warren e. buffet (presentation)

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Warren E. Buffet Financial Management Class - Group 1

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Page 1: Warren e. buffet (presentation)

Warren E. Buffet

Financial Management Class - Group 1

Page 2: Warren e. buffet (presentation)

GEICO Acquisition

August 25, 1995 Warren Buffet, CEO of Berkshire Hathaway acquire 49.6 % of GEICO Corporation.

The $2.3 billion deal would give GEICO shareholders $70.00 per share, up from the $55.75 per share market price before the announcement. Give 26 % premium than market price.

Page 3: Warren e. buffet (presentation)

Warren E. Buffet

One of richest individuals in the world (about $7 billion)

MBA from Columbia University, developing the philosophy of value-based investing. He chided business schools for the irrelevance of their theories of finance and investing.

Page 4: Warren e. buffet (presentation)

Questions

What were the key principles that guided Buffet ?

Could these be applied broadly in the late 1990s and into the 21st century, or were they unique to Buffet and his time ?

Under what assumptions would this 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 investment in Salomon Brothers, USAir, and Champion International ?

Page 5: Warren e. buffet (presentation)

Berkshire Hathaway, Inc.

1889 – Berkshire Cotton Manufacturing incorporated and become one of New England’s biggest textile producers. Market share 25% of country’s cotton textile production.

1955 – Merged with Hathaway Manufacturing. Declining because inflation, technological change and competition from foreign competitors.

1965 – Buffet and some partners acquired control of Berkshire Hathaway.

1985 – Exited the textile business. And purchase two insurance companies : National Indemnity Company and National Fire & Marine Insurance Company.

Page 6: Warren e. buffet (presentation)

Berkshire Hathaway, Inc.

1994 – Berkshire Hathaway described itself as “a holding company owning subsidiaries engaged in a number of diverse business activities.”

1995 – Astonished most observers. Closing share prices in 1977 was $ 89.00. On August 25, 1995 the closing share prices was $ 25,400.00. Standard & Poor’s 500 index grew from 107 to 560.

Page 7: Warren e. buffet (presentation)

Berkshire Hathaway’s Businesses Portofolio

•Insurance Group. The largest component of Berkshire’s portofolio focused on property and casualty insurance, on both a direct and reinsurance basis.• 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 confectionery products.• Childcraft and World Book. A publisher and distributor of encyclopedias and related educational and instructional material.• Campbell Housefeld. A manufacturer and distributor of air compressors, air tools, and painting systems.

Page 8: Warren e. buffet (presentation)

Berkshire Hathaway’s Acquisition Policy

We are eager to hear about businesses that meet all of the following criteria :1. Large purchases (at least $10 million of after-tax

earnings).2. Demonstrated consistent earning power (future

projections are of no interest to us, nor are “turnaround” situations).

3. Businesses earning good returns on equity while employing little or no debt.

4. Management in place (we can’t supply it)5. Simple businesses (if there’s lots of technology,

we won’t understand it).6. An offering price (we don’t want to waste our time

or that of the seller by talking, even preliminary, about a transaction when the price is unknown).

Page 9: Warren e. buffet (presentation)

Buffet’s Investment Philosophy

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.Accounting was conservative, backward looking, and governed by GAAP (Generally Accepted Acoounting Priciples). Investment decisions, on the other hand, should be based on the economic reality of a business where intangible assets such as patents, trademarks, special managerial know-how, and reputation might be very valuable.

2. The cost of the lost opportunity. Buffet compared an investment opportunity against the next best alternative, the so-called “lost opportunity.” In his business he choices “either/or” decision rather than “yes/no” decision.

3. Value Creation : time is money. Buffet assessed intrinsic value as the present value of future expected performance.

4. Measure performance by gain in intrinsic value, not accounting profit. The gain in intrinsic value was analogous to “economic profit” and “market value added.”

Page 10: Warren e. buffet (presentation)

Example 1 : Value Creation

Assume :• 5-year investment horizon, when you liquidate at “book” or

accumulated investment value• Initial invetment is $50 million• No dividends are paid, all cash flows are reinvested• ROE = 20%• Cost of equity = 15%

Year 0 1 2 3 4 5Book Value 50 60 72 86 104 124Market Value (or Intrinsic Value) = PV @ 15% of 124 = $61.65

Market/Book = $61.65/50.00 = 1.23

Value created : $1.00 invested becomes $1.23 in market value.

Page 11: Warren e. buffet (presentation)

Example 2 : Value Destruction

Assume :• 5-year investment horizon, when you liquidate at “book” or

accumulated investment value• Initial invetment is $50 million• No dividends are paid, all cash flows are reinvested• ROE = 10%• Cost of equity = 15%

Year 0 1 2 3 4 5Book Value 50 55 60 67 73 81Market Value (or Intrinsic Value) = PV @ 15% of 81 = $40.30

Market/Book = $40.30/50.00 = 0.80

Value destroyed : $1.00 invested becomes $0.80 in market value.

Page 12: Warren e. buffet (presentation)

Buffet’s Investment Philosophy (Continue)

5. Risk and discount rate. Conventional academic and practitioner thinking held that the more risk one took, the more one should get paid. Buffet define risk in different way, he using dictionary terms, as “the possibility of loss or injury.” His firm used almost no debt financing. He focused on companies with predictable and stable earnings.

“ 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.”

6. Diversification. Buffet disagree with conventional wisdom that investors should hold a broad portofolio of stocks in order to shed company specific risk.

“ 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.”

Page 13: Warren e. buffet (presentation)

Buffet’s Investment Philosophy (Continue)

7. Investing behavior should be driven by information, analysis, and self-discipline, not by emotion or “hunch.”

“ Anyone not aware of the fool in the market probably is the fool in the market.” 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. Buffet style : Strategy of patient and long-term investing,

8. Alignment of agents and owners. Explaining his significant ownership interest in Berkshire Hathaway, Buffet said. “I am a better businessman because I am an investor. And I am better investor because I am a businessman.” Every senior manager have shares in Berkshire, or were compensated under incentive plans.

Page 14: Warren e. buffet (presentation)

GEICO Acquisition History

1976 – Berkshire Hathaway began purchasing shares in GEICO.

1980 – Berkshire Hathaway had accumulated a 33 % shares for $ 45.7 million

1995 – 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.

Page 15: Warren e. buffet (presentation)

Why GEICO ?

1. The firm was the seventh largest auto insurer in the United States, underwriting policies for 3.7 million cars.

2. The firm’s senior managers were “extraordinary” and had an investment style similar to Buffett’s. These managers would add depth to Berkshire Hathaway’s senior management bench and provide continuity in case anything happened to Buffet (age 65) or Munger (age 72).

3. The firm was the lowest-cost insurance provider in the industry.

Page 16: Warren e. buffet (presentation)

Conclusion

What were the key principles that guided Buffet ?A : There are 8 philosphy for Buffet’s investment

Could these be applied broadly in the late 1990s and into the 21st century, or were they unique to Buffet and his time ?A : The fact is Buffet still one of richest man in the world. Off course these can applied until 21st century.

Under what assumptions would this acquisition make sense ?A : Buffet believe in stable earnings and business growth. And GEICO shows it.

What were Buffett’s probable motives in the acquisition ?A : GEICO was the sevent largest auto insurance, have good management and the lowest cost auto insurance.

Would the acquisition of GEICO prove to be a success ?A : Yes in the 1994 revenue from insurance was $1.4 billion and in 2004 revenue from GEICO only $9.2 billion (wikipedia.org).