To get back to our examination of GEICO: There are at least four factors that could account for the increased costs we experienced in obtaining new business last year, and all probably contributed in some manner.
First, in our advertising we have pushed “frequency” very hard, and we probably overstepped in certain media. We’ve always known that increasing the number of messages through any medium would eventually produce diminishing returns. The third ad in an hour on a given cable channel is simply not going to be as effective
as the first.
Second, we may have already picked much of the low-hanging fruit. Clearly, the willingness to do business with a direct marketer of insurance varies widely among individuals: Indeed, some percentage of Americans ¾ particularly older ones ¾ are reluctant to make direct purchases of any kind. Over the years,however, this reluctance will ebb. A new generation with new habits will find the savings from direct purchase of their auto insurance too compelling to ignore.
Another factor that surely decreased the conversion of inquiries into sales was stricter underwriting by GEICO. Both the frequency and severity of losses increased during the year, and rates in certain areas became inadequate, in some cases substantially so. In these instances, we necessarily tightened our underwriting standards.
This tightening, as well as the many rate increases we put in during the year, made our offerings less attractive to some prospects.A high percentage of callers, it should be emphasized, can still save money by insuring with us. Understandably, however, some prospects will switch to save $200 per year but will not switch to save $50. Therefore, rate increases that bring our prices closer to those of our competitors will hurt our acceptance rate, even when we continue to offer the best deal. Finally, the competitive picture changed in at least one important respect: State Farm ¾ by far the largest personal auto insurer, with about 19% of the market — has been very slow to raise prices. Its costs, however, are clearly increasing right along with those of the rest of the industry.
And, when a company is selling a product with commodity-like economic
characteristics, being the low-cost producer is all-important.
In 2000, we sold nearly all of our Freddie Mac and Fannie Mae shares, established 15% positions in several mid-sized companies, bought the high-yield bonds of a few issuers (very few — the category is not labeled junk without reason) and added to our holdings of high-grade, mortgage-backed securities. There are no “bargains”
among our current holdings: We’re content with what we own but far from excited by it.
Many people assume that marketable securities are Berkshire’s first choice when allocating capital, but that’s not true: Ever since we first published our economic principles in 1983, we have consistently stated that we would rather purchase businesses than stocks. (See number 4 on page 60.) One reason for that preference is
personal, in that I love working with our managers. They are high-grade, talented and loyal. And, frankly, I find their business behavior to be more rational and owner-oriented than that prevailing at many public companies.
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush ¾ and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.
Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.
Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component ¾ usually a plus, sometimes a minus ¾ in the value equation.
Alas, though Aesop’s proposition and the third variable ¾ that is, interest rates ¾ are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in
relation to value. (Let’s call this phenomenon the IBT ¾ Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a wellfounded positive conclusion. But the investor does not need brilliance nor blinding insights.
Now, speculation — in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it — is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.
At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it. Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”). Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.
Lately, the most promising “bushes” have been negotiated transactions for entire businesses, and that pleases us. You should clearly understand, however, that these acquisitions will at best provide us only reasonable returns. Really juicy results from negotiated deals can be anticipated only when capital markets are severely
constrained and the whole business world is pessimistic. We are 180 degrees from that point.
At Berkshire, full reporting means giving you the information that we would wish you to give to us if our positions were reversed. What Charlie and I would want under that circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business.
We would expect both a lot of financial details and a discussion of any significant data we would need to interpret what was presented.
When Charlie and I read reports, we have no interest in pictures of personnel, plants or products. References to EBITDA make us shudder ¾ does management think the tooth fairy pays for capital expenditures? We’re very suspicious of accounting methodology that is vague or unclear, since too often that means management
wishes to hide something.
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