A recent report by Yale University researchers argues that there are two reasons why Buffett outperforms the market:
1. He gains the advantage of leverage by using the cash generated by the various insurance companies owned by Berkshire Hathaway and;
2. He buys ”safe” quality stocks with low beta ratings at cheap prices.
The report credits him with being a good stock picker but asserts that, without the leverage of the insurance company funds, Buffett would be a great investor, but not the legend that he is. It also concludes that Berkshire Hathaway is an Alpha investment company with a high beta factor.
The report is well worth reading in full. It is however highly mathematical and needs to be read with an understanding of basic terms and the ways that insurance companies generate earnings. Bear in mind too what Benjamin Graham said in The Intelligent Investor about the use of higher mathematics in share analysis:
In 44 years of Wall Street experience and study, I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.
This article is in 2 Parts. We will look at the leverage argument in Part 1 and discuss the Alpha and Beta qualities of Buffett and Berkshire and their investments in Part 2 to be posted shortly.
What is leverage?
Leverage in the context of investment properties involves the use of borrowed money to improve investment returns.
Suppose that I buy an apartment for $100,000 and it returns in rentals $10,000 a year, after deductions for taxes, insurances and other expenses. If I pay cash for the apartment and do not borrow money to finance it, my investment return is 10 per cent(10000 x 100 / 100000).
Suppose however that I only put in $50,000 of my own money and borrow $50,000 to finance the transaction at an interest rate of 7 per cent. The interest per year will amount to $3500 and I will have to pay this from the net rental of $10,000. This leaves me a net income of $6500 ($10,000 – $3500). My return on my investment will be improved as I have only used $50,000 of my own money. The return is now 13 per cent (6500 x 100 / 50000). This is leverage.
This leverage applies whether you are buying real estate, shares, bonds or a business. There are obvious conclusions that we can make from this:
- The higher the percentage of the cost price borrowed, the greater is the increase in the margin.
- The lower the cost of the money borrowed, the greater is the increase in the margin.
- Leverage can work in reverse if interest rates increase and the investment income remains static or decreases.
Generally, Warren Buffett avoids buying stock in companies that have high amounts of debt because the use of this debt as leverage can give a distorted picture of the company’s real earning rates. The Yale report correctly argues however that he is not averse to using borrowed money in the form of premiums collected by Berkshire’s insurance companies to fund his investments and that he in fact does this at low cost. You can find the leverage of any particular company from ADVFN. (Subscriptions are free).
How an insurance company makes its money
A general insurance company works like this. The insurer collects amounts of money (premiums) from the insured person and in return promises the insured person that it will pay a sum of money (the insured amount) if a certain event takes place.
This event could be the destruction of a building by fire, damage to a motor car in an accident, loss of wages because of illness or injury or any event that the insurer and the insured can agree upon as an event that can be covered. There are even instances where celebrities insure their body parts against injury.
In most instances the insured event will not happen (the house does not burn down, the car is not in an accident, the insured is not off work, the body part is not injured) and the insurer collects all the premium without having to pay out anything; the insurer makes a full profit on the transaction. If however the insured event does happen, the insurer must pay out the insured amount. Whether it makes a profit or a loss on that particular transaction depends upon how long it has been receiving premiums for it.
An insurer needs to calculate the likelihood of paying out on an event. So for example, if it insures 100,000 houses in California against fire it will need to estimate how many of these houses are likely to be the subject of a claim in the next twelve months (the usual length of a home insurance policy). It does this by making an actuarial assessment (an assessment of risk) and calculates its premium rates on the likelihood of pay outs against the totality of the houses it has insured. So, again for example, a house in a high risk fire region would bear a premium higher than one in a low risk area.
In any event, an insurance company collects the premiums and has these funds available for investment. always keeping some in readily available form to cover potential payouts. It can put these funds into shares, bonds, property or other investments or can retain them as cash. The profits generated from these investments belong to the insurance company and form part of its earnings.
The majority of insurance company earnings come from the investments bought with the premiums collected. Indeed a company could even lose money on its insurance business but still be profitable through these investments.
The argument that Warren Buffett uses leverage to enhance his investment returns
Berkshire Hathaway owns several insurance and reinsurance companies. The Yale paper argues that because Berkshire Hathaway has access to the premiums it gathers, it can use them to buy businesses and shares that earn money. In essence its argument is that the premiums are borrowed money, in that they are borrowed against a possible further payout. This, it is argued, gives Berkshire Hathaway access to what is really almost-free money.
The researchers use mathematical calculations to conclude that the leverage on monies borrowed by Berkshire to buy stocks and businesses is about 1.6 to 1; that is for each dollar of its own money that it uses, it borrows (through premiums paid against possible future insurance claims) $1.60. They also calculate that the cost of this ”borrowing” has a notional interest rate of 2.2 per cent. They conclude that this leverage contributes about half of Berkshire’s annualized profits of Berkshire’s average excess return.
One school of thought says that the premiums collected (in insurance jargon the ‘float’) are not really borrowings. The reasoning here is that the premiums received by an insurance company are not borrowed from the policy holder but represent profits (if the total received exceeds the amount of any claim) or losses (if the total received is less than the amount of any claim). As such they belong to the company and, so long as government requirements are met, can be legitimately used by the insurance company as its own money.
The other and more general view is that the float is borrowed money and this is a view supported by Warren Buffett, who explained it like this in his 2012 letter to shareholders.
To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. Typically, this pleasant activity carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money.
A caution is appropriate here: Because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results, and that makes it very difficult for investors to calculate a company’s true cost of float. Estimating errors, usually innocent but sometimes not, can be huge. The consequences of these miscalculations flow directly into earnings. An experienced observer can usually detect large-scale errors in reserving, but the general public can typically do no more than accept what’s presented, and at times I have been amazed by the numbers that big-name auditors have implicitly blessed. As for Berkshire, Charlie and I attempt to be conservative in presenting its underwriting results to you, because we have found that virtually all surprises in insurance are unpleasant ones.
The fact that Buffett runs insurance companies and is able to use the float to fund investments does not in itself detract from his performance as both an investor and a manager. First, as he says, the float must be run, and premiums and risk managed, in such a way as to make a profit for the insurance company so that the float is available for investment and the cost of the float is cheaper than money market rates. Buffett’s insurance activities are highly successful due both to his oversight and his skill in choosing good managers like Ajit Jain, a possible Buffett successor.
Secondly, even though the availability of the float does give Berkshire and Buffett an edge over ordinary investors, it does not give them the edge over those investors with similar access to low cost funds like other insurance companies, banks, and hedge funds and mutual funds with low cost borrowings. If all that was needed was low cost leverage, there would be plenty of companies with results as enviable as those of Berkshire. And their managers would be as legendary as Buffett!
Banks in particular hold huge amounts of money at any given time on which they pay no or little interest as a result of business practices or technical innovation: no or low interest accounts; monies received by merchants from customers on their electronic payment machines that are debited immediately to the customer but not paid to the merchant until days later; checks banked to accounts where the proceeds are paid overnight to the collecting bank but not available to the customer for a few days under antiquated clearance rules formulated before the advent of electronic banking; wages paid electronically by employers debited immediately to their account but which do not become available to employees until a day or days later. On the argument of the Yale report, banks then should be the most successful of investors but they are not.
We don’t think it was leverage or float availability that made See’s Candies (a business that has earned Berkshire nearly a billion dollars in profits over the years) a good buy at $25 million or that caused Buffett to buy shares in Coca Cola and the Washington Post Company rather than in Dot-Com boom shares. We think it was great investment ability.
And Buffett must also get credit for his ability to choose managers of Berkshire insurance companies who are able to run those companies at a good profit because the benefits of the float are diminished if an insurer runs underwriting losses, which Buffett says is the norm with most insurers. Buffett has also said that it is not realistic to believe that the Berkshire insurance companies will necessarily continue generating such a float.