Much has been written about the investing methodology of Warren Buffett, yet most did not touch on one of the most important strategy : Using leverage!
It was only recently that there has been discussions about this, and an article in Forbes on this strategy. You can read this article
titled "Explaining The Secret Of Warren Buffett's Success: Double
Leverage" at this URL:
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Explaining The Secret Of Warren Buffett's Success: Double Leverage
The Economist has a nice piece detailing a good half of Warren Buffett’s incredible investment
success over the past 50 years. It is, as I have long maintained, because he is
running an insurance company. Yes, he’s clearly a great investor, there’s no
doubt about that. But his outperformance comes from his being able to finance
his investments from within the premium pool of those insurance
companies:
Without leverage, however, Mr Buffett’s returns would have been
unspectacular. The researchers estimate that Berkshire, on average, leveraged
its capital by 60%, significantly boosting the company’s return. Better still,
the firm has been able to borrow at a low cost; its debt was AAA-rated from
1989 to 2009.
Yet the underappreciated element of Berkshire’s leverage are its insurance
and reinsurance operations, which provide more than a third of its funding. An
insurance company takes in premiums upfront and pays out claims later on; it
is, in effect, borrowing from its policyholders. This would be an expensive
strategy if the company undercharged for the risks it was taking. But thanks to
the profitability of its insurance operations, Berkshire’s borrowing costs from
this source have averaged 2.2%, more than three percentage points below the
average short-term financing cost of the American government over the same
period.
If
you can borrow below market and make only market returns then you’re going to
outperform the market in your returns on equity.
And this really is the great big
secret about insurance companies. To some extent they’re really just large
investment funds that happens to run insurance premiums through their books. It
depends which specific insurance market you’re in but you might get to hang on
to those premiums for a few months or a few years. And the real profit in the
business (to the point that it’s not unusual at all to see an insurance company
making a loss on the actual insurance and underwriting side of the business)
comes from the performance of that investment fund. By the time you get to
being a reinsurance company (which Berkshire
Hathaway also is) you
might hang on to the premiums for a decade or more. Making the performance of
the investments really just about the only thing that matters to the company.
That’s one form of leverage that
Buffett has used. The other is that he went and bought an insurance company or
three in the first place. He made good money as an investor first, yes, he very
much did. Which he then used to purchase his way into the insurance business.
He then applied his investment technique, as the Economist describes it, to the
much larger investment funds that the insurance company controlled. Those funds
being a good multiple of the funds that it had cost to purchase the company.
Imagine, just as a made up numerical
example, that Buffett outperformed the market every single year by 1%. Another
made up number, he started with $1 million. He’s going to, over the decades,
make himself a very rich man that way. But look at it this way: if he uses the
$1 million to purchase control of an insurance company with $10 million to
invest, then he gets that 1% outperformance on that $10 million, then he’s
going to be making himself richer ten times faster than by not leveraging up by
buying the insurance company. For of course the outperformance in the
investments flows to those who own the insurance company.
As I say, these are entirely made up
numbers. But the basic point is true. Buffett’s superb investment record
obviously and clearly depends upon making the right investments at the right
time. But it’s also been hugely helped by that double leverage. Borrowing by the company itself and
being able to fund investments at less than market cost. Then the second level
of leverage, the very purchase of the insurance companies in the first place.
It’s been a stunning performance over the decades, most certainly. But the
sheer size of it has indeed been based on those two pieces of leverage.
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