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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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Page 16
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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