Oct 182011

Recently there has been a great deal of concern about Europe’s debt problems as well as the risk of a double dip recession in the U.S. The 2007 – 2009 financial crisis has resulted in a very slow economic recovery from the most severe recession, in both length of time and depth of decline, since the 1930’s.

Despite the outlook for relatively weak economic growth in the near future, the performance of the stock market in 2011 may outperform the current expectations of many based on historical precedent – namely, the “Presidential Cycle.”

A table on page 2 of the 2010 Berkshire Hathaway Annual Report (BRK.A), (BRK.B) displays a series of annual returns to the S&P 500 (including dividends). Over the 46 year period from 1965 – 2010 shown on this table, the compounded annual return to the S&P 500 has equaled 9.4%. However, in the 8 instances over this time period, in the third year of a president’s first term, the average annual total return to the S&P 500 has equaled 27.5%, with a range from 18.2% in 1979 to 37.6% in 1995. In the three cases of a Democrat in the White House (Johnson 1967, Carter 1979, and Clinton 1995) the average gain for the third year of their presidency was 28.9%. With Republicans in the White House (Nixon 1971, Ford 1975, Reagan 1983, George H.W. Bush 1991, and George W. Bush 2003) the average gain was 26.7%.

Is this observation just a statistical oddity, or is there a good explanation? One possible explanation of the “third year effect of a presidential cycle” is the desire of the incumbent to be re-elected. Since the state of the economy on election day is a major determinant of whether an incumbent president keeps his job, a stimulative fiscal policy (and frequently an accompanying stimulative monetary policy) can be expected. This is currently the case. Since the stock market forecasts future economic conditions, it would not be too surprising to see it rise in the year before the President seeks re-election. The S&P 500 through October 14, 2011 is down 2.6% year to date, while the Dow Jones Industrial Average is up 0.6%. If the above trend is to continue in 2011, which is the third year in President Obama’s first term, then the stock market would be expected to do very well over the remaining 75 days of 2011.

This article has been published by Seeking Alpha:


 Posted by at 8:30 am
Oct 072011

During his visit to the Robert H. Smith School of Business (University of Maryland) on September 26, 2011, Mike Campbell, CFO of GEICO, answered numerous questions by undergraduate finance majors relating to GEICO and the automobile insurance industry.

Mr. Campbell mentioned that GEICO is the third largest automobile insurer in the U.S. with a 9% market share.  State Farm is the largest with an 18% – 19% market share, followed by Allstate (ALL) in second place with a 10.5% market share.  There are 400 companies that sell automobile insurance in the U.S., although many of them sell insurance in only one state.  GEICO has been adding policyholders (customers) at a rate of 7% or 8% per year.  They currently have over 10 million customers and have added about 700,000 –  800,000 customers in the past year.  The U.S. automobile insurance market is growing by only 1% per year.  Therefore, GEICO’s growth is coming primarily from attracting new customers from its competitors through its advertising campaigns and lower prices.  In 1995, a year before GEICO was acquired by Berkshire Hathaway (BRK.A, BRK.B), it spent $30 million on advertising.  Currently, GEICO is spending $900 million per year on advertising, with its Gecko and Caveman commercials being very popular and well known.    People who switch to GEICO save 15% or more on their car insurance.   GEICO is not currently considering any expansion outside the U.S. and is focused on continuing to grow their U.S.  market  share.

GEICO spends more on advertising than its competitors.  One primary target is the 20-29 year old age group, since GEICO hopes to keep this age group as customers for many years.   There are three segments in the automobile insurance market:  preferred risk, standard risk, and high risk drivers.  Policy premiums are set in proportion to the level of risk.  Due to the cost of acquiring new policyholders, these customers need to be retained for at least 3 – 4 years for them to be profitable.  However, they might shop for lower premiums more often.  If rates change by a significant amount, customers are more likely to shop for lower premiums. Therefore, GEICO tries to keep its prices low and raise them by smaller amounts as necessary.

GEICO typically earns a 5 – 6% profit margin on its policies (premiums minus claims expenses and administrative costs).  Only two years in the last 15 did GEICO have an underwriting ratio exceeding 100%. (Claims and expenses exceeding premiums.)    However, there are catastrophes from time to time resulting in very large claims and there is a lot of variability in year to year results.  Gasoline price increases may at times be changing driving behavior resulting in policyholders driving fewer miles and, therefore, there are fewer accidents and lower claims.  GEICO uses a direct sale model primarily via the Internet and phone with salaried employees.   Inflation in wage costs will put upward pressure on expenses.  State Farm, by contrast, primarily uses an agency model where commissions are paid as a percentage of premiums.  Recently consumers have become more price sensitive because of the weak economy and, as a result, have been doing more shopping for lower rates.  This has created additional opportunities for GEICO to capture market share.  Allstate uses an agency model for most of its business, but recently purchased Esurance, which is a relatively small direct seller of insurance over the Internet.  One of GEICO’s goals is to be the number one Internet technology company in the automobile insurance industry.

Customers tend to shop for automobile insurance when they buy a new car, get married, or move to another State (with different rates and regulations).  This presents opportunities for GEICO to take customers away from its competitors.  GEICO is the largest automobile insurer in New York City with over a 25% market share.  It is also the largest in New Jersey, Connecticut, and Washington, DC.  GEICO’s opportunities to add market share are very large, since it controls only 9% of the market and, therefore, there is the remaining 91% of the market that they can compete for.  There is also a surprisingly large percentage of drivers in the U.S. who do not have automobile insurance, even though it is mandatory to have it in each State.

Warren Buffett, the CEO of Berkshire Hathaway, visits GEICO twice a year.  He encourages GEICO to continue to spend more on marketing where there are opportunities to gain customers at an acceptable cost, and he asks frequent questions about Internet technology and the sale of automobile insurance policies.  GEICO currently represents about 12 – 15% of Berkshire Hathaway’s revenues and profits, but those percentages change over the years as Berkshire acquires additional companies.   Berkshire Hathaway currently has $40 – $45 billion in cash and cash equivalents, with GEICO holding about $10 billion of that total.  A large part of GEICO’s equity portfolio was managed by Lou Simpson until his retirement at the end of 2010.  GEICO has a $22 billion investment portfolio (cash equivalents, stocks and bonds).  Recently hired Todd Combs is currently managing part of that portfolio along with Warren Buffett.  If GEICO was a standalone company, it would rank around number 160 – 170 (by revenues) in the Fortune 500.  GEICO’s cash equivalents are primarily invested in short term Treasury securities at a yield of less than 0.05%.  When interest rates move up, GEICO’s interest income would rise accordingly.  They need to put these funds somewhere, and because regulations restrict their choices, there are no other  practical places to invest these sums.

GEICO does relatively little outside hiring at senior levels of management.  The company promotes from within.  Many senior executives have 35 – 40 years of service at GEICO.  Mike Campbell has been with GEICO for 29 years.  The CEO of GEICO, Tony Nicely, has been with the company for 50 years.  To compensate for any lack of “new or fresh ideas” as a result of the paucity of recently hired “outside” senior managers, GEICO pays careful attention to what its competitors are doing and to what other leading non-insurance businesses are doing especially in the areas of technology and customer service.

GEICO’s rapid growth and profitability is providing a steady and strong contribution to shareholder value at Berkshire Hathaway.

 This article has also been published by Seeking Alpha:


 Posted by at 1:36 pm