The secret of Warren Buffett's success at Berkshire Hathaway

It's not all just about being a megabrain stock-picker

Secret number 2: Leverage

It's all about who has leverage...

The second point that can be found in Buffet's letter is closely linked to the first. Essentially, it is that the very existence of that vast float provides leverage. Sure, Buffett's a great stock-picker. But pretty much the first thing that Berkshire Hathaway did buy was an insurance company. And so instead of investing whatever capital it actually had, it was now investing the float of that insurance company, something many times larger than its original capital. This has been studied in detailed economic terms:

Berkshire’s more anomalous cost of leverage, however, is due to its insurance float. Collecting insurance premia up front and later paying a diversified set of claims is like taking a “loan.” Table 3 shows that the estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate. Hence, Buffett’s low-cost insurance and reinsurance business have given him a significant advantage in terms of unique access to cheap, term leverage. We estimate that 36% of Berkshire’s liabilities consist of insurance float on average.

Leverage, on its own, just isn't enough. Because if you gain leverage you need to do that by going out and borrowing money. But obviously, if you're going to borrow money then you're going to pay the market rate for it. Meaning that you're back at position 1, having to outperform the market in order to beat what everyone else is doing, which is borrowing money to provide leverage.

However, you can then become really clever and work out a way of borrowing money at below the normal market rate. If, just as an example, I had to borrow money to go and buy bonds ─ that would make me like a bank: I've got to pay out interest in order to have the money that buys me something that pays me interest. Great, people do do this.

But they don't make above market average profits doing this (and of course there are times when they lose bucketloads). Now imagine if I were a bank that can make its own money which I can then use to buy things that pay me interest. Because I've made the money I don't have to pay interest on it, but I'm lending it out at that lovely interest. This in fact makes me a central bank and this is exactly what the Federal Reserve and the Bank of England have been doing with quantitative easing. And they've been making vast fortunes doing exactly this, $40bn a year or so for the Fed.

Pretty good work if you can get it. And Buffett has been getting it. His financing costs from that float are not zero, but they are below market. Thus his returns, even if his investment performance only matches the market (ie, he's not in fact beating the market over the decades in violation of the efficient-market hypothesis) will be above market.

Buffett has always said that he's just following the investment precepts of a bloke called Benjamin Graham. And there's very definitely an element of that in his performance. He really is a good stock-picker and there's absolutely no doubt that he would be a very rich man today after his stock-picking of the past 50 years. However, what has vaulted him into the stratosphere of, in various years, vying with Carlos Slim and Bill Gates for richest man alive is the other side of the business. Buy an insurance company (and then many more such insurance companies) in mildly uncompetitive markets and then invest the float. That way you get both leverage and below market financing costs.

It is extremely clever, there's no doubt about it, but it's not necessarily a performance that is replicable. Why? Simply because all too many people now know how it was done and thus insurance companies tend not to be cheap enough to make it work these days.

Hats off to Buffett and Munger for spotting it and making it work, but it's really not all about their being perfect stock-pickers at all, there's much about it that comes from working out how to get that leverage at below market prices. For note that point in that second quote. Their financing costs are below the T-bill rate. That means they're borrowing to invest at rates lower than government does. So much so that they could have just invested that float in T-bills, no risk at all, and have been making good profits. ®