Tue Mar 10 2015
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Warren Buffett’s Secret of Success

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It’s difficult to grasp the sheer magnitude of Warren Buffett (Trades, Portfolio)’s success in growing the value of Berkshire Hathaway. Over the past 50 years, the returns, on a per share basis, have compounded up to numbers that are so far outside the normal range of experience and expectation as to almost defy comprehension.

In the 50.25 years since Oct. 1, 1964, which was the beginning of the fiscal year in which he took control, Warren Buffett (Trades, Portfolio) has increased Berkshire Hathaway’s book value per share from $ 19.46 to $ 146,186. This is an absolutely staggering gain of 751,113%. Amazingly, this represents a compounded return of “only” about 19.4% per year.

Berkshire’s market price per share has risen even faster than its book value and has increased by over one million per cent in those 50 years. A $ 1,000 investment in early 1965 would be worth over $ 15 million today.

Buffett’s success with Berkshire was achieved in part by earning (counting capital gains on its marketable securities as earnings) an average of almost 20% on equity for 50 years. But the real key was the fact that all earnings were retained, and that Buffett somehow found ways to earn that average 19.4% return on equity (ROE) despite the fact that the capital with which he was working was growing at an average of 19.4% annually, because of the retained earnings. Given a time span of decades, that is explosive exponential growth. The retaining of all earnings combined with the 19.4% ROE allowed the original book value or capital per share to continue to compound at an average of 19.4% for 50 years.

In his 2012 annual letter, Buffett himself explained that paying out a dividend would have greatly hurt Berkshire’s investors.

One way to generate an ROE of 20% would be with massive leverage. This enables the assets to become significantly larger than the equity. Banks, for example, typically leverage their equity at least 10 times. Before the 2008 financial crisis many large U.S. banks were leveraged about 20 times. With 20 times leverage, a 1% return on assets translates into a 20% ROE. However, Berkshire didn’t go that route, employing relatively modest amounts of leverage.

The normal way to achieve leverage is through debt. But debt costs money for interest payments. For much of the time that Buffett has controlled Berkshire, interest rates on even high quality corporate debt were high. If Berkshire had used long-term debt for leverage it would have had to pay interest rates of 8% or higher in many years.

However, as demonstrated below, Berkshire used little or no debt in its insurance and investing operation. (It did use debt in its small lending operation and in recent years in its utility and railroad businesses.) Berkshire’s two main sources of financial leverage were insurance “float” and deferred income taxes.

Insurance “float” was a low-cost form of leverage for Berkshire over most of the last 50 years. Float represents money earmarked for future insurance claim payments that meanwhile can be invested. In 2013, for example, Berkshire made an underwriting profit on insurance that amounted to 4% of its float. This meant that the float was effectively a form of leverage with a cost equivalent to a negative 4% interest rate. Most insurance companies face a positive cost of float. Berkshire has had a negative “cost” of float in more years than not.

In addition, Berkshire used deferred income taxes as an interest-free form of leveraging. Berkshire had an unusually large amount of deferred income taxes over much of the past 50 years. This was due in large part to the fact that it maintained large unrealized gain positions in its stock portfolio.

The negative overall “cost” of leverage provided by float and deferred income taxes boosted Berkshire’s ROE by an average of perhaps 2% per year. That may not seem like a lot but consider that money compounding at 19.4% for 50 years grows at a rate that is more than double the amount that money compounding at 17.4% grows to – 133% higher to be precise. Such is the power of compounding. A little higher rate of compounding goes a very long way when you talking about 50 years.

In the absence of high leverage, the way to achieve a high return on equity is to realize a high return on assets. It is therefore clear that Buffett and Berkshire Hathaway achieved a relatively high return on assets compared to most companies and that its return on assets was far higher than that of most insurance companies (which had far lower ROEs despite their much higher leverage).

Berkshire’s core activity since shortly after Buffett took control in 1965 has been to operate a property and casualty insurance operation which invests in stocks, bonds, and non-insurance subsidiary businesses with these assets and investments funded by, in order of importance: common equity, insurance float, accounts payable, “other” which includes deferred taxes, and a very modest amount of debt.

This operation differed from most other insurance companies in at least three major ways:

  1. Financial leverage (including debt and insurance float) was and is unusually low and the common equity ratio unusually high.
  2. Investments were and are concentrated in equities and even the ownership of entire businesses rather than in bonds.
  3. The insurance operation was and is unusually profitable (or had unusually small losses) even before considering profits from investments.

To illustrate, here is a simplified view of Berkshire Hathaway’s insurance and investment assets on a percentage basis and how they were financed as at the end of 2013. This excludes the railroad and utilities segments as well as the finance segment. Those two excluded segments do use a lot of debt leverage. The rail and utility sectors are more recent additions to Berkshire and are excluded because they do not reflect its core insurance and investing operation. The finance sector is excluded because it also does not reflect the core operation and is, in any case, quite small.

* May not round to 100% due to fractional percentages.

Some notable characteristics of this condensed balance sheet include:

  • A very high level of equity (which is composed largely of retained earnings).
  • Very little debt.
  • A significant but not overwhelming level of insurance float liabilities.
  • The famously high allocation to cash.
  • Only a modest level of investments in fixed maturity investments (bonds).
  • A very high level of investments in equities.
  • Substantial investments in subsidiary non-insurance operating businesses including purchased goodwill of these businesses and of the insurance businesses.

In summary, Buffett’s success came from entering the insurance business and running it in an unusually profitable manner. He largely shunned debt, which made his balance sheet much more conservative than most insurance companies. This conservative balance sheet allowed him to invest heavily in stocks and businesses that could be expected to earn more than the bonds usually favored by insurance companies. Superior selection of stocks and businesses boosted returns on assets.

The use of negative cost insurance float and zero-cost deferred income taxes to fund investments, when combined with high returns on assets, led to stellar returns on equity. He then retained all earnings and continued to compound those earnings at a high ROE for 50 years.

Additional keys to success 

Here is a summary list of the keys to the Buffett success story, including some not listed above. Some of these offer useful tips for the rest of us.

  • Setting a goal of growing value per share and sticking to it.
  • Relentlessly doing only what was good for shareholders.
  • Retaining all earnings. If you can compound money at 20%, it does not make sense to pay a dividend, no matter how popular that would be.
  • A high level of equity combined with low debt and ample cash in the insurance companies lowered risks, which allowed investing mostly in equities rather than fixed income.
  • Superior stock picking.
  • Superior business acquisition strategies.
  • Rarely issuing shares for acquisitions. Issuing shares would have boosted absolute growth but sharply curtailed growth on a per share basis.
  • Superior management of acquired companies.
  • Becoming the buyer of choice for those selling large private businesses.
  • Achieving profit on insurance operations, even before considering the profits from investing the insurance float
  • The use of insurance float and deferred taxes to fund stock investments.
  • Discipline and patience – sometimes going years between major acquisitions or major new stock investments.
  • Ignoring Berkshire’s stock price. Boosting the share price was never the goal. It was the value and not the price of the shares that Buffett focused on growing.
  • Speed – no large business could commit to an acquisition faster than Berkshire. No insurance company would commit to a huge insurance policy faster than Berkshire.
  • Keeping it lean – to this day there are a mere 25 people at head office.
  • Running a highly concentrated equity portfolio. One certainly cannot beat the stock market averages by holding a diversified portfolio that mimics the market. Finding a handful of stocks that beat the market enabled Buffett to outperform year after year. A concentrated portfolio in no way guarantees beating the market. But mimicking the market with a widely diversified portfolio would have precluded beating the market by any material amount.
  • Time management – Buffett managed to delegate or eliminate most tasks not related to his investment process.
  • Placing trust in managers and giving them full authority and autonomy.
  • Providing managers with appropriate financial incentives.
  • Heaping public praise and encouragement on his best managers.
  • Keeping tabs on his companies and investments through specially provided data reports.
  • Rationality – Buffett never did anything simply because others were doing it. He always acted in ways that he thought to be rational.
  • Investing in businesses as well as securities.
  • Controlling large capital expenditures at the top.
  • The ability to transfer earnings of subsidiary companies to other companies tax-free.
  • Wise consideration of income tax.
  • A total lack of pandering to Wall Street
  • Constantly reading, learning and thinking.

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