Bookworm: Buy and hold inspiration from an unlikely source

One of my favourite things about living in Sydney are the street libraries and book exchanges dotted around the suburbs. My local ferry wharf has a supersized one, so every few weeks I’ll drop by to see if there’s anything interesting in the business and finance section.

A couple of visits ago I found a “must borrow”. The widely acclaimed, often derided value investing opus. The book that Warren Buffett recommends every investor should read. The big dog. The Intelligent Investor.

Naturally, my thoughts turned to which insight I would highlight in this column. I landed on the very last thing written by Graham in my edition – and perhaps the most surprising pages in the whole book.

Today’s insight

In a departure from everything you thought you knew about Ben Graham, his post-script to the Intelligent Investor talks about where most of the returns generated for members of Graham’s investment partnership actually came from.

You might expect they were come from ‘rinsing and repeating’ Graham’s deep value approach. From buying stocks below liquidation value and selling when the valuation became less depressed. You would be wrong.

The lion share of Graham-Newman’s profits came from just one buy and hold investment. To be more accurate, they came from an initially dirt-cheap stock that turned into a multi-decade growth company.

That company was GEICO, a then-small auto insurer that would become one of the largest companies of its kind in the US. It is now housed within Warren Buffett’s Berkshire Hathaway conglomerate, as one of its major pieces no less.

“The profits accruing from this single investment decision far exceeded the sum of all the others realised through 20 years of wide ranging operations”

Most un-Graham like

The purchase of GEICO was classic Graham. His firm bought a 50% stake in the business below the liquidation value of its assets. But this is where the similarity with Graham’s usual approach would end.

Unlike most of Graham’s investments, GEICO was not sold after its stock rose considerably above asset value. In fact, most of the position was held despite market prices shooting far beyond what Graham and his partners in the fund considered reasonable levels.

“Almost from the start, the quotation appeared much too high by our partners’ usual standards” Graham writes. “But since they regarded the company as a kind of family business, they continued to maintain a substantial holding”.

Graham and his partners are often seen as the bastions of rational investment. Of having a set process and sticking to it. And yet, his best ever investment came from breaking that process for what Graham hints were irrational and maybe even sentimental reasons.

Perhaps he was just being modest.

After all, it’s not like Graham-Newman were your average run-of-the-mill outside investors in GEICO. They had a privileged insight into how things were going, what with their 50% ownership and Graham’s position as Chair of the board.

One of Graham’s key learnings from the GEICO experience also surprised me:

“One lucky break or one supremely shrewd decision - can we really tell them apart? - may count for more than a lifetime of journeyman efforts...”

When you think about it, this lines up with a lot of studies on stock market returns over long time periods: a tiny percentage of the stocks account for the vast majority of the overall market’s return. Why should it be any different for investors running a portfolio of stocks?

This is often used as one of the strongest cases for investing in index tracking funds instead of picking stocks. For buying the haystack rather than looking for the needle, as they say. What if you don’t pick (and hold on to) a GEICO?

By and large, though, this column is for those who are interested in stock-picking. So how might you pick one?

Decoding GEICO

Reverse engineering huge winners like GEICO comes with a large and unavoidable side of survivorship bias. But I keep coming back to the same two qualities exhibited by many of these companies.

1. A substantial growth runway

Over time, company valuations are underpinned by earnings and expectations of how those earnings can grow. Ideally you want a company that has clear tailwinds for growing these earnings over many years.

In GEICO’s case, there have been two obvious tailwinds at the industry level: US population growth and an increasing number of vehicles.

In 1948, the year Graham-Newman invested, the US had 146 million people according to data from Demographia and roughly 280 vehicles per thousand people according to data from the US Department of Energy. By 1973, the year this edition of the Intelligent Investor was written, the US had 211 million people and 615 vehicles per thousand people.

Those were big tailwinds at the industry level for GEICO, but they mean nothing unless you have the next quality as well.

2. A strong and durable competitive position

GEICO was different to most auto insurers in that it did not rely on external agents to sell policies. Instead, it had its own sales force and went direct to consumer. Not needing to pay commissions to brokers gave GEICO a distinct cost advantage over its peers.

Among other things, this meant it could offer cheaper premiums to drivers without taking on more underwriting risk. It also freed up more money for advertising, the costs of which were fractionalised over a larger and larger revenue base as it grew.

Other firms would eventually follow GEICO, but its competition at the time were largely tied to the old and more expensive way of doing things. Agents owned a lot of their customer relationships, and cutting them out would be problematic.

Despite these advantages, GEICO’s journey to being one of the US’s biggest auto insurers wasn’t pretty at times. In fact, in the mid seventies – yes, just after this edition of the Intelligent Investor was written – it almost went bankrupt.

Nonetheless, my rather obvious point about long-term business growth stands. Most of the really big winners over time have come from having a strong competitive position in an industry that had plenty of room to grow volume or pricing over time.

Just focus on buying?

I think the most remarkable thing about Graham’s investment in GEICO is the number of times they could have easily justified selling it.

More generally, it always amazes me how easily the gains forgone by exiting one big winner too early can overpower the benefits of ‘locking in a profit’ dozens of times elsewhere. This rings true in my own portfolio, where I have previously calculated that selling Texas Pacific Land in 2021 cost me an amount equal to 25% of my entire balance at the end of 2024.

While I am obviously scarred by that experience, I do wonder if it is just easier to ignore selling altogether and focus purely on buying well. By which I mean buying good companies with favourable long-term prospects at a good price and in a reasonably diversified manner.

This minimises the number of decisions you are forced to make later – decisions that could have a ruinous impact on compounding in your portfolio, even moreso when you consider the impact of capital gains tax and potential reinvestment risk.

Taking such an approach would also, one would hope, sharpen your focus on what makes it in to your portfolio in the first place.

My colleague Mark LaMonica wrote about the potential power of buy and hold investing here. He has also written about some options for when a stock becomes a bigger percentage of your portfolio than you may be comfortable with. You can find that article here.