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Warren E. Buffett, 1995
On August 25, 1995, Warren Buffett, the CEO of Berkshire Hathaway, announced that his firm would
acquire the 49.6% of GEICO Corporation that it did not already own. The $2.3 billion deal would give GEICO
shareholders $70 per share, up from the $55.75 per share market price before the announcement. Observers
were astonished at the 26% premium that Berkshire Hathaway would pay, particularly as Buffett proposed to
change nothing about GEICO, and there were no apparent synergies in the combination of the two firms. At
the announcement, Berkshire Hathaway’s shares closed up 2.4% for the day, for a gain in market value of $718
million.1 That same day, the S&P 500 Index closed up 0.5%.
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),2 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,3 but 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 and 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.
Numerous writers sought to distill the essence of Buffett’s success. What were the key principles that guided
him? Could those principals be applied broadly in the late 1990s and into the 21st century, or were they unique
to Buffett and his time? From an understanding of those principles, analysts hoped to illuminate Berkshire
Hathaway’s acquisition of GEICO. Under what assumptions would the acquisition make sense? What were
Buffett’s probable motives in the acquisition? Would the acquisition of GEICO prove to be a success? How
would it compare to the firm’s other recent investments in Salomon Brothers, USAir, and Champion
International?
The change in Berkshire Hathaway’s share price at the date of the announcement was $609.60. The company had outstanding 1,177,750 shares.
Buffett’s initial cost per share in Berkshire Hathaway in 1965 was about $17.578. On August 25, 1995, the price per share closed at $25,400.
3 Robert G. Hagstrom Jr., The Warren Buffett Way (New York, NY: John Wiley & Sons, 1994); Andrew Kilpatrick, Of Permanent Value: The Story of
Warren Buffett (Birmingham, AL: AKPE, 1994); Roger Lowenstein, Buffett: The Making of an American Capitalist (New York, NY: Random House, 1995).
1
2
This case was prepared by Professor Robert F. Bruner as a basis for class discussion rather than to illustrate effective or ineffective handling of an
administrative situation. Copyright © 1996 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order
copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or
transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.
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Berkshire Hathaway, Inc.
The company was incorporated in 1889 as Berkshire Cotton Manufacturing, and eventually grew to become
one of New England’s biggest textile producers, accounting for 25% of the country’s cotton textile production.
In 1955, Berkshire merged with Hathaway Manufacturing and began a secular decline due to inflation,
technological change, and intensifying competition from foreign competitors. In 1965, Buffett and some
partners acquired control of Berkshire Hathaway, believing that the decline could be reversed. Over the next
20 years, it became apparent that large capital investments would be required to remain competitive and that
even then the financial returns would be mediocre. In 1985, Berkshire Hathaway left the textile business.
Fortunately, the textile group generated enough cash in the initial years to permit the firm to purchase two
insurance companies headquartered in Omaha: National Indemnity Company and National Fire & Marine
Insurance Company. Acquisitions of other businesses followed throughout the 1970s and 1980s.
The investment performance of a
share
in
Berkshire
Hathaway
astonished most observers. In 1977,
the firm’s year-end closing share price
was $89.00. On August 25, 1995, the
firm’s closing share price was
$25,400.00. In comparison, the annual
average total return on all large stocks
from 1977 to the end of 1994 was
14.3%.4 Over the same period, the S&P
500 Index grew from 107 to 560. Some
observers called for Buffett to split the
firm’s share price, to make it more
accessible to the individual investor.
Buffet steadfastly refused.
Share Price of Berkshire Hathaway versus S&P 500
Index
$100,000
$10,000
$1,000
$100
BH
S&P500
$10
$1
In 1994, Berkshire Hathaway
described itself as “a holding company owning subsidiaries engaged in a number of diverse business activities.”5
Exhibit 1 gives a summary of revenues, operating profits, capital expenditures, depreciation, and assets for the
various segments. By 1994, Berkshire’s portfolio of businesses included:
Insurance Group. The largest component of Berkshire’s portfolio focused on property and casualty
insurance, on both a direct and reinsurance basis. The investment portfolios of the Insurance Group
included meaningful equity interests in 10 other publicly traded companies. The equity interests are
summarized in Exhibit 2, along with Berkshire’s share of undistributed operating earnings in those
companies. Because the earnings in some of those companies could not be consolidated with
Berkshire’s because of the U.S.’s generally accepted accounting principles (GAAP), Buffett published
Berkshire’s “look-through” earnings6—as shown in Exhibit 2, the share of undistributed earnings of
major investees accounted for 40%–50% of Berkshire’s total look-through earnings. Exhibit 3
Stocks, Bonds, Bills, and Inflation (Chicago: Ibbotson Associates, 1994), 10.
Berkshire Hathaway, Inc., annual report, 1994.
6 Look-through earnings were calculated as the sum of Berkshire’s operating earnings reported in its income statement, plus the retained operating
earnings of major investees not reflected in Berkshire’s profits, less tax on what would be paid by Berkshire if those earnings had been distributed to
Berkshire. The presentation used a 14% tax rate, the rate Berkshire paid on the dividends it received.
4
5
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summarizes investments in convertible preferred stocks7 that Berkshire Hathaway had made in
previous years, serving as a white squire to major corporations—each of those firms had been the
target of actual or rumored takeover attempts.
Buffalo News. A daily and Sunday newspaper in upstate New York.
Fechheimer. A manufacturer and distributor of uniforms.
Kirby. A manufacturer and marketer of home cleaning systems and accessories.
Nebraska Furniture. A retailer of home furnishings.
See’s Candies. A manufacturer and distributor of boxed chocolates and other confectionary products.
Childcraft and World Book. A publisher and distributor of encyclopedias and related educational and
instructional material.
Campbell Hausfeld. A manufacturer and distributor of air compressors, air tools, and painting systems.
H.H. Brown Shoe Company; Lowell Shoe, Inc., and Dexter Shoe Company. A manufacturer, importer, and
distributor of footwear.
In addition to those businesses, Berkshire owned an assortment of smaller businesses8 generating about $400
million in revenues.
Berkshire Hathaway’s Acquisition Policy
The GEICO announcement renewed general interest in Buffett’s approach to acquisitions. Exhibit 4 gives
the formal statement of acquisition criteria contained in the Berkshire Hathaway 1994 annual report. In general,
the policy expressed a tightly disciplined strategy that refused to reward others for actions that Berkshire
Hathaway might just as easily take on its own. Therefore, analysts scrutinized the criteria to assess where they
might offer winning ideas to Buffett.
One prominent example to which Buffett referred was Berkshire Hathaway’s investment in Scott & Fetzer
in 1986. The managers of Scott & Fetzer had attempted a leveraged buyout of the company in the face of a
rumored hostile takeover attempt. When the U.S. Department of Labor objected to the company’s use of an
employee stock ownership plan (ESOP) to assist in the financing, the deal fell apart. Soon the company attracted
unsolicited proposals to purchase the company, including one from Ivan F. Boesky, the arbitrageur. Buffett
offered to buy the company for $315 million, a figure that can be compared to its book value of $172.6 million.
Following the acquisition, Scott & Fetzer paid Berkshire Hathaway dividends of $125 million, even though it
earned only $40.3 million that year. In addition, Scott & Fetzer was conservatively financed, going from modest
debt at the acquisition to virtually no debt by 1994. Exhibit 5 gives the earnings and dividends for Scott &
Fetzer from 1986 to 1994. Buffett noted that in terms of return on book value of equity, Scott & Fetzer would
7 Convertible preferred stock was preferred stock that carried the right to be exchanged by the investor for common stock. The exchange, or
conversion, right was like a call option on the common stock of the issuer. The terms of the convertible preferred stated the price at which common
shares could be acquired in exchange for the principal value of the convertible preferred stock.
8 These included companies in conduit fittings, marketing motivational services, retailing fine jewelry, air compressors, sun- and shade-control
products, appliance controls, zinc die-cast fittings, automotive compounds, pressure and flow measurement devices, fractional horsepower motors, boat
winches, cutlery, truck bodies, furnace burners, compressed gas fittings, and molded plastic components.
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have easily beaten the Fortune 500 firms.9 The annual average total return on large company stocks from 1986
to 1994 was 12.6%.10
Buffett’s Investment Philosophy
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.
Over the years, Buffett had expounded his philosophy of investing in his CEO’s letter to shareholders in
Berkshire Hathaway’s annual reports. By 1995, those lengthy letters had accumulated a broad following because
of their wisdom and their humorous, self-deprecating tone. The letters emphasized the following elements:
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:
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.11
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.
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.
9 From the comparison firms emerging from bankruptcy in recent years. Buffett’s observation was made in the Berkshire Hathaway annual report,
1994.
10 Stocks, Bonds, Bills, and Inflation.
11 Berkshire Hathaway, Inc., annual report, 1994.
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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.12
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.13
To illustrate the mechanics of this example, consider the hypothetical case presented in Exhibit 6.
Suppose an individual has the opportunity to invest $50 million in a business—this is its cost, or book
value. This business will throw off cash at the rate of 20% 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.
12
13
Berkshire Hathaway, Inc., annual report, 1992.
Berkshire Hathaway, Inc., annual report, 1994.
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Consider an opposing case, summarized in Exhibit 7. The example is similar in all respects except for
one key difference: the annual return on the investment is 10%. The result is that every dollar invested
buys securities worth $0.80. Thus, value has been destroyed.
Comparing the two cases in Exhibits 6 and 7, 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.
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.14
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.
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 riskfree 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.15 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.16 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.17
Berkshire Hathaway, Inc., annual report, 1994.
The yield on the 30-year U.S. Treasury bond on August 25, 1995 was 6.86%. Berkshire Hathaway’s beta was 0.95.
16 Quoted in Jim Rasmussen, “Buffett Talks Strategy with Students,” Omaha World-Herald, January 2, 1994, 26.
17 Berkshire Hathaway, Inc., annual report, 1993, and republished in Andrew Kilpatrick, Of Permanent Value: The Story of Warren Buffett (Birmingham,
Ala.: AKPE, 1994), 574.
14
15
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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.18
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.”19 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.20
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.21
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.”22 Buffett also said, “Lethargy bordering on sloth remains
the cornerstone of our investment style,”23 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.24
Quoted in Forbes (October 19, 1993), and republished in Andrew Kilpatrick, Of Permanent Value, 574.
Quoted in Michael Lewis, Liar’s Poker (New York, NY: Norton, 1989), 35.
20 Originally published in the Berkshire Hathaway, Inc., annual report, 1987. This quotation was paraphrased from James Grant, Minding Mr. Market
(New York, NY: Times Books, 1993), xxi.
21 Peter Lynch, One up on Wall Street, (New York, NY: Penguin Books, 1990), 78.
22 Berkshire Hathaway, Inc., annual report, 1986.
23 Berkshire Hathaway, Inc., annual report, 1990.
24 Berkshire Hathaway, Inc., Letters to Shareholders, 1977–1983, 53.
18
19
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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.25
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.26
8. Alignment of agents and owners. Explaining his significant ownership interest in Berkshire Hathaway,
Buffett said, “I am a better businessman because I am an investor. And I am a better investor because
I am a businessman.”27 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.28
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.
GEICO Corporation
Berkshire Hathaway began purchasing shares in GEICO in 1976 and, by 1980, had accumulated a 33%
interest, or 34.25 million shares, for $45.7 million. During the period from 1976 to 1980, GEICO’s share price
had been hammered by double-digit inflation, higher accident rates, and high damage awards that raised the
costs of its business more rapidly than premiums could be increased. By August 1995, that stake had grown to
50.4% of the firm’s shares (because GEICO had repurchased some of its own shares while Berkshire had
maintained its holdings) and the original stake of $45.7 million had grown in value to $1.9 billion.29 Also,
GEICO had paid an increasing dividend each year (Exhibit 8). From 1976 to 1994, the average annual total
return on large company stocks was 13.5%.30
In explaining the decision to acquire the rest of the shares in GEICO, Buffett noted:
The firm was the seventh-largest auto insurer in the United States, underwriting policies for 3.7 million
cars.
Quoted in Andrew Kilpatrick, Of Permanent Value, 353.
Quoted in L. J. Davis, “Buffett Takes Stock,” New York Times, April 1, 1990, 16.
27 Quoted in Forbes (October 19, 1993), and republished in Andrew Kilpatrick, Of Permanent Value, 574.
28 “Owner-Related Business Principles” in Berkshire Hathaway’s annual report, 1993.
29 This assumes the preannouncement GEICO share price of $55.75.
30 Stocks, Bonds, Bills, and Inflation, 10.
25
26
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The firm’s senior managers were extraordinary and had an investment style similar to Buffett’s own.
Those managers would add depth to Berkshire Hathaway’s senior management bench and provide
continuity in case anything happened to Buffett (age 65) or Munger (age 72).
The firm was the lowest-cost insurance provider in the industry.
Some analysts sought to test the suitability of Buffett’s $70-per-share offer for GEICO using the discounted
cash flow (DCF) approach. On July 7, 1995, Value Line Investment Survey published a forecast of GEICO’s
dividends31 and future stock price within a range of possible outcomes. See Table 1.
Table 1. Value Line forecast information.
1996
1997
1998
1999
2000
Forecast stock price in 2000
Forecast
dividends
Low End of Range
High End of Range
$1.16
$1.25
$1.34
$1.44
$1.55
$90.00
$1.16
$1.34
$1.55
$1.79
$2.07
$125.00
Value Line also presented evidence consistent with a cost of equity for GEICO of 11%.32 GEICO had
67,889,574 shares outstanding as of April 30, 1995. Analysts noted that the timing of Berkshire Hathaway’s bid
followed closely Walt Disney Company’s bid to buy Capital Cities/ABC for $19 billion.
Conclusion
Conventional thinking held that it would be difficult for Warren Buffett to maintain his record of 28%
annual growth in shareholder wealth. Buffett acknowledged that “a fat wallet is the enemy of superior
investment results.”33 He stated that it was the firm’s goal to meet a 15% annual growth rate in intrinsic value.
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?
GEICO paid dividends quarterly, though Value Line presented only an annual forecast. Annual figures are given here for the sake of simplicity.
Analysts used the CAPM to estimate GEICO’s cost of equity. Value Line estimated GEICO’s beta at 0.75. In comparison, Berkshire Hathaway’s
beta was 0.95. The equity market risk premium was about 5.5%. And the risk-free rate estimated by the yield on the 30-year U.S. Treasury bond was
6.86%.
33 Quoted in Garth Alexander, “Buffett Spends $2 billion on Return to His Roots,” Times (London), August 17, 1995.
31
32
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1993
$1,591
201
199
193
209
145
370
122
568
$3,599
1994
$1,437
216
191
207
245
151
609
151
639
$3,847
Revenues
2
1
17
54
76
14
(192)2
$722
44
1994
$639
47
24
21
50
40
13
60
$1,246
41
1993
$961
40
19
Pretax Operating Profit1
22.6
5.2
17.9
4.6
10.7
$67.1
1.0
1994
$0.9
4.1
0.1
5.3
3.6
4.4
1.0
13.0
$35.0
1.5
1993
$1.2
4.3
0.7
Capital Expenditures
Business Segment Information for Berkshire Hathaway, Inc.
(dollars in millions)
Warren E. Buffett, 1995
Exhibit 1
Includes pretax charge of $269 representing another than temporary decline in value of investment in USAir Group, Inc., preferred stock.
Before interest expense.
Source: Berkshire Hathaway, Inc., annual report, 1994.
N.B. Columns may not sum to the total because of rounding.
Insurance
Candy
Encyclopedias
Home-cleaning
systems
Home furnishings
Newspaper
Shoes
Uniforms
Other
Total
Segment
Page 10
6.2
2.2
10.2
2.5
18.0
$49.6
4.2
1994
$0.9
4.1
1.4
2.7
1.9
5.2
1.8
17.3
$40.5
5.3
1993
$0.8
4.1
1.5
Depreciation
128
48
673
95
1,712
$21,338
42
101
45
642
88
2,324
$19,520
49
Identifiable
Assets
1994
1993
$18,494
$16,127
69
70
76
75
UV0006
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Page 11
Source: Berkshire Hathaway, Inc., annual report, 1994.
Berkshire’s Approximate Ownership
at Year End
1994
1993
American Express Co.
5.5%
2.4%
Capital Cities/ABC
13.0
13.0
Coca-Cola
7.8
7.2
Federal Home Loan Mtge.
6.3
6.8
Gannett
4.9
–
GEICO
50.2
48.4
Gillette
10.8
10.9
PNC Bank
8.3
–
Washington Post
15.2
14.8
Wells Fargo
13.3%
12.2%
Berkshire’s share of undistributed earnings
Hypothetical tax on those earnings
Reported operating earnings for Berkshire
Total look-through earnings for Berkshire
Berkshire’s Major Investees
Berkshire’s Share of Undistributed
Operating Earnings
1994
1993
$ 25
$ 16
85
83
116
94
47
41
4
–
63
76
51
44
10
–
18
15
$ 73
$ 53
$ 492
$422
(68)
(59)
606
478
$1,030
$841
Major Investees of Berkshire Hathaway and Look-Through Earnings
(dollars in millions)
Warren E. Buffett, 1995
Exhibit 2
UV0006
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Warren E. Buffett, 1995
Exhibit 3
9.00
8.75
9.00
9.25%
First Empire State Corp.2
The Gillette Company3
Salomon, Inc.4
USAir Group, Inc.5
1989
1987
1989
1991
1989
Year of Purchase
$ 358
700
600
40
$ 300
Cost
110
388
$
215
728
2,502
$
Market Value
(December 1995)
UV0006
1 The Champion International issue could be converted into common shares at $38.00 per share. At August 25, 1995, Champion International’s common share price was $57.50. By December 31, 1995,
Champion’s share price had fallen to $42.75.
2 The First Empire issue could be converted into common shares at a conversion price of $78.91 per share. First Empire has the right to redeem the issue beginning in 1996. At August 25, 1995, First Empire’s
common share price was $184.50.
3 The Gillette issue could be converted into common stock at $25.00 per share, and carried a mandatory redemption by Gillette after 10 years. In February 1991, following the highly successful introduction
of the Sensor razor, Gillette announced that it would redeem the issue at $31.75, which effectively forced Berkshire to convert its holding into common stock. Berkshire converted and received 12 million common
shares, or 11% of Gillette’s total shares outstanding. At August 25, 1995, Gillette’s share price was $43.00.
4 The Salomon issue could be converted into common stock at $38.00 per share. If Berkshire did not convert the preferred stock, Salomon would redeem it over five years, beginning October 1995. At August
25, 1995, Salomon’s common share price was $37.125.
5 The USAir issue could be converted into common shares at $60 per share. If Berkshire did not convert the series into common stock, USAir would have to redeem the preferred in 10 years. At August 25,
1995, the USAir common share price was $8.50.
Source: Berkshire Hathaway, Inc., annual report, 1995.
9.25%
Dividend Yield on
Par Value
Berkshire’s Investments in Private Purchases of Convertible Preferred Stocks
(dollars in millions)
Champion International Corp.1
Page 12
Page 13
UV0006
Exhibit 4
Warren E. Buffett, 1995
Berkshire Hathaway Acquisition Criteria
We are eager to hear about businesses that meet all of the following criteria:
1. Large purchases of at least $10 million in after-tax earnings.
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.
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.
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.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a fast answer—
customarily within five minutes—as to whether we’re interested. We prefer to buy for cash, but will consider
issuing stock when we receive as much in intrinsic business value as we give.
Our favorite form of purchase is one fitting the pattern through which we acquired Nebraska Furniture
Mart, Fechheimer’s, Borsheim’s, and Central States Indemnity. In cases like those, the company’s
owner/managers wished to generate significant amounts of cash, sometimes for themselves, but often for their
families or inactive shareholders. At the same time, those managers wished to remain significant owners who
continued to run their companies just as they had in the past. We think we offer a particularly good fit for
owners with such objectives and we invite potential sellers to check us out by contacting others with whom we
have done business in the past.
Charlie and I frequently get approached about acquisitions that do not come close to meeting our tests.
We have found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their
cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auctionlike sales: “When the phone don’t ring, you’ll know it’s me.”
Besides being interested in the purchase of businesses as described above, we are also interested in the
negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Capital Cities,
Salomon, Gillette, USAir, and Champion. We are not interested, however, in receiving suggestions about purchases we might
make in the general stock market.
Source: Berkshire Hathaway, Inc., annual report, 1994.
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Page 14
UV0006
Exhibit 5
Warren E. Buffett, 1995
Scott & Fetzer: Book Value of Equity, Earnings, and Dividends for 1986–1994
1986
1987
1988
1989
1990
1991
1992
1993
1994
Beginning Book
Value
$172.6
87.9
95.5
118.5
105.5
133.3
120.7
111.2
$90.7
Earnings
Dividends
$40.3
48.6
58.0
58.5
61.3
61.4
70.5
77.5
$79.3
$125.0
41.0
35.0
71.5
33.5
74.0
80.0
98.0
$76.0
Ending Book
Value
$87.9
95.5
118.5
105.5
133.3
120.7
111.2
90.7
$94.0
Source: Berkshire Hathaway, Inc., annual report, 1994.
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Page 15
UV0006
Exhibit 6
Warren E. Buffett, 1995
Hypothetical Example of Value Creation
Assume:
5-year investment horizon, when you liquidate at book or accumulated investment value.
Initial investment is $50 million.
No dividends are paid and all cash flows are reinvested.
Return on equity (ROE) = 20%.
Cost of equity = 15%.
Year
0
1
2
3
4
5
Investment or
book equity
value
50
60
72
86
104
124
Market value (intrinsic value) =
Market/Book
PV @ 15% of 124 = $61.65
= $61.65/50.00 = 1.23
Value created: $1.00 invested becomes $1.23 in market value.
Source: Case writer analysis.
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UV0006
Exhibit 7
Warren E. Buffett, 1995
Hypothetical Example of Value Destruction
Assume:
5-year investment horizon, when you liquidate at book or accumulated investment value.
Initial investment of $50 million.
No dividends are paid, and all cash flows are reinvested.
ROE = 10%.
Cost of equity = 15%.
Year
0
1
2
3
4
5
Investment or
book equity
value
50
55
60
67
73
81
Market value (intrinsic value)
Market/book
= PV @ 15% of $81 = $40.30.
= $40.30/50.00 = 0.80.
Value destroyed: $1.00 invested becomes $0.80 in market value.
Source: Case writer analysis.
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Page 17
UV0006
Exhibit 8
Warren E. Buffett, 1995
GEICO Dividend Payment History
Year
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
GEICO
Dividend
per Share
$0.00
0.01
0.04
0.07
0.09
0.10
0.11
0.14
0.18
0.20
0.22
0.27
0.33
0.36
0.40
0.46
0.60
0.68
$1.00
Total Dividends
to Berkshire
Hathaway
$0.00
0.34
1.37
2.40
3.08
3.43
3.77
4.80
6.17
6.85
7.54
9.25
11.30
12.33
13.70
15.76
20.55
23.29
$34.25
Note: Total dividends to Berkshire were estimated by multiplying the per-share dividend times the 34.25 million shares
that were Berkshire’s holdings in GEICO. This presentation assumes that all of Berkshire’s shares in GEICO were
acquired in 1976.
Source of annual dividends per share: Value Line Investment Survey.
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9-204-017
REV: JANUARY 23, 2004
RICHARD S. RUBACK
JULIA D. STEVENS
Carol Brewer's Investments
Carol Brewer had learned a great deal about investing in the past decade. In 1994, following her
husband’s death, Brewer had taken over the management of the portfolio her husband had built.
A social worker with a background in family therapy, Brewer had no prior experience with
investment but had taught herself as much as she could, and had enlisted the help of an investment
management company. She combined her new financial knowledge with her professional
background in family therapy and became a senior consultant for The Metropolitan Group,1 a
company that helped families resolve interpersonal conflicts around managing shared assets,
including family businesses and family philanthropies. In this capacity, Brewer had coached many
widowed and divorced women who were struggling with questions of investment management for
the first time in their lives. The struggles of these women reminded Brewer of the many difficult
decisions she had made following her husband’s death. Now 64 years old, Brewer hoped to retire in
six years and live on the income from her investments, while leaving some inheritance for her
children and grandchildren. She wanted to review her decisions and make any changes needed for
the future financial well being of her family.
Personal History
Carol and Jason Brewer were married in 1965 and settled in Washington, D.C., where they bought
a house and raised four children. Jason Brewer was a career officer in the U.S. Foreign Service. Carol
Brewer, a graduate of Radcliffe College with a master’s degree in social work, worked for various
psychiatric hospitals until 1982, when she started a private practice as a family therapist. She earned
her doctorate in social work at Catholic University in 1985.
In 1985, Jason Brewer retired from the Foreign Service and began to work for a policy think tank
in Washington, while Brewer continued in private practice. During the late 1980s and early 1990s,
their young adult children left for college and graduate school before launching into their own
professional lives. In 1987, Jason Brewer was diagnosed with cancer, and he and his family devoted
themselves to finding a cure. Jason Brewer struggled valiantly against his illness for seven years,
finally succumbing in August 1994.
1 For additional information on The Metropolitan Group, please see the company Web site at www.relative-solutions.com.
________________________________________________________________________________________________________________
Professor Richard S. Ruback and Research Associate Julia D. Stevens prepared this case. Certain details have been disguised. HBS cases are
developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of
effective or ineffective management.
Copyright © 2003 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical,
photocopying, recording, or otherwise—without the permission of Harvard Business School.
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800-988-0886 for additional copies.
204-017
Carol Brewer’s Investments
During their marriage, Jason Brewer had handled the couple’s investments while Carol Brewer
had handled their day-to-day finances. A few months before Jason Brewer’s death, the couple hired a
financial planner from an insurance company to review the way they were managing their finances
and to run some financial projections. They also met with an estate-planning lawyer who set up
trusts for them and updated their wills. As Jason Brewer reviewed his investments with the financial
planner, Carol Brewer learned about her husband’s investment choices and began to think about how
to proceed with the management of their investments after his impending death.
In spite of her deep grief at the death of her husband and her own lack of experience with
financial issues, Brewer read up on different philosophies of investment and learned that she could
choose between passive and active account management strategies. She decided she wanted the
benefit of the advice of an active account manager, and began to interview financial advisors
recommended by several older friends who had lost their husbands. As Brewer interviewed
advisors, she was surprised to discover that there was a wide range of support available, from people
“who do everything for you except tie your shoelaces” and people who say, “tell me what you want
to do and I’ll do it.” Brewer concluded that she did not want to independently manage her assets as
her husband had. She decided to find an expert who would work with her collaboratively, providing
advice on investment decisions while helping her to expand her knowledge of investments.
Brewer wanted to manage her investments conservatively to preserve assets for her four adult
children and their young families. She knew that her cautious investment approach was influenced
by the example of her parents. Jason Brewer, who had also been influenced by the conservative
investment behavior of his parents, had given significant gifts to each of their children for educational
expenses and even helped with downpayments on two new homes. Carol Brewer decided not to try
to equalize these gifts after his death, but to treat all her children as equitably as possible in the future
through her own good relationships with each of them.
Brewer continued to investigate the market and eventually settled on Marshfield Associates,
based in Washington, D.C. Marshfield’s asset base was small enough that Brewer felt she would get
the personal attention she wanted, and she felt that she could work well with the company’s
advisors. In addition, the company’s value-based investment philosophy made sense to her, and the
fee was competitive. (See Exhibit 1 for data on passive and active management fees.) It was
important to Brewer that her adult children also liked Marshfield’s approach and supported her in
her decision.
In 1998, Brewer remarried. She and her second husband, Stan Troutman, a psychologist
practicing in western Massachusetts, sold their houses and jointly bought an old farmhouse closer to
locations where their children had settled. Brewer took a consulting position at The Metropolitan
Group, helping families and family-owned businesses manage the relationship aspects of shared
assets. In 2003, Brewer lived on her earnings from her consulting job, Troutman’s earnings, and half
of Jason Brewer’s U.S. government pension.
Marshfield Associates
Marshfield Associates was an investment management firm located in Washington, D.C, which
managed approximately $1.2 billion for 500 clients in 2003, including individuals, associations, and
foundations. Marshfield focused on a research-intensive, value-based philosophy of investment that
2
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Carol Brewer’s Investments
204-017
could be summarized as “finding built-to-last companies in high return businesses that are selling,
for temporary reasons, at bargain prices.”2 (See Exhibit 2 for Marshfield’s Investment Philosophy.)
Marshfield focused on developing and managing concentrated stock portfolios for its clients, with
the belief that too much diversification could negatively impact portfolio performance. Marshfield
held approximately 30 companies across all accounts, and invested primarily in the top 15 of these
companies, known as core holdings. (See Exhibit 3 for Marshfield Core Holdings.) Individual
portfolios generally held between 15 and 20 individual stocks and had a turnover rate of less than
15%. Marshfield chose its holdings according to a discipline of “great companies at value prices.”3
This discipline included a careful evaluation of business and management quality, and a financial
assessment that indicated a company was priced at a “bargain” relative to its value. Central to the
Marshfield philosophy was the focus on the long term. The company emphasized the importance of
patience in the investment process, expressing a willingness to “tolerate the discomfort of waiting for
opportunities, for temporary problems to right themselves, and for out of favor stocks to regain
favor.”4
In accordance with their deliberate investment philosophy, Marshfield typically took two to three
years to fully invest a new account to its target allocations. This was especially true for equities,
because Marshfield preferred to wait to invest in a security until it was priced at a discount relative to
its actual value. This strategy helped avoid loss in the portfolio and preserved a “margin of safety”
for the client.5
Marshfield’s performance relative to the stock market had been favorable for the 13-year period
between 1990 and 2002. The company’s stocks had outperformed the S&P 500 for 9 of these 13 years,
and had also outperformed the Russell 3000 Value for 9 of these 13 years. (See Exhibits 4 and 5 for
composite annual and monthly returns for Marshfield stocks.)
The Investment Process
Assets At the time of his death, Jason Brewer’s portfolio included an irrevocable trust, several
life insurance policies, two IRAs, a rental property, and a brokerage portfolio. Following his death,
Brewer sold the real estate and transferred the remainder of the estate—the two IRAs and the Jason
Brewer trust, which contained his irrevocable trust, life insurance policies, and stock portfolio—to
Marshfield. Brewer worked with her Marshfield advisor to evaluate Jason Brewer’s stock portfolio,
which was allocated 77.6% to equities, 19.6% to fixed income mutual funds, and 2.8% to cash at the
time of his death. The portfolio contained many holdings in small start-up companies. Carol Brewer
knew that Jason Brewer had been a “venturesome” investor with a medium to high-risk tolerance
and had enjoyed investing his extra income in “nutty schemes,” especially new scientific
technologies. Brewer remembered when Jason Brewer had lost almost $50,000 in one such
investment, but she knew that some of his other investments had been fairly successful. She,
however, preferred the more conservative value-based approach advocated by Marshfield, and asked
her advisor to gradually sell the holdings and purchase positions in Marshfield stocks.
2 Letter sent to casewriter from Marshfield Associates on February 11, 2003.
3 Marshfield Associates brochure, p. 5.
4 Ibid.
5 Carolyn Rosen, Marshfield Associates, phone interview by casewriter, June 19, 2003.
3
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204-017
Carol Brewer’s Investments
At the time of her husband’s death, Brewer’s portfolio included a revocable trust of her own, a life
insurance policy, and an IRA. Her assets also included the couple’s Washington, D.C. residence and
a vacation home in Maine. After Jason Brewer’s death, Brewer gradually gifted her vacation home to
her children. She transferred her trust and IRA to Marshfield’s management.
Investment Allocation When Brewer opened her account at Marshfield in 1994, she planned
to continue working, and knew that she would be able to live comfortably on her earnings and the
income from Jason Brewer’s pension. Because she would not need to draw on investment income
until she retired, she wanted to focus the portfolio on growth to build assets for the next generation.
She set a portfolio allocation target of 100% equities, to be purchased over time according to
Marshfield’s deliberate investment philosophy. Marshfield selected the securities.
When Brewer remarried in 1998, she and Troutman opened a second account at Marshfield. This
joint account contained the revenue from the sale of Brewer’s Washington, D.C. residence and
Troutman’s Massachusetts residence. The couple allocated their joint account 100% to fixed income
and used the income from this account to pay for college tuition for Troutman’s two children. Once
the tuitions were paid off in 2001, the couple reallocated the account. The new allocation target was
100% equities. In 2003, the account was heavily invested in cash while awaiting reinvestment in
securities according to Marshfield’s deliberate investment strategy. (See Exhibit 6 for the joint
account portfolio.)
Evaluation of Performance Brewer reviewed the performance of her individual and joint
portfolios every month and met with her Marshfield advisor several times per year. She was pleased
that her portfolio had consistently outperformed the market and felt confident that Marshfield had
been the right choice for her and her family. In a little less than six years, Brewer planned to retire
and live on the income from her investments. She knew that she needed to reevaluate her portfolio to
make sure the account would provide the income she would need to continue to live comfortably,
maintain her current lifestyle, and provide for the future needs of her children and grandchildren.
After reviewing her needs, Brewer revised the allocation target for her trust and retirement portfolios
to 70% equities, 25% bonds, and 5% cash. In 2003, the account was in transition to the new allocation
targets. (See Exhibit 7 for Carol Brewer’s Portfolio.)
4
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Carol Brewer’s Investments
Exhibit 1
204-017
Fees for Passive and Active Management
Investment Company
Active Asset Management
State Street Global Advisors Private Asset Management
Asset Requirement
Fee
First $3 million
Next $2 million
1.00%
0.75%
T. Rowe Price Private Asset Management Services
First $2 million
Next $3 million
Over $5 million
1.00%
0.75%
0.50%
The Vanguard Group Asset Management & Trust Services
First $1 million
Next $1 million
Over $2 million
0.65%
0.35%
0.20%
Fidelity Private Portfolio Services
First $.5 million
Next $.5 million
Next $1 million
Next $1 million
1.10%
0.80%
0.70%
0.40%
$2,500
2.00%
$1,000,000
0.65%
Vanguard Capital Value
$3,000
0.42%
Fidelity Advisor Equity Value I
$2,500
0.58%
$10,000
0.16%
T. Rowe Price Equity Index 500 Fund
$2,500
0.35%
The Vanguard Group 500 Index Fund
$3,000
0.18%
Fidelity Blue Chip Growth Fund
$2,500
0.77%
Active Fund Managementa
State Street Research Large Cap Value C
T. Rowe Price Institutional Large Cap Value
Passive Fund Management
State Street Global Advisors S&P 500 Index
Sources: Compiled by casewriter from the following sources: Michael Lindquist , “Re: Private Asset Management,” to
Julia Stevens , May 15, 2003; Sherry Tillett , “Re: Private Asset Management,” to Julia
Stevens , May 13, 2003; “Vanguard Asset Management & Trust Services Fee Schedule,” The Vanguard Group Web site,
, accessed February 21, 2003; “Fidelity FundsManager
Program,” Fidelity Investments Web site, , accessed February 21, 2003;
“Fidelity Advisor Equity Value I,” Morningstar, Inc Web site, , accessed May 23, 2003; “Vanguard Capital Value,” , accessed May 23, 2003; “T. Rowe Price Instl Large Cap Value,”
Morningstar, Inc. Web site, ,
accessed
May
23,
2003;
“State
Street
Research
Lg
Cap
Val
C,”
Morningstar,
Inc.
Web
site,
, accessed May 23,
2003; “SSgA S&P 500 Index,” Morningstar, Inc. Web site, , accessed May 30, 2003; “T.Rowe Price Equity Index 500,” T.Rowe Price Investment Services, Inc. Web site,
, accessed May 16, 2003;
“Vanguard 500 Index,” Morningstar, Inc. Web site,
, accessed May 30, 2003; “Fidelity Blue
Chip Growth Fund,” Fidelity Investments Web site, , accessed
May 16, 2003.
aAsset requirements for Active Fund Management reflect the minimum initial investment. Minimum initial investments for
IRAs and AIPs may differ.
5
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204-017
Carol Brewer’s Investments
Exhibit 2
Marshfield Investment Philosophy
!
We believe that our investment process and the performance it yields distinguish us from comparable
firms. Specifically, our price discipline and patience prevent us from overpaying for a stock and
burdening our performance with good ideas at uneconomic prices. Our willingness to buy out-of-favor
stocks allows us to side-step the market’s group psychology, and our research intensive approach
permits us to engage in an objective analysis in support of those purchases. Concentrated portfolios
allow our best ideas to drive performance, while the impact of our worst is tempered by our price
discipline. We believe that these distinguishing features underlie the excellent performance with low
risk that we have been able to offer our clients over time.
!
Marshfield’s investment philosophy is based on the premise that there are two factors necessary to build
wealth while minimizing the risk of sizable loss. One is to limit investments to companies with
enduring competitive advantages that are difficult to duplicate. The other is to insist on a margin of
safety between price paid and a conservative estimate of what our research indicates a company is
worth. In short, Marshfield focuses on finding built to last companies in high return businesses that are
selling, for temporary reasons, at bargain prices.
!
Marshfield believes that a good company has value-creating and/or cost advantages that are difficult to
duplicate: strong financials; simple clean core values; proven ability to adapt to new circumstances; past
commitments that create unique capabilities; shareholder-oriented management; ample reinvestment
opportunities.
!
Marshfield believes that companies in good businesses have enduring bargaining power relative to
customers and suppliers: barriers to entry are high; product substitution opportunities are low;
competitive rivalry is low.
!
Marshfield believes that bargains occur when the market mistakes the normal ebb and flow of a business
or an adverse event for fundamental adverse changes in business structure and when the market is slow
to perceive significant changes in structure that strengthen a company’s bargaining power.
!
The key common characteristics of Marshfield’s portfolio companies are structure, strategy, and
management. With respect to measures such as capitalization we are largely indifferent, save insofar as
liquidity is implicated. With regard to yield, we are also indifferent, although we prefer to trade yield
for higher investment. With regard to cash positions, we do not attempt to time the market when raising
or employing cash. An account’s cash balance at any point in time reflects a lack of buying opportunities
at bargain prices and the rate of new infusions of cash.
!
Marshfield pursues a concentrated approach to stock holdings, typically holding between 15 and 20
stocks in a mature account. While we do not have inflexible rules about position/sector concentration,
we do not ordinarily invest more than 10% of a portfolio in one security or 40% in one industry sector.
!
By conducting independent research, Marshfield is able to think analytically but creatively, and by
casting ourselves as buy-and-hold owners rather than traders, we are able to find companies that have
enduring value propositions which, in a concentrated long-term portfolio, can provide high returns.
!
With respect to sell discipline: we sell under three conditions: 1. When we make a mistake in our original
purchase decision; 2. When the investment thesis is violated (business structure deteriorates, corporate
strategy changes, etc.); or 3. When good stocks have become so overvalued that there are better
opportunities to conserve capital and increase wealth.
Source: Marshfield company documents.
6
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Carol Brewer’s Investments
Exhibit 3
204-017
Marshfield Core Holdings
Company
Company Description
Berkshire Hathaway Holding company in diverse business activities, including insurance
nationwide and reinsurance worldwide.
Revenuea
($ billions)
Net Profit
Marginb
$42.70
10.00%
CCC Information
Services
Company automates the process of evaluating and settling automobile
claims by integrating information into organized electronic files.
$0.20
11.90%
Citigroup
Diversified holding company that provides financial services to consumer
and corporate customers worldwide.
$92.60
16.50%
Duke Energy
Company provides physical delivery and management of both electricity
and natural gas nationally and worldwide.
$15.70
6.60%
Gannett Inc.
Newspaper publication, broadcasting, and the marketing of commercial
printing, a newswire service, data services, and news programming.
$6.40
18.10%
Leucadia National
Banking and lending, manufacturing, winery operations, real estate
activities, copper mine development, and insurance and reinsurance.
$0.30
54.50%
Markel Corp.
Company markets and underwrites specialty insurance products and
programs to a variety of niche markets.
$1.80
4.30%
Martin Marietta
Materials
Company manufactures chemicals, aggregates used in construction, and
magnesia-based products used in the steel industry.
$1.70
5.10%
Mohawk Industries
Company manufactures carpets and rugs, and manufactures, markets,
and distributes ceramic tile and natural stone in the U.S.
$4.50
6.30%
Odyssey Re
Offers reinsurance and insurance capacity for property and casualty
products to insurance and reinsurance companies worldwide.
$1.70
12.30%
Sealed Air
Company manufactures and sells a range of food, protective, and
specialty packaging products.
$3.20
--
Washington Mutual
Consumer and commercial banking, mortgage lending, consumer
finance, and financial services offices in the U.S.
$1.90
20.50%
Wells Fargo
Diversified financial services company in banking, insurance,
investments, and mortgage and consumer finance worldwide.
$28.50
19.10%
White Mountains
Financial services holding company in property, casualty insurance, and
reinsurance.
$4.20
17.80%
YUM! Brands
Quick-service restaurants including A&W, All-American
Restaurants, KFC, Long John Silver’s, Pizza Hut, and Taco Bell.
$7.80
7.50%
Food
Source: Adapted and compiled by casewriter from “White Mountains Insurance Group,” “YUM! Brands Inc.,” “Washington Mutual Inc.,”
“Berkshire Hathaway,” “Odyssey Re Holding Corp,” “Martin Marietta Material,” “Duke Energy Corp,” “Citigroup,” “Markel Corp.,”
“Wells Fargo & Co,” “CCC Information Services Group,” “Leucadia National Corp.,” “Sealed Air Corp.,” “Mohawk Industries Inc.,”
and “Gannett Co Inc.,” available from Factiva, , accessed June 5, 2003 and
Hoover’s Company Capsule Annual Financials, available by company name from Hoover’s, , accessed
June 6, 2003.
aAnnual revenues for 2002.
bNet
profit margin for 2002. Net profit margin is equal to the total net income divided by revenue,
expressed
as
a
percentage.
7
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204-017
Exhibit 4
Carol Brewer’s Investments
Marshfield Composite Annual Returnsa through December 31, 2003
Date
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Equitiesb
0.1%
34.3%
11.8%
10.5%
4.8%
34.9%
24.8%
30.1%
22.2%
7.0%
17.4%
4.9%
-1.6%
S&P 500
-3.1%
30.3%
7.6%
10.1%
1.3%
37.6%
22.8%
33.4%
28.6%
21.0%
-9.1%
-11.9%
-22.1%
Russell 3000 Valuec
-8.8%
25.4%
14.9%
18.6%
-1.9%
37.0%
21.6%
34.8%
13.5%
6.6%
8.0%
-4.3%
-15.2%
U.S. Treasury Billd
7.8%
5.6%
3.5%
2.9%
3.9%
5.6%
5.2%
5.3%
4.9%
4.7%
5.9%
3.8%
1.6%
Sources: Adapted and compiled by casewriter from Marshfield company documents; “Russell 3000 Index,” Frank Russell
Company Web site, , accessed June 9, 2003; “Russell 3000 Value
Index,” Frank Russell Company Web site, , accessed
June 9, 2003; CRSP® database. (Center for Research on Security Prices, ).
aMarshfield returns are after commissions but before fees.
bIncludes cash to be invested in equities.
cThe Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization,
which represents approximately 98% of the investable U.S. equity market. The Russell 3000 Value Index measures the
performance of those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth values.
dAnnual returns.
8
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Carol Brewer’s Investments
Exhibit 5
Date
JAN-01
FEB-01
MAR-01
APR-01
MAY-01
JUN-01
JUL-01
AUG-01
SEP-01
OCT-01
NOV-01
DEC-01
JAN-02
FEB-02
MAR-02
APR-02
MAY-02
JUN-02
JUL-02
AUG-02
SEP-02
OCT-02
NOV-02
DEC-02
JAN-03
FEB-03
MAR-03
APR-03
204-017
Marshfield Composite Monthly Returnsa Through April 30, 2003
Equitiesb
-2.3%
0.7%
-2.0%
3.7%
1.9%
0.1%
0.6%
-2.9%
-3.3%
3.5%
1.4%
3.6%
0.4%
1.5%
2.2%
2.5%
-0.1%
-5.1%
-2.7%
1.1%
-6.3%
4.2%
3.1%
-1.7%
-2.5%
-2.1%
2.5%
7.4%
S&P 500
4.1%
-9.5%
-7.6%
10.6%
-0.3%
-1.8%
-1.6%
-6.6%
-8.3%
4.5%
4.4%
1.7%
-2.2%
1.0%
1.4%
-5.2%
-4.1%
-6.8%
-8.6%
3.7%
-7.3%
6.4%
3.9%
-5.7%
-2.1%
-2.8%
3.0%
6.9%
Russell 3000 Valuec
0.5%
-2.6%
-3.4%
4.9%
2.3%
-1.8%
-0.4%
-3.8%
-7.3%
-0.6%
5.9%
2.6%
-0.6%
0.2%
4.9%
-2.9%
0.2%
-5.5%
-9.7%
0.7%
-10.8%
7.0%
6.4%
-4.3%
-2.4%
-2.7%
0.2%
8.9%
Sources: Adapted and compiled by casewriter from Marshfield company documents; Datastream International, “Russell 3000
Index,” Frank Russell Company Web site, , accessed June 9,
2003; “Russell 3000 Value Index,” Frank Russell Company Web site, , accessed June 9, 2003.
aMarshfield returns are after commissions but before fees.
bIncludes cash to be invested in equities.
cThe Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization,
which represents approximately 98% of the investable U.S. equity market. The Russell 3000 Value Index measures the
performance of those Russell 3000 Index companies with lower price-to-book ratios and lower forecasted growth values.
9
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204-017
Exhibit 6
Carol Brewer’s Investments
Joint Account Portfolio, March 31, 2003
Security
Cash and Equivalents
Alliance Capital Reserves
Pershing Government Fund
Corporate Bonds
Mattel Inc.
American Express
Accrued Interest
Common Stock
Duke Energy Company
Martin Marietta Materials
Mohawk Industries
Odyssey Re Holdings
Sealed AirCorp.
TJX Companies Inc.a
Washington Mutual Inc.
White Mountains Insurance Group Ltd.
YUM! Brands Inc.
Total Portfolio
Market Value
Percentage of Assets
$ 77,733.63
$
853.64
$ 78,587.27
39.2%
0.4%
39.6%
$ 7,175.77
$ 30,385.76
$
616.09
$ 38,177.62
3.6%
15.3%
0.3%
19.2%
$
$
$
$
$
$
$
$
$
$
11,435.71
9,278.34
3,427.71
7,743.45
2,008.51
6,795.36
17,652.64
14,586.00
8,697.98
81,625.70
5.8%
4.7%
1.7%
3.9%
1.0%
3.4%
8.9%
7.4%
4.4%
41.2%
$198,390.59
100.0%
Source: Adapted by casewriter from Carol Brewer’s personal financial documents. Some numbers have been disguised.
aTJX Companies retailed off-price apparel and home fashions in the United States and worldwide. Marshfield had begun to
purchase stock in TJX Companies Inc. in 2003, in an amount that made it a new core holding.
10
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Carol Brewer’s Investments
Exhibit 7
204-017
Carol Brewer's Portfolio, March 31, 2003
Security
Cash & Equivalents
Alliance Capital Reserves
Pershing Government Fund
Government Bonds
Federal Home Loan Bank
Freddie Mac
Accrued Interest
Common Stock
Berkshire Hathaway Class A
CCC Information Services
Duke Energy Company
Gannett Inc.
HomeFed Corp.a
Leucadia National Corporation
Martin Marietta Materials
Nestle SAb
Odyssey Re Holdings
PepsiCo, Inc.b
TJX Companies Inc.c
Wells Fargo & Company
White Mountains Insurance Group Ltd.
YUM! Brands Inc.
Total Portfolio
Market Value
Percentage of Assets
$ 54,074.79
$ 186,175.33
$ 240,250.12
3.1%
10.7%
13.8%
$ 205,385.98
$ 50,441.02
$
4,708.59
$ 260,535.59
11.8%
2.9%
0.3%
15.0%
$ 91,234.00
$ 62,239.61
$ 51,980.50
$ 110,786.39
$
2,003.14
$ 39,302.21
$ 31,585.84
$ 55,598.40
$ 131,638.65
$ 22,880.00
$ 41,527.20
$ 96,503.55
$ 352,495.00
$ 146,821.82
$1,236,596.31
5.3%
3.6%
3.0%
6.4%
0.1%
2.3%
1.8%
3.2%
7.6%
1.3%
2.4%
5.6%
20.3%
8.5%
71.4%
$1,737,382.02
100.0%
Source: Adapted by casewriter from Carol Brewer’s personal financial documents. Some numbers have been disguised.
aHomeFed Corp. invested in and developed residential real estate projects.
The company was spun off from Leucadia
National Corporation. Marshfield wanted to wait for its value to increase before selling.
bNestle SA was the largest food company in the world in 2003, leading world sales of coffee and bottled water. Pepsico, Inc.
was involved in the snack food, soft drink, and juice businesses. Both companies were formerly core holdings. As both stocks’
prices increased, Marshfield stopped buying them for new accounts and removed them from its list of core holdings.
cTJX Companies retailed off-price apparel and home fashions in the United States and worldwide. Marshfield had begun to
purchase stock in TJX Companies Inc. in 2003, in an amount that made it a new core holding.
11
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Introduction to Cases and Questions
BUS 172A (Investment Analysis)
Description (Warren E. Buffett, 1995; Product number: UV0006-PDF-ENG)
Set in August 1995, enables students to assess Berkshire Hathaway's bid for the 49.6%
of GEICO Corporation that it does not already own. Students perform a simple valuation
of GEICO shares and consider the reasonableness of the 26% acquisition premium.
There are no obvious synergies, and Berkshire Hathaway has announced that it will run
GEICO with no changes. Student analysis can include the investment philosophy and
remarkable record of Berkshire's CEO, Warren E. Buffett.
Description (Carol Brewer’s Investments; Product number: 204017-PDF-ENG)
Following her husband's death in 1994, Carol Brewer took over the management of her
family's investments. This case describes the decisions Brewer made during this
process, including her choice to seek active account management, her selection of an
investment firm, and her determination of asset allocation within her portfolio. In 2003,
Brewer is reassessing her previous investment choices and considering changes she
might need to make in the future in light of her plans to retire in six years and live on the
income from her investments.
Learning objective
(1) Technical skills for active investments (The following is not necessary for passive
investment)
(1-1) Determine and compare the expected returns and required returns, and then
determine if the asset is undervalued or overvalued.
Notice: the case, “GMO-Value versus Growth Dilemma,” already covered this
part. But, the case (Warren Buffett) will reinforce this skill with sensitive
analysis.
(1-2) Determine Intrinsic values – and then determine if the asset is undervalued or
overvalued by comparing with market prices.
(2) Understanding passive versus active investment philosophy
(3) Establishing the statement of your “own” investment philosophy
1
1. Some of required basics to conduct case analysis
< Dividend Discount Model (DDM) as a specific form of discounted cash flow
valuation method >
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 (𝑃0 ) =
𝐷1
𝐷2
𝐷3
𝐷𝑁 + 𝑃𝑁
+
++
+ ⋯+
2
3
(1 + 𝑟)
(1 + 𝑟)𝑁
1 + 𝑟 (1 + 𝑟)
Where Dt and Pt are the divided per share and stock price at t, respectively. The “r” is
the discount rate (required return).
< “Back-Of-Envelope” Method To Expected Return >
STEP 1: With average earnings growth rate forecast tenth year earnings
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 10 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑛𝑜𝑤 × (1 + 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒)10 .
STEP 2: Use the expected P/E in year 10 to estimate the market value of equity in year
10.
𝑃
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑛 𝑦𝑒𝑎𝑟 10 = ( ) × 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑖𝑛 𝑦𝑒𝑎𝑟 10
𝐸
STEP 3: Calculate the annualized CGY for 10 year holding period.
1
Annualized CGY for 10-year holding =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 𝑖𝑛 𝑦𝑒𝑎𝑟 10 10
( 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑒𝑞𝑢𝑖𝑡𝑦 )
−1
STEP 4: Calculate the annualized total yield for 10 year holding period (call it the “longterm expected return”).
Long-term expected return= Annualized CGY for 10-year holding + Dividend yield
2
< The Factors that increase the return on invested capital >
Price premium via competitive
advantage
Innovative products: Difficult to
copy or patented products,
services or technologies
Quality
Brand
Cost and capital efficiency
Customer lock-in
Innovative business method
Unique resources: Advantage
resulting from inherent geological
characteristics or unique access
to raw materials
Economies of scale
Scalable product/process
< Return on Invested Capital >
𝐸𝐵𝐼𝑇(1 − 𝑡𝐶 ) = Net Operating Income After Taxes
= EBIT – Taxes (EBIT = “Operating income” or earnings before interests
and taxes.
= EBT + Interests - Taxes
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑅𝑂𝐼𝐶) =
𝐸𝐵𝐼𝑇(1 − 𝑡𝐶 )
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
= [𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡 − 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ − 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠] + 𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚 𝑎𝑠𝑠𝑒𝑡𝑠
OR
= 𝐿𝑜𝑛𝑔𝑡𝑒𝑟𝑚 𝐷𝑒𝑏𝑡𝑠 + 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ
Notice
For GEICO, sum up “Cash” and “Accrued investment income” to determine Excess
cash. See Appendix.
3
2. Directions
Read the case thoroughly.
There are directions in each question. Strictly follow them.
When reporting the case analysis, clearly specify which number of
question you are answering to.
Due date: July 11th (Tuesday)
Submit a hard copy in class and a soft copy on Canvas
Max points with optional questions = 240 points.
Max points without doing optional questions = 200 points.
3. Questions for case analysis
(1) Determining over-/under-valuation via interpreting market’s reaction
[ Before the acquisition announcement, the stock price of Geico was $55.75. The
acquisition price was $70. The number of shares of Geico that Warren Buffett
had already have in his firm was 34.25 million; and by acquisition Geico was
about to become a part of Berkshire Hathaway (BH), meaning the market value
of Geico’s 67.9 million shares outstanding was going to be added into BH’s
market value. The case shows on page 1 that the market value of BH went up by
$718 million on the acquisition announcement.
]
With the facts describe in [ ], we want to determine whether the market thought
that Geico’s stock had been undervalued before announcement or not, i.e., the
intrinsic value (at the time of announcement) that market thought was greater
than the before-announcement price of $55.75 or not.
Purpose: Developing the ability to interpret and quantify the reactions by the
market.
Direction: You have to use the market reaction (a rise by the amount of $718
million) to back out the intrinsic value from the facts in [ ]. Do What was the
intrinsic value if Geico’s stock that the market thought of? Use the following
4
equation to determine the intrinsic value “P.” Also Do state why the equation
makes sense to determine the intrinsic value from the market’s reaction.
$718 𝑚𝑖𝑙𝑙𝑙𝑖𝑜𝑛 = 34.25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × ($70 − 55.75) + 67.9 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × (𝑃 − $70)
Also Do by comparing the interpreted intrinsic value “P” with the beforeannouncement price of $55.75, determine whether Geico’s stock had been
undervalued or overvalued.
Also Do by comparing the interpreted intrinsic value “P” with the acquisition
price of $70, determine whether Warren Buffet was over paying premium or not.
(2) Determining over-/under-valuation via past IRR compared with opportunity cost
It is well known that Warrant Buffett detects unrevealed potentials of investments.
If the latent potentials are realized and publicly known, then the value of assets
go up. In other words, he has a talent to find out undervalued investments. One
possibility why he thought Geico had been undervalued is his experience with
investments in Geico stock he had made from 1976. He had purchased 34.25
million shares for $45.7 million. (This implies the per share price was about
$1.334 in 1976). Let’s simplify the situation assuming there was one time
purchase of 34.25 million shares for $1.334 per share in 1976 and no purchases
until the acquisition that occurred in 1995. With the 34.25 million share purchase,
he got dividend income stream as shown in Exhibit 8. Assume that Geico’s 1994
year-end market price was $51.25 (See Appendix).
Purpose: Developing the ability to determine under-/over-valuation by comparing
estimates of past IRR and required return (or opportunity cost).
Direction
Do Determine the annualized internal rate of return using the data in Exhibit 8
and the initial buy cost and the end price. And, determine and report the annual
capital gain yield and dividend yield, respectively. Recall chapter 7.
Also Do Answer: based on the realized IRR from this past investment in
Geico, was Geico adequately considered undervalued before acquisition? To
answer this question, compare the IRR with the required return on the Geico’s
equity as given on page 9.
Also Do Answer: Warren Buffett does not believe in the required return via the
CAPM. Since he said he tried to meet a 15% return on any investments (see
page 9), use this value as the opportunity cost in his mind. Then, by comparing
the IRR and this opportunity cost, was Geico well considered undervalued?
(3) Determining over-/under-valuation via using “Value Line” information
The case provides the information of Value Line’s forecasts of Geico dividends
and price. See Table 1.
5
Purpose: Developing the ability to determine under-/over-valuation by comparing
market price and estimates of intrinsic value
Direction
The discount rate of Geico’s stock was given in the case. In this case, the
discount rate was fixed. Do Use the concept of dividend discount model
(DDM) to determine the intrinsic value (for this, you will have the lower estimate
of intrinsic value and the higher estimate of intrinsic value.) Also do Answer:
do you think the before-announcement Geico stock was considered
undervalued?
(4) Determining over-/under-valuation via using “Value Line” information
The case provides the information of Value Line’s forecasts of Geico dividends
and price. See Table 1.
Purpose: Developing the ability to determine under-/over-valuation by comparing
estimates of future IRR and required return
Direction
Do use the data in Table 1 and the before-announcement price of $55.75 as
the potential buy cost (under no premium) to determine the annual IRR for each
of high and low ends of range, respectively.
Also do Answer: based on the estimated future IRR, was Geico adequately
considered undervalued before acquisition? Your answer should be separate for
each of high and low ends of range, respectively.
Try to understand why to use the before-announcement price instead of the bid
price ($70) for this. It is because the purpose now is to determine whether the
stock was undervalued or not by comparing with the required return.
--Now, we want to determine whether the bid price of $70 is an overpayment or
not. If it was an overpayment, then the net present value from the acquisition is
theoretically negative. Or, equivalently, if that was an overpayment, then the IRR
with the bid price ($70) as the buy cost will be lower than the required return
(11%).
Do Use the data in Table 1 and the bid price of $70 as the buy cost (which
included the premium) to determine the cost-embedded annual IRR for each of
high and low ends of range, respectively.
Also do Answer: based on the estimated cost-embedded IRR, determine
whether Warren Buffett was overpaying for the acquisition of Geico or not. Your
answer should be separate for each of high and low ends of range, respectively.
(5) Determining over-/under-valuation via using the Dividend Discount Model
We want to use the pure two-stage DDM to determine the intrinsic value instead
of using the Value Line’s forecasts. The case provides the information about past
dividend payment in Exhibit 8.
Purpose: Developing the ability to determine under-/over-valuation by comparing
market price and estimates of intrinsic value
6
Direction
Do First determine annual dividend growth rates using the data in Exhibit 8.
Then, determine the average annual dividend growth rates using only the last 5
years (with the end year 1994). And then use the value as the annual growth rate
of dividend to forecast future dividends till 2005. The terminal year is 2005. Since
then, the long-term growth rate is assumed to be 5.4%. Caution: the appendix
shows that the annual dividend for year 1995 was actually $1.08 per share.
Hence, use $1.08 for year 1995 and recursively forecast until 2005. For example
the forecasted dividend for year 1996 is (1 + 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒) × $1.08. And the
dividend for year 1997 is (1 + 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒)2 × $1.08.
Use the two stage DDM to determine the intrinsic value. The estimation of
intrinsic value is as of the end of 1995. Caution: do not include the dividend of
year 1995 in the intrinsic valuation. Also do Answer: do you think the beforeannouncement Geico stock was considered undervalued?
(6) Determining over-/under-valuation via using the Dividend Discount Model
We want to use the pure two-stage DDM to determine the future IRR. The case
provides the information about past dividend payment in Exhibit 8.
Purpose: Developing the ability to determine under-/over-valuation by comparing
estimates of future IRR (via dividend stream) and required return
Direction: Use the forecasts of dividend you constructed for the question (5).
Do Use the before-announcement price of $55.75 as the potential buy cost
(under no premium) to determine the annual IRR. Caution: the estimation of IRR
is as of the end of 1995. Hence, do not include the dividend of year 1995 in the
determination of IRR. Also do Answer: do you think the before-announcement
Geico stock was considered undervalued? You have to compare the IRR with the
required return.
(7) Determining over-/under-valuation via the “Back-of-Envelope Method to
Expected Return”
The Geico’s earnings per share (EPS) for year 1995 is shown in the Appendix.
With the stock price of the year end, the P/E ratio in 1995 was around 19.
Assume that the P/E ratio of 19 will remain until 2005 (for 10-year holding
period). Assume that the growth rate of EPS is equal to the average growth rate
of dividends that estimated for question (5).
Purpose: Developing the ability to determine under-/over-valuation by comparing
estimates of future IRR (via the Back-of-Envelope Method) and required return
Direction:
Do First, determine the EPS for year 10 (year 2005) [STEP 1]. And then do
the [STEPS 2 and 3] as shown in this guide. And then for [STEP 4] use the
dividend yield that you found for question (2) and determine the total yield (IRR).
Also Do Answer: based on the Back-of-Envelope IRR, was Geico considered
undervalued before acquisition?
7
Also Do Answer: Warren Buffett does not believe in the required return via the
CAPM. Since he said he tried to meet a 15% return on any investments (see
page 9), use this value as the opportunity cost in his mind. Then, by comparing
the IRR and this opportunity cost, was Geico well considered undervalued?
(8) Summarize the investment philosophy of Warren Buffett and Carol Brewer (via
her Asset Manager) in terms of asset selection (value versus growth), asset
allocation, portfolio management, and so on. Do they have any common
investment philosophy?
o Limit answer into a full one page with single space.
[Optional Questions – Max Extra Points: 30]
(9) Determine the Geico’s return on invested capital for year 1995? Recall that the
historical median ROIC of US companies has been 10% ~ 13% with the recent
value of 13%? (See the Lecture note for chapter 13).
o Limit your answer into less than a half page.
(10)
What potentials of competitive advantages and cost efficiency did Geico
have? Do you think the potentials could improve the ROIC of Geico and make it
stable over time? Did Geico have any characteristics that Warren Buffett liked?
What were they?
o Limit answer into less than one page with single space.
(11)
In the perfectly efficient market, the expected returns are always equal to
the required returns, and hence there are no undervalued or overvalued assets.
If we strongly believe this, then what is the typical steps/investment philosophy
for investment decisions? (Recall what you learned especially from chapter 1, 6
and 7)
Direction
o Limit answer into a full one page with single space.
o Must include the terms such as market efficiency, asset allocation, returnrisk tradeoff, holding period, diversification, market portfolio (and/or index
funds, index ETFs), CML, risk-free assets (and/or money market funds),
expected returns, required returns, risk, and so on.).
(12)
In the imperfectly efficient market, the expected returns are not always
equal to the required returns, and hence there can be undervalued or overvalued
8
assets. If that always bothers you, then what is the typical steps/investment
philosophy for investment decisions? (Recall what you learned especially from
chapter 1, 4, 6, 7 and 13)
Direction
o Limit answer into no less than one page with single space.
o Must include the terms such as expected returns, required returns, risk,
undervaluation, overvaluation, alpha, style, size (small, large), valuation
(value, growth), holding period, and so on.)
(13)
Imagine that your group is an incorporated, professional asset
management company. What is the statement of investment philosophy of your
company?
Direction
o Limit the statement into full one page with single space.
[Optional Question – Max Extra Points: 10]
(14)
Summarize the supporting facts for your investment philosophy that you
learned into no less than 90 bullet points. Single space. Below are some
examples.
Over the long term, stocks have historically outperformed all other
investments.
Risky assets generally pay more than safe assets.
The stock market is semi-strong form efficient.
Value stocks historically outperformed growth stocks on average.
….
9
Appendix
GEICO’S Financial Statements For Year 1995
https://www.sec.gov/Archives/edgar/data/277795/0000277795-96-000001.txt
Item 5.
Market for the Registrant's Common Equity and
Related Stockholder Matters.
The following table shows the quarterly high and low
prices for the Common Stock, as published in the tabulation of New
York Stock Exchange Composite Transactions. The table shows
dividends paid to shareholders of record in each quarter of 1995
and 1994.
Dividends
1995
High
Low
Paid
Fourth quarter
Third quarter
Second quarter
First quarter
70
68 7/8
59 3/8
51 1/8
68
54
49
47
1994
High
Low
Dividends
Paid
Fourth quarter
Third quarter
Second quarter
First quarter
51
51
57
57
49
47 5/8
49 5/8
51 1/8
$ .25
.25
.25
.25
1/4
1/2
5/8
1/2
1/4
1/2
1/2
5/8
10
$ .27
.27
.27
.27
GEICO CORPORATION
CONSOLIDATED BALANCE SHEETS
December 31, in thousands of dollars
1995
ASSETS
Investments:
Fixed maturities available for sale,
at market
U.S. Treasury securities and obligations
of U.S. government corporations and
agencies (amortized cost $922,574
and $873,440)
$ 955,230
Obligations of states and political
subdivisions (amortized cost $2,513,537
and $2,343,200)
2,592,202
Corporate bonds and notes (amortized
cost $89,040 and $105,523)
91,759
Redeemable preferred stocks (amortized
cost $41,257 and $41,259)
41,570
3,680,761
Equity securities available for sale,
at market
Common stocks (cost $477,462 and $534,370)
Nonredeemable preferred stocks (cost
$15,975 and $22,591)
Short-term investments
Total Investments
Cash
Accrued investment income
Amounts receivable from sales of securities
Premiums receivable
Reinsurance receivables
Prepaid reinsurance premiums
Deferred policy acquisition costs
Loans receivable, net
Federal income taxes
Property and equipment, at cost less
accumulated depreciation of $120,638 and
$113,612
Other assets
Total Assets
11
954,813
1994
$
842,086
2,292,622
97,554
37,863
3,270,125
759,791
16,248
971,061
22,917
782,708
341,325
50,033
4,993,147
4,102,866
50,339
69,974
280,018
125,660
7,988
73,984
11,339
-
27,580
67,255
2,022
238,653
127,189
10,361
72,359
59,448
98,975
146,317
36,739
141,741
49,656
$5,795,505
$4,998,105
1995
1994
LIABILITIES
Policy liabilities:
Property and casualty loss reserves
$1,872,037 $1,704,718
Loss adjustment expense reserves
340,008
307,606
Unearned premiums
813,726
747,342
Life benefit reserves and policyholders' funds
112,970
101,298
3,138,741
2,860,964
Debt
434,444
391,378
Amounts payable on purchases of securities
1,518
8,408
Federal income taxes
49,409
Other liabilities
302,945
291,414
Total Liabilities
3,927,057
3,552,164
SHAREHOLDERS' EQUITY
Common Stock - $1 par value,
150,000,000 shares authorized, 71,680,609 and
71,565,359 shares issued and 67,534,733 and
68,291,463 shares outstanding
71,681
71,565
Paid-in surplus
176,058
169,084
Unrealized appreciation of investments
389,722
91,167
Retained earnings
1,505,419
1,330,022
Treasury Stock, at cost (4,145,876 and
3,273,896 shares)
(212,816)
(167,115)
Unearned Employee Stock Ownership Plan shares
(61,616)
(48,782)
Total Shareholders' Equity
1,868,448
1,445,941
Total Liabilities and Shareholders' Equity$5,795,505$4,998,105
12
CONSOLIDATED STATEMENTS OF INCOME
For the year ended December 31, in thousands
of dollars except per share results
1995
1994
1993
REVENUE
Premiums
$2,787,011$2,476,276 $2,283,488
Net investment income
Realized gains on investments
Interest on loans receivable
Other revenue
226,804
21,587
3,704
14,909
Total Revenue
201,790
12,898
10,347
14,698
201,851
120,584
11,519
20,858
3,054,015 2,716,009
2,638,300
2,244,398 1,996,518
1,821,783
BENEFITS AND EXPENSES
Losses and loss adjustment expenses
Life benefits and interest on
policyholders' funds
Policy acquisition expenses
Other operating expenses
Impact of premium refunds
Interest expense
9,798
213,081
244,074
34,365
Total Benefits and Expenses
2,745,716 2,464,815
Net Income Before Income Taxes
Federal income tax expense
Net income before cumulative effect of
changes in accounting principles
Cumulative effect of changes in
accounting principles:
Postemployment benefits, net of tax
Income taxes
Postretirement benefits, net of tax
Net Income
8,573
200,044
231,984
27,696
$
13,521
197,545
213,555
(6,699)
19,975
2,259,680
308,299
60,675
251,194
42,379
378,620
92,193
247,624
208,815
286,427
-
(1,051)
-
247,624$
207,764 $
$3.66
$2.98
(8,814)
(3,935)
273,678
EARNINGS PER SHARE
Net income before cumulative effect of
changes in accounting principles
Cumulative effect of changes in
accounting principles
Net Income
$3.66
13
(.01)
$2.97
$4.01
(.18)
$3.83