, See's candles, Childcraft and World Book, Campbell Hausfield, H.H. Brown Shoe Company, Lowell Shoe, Inc., and Dexter Shoe Company.
Insurance Group is the largest component of the portfolio. It focused on property and casualty insurance on a direct and reinsurance basis. Buffalo News is a daily and Sunday newspaper in New York. Fechheimer is a manufacturer and distributor of uniforms. Kirby is a manufacturer and marketer of home cleaning systems and accessories.
Nebraska Furniture is a retailer of home furnishings. See's Candles is a manufacturer and distributor of boxed chocolates and other sweets products. Childcraft and World Book is a publisher and distributor of encyclopedias and related educational and instructional products. Campbell Hausfield is a manufacturer and distributor of air compressors, air tools and painting systems. H.H. Brown Shoe Company, Lowell Shoe Inc., and Dexter Shoe Company are manufacturers, importers and distributors of footwear.
Berkshire Hathaway's Acquisition Policy
GEICO had a renewed interest in Buffet's approach to acquisition shown in exhibit 4 of the case study, the formal statement of acquisition criteria in Berkshire's 1994 Annual Report. Berkshire invested in Scott & Fretzer, 1986, for $315 million compared to the book value of $176.6 million. "Scott & Fretzer was conservatively financed, going from a modest debt at the acquisition to virtually no debt by 1994. Exhibit 5 gives the earnings and dividends for Scott & Fretzer from 1986 - 1994. Buffet noted that in terms of return on book value to equity, Scott & Fretzer would have easily beaten the Fortune 500 firms.
The annual average total return on large company stocks from 1986 - 1994 was 12.6%." (This exempts from the comparison firms emerging from bankruptcy in recent years. Buffet's observation was made in Berkshire's 1994 Annual Report. Stocks, Bonds, Bills, and Inflation. Warren E. Buffet, 1995 (VA: Darden Business Publishing) pg 2 of case study.)
Buffet's Investment Philosophy
Buffet attended Columbia University where he studied under Professor Benjamin Graham. Graham developed a method of identifying undervalued stock, stocks whose price was less than "intrinsic value." It became the cornerstone of modern approach of "value investing." Graham focused on the value of assets which Buffet later modified to focus on valuable franchises that weren't recognized by the market.
Throughout the years to come, Buffet expressed and shared his philosophy in his letters to shareholders in the Annual Report. By 1995, the letter accumulated because of the wisdom, humorous, self-depreciating tone. They emphasized:
1.The economic reality, not the accounting reality - at the level of business itself not the market, the economy or the security. He analyzed and judged 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.
2. The cost of the lost opportunity; - comparing against the next best alternative, "lost opportunity." He used the potential rate of return from investing in common stocks of other companies as a benchmark of performance.
3.The value creation: time is money - intrinsic value as the present value of future expected performance. One need to focus on the prospective rates of return, and how they compare to the required rate of return.
4.The measure performance by gain in intrinsic value, not accounting profit - the gain in intrinsic value could be modeled as the value added by business above and beyond a charge for the use of capital. This focus on the ability to earn returns in excess of the cost of capital.
5.The risk and discount rates - rate of return is used on long-term U.S. Treasury bonds to discount cash flows because he avoided risk and therefore should use a risk-free discount rate.
6.The diversification - investors should wait for the one exceptional company.
7.The investing behavior should be driven by information, analysis, and self-discipline, not by emotion or "hunch"- "awareness" and information is the foundation of investing. "Anyone not aware of the fool in the market probably is the fool in the market"
8.The alignment of agents and owners - "I am a better businessman because I am an investor. And I am a better investor because I am a businessman. A managerial "wish list" will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control process 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." ("Owner-Related Business Principles" in Berkshire's 1994 Annual report.)
In 1976, Berkshire began to purchase shares in GEICO. By 1980, it accumulated 33% interest for $45.7 million. During 1976-1980, GEICO's share price had a double-digit inflation, higher accident rates and high damage awards that raised the cost of business rapidly.
In August 1995, the stake of $45.7 million had grown to $1.9 billion. ("Owner-Related Business Principles" in Berkshire's 1994 Annual report.) GEICO paid dividends that increased each year; the average annual total return for a large company was 13.5%. Analysts tested the suitability of Buffet's $70 per share offer using the discount-cash-flow approach. A value-line forecast was published of GEICO's dividends and future stock price within a range of 1996-2000. Evidently, it was consistent with the cost of equity for GEICO's 11%.
In conclusion, is the bid price appropriate? Would GEICO acquisition serve the long-term goals of Berkshire Hathaway? What might account for the share price increase for Berkshire Hathaway at the announcement? Yes the bid price for GEICO's shares was higher that what the actual price per share was. Buffet's track record for picking companies to purchase is outstanding. He has one of the best investment records in history and is well recognized by the financial community. Berkshire's year-end price in 1977 was $89.
In 1995, the firm's closing share price was $25,400, an increase of $25,311 per share in 18 years. This is a 284% annual rate of return. GEICO will be a part of the most profitable segment - insurance. It can be reasonably anticipated that margins will be in line with historical levels and the need for capital expenditures is extremely low based on past performance of the insurance segment.
Since the acquisition is in the most profitable segment, requiring the least amount of capital expenditures and has the highest identifiable asset base, the financial community and investors are anticipating a rise in the overall company's return, etc. GEICO is most likely anticipated as a provider or source of cash since it doesn't requires large capital outlays as the Home furnishings segment. This may lead to a larger than normal increase in dividends in the stock price.