John Huber's  Instablog

Geico is a company that is owned by Warren Buffett's Berkshire Hathaway. It's an incredibly interesting company to study. I recently read an outstanding presentation on the company by David Rolfe of Wedgewood Partners. This post is my take... a short summary of the story of GEICO from the notes of that presentation. I recommend studying the presentation for more details on the company itself-I learned a lot by doing so. It's a great case study. Now... for the story, and the broader lesson....

Throughout its 80 year history, GEICO has dominated the car insurance industry by directly selling insurance to consumers at a lower cost than its competitors. This business model was laughed at in its early years, as analysts said GEICO could never compete with the larger insurance firms and their armies of sales agents. But GEICO did compete, took market share, and grew and grew and grew.

But the reason the company is a fascinating case study is that it made a fortune for both Ben Graham and Warren Buffett. Not only that, but GEICO, for most of its storied history, was considered a high flying expensive growth stock. Buffett occasionally got interested in growth businesses, more so as his career evolved, but Graham was basically allergic to stocks selling for high price to earnings ratios or high price to book ratios.

So it was ironic that Graham ultimately made far more money in this single GEICO investment than all of the other investments he made during the course of his lengthy career... combined. It was also strange that Graham invested nearly 25% of his partner's capital into GEICO in 1948, acquiring 50% of the growing enterprise for the small sum of just $712,000. This would eventually grow to over $400 million 25 years later!! That is a 500 bagger. To make an understatement: For a guy who made a living hitting base hits, this was a home run.

Around this same time, a young 21 year old Warren Buffett became interested in GEICO after learning that Graham was chairman of the board. Buffett famously took the train to DC on a cold winter Saturday morning and luckily met Lorimer Davidson, an executive at GEICO who spent 4 hours with this "highly unusual young man".

Buffett began buying stock the next Monday after being "more excited about GEICO than any other stock in my life". He put 65% of his small fortune of $20,000 (the initial seedlings that would grow into his massive fortune). He also tried to sell the stock to every one of his clients, and wrote this excellent research report called The Security I Like Best.

So GEICO caused Graham to put 25% of his capital into the business when no other security ever represented more than 5% of his well diversified portfolio. And it caused a young Buffett to put the majority of his capital into the stock, also violating his mentor and role model's investment policy.

But it paid off for both, although much more for Graham, as Buffett sold the stock after a small gain to invest in even more undervalued securities (Buffett would later regret this decision as his initial $13,000 investment would have grown to $1.3 million in just a few short years).

My own investment strategy much more resembles the methodical, statistical approach that Graham and Walter Schloss (and an early Buffett) used to produce consistent returns than the present day Buffett and many of the Buffett followers. Buffett is an anomaly in that his judge of business and people (management) is unparalleled. This gives him a huge edge. He sees intangibles and is able to quantify those intangibles and deduce them down to actionable pieces of information that in turn helps him determine value. It's based on his lifetime of learning, reading, and experience, and just raw talent.

This is a tough thing to master-the qualitatives. Many try, but end up hugging the index because they buy these great companies at just mediocre prices and thus get average results... the stocks of the companies end up producing great results-high returns on capital and large profits, but because of the valuation paid by these investors, the shareholders returns are inferior to the splendid business results.

So the first thing I always try to do is be careful not to overpay for great businesses. I'm not Buffett, and I don't try to be. I love great businesses, but I don't want to overpay. So that leaves me buying cheap stocks, and methodically grinding out investment profits in the style of Graham and Schloss, which is something I enjoy doing very much.

However.... here is the lesson: while it's a prudent and safe strategy to methodically invest in a diversified basket of undervalued stocks-- that is, to invest in value stocks, sell them as they approach fair value, and reinvest profits into further undervalued stocks-- it is also prudent to be alert and always prepared for an opportunity to hit the home run ball.

Buffett hit a lot of home runs during the course of his career. Graham hit one. Buffett's a home run hitter. He's Barry Bonds (without the steroids). Ben Graham is Tony Gwynn. Tony never hit more than 17 home runs in his hall of fame career, and he hit more than 10 home runs in just 5 out of his 20 years that he played. But after batting .289 in his rookie year, he batted over .300 in 19 consecutive years, including .394 in 1994. Gwynn had an incredible career batting average of .338, and he got on base nearly 4 out of every 10 times he stepped to the plate. That's a lot of value. And that's what Graham did. Methodically hit base hit after base hit. But always be prepared for opportunity when it comes.

I'll end the post with one of my favorite passages from The Intelligent Investor, (which was also featured in the Rolfe presentation I linked to above):

We know very well two partners who spent a good part of their lives handling their own and other people's funds in Wall Street. Some hard experiences taught them it was better to be safe and careful rather than to try to make all the money in the world. They established a rather unique approach to security operations, which combined good profit possibilities with sound values. They avoided anything that appeared overpriced and were rather too quick to dispose of issues that had advanced to levels they deemed no longer attractive. Their portfolio was always well diversified, with more than a hundred different issues represented. In this way they did quite well through many years of ups and downs in the general market; they averaged about 20% per annum on the several millions of capital they had accepted for management, and their clients were well pleased with the results.

In the year in which the first edition of this book appeared an opportunity was offered to the partners' fund to purchase a half-interest in a growing enterprise. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company's possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.

In fact it did so well that the price of its shares advanced to two hundred times or more than the price of the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners' own investment standards. But since they regarded the company as a sort of "family business," they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates.

Ironically enough, the aggregate of profits accruing from this single investment-decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners' specialized fields, involving much investigation, endless pondering, and countless individual decisions.

Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money on Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision - can we tell them apart? - may count for more than a lifetime of journeyman efforts. * But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplines capacity. One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them.

"If you want to have a better performance than the crowd, you have to do things differently from the crowd." - John Templeton

The above quote is one of my all time favorites. It's a ubiquitous concept: we hear it all the time.... buy what others are selling, buy fear, sell euphoria, etc... The quote represents obvious importance. But the interesting thing is that although it's an oft used phrase, it is practiced much less often than you might realize. Taking a look at the portfolios of most large investment funds, you'll find many of the same securities. Some of this has to with the size of some of the funds. If you manage $10 billion, there are only so many stocks you can buy, especially if you have to be diversified.

However, a lot of the similarities come from the fact that it is hard to go against the crowd. It's hard to buy unknown stocks, and it's especially hard to buy hated stocks with well-known problems. This is difficult for everyone, amateurs and professionals alike. It's even difficult for value investors. Many of the value investors today model their portfolios and their investment philosophies after Warren Buffett (for good reason). I also spend an incredible amount of time thinking about Buffett and his methods, and studying his letters. But here is a challenge that we have to overcome: Buffett preaches the benefits of franchise businesses that can compound their net worth over time (for good reason).

The problem is this: everyone understands the fact that it's a good thing to own a business like that. Thus, the stocks of these businesses are often priced at a premium. Take a look at JNJ, MCD, WMT, KO, or PG just to name a few... these are some of the greatest companies in the world. They almost certainly will have wonderful futures and their stocks will likely be higher years down the road. These stocks are great in permanent portfolios, but I don't expect them to provide market beating returns over time at the current valuations. They likely will provide market matching returns with less risk, but they won't give you 20% annual returns over time.

This doesn't necessarily make them bad long term investments. I simply keep them on a list and observe their valuations during market corrections. I love buying and holding a quality business when the market offers me a price that will lead to above average future returns. But buying and holding a diversified basket of average priced (or in this current market-often overpriced) franchise businesses will not lead to significant long term outperformance. It might lead to moderate outperformance, but it won't lead to huge returns.

So if you want abnormal returns, you have to do something differently: you either have to concentrate your holdings like Buffett has done during the course of his career (or like Allan Mecham, when he put 50% of his assets into BRK last year-what a great decision that was at $105K per share)... or, if you want to maintain at least adequate diversification like I prefer, you have to buy stocks that others are selling at cheap valuations. This often means buying cheap stocks with problems. And it's difficult to do because there are hundreds of reasons why you shouldn't buy the stocks you're buying and there are many people who will call you crazy.

Take a look at the comments in any bullish Seeking Alpha article on JC Penney. You'll find extreme emotion. When people begin hurling insults at an author who merely suggests a contrarian view, it often means that the bad news is already priced into the stock. (I don't necessarily know about JCP specifically, but this is just a good example of maximum pessimism at the present time).

I often comment on how Buffett made 50% per year at the beginning of his career when he was managing a small sum of just his own capital. He also guaranteed he could do that today if he were managing a small sum. I'm sure Buffett could do that as well. He doesn't say things like that if he doesn't believe it. But the key to that now famous remark is this: he wouldn't be buying the same stocks he's buying now if his goal was 50% per year. Not even close.

His portfolio may have contained a few big positions in some great companies, but it also would have likely had numerous smaller positions in stocks trading at extremely cheap valuations. His portfolio would also be turning over much faster (he wouldn't be holding stocks forever, and he didn't hold stocks forever in his early years-he sold them as they reached fair value to raise cash to invest in more bargains).

To look at a great example of a current investor who thinks differently and also is generous enough to share his ideas, check out Reminiscences of a Stock Blogger. His portfolio is filled with smaller companies, many of them in the natural resource space (the author is Canadian). His portfolio looks a lot different than mine, but it also looks a lot different than everyone else's also. That's the key. He thinks independently, and he buys cheap stocks. Notice how it's worked out for him so far since he's been tracking his results.

Other famous examples of investors who thought and acted differently were Buffett in his early years, Walter Schloss throughout his career, Joel Greenblatt, and Michael Burry. They all owned stocks that others either hated or didn't even know about. They found bargains in a variety of areas using a number of different methods. But the one thing they had in common in addition to buying value was that they thought differently than the crowd. They wanted a better performance from the crowd, and they knew to do so, they had to act differently as well.

Templeton would have approved...

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Steven Romick is an outstanding investor with a long history of beating the market in the FPA Crescent Fund. Romick is an absolute value investor with a broad investment mandate. He invests in a variety of asset classes including stocks and bonds, but also alternative assets such as farmland and real estate.

Romick is a smart guy, and you can learn a lot by reading his letters and watching his interviews. He's different from most value investors because he willing to invest across capital structures, across asset classes, and across geographic boundaries. He's a "go-anywhere" investor, but at his foundation, he's an absolute value investor. As he says in the interview below, he's just looking to find bargains, wherever they are.

Here are just a few of the highlights from the interview with Steve Forbes:

• He's a contrarian. He invests all over the world, but he sums up his philosophy by asking "Where is the bad news?"
• He doesn't care for the Fed's monetary policy. Quantitative Easing is forcing people to accept more risk to get an acceptable return.
• He wants a margin of safety with all of his investments. "Prepare for the worst, hope for the best."
• Buy farmland over gold ("farmland is edible gold"). He doesn't know how to value gold, but farmland will benefit from the same reasons that gold will benefit (inflation), but it also is a play on emerging economies. Plus, farmland produces a yield vs gold that has no yield.
• He discusses his thesis on a variety of his holdings. He commented on one stock we own, which is Microsoft. He says MSFT is priced as if the future will be bleak… it's priced for no growth.

I always try to take one thing away from each thing I read or watch that might help me improve my own investing. There are a number of things to take away from this video, but one thing that I found interesting was his answer to Steve Forbes' question that was basically, 'why do you think Microsoft will do well in the future'? Romick's answer was:

"I don't know that it will. But it's priced as if it won't."

He caps it off by reminding us that "Good things happen to cheap stocks". This is important to remember as a value investor, as the stocks we invest in usually have problems, often significant problems in the underlying business. But this is what causes them to be cheap, and sometimes unduly cheap, thus offering an opportunity to make money. But the real benefit comes when/if the business itself does better than what the majority expect, which happens more often than most investors realize.

This "positive surprise potential" is an added benefit to owning unloved stocks, and it's what Romick is referring to when he says "good things happen to cheap stocks".

Watch the entire video here.

Disclosure: I am long MSFT.