Is Float Ever Bad? On Float Part 6

Is Float Ever Bad? On Float Part 6

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 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:

Today we’re going to answer the question “Is Float Ever Bad?

Is Float Ever Bad?

I’m a guy who likes to live by the above quote.  If I can make things simpler I always do.  Not only does this make things easier to understand but it also can save a ton of time.

When analyzing investments and dealing with complex topics like investment float this isn’t always possible.

Understanding the good things about investment float is definitely one of those things you can make only so simple.  The concept is simple to understand but the there are a ton of different nuances to understand which leads to complexity.  You can likely tell since it’s taken me 51 pages thus far in the five earlier posts to explain the good things about investment float.

Luckily the answer to the titled question is a simple one.  And also involves simple and easy to understand concepts as well.

Yes, certain investment float is bad.  And no, not all float is equal.

The heuristic or mental model I use when evaluating float is that if the company isn’t profitable – or near profitability – its float is useless.  And can even be a negative burden for a company.

Why?

Remember, float are liabilities that can become positive leverage if used well by management and the company is profitable.  But always remember leverage can go both ways as well.

If a company isn’t profitable and hasn’t produced profits in several years float turns into negative leverage.  This is because in the long run float are liabilities the company will have to pay at some point.

The longer a company goes without earning profits the longer it will take a company to pay its liabilities because it’s not earning enough money.  This also makes it harder to fund operations and grow in a healthy way without taking on a ton of debt or even more liabilities.

Let’s go through a quick example to show this.

Let’s say we have two insurance companies.  Company A has an average combined ratio of 90% over the last five years and Company B has an average combined ratio of 110% over the last five years.

Not only does this mean Company A’s profits are 20 percentage points better on average than Company B.  But it also likely means that Company B has continued racking up liabilities it can’t afford to pay when due or when a catastrophe strikes.

This is because Company B hasn’t earned a profit on average over the last five years.  And of course all else remaining equal a company earning 20 percentage points better profit’s on average is the higher quality company.

The same general rule goes for non insurance companies as well.  If they aren’t, haven’t been, and show no signs of becoming profitable float should be viewed as negative leverage for a company.

I use the following rules when evaluating all companies float…

  • To view float as a giant positive for any company I like to see consistent profitability in the last five years.  And/or seven of the last 10 years.
  • If a company has off and on profitability I view float as neutral.
  • And if the company is consistently unprofitable I view float as a huge negative for the company.

I consider profitability of operating margin, ROIC, ROCE, and FCF/Sales.  The company doesn’t have to produce huge excess profitability in each category.  I look for consistency and trend of profits more than anything when evaluating float.

This idea is a lot simpler to understand than the concept of what float is and makes it potentially great for companies and investors.

One last thing to remember when evaluating float is that whether the company has positive or negative acting float doesn’t matter if the company doesn’t allocate capital well.  And the management doesn’t know what float is or how to use it.

To evaluate these potentials see the previous five posts on this topic.

Summary

If I’ve explained everything well enough in the series so far we should understand –

  • What float is.
  • Why it’s important.
  • How companies can use float as positive leverage.
  • How Buffett got so rich using float.
  • How to find float on a balance sheet.
  • How to evaluate float.
  • How float affects a company and its margins.
  • Maybe the most important thing why float affects a company and its margins.
  • How float affects a company’s value.
  • And answered the question is float ever bad?

In the next and final seventh chapter of this series I’ll share the best resources I’ve learned from about float with you.

Knowing what we know now we should have a gigantic advantage over other investors who either don’t know about float.  Or aren’t willing to put in the time to learn what it is and what it can do for a company and investment.

If you have any questions, concerns, or comments on float up to this point please let me know in the comments section below.

***

Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

How To Find Float On The Balance Sheet – On Float Part 4

How To Find Float On The Balance Sheet – On Float Part 4

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:

Today I’m going to illustrate how to find float on the balance sheet.  And show you what float means in terms of the companies margins.

I’m going to do this by showing you float from two different companies I’ve evaluated and written up for Press On Research subscribers.  One is an insurance company.  The other isn’t.

On Float Part 4

How To Find And Evaluate Float

I’ve removed the names from both the companies below.  If you’d like to know which companies they are and see the full write ups on them you need to subscribe to Press On Research.

Insurance Company Float

When most people think of float they think of insurance companies so this is where we’ll start.

Below is the unedited float analysis I did on an insurance company I wrote up for Press On Research subscribers.

***

All numbers below are in USD $ millions unless noted.

Assets

  • Financial Assets: Fixed maturity securities of 94.3 + equity securities of 4.9 + trading securities of 0.1 + loans of 1.9 + cash and cash equivalents of 6.8 + accrued investment income of 0.8 + premiums and other receivables of 11.3 + deferred income tax assets of 3.8 = 123.9
  • Operating Assets: Deferred policy acquisition costs of 8.5 + PP&E net of 2 + other assets of 13.9 = 24.4
  • Total Assets = 148.3

Liabilities

  • Equity of 44.9
  • Short-term debt of 0.9 and long-term debt of 17.4 = 18.3
  • Float: Future policy benefits of 35.2 + policyholder funds of 1.6 + unearned premiums of 29.9 + taxes payable of 0.1 + other liabilities of 18.3 = 85.1

Total liabilities are 103.4

Float/operating assets 85.1/24.4 = 3.49.

Float supports operating assets 3.49 times.

And Float is “free money” because (NAME REMOVED) earns consistent underwriting profits as it’s earned underwriting profits in six of the last nine years.

Pretax profits have changed to underwriting profit below because normal pretax profits mean nothing for insurance companies.

(NAME REMOVED) had an underwriting profit – profit from operations before taxes here – for the full 2015 year of 6.4.

Underwriting profit/total assets = ROA

  • 6.4/148.3 = 4.3%
  • Compared to a Morningstar ROA of 3.2%

Underwriting Profit/(total assets – float) = levered ROA

  • 6.4/63.2 = 10.1%

If I were to rely only on Morningstar to get estimates for margins (NAME REMOVED) looks below average at only 3.2%.

Yes I know this isn’t an apples to apples comparison.  But normal profit metrics mean nothing for insurance companies.

When considering underwriting profit.  Its ROA is a still below average 4.3%.

But (NAME REMOVED) float magnifies its ROA higher.

When considering float, its levered ROA goes up to 10.1%.  Or 43% higher than what I calculate it’s normal ROA as.

Having a levered ROA of 10.1% isn’t great compared to normal companies I invest in… But for an insurance company this is a great margin.

One of my investment icons the great insurance investor Shelby Davis looked for insurance companies having an ROA above 10% so this meets his threshold.

Another important metric for insurance companies is ROE.  Most great insurance companies fall in the 10 – 15% ROE range.

I calculate (NAME REMOVED) ROE – underwriting profits/shareholders equity – as 14.3% not levered by any float.  Compared to Morningstar’s ROE estimate of 10.7.  This puts (NAME REMOVED) into the great insurance company category.  And there’s still more.

***

I continue on from here detailing this great small insurance company but now let’s explain what everything above means.

Why Does Float Magnify Margins?

As talked about in the post Buffett’s Alpha Notes – On Float Part 3 float is positive leverage instead of negative leverage like debt.  The positive leverage – float – boosted ROA 43% higher than its normal I calculated.

This magnification of margins happens at any company with float.  The more float – and profitability – the company operates on and produces the higher margins are magnified.

But why?

Let’s go back to the April 2016 Press On Research issue this to find out what this means over time for a company operating well.

***

Float is things like prepaid expenses.  Billings in excess of expected earnings.  Deferred taxes.  Accounts payable.  Unearned premiums.   And other liabilities that don’t require interest payments.

But they are the farthest thing from “normal” liabilities.

With normal liabilities you have to pay an agreed upon amount within a certain period or your customers and suppliers will stop paying you.

Float are things you won’t have to pay back for a while the company uses in the mean time to grow the business.

Instead of paying this money out now like normal liabilities.  Companies can use these “liabilities” to fund current operations.

Float is positive leverage instead of negative leverage like debt and interest payments.

Think of float as the opposite of paying interest on a loan.  Instead of paying the bank for the cash you’ve borrowed.  The bank pays you interest to use the money you borrowed.  And you can use this money to invest.

A nice example is long-term debt versus unpaid premiums.  Both liabilities are listed on the balance sheet.  But each is far different from a real world perspective.

With long-term debt you get money in exchange for agreeing to pay back a loan at an agreed upon rate for an agreed upon period.  If you don’t you can go into bankruptcy and/or go out of business.

With unpaid premiums you get paid a monthly amount from a customer – say for house insurance – and only have to pay back any amount when a disaster occurs.

If your clients don’t make big claims for a long time – or ever over the life of an individual policy – the company keeps using this “liability” to continue investing and growing the business.

Now let’s keep going with this example…

If you own a home with a mortgage you have home insurance in the United States.  The ranges of this vary but let’s say you own a home and pay $300 a month towards home insurance costs.

This $300 a month – $3,600 a year or $36,000 after 10 years – goes to the insurance company every month.  Year after year even if you never claim any insurance.

The insurance company holds this money on the balance sheet as a liability because the assumption – probability – is you’ll make an insurance claim at some point.

In the mean time the insurance company invests this money to grow assets.  This way it makes sure it has enough money to pay claims when it has to.

Now imagine this multiplied by thousands, tens of thousands, hundreds of thousands, or even millions of customers.

If the insurance company produces underwriting profits on top of the float it gets and invests this money well over a long period this money compounds exponentially.

This is how Buffett and Munger grew Berkshire to the giant it is today.

***

Remember also from Buffett’s Alpha On Float Part 3 of this series…  The paper found almost all Buffett’s excess performance was due to float and the positive leverage powers it has on a company.

This is why float and the positive leverage it produces for the companies using and growing it well over time is so important.  It magnifies all margins at a company not just the ones mentioned above.  And if a company operates well the internal value of the company compounds exponentially.

If you’re a Warren Buffett/Charlie Munger type value investor this is the exact situation you’re looking for.

Now let’s get to the non insurance company to finish explaining everything.

Non Insurance Company Float

When most people think about float – if they think about it at all – it’s when thinking about insurance companies.  But non insurance companies have float as well.  Remember from the previous post What Is Float? On Float Part 2:

To summarize the above float is anything listed in the liabilities section of its balance sheet you don’t pay interest on.

Interest based liabilities – NOT FLOAT – include capital leases, and short and long-term debt.

Most of the time these are the only interest based liabilities on a company’s balance sheet.  Make sure by checking the off-balance sheet transactions and total obligations notes – if any – in the companies footnotes.

Examples of non interest based liabilities – FLOAT – include prepaid expenses, accounts payable, taxes payable, accrued liabilities, deferred tax liabilities, unearned premiums, etc.

This means any company that has these kinds of liabilities have float.  And since most companies have at least small amounts of these liabilities most companies have float.

How much float a company operates on is what affects their margins.  Higher amounts of float compared to operating assets means a higher leveraging of margins.

Now let’s get to the float analysis of the non insurance company… Again, the following is unedited except for the removal of the company’s name.

***

All numbers below are in millions of dollars unless noted.

  • Financial Assets: Cash and cash equivalents of 2.7 + deferred tax assets of 1.9 = 4.6
  • Operating Assets: Accounts receivable of 39.1 + Inventories of 12.6 + prepaid expenses of 1.1 + other CA of 0.3 + net PP&E of 73.7 + goodwill of 2.4 + other IA of 0.6 = 129.8
  • Total Assets = 134.4

Liabilities

  • Equity of 86.2
  • Debt of 14.4
  • Float = Accounts payable of 13.3 + Taxes Payable of 0.5 + accrued liabilities of 8.9 + other CL of 1.3 + deferred tax liabilities of 1.4 + pensions and other benefits of 8 = 33.1
  • Total liabilities 47.5
  • Float/operating assets = 33.1/129.8 = 25.5%.

This means (NAME REMOVED) float supports 25.5% of its operating assets.

  • Pretax profits/total assets=ROA
  • 18.7/134.4= 13.9%

Compared to a Morningstar ROA of 10.1%

  • Pretax profits/ (total assets-float) = levered ROA
  • 18.7/101.3 = 18.5%

When I evaluated (NAME REMOVED) in 2012 I knew what float was. But not how to calculate and quantify what float meant for a company. So when I began looking at (NAME REMOVED)again in recent weeks I was shocked to see a big chunk of float helping operate and grow the company.

Why?

Because I expected a manufacturer to operate more on short and long-term debt than float. But (NAME REMOVED) float is 2.30 times higher than its short and long-term debt.

What this means for you is that (NAME REMOVED) operates and grows in a healthy way.

This is why its book value per share talked about above rose so much in recent years. But this isn’t all operating on float can do for a company… It also magnifies margins as well.

As you can see from the levered ROA calculation above. This is its true ROA when considering float. Float magnifies its ROA by 8.4 percentage points when compared to the “normal” ROA shown on Morningstar.

This will make a gigantic difference in the long-term. How big? Let me show you below using an example…

Let’s say we have one million dollars that compounds at a 10.1% rate every year for 10 years. With no additions the original million dollars will turn into $2.617 million at the end of 10 years. Great of course. But let’s see what an extra 8.4 percentage points every year will do to this same money over time.

Using the same numbers above. Same time frame. But 18.5% compound rate the original one million dollars will turn into $5.460 million at the end of 10 years. The 8.4 percentage point difference over 10 years time means we make an extra $2.843 million. Or more than double what we would earn with only a 10.1% compound rate.

This helps explain why (NAME REMOVED) book value has grown 2.61 times in only six plus years. And this is why I’m not worried about (NAME REMOVED) other “below exceptional” margins talked about above.

Float magnifies all these as well. Not as much as ROA. But by at least a few percentage points each bringing them up to the exceptional level of other Press On Research picks.

***

Now let’s get back to explaining what everything means.  Starting with the things I didn’t mention above.

The first thing to notice is the huge reversal in the amount of financial assets and operating assets the two companies have.  The insurance company had huge amounts of financial assets and few operating assets.  And the non insurance company had the inverse.

An insurance companies balance sheet should always look like this.

Non insurance companies vary more but in general they will have more operating assets than financial assets.

Float supporting operating assets is the amount of float that supports the harder assets of a company.  The ones regular companies – non insurance and financials – earn profits from in most cases.

Everything likely makes sense in its place of either financial assets or operating assets except goodwill and intangible assets.  Why are these included in operating assets and not financial assets?

Intangible assets (IA) is the easier to understand of the two.

Generally IA are things like patents, customers lists, trademarks, and brand names.  These have direct effect on the company operations and is why they’re included in operating assets.

For goodwill its more murky… Goodwill is a form of intangible assets that occur when a company acquires another and pays above book value for the company.  In effect this means the company pays extra in an acquisition for the companies operations so this is why goodwill is included in operating assets.

There are other reasons as well but for simplicity I stuck with the above reasoning.

The amount of float that supports operating assets line is important for all companies.  This is because as mentioned above the more float a company has compared to its operating assets the higher margins are magnified.

For companies having a lot of float and financial assets like insurance companies this number can go well over 100%.  For most normal companies this number will be below 100%.  But as always the higher this number is the better because it magnifies margins the higher it is.

Separating debt and float in the float analysis is a lot easier to do.  Any interest bearing liability – short and long-term debt, capital leases – goes into the debt category.  All other liabilities go into the float category.

Now lets sum this all up and bring it back to the beginning to explain how this all affects a company’s value.

Summary

If I’ve explained everything well enough in the series so far we should understand –

  • What float is.
  • Why its important.
  • How companies can use float as positive leverage.
  • How Buffett got so rich using float.
  • How to find float on a balance sheet.
  • How to evaluate float.
  • How float affects a company and its margins.
  • And maybe the most important thing – why float affects a company and its margins.

In the next and final chapter of this series we’ll go back to the beginning and explain how float affects a company’s value alluded to in On Float Part 1.

If you have any questions, concerns, or comments on float up to this point please let me know in the comments section below.

***

Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

Book Giveaway Update

Book Giveaway Update

Well that didn’t go as planned…

In the post at the end of March The Winner of The Book Giveaway Is… I announced a subscriber as the winner of more than $300 worth of books.  The books were supposed to go to David at my cost.  Key word being supposed.

At this point I’ve tried multiple times to get a hold of David with no response so another subscriber is getting these books sent to them at my cost anywhere in the world.

I’m a huge believe in Charlie Munger’s Mental Models and Worldy Wisdom philosophies that the more we read about a wide range of things the more we can know.  And the more we know the closer we are to reaching our goals, making a ton of money, and changing the world.

These books represent knowledge, power, goal and wealth attainment, and much more.  True knowledge is one of the most powerful forces in the world.  But few hold this power…

My goal is to help spread this power to as many as possible.  And today a lucky subscriber is getting a step closer to their goals by winning the following 20 books valued at more than $300.

And the new winner of more than $300 worth of books is now Andrealiz.  Your email starts with reyesa.  I will get a hold of you today to get your contact information so I can send you more than $300 worth of books at my cost.

The Winner Of The Book Giveaway Is…

The Winner Of The Book Giveaway Is…

Announcing The Winner of $300+ of Books

When I started learning about value investing I had no one to turn to for help or guidance except the infinite internet.  I sifted through thousands of articles, websites, books, videos, and other etc. information to get to where I am today.

Now that I have a solid knowledge base built I’m helping other value investors so they don’t have to struggle as much as I did when starting.

One of the ways I help is by giving away valuable books for free to subscribers.  And today more than $300 worth of books are going to a lucky subscriber.

I’m a huge believe in Charlie Munger’s Mental Models and Worldy Wisdom philosophies that the more we read the more we can know.  And the more we know the closer we are to reaching our goals, making a ton of money, and changing the world.

These books represent knowledge, power, goal and wealth attainment, and much more.  True knowledge is one of the most powerful forces in the world.  But few hold this power…

My goal is to help spread this power to as many as possible.  And today a lucky subscriber is getting a step closer to their goals by winning the following 20 books valued at more than $300.

The winner of the above $300 worth of knowledge for free is David.  Your email address starts with dzdown.  I’ll reach out to you soon to get your full name and mailing address.

Hopefully these books will help you get closer to whatever goals you have.

Thank you to all subscribers of both Value Investing Journey and Press On Research.  There will be more giveaways so if you haven’t won one of the three up to this point  make sure to stay subscribed.

I’ll leave you with an amazing quote I found from Helen Keller as I wrote this post..

Remember if you want access to my exclusive notes, preliminary analysis, a chance to win future giveaways, and access to all posts as they come out you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

And you can subscribe to Press On Research for only $49 if you’re a free Value Investing Journey subscriber.

If you have further questions about Press On Research go to its FAQ linked in this sentence.  Or email me at jasonrivera@valueinvestingjourney.com

Buffett’s Alpha Notes – The Power of Float – On Float Part 3

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 resultsWarren 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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