Buffett’s Alpha Notes – The Power of Float – On Float Part 3
The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day. The hope being that our knowledge will continue to compound over time so we’ll have huge advantages over other investors in the future.
The aim of today’s post is to continue this process by talking about a topic few investors know about. And even fewer understand.
Most people overlook float when evaluating companies because they either don’t know what it is. Don’t know the power it can have within a business. Or don’t know how to evaluate it.
This won’t be an issue here.
Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written. But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.
Today’s post is a continuation of the earlier posts: Charlie Munger On Deferred Tax liabilities and Intrinsic Value – On Float Part 1. And What is Float? On Float Part 2.
Today I’m going to illustrate how powerful float is over time.
Buffett’s Alpha Notes – The Power Of Float
My notes aren’t in the quoted areas unless in parenthesis. Bolded emphasis is mine throughout.
“Further, we estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks.”
“We show that Buffett’s performance can be largely explained by exposures to value, low-risk, and quality factors.”
“Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Buffett has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years.
Sharpe ratio is a measure for calculating risk adjusted returns. I don’t use this metric but It’s talked about a lot in the Buffett’s Alpha PDF so you need to understand what it is to understand the context of the article even if you never use it.
Alpha is another metric I don’t use… It’s a measure of risk adjusted performance. It’s the return in excess an investor/business generates when compared to an index.
For example if your stock picks have returned 20% every year over the last ten years while a comparable index has returned 10% every year for those ten years you’ve generated an alpha of ten percentage points every year.
“So how large is this Sharpe ratio that has made Buffett one of the richest people in the world? We find that the Sharpe ratio of Berkshire Hathaway is 0.76 over the period 1976-2011. While nearly double the Sharpe ratio of the overall stock market, this is lower than many investors imagine.
Adjusting for the market exposure, Buffett’s information ratio is even lower, 0.66. This Sharpe ratio reflects high average returns, but also significant risk and periods of losses and significant drawdowns.
If his Sharpe ratio is very good but not super-human, then how did Buffett become among the richest in the world?”
“The answer is that Buffett has boosted his returns by using leverage (FLOAT) and that he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion.”
Thus, his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and significant risk over a number of decades.”
If you read the article linked below ignore the academic talk of beta, efficient markets, and other academic terms that have little to no relevance in value investing.
“Buffett’s genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work, applying leverage without ever having to fire sale, and sticking to his principles. Perhaps this is what he means by his modest comment:”
Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1994.
“However, it cannot be emphasized enough that explaining Buffett’s performance with the benefit of hindsight does not diminish his outstanding accomplishment. He decided to invest based on these principles half a century ago. He found a way to apply leverage. (FLOAT) Finally, he managed to stick to his principles and continue operating at high risk even after experiencing some ups and downs that have caused many other investors to rethink and retreat from their original strategies.”
I disagree with the high risk mentioned in this entire article.
The academic version of risk is a lot different from what we as value investors think of risk. Most of the “excessive risk” mentioned throughout the article is attributed to volatility. Which isn’t risk in what we do.
“Why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? One reason might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate.” (FLOAT)
In summary, we find that Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance.
Buffett’s large returns come both from his high Sharpe ratio and his ability to leverage his performance to achieve large returns at higher risk. Buffett uses leverage (FLOAT) to magnify returns, but how much leverage does he use? Further, what are Buffett’s sources of leverage, their terms, and costs? To answer these questions, we study Berkshire Hathaway’s balance sheet, which can be summarized as follows:
We would like to compute the leverage using market values (which we indicate with the superscript MV in our notation), but for some variables we only observe book values (indicated with superscript BV) so we proceed as follows.
The above means the estimated 1.6 to 1 leverage the paper states Berkshire gets from its float is a low estimate. This is because they had to use book values as estimates for the wholly owned Berkshire subsidiaries.
These book values don’t represent any growth in value of the subsidiaries only the original purchase price in most cases. And knowing what kind of companies Buffett buys these companies have gained a ton of value over time meaning more leverage according to the papers logic.
The magnitude of Buffett’s leverage can partly explain how he outperforms the market, but only partly. If one applies 1.6-to-1 leverage to the market, that would magnify the market’s average excess return to be about 10%, still falling far short of Berkshire’s 19% average excess return.
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.
Based on the balance sheet data, Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment as provided for under the IRS rules. E.g., Berkshire reports $28 Billion of such deferred tax liabilities in 2011 (page 49 of the Annual Report). FLOAT
Berkshire Hathaway’s overall stock return is far above returns of both the private and public portfolios. This is because Berkshire is not just a weighted average of the public and private components. It is also leveraged, which magnifies returns.
While Buffett is known as the ultimate value investor, we find that his focus on safe quality stocks may in fact be at least as important to his performance. Our statistical finding is consistent with Buffett’s own words:
I could give you other personal examples of “bargain-purchase” folly but I’m sure you get the picture: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1989.
Given that we can attribute Buffett’s performance to leverage and his focus on safe, high-quality, value stocks, it is natural to consider how well we can do by implementing these investment themes in a systematic way.
In essence, we find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails.
Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.
This is the power of float illustrated over a long time period.
The above means his excess returns are attributed only to smart use of float and buying cheap great businesses over a long period.
This is why we must understand what it is and how to use it to our advantage to become better investors.
If you want to read the full 45 page PDF that includes the math, examples, and references download the paper Buffett’s Alpha here.
Most of Buffett’s and Berkshire’s float comes from insurance companies. But float can be found at any company. And next up I’ll show you how by analyzing a company’s balance sheet to find float.
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