The Boring Portfolio, Dec. 2, 1998

<THE BORING PORTFOLIO>
Our First Research Project
Berkshire Hathaway

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Dec. 2, 1998) -- Our First Research Project is Berkshire Hathaway (NYSE: BRK.A and BRK.B)

Like a toddler lurching forward, taking its first steps, or a foal arising for the first time on spindly legs, we embark today on our first research project on a prospective acquisition for the Boring Portfolio. What is it that intrigues us about Berkshire? Is it the reputation of legendary businessman Warren Buffett, the company's Chairman and CEO? Is it that we want a mutual fund of Nifty Fifty stocks and that we couldn't care less about the other parts of Berkshire? Do we buy into the Buffett mystique and want to pay a premium to net asset value for this closed-end mutual fund?

These are all strawman sorts of questions for us. They're pretty easily knocked down, but they're also rolled out by the financial press in attempting to sum up what it will become upon the closing of its merger with General Re -- the publicly traded company with the second-highest amount of equity capital in the world. We'll deal with these questions in our look at the company because people will probably be wondering about them.

That's pretty amazing considering there are no major sell-side firms covering this company and the mentions of Berkshire that do appear in the news are more like something that you would see on Entertainment Tonight than in serious news reports. Make no mistake about it, this company is not the mutant freak that it's portrayed to be in the news. It is different, though.

What the Company Does

Berkshire is a diversified holding company with interests in the insurance and reinsurance, flight training and ships' captains training, aircraft leasing services, media, furniture and home furnishings retailing, jewelry retailing, shoes manufacturing, quick-serve restaurant franchising, and confections. Among the insurance segment, we can further break down the company into: supercatastrophe, property & casualty, credit, life, commercial trucks and truckers, public auto, special types, garage and dealer, prize indemnification, general liability, and inland marine cargo.

The largest member of the Berkshire Group of insurance companies, by premium volume, is GEICO Direct Auto Insurance, a company that was built on the proposition that government employees are safer drivers and thus better risks. Thus the acronym that stands for Government Employees Insurance Company. The company was also built on the proposition that direct marketing would save on overhead, giving the company a competitive advantage over other insurance underwriters that used the traditional agency distribution channel.

When people say such-and-such a company is the "Dell Computer of industry X," one could correctly substitute GEICO in that sentence. Dell is the GEICO of the PC industry, and Amazon.com is the GEICO of the book retailing industry. To sharpen the point I'm making just a bit, GEICO is the low-cost leader in auto insurance and thus has quite a competitive advantage over other companies.

At this point, GEICO has about 3.85% of the U.S. auto insurance market (my estimate, using an A.M. Best midyear report and annualizing GEICO's Q3 earned premiums). Here's an interesting thing about GEICO: It's TOO PROFITABLE. How many times do you see that said about a company? Not too often. But from this year's 10-K:

"GEICO's underwriting performance during 1997 was exceptional and better than its pricing targets. Generally, the results produced by the industry with respect to private passenger auto insurance during this period have been good as well. GEICO has taken certain rate reductions in 1997 and will take further rate reductions in 1998 to adjust its rates to its pricing targets. Premium rates are also subject to downward pressure through competition and through the ordinary rate regulation processes of state insurance departments. In addition, while the level of claim costs (including catastrophe losses) in 1997 and 1996 have been relatively low, there is no assurance that these favorable conditions will continue. Accordingly, management expects that GEICO's underwriting profit margins will return to more normal levels as losses increase faster than premiums. Notwithstanding, Berkshire's management believes that GEICO's underwriting results will remain better than industry averages."

Once again, in the third quarter, the company missed its profit targets:

"Policy growth over the past twelve months was 15.7% in the preferred-risk auto business and 38.6% in the standard and non-standard auto lines. The in-force policy growth resulted from GEICO's ongoing marketing efforts and competitive prices. It is expected that voluntary policies in-force will continue to grow at the same or greater annual rates over the remainder of 1998 and into 1999. Premium rate reductions were taken in certain states during 1998 with the intention of better aligning premium rates with profit targets. Such reductions will be fully reflected in premiums earned over the next twelve months and are expected to reduce profit margins."

Think for a moment how many GEICO ads you see. Since the majority of GEICO that was not owned by Berkshire was acquired by Berkshire in 1996 (the merger was agreed to in 1995), the company's marketing message has become almost ubiquitous. You can't escape it. Sorry about that. We shareholders don't mind it, though.

More on Berkshire on Friday. One housekeeping note, though. As we start off with out look at Berkshire, it occurs to me that we should explain briefly how we will go about our decisions on a company once we've completed our initial research on it. Unlike the other portfolios in the Fool besides the DRiP portfolio, we tell you what we're looking at while we're looking at it and open up the process as we do so. We don't tell you we're going to buy something and then buy it.

As an extension of that, the natural end to some of the research will be that we won't like the results. The company under review wouldn't be attractive to us at any price other than "ridiculously cheap." And that's not really our game, anyway, so in effect, there are some companies we won't like at any price. Very often, though, there will be companies that we like at a certain price that happens to be below the current market price. We believe that buying beneath intrinsic value is as important to returns as the quality of the business.

To generate super-normal returns on equity, you can do a number of things. You can buy great companies and hope the intrinsic growth of those companies will be enough. Or you can buy great companies below their intrinsic value and look for the market price to catch up to the intrinsic value of the company as well as gain from the intrinsic growth of the company. To use the second allows a margin of error, because we're not always going to be correct on the intrinsic growth of a business. As I've said, we like to shoot for the middle of the green rather than challenge the pin on every approach.

Anyway, the upshot of this will be that we'll do often do research on companies and then come to the conclusion that the price isn't attractive to us. However, you get periods such as this October, the fall of 1990, July of 1996, or March of 1997 (not to mention some of the really ugly periods in market history) that take down the price of things you like. In such instances, the market will offer you the easy 4-foot putt straight uphill for the birdie. Lately, most of the putts have been 60-foot double-breakers on Augusta National-like greens.

Also, industry-specific or company-specific short-term problems can come along that don't really effect the long-term economics of a business but that cause short-term drops in the company's stock price. In the short-term, there are a lot of things that can cause prices to drop. If we've done our research correctly, then we can be prepared to act quickly during those periods. When we have completed research on a company but don't like the price that the market is offering, we'll just set it aside and keep an eye on it. So don't be surprised when we pull that out of the woodwork. In this we differ in method and ideology from other portfolios run by Fool managers.

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Stock  Change    Bid
ANDW  +  1/8   16.31
BGP   -  13/16 22.19
CSL   +  7/16  44.38
CSCO  -1 1/2   78.25
FCH   +  1/8   23.69
PNR   -  3/16  37.50
TBY   -  3/8   7.25

                   Day   Month    Year  History
        BORING   -1.12%  -0.54%  -2.60%  22.56%
        S&P:     -0.34%   0.65%  20.69%  88.42%
        NASDAQ:  -0.43%   2.34%  27.05%  91.67%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     78.25   226.65%
  2/28/96  400 Borders Gr    11.26     22.19    97.11%
  8/13/96  200 Carlisle C    26.32     44.38    68.57%
  4/14/98  100 Pentair       43.74     37.50   -14.27%
  5/20/98  400 TCBY Enter    10.05      7.25   -27.82%
  11/6/97  200 FelCor Sui    37.59     23.69   -36.98%
  1/21/98  200 Andrew Cor    26.09     16.31   -37.48%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  17606.25 $12216.26
  2/28/96  400 Borders Gr  4502.49   8875.00  $4372.51
  8/13/96  200 Carlisle C  5264.99   8875.00  $3610.01
  4/14/98  100 Pentair     4374.25   3750.00  -$624.25
  5/20/98  400 TCBY Enter  4018.00   2900.00 -$1118.00
  1/21/98  200 Andrew Cor  5218.00   3262.50 -$1955.50
  11/6/97  200 FelCor Sui  7518.00   4737.50 -$2780.50

                             CASH  $11273.22
                            TOTAL  $61279.47