Warren Buffett The Geico Years: The Snowball Part III

Berkshire Hathaway B shares Warren BuffettBy Mark Hirschey (Work of Mark Hirschey) [CC BY-SA 2.0], via Wikimedia Commons

Warren Buffett The Geico Years: The Snowball Part III

Compounding

If you have to make it simple, Warren Buffett is in the compounding business. That is what he has done since he was a young boy. He started with selling gum. He moved on to working inside the family firm.

Once his father moved onto DC as an idealistic Congressman, Buffett had a paper route, and as his assets began to grow, he bought a farm and other assets.  He was always trying to grow his net worth.  That is a constant with Buffett – he has always tried to grow his net worth.

By the time he linked up with Ben Graham, there were still a lot of “cigar butts” to pick up and puff.  In that era compounding was easy because the post-depression competition was so low in stock-picking.

But by the late 1960s almost all of the ‘cigar butts” had been picked up and smoked.  Easy pickings were gone, and Buffett was saddled with an unproductive textile company – Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B), and a mediocre-to-bad department store in Baltimore.

He decreased the activities of the textile company, and reinvested the free cash flows predominantly into insurance, including buying half of GEICO.

(As an aside, Buffett was not a great manager of insurance companies at the beginning, and even the middle.  His early companies had their issues.  Jack Byrne did well running GEICO, followed by Tony Nicely.  Buying Gen Re was a mistake, at least initially – he bought something so complex, and he assumed that all would be fine, setting himself up for losses in the derivative book, and also in the casualty book, where they were reinsuring losses to avoid accounting issues.)

Then came the era of investing permanent capital, where he bought the “sainted seven,” and they produced profits for him.  He made more money off his public equity investments in the era of the 80s & 90s, but in short order thereafter it shifted.  Berkshire Hathaway was no longer an investment company akin to a closed end fund or a business development company – it was a full-fledged conglomerate.  That’s how we should think of it today.  Berkshire Hathaway is a conglomerate that gets a lot of its funding from insurance premiums.

He occupies a unique niche in business.  He will acquire entire firms that are attractive to him, does not change their underlying culture, and rarely if ever sells them.  This appeals to entrepreneurs who built a unique culture, and love their employees.  They will sell to Buffett, because alternative acquirers very likely would destroy the employees and culture for the sake of short-term gain.  Buffett is focused on the long run, and is willing to let a subsidiary underperform for a while, before he sends in additional management to sort things out.

On Buffett’s Wisdom

Buffett has a tremendous memory. He knows all manner of statistics regarding industry, which informs him in his investment decisions.  That is one reason why he makes so many wise decisions.

But another area of Buffett’s wisdom was against the Efficient Markets Hypothesis.  Whether in his debate against Michael Jensen in 1984, which helped to produce the article, “The Superinvestors of Graham and Doddsville [PDF, 13 pages],” or in his annual shareholder letters, that risk is not volatility – risk is the permanent impairment of capital.

If you work with a margin of safety, and buy companies that will produce free cash flow, and can grow free cash flow, you will be safer than most investors, and probably more successful as well.

I’ll finish up this review tomorrow.

By David Merkel, CFA of Aleph Blog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.