Warren Buffett and GEICO Case Study

Security Analysis Case Study
Warren E. Buffett, 1995
UCLA Extension X433.02
Summer 2015
Presented by:
John Yannone
September 10, 2015

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Table of Contents
Foreword and Introduction ............................................................................................................. 4
History............................................................................................................................................. 5
Warren Buffett & Berkshire Hathaway Early History.................................................................... 7
Warren Buffett as Student of Value Investing............................................................................ 7
Berkshire Hathaway as a Holding Company.............................................................................. 9
Warren Buffett’s Investor/CEO Principles of Investment........................................................ 10
Berkshire Hathaway’s Goals & Acquisition Criteria................................................................ 17
Government Employees Insurance Company (GEICO)............................................................... 19
Warren Buffett & GEICO......................................................................................................... 19
GEICO’s Competitive Advantage ............................................................................................ 20
GEICO’s Business Principles ................................................................................................... 22
Lou Simpson - GEICO’s Superinvestor ................................................................................... 22
Lou Simpson’s 5 Principles of Investment ............................................................................... 24
Financial Analysis of GEICO Acquisition ................................................................................... 25
Acquisition Announcement ...................................................................................................... 25
Analysis of Value Line Forecast Using CAPM........................................................................ 26
How Warren Buffett May Have Analyzed the Same Value Line Data .................................... 28
Other Items Warren Buffett May Have Considered ................................................................. 29
Conclusions................................................................................................................................... 31
References..................................................................................................................................... 33
Publications............................................................................................................................... 33
Websites.................................................................................................................................... 34
Exhibits ......................................................................................................................................... 35
Exhibit 1.................................................................................................................................... 35
Exhibit 2.................................................................................................................................... 36
Exhibit 3.................................................................................................................................... 37
Exhibit 4.................................................................................................................................... 38
Exhibit 5.................................................................................................................................... 39
Exhibit 6.................................................................................................................................... 40
Exhibit 7.................................................................................................................................... 41
Exhibit 8.................................................................................................................................... 42
Exhibit 9.................................................................................................................................... 43
Exhibit 10.................................................................................................................................. 44

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Foreword and Introduction
In August of 1995, Warren Buffett, CEO of holding company Berkshire Hathaway which owned
approximately 50% of GEICO, announced a $2.3 billion deal to acquire the remaining publicly
traded stock. GEICO shareholders were offered $70 per share, a 25.6% premium, over the
$55.75 per share market price before the announcement.
Buffett proposed to change nothing about GEICO, and there were no apparent synergies (e.g.
reduction in fixed costs) in the combination of the two firms.
After the announcement, Berkshire Hathaway’s shares closed up for the day with a $718 million
gain in market value (after adjusting for the S&P 500’s increase of 0.5% for the day).
In the same year as the acquisition (1996), University of Virginia Professor Robert F. Bruner
wrote a case study about Warren Buffett.
The acquisition of GEICO renewed public interest in its architect, Warren E. 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. Although he had accumulated perhaps the best investment record in
history (a compound annual increase in wealth of 28% 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% of the company,
yet he 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 investing’s other
“stars,” Buffett acknowledged his investment failures both quickly and publicly. He held an MBA from
Columbia University and credited his mentor, Professor Benjamin Graham, with developing the philosophy
of value-based investing that guided him to his success. Buffett chided business schools for the irrelevance
of their finance and investing theories.
This paper looks at various aspects of Warren Buffett, Berkshire Hathaway and GEICO and will
answer the questions posed at the end of the case:
 Would the GEICO acquisition serve the long-term goals of Berkshire Hathaway?
 Was the bid price appropriate?
 What might account for the share price increase for Berkshire Hathaway at the
announcement?

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History
Although a history lesson is not the main intent of this case study, the following table
demonstrates the histories of Warren Buffett and GEICO were intertwined for 25 years before
the full acquisition.
Note: Reference for this timeline will be listed below
Date Event Reference
1888 Hathaway Manufacturing founded 3
1889 Berkshire Cotton Manufacturing founded 1
1929 Several textile operations (one of which was founded ~1806) merged
with Berkshire Cotton Manufacturing and renamed Berkshire Fine
Spinning Associates
3
1936 Government Employees Insurance Company (GEICO) founded 2
1948 Benjamin Graham’s firm (Graham-Newman) buys 50% of GEICO
Graham-Newman paid $0.7362 million on 7/6/1948
2
1949 Graham becomes member of GEICO Board of Directors 2
1951 Buffett meets Lorimer Davidson (a future CEO) at GEICO
Headquarters
4
1951 Buffett graduates from Columbia Business School; starts career as a
stock broker working for his father’s firm
4
1951 Buffett writes an article on GEICO (“The Security I like Best”) Article
1952 Buffett sells GEICO shares for $15,259.00 4
1953 New England textiles industry starts facing depressed conditions and
a rising cost of cotton
3
1954 Buffett joins Graham-Newman as an analyst 3
1955 Berkshire Fine Spinning Associates (cotton based business) merged
with Hathaway Manufacturing (synthetics based business). Name
changed to Berkshire Hathaway (diversified business)
FY ending 9/30/1955 balance sheet book value = $51.4 million
3
1956 Graham dissolves Graham-Newman; Buffett moves back to Nebraska 4
1957 Buffett creates Buffett Partners Limited (BPL) 3
1959 Buffett is introduced to Charlie Munger 3
1962 BPL start purchasing shares in Berkshire Hathaway (initially at $7.60
per share)
3
1964 Berkshire Hathaway 10/3/1964 adjusted balance sheet book value =
$35.2 million (shareholder equity $22.1 million +$13 million in share
repurchases) a significant decline from 1955
3
1965 Warren Buffett and partners acquire controlling interest in Berkshire
Hathaway and Buffett was elected as a Director of the corporation
1
1967 Berkshire Hathaway enters insurance business by acquiring National
Indemnity Company and National Fire and Marine Insurance
Company
3
1969 Buffett closes Buffett Partnership 5

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1970 Warren Buffett elected Chairman of the Board of Berkshire
Hathaway
3
1976 Berkshire Hathaway begins purchasing GEICO as share price drops
to multi-decade low of $2 per share
(near bankruptcy and share price down from $60 3 years earlier)
2
1979 Lou Simpson hired by GEICO with endorsement by Buffett 6
1980 Berkshire Hathaway increases stake in GEICO to 7.2 million shares
representing 33% of the equity
Total invested was $47 million
4
1985 Berkshire Hathaway shuts down textile business 1
1988 Berkshire Hathaway purchases General Re for $22 billion 3
1988 Berkshire Hathaway listed on New York Stock Exchange 3
1993 Tony Nicely and Lou Simpson become co-CEOs of GEICO 7
1995 Buffett announces Berkshire Hathaway to acquire balance of GEICO
Value of GEICO before the announcement was $3.695 billion
Value of GEICO based on the announcement was $4.637 billion
1
1996 Berkshire Hathaway issues 450 thousand shares of Class B Common
Stock. Warren Buffett states Berkshire Hathaway is overvalued in
the Prospectus.
3
1996 Berkshire Hathaway becomes 100% owner of GEICO
[adds ~$1.5 billion of goodwill to balance sheet]
4
2015 Berkshire Hathaway A Shares (never split since acquired) trade for
over $200,000 for the first time
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References
1. Case Study
2. The Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin Graham
3. Berkshire Hathaway Inc.: Celebrating 50 Years of a Profitable Partnership
4. Buffett Beyond Value
5. Superinvestors of Graham-and-Doddsville
6. Washington Post
7. Warren Buffett Wealth

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Warren Buffett & Berkshire Hathaway Early History
“Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is
likely to be more productive than energy devoted to patching leaks” –Warren E. Buffett
Berkshire Hathaway was once New England’s largest textile producers and held a 25% share of
the US fine cotton textile production market. It survived the Great Depression (partially by
cutting preferred dividends between 1930 and 1936 and by refurbishing used equipment to make
it more efficient) and then prospered during and after the Second World War. A recession in the
industry and a troubled executive team (members of the executive team and board of directors
disliked each other) ultimately led to Berkshire Hathaway selling well below net working capital
(current assets less current liabilities) in the late 1950’s and early 1960’s.
Professor Bruner’s case provides a concise description of the economics affecting Berkshire
Hathaway in the decade prior to Warren Buffett and his partner’s acquisition of control in early
May 1965 and troubles encountered in the decades afterwards (primarily increasing competition
from non-union textile plants in southern states and abroad, where there were several economic
advantages).
[Berkshire Hathaway] 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.
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 throughout the 1970s and 1980s.
Warren Buffett as Student of Value Investing
“Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1.” –Warren E. Buffett
Professor Bruner’s case describes Warren Buffett’s introduction to the teachings of Benjamin
Graham:
Warren Buffett was first exposed to formal training in investing at Columbia University in New York, where
he studied under Professor Benjamin Graham. The coauthor of a classic text, Security Analysis, Graham
developed a method for identifying undervalued stocks (i.e., stocks whose price was less than their 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.
From 1957 through 1969, the Buffett Partnership achieved extraordinary results by beating the
Dow every year without using leverage (see Exhibit 1). Buffett used the deep value approach
(short to mid-range focus) he learned from Graham, while a student at Columbia. By the mid-
1960s he made two investments, American Express and Disney, which were a departure from
Graham’s teachings and the beginnings of a reorientation of his investment philosophy toward
higher-quality companies with durable competitive advantages (and a longer term focus).

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In a letter to the shareholders of Berkshire Hathaway titled “Berkshire – Past, Present and
Future”, Buffett indicates Charlie Munger’s influence was largely responsible for his change in
philosophy:
From My perspective, though, Charlie’s most important architectural feat was the design of today’s
Berkshire. The blueprint he gave me was simple: Forget about what you know about buying fair
businesses at wonderful prices; instead, buy wonderful businesses at fair prices
On May 17, 1984, Warren Buffett gave a speech at Columbia Business School that was later
published as “The Superinvestors of Graham-and-Doddsville”, where he discussed a group of
investors who were all taught by Graham and later consistently beat the Standard & Poor’s 500
stock index (S&P500). They all “search[ed] for discrepancies between the value of a business
and the price of small pieces of that business in the market” and did “not discuss beta, the capital
asset pricing model, or covariance in returns among securities”. “The investors simply focus[ed]
on two variables: price and value.”
The following table includes the “superinvestors” Buffett described that had been taught by
Graham.
After introducing these “superinvestors” (and 5 others that were not students or employees
of Graham) Buffett starts discussing risk and his disdain for the CAPM…
It's very important to understand that this group has assumed far less risk than average; note their record
in years when the general market was weak. While they differ greatly in style, these investors are, mentally,
always buying the business, not buying the stock. A few of them sometimes buy whole businesses. Far more
often they simply buy small pieces of businesses. Their attitude, whether buying all or a tiny piece of a
business, is the same. Some of them hold portfolios with dozens of stocks; others concentrate on a handful.
But all exploit the difference between the market price of a business and its intrinsic value.
Superinvestor Years
Annual
Compound Rate Comments
Walter J
Schloss
Partnership
1956 – Q1
1984
16.1% vs. 8.4% for
S&P500
Took a class from Graham; worked for
Graham-Newman
 Over 100 stocks
 High aversion to loss
 Margin of Safety
Tom Knap of
Tweedy,
Browne Inc.
Q2 1968 –
1983
16.0% vs. 7.0% for
S&P500
Took classes from Graham and Dodd;
worked for Graham-Newman
 Wide diversification
Warren Buffett
Partnership
1957 - 1969 23.8% vs. 7.4%
for the Dow
Took classes from Graham; worked for
Graham-Newman
 Closed partnership in 1969
since could not find investments
with sufficient margin of safety
Sequoia Fund 3Q 1970 – 1Q
1984
17.2% vs. 10% for
S&P500
Took classes from Graham; worked for
Graham-Newman

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I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have
successfully exploited gaps between price and value. When the price of a stock can be influenced by a
"herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person,
or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market
prices are frequently nonsensical.
I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in
a positive fashion…
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you
buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the
potential for reward in the value portfolio, the less risk there is.
He continues with a quick example that illustrates the essence of value investing and in
particular how Buffett thinks about investing:
The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you
could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably
more. The company owned the Post, Newsweek, plus several television stations in major markets. Those
same properties are worth $2 billion now, so the person who would have paid $400 million would not have
been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80
million, its beta would have been greater. And to people that think beta measures risk, the cheaper price
would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why
it's riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of
fact, if you buy a group of such securities and you know anything at all about business valuation, there is
essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million
piles of $8 million each. Since you don't have your hands on the $400 million, you want to be sure you are
in with honest and reasonably competent people, but that's not a difficult job.
You also have to have the knowledge to enable you to make a very general estimate about the value of the
underlying businesses. But you do not cut it close. That is what Ben Graham meant by having a margin of
safety. You don't try and buy businesses worth $83 million for $80 million. You leave yourself an enormous
margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound
trucks across it. And that same principle works in investing.
Berkshire Hathaway as a Holding Company
In 1967 Buffett started investing in insurance companies because they could generate float, cash
premium income in advance of losses and expenses (which could be viewed as an interest free
loan). He would then invest the float very selectively, buying both publicly traded securities and
wholly owned businesses under opportune circumstances.
A viewing of share price performance of Berkshire Hathaway from 1976 (same year as initial
purchase of GEICO shares) to present (Exhibit 2) shows an incredible performance compared to
the S&P 500.
By 1995, Berkshire Hathaway was engaged in several diverse operating business segments and
also held a concentrated portfolio of equity securities (which included ~50% of GEICO).

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Exhibit 3 shows the insurance segment made up ~40% of revenues (and almost 90% of pretax
operating profits). These were property and casualty insurance operations (on both a direct and
reinsurance basis) that held meaningful equity interests in 10 other publicly traded companies.
Exhibit 4 is a copy of the “Common Stock Investments Table from Berkshire Hathaway’s 1994
Annual Report which lists these equities. GEICO was the second to lowest cost, but was the 4th
largest holding based on year end 1994 market price.
Exhibit 5 shows financial performance for equity interests disclosed by Berkshire Hathaway
Key metrics include
 Berkshire Hathaway’s approximate ownership
 Berkshire Hathaway’s share of undistributed operating earnings
Berkshire Hathaway also owned several convertible preferred stocks (preferred stocks that could
be viewed as a hybrid between a bond like preferred stock and a call option). These gave
Berkshire Hathaway the right to exchange them for common stock and several had very
favorable terms because they were negotiated purchases when the companies involved were
takeover targets and in need of a white knight.
Fast forward to today (August 2015) and Berkshire Hathaway can best be described as a hybrid
between an operating conglomerate and a holding company; it is one of the largest companies in
the world with a market capitalization of ~$350 billion and annual sales ~$200 billion (price to
sales ~1.75). The bulk of sales comes from wholly owned operating subsidiaries (like GEICO)
and its stock portfolio had a market value of $115 billion (end of 2014).
Warren Buffett’s Investor/CEO Principles of Investment
“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether
were talking about socks or stocks, I like buying quality merchandise when it is marked down.”
–Warren E. Buffett
The following table is from the “Buffett’s Investment Philosophy” section of Professor Bruner’s
case and includes several of Warren Buffett’s principles of investment that were compiled by
reading the Chairman Letters included in Berkshire Hathaway annual reports.
Principles that were part of Buffett’s Investment Philosophy in 1995 as listed in Professor Bruner’s case
1. 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:

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…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. [Berkshire Hathaway, Inc., 1994 Annual Report, 2.]
Accounting reality was conservative, backward-looking, and governed by 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 expertise,
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.
Comments
The above quote is also from two of Buffett’s “OWNER-RELATED BUSINESS
PRINCIPLES”, #5 and #6.
#5 is a statement that Berkshire Hathaway will report important information to investors beyond
what is required by accounting principles, and #6 argues more earnings is better than less
earnings regardless of its reportability. The result of using economic reality is that they have
made investments in companies that “have garnered far more than a dollar of value for each
dollar they have retained”. In other words the return on retained earnings was greater than cost
of capital and that they used numbers based on economic reality (not accounting reality) when
doing discounted cash flow analysis.
As Professor Bruner indicated, these are key principles, but they are also timeless. By using
one’s knowledge of a business and its economics, it is possible to arrive at an intrinsic value that
is different from that obtained using certified accounting numbers.
2. 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 the common stocks of other companies. Buffett held that there
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.
Comments
Opportunity cost is associated with the fundamental economic problem: scarcity and choice.
This is another timeless principle and it also helps concentrate a portfolio when it is used in
conjunction with Buffett’s other principles. By incorporating opportunity cost into the decision

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making process, it forces an investor to only invest in the best opportunities. Over time the
quality of the portfolio should improve because new acquisitions must be better than all
alternatives available at the time.
3. 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.
[Berkshire Hathaway, Inc., 1992 Annual Report, 14]
Expanding 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 us 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 noneconomic 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. [Berkshire
Hathaway, Inc., 1994 Annual Report, 7]
To illustrate the mechanics of this example, consider the hypothetical case presented in
Exhibit 6 [of the case]. 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% 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% 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%—
suppose that this is the investor’s opportunity cost, the required return that could have been
earned elsewhere at comparable risk. Dividing the present value of future cash flows (i.e.,
Buffett’s intrinsic value) by the cost of the investment (i.e., Buffett’s book value) indicates that
every dollar invested buys securities worth $1.23. Thus, value has been created.
Consider an opposing case, summarized in Exhibit 7 [of the case]. The example is similar in all
respects except for one key difference: the annual return on the investment is 10%. The result is

13
that every dollar invested buys securities worth $0.80. Thus, value has been destroyed.
Comparing the two cases in Exhibits 6 and 7 [of the case], the difference between value
creation and destruction is driven entirely by the relationship between the expected returns and
the discount rate: in the first case, the spread is positive; in the second case, it is negative. Only
in the instance where expected returns equal the discount rate will book value equal intrinsic
value. In short, book value or the investment outlay may not reflect economic reality: one needs
to focus on the prospective rates of return, and how they compare to the required rate of return.
Comments
Buffett’s definition of intrinsic value [“It is the discounted value of the cash that can be taken out
of a business during its remaining life”] clearly suggests the present intrinsic value is a function
of
 Future cash flows (which are a function of expected rates of return)
 Discount rate
 Timing of cash flows
Professor Bruner’s hypothetical examples demonstrate that for a firm with no debt, value is
created when the cost of equity is less than the return on equity and if the security is fairly
valued, the book value will be greater than 1 (present value > invested capital).
Buffett uses intrinsic value as a way to weigh relative attractiveness of investment options; this is
a timeless principle and is based on one of the fundamental finance equations (series of present
values).
4. Measure performance by gain in intrinsic value, not by accounting profit.
Buffett wrote:
Our long-term economic goal … is to maximize the average annual rate of gain in intrinsic business value
on a per-share basis. We do not measure the economic significance or performance of Berkshire by its
size; we measure by per-share progress [Berkshire Hathaway, Inc., 1994 Annual Report, 2]
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 at leading corporations to
assess financial performance. Those measures focus on the ability to earn returns in excess of the
cost of capital.
Comments
The above quote is also from Buffett’s “OWNER-RELATED BUSINESS PRINCIPLES”, #3.
This is the intrinsic value concept, which was described in the previous principle, applied to
Berkshire Hathaway.
As an aside, by “analogous to economic profit and market value added”, Professor Bruner is
referring to the Economic Value Added (EVA) measure of profitability and Market Value Added

14
measure of wealth creation developed Stern Stewart.
EVA = NOPAT – WACC x TC
 NOPAT = Net operating profit after taxes
 WACC = Weighted Average Cost of Capital
 TC = Total Capital
MVA = Market Value – Total Capital
As another aside, Buffett makes an important cautionary statement in #3:
We are certain that the rate of per-share progress will diminish in the future – a greatly
enlarged capital base will see to that. But we will be disappointed if our rate does not
exceed that of the average large American corporation.
5. Risk and discount rates.
Conventional scholarly 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
(such as a 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 chair Charlie Munger, sat on the boards of directors where they obtained a
candid, inside view of the company and could intervene in managements’ decisions, 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. [Quoted in Jim Rasmussen, “Buffett Talks Strategy with
Students,” Omaha World-Herald, 2 January 1994, 26] 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 databases 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. [Berkshire Hathaway,
Inc., 1993 Annual Report, and republished in Andrew Kilpatrick, Of Permanent Value: The Story of
Warren Buffett (Birmingham, Ala.: AKPE, 1994), 574]
Comments
Buffett’s “OWNER-RELATED BUSINESS PRINCIPLES”, #7 indicate Berkshire Hathaway
“use[s] debt sparingly and, when [they] do borrow, [they] attempt to structure [their] loans on a
long-term fixed-rate basis.

15
A real example of how Buffett evaluates a company (Washington Post) was given in the
“Warren Buffett as Student of Value Investing” section of this paper. This is another timeless
and very important principle, since the discount rate is used for discounted cash flow
calculations to assess intrinsic value. This principle, however, would not be applicable to
investors buying index funds or assuming additional risks (e.g. using debt for the investment).
Professor Bruner’s discussion on use of CAPM to determine discount rate from risk can be
summarized with the following two equations:
E(rD ) = rf + βD x (Market Risk Premium)
 E(rD ) = expected rate of return of an asset
 rf = risk-free-rate
 βD = asset’s systematic risk measure, which is called beta
Market Risk Premium = E(rM ) - rf
 E(rM ) = expected rate of return of the market
6. Diversification. Buffett disagreed with conventional wisdom that investors should hold a
broad portfolio of stocks in order to shed company-specific risk. In his view, investors typically
purchased far too many stocks rather than waiting for the one exceptional company. Buffett said:
Figure businesses out that you understand, and concentrate. Diversification is protection against
ignorance, but if you don’t feel ignorant, the need for it goes down drastically. [Quoted in Forbes
(October 19, 1993), and republished in Andrew Kilpatrick, Of Permanent Value, 574]
Comments
As can be seen in Exhibit 4, Berkshire Hathaway has a concentrated stock portfolio (the majority
of funds are invested in 4 firms: Coca-Cola, Gillette, Capital Cities/ABC and GEICO). This is
not a key principle, but is a natural result of the other principles in action. Furthermore, this
principle would not be applicable to most non-professional investors or anyone using passive
investment strategies.
7. Investing behavior should be driven by information, analysis, and self-discipline, not by
emotion or hunch.
Buffett repeatedly emphasized awareness and information as the foundation for investing. He
believed that “anyone not aware of the fool in the market probably is the fool in the market.”
[Quoted in Michael Lewis, Liar’s Poker (New York, NY: Norton, 1989), 35] 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 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, 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 operation and financial position. [Originally published in Berkshire
Hathaway, Inc., 1987 Annual Report. This quotation was paraphrased from James Grant, Minding Mr.
Market (New York, NY: Times Books, 1993), xxi]

16
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. [Peter Lynch, One up
on Wall Street, (New York, NY: Penguin Books, 1990), 78]
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 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.” [Berkshire Hathaway, Inc.,
1986 Annual Report, 16] Buffett also said, “Lethargy bordering on sloth remains the
cornerstone of our investment style,” [Berkshire Hathaway, Inc., 1990 Annual Report, 15] 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. [Berkshire Hathaway, Inc., Letters to
Shareholders, 1977–1983, 53]
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 was 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. [Quoted in Andrew Kilpatrick, Of Permanent Value,
353]
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. [Quoted in L. J. Davis, “Buffett Takes Stock,” New York
Times, 1 April 1990, 16]
Comments
Buffett also stated the following in his Superinvestors paper:
I'm convinced that there is much inefficiency in the market. These Graham-and-Doddsville investors have
successfully exploited gaps between price and value. When the price of a stock can be influenced by a
"herd" on Wall Street with prices set at the margin by the most emotional person, or the greediest person,
or the most depressed person, it is hard to argue that the market always prices rationally. In fact, market
prices are frequently nonsensical.
This is another very important principle with timeless applicability for value investors.
8. Alignment of agents and owners.
Explaining his significant ownership interest in Berkshire Hathaway, Buffett said, “I am a better

17
businessman because I am an investor. And I am a better investor because I am a businessman.”
[Quoted in Forbes (19 October 1993), and republished in Andrew Kilpatrick, Of Permanent
Value, 574]
As if to illustrate this sentiment, he further stated:
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. [“Owner-Related Business
Principles” in Berkshire Hathaway’s 1994 Annual Report, 3]
For four of Berkshire’s six directors, over 50% of their families’ 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.
Comments
The above quote is also from Buffett’s “OWNER-RELATED BUSINESS PRINCIPLES”, #3.
The “principal-agent problem” (microeconomics) can be a source of source of market failure
(e.g. inefficient operations; in extreme cases fraud). Agents (e.g. corporate management) are
hired to run a business on behalf of the principals (shareholders). The primary goal of a publicly
owned firm interested in serving its stockholders should be to maximize shareholder equity (or
wealth). Problems occur when there is poor alignment between these two groups and the agents
pursue self-interests.
While this principle describes management philosophy at Berkshire Hathaway, it can also be
used by investors to seek better investments (ones with alignment between agents and principals)
and is certainly one of the things Warren Buffett looks for when analyzing businesses.
While Professor Bruner has done an excellent job of compiling these principles, it is not an all-
inclusive-list and some are presented out of context. Investors who want a fuller understanding
of Warren Buffett’s principles, should read his OWNER-RELATED BUSINESS PRINCIPLES
easily accessible from the Berkshire Hathaway website.
Berkshire Hathaway’s Goals & Acquisition Criteria
(Buffett’s Investing Principles in Action)
The case indicated “the GEICO announcement renewed general interest in Buffett’s approach to
acquisitions” and that the acquisition policy was a “tightly disciplined strategy”.
The following is Berkshire Hathaway’s Acquisition Policy (from the case, but originally from
Berkshire Hathaway’s 1994 Annual Report) and comments about GEICO

18
Berkshire Hathaway Acquisition Policy Comments about the GEICO Acquisition
1. Large purchases of at least $10 million in
after-tax earnings
GEICO met this criteria
2. Demonstrated consistent earning power
Note that future projections are of no interest
to us, nor are turnaround situations.
3. Businesses earning good returns on equity,
while employing little to no debt
4. Management in place. We cannot supply it GEICO met this criteria
5. Simple businesses only: if there is a lot of
technology, we will not understand it
6. An offering price. We do not want to waste
our time or that of the seller by talking, even
preliminarily, about a transaction when the
price is unknown
N/A, since the acquisition was initiated by
Berkshire Hathaway
To be considered, a company had to meet all of
the acquisition criteria
GEICO met all of the applicable criteria
The larger the company, the greater will be
our interest: we would like to make an
acquisition in the $2 billion to $3 billion range.
The GEICO acquisition was in this range
We will not engage in unfriendly takeovers The GEICO acquisition does not appear to
have been unfriendly
As commented above, GEICO met all of Berkshire Hathaway’s acquisition criteria.
As Professor Bruner mentions in the case, Buffett had “stated that it was the firm’s goal to meet
a 15% annual growth rate in intrinsic value.”
Buffett’s “OWNER-RELATED BUSINESS PRINCIPLES” #3 gives Berkshire Hathaway’s
goals:
Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s
average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the
economic significance or performance of Berkshire by its size; we measure by per-share progress. We are
certain that the rate of per-share progress will diminish in the future – a greatly enlarged capital base will
see to that. But we will be disappointed if our rate does not exceed that of the average large American
corporation.
And, a way of tracking intrinsic value:
Inadequate though they are in telling the story, we give you Berkshire’s book-value figures because they
today serve as a rough, albeit significantly understated, tracking measure for Berkshire’s intrinsic value.
The following are figures provided by GEICO in their 1994 Annual Report:

19
1990 1991 1992 1993 1994
Book
Value/sh
$13.06 $16.67 $18.16 $21.66 $21.17
Common
shares
outstanding
74.253 M 71.047 M 71.184 M 70.834 M 68.291 M
ROE 27.8% 24.6% 19.4% 18.7% 16.4%
Using a financial calculator, we can see GEICO grew its proxy for intrinsic value at 18.3% per
year from 1990 to 1993. 1994 was not used for this calculation since it saw a series of
catastrophic losses:
While the overall underwriting results were satisfactory, 1994 was impacted significantly by a series of
catastrophic losses including winter freezing in the northeast and the Northridge, California earthquake.
Based on this calculation and Berkshire Hathaway’s experience with insurance, the GEICO
acquisition should serve the long-term goals of Berkshire Hathaway.
Government Employees Insurance Company (GEICO)
As will be seen in the next sections, Warren Buffett had a deep understanding of the insurance
industry at the time of the acquisition and had been following GEICO for a long time.
Warren Buffett & GEICO
“When I count my blessings, I count GEICO twice.” –Warren E. Buffett
William Thorndike’s book The Outsiders: Eight Unconventional CEOs and Their Radically
Rational Blueprint for Success gives a concise description of Warren Buffett’s early interactions
with GEICO:
After graduation in 195[1], Buffett asked Graham for a job at his investment firm, but was turned down
and returned to Omaha, where he took a job as a broker. The first company he recommended to clients was
GEICO, a car insurance company that sold policies directly to government employees. The company had
initially attracted Buffett’s attention because Graham was its chairman, but the more he studied it, the
more he realized GEICO had both important competitive advantages and a margin of safety, Graham’s
term for a price well below intrinsic value (the price a fully informed, sophisticated buyer would pay for the
company). He invested the majority of his net worth in the company and attempted to interest his firm’s
clients in the stock. He found this a hard sell, however, and more generally found the brokerage business to
be far removed from the investment research he had come to love.
An article Buffett wrote in 1951 (Exhibit 6) demonstrated his understanding of the economics
associated with the automobile insurance industry and the competitive advantage and good
business foundation GEICO held in the marketplace:

20
 Auto insurance is regarded as a necessity by the majority of purchasers.
 Other industry advantages include lack of inventory collection, labor and raw material
problems. The hazard of product obsolescence and related equipment is also absent.
 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.
 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 6.7% for the 135 stock casualty and surety companies summarized by
Best’s.
 At the end of 1950, the 10 members of the Board of Directors owned approximately one-
third of the outstanding stock.
Some of the attributes associated with insurance companies can be discerned from Exhibit 1 of
Professor Bruner’s Case, which shows the business segments of Berkshire Hathaway. Inspection
of the 1994 data reveals the following from the insurance segment:
 Compared to pretax operating profit, there is little capital expenditures
 Compared to identifiable assets, there is little depreciation
 Compared to revenues, pretax operating profits are high
GEICO’s Competitive Advantage
"I am perfectly willing to spend whatever it takes to get everyone in the country to check our
price” –Warren E. Buffett
In the 1986 Chairman’s Letter, Buffett states the following:
The difference between GEICO’s costs and those of its competitors is a kind of moat that protects a
valuable and much-sought-after business castle. No one understands this moat-around-the-castle concept
better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still
more, thereby defending and strengthening the economic franchise. Between 1985 and 1986, GEICO’s
total expense ratio dropped from 24.1% to the 23.5% mentioned earlier and, under Bill’s leadership, the
ratio is almost certain to drop further. If it does - and if GEICO maintains its service and underwriting
standards - the company’s future will be brilliant indeed…
In sum, GEICO is an exceptional business run by exceptional managers. We are fortunate to be associated
with them.
A recent Wall St Journal Article recently added:
The architect of Geico's strategy, ironically, is a publicity-shy chief executive who rarely
gives interviews. Tony Nicely, who started as a Geico clerk, initiated the ad push, with
Mr. Buffett's encouragement, soon after he took the top job in 1993. Mr. Nicely has long
been one of Mr. Buffett's top lieutenants.

21
Since 1995, Geico's market share of the U.S. personal auto-insurance market has jumped
to about 10% from 2.5%. Last year [2013], Geico became the second-largest U.S. auto
insurer by premiums, behind State Farm and ahead of Allstate Corp. and Progressive
Corp.
One reason advertising is so important to Geico is that the firm doesn't use insurance
agents, which keeps its costs low. It instead offers policies directly to customers over the
Web or phone.
In the 1993 Chairman letter, Buffett wrote:
When I was first introduced to GEICO in January 1951, I was blown away by the huge cost advantage the
company enjoyed compared to the expenses borne by the giants of the industry. That operational efficiency
continues today and is an all-important asset. No one likes to buy auto insurance. But almost everyone likes
to drive. The insurance needed is a major expenditure for most families. Savings matter to them – and only
a low-cost operation can deliver these.
GEICO’s cost advantage is the factor that has enabled the company to gobble up market share year after
year. Its low costs create a moat – an enduring one – that competitors are unable to cross. Meanwhile, our
little gecko continues to tell Americans how GEICO can save them important money. With our latest
reduction in operating costs, his story has become even more compelling.
The following table from GEICO’s 1994 Annual Report shows GEICO had better underwriting
ratios, a key metric used by insurance companies as a measure of profitability of operations
(lower numbers are better; values above 100% indicate the firm is not making a profit), than the
industry:
Note: Hurricane Andrew caused the profitability measures to suffer in 1992.
Lastly, Exhibit 7, a historical record of GEICO’s share price (prior to stock splits) shows GEICO
significantly outperformed both its industry and the market.

22
GEICO’s Business Principles
GEICO’s 1994 Annual Report contains a list of five business operating principles at GEICO:
In our 1986 Annual Report we discussed our five operating principles.
To remind you, those principles are:
 Be fanatics for good service
 Achieve an underwriting profit
 Be the low-cost provider
 Maintain a disciplined balance sheet
 Invest for total return
As we have said many times, we think that over time, shareholder value is most enhanced
by investing for long-term total returns. We feel this approach helps keep us from making
poor short-term decisions when it comes to sector allocation or investing in the latest
Wall Street craze. Over the years, the superior performance of your common stock
portfolio segment in particular has added much value to the Corporation. In the selection
of common stocks, we continue to be guided by the same five criteria that we detailed in
our 1986 Annual Report:
 Think independently
 Invest in high-return businesses run for the shareholders
 Pay only a reasonable price, even for an excellent business
 Invest for the long term
 Do not diversify excessively
Since we last mentioned these principles in 1986, the Corporation has seen its ups and
downs, but mostly ups. In reviewing this history, management asks itself what we could
have done better. As the expression goes, hindsight is always 20-20, and we would
possibly have done certain things differently. We can assure you, however, that we would
not have changed any of our five operating principles or our dedication to them. They
have served us well in the past and we expect to be guided by them in the future.
We intend to continue to focus our concentration on profitably growing our core personal
lines automobile business, through concentrating on providing superior customer service
and achieving greater operating efficiencies.
By 1995, Warren Buffett would have been intimately aware of the job Nicely and Simpson were
doing living up to these principles.
Lou Simpson - GEICO’s Superinvestor
“The second stage of the GEICO rocket is fueled by Lou Simpson, Vice Chairman, who has run
the company’s investments since late 1979.” –Warren E. Buffett

23
Prior to 1979, Lou Simpson was unknown by Warren Buffett.
By 2004, Simpson was managing ~$2.5 billion of equities held by GEICO and Buffett had this to
say:
You may be surprised to learn that Lou does not necessarily inform me about what he is doing. When
Charlie and I assign responsibility, we truly hand over the baton – and we give it to Lou just as we do to
our operating managers. Therefore, I typically learn of Lou’s transactions about ten days after the end of
each month. Sometimes, it should be added, I silently disagree with his decisions. But he’s usually right.
Exhibit 8 from Berkshire Hathaway’s 2004 chairman letter shows that Simpson had compounded
investment returns at 20.3% annually from 1980-2004 vs. 13.5% for the S&P 500
A Washington Post article provides more insight into Lou Simpsons Investing Principles and it is
no wonder Warren Buffett took a liking to him when they met in 1979.
According to the article:
In 1960, he completed a master's degree in economics at Princeton University. Simpson
considered a career teaching economics, but soon abandoned that in favor of a job with a
Chicago investment firm. The deciding factor, he said, was that the Chicago job offered
greater financial rewards. Before Buffett and former Geico chairman Jack Byrne
persuaded him to join Geico in 1979, Simpson worked about 10 years as a money
manager and in other capacities for Western Asset Management Inc. in California.
Simpson says there is no mystery to his stock market magic. A voracious reader, the 50-
year-old vice chairman of Geico searches daily newspapers, magazines, annual reports
and newsletters for clues that might spark investment ideas. His four-member investment
team uses computer screens to identify stocks that, on the basis of financial data, appear
to be bargains.
"One of the things I have learned over the years is how important management is in building or subtracting
from value. We will try to see a senior person and prefer to visit a company at their office, almost like
kicking the tires. You can have all the written information in the world, but I think it is important to figure
out how senior people in a company think."
"Indeed, it's a little embarrassing for me, the fellow responsible for investments at Berkshire, to
chronicle Lou's performance at Geico," Buffett wrote. "Only my ownership of a controlling block
of Berkshire stock makes me secure enough to give you the following figures. These are not
only terrific figures, but, fully as important, they have been achieved in the right way. Lou has
consistently invested in undervalued common stocks that, individually, were unlikely to present
him with a permanent loss and that, collectively, were close to risk-free."
Buffett said he talks to Simpson about once a week. "Lou has made me a lot of money," Buffett
said. "Under today's circumstances, he is the best I know. He has done a lot better than I have
done in the last few years. He has seen opportunities I have missed. We have $700 million of
our own net worth of $2.4 billion invested in Geico's operations, and I have no say whatsoever
in how Lou manages the investments. He sticks to his principles. Most people on Wall Street
don't have principles to begin with. And if they have them, they don't stick to them."

24
Lou Simpson’s 5 Principles of Investment
1. Think Independently
"We try to be skeptical of conventional wisdom and try to avoid the waves of irrational behavior and
emotion that periodically engulf Wall Street. We don't ignore unpopular companies. On the contrary, such
situations often present the greatest opportunities."
Comments
This principle is similar to Buffett’s: Investing behavior should be driven by information,
analysis, and self-discipline, not by emotion or hunch.
2. Invest in High-Return Businesses Run for the Shareholders
"Over the long run appreciation in share prices is most directly related to the return the company earns on
its shareholders' investment. Cash flow, which is more difficult to manipulate than reported earnings, is a
useful additional yardstick.
"We ask the following questions in evaluating management:
 Does management have a substantial stake in the stock of the company?
 Is management straightforward in dealings with the owners?
 Is management willing to divest unprofitable operations?
 Does management use excess cash to repurchase shares?
The last may be the most important. Managers who run a profitable business often use excess cash to
expand into less profitable endeavors. Repurchase of shares is in many cases a much more advantageous
use of surplus resources."
Comments
This principle contains elements from four of Buffetts’ principles:
 Economic reality, not accounting reality
 Value creation: time is money
 Measure performance by gain in intrinsic value, not by accounting profit
 Alignment of agents and owners
3. Pay only a reasonable price, even for an excellent business
"We try to be disciplined in the price we pay for ownership even in a demonstrably superior business. Even
the world's greatest business is not a good investment if the price is too high. The ratio of price to earnings
and its inverse, the earnings yield, are useful gauges in valuing a company, as is the ratio of price to free
cash flow. A helpful comparison is the earnings yield of a company versus the return on a risk-free long-
term United States Government obligation."
Comments
This is related to Buffett’s value creation: time is money principle and the value investing margin
of safety concept.

25
Invest for the long-term.
"Attempting to guess short-term swings in individual stocks, the stock market or the economy is not likely to
produce consistently good results. Short-term developments are too unpredictable. On the other hand,
shares of quality companies run for the shareholders stand an excellent chance of providing above-average
returns to investors over the long term. Furthermore, moving in and out of stocks frequently has two major
disadvantages that will substantially diminish results: transaction costs and taxes. Capital will grow more
rapidly if earnings compound with as few interruptions for commissions and tax bites as possible.”
Comments
This is an element of Buffett’s investing behavior should be driven by information, analysis, and
self-discipline, not by emotion or hunch principle. Both of these very successful investors have a
long-term investment horizon.
Do not diversify excessively
"An investor is not likely to obtain superior results by buying a broad cross-section of the market. The more
diversification, the more performance is likely to be average, at best. We concentrate our holdings in a few
companies that meet our investment criteria. Good investment ideas-that is, companies that meet our
criteria-are difficult to find. When we think we have found one, we make a large commitment.”
“The five largest holdings at Geico account for more than 50 percent of the stock portfolio."
"One lesson I have learned is to make fewer decisions. Sometimes the best thing to do is to do nothing. The
hardest thing to do is to sit with cash. It is very boring."
Comments
This principle contains elements from two of Buffetts’ principles:
 Diversification
 The cost of the lost opportunity
Both of these very successful investors have similar view about diversification and concentrating
a portfolio to the best ideas.
Like all of Warren Buffett’s principles’, these are timeless advice for value investors but not
always applicable (e.g. portfolio concentration) to all investors.
Financial Analysis of GEICO Acquisition
Acquisition Announcement
Although Professor Bruner did an excellent job describing the Acquisition Announcement,
additional information is available in the Exhibits.

26
Exhibit 9 is the joint press release issued by Berkshire Hathaway and GEICO on August 25,
1996.
As a result of the transaction GEICO will become a subsidiary of Berkshire Hathaway.
Olza M. (Tony) Nicely and Louis A. Simpson will continue as Co-Presidents and Co-
Chief Executives of GEICO. They noted that, since GEICO will continue to be run by its
present management team as a separate business operation, they and Warren E. Buffett,
the Chairman of Berkshire Hathaway, do not expect any reduction in staff at GEICO as a
result of the merger.
Exhibit 10 is a New York Times Article describing the offer from Buffett the following day.
Analysis of Value Line Forecast Using CAPM
Columbia Business School Professor Noron Nissim wrote and excellent paper on the analysis
and valuation of insurance companies.
While free cash flow valuation is the primary fundamental valuation approach used to
value non-financial companies, it is rarely used to value financial service companies. This
is due to the differences between financial and non-financial companies discussed at the
beginning of Section 3.7. Instead, financial service companies are typically valued by
discounting expected cash flows or earnings that flow to or accrue to equity-holders.
Three types of models are used: (a) discounted dividend per share, (b) discounted net
equity flows, and (c) the residual income model. Although these models are analytically
equivalent, in practice their implementation involves different assumptions and hence
results in different value estimates.
Since we have dividend data for GEICO, we can use the discounted dividend per share method.
Professor Bruner’s case provides the following key data and forecast data from Value Line:

27
Note: The relevancy of the Capital Cities/ABC deal is that it would provide the cash Buffett
needed to close the deal with GEICO.
Using CAPM, we can calculate the required return:
GEICO's Beta β = 0.75
Equity market risk premium E(rM ) - rf = 5.50%
30-year Treasury Yield rf = 6.86%
Discount Rate K = rf + β x ( E(rM ) - rf ) = 10.985%
The following tables use this discount rate with the Value Line forecast to calculate present
values for GEICO.
Cash Flows
Year 1995 1996 1997 1998 1999 2000
Low Forecast
Cash Flows N/A
$
1.16
$
1.25
$
1.34
$
1.44
$
91.55
Present Value
for 1995 N/A $1.05 $1.01 $0.98 $0.95 $54.37
Low Estimate of
Value for 1995 $58.36
The low estimate of present value is slightly above the $55.75 market price before the
announcement was made.

28
Cash Flows
Year 1995 1996 1997 1998 1999 2000
High Forecast
Cash Flows N/A
$
1.16
$
1.34
$
1.55
$
1.79
$
127.07
Present Value
for 1995 N/A $1.05 $1.09 $1.13 $1.18 $75.46
High Estimate
of Value for
1995 $79.91
The high estimate of present value is almost $10 higher than the $70 offer price.
If we assume either outcome has a 50% chance, we can come up with a value very close to the
offer price:
50% x $58.36 + 50% x $79.91 = $69.14
So using CAPM and assuming Value Line’s security analysts represent a typical security analyst
following GEICO, it appears the offer was a fair one (and proof was in its acceptance). We will
revisit this in the next section.
How Warren Buffett May Have Analyzed the Same Value Line Data
“GEICO’s sustainable cost advantage is what attracted me to the company way back in 1951,
when the entire business was valued at $7 million. It is also why I felt Berkshire should pay $2.3
billion last year [1996] for the 49% of the company that we didn’t then own” –Warren E. Buffett
From Professor Bruner’s case, we know Buffett would use a risk free rate (e.g. rate of return on
the long-term 30-year U.S. Treasury bond) to discount future cash flows to the present. The case
also provided the following data:
Yield of 30-year U.S. Treasury bond on August 25, 1995 was 6.86%
If Buffett used this risk-free rate as the discount rate along with the low forecast from Value Line
(which would be required as a conservative investor attempting to determine the more certain
outcome), Buffett would have calculated an intrinsic value of ~$70.00, which is the offer price

29
Cash Flows
Year 1995 1996 1997 1998 1999 2000
Low Forecast
Cash Flows N/A
$
1.16
$
1.25
$
1.34
$
1.44
$
91.55
Present Value
for 1995 N/A $1.09 $1.09 $1.10 $1.10 $65.70
Low Estimate of
Value for 1995 $70.09
This discounted cash flow analysis using conservative estimates and a risk free discount rate
suggests that the bid price was appropriate, but did not appear to have a margin of safety. As we
will see in the next section, the acquisition had hidden benefits that would allow the acquisition
to make sense to an investor like Buffett.
Other Items Warren Buffett May Have Considered
This section will explore some things that Buffett may have considered and were probable
motives for making an offer close to the probable intrinsic value calculation from the last section.
Professor Nissim’s paper also discusses taxation of insurance companies.
With Berkshire Hathaway owning 50.4% of GEICO’s 67,889,574 shares outstanding
(approximately 34.2 million shares), Berkshire Hathaway would have an effective tax rate (TR)
(20% x 35%) + (15% x 80% x 35%) = 11.2% on dividend income from GEICO (although
footnote 6 of the case indicated Berkshire Hathaway paid 14% tax rate on dividends, we will use
the calculated rate of 11.2% below).
With a forecast dividend for 1996 of $1.16, Berkshire Hathaway would earn ~$39.7 million in
dividend income from GEICO and pay ~$4.45 million in taxes.
However, by fully acquiring GEICO, this effective tax rate would drop to 0% on dividends.
Assuming GEICO’s dividend grows 7.5%/year (growth rate found using financial calculator and
Value Line’s low forecasts), we can use the constant growth Dividend Discount Model to
determine how much Berkshire Hathaway would save in taxes after the acquisition.

30
TR = 11.2%
T1 = TR * D1 = 11.2% * $39.7 million = $4.446 million
G = 7.5%
To be conservative, we will use GEICO’s cost of equity, so K = 11% (Value Line)
Present value of all future taxes on dividends:
PV = T1 / (K – G) = $4.446 million / (11% - 7.5%) = $127 million
It should be noted that GEICO’s cost of equity could be significantly lower post acquisition
(Berkshire Hathaway had a beta closer to one, meaning the typical security analyst would view
Berkshire Hathaway less risky).
It was also likely Buffett would cancel the “dividends” altogether and allow Simpson to invest
all of the earnings.
Buffett may have also considered:
Berkshire Hathaway paid ~$50 million for its state in GEICO
At preannouncement market price, Berkshire Hathaway’s stake in GEICO was $1.825 billion.
By purchasing GEICO, Berkshire Hathaway would never have to pay capital gains tax on the
original investment! A tax liability of 35% x $1,825 million = $638.75 million
If we add the tax savings on dividends ($127 million) and the thwarted capital gain tax ($638.75
million), Berkshire Hathaway is saving ~$765 million by buying GEICO. This is the most
likely reason Berkshire Hathaway’s share price increased in value on the same day as the
announcement.
Although Berkshire Hathaway owned more than 50% of GEICO, it was not a controlling interest
(had it been, the acquisition price would have been a lot lower). By making the deal, Berkshire
Hathaway would assume full control.
The 1980 Chairman Letter states:

31
The deal would also add more float and an executive (Lou Simpson) who could fill Buffett’s
position as chief investment officer if something were to happen to Buffett (something that
investors were worried about due to Buffett’s age). Note: Buffett was 65 years old in 1996.
The 2014 Annual Report provides a good introduction to float at Berkshire Hathaway:
Conclusions
This paper looked at various aspects of Warren Buffett, Berkshire Hathaway and GEICO and
answered the questions posed at the end of the Professor Bruner’s case:
 Would the GEICO acquisition serve the long-term goals of Berkshire Hathaway?
Yes; GEICO met all of Berkshire Hathaway’s acquisition criteria and would serve the
long-term goals of Berkshire Hathaway to outperform the average large American
corporation. Note: See the section of this paper titled Berkshire Hathaway’s Goals &
Acquisition Criteria for the full details.
 Was the bid price appropriate?
Yes; a conservative calculation of GEICO’s intrinsic value was in line with the offer
price. By factoring in other items including tax savings, bringing another superinvestor
on board and corporate control, there was also a margin of safety. Note: See the sections
of this paper titled Analysis of Value Line Forecast Using CAPM and How Warren
Buffett May Have Analyzed the Same Value Line Data for the full details.

32
 What might account for the share price increase for Berkshire Hathaway at the
announcement?
In buying GEICO, Berkshire Hathaway would never have to pay capital gains tax on gain
of the first half of the company they already owned and would no longer have to pay tax
on the dividends. Note: See the section of this paper titled How Warren Buffett May
Have Analyzed the Same Value Line Data for the full details.
In closing, we all owe a debt of gratitude to Benjamin Graham, Warren Buffett, Lou Simpson
and others who have candidly shared their value investing philosophies and principles over the
years.

33
References
Publications
Case Study: Professor Robert F. Bruner (1996), “Warren E. Buffett, 1995”, Darden Business
Publishing (UV0006 V1.7)
1995 Annual Report (10K) – GEICO
1996 Annual Report – Berkshire Hathaway
2004 Annual Report – Berkshire Hathaway
Berkshire Hathaway Inc.: Celebrating 50 Years of a Profitable Partnership, 2014
Buffett, Warren E., “The Security I like Best”, The Commercial and Financial Chronicle,
December 6, 1951
Buffett, Warren E., "The Superinvestors of Graham-and-Doddsville", Hermes, Columbia
Business School Magazine, Fall 1984
Joe Carlen, The Einstein of Money: The Life and Timeless Financial Wisdom of Benjamin
Graham, Amherst, New York, Prometheus Books, 2012
Anupreeta Das, “Berkshire Sees Green With Geico”, Wall Street Journal, Aug. 24, 2014
Easton P., Wild J., Halsey R. & McAnally M., 2013, Financial Accounting for MBAs, 5th ed.,
Cambridge Business Publishers, Westmont, Illinois
Prem C. Jain, Buffett Beyond Value: Why Warren Buffett Looks to Growth and Management
When Investing, Hoboken, NJ, John Wiley & Sons, 2010
Koller T., Goedhart M. & Wessels D. 2010, Valuation: Measuring and Managing the Value
Companies, 5th ed., John Wiley & Sons, Hoboken, New Jersey
Ehrbar, Al, EVA: The Real Key to Creating Wealth, New York, NY: John Wiley & Sons, 1998
Robert G. Hagstrom Jr., The Warren Buffett Way: Investment Strategies of the World’s Greatest
Investor, New York, NY, John Wiley & Sons, 1994
Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett, Birmingham, AL, AKPE,
1994
Robert P. Miles, Warren Buffett Wealth: Principles and Practical Methods Used by the World’s
Greatest Investor, Hoboken, NJ, John Wiley & Sons, 2004
Doron Nissim, “Analysis and Valuation of Insurance Companies”, Columbia Business School,
November 2010

34
Sharpe, Alexander & Bailey, Investments, 6th Edition, Upper Saddle River, NJ: Prentice Hall,
1995, p228
William Thorndike, The Outsiders: Eight Unconventional CEOs and Their Radically Rational
Blueprint for Success, Boston, MA, Harvard Business School Publishing, 2012
David A. Vise, “Geico's Top Market Strategist Churning Out Profits; Lou Simpson’s Stock Rises
on His Successful Ideas”, The Washington Post, 11 May 1987
Websites
Berkshire Hathaway share prices: http://bigcharts.marketwatch.com/historical/
Information on the insurance industry:
http://www.agencyrevolution.com/resources/all-resources/26-state-of-the-industry-3-r

35
Exhibits
Exhibit 1
From 1957 through 1969, the Buffett Partnership achieved extraordinary results by beating the
Dow every year.
Source: The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, P171

36
Exhibit 2
Share price performance of Berkshire Hathaway from 1976 compared to S&P 500
Source: http://www.economist.com/news/briefing/21601240-warren-buffetts-50-years-running-berkshire-hathaway-have-been-one-businesss-most-impressive

37
Exhibit 3
Dollar amounts in $ millions

38
Exhibit 4
Source: Berkshire Hathaway 1994 Annual Report

39
Exhibit 5

41
Exhibit 7
Source: The Warren Buffet Way, 1st
Ed., P129

42
Exhibit 8

43
Exhibit 9
Source: http://www.thefreelibrary.com/BERKSHIRE+HATHAWAY+AGREES+TO+BUY+BALANCE+OF+GEICO+STOCK+FOR+$70+PER...-a017239377

44
Exhibit 10
Buffett Moves To Acquire All of Geico
By MICHAEL QUINT
Published: August 26, 1995
Warren E. Buffett is returning his focus to one of his earliest successes. Berkshire Hathaway
Inc., which he controls, announced a $2.3 billion cash offer yesterday to buy the 49 percent of
the Geico Corporation it does not already own.
Geico, the country's sixth-largest car insurer, has been a solidly profitable company in recent
years with a good record for low losses and low expenses in comparison with others in its
business. These results have been possible because the company bypasses agents, selling directly
to the consumer, concentrating on low-risk drivers.
For Mr. Buffett, the renowned investor, the cash offer was for the company that caught his eye
more than four decades ago. "In 1951, when I was 20, I invested well over half of my net worth
in Geico," Mr. Buffett said. In the mid-1970's, when Geico was reeling from heavy losses, Mr.
Buffett sharply increased his investment, which rose in value many-fold as the company
recovered.
In yesterday's announcement, Mr. Buffett did not elaborate on his views of Geico or the auto
insurance business in general, except to say that he was happy with the old investment and
"equally comfortable" with the new purchase.
Ira Zuckerman, an insurance analyst at UBS Securities, said the Geico investment could be an
indirect result of the Walt Disney Company's $19 billion bid to acquire Capital Cities/ABC Inc.,
in which Berkshire Hathaway owns 20 million shares. That stake would be worth $1.5 billion if
all the shares were sold to Disney.
"There is a big chunk of cash coming in from the Cap Cities/ABC shares that has to be
redeployed," Mr. Zuckerman said, "and I think that he looked around and decided he did not see
anything that was more attractive than the Geico business, which he already knows."
The Berkshire Hathaway offer of $70 a share was 26 percent higher than Thursday's closing
price for Geico of $55.75. Geico stock closed yesterday at $68.625.
A rise in the stock of many automobile and property insurers followed the Berkshire Hathaway
announcement, as investors and traders tried to imitate Mr. Buffett's decision, and as insurance
investors bought shares in other companies to replace their Geico holdings. Shares of the Allstate
Corporation of Northbrook, Ill., the second-largest seller of personal auto insurance behind the

45
State Farm Mutual Automobile Insurance Company of Bloomington, Ill., rose 75 cents, to
$32.50, while the Progressive Corporation of Mayfield Village, Ohio, rose $1.125, to $42.50,
and 20th Century Industries rose 62.5 cents, to $14.75. Rising bond prices also helped lift prices
of insurance stocks yesterday.
Auto insurance for individuals, a business that collects more than $90 billion of premiums a year,
has been more profitable for insurers than many kinds of property and liability insurance.
Members of the baby boom generation have become safer drivers and the number of claims has
decreased with tougher penalties for drunken driving and more safety features on cars.
Unlike most auto insurers, Geico sells policies directly to consumers using the mail and cable
television, and quoting its prices by telephone. That approach saves paying commissions to sales
agents, who typically collect 10 percent or more. As a result, the company can offer lower prices
to the customers it wants -- primarily the lowest-risk, safest drivers.
"I think the auto insurance business, like property insurance in general, is undervalued in the
market," Mr. Zuckerman said. Part of the problem, he said, is that too many investors allow their
judgment to be colored by their own unpleasant experiences with insurers, and overlook
favorable trends in growth and profits.
The Geico strategy has also attracted Maurice Greenberg, chairman of the American
International Group, an insurance company that last year invested more than $200 million in
20th Century Industries, an auto insurer based in Woodland Hills, Calif., with a strategy similar
to Geico's. The company was profitable until the Northridge earthquake in 1994 caused losses on
homeowners' policies, threatening to put the company out of business.
Besides restoring 20th Century's financial strength, American International has helped the
company to expand its business into other states. Geico, which is based in Washington, does
business in every state except New Jersey and Massachusetts. And like 20th Century, Geico has
recently announced plans to leave the homeowners' market.
Source: http://www.nytimes.com/1995/08/26/business/buffett-moves-to-acquire-all-of-geico.html

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