“Our calculus is different: We simply measure whether we are creating more than a dollar of value per dollar spent — and if that calculation is favorable, the more dollars we spend the happier I am.” —Warren Buffett
Accounting vs. Economic Profit: Acquisition of New Policy Holders
Sanjay Bakshi has written about Warren Buffett’s views about the decisions relating to customer acquisition costs for GEICO. Bakshi refers to an interview with Tom Russo “where he talked about the logic of Buffett’s decision to lay out large sums of money to acquire new, likely to be profitable customers for GEICO, even though such actions would severely penalise near term earnings.”
In this interview Tom Russo gives some insight as to how to think about the short-term earnings impact from acquiring additional policy holders, versus the change in intrinsic value (emphasis added).
When Warren Buffett bought GEICO, the company had something like two million policyholders, and Berkshire’s belief was that they were the best insurer in the country. So why should they have a bigger than two percent market share? And the answer was that every new policy that they put on the books reported losses to the firm of $250 of operating losses: reported losses at least when they would sign up for those new policies. And of course at the same time because of high persistency and because of the great business model of GEICO the net present value of each new insured was $1500. So when it was a separately run public company, GEICO was constrained by not being able to take the steps to grow the business optimally because they had to report a $250 loss for every new insured and they kind of measured their growth in the modest pace. Once it came inside of Berkshire, Warren who doesn’t really care about reporting profits, he was delighted to take steps that could increase the firm’s net present value by adding new policy holders even if it meant that in the year of acquisition, he showed more losses. And you have seen as anybody who has inhabited the earth over the past two decades would have seen this extraordinary life of lizards and cavemen and other forms of spokespeople for Berkshire’s GEICO division and they cost a lot of money. His advertising budget went from $30 million to $950 million over those years. And yet the number of insured went from two million to 10 and with $1500 NPV for every new insured customer the value was around $15 billion. Berkshire did that in part because they were permitted to suffer the report the losses of the first year of and celebrate the NPV gains that they picked up. That is one example how Berkshire showed the value of this approach.
In the table below, I have visualized the two scenarios that Geico faces when deciding whether or not to acquire an additional policy holder. The short-term effect is an expense of $250, that will lower reported earnings for the fiscal year in wich the policy holder is aquired. The short-term impact is negative when looking at the accounting profit for the year. But, the long-term effect is just the opposite, since in this case adding a new policy holder results in a net present value (NPV) of $1,500, i.e. the economic profit that adds to Geico’s intrinsic value.
First-Level vs. Second-Level Thinking
When I read the text above about the short-term P&L impact from acquiring a new policy holder, versus the long-run value creation that adds to the business’s intrinsic value, I came to think of Howard Marks and his mental models first- and second-level thinking. It looks like the Geico acquisition case above fits right into these models.
Let’s refresh our minds, and start with Howard Marks description, from his book The Most Important Thing, about what separates first-level thinking from second-level thinking.
Howard Marks answers the question “What is second-level thinking?” by giving a few examples, among them this one:
• First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall less than people expect, and the pleasant surprise will lift the stock; buy.”
Marks then goes on to explain the two different ways of thinking.
First-level thinking is simplistic and superficial, and just about everyone can do it (a bad sign for anything involving an attempt at superiority). All the first-level thinker needs is an opinion about the future, as in “The outlook for the company is favorable, meaning the stock will go up.”
Second-level thinking is deep, complex and convoluted. The second-
level thinker takes a great many things into account:
• What is the range of likely future outcomes?
• Which outcome do I think will occur?
• What’s the probability I’m right?
• What does the consensus think?
• How does my expectation differ from the consensus?
• How does the current price for the asset comport with the consensus view of the future, and with mine?
• Is the consensus psychology that’s incorporated in the price too bullish or bearish?
• What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?
Geico: From a Second-Level Thinking Perspective
From the Geico policy holder acquisition case above, we could formulate our own rules as:
• First-level thinking says, “The company’s earnings will fall; don’t acquire any/or too many new policy holders in a certain fiscal year.” Second-level thinking says, “NPV for each new policy holder signed up is $1,500; acquire additional policy holders as long as the NPV for every new policy holder is positive.”
Let’s end this post with another Buffett quote worth remembering.
“Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.” —Warren Buffett