When Warren Buffett invests in a business model innovation

Warren Buffett is famous for his non-investment in technology innovations. I wrote about it two years ago in Warren Buffett and disruptive innovation and again last year on his non-investments in two companies: Intel and Microsoft. This may give an impression that Buffett does not invest in innovations. And that is not true. In fact, at one point, Buffett invested three quarters of his portfolio in a single tiny company with less than one percept market share touting business model innovation. This investment in a company called GEICO turned out to be a jewel in the crown for Buffett over the decades. How did Buffett, averse to investing in technology innovations, fall for a business model innovation? Let’s explore it in this article.

It was Fall 1950 and Buffett was 20 years old. It had already been nine years since Buffett purchased his first stock at age 11 and four years since he started filing income tax return. He had come to New York City from a mid-western city of Omaha to study at Columbia, more specifically under Graham and Dodd, the authors of “The Intelligent Investor”. The book got published just a year ago in 1949 and Buffett already knew it by heart. Before Graham’s seminar, Buffett was studying everything about Graham and his method of investing. Through Moody’s manual he discovered that Graham and Newman Corporation, Graham’s fund, owned fifty five percent of an insurance company called GEICO – Government Employee Insurance Company. What was this GEICO? Buffett got curious. So on a cold wintry Saturday morning a few weeks later, he jumped on the earliest train Washington D.C. and showed up at GEICO’s door.

There was no one around. Buffett asked the guard whether anyone was there who might explain GEICO’s business to him. He made sure to mention that he was a student of Ben Graham’s. Fortunately for Buffett, the guard took him upstairs to Lorimer Davidson, GEICO’s financial vice president. Davidson thought to himself, “Being a pupil of Ben’s, I would give him five minutes and think him, find a polite way of sending him on his way.” He told the guard to show Warren in.

Davidson recalls, “After about ten to twelve minutes of his questions, I realized I am talking to a highly unusual young man. He was asking questions like an experienced insurance stock analyst”. Buffett recalls, “I just kept asking questions about insurance and GEICO. He didn’t go to lunch that day – he just sat there and talked to me for four hours like I was the most important person in the world. When he opened that door to me, he opened the door to the insurance world”.

GEICO sought to make the auto insurance cheaper by marketing through the mail without an agent. That was a revolutionary concept at the time. To avoid risky drivers, the company decided to sell insurance to only government employees because they tended to be law-abiding. And there were a lot of them. Buffett was amazed by what he learned from Davidson. GEICO was growing so fast that he felt confident of being able to predict what it would be worth in a few years. On that basis, it was cheap.

That Monday, less than forty eight hours after he arrived back in New York, Buffett dumped stocks worth three quarters of his growing portfolio and used the cash to buy 350 shares of GEICO. When he mentioned this to the most prominent brokerage firms specializing in insurance, they thought Buffett was nuts.

Perhaps this is no different from Bill Gates feeling in 1991 that Microsoft is the best stock to invest. Buffett would call it – using “circle of competence” to valuate a business potential and assess “Margin of safety” in its purchase price. Question is: do you see how the idea is working today and how it will work tomorrow?

(source: The Snowball by Alice Shroeder).