Warren Buffett’s Ground Rules

“…I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.”

—Warren Buffett, January 18, 1963

Ground Rules, Partners, and Reasonable Expectations

I am currently reading Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, authored by Jeremy Miller. This book contains, for the first time, a compilation of Warren Buffett’s Partnership letters, and Buffett’s own words written to his partners about his investment principles, for example his view on diversification strategy, compounding interest, preference for conservative rather than conventional decision making, and his goal and tactics for bettering market results by at least 10% annually. Demonstrating Buffett’s intellectual rigor, they provide a framework to the craft of investing that had not existed before: Buffett built upon the quantitative contributions made by his famous teacher, Benjamin Graham, demonstrating how they could be applied and improved.

I have read the Buffett Partnership Letters before, and they are well worth reading. In one of the letters, dated January 18, 1963, Buffett lays out his “Ground Rules.” These rules provide a great example of how to make sure that partners have reasonable expectations about what results could be expected from the Partnership itself, and Buffett himself as the sole investment manager. For this reason I wanted to put the rules up on the blog to keep them with me on my investing journey.

“The Ground Rules” written by Buffett in a letter to his partners in the beginning of 1963 are as follows.

The Ground Rules

Some partner have confessed (that’s the proper word) that they sometimes find it difficult to wade through my entire annual letter. Since I seem to be getting more long-winded each year, I have decided to emphasize certain axioms on the first page. Everyone should be entirely clear on these points. To most of you this material will seem unduly repetitious, but I would rather have nine partner out of ten mildly bored than have one out of ten with any basic misconceptions.

  1. In no sense is any rate of return guaranteed to partners. Partners who withdraw one-half of 1% monthly are doing just that—withdrawing. If we earn more than 6% per annum over a period of years, the withdrawals will be covered by earnings and the principal will increase. If we don’t earn 6%, the monthly payments are partially or wholly a return of capital.
  2. Any year in which we fail to achieve at least a plus 6% performance will be followed by a year when partners receiving monthly payments will find those payments lowered.
  3. Whenever we talk of yearly gains or losses, we are talking about market values; that is, how we stand with assets valued at market at yearend against how we stood on the same basis at the beginning of the year. This may bear very little relationship to the realized results for tax purposes in a given year.
  4. Whether we do a good job is not to be measured by whether we are plus or minus for the year. It is instead to be measured against the general experience in securities as measured by the Dow-Jones Industrial Average, leading investment companies, etc. If our record is better than that of these yardsticks, we consider it a good year whether we are plus or minus. If we do poorer, we deserve the tomatoes.
  5. While I much prefer a five-year test, I feel three year is an absolute minimum for judging performance. It is certainty that we will have years when the partnership performance is poorer, perhaps substantially so, than the Dow. If any three-year or longer period produces poor results, we all should start looking around for other places to have our money. An exception to the latter statement would be three years covering a speculative explosion in a bull market.
  6. I am not in the business of predicting general stock market or business fluctuations. If you think I can do this, or think it is essential to an investment program, you should not be in my partnership.
  7. I cannot promise results to partners. What I can do is that:
    1. Our investments will be chosen on the basis of value, not popularity;
    2. That we will attempt to bring risk of permanent capital loss (not short-term quotational loss) to an absolute minimum by obtaining a wide margin of safety in each commitment and a diversity of commitments, and
    3. My wife, children and I will have virtually out entire net worth invested in the partnership.

To read the full Buffett Partnership letter quoted above, click here.

To read a sample from the book Warren Buffett’s Ground Rules, click here.

Bruce Greenwald: From Graham to Buffett and on to Modern Value Investing

“It is not the strongest or the most intelligent who will survive but those who can best manage change.” —Leon C. Megginson

The Past, Present, and Future of Value Investing

There’s a new video out, as part of the celebration of Columbia Business School’s storied history over the past 100 year, in which Professors Bruce Greenwald and Tano Santos sits down and discusses a few different topics related to value investing.

Click image below to watch and listen to the interview.

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Bruce Greenwald on Warren Buffett’s Approach to Industry and Business Analysis

Below is a transcript of a part of the interview where Bruce Greenwald discusses a few different industries and businesses that Warren Buffett successfully has invested in, and why these industries may have caught Buffett’s interest. Transcript is from 28:05 — 33:57 (emphasis added).

Tano Santos: But what I mean with evolution is something different. I want to understand a little bit, you know, a want to think… if I think about Warren Buffett’s career, and if I think about the distinct phases he’s gone through, you know the traditional Graham & Dodd, his practice of franchise, his recent partnership with 3G, and…

Bruce Greenwald: So let me talk about that. If you’re talking about the intellectual evolution

Tano Santos: Exactly, that’s what I’m talking about.

Bruce Greenwald: We’ve done the exact right thing. We’ve watched what’s successful practitioners have done, and we’ve shamelessly appropriated them. And basically, what I think Graham didn’t understand, although he had inklings of it was that you could make money without assets if you were in an economic position that kept out the competition. That if you were in, what in Warren Buffett’s language is now called a franchise business, and the next evolution is that, I think mostly Warren Buffett, but I think there are others who understand this fairly early on in the 60s and 70s too, begin to understand that these economic forces will create hugely valuable businesses, and valuable businesses in a sense that the old Ben Graham businesses were not. So to grow profits in the old Ben Graham world you had to invest. And in the face of competition you were likely to earn what you had to pay the investor. So the growth didn’t add value. I mean you had to raise money at 10 percent, and there were lots of people willing to invest at 10 percent, and there where no protected economic positions competition was gonna drive the return to 10 percent. So you make 10 percent and you pay 10 percent, there’s no value in growth. And that’s why Benjamin Graham was never particularly interested in growth companies. He talks a little about how R&D can create pattern protected industries. But there is a sense that he had that it’s rare, and the cost of finding those technologies may be just another form of assets.

What Buffett does is he looks very carefully at these industries that’s interestingly enough. He does it in industries that he knows a lot about. And the first one I think, going back, are industries around Omaha. So he right away understands things like Nebraska Furniture Mart, and dominate the Omaha furniture market. And it it’s got 70 percent of the business, it’s got distribution economies, advertising economies that are gonna be very hard for a competitor to replicate. And Omaha is sort of an isolated city. And he understood that the force of that dominant market position meant first of all that they we’re gonna have in the end, cost advantages due to economies of scale and that they could exploit… and pricing power cause they could keep other people out. And as the market grew they we’re gonna get that market without having, because they had the economies of scale, additional investment. He clearly understands that about newspapers. Local newspapers have a hugely expensive distribution, advertising sales and reporting infrastructure. If you are established as a local paper and everybody is renewing their subscription, then nobody is gonna be able to enter that market. And again, you’re gonna be able to charge for it and have the economies in distribution and you get the growth. And then he understood, I think, in banking… there are famous instances in banking. The one was, for years, tobacco lending in actually Virginia and North Carolina and the rest of the back of the south was dominated by Wachovia Bank, and they knew all about the growers, and they knew all about the warehouse processes, they knew everything. And that meant they knew about good risk and bad risk. And I think a foreign bank decided these were the most profitable loans out there and they we’re gonna go in and enter that market. And what they did was of course they went to the Wachovia customers and they offered them lower loan rates. If that lower loan rate was profitable, Wachovia knew it and they would match it and they kept all the good risks. And if it was a marginal credit that wasn’t, Wachovia would call ’em in and say “God, we really like to keep you but that’s such a good offer. We suggest you go to this European bank.” And the European bank wound up with a 90 percent default rate. And in addition there were all the economies of scale in information collection in news. And really all economies of running local branches, which are like local economies. So he seems to have understood that. And then with Coca-Cola where there are huge economies in distribution. And in all these cases you could protect your market share cause there’s a lot of customer captivity. So he started to develop an idea of what these franchise businesses looked like. And I think also how you go ahead and value them, cause now assets are irrelevant and you have to think about other things, and growth matters a lot. And I think it’s that evolution that really starts to get you into modern value investing.

FCIC Interview of Warren Buffett, May 26, 2010

“There is no staff. I make all the investment decisions and I do all my own analysis.” —Warren Buffett

FCIC Interview of Warren Buffett, May 26, 2010

On May 26th, 2010, the Financial Crisis Inquiry Commission—that was formed by Congress in 2009—interviewed Warren Buffett as part their investigation of the causes of the financial crisis, both globally and domestically, and to do a report due at the end of this year, December 15, 2010, to the President and to Congress, which we also plan to release to the American public. Tasked not only with investigating the causes of the financial crisis, but also looking at specific issues that Congress had enumerated in the Fraud Enforcement Recovery Act, which formed the Commission.

In the interview Warren Buffett is asked a few questions, and shares his views and insights, to enable the Commission to better understand the causes of the financial crisis.

Further the Commission also asks a few questions about Moody’s, since Warren Buffett was (at the time) a significant shareholder in Moody’s.

The recording of the interview, as well as a transcript of it has been made public. To listen to the interview, click here, and to read the transcript click here (for PDF) and here (for Word).

Warren Buffett: Dun and Bradstreet and Moody’s are Great Businesses

Let’s see what Warren had to say about why he thought both Dun and Bradstreet and Moody’s were such a great businesses (emphasis added).

MR. BONDI: I understand, sir, that in 1999 and in February 2000, you invested in Dun and Bradstreet.

MR. BUFFETT: That’s correct. I don’t have the dates, but that sounds right. Yes, sir.

MR. BONDI: And am I correct, sir, in saying  you made no purchases after Moody’s spun off from Dun and Bradstreet?

MR. BUFFETT: I believe that’s correct.

MR. BONDI: Okay. What kind of due diligence did you and your staff do when you first purchased Dun and Bradstreet in 1999 and then again in 2000?

MR. BUFFETT: Yes. There is no staff. I make all the investment decisions, and I do all my own analysis. And basically it was an evaluation of both Dun and Bradstreet and Moody’s, but of the economics of their business. And I never met with anybodyDun and Bradstreet had a very good business, and Moody’s had an even better business. And basically, the single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.

MR. BONDI: Now, you’ve described the importance of quality management in your investing decisions and I know your mentor, Benjamin Graham — I happen to have read his book as well –- has described the importance of management. What attracted you to the management of Moody’s when you made your initial investments?

MR. BUFFETT: I knew nothing about the management of Moody’s. The –- I’ve also said many times in reports and elsewhere that when a management with reputation for brilliance gets hooked up with a business with a reputation for bad economics, it’s the reputation of the business that remains intact.

If you’ve got a good enough business, if you have a monopoly newspaper, if you have a network television station — I’m talking of the past — you know, your idiot nephew could run it. And if you’ve got a really good business, it doesn’t make any difference.

I mean, it makes some difference maybe in capital allocation or something of the sort, but the extraordinary business does not require good management.

MR. BONDI: What interaction —

MR. BUFFETT: I’m not making any reference to Moody’s management, I don’t really know them. But it really –- you know, if you own the only newspaper in town, up until the last five years or so, you have pricing power and you didn’t have to go to the office.

MR. BONDI: And do you have any opinions, sir, of how well management of Moody’s has performed?

MR. BUFFETT: It’s hard to evaluate when you have a business that has that much pricing power. I mean, they have done very well in terms of huge returns on tangible assets, almost infinite. And they have –- they have grown along with the business that generally the capital markets became more active and all that.

So in the end –- and then raised prices –- we’re both — we’re a customer of Moody’s, too, so I see this from both sides, and -– we’re an unwilling customer, but we’re a customer nevertheless. And what I see as a customer is reflected in what’s happened in their financial record.

MR. BONDI: And I’ve seen in many places where you’ve been referred to as a passive investor in Moody’s. Is that a fair characterization, and what sort of interactions and communications have you had with the board and with management at Moody’s?

MR. BUFFETT: At the very start, there was a fellow named Cliff Alexander who was the chairman of Dun and Bradstreet while they were breaking it up.

He met me –- I met him in connection with something else, years earlier; and so we had a lunch at one time. But he wasn’t really an operating manager. He was there sort of to see –- oversee the breakup of the situation.

Since we really own stock in both Dun and Bradstreet and Moody’s when they got split up, I’ve never been in Moody’s office, I don’t think I’ve ever initiated a call to them. I would say that three or four times as part of a general road show, their CEO and they think they have to do that. I have no interest in it basically, and I never requested a meeting. It just –- it was part of what they thought investor relations were all about. And we don’t believe much in that.

MR. BONDI: What about any board members? Have you pressed for the election of any board member to Moody’s —

MR. BUFFETT: No, no —

MR. BONDI: — board?

MR. BUFFETT: — I have no interest in it.

MR. BONDI: And we’ve talked about just verbal communications. Have you sent any letters or submitted any memos or ideas for strategy decisions at Moody’s?

MR. BUFFETT: No.

MR. BONDI: In —

MR. BUFFETT: If I thought they needed me, I wouldn’t have bought the stock.

MR. BONDI: In 2006, Moody’s began to repurchase its shares, buying back its shares that were outstanding, and they did so from 2006 to 2008, according to our records.

Why didn’t you sell back your shares to Moody’s at that time? I know subsequent in 2009 you sold some shares, but from ‘06 to ‘09, during the buyback, did you consider selling your shares back, and if so, why didn’t you?

MR. BUFFETT: No, I thought they had an extraordinary business, and — you know, they still have an extraordinary business. It’s now subject to a different threat, which we’ll get into later, I’m sure.

MR. BONDI: Uh-huh.

MR. BUFFETT: But –- but I made a mistake in that it got to very lofty heights and we didn’t sell –- it didn’t make any difference if we were selling to them or selling in the market. But there are very few businesses that had the competitive position that Moody’s and Standard and Poor’s had. They both have the same position, essentially. There are very few businesses like that in the world. They are — it’s a natural duopoly to some extent. Now, that may get changed, but it has historically been a natural duopoly, where anybody coming in and offering to cut their price in half had no chance of success. And there’s not many businesses where someone can come in and offer to cut the price in half and somebody doesn’t think about shifting. But that’s the nature of the ratings business. And it’s a naturally obtained one.

It’s assisted by the fact that the two of them became a standard for regulators and all of that, so it’s been assisted by the governmental actions over time. But it’s a natural duopoly.

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Warren Buffett: The Reason Why I Sold Freddie Mac and Fannie Mae

MR. BONDI: Now, earlier you referenced the GSEs and it’s been reported than in 2000 you sold nearly all of your Freddie Mac and Fannie Mae shares. What persuaded you in 2000 to think that those were no longer good investments?

MR. BUFFETT: Well, I didn’t know that they weren’t going to be good investments, but I was concerned about the management at both Freddie Mac and Fannie Mae, although our holdings were concentrated in Fannie Mac.

They were trying to -– and proclaiming that they could increase earnings per share in some low double-digit range or something of the sort. And any time a large financial institution starts promising regular earnings increases, you’re going to have trouble, you know?

I mean, it isn’t given to man to be able to run a financial institution where different interest-rate scenarios will prevail on all of that so as to produce kind of smooth, regular earnings from a very large base to start with; and so if people are thinking that way, they are going to do things, maybe in accounting -– as it turns out to be the case in both Freddie and Fannie –- but also in operations that I would regard as unsound. And I don’t know when it will happen. I don’t even know for sure if it will happen. 

It will happen eventually, if they keep up that policy; and so we just decided –- or I just decided to get out.

MR. BONDI: The Washington Post reported on October 31 st , 2007, that you had provided some testimony the day before in a case against Freddie Mac’s CEO where you had indicated that you became troubled when Freddie Mac made an investment unrelated to its mission.

And you were quoted in that article as saying that you didn’t think that it made any sense at all and you were concerned about what they might be doing that I didn’t know about.

MR. BUFFETT: Yes, well, that was —

MR. BONDI: What was that investment that was unrelated to its mission?

MR. BUFFETT: As I remember, it was Phillip Morris bonds. I could be wrong. It might have been R.J. Reynolds or something. But they had made a large investment in that.

Now, they are dealing essentially with government-guaranteed credit, so we know about that and we had it ratified subsequently about what has happened.

So, here was an institution that was trying to serve two masters: Wall Street and their investors, and Congress. And they were using this power to do something that was totally unrelated to the mission. And then they gave me some half-baked explanation about how it increased liquidity, which was just nonsense.

And the truth was that they were arbitraging the government’s credit, and for something that the government really didn’t intend for them to do. And, you know, there is seldom just one cockroach in the kitchen. You know, you turn on the light and, all of sudden, they all start scurrying around. And I wasn’t –- I couldn’t find the light switch, but I had seen one.

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Buffett, IBM and Key Economic Characteristics

Berkshire’s Investment in IBM

Berkshire Hathaway started buying IBM shares during 2011, and has since increased its IBM investment. See table below for data of Berkshire’s IBM investment in 2014 compared to 2013. The one thing that did not increase during 2014 was the market value of the IBM investment. All other metrics showed a positive change.

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No Surprises at IBM: Buffett

See here for the interview of Warren Buffett from CNBC quoted below.

[BECKY QUICK] Why are you buying more IBM?

[WARREN BUFFETT] Well, I buy it because I like it. It’s kind of been doing exactly what I like since we first started buying it. […] There’s been no surprises at IBM since we started buying a few years ago. […] The pleasant surprise is that the stock has been going down.

And then, later on in the interview about Buffett’s understanding of IBM’s competitive advantage…

[BECKY QUICK] You’ve often said though that you don’t understand technology, so what makes you think you understand IBM’s competitive moat?

[WARREN BUFFETT] Well, I don’t understand it, there’s no question I don’t understand technology as well as I understand the railroad or I understand insurance. But I don’t understand every aspect of insurance, I understand some of the key economic characteristics of insurance and the same way with the railroad. I know a lot of things about parts of the railroad that lead to an economic conclusion. But, there are a lot of things I don’t understand, I mean, and that’s true of industry after industry. We competed, I personally was chairman of the board of a company that competed with IBM for ten years in the 1960’s. And I didn’t understand all of IBM’s business then, but we actually did quite well competing with IBM in the tab-card business… I think I know enough about IBM to make an investment decision. But, whatever, whatever…

[BECKY QUICK] You just said we were competing with them in the tab-card business, that is punchcard, that is not the cloud, this is not the stuff that…

[WARREN BUFFETT] It changes, it changes, and IBM’s changed with it. And it was one time when they didn’t change so well with it, then they made enormous progress under Lou. So it is, the insurance business has changed. We used to sell at GEICO, we used to sell all by direct mail primarily, then it went to phone, then it goes to the Internet, now it goes to the mobile. Companies have to change. But, I think Ginni’s done a great job of fostering change at IBM, but it doesn’t happen overnight.

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Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

The Security I Like Best: Western Insurance Securities

“You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $30/share when it was earning $20/share! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.” —Warren Buffett

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Click here for the article in PDF format.

The Security I Like Best

A continuous forum in which, each week, a different group of experts in the investment and advisory field from all sections of the country participate and give their reasons for favoring a particular security

(The articles contained in this forum are not intended to be, nor are they to be regarded, as an offer to sell the securities discussed.)

WARREN E. BUFFETT

Buffett-Falk & Co., Omaha, Nebr.

Western Insurance Securities Common Stock

Again my favorite security is the equity stock of a young, rapidly growing and ably managed insurance company. Although Government Employees Insurance Co., my selection of 15 months ago, has had a price rise of more than 100%, it still appears very attractive as a vehicle for long-term capital growth.

Rarely is an investor offered the opportunity to participate in the growth of two excellently managed and expanding insurance companies on the grossly undervalued basis which appears possible in the case of the Western Insurance Securities Company. The two operating subsidiaries, Western Casualty & Surety and Western Fire, wrote a premium volume of $26,009,929 in 1952 on consolidated admitted assets of $29,590,142. Now licensed in 38 states, their impressive growth record, both absolutely and relative to the industry, is summarized in Table I below.

Western Insurance Securities owns 92% of Western Casualty and Surety, which in turn owns 99.95% of Western Fire Insurance. Other assets of Western Insurance Securities are minor, consisting of approximately $180,000 in net quick assets. The capitalization consists of 7,000 shares of $100 par 6% preferred, callable at $125; 35,000 shares of Class A preferred, callable at $60, which is entitled to a $2.50 regular dividend and participates further up to a maximum total of $4 per share; and 50,000 shares of common stock. The arrears on the Class A presently amount to $36.75.

The management headed by Ray DuBoc is of the highest grade. Mr. DuBoc has ably steered the company since its inception in 1924 and has a reputation in the insurance industry of being a man of outstanding integrity and ability. The second tier of executives is also of top caliber. During the formative years of the company, senior charges were out of line with the earn- ing power of the enterprise. The reader can clearly perceive why the same senior charges that caused such great difficulty when premium volume ranged about the $3,000,000 mark would cause little trouble upon the attainment of premium volume in excess of $26,000,000.

Adjusting for only 25% of the in- crease in the unearned premium re- serve, earnings of $1,367,063 in 1952, a very depressed year for auto insurers, were sufficient to cover total senior charges of $129,500 more than 10 times over, leaving earnings of $24.74 on each share of common stock.

It is quite evident that the common stock has finally arrived, although investors do not appear to realize it since the stock is quoted at less than twice earnings and at a discount of approximately 55% from the December 31, 1952 book value of $86.26 per share. Table II indicates the postwar record of earnings and dramatically illustrates the benefits being realized by the common stock because of the expanded earnings base. The book value is calculated with allowance for a 25% equity in the unearned premium reserve and is after allowance for call price plus arrears on the preferreds.

Since Western has achieved such an excellent record in increasing its industry share of premium volume, the reader may well wonder whether standards have been compromised. This is definitely not the case. During the past ten years Western’s operating ratios have proved quite superior to the average multiple line company. The combined loss and expense ratios for the two Western companies as reported by the Alfred M. Best Co. on a case basis are compared in Table III with similar ratios for all stock fire and casualty companies.

The careful reader will not overlook the possibility that Western’s superior performance has been due to a concentration of writings in unusually profitable lines. Actually the reverse is true. Although represented in all major lines, Western is still primarily an automobile insurer with 60% of its volume derived from auto lines. Since automobile underwriting has proven generally unsatisfactory in the postwar period, and particularly so in the last three years, Western’s experience was even more favorable relative to the industry than the tabular comparison would indicate.

Western has always maintained ample loss reserves on unsettled claims. Underwriting results in the postwar period have shown Western to be over-reserved at the end of each year. Triennial examinations conducted by the insurance commissioners have confirmed these findings.

Turning to their investment picture, we of course find a growth in invested assets and investment income paralleling the growth in premium volume. Consolidated net assets have risen from $5,154,367 in 1940 to their present level of $29,590,142. Western follows an extremely conservative investment policy, relying upon growth in premium volume for expansion in investment income. Of the year-end portfolio of $21,889,243, governments plus a list of well diversified high quality municipals total $20,141,246 or 92% and stocks only $1,747,997 or 8%. Net investment income of $474,472 in 1952 was equal to $6.14 per share of Western Insurance common after minority interest and assuming senior charges were covered entirely from investment income.

The casualty insurance industry during the past several years has suffered staggering losses on automobile insurance lines. This trend was sharply reversed during late 1952. Substantial rate increases in 1951 and 1952 are being brought to bear on underwriting results with increasing force as policies are renewed at much higher premiums. Earnings within the casualty industry are expected to be on a very satisfactory basis in 1953 and 1954.

Western, while operating very profitably during the entire trying period, may be expected to report increased earnings as a result of expanding premium volume, increased assets, and the higher rate structure. An earned premium volume of $30,000,000 may be conservatively expected by 1954. Normal earning power on this volume should average about $30.00 per share, with investment income contributing approximately $8.40 per share after deducting all senior charges from investment income.

The patient investor in Western Insurance common can be reasonably assured of a tangible acknowledgement of his enormously strengthened equity position. It is well to bear in mind that the operating companies have expanded premium volume some 550% in the last 12 years. This has required an increase in surplus of 350% and consequently restricted the payment of dividends. Recent dividend increases by Western Casualty should pave the way for more prompt payment on arrearages. Any leveling off of premium volume will permit more liberal dividends while a continuation of the past rate of increase, which in my opinion is very unlikely, would of course make for much greater earnings.

Operating in a stable industry with an excellent record of growth and profitability, I believe Western Insurance common to be an outstanding vehicle for substantial capital appreciation at its present price of about 40. The stock is traded over-the-counter.

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The Security I Like Best: GEICO

“Of course the investor of today does not profit from yesterday’s growth. In GEICO’s case, there is reason to believe the major portion of growth lies ahead.” —Warren Buffett

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Click here for the article in PDF format.

THE SECURITY I LIKE BEST

The Government Employees Insurance Co.

Full employment, boom time profits and record dividend payments do not set the stage for depressed security prices. Most industries have been riding this wave of prosperity during the past five years with few ripples to disturb the tide.

The auto insurance business has not shared in the boom. After the staggering losses of the immediate postwar period, the situation began to right itself in 1949. In 1950, stock casualty companies again took it on the chin with underwriting experience the second worst in 15 years. The recent earnings reports of casualty companies, particularly those with the bulk of writings in auto lines, have diverted bull market enthusiasm from their stocks. On the basis of normal earning power and asset factors, many of these stocks appear undervalued.

The nature of the industry is such as to ease cyclical bumps. The majority of purchasers regards auto insurance as a necessity. Contracts must be renewed yearly at rates based upon experience. The lag of rates behind costs, although detrimental in a period of rising prices as has characterized the 1945-1951 period, should prove beneficial if deflationary forces should be set in action.

Other industry advantages include lack of inventory, collection, labor and raw material problems. The hazard of product obsolescence and related equipment obsolescence is also absent.

Government Employees Insurance Corporation was organized in the mid-30’s to provide complete auto insurance on a nationwide basis to an eligible class including: (1) Federal, State and municipal government employees; (2) active and reserve commissioned officers and the first three pay grades of non-commissioned officers of the Armed Forces; (3) veterans who were eligible when on active duty; (4) former policyholders; (5) faculty members of universities, colleges and schools; (6) government contractor employees engaged in defense work exclusively, and (7) stockholders.

The company has no agents or branch offices. As a result, policyholders receive standard auto insurance policies at premium discounts running as high as 30% off manual rates. Claims are handled promptly through approximately 500 representatives throughout the country.

The term “growth company” has been applied with abandon during the past few years to companies whose sales increases represented little more than inflation of prices and general easing of business competition. GEICO qualifies as a legitimate growth company based upon the following record:

Year— Premiums Written Policy Holders
1936… $103,696.31 3,754
1940… 768,057.86 25,514
1945… 1,638,562.09 51,697
1950… 8,016,975.79 143,944

Of course the investor of today does not profit from yesterday’s growth. In GEICO’s case, there is reason to believe the major portion of growth lies ahead. Prior to 1950, the company was only licensed in 15 of 50 jurisdictions including D. C. and Hawaii. At the beginning of the year there were less than 3,000 policyholders in New York State. Yet 25% saved on an insurance bill of $125 in New York should look bigger to the prospect than the 25% saved on the $50 rate in more sparsely settled regions.

As cost competition increases in importance during times of recession, GEICO’s rate attraction should become even more effective in diverting business from the brother-in-law. With insurance rates moving higher due to inflation, the 25% spread in rates becomes wider in terms of dollars and cents.

There is no pressure from agents to accept questionable applicants or renew poor risks. In States where the rate structure is inadequate, new promotion may be halted.

Probably the biggest attraction of GEICO is the profit margin advantage it enjoys. The ratio of underwriting profit to premiums earned in 1949 was 27.5% for GEICO as compared to 3.7% for the 135 stock casualty and surety companies summarized by Best’s. As experience turned for the worse in 1950, Best’s aggregate’s profit margin dropped to 3.0% and GEICO’s dropped to 13.0%. GEICO does not write all casualty lines; however, bodily injury and property damage, both important lines for GEICO, were among the least profitable lines. GEICO also does a large amount of collision writing, which was a profitable line in 1950.

During the first half of 1951, practically all insurers operated in the red on casualty lines with bodily injury and property damage among the most unprofitable. Whereas GEICO’s profit margin was cut to slightly above 9%, Massachusett’s Bonding & Insurance showed a 26% loss, New Amsterdam Casualty an 8% loss, Standard Accident Insurance a 9% loss, etc.

Because of the rapid growth of GEICO, cash dividends have had to remain low. Stock dividends and a 25-for-1 split increased the outstanding shares from 3,000 on June 1, 1948, to 250,000 on Nov. 10, 1951. Valuable rights to subscribe to stock of affiliated companies have also been issued.

Benjamin Graham has been Chairman of the Board since his investment trust acquired and distributed a large block of the stock in 1948. Leo Goodwin, who has guided GEICO’s growth since inception, is the able President. At the end of 1950, the 10 members of the Board of Directors owned approximately one third of the outstanding stock.

Earnings in 1950 amounted to $3.92 as contrasted to $4.71 on the smaller amount of business in 1949. These figures include no allowance for the increase in the unearned premium reserve which was substantial in both years. Earnings in 1953 will be lower than 1950, but the wave of rate increases during the past summer should evidence themselves in 1952 earnings. Investment income quadrupled between 1947 and 1950, reflecting the growth of the company’s assets.

At the present price of about eight times the earnings of 1950, a poor year for the industry, it appears that no price is being paid for the tremendous growth potential of the company.

TSILTB2

Video & Notes: Warren Buffett Speaks with Florida University

“You have to understand the business. You can understand some businesses but not all businesses.” —Warren Buffett

Warren E. Buffett Lecture at the University of Florida School of Business October 15, 1998

 

A Few Notes and Quotes

Go here for full transcript of the above talk.

Below are a few great parts from the Buffett video that I like. There are many more, just watch the video and read the transcript to find them. I watched it yesterday night, and I have seen it a couple of times before. It’s really a great talk from Buffett with a lot of useable and important (and knowable) stuff to take away and remember.

Isn’t it wonderful, being able to read so much and look at great videos like this one. Too bad we didn’t learn this in school. But anyway, good to catch up now, having your own little Value Investing University. All you have to do is open up the Internet browser and start searching and learning. Awesome. Okay, so back to the quotes.

See’s Candies

“See’s Candy was a $25 million business when we bought it. If I can find one now, as big as we are, I would love to buy it. It is the certainty of it that counts.”

“It is a tough thing to decide but I don‘t want to buy into any business I am not terribly sure of. So if I am terribly sure of it, it probably won‘t offer incredible returns. Why should something that is essentially a cinch to do well, offer you 40% a year? We don‘t have huge returns in mind, but we do have in mind not losing anything. We bought See’s Candy in 1972, See’s Candy was then selling 16 m. pounds of candy at a $1.95 a pound and it was making 2 bits a pound or $4 million pre-tax. We paid $25 million for it—6.25 x pretax or about 10x after tax. It took no capital to speak of. When we looked at that business—basically, my partner, Charlie, and I—we needed to decide if there was some untapped pricing power there. Where that $1.95 box of candy could sell for $2 to $2.25. If it could sell for $2.25 or another $0.30 per pound that was $4.8 on 16 million pounds. Which on a $25 million purchase price was fine. We never hired a consultant in our lives; our idea of consulting was to go out and buy a box of candy and eat it.”

“What we did know was that they had share of mind in California. There was something special. Every person in California has something in mind about See’s Candy and overwhelmingly it was favorable. They had taken a box on Valentine‘s Day to some girl and she had kissed him. If she slapped him, we would have no business. As long as she kisses him, that is what we want in their minds. See’s Candy means getting kissed. If we can get that in the minds of people, we can raise prices. I bought it in 1972, and every year I have raised prices on Dec. 26th, the day after Christmas, because we sell a lot on Christmas. In fact, we will make $60 million this year. We will make $2 per pound on 30 million pounds. Same business, same formulas, same everything–$60 million bucks and it still doesn‘t take any capital. And we make more money 10 years from now. But of that $60 million, we make $55 million in the three weeks before Christmas. And our company song is: ―What a friend we have in Jesus. (Laughter). It is a good business? Think about it a little. Most people do not buy boxed chocolate to consume themselves, they buy them as gifts—somebody‘s birthday or more likely it is a holiday. Valentine‘s Day is the single biggest day of the year. Christmas is the biggest season by far. Women buy for Christmas and they plan ahead and buy over a two or three week period. Men buy on Valentine‘s Day. They are driving home; we run ads on the Radio. Guilt, guilt, guilt—guys are veering off the highway right and left. They won‘t dare go home without a box of Chocolates by the time we get through with them on our radio ads. So that Valentine‘s Day is the biggest day. Can you imagine going home on Valentine‘s Day—our See’s Candy is now $11 a pound thanks to my brilliance. And let‘s say there is candy available at $6 a pound. Do you really want to walk in on Valentine‘s Day and hand—she has all these positive images of See’s Candy over the years—and say, ―Honey, this year I took the low bid.‖ And hand her a box of candy. It just isn‘t going to work. So in a sense, there is untapped pricing power—it is not price dependent.”

Why Smart People Do Dumb Things

“But to make money they didn’t have and didn’t need, they risked what they did have and what they did need.”

Circle of Competence

“Everybody has got a different circle of competence. The important thing is not how big the circle is, the important thing is the size of the circle; the important thing is staying inside the circle. And if that circle only has 30 companies in it out of 1000s on the big board, as long as you know which 30 they are, you will be OK. And you should know those businesses well enough so you don‘t need to read lots of work.”

Understand the Business

“You have to understand the business. You can understand some businesses but not all businesses.”

“I like businesses that I can understand. Let‘s start with that. That narrows it down by 90%. There are all types of things I don‘t understand, but fortunately, there is enough I do understand.”

Macroeconomics

“I don‘t think about the macro stuff. What you really want to in investments is figure out what is important and knowable. If it is unimportant and unknowable, you forget about it.”

The Business to Buy

“So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten years from now.”

Buying a Business

“You really want your decision making to be by looking in the mirror. Saying to yourself, ―I am buying 100 shares of General Motors at $55 because…… It is your responsibility if you are buying it. There‘s gotta be a reason and if you can‘t state the reason, you shouldn‘t buy it. If it is because someone told you about it at a cocktail party, not good enough. It can‘t be because of the volume or a reason like the chart looks good. It has to be a reason to buy the business. That we stick to pretty carefully. That is one of the things Ben Graham taught me.”

Beta and Risk

“They thought that the Beta of the stock told you something about the risk of the stock. It doesn‘t tell you a damn thing about the risk of the stock in my view.”

The Superinvestors of Graham-and-Doddsville

The last post of this year will be a short one, consisting of two links to some great reading.

The Superinvestors of Graham-and-Doddsville

The Superinvestors of Graham-and-Doddsville is a well-known piece by Warren Buffett. See here for a full PDF of the article. I read this article a few years back and it’s a great one.

Journey Into the Whirlwind: Graham-and-Doddsville Revisited

I found this this link to a 2006 talk by Lou Lowenstein via Greenbackd. Check it out here.

See here for the Greenbackd post about the articles referred to above.

Since this is the last post this year I want to wish you all a HAPPY NEW YEAR!

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Duracell: A Durable Cell Battery “Trusted Everywhere” Moves In With Berkshire

“‘I have always been impressed by Duracell, as a consumer and as a long-term investor in P&G and Gillette,’ commented Warren E. Buffett, Berkshire Hathaway chief executive officer. ‘Duracell is a leading global brand with top quality products, and it will fit well within Berkshire Hathaway.'” ―Berkshire Hathaway Inc. News Release

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SEC filing: “Berkshire Hathaway to Acquire Duracell in Exchange for P&G Shares”

“‘I have always been impressed by Duracell, as a consumer and as a long-term investor in P&G and Gillette,’ commented Warren E. Buffett, Berkshire Hathaway chief executive officer. ‘Duracell is a leading global brand with top quality products, and it will fit well within Berkshire Hathaway.’

Berkshire’s stock ownership is currently valued at approximately $4.7 billion. P&G said it expects to contribute approximately $1.8 billion in cash to the Duracell Company in the pre-transaction recapitalization.

P&G said the transaction maximizes the after-tax value of the Duracell business and is tax efficient for P&G. The value received for Duracell in the exchange is approximately 7-times fiscal year 2014 adjusted EBITDA. This equates to a cash sale valued at approximately 9-times adjusted EBITDA.”

Source: SEC Edgar System, 2014 P&G ANALYST MEETING PRESS RELEASE

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Company History

  • 1935: P.R. Mallory founds Duracell’s predecessor company.
  • 1944: Inventor Samuel Ruben joins forces with Mallory, kicks off battery business.
  • 1966: Earnings per share hit $2.34 before falling off with recession related drop in consumer spending.
  • 1972: Sales of electrical and electronic items to industry are boosted.
  • 1978: P.R. Mallory is acquired by Dart Industries.
  • 1980: Dart merges with Kraft Inc.
  • 1986: Kraft retains Duracell portion of business after split with Dart.
  • 1988: Kohlberg Kravis Roberts takes over Duracell during leveraged buyout spree.
  • 1989: Duracell goes public.
  • 1996: The Gillette Company acquires Duracell.
  • 2005: Procter & Gamble is set to buy Gillette.
  • 2014: Berkshire Hathaway acquires Duracell from Procter & Gamble.

Sources: Referenceforbusiness.com; Wikipedia.com

The Procter & Gamble Company 2014 Analyst Meeting

Source: P&G Investor Relations

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Duracell Inc, 1996 10-K

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Source: SEC EDGAR

What Does Buffett See in Batteries?

Morningstar’s view on today’s Berkshire deal:

“We’re not sure what to make of wide-moat Berkshire Hathaway’s $4.7 billion purchase of the Duracell battery business from Procter & Gamble, another wide-moat firm. While one would have expected to see Warren Buffett use some of the more than $40 billion in excess cash on Berkshire’s books at the end of the third quarter to finance a deal of this size, the transaction has actually been structured as a tax-exempt transfers of assets, with P&G accepting Berkshire’s 52.8 million share equity stake in the consumer products firm (worth $4.7 billion at yesterday’s market close) for Duracell. That said, it remains to be seen whether P&G’s $1.8 billion pre-transaction recapitalization of the battery business will be viewed as a taxable event for Berkshire. We are leaving our fair value estimate in place.”

Source: See link to Morningstar analyst report below. 

Further Reading

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Four Books Warren Buffett Particularly Treasure

“My intellectual odyssey ended, however, when I met Ben and Dave, first through their writings and then in person. They laid out a roadmap for investing that I have now been following for 57 years. There’s been no reason to look for another.”—Warren Buffett

Warren Buffett’s Forward to the Sixth Edition of Security Analysis

SAGD1“There are four books in my overflowing library that I particularly treasure, each of them written more than 50 years ago. All, though, would still be of enormous value to me if I were to read them today for the first time; their wisdom endures though their pages fade.

Two of those books are first editions of The Wealth of Nations (1776), by Adam Smith, and The Intelligent Investor (1949), by Benjamin Graham. A third is an original copy of the book you hold in your hands, Graham and Dodd’s Security Analysis. I studied from Security Analysis while I was at Columbia University in 1950 and 1951, when I had the extraordinary good luck to have Ben Graham and Dave Dodd as teachers. Together, the book and the men changed my life.

On the utilitarian side, what I learned then became the bedrock upon which all of my investment and business decisions have been built. Prior to meeting Ben and Dave, I had long been fascinated by the stock market. Before I bought my first stock at age 11—it took me until then to accumulate the $115 required for the purchase—I had read every book in the Omaha Public Library having to do with the stock market. I found many of them fascinating and all interesting. But none were really useful. My intellectual odyssey ended, however, when I met Ben and Dave, first through their writings and then in person. They laid out a roadmap for investing that I have now been following for 57 years. There’s been no reason to look for another.

WB2Beyond the ideas Ben and Dave gave me, they showered me with friendship, encouragement, and trust. They cared not a whit for reciprocation—toward a young student, they simply wanted to extend a one-way street of helpfulness. In the end, that’s probably what I admire most about the two men. It was ordained at birth that they would be brilliant; they elected to be generous and kind.

Misanthropes would have been puzzled by their behavior. Ben and Dave instructed literally thousands of potential competitors, young fellows like me who would buy bargain stocks or engage in arbitrage transactions, directly competing with the Graham-Newman Corporation, which was Ben’s investment company. Moreover, Ben and Dave would use current investing examples in the classroom and in their writings, in effect doing our work for us. The way they behaved made as deep an impression on me—and many of my classmates—as did their ideas. We were being taught not only how to invest wisely; we were also being taught how to live wisely.

The copy of Security Analysis that I keep in my library and that I used at Columbia is the 1940 edition. I’ve read it, I’m sure, at least four times, and obviously it is special.

But let’s get to the fourth book I mentioned, which is even more precious. In 2000, Barbara Dodd Anderson, Dave’s only child, gave me her father’s copy of the 1934 edition of Security Analysis, inscribed with hundreds of marginal notes. These were inked in by Dave as he prepared for publication of the 1940 revised edition. No gift has meant more to me.”

4BWBDisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. This article is informational and is in my own personal opinion. Always do your own due diligence and contact a financial professional before executing any trades or investments.